Subdued medium-term outlook for inflation, not deteriorating
Friday’s flash inflation numbers showed a drop to the lows of October last year and added some pressure on the ECB to ease again. The previous two ECB rate cuts – May and November 2013 – followed immediately after downside surprises to inflation. Maybe that is why some analysts called for ECB rate cuts after Friday’s numbers.
However, the downside surprise this time was much smaller, and we do not believe this data alone will be enough to prompt new easing, especially when other data such as the PMIs, the Ifo, the lending data, and the ECB lending survey were positive over the month.
The ECB believes that inflation will be subdued in the medium term, ie low. This can be seen from the December staff projections of just 1.1% inflation in 2014 and 1.3% in 2015.
We do not believe the recent low prints are enough for the medium-term outlook to have deteriorated. The inflation projection for 2014 will probably have to be revised down in conjunction with the March update of staff projections, but the more important forecast for inflation in 2015 is likely to be unchanged.
Moreover, inflation expectations remain firmly anchored, though pressure is looming. 5Y5Y inflation forward rate at 2.14% is now at the low it encountered in November 2013, whereas we have to go back to 2011 for levels comparable to the 2.11% hit for 30Y inflation swaps on Friday. The 5Y5Y forward rate is down 9 bp on the year and is quickly approaching the lows from 2010-2011 as well.
In terms of market reaction to the flash estimate on Friday, 1Y inflation swaps corrected the most, moving down 8bps. This variable is however not directly a decision parameter for the ECB.
Money market tightening is not more “unwarranted” than in January
The pressure stemming from money market rates has subsided quite a bit with short swaps at levels of about 15bps instead of almost 25bps. Fixings, both Eonia and Euribors have also tailed off. This has a lot to do with net liquidity inflow from both less than full SMP sterilisations and from standard liquidity operations.
Excess liquidity is now EUR 40bn higher than a week and a half ago, as banks have taken more liquidity at the weekly ECB operations. The 4-week moving average – disregarding volatility within maintenance periods – is around EUR 180 bn, which, if history is any guide, should be enough to allow EONIA to move back to the lower end of the ECB corridor and, in turn, should help the short-end of the money-market curve gradually lower in the near term.
Moreover, the EUR has weakened just a bit against the USD despite the tightness in EUR money markets, and medium- to longer-term swap rates have come down. If anything, monetary conditions are less tight now than in early January.
Thus, we find it unlikely that the ECB will find the money market tightness more “unwarranted”. Mr Draghi will probably say that money markets will be monitored closely, which would be an unchanged language.
The inversion in the short end of the Eonia curve is however still present with the 1Y swap in just 10bps and 1Y1Y in 16bps. This can easily be seen as prospective action on the ECB being priced, e.g. a cut in the refi-rate. If we are right and the ECB delivers nothing on Thursday and the tone at the same time is less than super dovish, then we can expect 1Y end 1Y1Y Eonia swaps to move upwards, possibly quite significantly.
We could be wrong – refi rate cut is the most likely option
We could be wrong in our assessment of the two triggers being hit. If so, we believe the most likely easing measure would be a 10-15 bp refi rate cut, which would ease monetary conditions a bit and signal the ECB’s intention to fight low inflation.
Nordea