ECB signals fresh stimulus, with investor attention now turning to the Fed which is expected to lower interest rates for the first time in ten years
Euro area incoming data point to muted growth in Q2/Q3, suggesting less likelihood of a rebound in GDP growth in H2:2019. The balance of growth risks remains to the downside (trade, Brexit, emerging markets’ slowdown), albeit with little expectations for recession. Growth expectations for Q2 real GDP (due on July 31st) are for circa 1% qoq annualized growth (+1.2% yoy).
Indeed, the downturn in the euro area manufacturing deepened further, according to July PMIs, while services continue to hold up (see graph below). The manufacturing sector PMI declined substantially by 1.2 pts to 46.4, the weakest outcome since December 2012 and below the expansion/contraction threshold of 50 for a 6th consecutive month. On a positive note, the services sector PMI declined only slightly (-0.3 pts), to a still resilient 53.3. Moreover, credit expansion remains healthy, with bank loans to the private sector at 3.5% yoy, albeit with a small tightening of credit standards envisaged for Q3 according to the ECB Bank Lending Survey (see Economics).
On the price front, realized and expected inflation rates are muted. Core CPI has remained at c. 1% yoy on average during the past two years, while market-based inflation expectations have declined sharply with 5Year/5Year inflation swap rates at 1.35% (albeit up by circa 15 bps since President’s Draghi speech at Sintra on June 18). Moreover, according to the latest ECB Survey of Professional Forecasters, average longer-term (5-years ahead) inflation expectations declined from 1.8% to 1.7% in Q3:2019 (see graph below). Overall, convergence towards the ECB’s symmetric (newly added reference) inflation aim of close to but below 2% is not expected in the medium term.
As a result, the ECB on July 25th tasked its relative committees to examine options to ensure inflation moves towards its target in a sustained manner, including, inter alia, (i) the reinforcement of forward guidance on policy rates; (ii) mitigating measures such as a tiered-reserve system; and (iii) the size and composition of potential new asset purchases. Recall that the ECB accumulated circa €2.65 trillion in assets or 23% of euro area GDP during 2014-2018. In that context, the Governing Council’s expectations for interest rates “to remain at their present levels through the first half of 2020” changed to “at their present or lower levels through the first half of 2020” laying the ground for fresh monetary policy action, more probably at the September meeting. By then, more economic data will be available and the quarterly ECB staff forecasts for GDP and inflation will have been updated, allowing policy makers to calibrate the accurate policy package. A dovish statement, coupled with less-dovish-than-expected comments by Mr. Draghi at the press conference, led to high intra-day asset volatility (see graphs at page 3 – Markets section).
Investor attention now turns to the Fed meeting on July 31st, when it is expected to lower interest rates for the first time in over a decade (see page 8) by 25 bps to 2%-2.25% (markets price in a 19% likelihood of a 50 bp move). Economic data has been better than expected, mainly driven by solid consumer spending (see Economics for real GDP of +2.1%). However, trade uncertainty continues to hurt business investment, while inflation pressures remain muted. Moreover, the Fed may end its balance sheet unwinding on Wednesday (instead of September 2019) at circa $3.7 trillion (18% of US GDP) from $4.45 tn in October 2017.