Looking through the noise
20 February 2018
Despite the perception that early February’s spike in equity volatility was largely a US phenomenon, the aftershocks were felt across the developed markets, including in Europe. In local currency terms, European equities declined by almost 10% peak-to-trough and despite edging up over recent trading sessions they remain below where they began the year (see Chart 6). Indeed there has now been only a modest net gain in equity prices over the past 12 months. Other indicators also point to a tightening in financial conditions over recent weeks. The severe spike in equity volatility did not last but both 1 and 3-month implied volatility remain above their year-end levels. Investment grade and high-yield credit have followed similar paths to equity volatility with the latter currently trading at wider spreads than it did through most of 2017. The German 10-year yield has increased close to 30bp since the beginning of the year and at 0.71% is well above its 2017 average. Meanwhile, the euro has been appreciating both against the dollar and in trade-weighted terms with the former up nearly 20% over the past 12 months and the latter nearly 10% higher over the same period.
Will this bout of financial stress worry the ECB enough to alter the course of policy? Not yet. Despite the wobble most financial indicators are at still levels consistent with conditions that are more accommodative than average. In fact, many officials may even be a little pleased to see some of the froth blown off the top of risk assets, as well as the fact that there was no contagion into the peripheral bond market; BTP spreads over German bunds have actually narrowed since the beginning of the year (see Chart 7). The one price development that could worry members of the Governing Council at little more is that of the euro. Its appreciation will put some downward pressure on inflation at a time when core inflation is still running well below the rates consistent with the ECB’ price stability mandate. Moreover, several officials have expressed concern about the way that senior US government figures have been trying to talk the dollar down over recent months. So far, however, there is no evidence that the euro’s movements are halting the economy’s momentum. Business and consumer confidence are at decade highs. Industrial production is growing at a pace that is above even the average of the pre-global financial crisis cycle. And consumer spending continues to grow solidly despite the corrosive effects of rising oil prices on purchasing power. Together they point to an economy growing well-above trend, which will pull the unemployment rate down further over the coming quarters.
The upshot is that we see no reason to change our expectations for ECB policy over the next two years. As long as we have seen the worst of the financial stress then economic momentum remains strong enough to allow the asset purchase programme to come to a halt later this year. We then see the deposit rate being lifted in H1 2019, as long as the upward trend in labour costs is sustained and begins to translate into stronger underlying inflation in line with ours and the ECB’s staff forecasts. The first increase in the main refinancing rate should follow in the second half of the year, though we expect the policy tightening cycle to be a long, drawn out affair and do not see the main refinancing rate getting above 2% during the current cycle.