- What are the prospects for fiscal stimulus in the eurozone?
- Monetary policy or the benign status quo
- A little higher (but still low) interest rates in 2020
No fiscal shock in sight
A movement is underway among European policymakers, and it could significantly alter economic and market conditions in the medium term.
As globalisation recedes, some policymakers (governments, ECB council members, European Commissioners) are arguing for fiscal stimulus.
In the Netherlands, the government plans to create a fund of EUR 50 billion, financed by additional market debt.
In Germany, there have been calls from groups – including organisations representing employers – for an end to the ‘Schwarze Null’ (literally ‘black zero’, referring to the German government's policy of aiming for a budget that's either balanced (zero) or in the black). A railway infrastructure improvement plan (EUR 82 billion over 10 years) and a climate change plan are under discussion.
If large structural investments were to be made by these governments, the potential output of these countries, as well as the short-term growth of the eurozone, could increase and finally have a positive impact on investors' inflation expectations. These could lead, for example, to a steepening of the yield curve as investors would require a higher yield to reflect a higher probability of an increase in inflation in the future.
For the time being, however, public spending plans remains limited. We will likely see a slight upward drift in government spending rather than a real fiscal shock.
Exhibit 1: Eurozone fiscal deficit and German yield curve slope have been moving in tandem for years - graph shows the gap between short and long-term yields narrowing as budget funding pressures diminish
Monetary policy: Wait-and-see mode prevails
In the short term, we do not expect the replacement of Mario Draghi by Christine Lagarde as head of the European Central Bank (ECB) to result in any changes to the measures announced by the ECB in September (the deposit rate remains at -0.50% with a modulated rate system (‘tiering’), 3-year TLTRO and purchase programme of EUR 20 billion a month).
However, the ECB seems increasingly to acknowledge the negative effects resulting from excessive low rates. In its review of financial stability, the ECB explicitly mentions the risk that if bank profitability is too low it will weigh on the transmission of monetary policy to the economy. The ECB also acknowledges the imbalances created by the sharp increase in the money supply.
Worries over possible negative effects of negative interest rates on the banking system are not new. The minutes of the ECB meeting in March 2019 noted that “Concerns were voiced that over time, the effects of persistently low rates could depress banks’ interest margins and profitability, with negative effects on banks intermediation and financial stability in the longer run” .
We therefore do not expect much more in the way of accommodative measures from the ECB in the coming months. Christine Lagarde herself has indicated that the next step should be a fiscal policy response.
In the medium term, the review of the ECB's objectives could be crucial: Transforming the inflation target of close to, but below, 2% into (for example) a symmetrical inflation range around 2% (1.5% -2.5%) would lead to much less reactivity.
At the press conference after the 23 January Governing Council meeting, Christine Lagarde launched what will be only the second strategic review in the 20-year history of the ECB. The full agenda for this review is being finalised. One question is whether or not the agenda will reflect Christine Lagarde's declared goal of making climate change a "mission-critical" priority for the ECB.
The purpose of this review is to kick the tyres of every aspect of the ECB's monetary policy toolkit. The audit will examine both the adverse effects of low interest rates and the quantified definition of price stability as well as the approaches and instruments to achieve it.
She also underlined the importance of looking closely at just how inflation is measured with the relevant conclusions communicated to Eurostat. In particular, Christine Lagarde stressed the difficulties posed by the fair valuation of the cost of housing. Indeed, the way in which rents and, above all, owner-equivalent rents are incorporated into price indices can radically change the level of inflation.
Christine Lagarde hopes to present the conclusions of the strategic review this December. We may have to get used to hearing something different to the mantra of ‘inflation below, but close to, 2%’ when the ECB talks about its inflation target. This formula, which seems to us to be set in stone at the ECB's headquarters in Frankfurt, was one of the results of the last strategic review in 2003.
Behind the semantics, the new objective will above all be a translation of the approach to monetary policy that the ECB wishes to foster in the coming years. While we expect a status quo for 2020, these debates, and any leaks on possible policy changes, could lead to higher market volatility.
Modest (and volatile) rise in long-term yields in 2020
Since the lows hit at the end of August, German 10-year bond yields have risen slowly, although they have lagged the relatively positive economic news (relative to the consensus). In the first half of 2020, short-term yields are not expected to experience high volatility given the anchoring provided by the deposit rate at -0.50%.
Exhibit 2: We expect the yields of 10-year German government bonds to rise above zero in coming months - graph shows the change in 10-year Bund yields 2007 - 29/01/2020
Source: Bloomberg, BNPP AM
Long-term yields, on the other hand, could be subject to higher volatility, with the German 10-year rate initially fluctuating between 0% and -0.40% while gradually increasing. Any news of fiscal stimulus in the eurozone, particularly via government investment plans, would result in a much faster rise. (Geo)political tensions and concerns over the effects of the spreading coronavirus could, however, take yields to lower levels.
How might southern European bond markets fare?
- Spanish risk premia fell significantly in 2019 and are therefore now more vulnerable to political shocks and a less favourable economic environment. This leads us to reduce our overweight.
- Portugal appears expensive at the short end of the curve, but should continue to benefit from political stability, a decline in its debt to GDP ratio as well as low issuance in 2020. We remain confident on the evolution of spreads on long maturities.
- Italy will be the country with the most attractive rates – and the most volatile ones. The current ruling coalition looks quite pro-European, but the question of its continued existence will be a central concern for investors, even if the results of the recent regional elections can be seen as reassuring in the short term. We will need to be alert to any opportunities that arise.
Exhibit 3: Eurozone 'peripheral' bonds - 10-year risk premia over Germany have fallen - graph shows a steady decline for Spain and Portugal and more volatile moves for Italy
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