Europe: It’s all about politics with ECB likely on hold - BBH

Analysts at BBH suggests that at the moment in Europe, it’s all about politics and given solid PMI readings and evidence that price pressures are rising, will the ECB adjust its policy initiatives accordingly?

Key Quotes

“Anxiety over European politics remains elevated, but it has eased by nearly any metric one chooses.  The interest rate premium investors demand for holding French paper over German narrowed last week at both the two- and 10-year sectors.  The French 10-year premium has narrowed nearly 20 bp from its peak, while the two-year premium has been by around 13 bp.  There is scope for one major twist in the drama.  The beleaguered Fillon could pull out of the race and be replaced by Juppe, who could catapult toward the top of the polls.  Meanwhile, Le Pen has her own legal difficulties.  In the Netherlands, the latest polls suggest the populist-nationalists have also slipped recently.”

“More generally throughout the EMU, premiums narrowed, and importantly, the narrowing occurred in a rising interest rate environment.  Often the spreads have been more sensitive to the overall direction of interest rates.  The rising rates should also be kept in perspective.  Not just Germany, but France, the Netherlands, Italy, Spain, Portugal, and Ireland can all borrow for two years at negative interest rates.  Indeed, it appears that nearly all EMU members, save Greece, are paid to borrow for two years.”

“ECB policy is on hold, probably through the Q3.  Draghi will likely be encouraged by the recent PMIs, which suggest that the region's economy may even be accelerating a bit.  The staff will update its forecasts, and there is scope to lift growth and inflation projections a little.  That said, the January industrial production reports may be softer than the PMIs implied.  Draghi is likely to be disappointed that his calls for structural reforms continue to find few takers.”

“Questions about the ECB's inflation credibility will be rebuffed.  The increase in headline inflation is largely a function of higher energy costs, and secondarily seasonal foods (weather-related).  Many on the ECB want to look through this temporary impact.  Instead, they are focusing on the core rate, which remains in the trough near 0.9% (having bottomed at 0.6%).  We also think that relatively higher German inflation within the EMU is not an urgent problem. It is not the most desirable way for other countries to gain competitiveness over Germany, but it is one way.”

“A month ago, it looked as if UK Prime Minister would formally trigger Article 50 on March 8-9.  However, that time frame is unlikely now that the House of Lords passed an amendment to the bill (seeking to protect the rights of EU citizens in the UK).  It seems procedurally more significant than substance, as some government officials were sympathetic with the sentiment.  It may delay the actually triggering by a week or so.”