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ECB prepares to look through inflation

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Now that the first round of the French election is out of the way, markets are very relaxed about the second round playoff between Macron and Le Pen, given the former’s still roughly 20 point lead in the polls. Although Macron’s polling has been slipping versus Le Pen in recent days, he is still expected to comfortably win the second round, even without the support of two-thirds of Mélenchon’s supporters, who are set abstain or spoil their ballot papers.

Politics remain to the fore in the UK as the right-wing British broadsheet newspaper, the Daily Telegraph this morning accuses senior officials in Germany and Brussels of having ‘openly mocked’ Theresa May as regards her negotiation stance on Brexit, with some of May’s supporters apparently suggesting that Germany and the EU are embarking on another round of ‘Project Fear’, in an attempt to undermine the Prime Minister and even influence the UK General Election on 8 June. 

If the Brexit negotiations are starting to look a little bitter, this is only to be expected. However, the Financial Times’ front page story that the EU has raised Britain’s Brexit bill to €100 billion – up from the €60 billion originally mooted by Jean-Claude Juncker, is more of a concern. Money can ease many difficulties but €100 billion threatens to create more than it solves – particularly as it represents a demand from an organisation that has never managed to have its own accounts signed off. 

Nonetheless, if sabres have to be rattled, now is the time to do it. We are in a period of ‘phoney Brexit negotiations’. Not much can seriously be discussed until after the German elections in September, so both sides can, until then, happily maintain entrenched positions based on the most extreme initial demands. It looks as if we are in for a long, acrimonious summer before a little common sense returns to negotiations in the autumn.

We have raised concerns recently that Angela Merkel could face the unenviable prospect of facing the election in September with German inflation very much above 2% – and, quite possibly above 3%. February’s German inflation number was 2.2%. This dropped to 1.6% in March, before bouncing to 2.0% in April. At least it did not simply continue higher after February. We argued that, despite much protest from Germany, the ECB would not be deviating from its ultra-loose monetary policy any time soon, particularly given that Eurozone core inflation remained benign. From December to February, core inflation was steady at 0.9%, before dipping to 0.7% in March. Last week, however, we learnt that the core rate had jumped to 1.2% in the year to April. 

Meanwhile, the Eurozone headline rate is 1.9% although, at the last ECB press conference on 27 April, Mario Draghi stressed ‘the need to look through transient developments in HICP inflation, which have no implication for the medium-term outlook for price stability’. In other words, he is quite prepared to see headline inflation considerably overshoot the target of ‘close to, but below, 2%’ in the near term. While it will be more difficult to run core inflation at a rate in excess of 2%, Draghi could probably afford to ‘look through’ even this eventuality in the short term, despite the inevitable howls of protest from Germany. Indeed, when he said regarding official interest rates, ‘we continue to expect them to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases’, in the absence of a very sharp rise in inflation, one can reasonably assume no tightening of policy at all until 2018 at the earliest. 

Indeed, based on the forward guidance provided by the ECB statement, the eurozone appears set to live in a world of negative policy rates for at least another year. Unless core inflation picks up dramatically in the coming months, it is likely that the asset purchase program will just shrink, not stop from December 2017; if this proves to be true, it is then likely that negative rates will continue well into 2018.

While this is brilliant news for borrowers, they must exercise caution as regards the widespread imposition of minimum Euribor rates, typically at 0.0%, on the overall economics of financing. Lenders seem very happy to lower the margins on their deals, as long as there is a floor on the floating rate of interest in their facilities. The reason is not hard to understand. The market is pricing Euribor to continue fixing at negative levels until May 2019 and, regardless of whether this projection proves correct or not, the intrinsic value today of the conceded 0% floor option on a 5-year bullet facility of EUR 100,000,000 is EUR 430,000, or 10 basis point per annum over the five years. The total financial value – including the time value of the option – would be closer to EUR 1,350,000 or 1.35% of the notional. The economic cost, and the constraints such an embedded floor places on suitable hedging arrangements, make this item a hot topic. Discussing it in an open and transparent way before committing to a financing agreement termsheet is the best way to proceed. The floor is a structural clause within a credit-approved termsheet, and it becomes very difficult to amend once the process has already started.

The endless source of political risk that is Europe will soon move past the fight between croque madame and croque monsieur. Italy will soon regain centre stage after playing second fiddle for a little while. A much quieter figure than Renzi, the current Prime Minister, Mr. Gentiloni, together with his ministers, is carrying out a much appreciated, low-key negotiation process with the European Commission. At the moment elections are due in March-May 2018, but it would be very surprising if Renzi, having received more than 1.2m votes, and close to 70% of internal consensus within Partito Democratico (PD), to be confirmed as political leader of the PD, accepts remaining sidelined and allows the government to move along in solid continuity. The electoral law and the election date will become key discussion topics soon. That will remind the market that the projected leading political party in Italy is Grillo’s Five Star Movement, with its incoherent policies on Europe, investment and financial markets.

All views expressed here are the author’s own and are based on information available at the time of writing.

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