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Market Comment | North Korea triggered risk-off mood in the ECB week



  • Risk-off mood in financial markets due to a new North Korea nuclear test (see). This action escalated the tension in the geopolitical field sending, a belligerent message and renewing fears of potential military action. By now the international community could support stronger sanctions (see).
  • In this context, demand for safe-haven assets increased sharply on US Labor Day (US markets will remain closed): gold hovered around its highest level since 2014, while safe-haven currencies (JPY and CHF) appreciated against the USD. Consequently, equity indices dropped in the euro area following losses in Asia’s equity indices, while EZ bond markets remained almost unchanged waiting for this week’s ECB meeting (see the preview below).
  • Although movements in the FX market showed the market’s risk aversion, the EUR remained strong against the USD, despite geopolitical uncertainties (see) and ahead of the ECB policy meeting this week.
  • Portugal’s sovereign bond yields inched down, after Moody’s rating agency reviewed (see) the credit rating outlook to positive from stable, citing improving resilience of economic growth and fiscal improvements.
  • Gasoline prices declined and oil prices inched down, after refineries restarted once Hurricane Harvey started to fade, downgraded to a tropical storm (see). At the same time EM currencies showed a mixed performance, with little variation across the board.


ECB Preview: What to expect at the September meeting?

  • A revision of Staff forecasts is expected, especially of inflation given the recent euro appreciation, but the strength of growth continues.
  • A higher euro forces the ECB to be very cautious, but it should start communicating its strategy as soon as possible in order to guide expectations.
  • At the July meeting the ECB President Mario Draghi stated that the Governing Council (GC) would take a decision on the roadmap for the monetary policy normalization process in the autumn. This was confirmed by the July meeting minutes: “the Governing Council would, in the autumn, consider the future course of its monetary policy and, in particular, its strategy for asset purchases beyond the currently communicated horizon.”
  • Since then the ECB has given no clues about the exit strategy, either on when to start it or on how to implement it. But in the meantime, the economic and financial outlook has continued to evolve in a way that poses some challenges for the monetary policy stance. On the one hand, the euro zone economy continues to advance above its potential growth, at a solid pace (0.6% QoQ in 2Q17), boosted by the strength of domestic demand. Headline inflation increased to 1.5% YoY in August, but the energy base effect along with the recent appreciation of the euro could push it down by year end and the first quarter of 2018 to around 1% YoY. Core inflation has increased by 0.4 pp since January, to 1.3% YoY, while a very gradual increase is expected going forward, it is still failing to show a sustainable upward trend towards the ECB’s target. On the other hand, the euro vis-à-vis the USD has accelerated its appreciation trend (by around 5% since July). Certainly, the strengthening of the euro reflects the stronger momentum in the euro zone economy and the expected normalization of monetary policy, but it also challenges the ECB’s exit strategy. The euro is now around 8% more appreciated versus the USD than the assumption included in the June Staff’s macroeconomic projections. According to their sensitivity analysis, ceteris paribus, the stronger euro could dampen GDP growth and inflation by around 0.3 pp and 0.6 pp respectively from next year onwards.
  • Thus, at this meeting the update of macroeconomic projections and the assessment on the euro would be particularly relevant. Regarding GDP growth, we think that stronger domestic demand and the lagged effect of the stronger currency could lead to a slight upward revision of ECB growth forecasts this year (by around 0.1 pp or 0.2 pp from the 1.9% figure in June), while minor changes are expected over the forecast horizon (1.8% in 2018 and 1.7% in 2019). On inflation, the headline figure could be unchanged this year (1.5%) and revised down in 2018 and 2019 by around 0.2 pp from the June projections (1.3% and 1.6%, respectively), while more limited pass-through to core components could lead to slight downward revisions of underlying inflation (around 0.1 pp from 1.4% in 2018 and 1.7% in 2019). On the assessment of the euro, the ECB will probably signal that a (sharp) appreciation of the exchange rate requires a more prudent approach as long as it translates into a slower and more gradual convergence of inflation towards the target. Moreover, the ECB could be particularly cautious considering the lingering uncertainty in the US, which could result in a more dovish Fed carrying on the normalization of its monetary policy.
  • All in all, while the euro is expected to weigh in the ECB’s reactions going forward the improvement in the economic outlook in the euro zone is consistent with the ECB’s gradual exit from QE. While it will maintain a very cautious stance, we expect it to remove the “explicit” downward bias regarding the asset purchase programme (APP), gaining (the desired) flexibility ahead of the announcement of a reduction of the APP in October. The ECB should not forget the importance of guiding expectations in advance.


Update 18.0 CET 01 September, 2017

Table 1

Source: Bloomberg, Datastream and Haver

* With one day delay


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