Monthly Cash Review - EUR

Policy

The Governing Council of the European Central Bank (ECB) met on 10 December, when they kept rates unchanged (the deposit rate remains at -0.50%, the main refinancing rate at 0%, and the marginal lending rate at 0.25%), but adjusted its main policy tools. The Pandemic Emergency Purchase Program (PEPP) was increased by €500 billion, to €1.850 trillion, with an extension of the program until at least March 2022 (from June 2021). The Asset Purchase Program remained unchanged at €20 billion per month. The ECB announced that they would recalibrate its Targeted Long-term Repo Operations (TLTRO-III); the special interest rates was extended
to December 2021; three additional auctions than previously scheduled were announced for between June and December 2021; the total amount that banks can draw down was increased to 55% from 50% of eligible loans.

The key message was that the extraordinary measures introduced during the pandemic will remain until the economy and inflation return to their pre-pandemic path. ECB President Lagarde reiterated that the PEPP need not be used in full and amounts purchased will depend on financial conditions. With expectations of GDP growth setbacks in Q4, the ECB is trying to preserve current conditions. President Lagarde unsurprisingly reiterated that the EUR is not a policy target, but that it will remain very closely monitored given the consequences on medium-term inflation.

Outlook

With further containment measures across Europe in response to a strong resurgence of coronavirus, it is widely expected that activity will decline in the fourth quarter and remain subdued into the first quarter of 2021. On an optimistic note, the rollout of the COVID vaccines has commenced and there is hope that the pandemic will be brought under control. Market expectations are that the ECB, along with central banks around the globe, will continue to do whatever it takes to keep financial conditions accommodative for as long as it takes the global economy to stage a full recovery. The next council meeting is on 21 January 2021. The market doesn’t expect the ECB to cut rates further, although the euro has continued to appreciate. At the end of 2020, the futures markets are pricing in a 67% probability for the overnight rate to be around seven basis points (bps) lower by September 2021 (at the end of November this probability was 55%). 

Data

The ECB expects GDP growth in the fourth quarter to decline by -2.2% quarter-on-quarter (q/q), which is more positive than consensus expectations of -2.8%. Third-quarter eurozone GDP was revised down slightly to 12.5% q/q. Second-quarter eurozone GDP had contracted -12.1% q/q, and this followed a -3.6% fall in Q1. There were variations among the region’s economies (revised data): output expanded by 18.7% in France (after -13.8% contraction in Q2), 16.4% in Spain (after
-17.9% contraction in Q2), 15.9% in Italy (after contracting -13% in Q2) and 8.5% in Germany (after contracting -9.8% in Q2). The latest lockdown restrictions are likely to put the recovery on hold in Q4, with some countries more impacted than others; a contraction of -3% q/q is forecast for the eurozone economy in Q4. The ECB updated their projections at the December meeting, to estimate the economy contracting by -7.3% in 2020 (compared to a September projection of
-8%), before growing by 3.9% (5%) in 2021 and 4.2% (3.2%) in 2022. The bank also projected the economy will grow by 2.1% in 2023.

Eurozone headline annual inflation was unchanged at -0.3% year-on-year (y/y) in November, compared to October. The core rate (which excludes energy, food and tobacco) remained unchanged at an all-time low of 0.2% y/y. The overall trend remains persistently low. With the lengthening of lockdown measures into December and in some countries into January, demand is likely to remain weak, keeping price pressures subdued. The ECB’s latest projections foresees HICP inflation rebounding from 0.2% in 2020 to 1.0% in 2021 and then gradually increasing further to 1.1% in 2022 and 1.4% in 2023. Compared with the September 2020 ECB staff projections, HICP inflation has been revised down for 2020 (0.3%) and 2022 (1.3%).

Unemployment in the euro area was up in October at 8.4%, compared to September at 8.3% — revisions were made which highlighted that there was over a million more people out of work in July than previously estimated. Among the bloc’s largest economies, the highest jobless rates were recorded in Spain (16.3%); Italy edged up to 9.8% (from 9.7%); France rose to 9% in Q3 (up from 7.1%). Meanwhile, the lowest rate was observed in Germany where it was unchanged at 4.5% since August. Short-time work schemes have kept unemployment artificially low throughout the lockdown period and estimates suggest that the jobless rate would be closer to 10% if these measures were not in place. The ECB’s latest projections for unemployment (compared to September) are 8% (9.1%) for 2020, 9.3% (10.1%) for 2021 and 8.2% (9.1%) for 2022 and 7.5% for 2023.

The latest eurozone industrial production data surprised on the upside, increasing by 2.1% in November, leaving production just -3.5% below pre-pandemic levels. Amongst the largest euro area economies, Germany, France, Italy and Spain all recorded output gains. The eurozone composite purchasing managers’ index (PMI) also showed some improvement and resilience to the second wave, increasing from 45.3 in November, to 49.8 in December. The service sector jumped from 41.7 to 47.3, in part showing optimism about future conditions due to the vaccines and also due to the reopening of non-essential business in France. The manufacturing PMI also increased from 55.3 to 56.5 in December.

The German Ifo Business Climate Index increased to 92.1 in December, from a revised 90.9 inNovember, with companies more optimistic about current conditions and expectations. TheGerman economy is showing resilience, but the lockdown is still causing the services sectorto struggle.

Markets

Excess liquidity deposited with the ECB increased in December, averaging €3.433 trillion. TheEuro Short-term Rate (€STR) averaged a yield of -0.558%, stable over the month but closinglower at year-end at -0.583%. Euribors continued to drift lower, driven by the large amount ofexcess liquidity, central bank activity and year end pressure. One-month Euribor averaged-0.56%, 2 basis points (bps) lower than November; three-month Euribor averaged -0.54%, 2bpslower than November; six-month Euribor averaged -0.52% and one-year Euribor averaged-0.50%, 1bp and 2bps lower than October, respectively. Euro cash overnight deposit rates rangedover the period between -0.55% and -0.65%, trading lower over year-end to -1.00%. Governmentrepo traded -0.58/-0.68%, moving gradually lower as we approached year-end, trading as lowas -2%.

Global equities continued to gain, albeit not as impressively as seen in November. Spurredby vaccine hopes, progress on the US stimulus package and a Brexit deal ratified by the UKparliament in the final hours of 31 December! European government bond yields moved lowerover the month. Investors are balancing optimism with the rollout of the COVID-19 Vaccines,with concerns that tighter restrictions may be imposed. Ten-year German Bund yields averaged-0.58% over the month, closing lower at year-end at -0.60%. In the UK, 10-year UK Gilt yieldsaveraged 0.26%, but ranged from a 0.17% low and a high of 0.35%, ending the year at 0.19%.Italian 10-year government yields started December at 0.67% and closed the year at 0.54%.The Italian spread over Germany’s 10-year bond was at one point 113 bps, close to the lowestsince early 2018.

Fund

At the fund level, the weighted average maturity (WAM) averaged 46 days in December,increasing from 38 days in November. With year-end approaching, issuance was limited andexpensive. We selectively targeted high quality credit issuers in the three-to-six month durationrange, along with some shorter-dated government bills. Asset-backed paper continued to be ingood supply, offering flexible duration and attractive returns compared to vanilla paper. Supra/Sovereign/Agency issuers offered good supply in the shorter dates (one to two weeks) but eurodenominatedissuance into January was substantially reduced. Fund liquidity was covered witha combination of government and agency holdings, government/supranational repo and bankdeposits. Year-end continued to be challenging as collateral givers and bank cash deposit takersreduced their requirements as balance sheet contractions and regulatory requirements kickedin. As always, liquidity and capital preservation remained the key drivers for the portfolio, withyield a distant third.

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