The Governing Council of the European Central Bank (ECB) met on 16 July, keeping policy and rates unchanged as expected: the deposit rate at -0.50%, the main refinancing rate at 0%, and the marginal lending rate at 0.25%. The Pandemic Emergency Purchase Programme (PEPP) is unchanged from €1.35 trillion until at least June 2021, with the bank pledged to reinvest principal payments until at least the end of 2022, and longer if needed. The ECB President Christine Lagarde acknowledged at the post-meeting press conference that the ECB will continue doing what it thinks is needed, for as long and as strongly as needed. The ECB will also continue to provide sample liquidity through its refinancing operations. In particular, the latest operation of targeted longer-term refinancing operations (TLTRO III) has registered a very high take-up of funds, supporting bank lending to firms and households, with a net liquidity injection of €548 billion.
After four days of negotiations, the European Commission achieved a final agreement on two major policy components. The first of these was the EU budget which covers the next seven years and is worth €1.074 billion; this is to be funded by annual contributions from member states. The second is the €750bn coronavirus recovery fund to help the countries that are worstaffected by the pandemic; the EU will borrow this amount on the capital markets, with the funds to be repaid in 2058. The original proposal was for this to split between €500 billion in grants and €250 billion in cheap loans. The grant element has been scaled back to €390 billion, following resistance from the “frugal four” of Austria, Denmark, the Netherlands and Sweden.
The ECB stands ready to do more if needed. The market doesn’t expect them to cut rates further at this stage, considering it more likely the bank will increase the PEPP purchases and perhaps innovate the TLTRO-IIIs. The ECB next meets on 10 september. Market expectations are for policy rates to move lower over time, with five basis points (bps) of rate cuts forecast by 2021.
Eurozone GDP for the second quarter was aligned to consensus, following up a -3.6% fall in Q1 with a -12.1% contraction, quarter-over-quarter (q/q). On a national level, the biggest hit was in Spain (-18.5% q/q), followed by France (-13.8%) and Italy (-12.4%). Germany got away relatively lightly with a decline of -10.1%, but this was still the country’s biggest contraction on record, and equated to a -34.7% fall on an annual basis, with declines seen in exports, consumer spending and investment. The ECB’s latest projections envisage the economy contracting by -8.7% in 2020, followed by a strong recovery of 5.2% in 2021 and 3.3% in 2022.
Eurozone headline annual inflation surprised on the upside in July, rising to 0.4% compared to 0.3% in June. This was higher than expected given that Germany’s VAT rate was cut by 3% and expectations was for a lower print. The core rate (which excludes energy, food and tobacco) jumped by 0.4% to 1.2% in July, up from 0.8% in June. The delayed summer sales periods in France and Italy seem to explain the surprise rise. The ECB expects the inflation outlook to be disinflationary, with the headline forecast at 0.3% for 2020 (down from 1.2% in 2019), 0.8% for 2021 and 1.3% for 2022. These are well below the bank’s stated target of “close to 2%”.
Unemployment in the euro area increased to 7.8% in June, from a revised 7.7% in May. On a national level, Spain’s unemployment rate rose from 14.4% to 15.3% in the second quarter, with a 6% rise in youth unemployment. The outlook continues to deteriorate for the vital tourism sector and with outbreaks of the virus increasing, some regions have had to clamp down on activities again. The ECB’s latest projections for unemployment are 9.1% for 2020 (up from 7.6% in its March forecast), 10.1% for 2021 and 9.1% for 2021. Short-time work schemes have kept unemployment artificially low throughout the lockdown period and we expect unemployment to continue to rise for some time.
On a positive note, we are seeing some elements of recovery. The eurozone flash Composite PMI increased from 48.5 in June to 54.8 in July, a significant jump that continues to signal that economic output is rapidly recovering as restrictions ease. Eurozone retail sales rebounded in May by 17%, regaining about two-thirds of the 21% fall between February and April. The outlook for June looks very positive too, although consumer confidence remains low and auto sales have not rebounded as much as retail. Industrial production is recovering more slowly. German business sentiment improved in July. The main IFO business climate index rose 4.2 pts to 90.5, 16pts higher than April. Companies’ assessments of their current situations have improved and the manufacturing sector has seen a strong rebound in expectations.
The further increase in the Eurozone Economic Sentiment indicator, from 75.8 in June to 82.3 July, echoes the message from other surveys, that the recovery continues. It remains well below its February level of 103.4, but improvement was seen in business sentiment, particularly in the services sector.
Excess liquidity deposited with the ECB increased over the month, a net increase of €76 billion, reaching an historic high on 31 July at €2.855 trillion. Overnight Index Average (Eonia) averaged a yield of -0.465%, remained stable over the month. Eonia, since October 2019, tracks €ESTR (the ECB’s new short-term rate) plus a spread of 8.5 bps.
Euribor moved lower over the month: one-month Euribor averaged -0.51%, 1 basis points (bps) lower than June; three-month Euribor averaged -0.45%, 7 bps points lower than June; Six-month Euribor averaged -0.35% and one-year Euribor averaged -0.28%, both 13 bps lower than June. At the end of July, EUR LOIS (3m Libor vs overnight swap) was less than 1 bp, a considerable improvement in comparison to March, when this gap reached 30 bps. Overnight government repo and cash deposits ranged between -0.55% and -0.60%, with core government repo trading slightly lower, as we approached month-end.
Despite the Q2 surge in equities, optimism has been shaken as accelerating infection rates threaten to set back the reopening of global economies. With recent weakness in the US dollar and ongoing tensions between the US and China, gold has emerged as a safe-haven choice for investors. Gold futures briefly traded at an all-time high of $2,000, having already risen by 27% in 2020. Global bond yields continued to move lower: 10-year US Treasury yields started July at 0.68%, closing lower at 0.55% (approaching the all-time low recorded on 9 March at 0.54%). Ten-year German Bund yields began July at -0.40%, closing lower at -0.53%. In the UK, there continued to be market discussions as to whether negative rate policy will be on the agenda for the Bank of England; 10-year UK Gilt yields moved lower, beginning July at 0.21% and closing at 0.10% (we are already seeing two-to-eight year gilts trading at negative yields). Italian government debt continued to rise, with yields moving lower and spreads tightening; 10-year bond yields moved lower, beginning July at 1.27% and closing at 1.01%.
At the fund level, the weighted average maturity (WAM) averaged 42 days in July, up from 35 days in June. With the excess liquidity in the market, bank issuer levels are starting to look expensive, with spreads compressed across the money market curves. Investments were mainly in the one-to-three months duration range, with selective investments out to six months. Assetbacked paper continues to be in good supply, offering flexible duration and attractive returns compared to vanilla paper. Short-term liquidity ratios remained above average in both overnight and one-week maturities. Fund liquidity was covered with a combination of government and agency holdings, government/supranational repo and bank deposits. As always, liquidity and capital preservation remained the key drivers for the portfolio, with yield a distant third.