Monthly Cash Review – EUR State Street EUR Liquidity LVNAV Fund, December 2023
Policy
In line with expectations, the European Central Bank (ECB) Governing Council (GC) maintained the deposit rate at 4.00% at its 14 December meeting. In addition, it was announced that monthly reinvestments under the Pandemic Emergency Purchase Programme (PEPP) would be halved to €7.5bn from July until the end of 2024, at which point reinvestments would be discontinued – this will mean a reduction of €15bn per month.
ECB Forecasts
The ECB has revised down its inflation forecasts with headline inflation for 2023 now expected to be 5.4%, down 0.2% from its previous projection, while core inflation was cut by 0.1% to 5.0%. For 2024, both headline and core inflation are expected to fall to 2.7%, down from previous forecasts of 3.2% and 2.9%, respectively. The forecast for headline inflation in 2025 was left changed at 2.1%, while core inflation was marginally revised up to 2.3%. GDP for 2023 was revised down to 0.6% (0.1% lower); 0.8% (-0.2%) for 2024 and unchanged at 1.5% for 2025. The forecasts were made with a 22 November cut-off date and did not incorporate the larger-than-expected fall in inflation at the end of November. The markets already consider the forecasts to be out of date. The next projections are due in March 2024, when the inflation estimate is expected to be revised down.
Data
- Final inflation for November was unrevised from flash data at 2.4% from 2.9% in October and core inflation at 3.6% from 4.2%.
- The final Q3 2023 GDP number was left unchanged, confirming a -0.1% contraction.
- The composite purchasing managers index (PMI) fell from 47.6 in November to 47.0 in December, lower than consensus expectations of 48.0. Readings below 50 are indicative of contracting activity. The deterioration was largely driven by services, which printed at 48.1, down 0.6 from November. The employment PMI came in below 50 for a second successive month.
- The unemployment rate for October remained stable at 6.5%.
Outlook
The slowing down and ultimately the end of PEPP reinvestments is expected to have limited impact on bond markets and wider financial conditions. ECB President Christine Lagarde has stated that that quantitative tightening (QT) will not have a bearing on the outlook for interest rates.
In its post-meeting guidance, the ECB removed the sentence that inflation is still expected to stay "too high for too long" and commented that domestic prices pressures were "elevated" rather than "strong". However, the ECB provided a pushback on market expectations for an early interest rate cut with President Lagarde stating that rate cuts were not discussed at the GC meeting. There are concerns that “domestic price pressures remain elevated” particularly from the impact of wage growth. The ECB also noted that the new lower inflation forecasts were based on higher interest rates than were being priced by the markets. It seems that the ECB needs to see evidence that the labour market is normalising and wage inflation is coming down before considering rate cuts.
From an economic data perspective, the PMIs show that activity and demand have continued to decline and are indicative of a further modest contraction in GDP for Q4 2023. Given the slight contraction in Q3 2023, this would mean a shallow recession. While inflation continues to decline, this has also been combined with wage growth. This implies an increase in household disposable income, but this has not resulted in an increase in spending. Inflation is expected to continue to fall, although the base effects from energy will be less positive going forward. With the ECB guiding the markets against expecting early interest rate cuts, the March 2024 forecasts will provide further insight into the inflation outlook and the development of wage settlements.
Market expectations remain inclined towards interest rate cuts, with the implied rate for January 2024 finishing the month at 3.88%. The market is pricing in a rate cut from March 2024, with an implied rate of 3.74%. Additional rate cuts are expected, with the implied rate for September 2024 falling to 2.66%.
Forecast are based upon estimates and reflect subjective judgments and assumptions. There can be no assurance that developments will transpire as forecasted and that the estimates are accurate.
Fund
The weighted average maturity (WAM) averaged 39 days in December and the weighted average life (WAL) averaged 57 days. The focus was on managing liquidity with the year-end approaching. Investments were made in high-quality credit issuers, from one week to three months, with some selective longer-dated investments. Investments in sovereign, agency, and government-guaranteed holdings were maintained to provide high credit quality and maintain liquidity buffers. Investments in bank floating money market securities, linked to the €STR overnight index, were maintained, offering attractive spreads and diversification. Asset-backed commercial paper continued to be in good supply, offering flexible duration and attractive returns compared to vanilla paper. The year-end was challenging but manageable, with collateral givers and bank cash deposit takers reducing their requirements as balance sheet contractions and regulatory requirements kicked in. Liquidity and capital preservation remained the key drivers for the portfolio.