Societe Generale analysts Ciaran O’Hagan and Vincent Chaigneau look at the ECB’s options in the context of the surprise volte-face by the Fed on monetary stimulus tapering. With a previous track record of peripheral friendly policies guised under nationalistic rhetoric, Angela Merkel’s new coalition government is expected to instill more such reforms over the next 15 months, but in the near term the dovish Fed and ECB justify risk-on, euro area compression trades.
Short term tightening
The Fed’s action could lead to short term tightening of spreads due to higher corporate debt issuance, but the analysts feel in the longer term wider spreads would prevail, probably in the range of 5bp on the USD 30y swap spreads. The Fed’s “credible irresponsibility” could fuel inflation, and this could lead to higher inflation premia in the USD long end products.
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The Fed’s decision, as well as the German elections, is pushing EUR/USD higher but this could work to the detriment of EA exports, as well as pressure landed import costs.
The latter could lead to disinflation, an aggravation of already soft inflation trends. The analysts feel, however, that chronic inflation under-shooting “aggravates the debt dynamics” of the non-core countries in the EA.
Excess liquidity is fast vanishing as banks continue to repay LTRO loans as per the chart below:
ECB in favor of monetary easing
All things considered, the factors of the Fed move, strength in the Euro, and tightening liquidity, as well as low inflation, may result in the ECB having to act in favor of easing, sooner rather than later.
The analysts recommend being long 3m1y receivers and long ATMF-51bp 2y1y receivers.