ECB facing up to downside risks

ECB facing up to downside risks Today is ECB day and the data coming out of Europe is not good. The flash PMI figures out this morning continue to paint a picture of persistent softening in the eurozone. Activity in France has been clobbered, with the French composite PMI declining to 48.7, signalling the worst contraction in four years. German manufacturing contracted again although the service sector was stronger. Despite this it was a bad PMI and there was a notable decrease in overall inflows of new business. Importantly these PMIs only add to the sense that the downturn is not temporary. The full Eurozone PMI showed the economy was ‘close to stagnation' at the start of 2019, sliding to a 66-month low at 50.7.

Whilst we don't expect any change any policy at this stage, not least since the ECB only last month ended its QE programme, there could be a noticeable shift in the language as policymakers acknowledge the deterioration in the data and growing risks to the outlook.

The ECB may well shift its tone to describe risks as no longer balanced but tilted to the downside. The only problem with such a change in the language would be that markets would start to anticipate forthcoming policy action. The fact is though that the eurozone economy is slowing down and things like the trade conflict and Brexit are not positives.

The high frequency eco data has not been encouraging. Inflation in December slowed to 1.6% from 1.9% the month before while core inflation held at 1.1%.

Consumer confidence has picked up a bit in January, but this is only a small bright spot as inflation remains low and wage growth accelerates. Growth is trending around 0.3% a quarter – whilst not immediately signalling a recession it would not take a lot to see growth flatten out, particularly as the stimulus blanket has just been removed at a time of heightened global risks.

Hard data and sentiment indicators are weakening, and there is mounting evidence that this is not just a temporary phenomenon stemming from things like the yellow vest movement in France and the German auto industry's problems; but also growing into something more persistent. Albeit domestic demand looks solid enough, there is a growing fear that external factors like the US-Sino trade war or Brexit will lead to a deeper malaise. The ECB's forecast for growth of 1.7% in 2019 looks rather ambitious given the current trend and this should be revised lower, although perhaps not until the summer projections.

Indeed, it seems unlikely that the ECB would hit the panic button just yet. Whilst there are signs of softness in Europe and globally, it would seem precipitous to do anything about it at this meeting. Market expectations currently suggest the first hike in mid-2020, pushed back since the December meeting from the previous expectations for a rate rise in 2019. With the can well and truly kicked down the road as far as the market is concerned, it seems unlikely that the ECB will seek to change this this view.

The ECB needs to be careful though. Its raised too early before – it needs to not make the same mistake again by being complacent about the risks to the eurozone economy. Again I would reiterate as we did throughout 2018 that there is a greater chance the ECB will loosen policy in 2019 than tighten.

EURUSD was steady running into the meeting around 1.1340. A dovish remark on the tightening schedule or a noticeably more pessimistic outlook on risks to the economy could tilt the euro below 1.13, although there is a sense that a lot of the downside is already baked in as markets expect the ECB to be dovish. The trouble for euro bulls is that even if the ECB sounds confident or even hawkish it would defy logic and suggest that the ECB is blind to the risks, a scenario unlikely to support the euro long term.

Meanwhile sterling has held the bulk of its gains and was last sitting on 1.3040. Big resistance at 1.3075, the 200-day moving average may cap the upside, but the pound remains acutely sensitive to Brexit news flow. Watch for anything that suggest an extension of Article 50 beyond March 29th as this would likely cause the pound to be bid higher as it would reduce the chances of a no-deal exit.