ECB PreviewOn autopilot for now

Aila Mihr Jens Peter Sørensen Christin Tuxen Sverre HolbekAnalyst Chief Analyst Chief Analyst Senior Analyst+45 45 12 85 35 +45 45 12 85 17 +45 45 13 78 67 +45 45 14 88 82 amih@danskebank.dk jenssr@danskebank.dk tux@danskebank.dk holb@danskebank.dk

8 December 2017

Investment Research – General Market Conditions

Important disclosures and certifications are contained from page 12 of this reportwww.danskebank.com/CI

22

Summary: ECB on autopilot for now

Following the decision to extend the QE programme foranother nine months in 2018, we do not expect the ECB to

make any changes to its policy stance at its upcoming

meeting. Instead, we think policymakers will put off anysubstantial discussion about the next move or changes tothe forward guidance until well into 2018.

Activity indicators have remained strong and we expect theECB to revise its growth and inflation forecasts upward inlight of the ongoing strong economic momentum.

Consensus seems to be growing in the Governing Councilthat the October QE extension was the last one, as the ECBis increasingly shifting towards a more holistic view of the

economy and inflation. Based on this, we think it isimportant to watch developments in ‘super core’ inflation.

Other topics that could come up during the Q&A includethe recent volatility in the Eonia fixing and the repo market

over year end.

We think it is likely that the corporate bond and covered

bond purchase programmes’ share of QE will be increasedfrom January 2018.

In our view, it is too early for the ECB to spur the next ‘waveof normalisation’ pricing just yet, so we project EUR/USD

within a 1.17-1.20 range near term.

We expect the trend for tighter spreads and flatter curves

in the euro fixed income market to continue.

The ECB expects key ECB interest rates to ‘remain at presentlevels…’

(1) Level of policy rates

‘…for an extended period of time and well past the horizon ofour net asset purchases.’

(2) Policy rates horizon

‘Net asset purchases are intended to continue at a monthlypace of EUR30bn until the end of September 2018, or beyond,if necessary…’

(3) QE magnitude

‘…and in any case until the Governing Council sees a sustainedadjustment in the path of inflation consistent with its inflationaim.’

(4) QE tapering condition

‘If the outlook becomes less favourable, or if financialconditions become inconsistent with further progress towardsa sustained adjustment in the path of inflation, we stand readyto increase the asset purchase programme in terms of sizeand/or duration.’

(5) QE flexibility

No changes to ECB’s forward guidance

33

ECB’s dilemma: economy steaming ahead but inflation pressures

staying subdued

Source: EC, Markit, Eurostat, Macrobond Financial, Danske Bank

Growth has surprised on the upside in 2017

and PMIs point to more to come…

…but rising underlying inflation pressure is

still not in sight

Source: Eurostat, Macrobond Financial, Danske Bank

Core inflation at 0.9% for two consecutivemonths is clearly a disappointment for theECB, which is likely to revise down its 2017core inflation forecast as a consequence.

Aila Mihr, Analyst, amih@danskebank.com, +45 45 12 85 35

44

ECB December forecasts set to paint a rosier outlook for growth

and inflation

Growth

Strong economic data in recent months and comments fromECB members point to an upward revision of the ECB’s GDPforecast.

Jens Weidmann: ‘Evidence is mounting the economic

outlook will be at least as good as previously forecast, if

not even better.’

Yves Mersch: ‘No-one would be overly surprised if we

would again slightly revise upwards our projections for

growth.’

Inflation

We expect the ECB to revise up its inf lation forecast for2018 due to higher energy price inf lation driven by recenthigher oil prices (see also Euro Area Research – ECB

inflation gap persists in 2019, 4 December). The new 2020forecast will probably show a further pickup in inflationtowards the target, driven by the ECB’s belief in increasingunderlying inf lation pressures in the light of the continuedstrong economic momentum and a growing urge in theGoverning Council to move ahead with monetary policynormalisation.

2020 inflation forecast set to show inflation

close to target

Exp. ECB projections

(December 2017)2017 2018 2019 2020

HICP inflation1.5%

(1.5%)

1.3% (1.2%)

1.5%

(1.5%) 1.8%

Core inflation1.0%

(1.1%)

1.3% (1.3%)

1.5%

(1.5%) 1.7%

GDP growth2.3%

(2.2%)

2.0%(1.8%)

1.9%

(1.7%) 1.7%

Unemployment rate9.1%

(9.1%)

8.4% (8.6%)

8.0%

(8.1%) 7.7%

Wage growth1.6%

(1.5%)

2.0% (2.0%)

2.3%

(2.3%) 2.4%

Parenthesis are the old ECB projections (from September 2017)Note: Figures in parentheses are the old ECB projections from September 2017

Source: ECB, Danske Bank

Aila Mihr, Analyst, amih@danskebank.com, +45 45 12 85 35

55

ECB shifting towards a more holistic view on inflation and

economy

The ECB is increasingly shifting focus towards a more

holistic view of the euro area economy and inflation, witha strong belief that the closing output gap in light of ongoingexpansion and continued employment gains will eventuallypush underlying inflation pressures higher.

In line with this thinking, the so-called ‘super core’ inflation

measure has increasingly featured in recent speeches byECB members. Super core consists of a sub-index of allHICP items that have been closely correlated with theoutput gap in the past and could hence provide importantsignals about turning points in inflation.

The ECB does not publish the series but using the ECB’smethodology we have tried to replicate it (see also Euro

Area Research – ECB inflation gap persists in 2019, 4December).

Both our and the ECB’s super core inf lation measuresindicate an upward trend since 2017.

Should this increasing trend continue, it would support

the ECB’s argumentation of a pickup in underlying

inflation pressures, providing it with a good ‘excuse’ to end

the QE programme in 2018.

Source: ECB, Eurostat, Macrobond Financial, Danske Bank

Source: ECB, Eurostat, Macrobond Financial, Danske Bank

Aila Mihr, Analyst, amih@danskebank.com, +45 45 12 85 35

66

Markets are so far still very complacent, pricing in the first

ECB 10bp hike not before July 2019. Hence, further

hawkish comments in coming months hinting at the

possibility the ECB could phase out QE purchases earlier

than markets are currently looking/wishing for could be a

trigger for a reassessment of current market expectations.

Consensus is growing in the Governing Council that October QE

extension was the last one

Recent remarks from ECB members have repeatedly hintedat a preference for the October QE extension to be the lastone.

Yves Mersch: ‘Market would be wrong to expect another

QE extension’; ‘CB toolbox not limited to asset purchases’.

François Villeroy de Galhau: ‘There shouldn’t be

excessive focus on the net QE purchases.’

Benoît Cœuré: ‘I hope that asset purchases will end in

September’

The minutes from the October meeting also revealed that‘several members’ favoured decoupling the forwardguidance on QE from the requirement for a sustained rise ininf lation, instead linking it to the overall monetary policystance, i.e. the combination of new asset purchases, theexisting stock of QE assets plus reinvestments and theforward guidance on policy rates.

If this view were to become more prominent in the

Governing Council over coming months, it would open up

the possibility of the ECB ending the QE programme in

2018, even without a clear pickup in inflation.

Source: Danske Bank

0.6 0.6 0.4 0.0

-0.2 -0.3 -0.1

0.3 0.71.5

3.7

6.1

8.4

10.8

13.3

16.0

18.9

22.0

-5

0

5

10

15

20

25

Dec 17 Mar 18 Jun 18 Sep 18 Dec 18 Feb 19 May 19 Aug 19 Nov 19

bp

ECB dated Eonia swaps (assuming neutral Eonia is 5bp above deposit rate)

Aila Mihr, Analyst, amih@danskebank.com, +45 45 12 85 35

77

ECB’s exit strategy set to become a theme in 2018: QE programme

set to end in Q4 18, with first hike in Q2 19

For more details on the ECB’s exit strategy from extraordinarymonetary policy measures, see Special Report: The Euro-

Scandi exit and what it implies for markets, 30 November. Source: ECB, Danske Bank

We expect the ECB to stick to its communicated exitsequence and end QE before hiking rates.

We think the ECB will end the QE programme in 2018 dueto the following.

Core inflation staying above 1.0% in 2018 and 2019.

Binding technical restrictions.

The growing size and importance of reinvestments of maturing bonds.

Deflation risks have disappeared.

Given rising underlying inflation pressure, we expect the ECB to deliver its first 10bp hike in Q2 19, as, in our view, it will be keen to regain room to manoeuvre for future crises and avoid falling behind the curve.

0

5

10

15

20

25

30

Dec17

Jan18

Feb18

Mar18

Apr18

May18

Jun18

Jul18

Aug18

Sep18

Oct18

Nov18

EUR bn

QE redemptions to grow in size in 2018

PSPP CSPP CBPP ABSPP

Source: ECB, Macrobond Financial, Danske Bank

Aila Mihr, Analyst, amih@danskebank.com, +45 45 12 85 35

88

Four out of six dovish executive board members will end their

term by 2019 – opening door for a more hawkish ECB in 2019?

Draghi (dovish) Oct 2019

Vito Constâncio (dovish) May 2018

Peter Praet (dovish) May 2019

Cœuré (dovish-neutral) Dec 2019

Sabine Lautenschläger (hawkish) Jan 2022

Mersch (hawkish-neutral) Dec 2020

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Source: ECB, Danske Bank

Aila Mihr, Analyst, amih@danskebank.com, +45 45 12 85 35

99

0%

10%

20%

30%

40%

50%

Indicative ECB ownership rates across QE portfolios

CBPP3 Supras PSPP (excl supras) CSPP

Credit: Private-sector purchases to remain sizeable

We think QE composition could also factor in thediscussions at the December meeting.

The October ECB Minutes stated that ‘the purchase

volumes under the three private sector purchase

programmes would remain sizeable and the private

sector programmes would not be adjusted in strict

proportion to the overall scaling-down of the APP’.

In our view, this suggests that the corporate bond andcovered bond purchase programmes’ (CSPP and CBPP3,respectively) share of total net purchases will beincreased from January 2018. The ABS purchaseprogramme has played only a minor role due to the lack ofeligible assets.

In our view, CSPP is likely to account for the bulk ofprivate sector purchases, given that the ECB’s ownershiprate is lower within the corporate market. However, theECB is also likely to remain active in the covered bondmarket, particularly in the primary market. Furthermore,purchase flows will also be supported by redemptions,with EUR1.6bn of covered bonds maturing per month onaverage from January through to end-September 2018.

Source: ECB, Danske Bank

0%

20%

40%

60%

80%

100%

0%

5%

10%

15%

20%

25%

Share of net purchases by component

CSPP CBPP3 PSPP (right axis)

Source: ECB, Markit, Danske Bank

Sverre Holbek, Senior Analyst, holb@danskebank.dk, +45 45 14 88 82

1010

We expect the trend for tighter spreads between

core-EU and semi-core/periphery to continue eventhough the spread between, for example, France andGermany is very tight.

We expect the slope of the German curve in the

10-30Y segment to flatten as the ECB is slowlymoving towards the exit.

Fixed income: tighter spreads and flatter curves

Source: Danske Bank, Macrobond Financial Source: Danske Bank, Macrobond Financial

Jens Peter Sørensen, Chief Analyst, jenssr@danskebank.dk, +45 45 12 85 17

1111

2018: An ECB shift towards a more ‘holistic’ viewon the economy should foster the next ‘wave of ECB

normalisation trades’ in mid-2018 EUR/USD

eventually towards 1.35 in ECB ‘exit’ scenario

December 2017: An unchanged policy stance butupward growth/inflation revisions from the ECBshould keep EUR/USD afloat and (roughly) within

the 1.17-1.20 range near term despite USD ratesupport.

FX: too early for ECB to spur next ‘wave of normalisation’ pricing

(just yet)

Source: Macrobond Financial, Danske Bank Source: Macrobond Financial, Danske Bank

1212

This research report has been prepared by Danske Bank A/S (‘Danske Bank’). The authors of this research report are Aila Mihr (Analyst), Jens Peter Sørensen (Chief

Analyst), Christin Tuxen (Chief Analyst) and Sverre Holbek (Senior Analyst).

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Report completed: 7 December 2017, 16:34 CET

Report first disseminated: 8 December 2017, 07:00 CET