Draghi limitations exposed with inflation downside risks in 2017

Bloomberg

Investors may grow increasingly skeptical of the European Central Bank meeting its inflation target, with a host of factors — some beyond the control of President Mario Draghi — exposing the limitations of policy makers’ toolkit.
The monetary authority’s efforts to bring inflation close to 2 percent “without undue delay” are being curbed by judicial hurdles to changing the parameters surrounding quantitative easing, fiscal inaction in the euro area and German inflation acting as a cap on peripheral price pressures. All these suggest that the long end of the nation’s yield curve may face flattening pressure, while peripheral spreads may widen in the second half of 2017.
The ECB’s own 1.7 percent inflation forecast for 2019 is casting doubts on the goal of reaching 2 percent, particularly at a time when the euro zone’s core harmonized measure of inflation is running at just 0.8 percent. This is already being reflected in the inflation-options market, with the premium to cover the risk of inflation exceeding 1.5 percent within three years suppressed at 30 basis points, not far from this year’s low of about 10 basis points.
Core inflation in Germany is now 1 percent, which needs to accelerate for price pressures elsewhere in the region to take a foothold. After all, peripheral economies such as Spain, Italy and Portugal need core inflation to remain below that in the northern euro-area in order to protect competitiveness.
The stress in the German repurchase-agreements market is still looming large even though Draghi allowed the use of cash as collateral earlier this month. This is clearly seen in the front end of the nation’s yield curve: while rates on 10-year bonds have surged 30 basis points this quarter, those on two-year notes have fallen 11 basis points. With two-year rates deep in negative territory, investors who are yield-hungry amid capped inflation break-evens are likely to be pushed further out the curve, supporting long-end debt.
With the average maturity of ECB purchases set to drop after the latest tweaks to quantitative easing, the German yield curve would face steepening pressure. However, the longer end may face flattening pressure and the belly may outperform from the richening in the front end as well as disinflationary pressures stemming from a weaker yuan.
Policy makers also face potential legal constraints in raising the amount of bonds the monetary authority buys back from the secondary market, particularly in Portugal, where the central bank is close to the mandated 33 percent limit.

Draghi did acknowledge this in the latest ECB meeting, saying that there is “an increasing awareness of legal and institutional constraints” on increasing the issuer limit because there are concerns a change may contravene the Maastricht Treaty on monetary financing.

Upcoming elections in the Netherlands, France and potentially Italy as well as new issuance at the start of the year may see investors fade any spells of tightening. Widening pressure on peripheral bond spreads may increase in the second half of 2017 to price further tapering risks in the following year.