Signs of change in Euro area policy response?

• Confirmation of euro area recession to supplement political uncertainty.

• BoE’s Inflation Report to focus on higher inflation as key deterrent to stimulus in May.

• Key US data guides near term outlook, with FOMC minutes in focus.

European elections left their mark on financial markets, with the Bank of England ’s halt to QE also impacting domestic markets. The aftermath of the Greek elections and successive failures to form a government have again raised the prospect of Greece stumbling out of the currency union. Equity markets lost ground and although bond markets are broadly unchanged on the week, mid-week saw new record low yields in ‘core’ economies, while peripheral spreads widened. The euro area will remain the focus of the coming week, although the BoE Inflation Report will provide domestic interest and the US sees a packed calendar.

The European week begins with results from the German State North-Rhine Westphalia election. Chancellor Merkel ’s CDU party is expected to struggle against a resurgent SPD. Yet this could help moderate Germany’s hardline austerity. There are signs of shifting sands across the euro area. The Commission has advocated pushing out Spain’s budget deficit target and conducting an independent banking review. The Bundesbank also acknowledged that German inflation would temporarily be above the euro area average, while Finance Minister Schaeuble discussed above inflation wage increases as alleviating wider euro area pressures. The coming week’s EU finance ministers meetings will discuss additional growth measures. Friday’s G8 Summit in the US could see international pressure brought to bear.

Next week brings first estimates of Q1 euro area GDP. Our global team forecasts an above -consensus euro area outturn, supported by firmer output in Germany. Indeed, recent industrial output and export data look likely to underpin a more resilient than feared German ZEW survey – the first of the euro area’s May business indicators. However, euro area wide GDP data look set to confirm a currency union wide recession, which will add gloomy political backdrop.

Domestically, the Bank of England’s Inflation Report press conference should explain why this downbeat outlook for the euro area, coupled with a UK economy already in recession, did not prompt further stimulus. The conference should focus on higher projected inflation, although in turn this is likely underpinned by a belief in more resilient economic activity than officially reported. The focus on inflation could unsettle interest rate markets that envisage no tightening over the next two years, which could nudge short-end yields higher. We believe growth will underperform the Bank’s February forecasts, and do not expect these to be revised significantly next week. But an eventual down shift in these projections would ease medium-term inflation concerns; reinforce the likelihood of a still distant policy tightening; and open the way for further QE before year-end. This would be exacerbated if tensions in the euro area escalated further.

The US sees a busy calendar. The first of May’s key business surveys may give a clearer directional steer for the economy after recent mixed signals. We expect modest gains in both the Empire and Philadelphia Fed surveys reflecting firmer ISM and NFIB reports recently and in turn boosted by falling gasoline prices. Gas price fal ls should be evident in April’s CPI inflation and retail sales. Minutes to the last FOMC meeting are also scheduled for Wednesday. With several non-voting members advocating policy tightening sooner than the FOMC’s consensus view of end-2014, the minutes should provide a clearer insight into the voting-members’ views. These are likely to maintain that the recovery to date remains modest and that the FOMC stands ready to provide further stimulus if necessary. We remain of the view that this is unlikely in the short-term unless the situation in the euro area unravels significantly. 

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