Euro area rates review

The stimulus package announced by ECB President Draghi at the December policy meeting underwhelmed market expectations. Having previously indicated that "we will do what we must to raise inflation as quickly as possible", in the end, the ECB announced a 10bps reduction in the deposit rate to -0.30%, less than markets had been pricing in. The extension to the QE programme was also less than had been expected. 

Yet crucially, the ECB revised lower its CPI inflation by 0.1pp for both 2016 and 2017 to 1.0% and 1.6%, respectively. This implied an even greater undershoot of the 2% target ceiling than previously forecast, although Mr Draghi noted that inflation expectations were largely unchanged, despite further declines in the oil price. This seemed to be a nod to the views of the more hawkish members of the Governing Council, who were likely against increasing the pace of asset purchases, that existing QE measures are already working well. 

While this may be the case, unlike the US and the UK, domestic price pressures in the euro area are likely to remain weak, given the greater degree of spare capacity. Euro area GDP growth slowed a little to 0.3%q/q in Q3, but the economy appears to have weathered the softening of global activity, helped by signs of strength in domestic demand. Nevertheless, the pace of overall growth remains moderate. As such, further easing remains a distinct possibility. 

While some Governing Council members have expressed concern that further monetary easing could delay the pace at which member states deliver structural reforms, any significant downturn in inflation expectations is likely to reduce opposition to further monetary easing. A further reduction in the deposit rate, an extension to the QE programme beyond March 2017 and an increase in the pace of monthly purchases remain the most likely options. Consequently, 2-year benchmark German bond yields are projected to remain in negative territory throughout 2016. 

"We expect 10-year benchmark German bunds to outperform their US and UK counterparts, with 10-year yields at 0.9% at end-2016", says Lloyds Bank.