We expect ECB to turn more dovish at the meeting later this week, as economic data have pointed to further weakness. There are several issues worth watching for the meeting: rhetoric on economic outlook, instruments to alleviate tightening of credit conditions after the end of QE, and forward guidance on interest rates. Since macroeconomic data have surprised to the downside since the last meeting, we expect ECB to turn more dovish on the economic outlook. It would likely suggest that risk to growth is tilted to downside. On the monetary policy outlook, it would refrain from making any change to the forward guidance, although the market has already pushed back their rate hike expectations.

Further Deceleration in Economic Activities

Germany, the largest economy in the Eurozone, recorded the weakest growth in 5 years in 2018. GDP growth slowed to +1.5% y/y, compared with +2.2% in each of 2016 and 2017. Growth last year was supported by household consumption and government expenditure. Yet, the pace was significantly lower than in the last three years. A report from IFO Institute suggested that “the main reason for the slowdown was the weak rise in value added in German industry, which suffered from the global economic turbulence of last year”. It added that “the uncertainties surrounding the reintroduction of tariffs, the outcome of the Brexit negotiations and the new Italian government’s budget plans have left deep scars on Germany’s key sales markets. But homemade problems, especially related to new emission standards in the German automotive industry, also dampened the economy”.

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Meanwhile, other data signaled that the weakness might not be temporary but could likely persist. As we mentioned in our report last week, headline inflation eased for two straight months, falling to 8-month low of +1.6% y/y in December. Core CPI steadied at +1% y/y during the month, due to weakness in energy prices. PMI, surprising to the downside, fell to a 4-year low of 51.1 in December.

The positive note comes from the employment market, though. The unemployment rate continues to fall, reaching a decade-low of 7.9% in November. However, divergence remains high across countries. While the unemployment rate in Germany was 3.3%, the rate in Spain was still elevated at 14.7%.

At the testimony before European Parliament last week, President Mario Draghi indicated that the region is not heading towards recession. Yet, he admitted that the slowdown could persist longer than expected. At the upcoming meeting, we expect ECB to turn more dovish on the economic outlook. It could likely adjust the rhetoric that the risks surrounding Eurozone’s growth outlook are “skewed to the downside”, rather than “broadly balanced”.

TLTROs

ECB officially terminated the asset purchase program in December. While it would reinvest the proceeds for “an extended period of time” which should well past that of the first rate hike, the credit conditions have inevitably tightened. The increase in borrowing costs would be further exacerbated by the weakening in the macroeconomic conditions. As we have mentioned previously, ECB should offer more hints on a new TLTRO at the upcoming meeting, if it is not going to announce a launch of it. We expect the central bank to make formal announcement in the first quarter of the year.

Forward Guidance on Interest Rates

The market has already pushed back their expectations on the first rate hike to mid-2020. Yet, we expect ECB to maintain its forward guidance that interest rate would stay unchanged “at least through the summer 2019”. ECB probably would wait for more incoming data before making such a change.

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