Euro area: clouds on the horizon
The short-term outlook for the euro area has deteriorated rapidly as restrictions taken by different governments to contain the renewed spread of the coronavirus kick in. We now see euro area GDP contracting by 3.5% q-o-q in Q4, leaving GDP 7.7% below its level the year before. Risks to our growth outlook remain titled to the downside. The key uncertainty is how quickly European countries manage to bring the infection rate down and keep it down. We could end up with a longer lockdown than initially planned by most governments just as renewed restrictions are being increasingly challenged.
In our baseline scenario, we assume that at least some restrictions will endure into early 2021, meaning that the rebound in economic activity in Q1 is likely to be modest (+1.2% q-o-q). Growth could accelerate in Q2 should a vaccine appear that allows governments to ease measures and restores business and household confidence.
The impressive rebound in Q3 shows how successful European economic policy was at mitigating much of the damage from the lockdowns of March/April. More of the same will be needed to sustain the recovery going forward. Countries have already been announcing fresh packages to cushion the impact of the new lockdown measures. At the EU level, approval for Next Generation EU funds needs to come by December for deployment as quickly as possible.
At its latest policy meeting, the ECB was unusually clear in signalling that further easing of its monetary stance was coming in December. We expect its Pandemic Emergency Purchase Programme (PEPP) to remain the ECB’s preferred tool of choice. We are sticking with our forecast of a €500bn expansion to the PEPP programme in December and think more is coming further down the line. As well as the PEPP, the ECB’s regular open-ended asset-purchase programme could be expanded, perhaps from €20bn to €40bn per month. We also expect the ECB to ease TLTRO-III conditions.
Despite the uncertain outlook, in our central scenario we continue to see the 10-year Bund yield rebounding slightly to -0.4% by year’s end (although this is less than our previous forecast of a rebound to -0.2%). Contrary to current market expectations, we do not expect the ECB to cut the deposit rate in December, remaining focused instead on quantitative easing. Moreover, current lockdown measures should hurt economic growth less than in spring while the likely announcement of a vaccine could boost market confidence in H1—and also inflation expectations.