The period of GDP contraction and tumbling inflation has ended in the Eurozone. The recession has technically ended in France and Germany and inflation will start to tick higher in August. Despite this more favorable picture, we believe that tighter monetary policy is still a long way down the road for the ECB. The current economic recovery is driven primarily by temporary factors and we believe that sustainable recovery will be very slow in the making. The output gap – the single most important gauge of inflationary pressure - is set to remain wide for at least the next two years. In our opinion, the first rate hike from the ECB is unlikely to occur before the second half of 2010, and even then we expect only gradual policy tightening. The recent steepening of European yield curves reflects this, and we see some risk of further steepening.

Slow Recovery…
The second half of 2009 is likely to see a return to positive territory for both GDP growth and inflation. On the growth side, after the improvement seen in Q2, fiscal stimulus, the end of the de-stocking process and the global recovery will continue to support the Eurozone economy. On the inflation side, higher commodity prices will start to impact prices as soon as August. However, the sustainability of the recovery remains uncertain. New catalysts for growth will be needed once the positive impact of the inventory cycle and fiscal stimulus is over. Lending standards remain tight and the labor market deterioration is far from over. As a result, Eurozone growth is set to stay below trend (i.e. below 2%) at least until 2012.

… Will Leave a Large Output Gap
The slump in demand has resulted in a massive widening of the output gap to the highest levels seen in the post war era. Even with an optimistic growth scenario (3.5% in 2010 and 2011), the output gap would not close in 2011. As long as the output gap remains wide, unemployment will climb higher and pricing power and wage growth will remain weak, keeping inflationary pressures muted. Importantly, the impact of the crisis on potential output is unknown. But the odds are that it has been reduced with some parts of financial intermediation permanently impaired. This would imply a lower output gap (given lower trend potential growth) and higher inflationary pressure. This combined with structurally higher public debt could result in higher market interest rates than over the last decade.

First In, Last Out for Monetary Policy Measures
Given a still wide output gap, the ECB can maintain its current loose monetary policy stance without jeopardizing its price stability objective despite the ongoing recovery. In our opinion, the ECB is very likely to keep its interest rate at 1% until H2.10. This is also consistent with recent ECB rhetoric.
Nevertheless, ECB policymakers have to plan their exit strategy. We believe that the ECB will reel in unorthodox measures well-before it actually hikes rates. If the ECB were to raise rates before its 1-year refinancing operations come to an end, the ECB would then earn less on these operations than it would pay for its short-term re-borrowing operations. To avoid that the ECB could add a premium to the interest charged in its future long-term repo operations. The next one – due in September – will give some indication of the future ECB rate path.

Risks of More Bear Steepening
Recovery has brought some steepening of the yield curve, but in an atypical shape, as the steepening at the short end (repo to 2-year) has been fairly modest. On the medium to longer segments, however, the curve is close to historic peaks with the 10-year to 2-year spread now at just over 200bp. This is consistent with our view of a slow tightening from the ECB. In a typical recovery, bear flattening comes a few months before the central bank starts hiking. In our opinion, however, short term, the risk remains that the curve could steepen further.