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The Fed is accordingly expected to proceed cautiously at least initially. In part for that reason our fixed income and FX strategists have only a modest further increase in bond yields and the USD in their forecasts for next year. They project 10Y US Treasuries rising to 2.65% and the USD to 1.02 vs the EUR. The dollar is expected to strengthen more aggressively against both the GBP and the JPY, but even so the gain in the currency overall has been frontloaded into 2016.

Our economists and strategists are cautious partly because the fiscal stimulus is expected to have only a modest impact on growth, at around 0.5% of GDP. That is based on the assumption that some of the proposals will get watered down and that the tax cuts have a relatively low fiscal multiplier. Our US economists think that should the fiscal stimulus be larger and more effective (for which read more infrastructure) then US growth could surprise on the upside to around 3% in 2017 and 3.5% in 2018. That in turn would mean a more aggressive Fed and in all likelihood a bigger rise in yields and the USD.

Chart 15: BofAML sees GDP accelerating into 2018...
Global GDP growth %
DM GDP growth %
EM GDP growth %
[Bar chart data showing projections for 2015, 2016F, 2017F, 2018F]
Source: BofA Merrill Lynch Global Research

Chart 16: ...with inflation picking up too
Global CPI inflation %
DM CPI inflation %
EM CPI inflation %
[Bar chart data showing projections for 2015, 2016F, 2017F, 2018F]
Source: BofA Merrill Lynch Global Research

Reversal: There is good taper and bad taper
The outcome of that would likely affect ECB behaviour too. Our central expectation is for Euro Area growth of around 1 ½% and inflation nudging only modestly higher. A much more robust global economy and a stronger USD (presumably weaker EUR) would likely put upward pressure on both of those. Indeed, in such an environment it is not impossible to think of 10Y Treasuries pushing through 3% and the USD breaking parity against the EUR.

That in turn would increase the pressure on the ECB to start to reverse its very loose monetary policy stance. Tapering would then become much more likely. It would likely push European bond yields higher too, certainly above the 65bp forecast for Bund yields at the end of 2017.

An ECB that tapers because growth and inflation are improving would not be a bad thing for markets. Frankly for some parts of the market, notably banks, anything which gets the ECB away from its current policy stance back towards normality is a positive. Indeed, the prospect of negative interest rates being reversed is the kind of thing which Alastair Ryan (our banks strategist) lies awake at night dreaming of ( see European Banks Strategy: repressed).

But and it is a big but, if the ECB chooses to taper because it is running out of options or the ability to do QE that is not a good thing. Some of the hawks on the ECB would choose to taper at the first opportunity because they never really liked the idea of QE in the first place. A tapering at next week's meeting even if it is couched in terms of doing less for longer would not be good news for equity markets.

Bank of America Merrill Lynch
European Equity Strategy | 01 December 2016
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