Will he, or won’t he?
Tomorrow was supposed to be the ECB meeting when Mario Draghi unveils the “guidance switch”, hinting if not at the (eventual) interest rate increase then at least a small step toward a QE exit. And then today’s Bloomberg trial balloon hit.
As reported earlier, a Bloomberg “sources” story suggested that the ECB will cut its inflation forecasts to 1.5% (from 1.7%, 1.6% and 1.7% for 2017, 2018 and 2019, respectively). If confirmed, this would be rather dovish, and may put any “switchover” plans on indefinite hold. According to SocGen, although the report cites the recent fall in energy prices behind the forecast change, this wouldn’t explain the two-tenths change for 2019, which would need to be explained by a downward revision of core inflation (which remained very optimistic at 1.8%).
The other key elements to focus on will be the risk assessment for growth and the rate guidance. On the first one, the ECB is expected a move to a “broadly balanced” risk profile. That is understandable given the recent trend in business confidence and progress in labour markets. Analysts also expect the ECB to drop the “or lower” and a dropping of the word “well” in “well past.”
That’s the short preview version. Below, courtesy of ABN Amro is the longer one.
ECB Preview: Dovish talk to compensate for guidance switch – The ECB meeting later this week could represent the first small step towards the QE exit. We think the Governing Council will want to strike a balance between making that step and making sure that financial markets do not run too far ahead in pricing in the end of QE. One approach to this would be to alter the risk assessment and forward guidance, but at the same time committing to exceptional monetary stimulus in the immediate future. Specifically, at the June meeting, we expect the ECB to see the risks to economic growth as being ‘balanced’, while dropping the easing biases from the forward guidance. We expect the ECB to drop references to lower interest rates or an extension or expansion of the QE programme. On the other hand, the ECB should continue to signal that QE will continue at least to December 2017 and that interest rates will not rise until well beyond the end of the programme. In addition, the tone should generally be dovish, especially on the ongoing weak evolution of underlying inflationary pressures. Its new projections (see below) will also support such a view. All this would have the aim of curtailing expectations of an early end to the QE programme or early rate hikes. Our base case is that the ECB will start to taper its asset purchase programme from January 2018 onwards. This is not justified by the inflation outlook, but given limits to the programme, we think the ECB has limited options. (see also bullet on the ECB’s buying behaviour below – Nick Kounis)
ECB Staff Forecasts: Lower inflation – The ECB will also publish its new staff macroeconomic projections for GDP growth and inflation later this week. These projections are based on technical assumptions about bond yields, the euro exchange rate and oil and other commodity prices. Looking at the changes in these variables and changes in market expectations, it seems that the ECB will have to significantly lower the assumed levels of oil and other commodity prices and raise its assumption for the euro exchange rate. Taking this into consideration and also looking at recent economic data and changes in economic sentiment, we think that the ECB will keep its forecasts for GDP growth roughly unchanged (at 1.8% for 2017 and 1.7% for 2018). However, its forecasts for headline inflation in 2017 and 2018 will probably be reduced by around 0.2-0.3 percentage points. With regard to core inflation, we think that the ECB will stick to its March forecasts (1.1% in 2017, 1.5% in 2018 and 1.8% in 2019), although we do consider these forecasts – as well as the ECB’s forecasts for wage growth – to be too high. (Aline Schuiling)
Euro Government Bonds: ECB QE data confirms German bond scarcity headache – Purchasing data from the ECB’s QE programme suggests that while the ECB is still able to buy more than its monthly targeted purchase amount overall, it continues to struggle to meet the amount of German bonds it should buy according to the capital key. The main bottleneck of the QE programme continues to be the combination of the relatively small German bond market (relative to the country’s GDP) in combination with the ECB’s self-imposed capital key and issue(r) limit rules. More specifically, the data shows that for the second month in a row, the Bundesbank bought less German bonds than it needs to buy according to the ECB capital key. Furthermore, the German monthly weighted average maturity reached a record low of 3.99 years. This indicates that the ECB unceasingly is forced to buy German shorted dated bonds to even be close to the prescribed monthly purchase amount.
At the same time, the ECB tries to fill in the gaps by buying more of French and Italian bonds. In addition, the ECB has bought less of Dutch bonds than implied by the capital key for the first time, though the undershoot was negligible. Overall, we think that the Bundesbank is slowing down its German government bond purchases, given that it is aware that it would breach issue(r) limits if it did not do so. This underlines that it would not be able to further extend assets purchases beyond December 2017 at the current pace and this is the key reason we expect it to taper from early next year onwards. (Kim Liu)
Some further thoughts from Bank of America on expected language changes:
Change number 1: balance of risks to neutral (on growth)
We think the ECB may acknowledge that the balance of risks around the growth outlook has turned neutral. Actually in April we were close to that, with this notion that the risks were “moving towards a more balanced configuration”. This would be marking to market the ECB’s expectations for growth to the data flow. But at the same time, just like in April, we expect a lot of qualifiers around the inflation trajectory, whose return to a path consistent with price stability would still be deemed dependent on “extraordinary supportive monetary stimulus”. The Philips curve has shifted and it takes more on the real economy to get the same level of inflationary pressure than before the crisis.
Change number 2: remove notion that rates could go lower
If the balance of growth risks turns neutral, it would make sense that the forward guidance around the policy stance stops being asymmetric, ie. that the idea that rates could go lower is removed from the prepared statement. In our view, this is likely to be the most hawkish component, even though it is a “cheap” concession to the hawks.
In principle, the ECB should be ready to take the deposit rate down further, but the central bank has been communicating on the idea that there is such a thing as a “reversal point” beyond which such instrument becomes counter-productive, as the cost to banks’ profitability triggers a drop in credit supply. We are not there, but quite logically, we would get faster to this reversal point if the deposit rate were to fall further.
Such a move would also play well with Benoit Coeuré’s point about the need for the ECB’s forward guidance to be “realistic”. The market has not been pricing a rate cut for a long time. Making no move at all towards an exit strategy – or in the particular case more a tiptoe away from the possibility to do more – could in the end generate a cost to the ECB, if it had to move in the matter of very few Council meetings from dovish asymmetry to the beginning of policy normalization in the second half of the year.
At the same time, we think that “shortening the delay”, ie. removing the “well” from “well after the end of” QE would not make sense at this stage, although Peter Praet has been open to it. The euro has appreciated recently, and even if we think that in practice the first deposit rate hike would not wait long after the end of the net purchases, it would be more prudent in our view to know more about the Fed’s intentions for after the June meeting before making this move. But such “hawkish risk” exists nonetheless as a potential concession to the most conservative wing of the Governing Council.
In theory, if asymmetry goes away from the forward guidance, it should also disappear for QE, and the idea that the program could be upgraded should also be removed. However, we disagree. Forward guidance on rates is explicitly an expectation, ie. the most likely path for the policy stance according to the ECB if their baseline scenario for growth and inflation unfolds. But the notion that QE could be re-upgraded if need be is a “readiness”, ie. a statement on what the ECB would do if an adverse scenario were to materialize. So we believe the change in language on this matter would be a mere qualifier, signaling that this adverse scenario under which the ECB would increase QE’s quantum has become less likely. This would keep the idea alive that the ECB’s self-imposed limits could be reviewed in a bad case scenario for the economy.
Finally, market implications and how to trade the EUR, again from BofA:
EUR implications: buy the dip
The Euro has been strengthening in recent weeks and the market is now long. Eurozone data surprises have been the strongest in G10 economies. ECB officials have been making headlines on the pace of QE tapering and the sequence with depo rate hikes. US data have been mixed at the same time. Following market disappointment that the Euro did not strengthen much after the French elections, the strong data have done the heavy lifting more recently.
In our view, the risks for the EUR are slightly to the downside from the ECB meeting. We expect the ECB to follow a very gradual exit path from unconventional policies and keep its options open for now. Despite the changes that we expect in forward guidance on removing the option to cut rates further, we believe Draghi will likely avoid any details on QE tapering for now and, in any case, will eventually push for stretching (a smaller) QE until end-2018.
However, we would expect the market to buy the EUR dip, if we get one. Our quant indicators and flows still show strong demand for EUR. We also note that the market bought the EUR after dovish comments by Draghi and negative headlines from Greece and Italy pushed it down last week. The fact remains that the ECB will announce this fall its plan for the end of QE next year. Our favorite EUR long trade for the rest of the year is against GBP, as we expect a difficult start for the Brexit negotiations.