Traders are eagerly anticipating Thursday’s meeting of the European Central Bank (ECB), with some contemplating whether President Mario Draghi’s actions could radically reschedule when the central bank’s first rate hike could come.
Back in July, Draghi said that discussions regarding a change in monetary policy stance will begin in the fall. In September, he then indicated that the bulk of the decisions regarding the asset purchase program are likely to be made in October. With autumn leaves now lining the streets, markets are expecting the “fall” decision to come this Thursday.
Herein lies the challenge. What can the ECB do that will simultaneously:
-Keep the doves happy (including Draghi himself who has said that considerable stimulus may still be needed to get inflation back up to 2 percent)
-Placate the hawks who are getting nervous about too much accommodation backfiring
-Keep peripheral yields pinned (especially given the Catalan backdrop and Italian elections next year)
-Ensure that the market doesn’t materially bring forward the timing of the first rate hike which would then cause an unwarranted appreciation in the currency
-Avoid running into any (self-imposed) technical constraints due to the limited supply of bonds left in the universe for the ECB to buy, particularly pronounced in Germany.
It’s no easy task. Which is why the compromise may be that the asset purchase program — which is set to expire in December — is extended into the latter half of next year but with a much smaller monthly net purchase amount. (Gross purchases will stay positive as the ECB re-invests the proceeds it gets from buying debt, which will average about 15 billion euros per month in 2018).
The central bank has remained ultra-accommodative in the years since the global financial crash and the euro zone sovereign debt crises, and also introduced U.S.-style quantitative easing (QE) — buying assets to stimulate lending — which is used to stoke inflation and boost the economy.
While analysts agree that the program will be pushed out into 2018, there are a range of views on both the size and duration of that extension. In the last few weeks the consensus has shifted towards a longer horizon, with the expectation now potentially a nine-month extension of 30 billion euros a month (versus the current 60 billion euros). This would constitute a tapering of some sorts though the ECB will argue that it is a re-calibration rather than a path towards zero.
‘Most market neutral’ outcome
Citi analysts estimate that the “most market neutral” outcome is a total 270 billion euro package. According to their analysis, any permutation less than that amount would be hawkish. For example an announcement of say 20 billion euros for nine months would be very bearish for fixed income and positive for the currency.
Language on forward guidance will also be parsed closely. Most analysts expect that the ECB will reiterate that key interest rates are “likely to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases” in its opening statement.
The wording is crucial because of the sequencing argument that purports that a first rate hike can only happen once the asset purchase program has fully terminated. UBS analysts think that a “(relatively) long nine-month commitment on the QE (quantitative easing) side should support (the) ECB’s guidance that interest rates will not go up for some time.”
Short-term interest rate traders agree that the duration of the extension is a lot more relevant for interest rate expectations than the monthly purchase amount.
The market is currently pricing in the first 10 basis point hike by the ECB in the first quarter of 2019 and the first full 25 basis point hike in early 2020. If the ECB only announces a six-month extension, traders think the market would be quick to bring forward the timing of the first rate hike.
The other big question is whether or not the ECB is going to leave the door open to add more purchases. Currently the ECB suggests that the net asset purchases are intended to run until the end of December 2017 “or beyond if necessary.” The ECB may choose to keep the end date open-ended (by keeping the “beyond if necessary”) but removing the phrase would signal a finite end to QE — another hawkish signal.
With the single currency having given back some of its strength versus the greenback since the last ECB meeting, exchange rates should feature less in these October discussions. However, the committee will no doubt be looking to engineer an outcome that avoids another leg up in the currency and a tightening of financial conditions.