Market consensus leading up to this Thursday’s ECB Governing Council meeting is that there is likely to be no announcement of any change in monetary policy. Instead, topics that economists and market participants are hoping to have addressed are the ECB strategy review, including inflation targeting and the effectiveness of the current debt purchase program, especially following the Fed’s recent dovish monetary announcement, and the effects the second wave of coronavirus across Europe is having on the path to economic recovery.
Below we preview the ECB meeting with commentary from Konstantin Veit, Portfolio Manager at PIMCO, Gilles Moëc, Chief Economist at AXA IM, and Alex Botte, Global Strategist at Ostrum AM.
Konstantin Veit, Porfolio Manager at PIMCO
The ECB Governing Council meets on Thursday and we expect no material changes to monetary policy, after having upsized and extended the Pandemic Emergency Purchase Programme (PEPP) in June. For now the ECB is on auto-pilot. Looking ahead, we expect it to upsize and extend the PEPP again in December, from the current €1.35 trillion purchases through to end June 2021, as the inflation outlook fails to sufficiently converge towards the pre-pandemic configuration over time. The Governing Council might use next week’s meeting to prepare the market for further easing in December.
ECB policies support European risk assets but spreads have come in a long way, the environment remains characterised by higher than usual uncertainty about the macroeconomic outlook and question marks persist about national and pan-European leaders responding to the crisis in sufficient quality and scale.
President Lagarde might get questions during the press conference on the status of the ECB’s strategy review, particularly after Fed’s adoption of average inflation targeting. ECB Executive Board members keep reiterating that lessons from the policy response to the pandemic shock will also feed into the monetary policy strategy review, so we would expect questions on what those lessons might be in light of the Fed’s changes. The pandemic postponed the review by around half a year; it is supposed to resume this month and the ECB aims at presenting the outcome of the deliberations during the second half of 2021. So while questions might come up now and the review comes into sharper relief during the rest of the year, it is probably too early for Lagarde to disseminate significant insights at this stage. We continue to expect evolution instead of revolution and, similar to the last review in 2003, we don’t expect radical investment implications as a result of the exercise.
President Lagarde will almost certainly get questions on the Euro’s recent strength. In line with traditional ECB communication on that matter, we believe she is likely to repeat that the ECB does not target the exchange rate while acknowledging that the currency has an impact on inflation. Similar to ECB colleagues, she might highlight that the Euro is not overvalued, context matters and that the extent of pass-through into inflation is uncertain. Overall, while she will surely refrain from encouraging adverse exchange rate developments, we don’t think she will display serious unease about the value of the common currency at this stage and expect her remarks to be balanced.
Gilles Moëc, Chief Economist at AXA IM
Unlike Jens Weidmann, Philip Lane, the ECB’s chief economist clearly welcomes strong – and lasting – fiscal support. In his speech in Jackson Hole he explicitly saluted the emergence of the ERRF and concluded that “an ambitious, high-quality and coordinated fiscal stance is central to securing a strong recovery across the euro area and constitutes a vital complement to the support provided by monetary policy”. Through this unambiguous statement we can feel the ECB’s concerns over its capacity to deliver on its target alone.
The heart of his argument is that the pandemic – without policy reaction – shifts the inflation trajectory downward. The recent dataflow on this front unfortunately confirms the deflationary impact of the crisis, with consumer prices even falling in negative territory in August in the Euro area. Accepting this downward shift would create risks of a self-fulfilling deflationary spiral, with (i) real interest rates remaining too high and (ii) ultra-low inflation becoming entrenched in the expectations of economic agents. This calls for a two-step approach from the ECB. First, the Pandemic Emergency Purchase Programme is described as a temporary but “intense” phase of additional monetary stimulus to offset the pandemic shock. Then, to quote Lane’s exact words, “once the negative shock has been sufficiently offset, the second stage is to ensure that the post-pandemic monetary policy stance is appropriately calibrated in order to ensure timely convergence to our medium-term inflation aim. To these ends, the ECB Governing Council stands ready to adjust all its instruments, as appropriate”. We would interpret this as a signal that quantitative easing would be boosted and remain in place long after the end of PEPP.
A thorny issue though is that while the ECB has explicitly taken “liberties” with its usual limits with the PEPP, at least for now this does not apply to the other quantitative easing programmes. So, from a technical point of view, assuming inflation remains stuck on a slow pace, the ECB will have to either turn the PEPP into its de facto “go to” instrument or extend to the Public Sector Purchase Programme the same relaxation in limits. Understandably, this is a discussion the Governing Council would rather have later than sooner. For now, the hawks at the Governing Council would probably prefer to see as little change to the current framework as possible. Extending in time or in size PEPP could be seen as a signal it is turning into a permanent instrument.
Axel Botte, Global Strategist at Ostrum AM
ECB chief economist Philip Lane reminded market participants that the euro exchange rate “mattered” as the single currency breached $1.20. ECB talk triggered unwinding of long positions on the euro causing a pullback to $1.18 whilst reversing US curve steepening. The dollar regained ground against most currencies. In terms, Bund yields fell back to -0.45%. After a drop to 0.65% area, T-note yields closed last week above 0.70%. Nasdaq dropped sharply intraday on both Thursday and Friday. The weakness in the Tech-heavy index did not spark widespread risk aversion but it does highlight the speculative nature of the summer rally. European markets have resisted, especially the battered bank sector in response to consolidation efforts in Spain. Sovereign spreads (Italy 10-year near 150bp) have absorbed heavy bond supply last week. Credit spreads were unchanged last week (115bp against Bunds). High yield tightened despite wider synthetic spreads in the wake of the implied volatility’s rise.
ECB jawboning the euro
Last week in financial markets saw the euro rise above the $1.20 threshold. ECB chief economist Philip Lane intervened recalling market participants that the exchange rate “mattered”. The single currency traded down to $1.18 shortly after the comments. Currency appreciation amid near-zero inflation in the euro area is unwelcome for future price developments. Christine Lagarde’s message next Thursday after the governing council will likely echo Lane’s comments. The policy stance is unlikely to change, even though the ECB still has the possibility to sweeten TLTRO-III terms or prolong asset purchase programs.