• Minor downgrades to ECB’s growth outlook
  • Guidance on rates to remain unchanged, but its flexibility may be emphasised Prospect of new TLTRO’s in June
  • Gently positive for EUR/USD and EUR rates

We retained two things from the ECB’s first policy meeting of the year back in January. First, the central bank didn’t wait for new growth and inflation projections to downgrade the balance of risks to the eco scenario. The central bank clearly stated that they moved to the downside. Second, ECB President Draghi highlighted a split between governors who fear that the temporary slowdown will affect the confidence channel and hence take on a permanent character and those who expect that weakness would likely be temporary and would accordingly be irrelevant given the medium term orientation of ECB policymaking.

Over one month has passed since the January 24 ECB meeting and developments in the interim have been broadly consistent with the second view that current weakness may prove temporary. From an event risk point of view, the economic clouds are not quite as dark. US President Trump dropped (at least for now) his threat to impose 25% tariffs on all Chinese exports, the probability of a hard or no-deal brexit appears to have declined and the US government shutdown has ended. However, rising trade tensions between the EU and the US over car (parts) imports is a new short term risk.

The stabization of EMU eco data also suggests that the EMU economy is not in freefall and could gradually recover from a dismal Q3 and Q4 2018. Q1 2019 GDP won’t be bright, but at least another big setback will be avoided. The EMU composite PMI ended a 5-month declining strike by ticking up from 50.7 to 51.4. The January and February data suggest 0.1% Q/Q growth in the first quarter. Details showed a significant dispersion between externally oriented manufacturing (weak) and domestically driven services (strong) gauges. This variation will likely prompt some ECB officials to argue that there is no pressing case to boost domestic demand further through increased monetary accommodation and that the continuation of the current very slow pace of normalization remains the appropriate policy path.

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Inflation pressures remain subdued, but the situation also didn’t deteriorate. EMU core inflation is stubbornly low at 1% Y/Y in February while headline inflation picked up towards 1.5% Y/Y, thanks to the revival of the oil price. Importantly, inflation expectations, as measured by the 5y5y EMU forward inflation swap, stopped declining. The measure fell from 1.7% early November to 1.43%in February. Over the past days, we’ve seen a welcome if modest rebound to 1.5%. The majority within the ECB is still of the view that tight labour markets and upward wage pressure will lift core inflation to the central bank’s 2% inflation target over the medium term even if there is an acceptance that this process may take more time than previously thought.

The ECB council will consider new staff growth and inflation projections at this week’s meeting. In December, the central bank forecasted 1.7% growth this year and in 2020 and 1.5% in 2021. CPI was expected to gradually rise from 1.6% this year to 1.7% next year and 1.8% in 2020. Growth forecasts will be subject to downward revisions, especially for 2019 given the disappointing end year figures for 2018, but the likelihood is that revisions will be relatively modest for 2020. Market expectations have been building that a new downgrade would be complemented by a change/delay in the ECB’s forward guidance on interest rates. The ECB, since June last year, has vowed to keep policy rates unchanged at least though the summer of 2019. However, markets anticipate a longer wait for the first tightening move. The 3- month forward Euribor strip curve only discounts a 20 bps deposit rate hike by the end of 2020.

Recent rhetoric from prominent ECB members suggests that developments don’t warrant changes to the ECB’s (interest rate) normalization plans.The current wording is open ended in terms of when tightening might begin and this aspect will only become meaningless in terms of guidance as we move into summer.

At the January meeting, ECB president Mario Draghi emphasized that markets fully understood its dual nature that made it date and state contingent. Hence, as the ECB has committed not to tighten before the end of the summer and not until it is confident that inflation is clearly set on a path towards its medium term target of below but close to 2%, there is no need at present to significantly alter this forward guidance at this point in time. A pressing case for a substantive change in guidance would only be warranted now if the ECB felt financial conditions were too tight or the risks of a lasting and severe stepdown in growth and hence in inflation prospects had greatly increased.

The message from recent comments from a range of officials suggest this is not the case. Philip Lane, who succeeds chief economist Praet in June, said that Europe isn’t in a “super fragile situation”. The ECB’s current strategy can deal with the downward revisions in data. It needs a bigger or more persistent shock (eg unemployment to go up again and inflation to actually go in reverse) to prompt action to reach the 2% inflation target over the medium term. French ECB member Villeroy de Galhau warned against applying negative interest rates for too long because of “possible adverse consequences for the smooth transmission of monetary policy”. Hawkish Bundesbank governor Weidmann clearly stated that there’s no acute need to adjust the ECB’s rate guidance, nor to be overly pessimistic about the outlook.

One special topic likely to command increasing market attention will be the prospect of developments in regard to the ECB’s liquidity providing policy. The ECB’s 4 remaining outstanding Targeted longer-term refinancing operations mature between June 2020 (€379.85bn) and March 2021 (€233.2bn). The September 2020 (€44.31bn) and December 2020 (€61.48bn) maturities are smaller. Over the past months, rumours repeatedly suggested the ECB might announce an extension of these TLTRO loans by mid- 2019. The TLTRO-loans are included in commercial banks’ long-term liquidity ratio’s (NSFR). These will face a negative impact when the residual maturity drops below 12 months (50% haircut) and below 6 months (100% haircut). Cashstrapped banks will have to rely on market funding to replace these TLTRO’s which might come at a heavy cost and effectively amount to a monetary policy tightening. We don’t think that the ECB wants to send such signal. Indeed, the account of the December policy meeting suggest the matter had been raised by some governors.Therefore, ECB President Draghi might this week ask an ECB task force to exploit the options to replace TLTRO’s.

Markets currently expect a TLTRO extension. We expect a significant market reaction (widening spreads, higher yields, slightly stronger euro) if the ECB doesn’t address this issue or hints at an end to the TLTRO-programme. A largely unchanged forward guidance on interest rates, ie while Mr Draghi may emphasise the policy flexibility that the current guidance allows, is also likely to keep open the option of an end of 2019 rate hike. In current market sentiment, the absence of a clear shift in ECB guidance could help the euro higher and extend the recent rebound in European yields, steepening the curve. Rather than fundamentally alter the ECB’s message, Draghi could remind markets that patience has been repeatedly emphasized as a key element in the ECB’s policy stance and that at least in this regard the US Federal Reserve may now be following the ECB’s lead. In such circumstances, markets might enjoy new reflationary momentum with increased confidence that central banks are side-lined, event risk is diminishing and growth and inflation data may be set to pick up.


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