• At the coming ECB meeting we expect a continuation of the recent ‘delayed, not derailed’ communication entailing a continued easing bias and downside growth risk assessment and no change in forward guidance.
  • We expect the changes to the updated staff projections to be relatively minor and, therefore, still point to an upward trend on both core inflation and the growth outlook.
  • We expect the ECB to announce (favourable) TLTRO modalities, potentially with an incentive structure to a rate of the current deposit rate of -40bp. Further, we expect it to put the tiering discussion in the background.
  • In terms of the financial market implications, we see short-end rates markets suffering initially, although we expect the low for longer/hunt for carry narrative to continue to prevail beyond next week’s meeting. The EUR/USD has not reacted much to ECB policy changes at past meetings, so we do not expect this meeting to be a game changer.

Communication – walking a tightrope…

Financial market participants are much anticipating next week’s ECB meeting. Since the ECB watchers conference in late March, when speculation about a potential tiering system caught significant attention, ECB officials have been silent on policy signals. In our view, the new updated staff projections will gain traction, as hard data have been holding up, while survey data have been on a weaker footing in certain jurisdictions. Combined with lingering risks to the growth outlook, the ECB faces a difficult exercise to communicate confidence in the baseline projections, albeit acknowledging downside risks (intensification of trade war, Brexit and China).

…as market-based inflation expectations deteriorate

Since the end of 2018, market-based inflation expectations have deteriorated markedly. The decline has intensified over the past few weeks. The 5Y5Y and 2Y2Y inflation swap is trading close to an all-time low. As the ECB has previously stepped up its policy stimuli when inflation expectations declined from much higher levels, markets have recently been speculating increasingly about the next stimuli measure. Most prominently, the inflation expectation for the 5Y5Y was just below 2% when Mario Draghi warmed up to do QE in August 2014, which is well above the 1.32% at the time of writing. However, as growth and realised spot inflation are still holding up, we find new stimuli measures premature. Should further stimuli be needed in a risk scenario, we expect the ECB to restart QE (see Guns (and not bazookas) dominate ECB’s crisis arsenal, 9 January).

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Policy measures – TLTRO3 modalities announced, no tiering

We expect the ECB to announce (favourable) TLTRO3 modalities at next week’s meeting. We have previously heard Governing Council members, such as Finland’s Olli Rehn, calling for an announcement at the June meeting. As we argued in ECB Research – TLTRO3: Italy to be main beneficiary, 9 November 2018, the need for new liquidity operations is due mainly to the effect on the Italian banking sector and we find no particular need in other jurisdictions. The minutes from the April meeting (as well as during the press conference) gave a clear message; the TLTRO modalities will depend on bank transmission and the economic outlook.

The most prominent outlier to otherwise relatively strong bank lending data for April was Italy and with risks to the economic outlook on the downside, we expect the ECB to announce favourable TLTRO requirements (potentially down to a deposit rate of -40bp as part of the incentive structure). With the high excess liquidity and current yield levels, we do not expect the series of operations to lead to a balance sheet expansion, as take up would be concentrated primarily in peripheral countries, which already have high take-ups.

The tiering discussion, which gained traction immediately after the ‘The ECB and Its Watchers’ conference (where Draghi said they should be looking into measures mitigating the side effects of negative interest rates, if any), should go into the background. Since then we have heard important Governing Council members, such as the ECB’s Benoît Coeuré, Germany’s Jens Weidmann (German banks stand to gain the most from tiering) and France’s François Villeroy de Galhau (who originally spoke in favour of this), all sounding lukewarm on the idea. Furthermore, the April Bank Lending Survey showed a positive impact on lending volumes from the negative interest rate policy. Similarly, an ECB paper pointed to the positive impact of NIRP outweighing the negative effects. Therefore, we expect Draghi to strike a more muted tone on tiering and repeat that the ECB is always having an holistic review of its policy measures without going further into the details (see more under ECB set to disappoint the fixed income market below).

Importantly, with the tiering discussion, Draghi achieved two important goals: (1) making financial conditions easier and (2) no policy rate changes in the near future, as tiering is part of a low-for-longer narrative. Looking ahead, we do not see the ECB moving on the forward guidance next week, due to the minor changes in staff projections. We update our view so we no longer expect policy rate changes until at least the end of 2021.

A more clouded growth outlook…

At the April meeting, the ECB maintained its downside growth risk assessment and we expect it to continue to do so at the June meeting, despite the better-than-expected Q1 growth rate of 0.4% q/q. One important uncertainty on the updated forecasts is whether they will still show a pickup in economic momentum towards the end of this year. Since March, hard data has generally outperformed soft data. However, despite signs of strengthening domestic demand, business surveys point to continued headwinds in the manufacturing sector, with the risk of these broadening out to the service sector. In recent months, the ECB has increasingly become concerned about the negative impact of persistent political uncertainty on business confidence and investments and, in light of the re-escalating US-China trade war, this risk has become even more pressing. Note that staff projections will not include the effects of tariffs that have not taken effect.

Some Governing Council members were already losing confidence in the projected upturn at the April meeting as the minutes revealed. Hence, in the updated ECB projections, we expect to see a more cautious growth message, with a downward revision of the growth forecasts for 2020 and 2021 to 1.5% and 1.4%, respectively (see table below). That said, we expect Draghi to emphasise that the economy remains some way off recessionary territory and, therefore, does not yet warrant further policy measures beyond favourable TLTRO3 terms.

…leaves markets sceptical about any pickup in core inflation

Despite an increase in oil prices of almost 40% since the start of the year and core and headline inflation surprising on the upside at 1.3% and 1.7%, respectively, in April, inflation market pricing has remained subdued. As fears about a cyclical downturn in the economy have intensified, market-based inflation expectations have continued to slide, with 2Y2Y falling below 1%, the lowest rate since 2016.

The ongoing fall in inflation expectations is an obvious worry for the ECB but we expect it to hold on to its narrative that rising wages will eventually push up underlying inflation pressures. Technical assumptions of higher oil prices and a broadly unchanged effective euro, plus easier financial market conditions, should, on balance, lift the ECB’s inflation profile. However, we expect a weaker growth outlook and energy price base effects exerting a stronger drag in 2020 due to the steeper slope of the oil forward curve to offset this.

Since March, the ECB’s narrative has stressed that the inflation pickup has been delayed, not derailed. We agree with Draghi that the structural conditions for pass-through from wages to prices remain in place and we still see strong arguments for core inflation to reach 1.3-1.4% by year-end. However, in light of the slowing expansion pace, core inflation rates at 1.6% on average in 2021 as the ECB is likely to predict still seem optimistic to us (see also Euro Area Research – Inflation under the microscope: simmering, not boiling, 13 May).

We do not think the appointment of Philip Lane as the ECB’s new Chief Economist will have impact on the economic outlook or assessment.

ECB set to disappoint the fixed income market

ECB set to price lower probability of a rate cut

The European fixed income market might be in for at least a short-term disappointment if the ECB delivers the message we expect. In particular, the short-end could see upward pressure. Over the past month, the market has started to price in 5bp of accumulated rate cuts over the next 12 months. This compares with the end of April, when very little was priced in the curve. We find the pricing stretched if the ECB does not open the door for further easing.

For the current market pricing to materialise (on a 12-month horizon), we would have to see either (1) a discussion on rate cuts as a stimuli tool or (2) a stepping up of the discussion on a tiered rates system, including a cut in the lower-bound rate. We do not see an extension of the current forward guidance at this stage due to the only minor changes to staff projections. Furthermore, note that the current guidance of ‘at present levels’ means neither cut nor hike in the forward guidance period. Recall that the ECB removed ‘at present or lower levels’ from its guidance in June 2017. Therefore, should markets put weight on Draghi’s words, the confirmation or potential extension of forward guidance may put a mark in the front of the curve, at least initially. It is still too early for markets to remove completely the probability that the next move might be a cut but as we doubt the ECB will opt for any of these options as its policy response toolbox, we repeat our recommendation from Government Bonds Weekly, 16 May, to pay 9M3M EONIA

Little impact on 10Y yields expected

Bunds have seen support over the past couple of weeks and the 10Y yield has fallen to -15bp. If our expectations are correct, we should expect to see a modest repricing of ECB expectations. However, the result should be a modest bearish flattening of the 2s10s German curve. We strongly doubt the market will move forward ECB hike expectations. In addition, as a disappointment would tend to weigh on risk appetite and support Bunds, we are reluctant to call for any significant move higher in 10Y yields after the ECB meeting.

FX market isn’t buying ECB’s easing bias

Contrary to the rates markets, the FX market does not share the general perception of fixed income markets. In other words, the FX market is calling the ECB’s bluff. Following all three ECB meetings this year, the market has bought EUR/USD – in particular, this was the case after the first two meetings, when the ECB made its policy shift (see chart below left).

We envisage a broader trend emerging this year: inflation expectations are declining to worryingly low levels and the euro has started to appreciate recently (see chart below right). The FX market seems to be concluding that the ECB is about to fall to the liquidity trap and it needs action, not words, before selling the euro. Since, we do not expect any news from the ECB at the upcoming meeting, we see small upside risks to EUR/USD around the meeting given that the market already prices in the rather bleak outlook for inflation.

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