• The ECB’s decision today to extend the forward guidance to ‘at present levels at least through H1 2020’ were on the dovish side of our expectations, but significantly more hawkish than markets expected. However, the price action after the press conference suggest that markets don’t expect Draghi to have been dovish enough. TLTRO3 modalities came in as broadly expected.
  • The European hunt for yield environment continues after today’s meeting. Front end fixed income markets reacted strongly to the decision of rates not being cut in the near future, with EONIA 1y1m EONIA jumping 4bp on the decision. Long dated yields basically unchanged. Markets will not sell EUR until rate cuts or ECB easing measures are clearly discussed.
  • The updated staff projections were broadly unchanged, leading to an unchanged baseline narrative, although the external environment posed a more prominent risk than previously.

A Draghi special

Draghi was on the dovish side today raising concerns with the risks to the baseline narrative stemming from the external environment. However, Draghi was not dovish enough to deliver on the front end as ECB confirmed that rates will remain at present levels at least through the first half of 2020. As a result, the major expectations that were built up in markets ahead of the ECB meeting to cut rates by end year saw major disappointment. Prior to the meeting markets priced almost a 50-50 chance of a rate cut in September this year.

Draghi made sure several times during the press conference to stress that all options are on the table, including rate cut and restart QE, which was mentioned during the discussions in case of contingencies. Therefore, we do not find that surprising (in fact prudent), as a central bank should always discuss all its policy options. Unfortunately, Draghi didn’t provide any flesh to the discussion as the real details and how to structure a potential restart of QE were left unsaid.

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The TLTRO3 modalities came in as broadly expected mirroring the TLTRO2, although with the incentive structure build from MRO+10bp to depo+10bp (compared to TLTRO2 which were MRO to depo rate). There are no options to repay early in the operations, which makes the TLTRO3 a liquidity measure rather than a monetary policy measure.

The growth and inflation remain broadly unchanged although with more prominent risks (Brexit, trade war and China) and labour market tightness (see more in next section).

As expected, Draghi said that the deteriorating inflation expectations are being taken seriously, but nothing that warrants change so far in the monetary policy stance as inflation expectations are anchored in the surveys (note the SPF from April pointed to inflation at 1.8% in the longer term). He further noted that there is no risk of deflation but there was the shift in inflation pricing distribution. In other words, the negative risk premium and the cyclical nature of the inflation market pricing makes the ECB believe no real de-anchoring at this stage.

Staff projections: a broadly unchanged narrative

The staff projections were little changed compared to the March vintage. Most noteworthy was the 2020 growth projection which was revised down by 0.2pp as well as an upward revision of 2019 growth (which is attributed to a strong Q1 figure of 0.4% q/q). That said, the risk drivers were more prominent than previously as Draghi also pointed to a somewhat weaker growth momentum in Q2 and Q3 this year, mainly reflecting the external trade environment which weighed on the euro area manufacturing sector.

The overall narrative of economic expansion continuing was emphasised several times as ECB stressed that the expansion is expected to continue due to favourable financing conditions, fiscal support and the strong labour market – although there were nothing new in this.

The inflation projections were only marginally changed, although with a small revision this year driven by the energy component. The ECB continues to find the underlying inflationary pressures generally muted albeit with a confidence in a tight labour market and ‘stronger wage growth’. Importantly, core inflation was broadly unchanged. In other words, inflation is delayed, not derailed.

Note that the ECB projections do not take into account the recent escalation in the USChina trade deal.

 

FI: Draghi to flatten the curve 5s10s

The ECB statement and press conference was a disappointment for the fixed income market and the market has consequently lowered the probability of a rate cut. There is now priced 8bp of cut on a 12M horizon. However, importantly Draghi did mention during the press conference that ECB board members had during today’s session raised the possibility of rate cuts or restarting QE as a contingency tool, however we believe that it should be seen in a context of a broader discussion on contingency plans.

We doubt we are in for an extended Bund sell-off. The market will still see the risk skewed towards a future rate cut given the prominent risks lurking in the horizon. Furthermore, today’s announcement will do very little to lift inflation expectations that trade close to an all time low and arguments of it being de-anchored have floated the markets. 5y5y EUR inflation forward falling further after the announcement, now standing at 1.27% – a level where ECB previously stepped up its stimuli at an earlier stage. Hence, today’s flattening of the German curve 2s10s and 5s10s is fair.

The direction of Bunds for the coming days will depend on how other risk-markets receive this. The ECB on hold in a situation where the Fed is embarking on easing does not necessarily bode well for risk-appetite and EUR/USD could be pushed higher – adding further downside for eurozone inflation.

We saw today that the Italian bond market came under pressure as stimuli were lacking and as the modalities of the new TLTRO were marginally less attractive than expected. Draghi actually underlined that there is a risk that the TLTRO’s will justify ‘carry trades’. Remember, the TLTRO’s are basically designed to support periphery banks. Spain and Portugal continued to outperform as investors look for alternatives to negative yielding core and semi-core bonds.

FX: EUR rises on (not enough) dovish ECB, compared to market

EUR rose across the space of G10 currencies today as the dovish market expectations were left gravely disappointed. The lack of clear hints that easing, either in terms of rate cuts or QE, is coming means that the market will find a hard time selling EUR on the expectation of easing unless ECB officials start addressing this in public. After a week where Fed and ECB monetary policy has been in focus the market is now left with a Fed ready to cut rates and an ECB which has only started discussing how it would respond if the economy deteriorated even further. The monetary policy divergence supports our 6M forecast for EUR/USD of 1.15.

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