ECB: Contours of a Cautious Exit Plan

Published on May 31, 2017
SGH Insight
A dovish ECB - even as it exits from QE and negative rates - may put some initial downward pressure on the Euro. But an ECB embarked on policy normalization that faces little if any inflation pressures can remain highly supportive of the Eurozone recovery, and in the context of a market eager to embrace a positive European growth story, capital flows may if anything support and push the Euro higher. We think that could be all the more so when juxtaposed with a US outlook that has turned cautious over political gridlock, second half rate hikes, and inflation.

Market Validation
(Bloomberg 6/29/17)
Euro at 13-Month High as Bulls See Opportunity in ECB Taper Talk

The euro rallied to the highest level in more than a year while a slump in German bunds deepened on speculation that the European Central Bank is edging closer to a decision to scale back monetary stimulus.
Europe’s common currency has strengthened against all but two of its major peers in the past week as President Mario Draghi said Tuesday that reflationary forces had replaced deflationary ones in the region. Yields on German 10-year bonds are headed for the biggest weekly increase since early March.
While the sharp currency and bond swings may have vexed ECB officials, prompting comments that markets had misinterpreted Draghi’s remarks, many analysts and investors remain convinced that this week marked a turning point in the outlook for euro-area monetary policy.

The shared currency rose 0.4 percent to $1.1425 as of 9:57 a.m. in London, taking its gains in the past five days to 2.4 percent.

With growth, and a bit of inflation, finally taking hold across the Eurozone, the leadership of the European Central Bank has started the process of steering market expectations towards an exit from its highly accommodative, unconventional monetary policy.

*** As a first step, the ECB will adjust its balance of risk assessment to the upside when it meets on Thursday, June 8, in Tallinn, Estonia (SGH 4/26/17, “ECB: Roadmap to an Exit”). Our understanding, however, is that while the Governing Council is almost certain to adjust its balance of risk assessment for growth next week as expected from the downside to neutral, it may very well choose to keep its balance of risk for inflation still leaning to the downside. ***

*** That caution on inflation going forward will permeate a press conference where President Mario Draghi will have a good deal to be pleased about on the growth outlook, but which will be tempered by an inflation forecast for 2018 that may even be revised downward from the quarterly forecasting exercise conducted last March, and still heavily dependent on accommodative policy. ***

*** A low inflation, yet solid and broad-based growth outlook, will reinforce expectations for an extremely cautious policy path and exit plan from unconventional monetary policy when it is likely to be formulated next quarter, at the ECB’s September 7 meeting. The Governing Council will studiously avoid any bond tapering specifics at this meeting, but as things stand, we expect the ECB will announce in September and start to taper its 60 billion Euros per month bond purchase program in January of 2018 at a pace of 10 billion Euros per month. ***

*** And despite constant speculation to the contrary, there is absolutely no rush, or pressure from so-called hawks or elsewhere, to get on with rate hikes even from the highly unconventional -0.4% deposit rate. The first hike is likely to come at the very earliest in the third quarter of 2018, after the taper is fully completed, and could come even later than that. ***

A dovish ECB – even as it exits from QE and negative rates – may put some initial downward pressure on the Euro. But an ECB embarked on policy normalization that faces little if any inflation pressures can remain highly supportive of the Eurozone recovery, and in the context of a market eager to embrace a positive European growth story, capital flows may if anything support and push the Euro higher. We think that could be all the more so when juxtaposed with a US outlook that has turned cautious over political gridlock, second half rate hikes, and inflation (see SGH 5/22/17, “Fed: A September Pause”).

Broadly United on Rates

After some early misfires, the core leadership at the ECB is now fully aligned in sequencing rate hikes to follow the end of the taper of its asset purchase program, even if the exact pace and timing of its exit plan is yet to be determined by economic developments and the forecast.

Strongest on this message has been Chief Economist Peter Praet, who was quick to clamp down on the short-lived but violent de-anchoring and volatility along the entire yield curve that was caused when Austrian National Bank Governor Ewald Nowotny questioned the need to necessarily keep the short-term deposit rate negative for too long. Praet’s message on sequencing and rates was then reinforced by Draghi himself.

Benoit Coeure, whose brief covers the money markets, and who is widely seen as Draghi’s other key lieutenant at the Executive Board, has perhaps been more open to adjusting negative rates a bit sooner rather than later. But even Coeure appears now fully on board with the sequencing envisioned by the ECB forward guidance, and that for all the complaining by the banking sector, there is little to no serious detrimental side effect of negative rates that would argue for that sequencing to be scrapped or reversed.

And finally, as opposed to what some analysts may presume, even the institutionally more hawkish German Bundesbank and its President, Jens Weidmann, are on board – more disposed to winding down non-conventional, quantitative easing and bond purchases, with its risks of overstepping mandates and infringing on markets, first, and then adjusting negative rates afterwards.

A Hike is a Hike, and Managing the Curve

With no real rush to move on rates, there is also no-one within the ECB itself who has bought into the Street narrative that the ECB could “take back” part of its rate cuts into negative territory and sell it as a “normalization,” rather than an actual hike.

Some European banks may like, or even push, such speculation that also happens to help their margin income, but ECB officials dismiss it out of hand. They point out that while negative rates may hurt bank margins a little and companies that might be sitting on piles of cash, ordinary people are not paying negative rates, and they maintain a hike, no matter how it is dressed, is a hike.

Indeed, ECB officials appear to be keen on keeping short rates low, and managing a positively sloped yield curve as they exit from unconventional policies.

To wit, of the three main sources of potential risk highlighted by Draghi if unconventional policies were to be held in place too long, two are a result of too much compression in the long end – and only one on the short end, and partially at that.

First is the risk of banks grasping along the curve for yield, and taking excessive risks in both the volume and credit quality of loans. Second is the institutional search for yield from the Eurozone’s enormous pension and insurance industries.

And finally, as to the third risk – pressure on bank net interest margins – even there ECB officials maintain the slope of the yield curve is just as important to the banks making a living off borrowing short and lending long, as is the absolute level of short rates.

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