Inflation no hurdle to more QE for the ECB

On Thursday 9^th March the ECB will announce its latest policy decision. The market expects no change to policy, and we agree. Whether or not this meeting triggers a market reaction will depend on the press conference held by ECB President Draghi at 1330 GMT.

There are three key issues that the market will focus on during Thursday’s press conference: firstly: how will the ECB justify continuing QE when inflation is rising, secondly, is the ECB considering an early taper to its QE programme, currently purchases are expected until end of 2017. Lastly, the market wants to know how the ECB will deal with the bond scarcity problem that its QE programme has created; basically, the Eurozone’s strict fiscal rules for members limits borrowing, and the ECB is gobbling up all of the bonds out there, soon it may not be able to meet its EU60bn per month purchases (purchases will reduce to EU 60 bn from EU 80 bn as of next month).

Post-inflation era for the ECB?

Looking at inflation first, we seem to have entered a post-inflation era for central bankers, who used to try and prevent price pressures from building. Now we tend to see a willingness for central banks, including the Bank of England, the ECB and, to a smaller extent, the Federal Reserve, to look through periods of high inflation in order to protect growth. Thus, the fact that headline CPI reached 2% is unlikely to deter the ECB from keeping rates in negative territory and maintaining asset purchases, potentially into 2018. We do expect the ECB to revise up its long-term inflation forecast at tomorrow’s meeting, which could trigger some euro buying as the market anticipates a premature end to the ECB’s QE programme.

Taper talk too soon for ECB

We also don’t expect the ECB to announce any plans to taper its asset purchases any time soon. Firstly, growth in the region remains uneven, for example, the Greek economy contracted sharply at the end of 2016, Finnish growth was flat and Italy could only muster growth of 1%. These are economies that need support from their central bank, and even the German finance minister in a recent speech noted that the ECB was doing a good job to balance policy for all Eurozone members. We think that the ECB is approx. 6-months away from announcing a taper to its QE programme.

The final point is more interesting. There is currently a scarcity of Europe’s top-rated bonds. Although Wednesday’s 5-year German debt auction was technically uncovered, there is no shortage of central bank demand for German debt, which is why its yields are at exceptionally low levels. To combat this problem, the ECB could shift some of its purchases into ETFs – stock market trackers – which is not unheard of by central banks, the BOJ buys Japanese stocks, for instance. This may be a step too far for the generally conservative ECB, however, and the bank may decide that political risks are too large to mess with the composition of QE at this stage.

ECB keeps big guns in war chest ahead of key political risks

Another area that the ECB may touch upon on Thursday is how it plans to deal with political risks. The market wants to know what the ECB will do if Marine Le Pen becomes the next French President in May. She has threatened to take France out of the euro and reinstall the franc, which could cause shock-waves across the Eurozone economy, and lead to even greater demand for German debt, which acts as a safe haven. There are already signs that the market is nervous about the French election. EUR/USD risk reversals, which measures bullish and bearish positions in the FX options market, shows a large bearish position in the 3-month contract, which is right around the time the new French President is elected. Added to this, Japanese investors have shifted out of French bonds and into German bonds in the lead up to the election. We expect that the ECB is likely to sound confident that it could protect the economy in the face of political risks, perhaps by re-starting the OMT programme that purchases bonds of nations in economic trouble.

Overall, we expect this to be a fairly neutral ECB meeting, even though Draghi may have to answer some tough questions, as mentioned above. Due to this, the impact on Eurozone assets is likely to be minimal. The biggest risk is an announcement of an early taper to its QE programme on the back of rising inflation expectations. If this happens then we would expect a large uptick in EUR/USD and EUR/GBP, which could return to 0.9000, a key resistance level. It could also weigh on European equity indices. We think there is a low probability of this occurring, and as such, we expect the ECB’s impact on the euro to be small with a bearish bias, especially versus the US dollar.