The European Central Bank (ECB) will be meeting in Frankfurt on Thursday in what is shaping up to be a critical juncture for its large scale quantitative easing programme.
In July, President of the European Central Bank (ECB) Mario Draghi claimed that discussions on the future of its QE programme would take place ‘in the autumn’. With autumn now upon us, investors are gearing up for a major announcement on the bank’s stimulus measures at this week’s highly anticipated meeting. Policymakers in the Eurozone are expected to announce both an extension and a reduction in monthly asset purchases.
At the most recent monetary policy meeting in early-September, Draghi reiterated that the bank needed to remain patient and persistent with the QE programme which had not yet translated into stronger inflation dynamics. Yet, recent rhetoric has suggested that the ECB is becoming growingly confident that inflation will eventually return to target and there has become a broad agreement within the Governing Council that the Eurozone economy is recovering at a stronger pace than originally expected.
Draghi claimed last month that the ‘bulk of decision’ on the stimulus programme would take place in October. We now think we’ll have an announcement that the bank is ready to begin tapering its asset purchases below the existing €60 billion a month level, particularly as it is beginning to approach its self-imposed limit on the amount of debt it can hold from some countries.
Eurozone activity picks up pace in third quarter
The shift to a less accommodative monetary policy stance has been a gradual one, coming in line with the general improvement in economic conditions in the Euro-area. Since the last meeting in September, the Eurozone economy has shown continued signs of strength. The Eurozone’s composite PMI rose to 56.7 in September, just shy of its highest level in over six years. Core inflation is still well below target, although the headline rate is at least at a five month high 1.5% (Figure 1).
Figure 1: Eurozone Inflation Rate with forecast (2013 - 2018)
Source: Thomson Reuters Datastream Date: 19/10/2017
What to expect from the ECB on Thursday
With core inflation still lagging well behind the central bank‘s ‘close to, but below’ 2% target the ECB is highly likely to use the October meeting as an opportunity to announce an extension of the QE programme beyond the existing December 2017 end date.
We think a six month extension will be the bare minimum, with risks skewed towards a longer extension in the order of nine months following recent ‘lower for longer’ comments from chief economist Peter Praet. The ECB’s inflation forecasts for 2018 remains low at a mere 1.5% and a reduction in the size of the QE programme would undoubtedly increase the risk of undershooting this forecast. As we have mentioned previously, we think the ECB will refrain from announcing an end date of its asset purchases and instead keep its options open to extend the programme further, should it be required.
Beyond the expected extension, the real question will be by how much the ECB lowers its monthly asset purchases. Expectations range from a modest €5 billion cut to as much as €40 billion, with the median falling around the €20 billion a month level. We err on the lower end of these estimates given that core inflation has, as yet, shown no real signs of a sustained rebound.
As for the ECB’s communications, we think that the Governing Council faces a very delicate balancing act and will be reluctant to materially shift away from its fairly dovish stance for risk of unleashing a flurry of bullish Euro bets. We expect forward guidance to remain very dovish, with Draghi statement to stress that more QE is possible and that interest rate hikes will only come ‘well past’ the horizon of asset purchasing.
What will the impact on the Euro be?
With an announcement on a winding down in stimulus measures well telegraphed and mostly priced in by the market, the technical details of the reduction in the programme will be of high importance to the single currency.
The very limited market reaction to a Bloomberg report released earlier in the month that suggested the ECB was ready to cuts its pace of asset purchases by more than half leads us to believe that the market is pricing in a rather significant tapering in the QE programme. A reduction in purchases to a net €40 billion a month, combined with more dovish forward guidance, may be seen as somewhat conservative and could lead to an immediate sell-off in the Euro. Contrastingly, a more meaningful reduction in purchases to the €30 billion a month or less level, accompanied by less dovish rhetoric and a shorter extension, could provide a catalyst for a renewed push in EUR/USD back towards the 1.20 level.
Recent communications out of the ECB lead us to believe that Mario Draghi will disappoint the market by maintaining his cautious stance. We expect a more modest reduction in monthly purchases of €20 billion or less and an extension of at least nine months, both of which we think could send the Euro lower against most major currencies.