Today’s ECB meeting was always a question of how the central bank could communicate an improvement in economic growth forecasts in a fashion that doesn’t move market expectations of policy tightening preemptively.
With growth revised upwards from 4% to 4.1% in 2021 and from 4.6% to 4.7% in 2022, Christine Lagarde offset any spillover this would have to expectations of policy tightening by reading through the ECB’s inflation projections.
The central bank upwardly revised headline HICP (Harmonised Index of Consumer Prices) from 1.5% in 2021 to 1.9% and from 1.2% in 2022 to 1.5%, but stressed the upgrade was due to transitory effects.
In 2023, where most other G10 economies are expected to begin hiking rates, the ECB maintained its inflation forecast at 1.4% – a reading significantly below the central bank’s target. The growth improvement is instead expected to increase core inflation, which was revised up to 1.4% in 2023. By doing so, the ECB has maintained room to keep policy significantly loose despite the improvement in underlying growth conditions and the overall economic recovery. The question now is what does “significantly higher” PEPP purchases mean throughout the Summer period where liquidity conditions and issuance moderates. Given the latest projections, we argue the ECB has room to reduce the pace of purchases somewhat in the early parts of Q3 from the monthly pace of €80bn a month seen throughout Q2, while maintaining a “significantly higher” pace of purchases relative to Q1.
The theme of the Q&A session was uncertainty…
Most of Lagarde’s answers contained a repetition of how the evolution of the pandemic and the lifting of containment measures are uncertain, signalling that it is too early for a PEPP exit at present and confirming why the ECB is holding a “steady hand”. It did become clear that there have been discussions around the pace of PEPP purchases, although policymakers unanimously agreed to keep purchases significantly higher for the time being. When considering the Q&A session in isolation, the tone struck was slightly more conservative than the upgraded forecasts implied. This is likely due to Lagarde’s commitment to discouraging speculation around tightening measures.
Price action in European bond markets was largely driven by a spillover from UST’s as back-end yields rose despite a commitment by the ECB to keep PEPP purchases high
The market reaction was relatively muted to the fresh staff projections and Lagarde’s responses to the Q&A. Eurozone yields partially rose at the back-end of the curve, with the German 10-year rising back above -0.23%, while EURUSD flirted with posting minor gains on the day but failed to continue to trade in the green. However, much of the market reaction is arguably due to a spillover from the US CPI data which was released at the same time. One wouldn’t normally expect such a dovish tone from the central bank and a sustained period of elevated bond purchases to correspond with rising yields and a brief rally in the respective currency. However, the market reaction must be viewed in the light of a mildly weakening US dollar and rising US yields after a bumper inflation print from the US.
We argued previously that today’s ECB meeting wouldn’t be a major source of intraday volatility for the euro, however, the decision by the central bank would be more important for the next trend in EURUSD over the coming quarter. Today’s market reaction confirms this view, with the overarching trend in EURUSD likely to become visible after the ECB’s growing optimism in the recovery but cautious stance on altering policy is measured against the Fed’s latest outlook.
Beyond this, market participants will continue to speculate on what “significantly higher” means in terms of a quantitative level of purchases by going back to analysing Monday’s weekly PEPP data. We maintain our view that the ECB could reduce purchases by around €5-10bn a month to reflect reduced bond market liquidity and issuance over the summer period, while maintaining a commitment to higher purchases relative to Q1. Our conviction over this view has increased over the past week as US yields moderate and peripheral spreads narrow, but the ECB may decide to maintain a monthly pace of €80bn in order to deter speculation that their normalisation cycle has begun.
Author: Ima Sammani, FX Market Analyst