Today’s European Central Bank decision came as music to the ears of EUR bulls. With the Russian invasion of Ukraine having materially changed the eurozone risk profile in a matter of weeks, the last thing markets expected was for the ECB – which is usually very cautious around its wording – to come out with a definitive announcement of a faster taper to their QE programme.
Although the relevant caveats have been installed given the increased level of risk to forecasts, the central bank suggests APP will end in Q3 instead of Q4, while at the same time it dropped the wording that it could lower rates in the future. EURUSD rallied to a new high of 1.1121, while eurozone bond yields reversed an earlier drop. Despite the initial bullish reaction in FX and bond markets, the ECB is playing a risky game given the level of uncertainty in both the inflation and growth outlook at the moment. Traders have now brought forward their ECB rate bets to price in 25 basis points of hikes in September.
However, the uncertain outlook exposes the ECB to the risk of growth and inflation taking a U-turn mid this year, causing the central bank to have to undo their forward guidance.
EURUSD enjoys the hawkish ECB surprise in the statement, but risks to the outlook are plentiful
ECB shifts the onus to fiscal policy for ensuring growth
In the press conference, ECB President Lagarde immediately addressed the tragedy that is the war in Ukraine. She discussed the war will have a material impact on the eurozone economy and inflation, but the extent hereof depends on how the conflict evolves. For this reason, the ECB has studied a range of scenarios. Lagarde states the war poses substantial upside risks to inflation and downside risks to growth, which is reflected in the sharp revisions in the forecasts. 2022 inflation is forecasted to average at 5.1% vs 3.2% projected in December, 2.1% vs 1.8% in 2023 and 1.9% vs 1.8% in 2024. Lagarde adds that inflation is expected to stabilise at 2% over the medium-term. The sharp increase in the near-term forecast is largely due to the higher energy prices, and the ECB expects the impact to fade over time.
The retracement of the euro throughout the press conference is telling of the fact that the faster taper of QE combined with the uncertain outlook poses substantive risks to economic growth.
Lagarde mentioned the discussions within the ECB were intense, with some members wanting to move ahead, while other members wanted to keep policy as is given the uncertainties of Russia-Ukraine. The currently presented policy stance is a compromise that provides “maximum agility and flexibility.” However, the ECB must know the war in Ukraine could further impact supply-side constraints and hit consumer and investor sentiment further – if a de-escalation comes through much later than markets expect. In such a scenario, the ECB will stand ready to revise asset purchases in both size and duration, according to Lagarde – but there is a risk that at that point, it will be a case of putting the genie back into the bottle. And that is exactly the risk markets started to factor in throughout the press conference. Over the course of the hour-long communiqué, EURUSD pared back all of its post-statement gains to trade back at fresh session lows, while eurozone periphery bond yields have spiked dramatically in response to the growth risk and signs of faster policy normalisation.
EURUSD pares back gains throughout press conference to reach fresh session lows
“We are not in any way accelerating”
Lagarde made sure to let listeners know today’s decision was not to accelerate normalisation, and markets shouldn’t interpret it as if it was. She noted that the ending of net purchases via APP is conditional, and that optionality and flexibility are key going forward. The flexibility is reflected in how the ECB now approaches sequencing: the ECB has changed their tone on ending QE from “shortly before” rate hikes to any adjustments will “take place some time after the end of net purchases,” giving them the opportunity to hold a longer period of wait-and-see before starting to lift rates. This gave today’s hawkish surprise dovish undertones; while the ECB is eager to wind QE down, markets should not immediately expect a rate hike after.
Ima Sammani, FX Market Analyst