The ECB announced the recalibration of its asset purchase program (APP), with an open end, starting from January 2018, as broadly expected: 1) monthly purchases will be halved from EUR 60 bn to EUR 30 bn; 2) purchases will last until September 2018, but with an open-end, which could run beyond if necessary
This week, the ECB will hold its monetary policy meeting on Thursday (July 20th), three weeks after Draghi’s upbeat speech in Sintra which spooked the significant rise of bond yields and the euro. In our view, based on the current economic condition, it is almost inevitable that the ECB will start tapering in 2018, given the steady economic recovery of the Eurozone. Thus, as we have addressed, no major policy shifts are expected in 2017; but the focus of this week’s meeting should be setting the stage for tapering, i.e., clarify the ECB’s action plan of QE tapering to get the market prepared; and at the same time also prevent any involuntary tightening of financial conditions.
More important, in order to continue to provide favorable liquidity and financial conditions, the ECB announced to continue to reinvest the principal payments from maturing securities under the APP for an extended period well beyond the end of net purchases and as long as necessary
To be specific, firstly, there is no need for the ECB to row back the hawkish stance, as the tapering is already in prospect. The Eurozone’s recovery has consistently been resilient. After a solid growth of 0.6% QoQ in 1Q, the PMI readings kept suggesting a 0.6-0.7% QoQ growth in 2Q. Moreover, the upbeat in PMI data was finally confirmed by hard data: the May industrial production grew by 1.3% MoM, the best performance since last November, suggesting the realized gains in production. So far, we see no signs showing that the impressive economic performance could end soon.
Besides, the ECB re-emphasized its guidance on policy rates that the interest rates will be kept well beyond the net asset purchases, which should be able to push back any rate hike expectations into 2019 and maintain the highly accommodative financial conditions
Besides, the ‘scarcity’ of eligible German debt has become a notable technical issue. The German sovereign bonds purchases have been falling in recent months, as the 33% limit is about to be reached; and due to the capital key restriction, it is hard to substitute the German bonds with other sovereign bonds. So, without any adjustments to the purchasing rules, such technical limits suggest the need for QE tapering in the near future.
The recalibration mainly reflects the central banks’ confidence in the robust economic growth, but inflation remained subdued: although inflation expectations slightly recovered recently due to the weakened euro and the rising oil price, but there is still not much evidence to show that underlining inflation is on an upward trend; thus, an ample degree of monetary stimulus is still needed
Thus, with the tapering in prospect, corrections in asset prices are inevitable. But, it will be better to have the corrections in a series of smaller steps that can be digested by markets rather than in one large bound. So, in our view, turning back to dovish stance in the July meeting will be unwise.
The dovish stance came from the reinvestment of maturing securities, which is estimated to be averaged around EUR 10 bn per month for 2018; and on top of the net purchases, the gross purchase could be more than EUR 40 bn per month, higher than market expectations
Secondly, to prevent any involuntary tightening of financial conditions, the ECB will need to clarify its action plans that the current QE program will last until the end of this year and any actual policy shifts would only happen next year. We expect the ECB to send signals that the official announcement of QE tapering (with specific details and timeline) will be in September, and the tapering will start at the beginning of 2018. Such action plans are basically consistent with the ECB’s guidance from previous meetings and are more or less in line with market expectations. Thus, in our view, it is less likely to trigger dramatic market moves further.
Market reacted to the dovish recalibration with falling bond yields and further weakening of the euro against the dollar
Are there any possibilities that the ECB will surprise the market? We see two scenarios, but both with low odds: 1) start QE tapering in end 2017; and 2) taper the QE program at a faster pace compared to market expectations (for example from EUR 60 billion per month to 0). Either of the two scenarios could spook the surge of Eurozone bond yields and euro. But in our view, the odds for both cases are very low. The recent upbeat of economic performance, especially the manufacturing factor, still relies on the weak euro; and the weak inflation momentum should keep the ECB cautious. The euro has already appreciated against the dollar by almost 10% this year; further appreciation could weigh on the economic recovery and inflation.
In sum, we expect the ECB to clarify its action plans in the July meeting, but not necessarily switching to a dovish tone. As the market has more or less priced in such a tapering after the recent speeches from the ECB, we do not expect dramatic market moves only upon hawkish tones anymore.
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