As Bloomberg notes, “while the ECB is unlikely to surprise today, the central bank meeting may constrain primary and secondary credit market activity [as] President Draghi’s comments will be closely watched for evidence of how the Bank plans to tread the fine line between conveying economic expansion and assuaging fears of near-term tapering.”
And there’s the rub, right? You don’t want to not acknowledge growing inflationary pressure (readily apparent in Germany, for instance) and improving growth prospects, but then again, you don’t want to derail those very same dynamics by spooking everyone with needlessly hawkish banter. Fortunately core inflation is still low, so they’ve got that “going for them.”
And you know, you probably want to address the whole angry populist uprising thing that’s recently caused OAT-bund spreads to explode wider and threatens to tear the entirely damn single currency project apart at the seams.
Oh, and maybe say a little something about the fact that buying under the depo rate has contributed to dramatic richening in the front end of the German curve and how that, in concert with CSPP, has created all manner of aberrations, including, but probably not limited to:
- iTraxx Main trading inside 2Y swap spreads for the first time since 2008
- a veritable explosion of negative spread corporates
Whatever. It’s too early for this.
Below, find some color from BofAML that should serve as a decent last minute primer on what to expect from everyone’s favorite former Goldmanite who looks really scary when he’s donning the Draghi death stare, but folds up like wet cardboard when cute girls dump glitter on him.
We think the current “truce” between the hawks and doves will be reflected in a dovish tone by Draghi this week, with no decision. After the summer, though, we think a proper debate about the future of QE will be unavoidable.
Draghi’s dovish performance at the January press conference reflected, in our view, a “truce” between the doves and hawks. The debate on the next step for monetary policy is now frozen, and we think it will remain so as long as political risks abound and sovereign spreads widen. Jens Weidmann in his recent public statements came out as quite relaxed on inflation. He also called the current stance “appropriate”. Uber-hawk Hansson stated unambiguously that the central bank needs several months of data before embarking on further decisions. We thus expect a bland/dovish press conference this week.
We expect the ECB meeting to be a non-event for the Euro. Draghi bought time when he extended QE by a year last December and he intends to use it. The USD and European politics are the main EUR drivers for now, in our view. Assuming no surprises in the European elections, we expect the Euro to strengthen, particularly against JPY. Three points of focus for rates. Will the statement on rates staying “at current levels or lower” be maintained? Will additional TLTROs be announced? Will there be more transparency on QE implementation?
If we look at the forecasting exercises beyond March, the ECB could have a concerning credibility issue in the near future. Core inflation has not moved much in the last three years. The ECB expects core inflation to average 1.1% in 2017. It is 0.9% today, a low 0.9% (0.87). It will fall even lower in March due to the Easter effects (0.7%). This is very close to the lows during the QE period. It is expected to recover from there, with an abrupt increase in April to 1.1% (again, Easter). But it will lack traction for the rest of the year. The ECB is probably expecting core inflation above 1.1% for a substantial part of the year to meet the average forecast for 2017. The discussion above clearly highlights for us that the ECB is likely to be surprised on the downside. And even if they are on track, 1.1% is pretty much half the target of the central bank. Can the ECB start a discussion on whether to taper beyond December 2017 with core inflation still a long way from target? We do not think it should; we think the credibility cost would be large. But this is no longer about economics, this is about politics.
Trade-off buying below depo vs capital keys: important for Schatz, periphery As the accounts of the Jan ECB meeting referred to a trade-off between QE purchases below the deposit rate and deviations from capital keys, Draghi may be prompted to provide additional details. Any comment from his part will be used to gauge the extent to which flexibility around QE implementation can provide for:
- A temporary floor on German yields, in cases of extreme rally (such as last month?)
- A temporary cap on peripheral spreads, in cases of a significant rise in risk aversion We have argued that deviations from capital keys are already occurring as some NCBs have already run out of domestic bonds to purchase.
We also highlighted that deviations did occur, in favor of Spanish and Italian bonds, around the time of the UK referendum. However, we believe QE flexibility is unlikely to be presented as a policy tool to cap spreads over the long term.
More interestingly, given the substantial rally in Schatz and Bobl yields last month, Draghi may be asked about the existence of a yield level below which the ECB or Bundesbank may be unwilling to buy German bonds. While the -40bp deposit rate is no longer a floor, would the Bundesbank still buy Schatz if it were to trade well below 1%? There, the possibility to deviate temporarily from capital keys could be useful. In fact, we argued last week, that if the ECB/Bundesbank were to become concerned about driving German yields too low, some of the options on the table would be:
- For the Bundesbank to buy less than implied by capital keys, temporarily
- To shift a greater portion of German QE buying to the 5y+. We estimate Buba could still do so for 1-2 months, while also relying to a greater extent on agencies.
- For the ECB/Bundesbank to make additional changes to the securities lending facility (eg, lengthening the terms of the repo/reverse repo, or increasing the amount of bonds lent against cash)
- For the ECB to start issuing debt certificates to alleviate scarcity of HQLA
Any reference to those has the potential to drive further tightening in 2y swap spreads.