Global Daily – ECB Preview: No change in guidance, but verbal intervention on euro

by: Nick Kounis , Georgette Boele , Kim Liu , Aline Schuiling

ECB View: Draghi may try to scale back rate hike expectations and euro strength – The ECB meeting on Thursday comes against the background of growing signals that the central bank is not minded to extend its QE programme further. The minutes of the December Governing Council meeting suggested that the ECB could change the forward guidance on QE early this year. We expect such changes in communication to come in March. At this week’s press conference, we think ECB President Draghi’s priority will be to talk down growing expectations of early interest rate hikes and a strengthening euro (please see below). Even hawkish officials, such as Jens Weidmann have suggested that the middle of 2019 is a reasonable timing for the first rate hike, while markets are banking already on the first quarter of next year. Indeed, the ECB seems very committed to its forward guidance on interest rates that policy rates will not rise well past the end of asset purchases. We expect that this commitment will only grow in importance. Our own view is that there will be no further extension of QE after September 2018. On the other hand, a taper period may keep asset purchases going until March 2019. In addition, we do not expect the first rate hike until the second half of next year (we have pencilled in September). We think the subdued outlook for underlying inflation points to the ECB taking its time with rate hikes.

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Rates and FX View: Market pricing for rate hikes too aggressive – Since the beginning of the year, the market has started to price in an increased probability of early ECB deposit rate hikes. According to Eonia forwards, the market now assigns a 50% likelihood of a 10bps deposit rate hike in December of this year. In addition, the market has fully priced in a 13bps rate hike in Q1 2019 and another hike by Q3 2019. Assuming that the ECB will not hike during its QE programme, the market expects (a) the ECB to stop its QE programme by September 2018 and to hike 6 months thereafter or (b) a super quick taper (of say 3 months) and a rate hike 3 months thereafter. As discussed above, we judge that current pricing is too aggressive. The increased likelihood of early rate hikes poses a downward risk to the ECB’s inflation forecasts as it has led to euro strength.  Indeed, we observe a strong relationship between 1y1y Eonia forwards and the euro/dollar exchange rate. We estimate that the recent euro strength will reduce the ECB’s projections for core inflation by around 0.1-0.2pps. Considering that the central bank’s current forecast for 2020 is merely 1.8%, a downward revision by 0.1-0.2 pps would push it to below the central bank’s target. Against this background, we expect a dovish January ECB meeting, resulting in euro weakness and a short term correction in yields. For more details, please see our Short Insight Publication ‘Why Draghi wants to push back rate hike expectations’. If you are eligible to receive our Fixed Income and FX publications and want to be added to our mailing lists, please let us know.

Euro Macro: Germany’s ZEW off to a good start in 2018  – Germany’s ZEW economic sentiment indicator increased to 20.4 in January, up from 17.4 in December. The indicator is measured amongst financial analysts and economists and it tends to be largely driven by sentiment in financial markets, particularly equity prices. It gauges the expectations for the German economy during the next six months and its historical pattern shows that it tends to signal turning points in the business cycle quite well. The ZEW indicator has been hovering between a level of 10 and 21 since the start of last year. At these levels it is consistent with GDP growth of around 0.7-0.8% qoq, which is well above the trend growth rate for Germany and also somewhat higher than growth in the eurozone economy as a whole. We expect the German economy to continue to grow at around these levels in the coming quarters. Domestic demand should continue to be supported by favourable financial conditions. Moreover, wage growth in Germany has risen to levels well above the inflation rate, which stimulates private consumption,  while solid corporate profitability and strong industrial production growth should fuel fixed investment. Finally, healthy growth in the global economy is expected to stimulate exports.