Global Daily – What do markets now expect from the ECB?

by: Nick Kounis , Bill Diviney

Euro Rates: Markets now back to pricing in a June rate hike – ECB Chief Economist Peter Praet (see below), as well as Bundesbank President Jens Weidman and DNB President Klaas Knot, signalled to markets that net asset purchases will soon be wound down. Financial markets priced in somewhat earlier interest rate hikes following the various ECB commentary – with those of Mr Praet being most important, given his crucial role in formulating policy as well as his ultra-dovish tendencies. Investors are now pricing in a very high probability (almost 90%) of a 10bp rate hike by June of next year. However, the more significant shifts were in the pricing in of a steeper rate hike cycle in the quarters thereafter, especially in 2020 and 2021. Consequently, there was a sell-off in government bond markets and a steepening of yield curves (2s5s and 2s10s). The short-end seems to be more anchored than the long end, given the low likelihood of a rate hike before June of next year and we think that will remain the case, with the steepening trend in yield curves likely to persist in the second half of the year. Interestingly, country spreads – although volatile – were up only very modestly by the end of the day. This is consistent with the view that the stock rather than flow effects of QE are dominant, and that the sell-off in bond markets is more driven by expectations of the steepness of the rate hike cycle. Meanwhile, investors appear to be factoring in a 3-month tapering period after September, which is also consistent with analyst surveys. (Nick Kounis)

ECB View: End of net asset purchases to be announced next week – In a landmark speech, ECB Chief Economist Peter Praet said that the Governing Council would judge whether the inflation conditions to end net asset purchases had been met at the June meeting. He also suggested that these conditions have been met. This means an announcement to gradually wind down net asset purchases will likely come this month. However, there is a possibility that the Governing Council takes a two-step approach, as it has done in the past. For instance, it could signal the wind down in June, with the details (on the tapering period and the purchase sizes) following in July.

Mr Praet made his speech earlier today in Berlin (see here). He clearly signalled that this month’s meeting will be a decision moment, saying that ‘next week, the Governing Council will have to assess whether progress so far has been sufficient to warrant a gradual unwinding of our net purchases’.He also made it clear that the three criteria (convergence, confidence and resilience), for assessing whether there is a sustained adjustment in the path of inflation towards the goal, have been met. He noted that ‘signals showing the convergence of inflation towards our aim have been improving, and both the underlying strength in the euro area economy and the fact that such strength is increasingly affecting wage formation supports our confidence that inflation will reach a level of below, but close to, 2% over the medium term. As for our third criterion, resilience, waning market expectations of sizeable further expansions of our programme have been accompanied by inflation expectations that are increasingly consistent with our aim’.

We are unconvinced about whether the inflation criteria have indeed been met. It seems there is more uncertainty now than a few months ago about the economic outlook, and core inflation and wage growth remains subdued. Rather, the ECB was always minded to wind down net asset purchases after September. The constraints for the PSPP are fast approaching, as the Bundesbank’s holdings of German public sector bonds will be at or very close to the issue(r) limit by then. In addition, the ECB believes that the stock effect of purchases is the dominant effect on financial conditions and that the stock is already large enough to ensure this. Indeed, the Chief Economist noted that ‘the stock of long-duration assets held in our portfolio will continue to put downward pressure on longer-term interest rates well beyond the end of our net purchases’.

We think that the ECB’s key policy instrument going forward will be managing expectations about the path for its policy rate. Mr Praet once again suggested that the ECB would put more emphasis on this, saying that ‘our forward guidance on policy rates will then have to be further specified and calibrated as appropriate for inflation to remain on the sustained adjustment path to levels below, but close to, 2% over the medium term’.

We expect a tapering period of 6 months (3 months EUR 20bn p/m and 3 months EUR 10bn p/m), meaning that net asset purchases will not end until March 2019. The tapering period could well be shorter (3 months), though we do not think the length is crucial. We do not expect the first rate hike to follow until September 2019. Furthermore, we expect the ECB to strengthen its forward guidance on interest rates when it announces a wind-down of net asset purchases. The recent weakness in economic data raises the risk that rate hikes will come even later than in our base case. (Nick Kounis)

US Macro: Underlying productivity trends remain strong – Non-farm productivity was revised down slightly in Q1, to 0.4% qoq annualised from 0.7% previously. However, annual productivity growth was unrevised at 1.3% yoy, holding up just above the post-crisis average of 1.2%. While productivity growth has cooled a touch compared with mid-2017, the leading indicators – investment and the ISM new orders index – continue to point to higher productivity growth in the coming quarters. Investment remained exceptionally strong in Q1, growing 5.7% qoq annualised, following an 8.6% jump in Q4 17. Having declined in the early part of 2018, the ISM manufacturing new orders index picked up again in May to 63.7 – levels that are well above long-term averages (around the mid-50s), and consistent with investment growing at rates above 6% for the remainder of 2018. As we discussed in our recent note on inflation (see here), higher productivity growth will likely be crucial in keeping unit labour cost growth in check, even as the tight labour market spurs higher wage growth. Indeed, attempts by business to improve productivity growth to combat labour market constraints can be seen not just in higher investment, but also in more qualitative evidence, such as an increased emphasis on education and training. For instance, alongside wage rises, retailer Walmart – the biggest single employer in the US – recently began offering its 1.5 million employees heavily subsidised college tuition. As labour market constraints continue to bite, the pressure to get more out of existing workers is likely to build further, in our view. (Bill Diviney)