ECB preview: Bond market strategy and economic outlook top of mind for Thursday’s meeting – The monetary policy meeting of the Governing Council this week is unlikely to result in new policy announcements, however investors will be looking for more clarity on two issues. First, the ECB’s strategy with regards to capping government bond yields. Second, on how the central bank’s views on the economic outlook are developing.
At the last Governing Council meeting, the ECB appeared to draw a line in the sand with regards to rising government bond yields. To paraphrase the Council, the big picture message was that rising yields were inconsistent with the ECB getting inflation back on track to get closer to its objective over the medium term, so it was willing to use its tools to curb yields. In the near term, it would step up net purchases under the PEPP with this aim. Subsequently, Chief Economist Philip Lane even suggested the level of the December curve (when the weighted eurozone 10y bond yield stood at around -0.2%) as benchmark.
Things do not seem to have gone to plan, or at least one could say the ECB’s strategy has not been completely clear. At time of writing the eurozone 10y yield stood at +0.12% (average for April is +0.05%), even though the upswing in US yields has lost momentum. The step up in ECB purchases has not been very impressive (at an average of around EUR 17bn compared to around EUR 14bn previously). In the past, yields at these levels have triggered higher purchases than what we have seen so far. In addition, the message has been blurred by some officials talking about tapering asset purchases in the second half of the year.
The upward pressure on yields is partly due to increased optimism about the economic outlook. So another focus of investors will also be whether the ECB is also becoming more upbeat. Compared to the ECB we are indeed more optimistic about the second half of the year (see chart below). This reflects the view that the lockdowns will be lifted toward the end of Q2 and especially in Q3. In addition, we have already factored in the impact of improving global developments (the global industrial upswing and the US fiscal stimulus). On the other hand, we are more downbeat than the ECB about the first half of the year given that it assumes better outcomes, which seem unlikely given ongoing lockdowns. These factors seem to offset each other in terms of where the level of GDP will end up in the coming quarters.
The ECB will likely hold its cards somewhat close to its chest on both these topics at the April meeting, given that in June it will update its projections and will also consider whether to sustain the step up of purchases in Q3. So significant further communication from the ECB may not come until the June meeting. More fundamentally we judge that the view that the medium term outlook for inflation remains weak (and unsatisfactory relative to the ECB’s goal) will remain in place in coming quarters. Despite a strong recovery in the second half of the year, a large output gap will remain in place that will continue to bear down on underlying inflationary pressures. Against this background, the rate hike cycle priced in by markets over the coming years, which has been the key factor driving up yields, looks unlikely.