Market is pricing a dovish ECB

June 29, 2018 09:30
Prior to the June ECB meeting the market consensus was for two hikes in 2019, but now the expectation has fallen to one hike. Photo: Reuters

After the June ECB meeting, the first rate hike was pushed from June to September 2019. Before the meeting the June Euro Over Night Index Average (EONIA) priced in 8bps of higher yields; this fell close to 2bps afterwards. However, this drop in pricing didn’t translate into a higher pricing for September EONIA. September EONIA continues to price around 8bps of higher yields. This implies that the market shifted at the time of the first hike and also the amount of tightening.

While prior to the June ECB meeting the market consensus was for two hikes in 2019, the expectation has fallen to one hike. Until the end of 2019, the market currently prices 15bp of tightening. The market approximately splits these 15bp evenly across the September and December 2019 meetings. The pricing is in line with our own scenario for the ECB. We expect the ECB to tighten policy once in 3Q19 by 15bps.

However, from a risk/reward perspective, we believe playing the July 2019 EONIA meeting date is an attractive hedge against a more hawkish turn by the ECB. The market currently prices only 3bps of tightening until July 2019. We believe very little risk premium has been priced in, particularly since the ECB forward guidance on rates only states that it expects rates to hold at the current level through summer 2019. Several speakers indicated that this guidance is data dependent, which implies that if data strengthens, the first hike might be shifted forward.

Bank of England on course to tighten policy in August

The Monetary Policy Committee (MPC) members of the BoE voted with a majority of 6:3 to keep policy rates unchanged. The split was a hawkish surprise to the market, where consensus was for a 7:2 vote to keep the bank rate unchanged. We believe this supports our call of a 25bps hike in August. The market currently prices 15bps of tightening for the August meeting. Hence, in case of a hike, we would expect a further sell-off in bond markets.

Higher bond yields could also come from the MPC’s guidance on when it intends to start shrinking its balance sheet. Prior to yesterday’s meeting, the MPC did not intend to start shrinking the balance sheet before the bank rate reaches 2 percent. This number was lowered to 1.5 percent. Therefore, the BoE could start shrinking its balance sheet after four 25bps hikes instead of six. Given the current market pricing, the BoE might reach this level around 2020/21.

At his annual Mansion House speech in June, BoE Governor Mark Carney reiterated the earlier decisions about policy rates and winding down the balance sheet. Yet, he mentioned an additional hawkish point – that the Term Funding Scheme (TFS) will be transferred to the BoE balance sheet in 2018/19. This should be first in winding down the asset purchases.

We maintain our short UK duration recommendation despite the trade war risk. UK yields remain at extremely low levels, with the 10-year UK gilt real yield still trading at a negative 1.7 percent. This is the lowest 10-year real yield among the major developed bond markets and leaves significant room for an increase in bond yields.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin