Market prices a dovish ECB despite balanced outlook for growth

September 28, 2018 08:32
The policy tools of the Europian Central Bank would ensure accommodative monetary conditions for a prolonged period,  Mario Draghi said. Photo: Reuters

In a press conference on Sept. 13, European Central Bank (ECB) president Mario Draghi presented a fairly optimistic economic outlook with risks to the downside as well as to the upside.

While the Governing Council (GC) confirmed that asset purchases are expected to end this year, Draghi stressed that monetary policy would remain accommodative. Reinvestments of asset purchases will take place for an extended period. Further decisions regarding those reinvestments will only be made at the GC meeting in October or December.

However, Draghi indicated that those are unlikely to deviate from the capital key. Despite Draghi’s more upbeat assessment, the market continues to price in an extremely slow pace of expected rate increases. The market prices a 20 basis points tightening by the end of the first quarter of 2020 while our own projections are for a 20bp tightening by end-2019 and another 20bp by the end of the first quarter of 2020.

The ECB maintains a positive view on the economic outlook even though growth projections were 2.0 percent for 2018 and 1.8 percent for 2019. It sees both downside and upside risks to future growth – the latter also originating in a more expansionary fiscal policy. The ECB inflation forecasts were kept at 1.7 percent for 2018-2020 while underlying inflation is expected to pick up on the back of economic expansion and rising wage growth.

Draghi gave little guidance on future monetary policy steps. He said it was premature to discuss whether interest hikes in 10bp steps would be considered next year. He also indicated that the policy tools of the ECB – namely its stock of purchases with the promise of reinvestments and the forward guidance – would ensure accommodative monetary conditions for a prolonged period.

Draghi also indicated that the GC discussed no measures that would contain a widening of Italian bond spreads. While the form of reinvestments of asset purchases would take place, or whether an “operation twist” would be considered, Draghi stressed that the GC would be unlikely to deviate from an allocation of investments according to the capital key – which could have benefited Italy.

He also stressed that the mandate of the ECB is not to ensure government financing under all conditions and that investors will form their views on the coming draft budget in Italy.

The slightly hawkish surprise to the market was that the ECB GC’s statement was pretty much unchanged with continued balanced risk assessment to growth despite the slight downward revisions to economic growth projections. The market continues to price in an extremely slow pace of expected rate increases.

The EONIA curve implies a 10bp tightening by the end of 2019 and a cumulative 20bp tightening by March 2020. Our own projections have a 20bp of tightening until the end of 2019 and another 20bp until the end of 1Q20. Hence, we expect 20bp more tightening than the ECB.

Our forecast is based on the euro area economy growing above potential for quite some time and even the ECB expects a continued convergence of inflation rates toward its 2 percent target over the medium term. In fact, its annual HICP projections are now 1.7 percent, which is their target, in 2018, 2019, and 2020. In addition, we expect continued strong growth in the United States and a re-acceleration of growth in China during 2019.

Given the extremely dovish pricing against a more positive economic outlook, risks are tilted to higher bond yields in Europe, in our view. We expect 10-year Bunds to reach 0.7 percent by the end of 2018 and continue to increase in 2019.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin