ECB a lesson in how to be hawkish and dovish at the same time

The ECB will announce its latest policy decision on Thursday 26^th October, while no change in interest rates is expected, all focus will be on the ECB’s Asset Purchase Programme (APP). Expectations are mounting that the ECB will announce an extension to its QE programme at the same time as announcing a tapering of the size of purchases that it makes each month.

This is the most hotly anticipated ECB meeting of the year, they have most recently been considered a snooze fest, for two reasons: On the one hand the ECB is expected to extend its QE programme, most likely until September 2018, but with some expectations building that it may be extended to December 2018, which is considered dovish, however on the other hand they are expected to start tapering off their asset purchases next year, which could be considered hawkish.

As we head into this meeting, market expectations are:

• An extension of the QE programme into 2018, currently it is expected to end in December 2017.
• Market expectations are for an extension of the QE programme until June or September 2018.
• A tapering of asset purchases in 2018 from the current monthly net purchases of EUR 60 bn per month to approx. EUR 30-40bn per month.
• The market is also considering the prospect of a further recalibration by the ECB of the APP once the 2018 APP extension is up, which could see the APP extended through to the end of 2018, but with a further tapering of monthly asset purchases to EUR 20 bn per month.
• Overall, the market expects the ECB’s balance sheet to extend by no more than EUR 300bn in total next year, including a further recalibration of the APP programme in approx. mid-year 2018.

Good cop/ bad cop at the ECB

The ECB needs to consider various inputs before it makes its decision. The economy is strengthening, the most recent data has been strong and its quarterly GDP growth rate is outpacing that of the US and the UK. However, political problems threaten the Eurozone once more: the threat of Catalan independence and the break-up/ civil discord in Spain, as well as next year’s Italian election that could see anti EU parties take control of Rome. Thus, the ECB needs to tread carefully at this meeting. However, at the same time the end of the current APP programme upon us, so Draghi and co. need to give the market a clear idea of what the future holds for the ECB’s QE efforts.

What does the market make of ECB’s balancing act?

From a market sentiment perspective the battle is on: will the market view the ECB decision as hawkish or dovish? Essentially it is a bit of both, however, although an extension of the programme is undoubtedly dovish, it’s the size of the programme that counts, and by reducing the size of its annual APP from EUR 720 bn to EUR 300bn maximum that is undoubtedly a hawkish shift in ECB policy. Thus, the scale of the bank’s tapering is what really matters, and what could really move the dial for Eurozone asset prices.

Will the ECB sacrifice the euro in favour of the bond market?

Another factor that could weigh on the ECB’s decision is the euro. The ECB appeared uncomfortable when the EUR began to rise above $1.18 in recent months, however, a hawkish taper could see the euro surge back towards $1.20 and even higher. So, the ECB needs to decide if it will tolerate currency appreciation, or if it will protect the currency in favour of causing bond market disruption. The ECB can only buy EUR 300bn of eligible bonds for its APP programme next year because there isn’t enough supply. It could lower the bar and accept lower quality assets or buy up more corporate bonds, however, that could threaten the sanctity of the ECB’s balance sheet and may well draw the ire of the hawks, especially Germany.

This leads us to expect that the ECB will sacrifice the currency over the quality of its balance sheet, but only to a certain extent. It may well extend its APP programme outright until the end of 2018 or even into 2019, while at the same time tapering the size of its purchases. While this is still likely to have an upward impact on the euro, it is likely to limit gains to $1.20, especially now that US Treasury yields are rising, which has helped to push the USD to its highest level for 2-weeks. Of course, a “dovish” move by the ECB, such as less aggressive tapering, could see the euro fall sharply, $1.1670 is a key level of support for EUR/USD, ahead of $1.15, the lowest level since July. Versus the pound, the next key support level for EUR/GBP is 0.8750 – the 200-day sma.

Could politics play into the ECB decision?

The bond market has been extremely jittery ahead of this meeting, with German, French and Italian bond yields all rising, prices falling, as the market adjusts to the prospect of a taper from the ECB. Also worth watching is the spread between Italian, Portuguese and Spanish bond yields vs. German bond yields, as you can see below. These yields have been remarkably stable, even in the face of Catalan’s vote for independence. However, if the ECB is perceived as hawkish then we could see spreads start to rise, which may cause concern among ECB officials since any escalation in the Spanish constitutional crisis with Catalonia could add a significant political premium to Spanish bond yields at some stage. This is yet another reason why the ECB needs to tread carefully as it walks the tight rope at this week’s meeting.

Chart 1:

Source: City Index and Bloomberg