Forex trading: ECB meeting preview

The European Central Bank meets on Thursday (Oct 26) for a key meeting for the markets. Expectations that the central bank will outline a path to tapering its quantitative easing programme are extremely high.

In summary we see this as a case of not whether the ECB will taper, but exactly how quickly it plans to do so. On this it is likely to take its time as way to push back on interest rate hike timings.

What’s changed since the last meeting?

In short, not a huge amount has changed. Economic growth still looks pretty robust, although there was a slightly softer composite PMI survey released Tuesday. While the Flash Eurozone PMI Composite Output Index slipped to a 2-month low at 55.9, it nevertheless signals continued strong private sector output at the start of Q4. GDP looks to be around the 0.7% mark, consistent with Q3.

Inflation continues to undershoot. Inflation rose at 1.5% in September, while core inflation ran at just 1.3%. This was a little shy of expectations and, given the persistent inability throughout the year to break above this sort of level, is considered perhaps the biggest obstacle to the ECB offering a hawkish surprise on Thursday.

At the September meeting inflation was revised down to 1.2% in 2018 (prev 1.3%) and 1.5% in 2019 (prev 1.6%). The 2017 inflation projections were unchanged at 1.5%. Draghi hinted at a decline in headline inflation due to sliding energy prices towards the year end. But he was a touch more upbeat on underlying pressures, saying inflation ex-fuel and food is showing signs of picking up but, critically, is yet to show ‘convincing’ signs of sustained upward trend. Although market gauges of inflation have improved no ‘hard’ evidence has emerged since then to suggest this view has altered.

The euro has eased, which should offer some comfort for the ECB policymakers who had signalled they were concerned about its strength. The retreat from 1.20 in EURUSD seems to be partly down to expectations the ECB may be a) even slower to taper/tighten than thought and b) a result of some dollar firmness post-FOMC meeting and progress (albeit limited) on the GOP tax reform package.

A softer euro does remove immediate dangers to the ECB’s hoped-for path out of unconventional monetary policy but we should remain cautious as the market is finely attuned to jump on any hawkish signal from the ECB as a sign to bid up EUR. Nevertheless, the chances of a hawkish surprise from the ECB look low given the market now fully expects a taper to be announced.

How much will it reduce bond buying?

The big question hinges on whether the ECB cuts more aggressively and remains in the market for longer, or trims the monthly bond purchases and exits sooner. Currently the ECB is buying bonds at a rate of $60bn a month and this is slated to end in December. With the ‘end’ in sight it has got to outline its next steps for QE, which are widely expected to amount to an extension of the programme into 2018 but at a reduced level – a taper.

Consensus seems to be that the ECB has moved away from a reduction to $40bn a month and an exit by mid-2018 in favour of cutting QE to €30bn, or even €20bn a month and to maintain this pace until the end of 2018.

Given a scarcity of eligible bonds is forcing its hand to a degree, this would allow the ECB to tread the fine line it must in order to satisfy the market that it has an exit strategy without roiling bond markets and sparking a undesirable ramp in the EUR. Following a fairly well-worn path trod by the Fed, the pre-announcement is what matters in order to smooth the transition in the markets and so it would seem unlikely, though not impossible, that Draghi will deliver a hawkish surprise.

In particular, the task is to stop the euro appreciating. Draghi himself has previously said that each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points. And even under its current projections inflation will still be undershooting in 2019.

A firming dollar may allow some more leeway but given the lack of real momentum behind the dollar (markets are still sceptical about the Fed, GOP tax reform and US inflation, although as previously set out this may be misplaced) the ECB can do enough without needing to sound more hawkish now. Euro appreciation has already done some of the tightening so it would seem unusual if the ECB decided to press that button more. Moreover, having notched two policy mistakes already in tightening too soon, the ECB is focused on not making it three.

Forward guidance

By lowering the amount of bonds it purchases to €20bn a month it will allow the ECB to remain in the market for longer, perhaps for the entirety of 2018. This would imply a pushback on interest rate rises until 2019 as the ECB has consistently stressed that rates would not rise until “well past” the end of QE.

Key points from ECB statement and press conference 07/09/17

  • ‘Bulk’ of QE decisions to be taken at October meeting
  • EZ growth stable and broad based - GDP outlook revised up to 2.2% in 2017, best growth since 2007
  • Medium-term inflation projections revised lower chiefly due to euro appreciation
  • Measures of underlying inflation have ticked up but remain at very subdued levels
  • Broad ‘dissatisfaction’ with inflation, but this is tempered by confidence that inflation will eventually converge with target
  • Most members reiterated worries about exchange rate pressures first raised by some policymakers at the last meeting
  • Appreciation of euro has ‘unquestionably’ led to tightening of financial conditions
  • ECB monitoring euro exchange rate, but doesn’t seem overly concerned about overshoot at present. (Could change if EURUSD hits 1.25?)
  • Interest rates will remain at present levels well past end of QE finishes; ECB still stands ready to increase the QE programme in terms of size and/or duration
  • No discussions on scarcity of bonds (seems unlikely), Draghi says ECB has repeatedly shown it can cope with scarcity issue
  • Draghi keen to stress that patience is needed, wont ‘experiment’ with interest rate forecasts
  • Draghi reiterated need for structural reforms to be substantially stepped up
  • ECB not resigned to permanently low inflation, expects convergence with target sooner or later