The ECB faces a stern ‘taper tantrum’ test on Thursday as markets watch for any signs about how and when it will consider reducing the size of its bond buying programme.

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It’s the first time Mario Draghi will speak publicly on monetary policy since remarks in June that the market saw as hawkish. The Sintra speech (coupled with dollar weakness as the market edges away from its most hawkish expectations for the Fed) has fuelled a euro rally that has seen EURUSD rise above $1.15 to its strongest level since May 2016.

Bond markets were rattled and yields climbed sharply. The German 2-year bund yield spiked to its highest in a year but has since retraced this move and is now trading at a level it was at before Draghi’s speech in Portugal. The tantrum looked a bit overdone – as stated at the time the comments were not ‘hawkish’ but a reiteration of known values and expectations.

In June Draghi suggested inflation is becoming more sustainable and deflationary forces have been replaced by reflationary forces. Importantly he suggested deflationary forces are external, temporary shocks and the ECB can overlook. The question is whether the Eurozone would survive without the QE support.

As we stated then:

Draghi sounded more circumspect on that front, arguing that he is confident that monetary policy is working but still needs to remain very loose. Again it’s a stretch to describe it as hawkish – Draghi is simply affirming that loose monetary policy is working without significant adverse consequences and therefore should be maintained. He’s not advocating tightening any time soon. Persistence is required, he argues, noting that ‘a considerable degree of monetary accommodation is still needed for inflation dynamics to become durable and self-sustaining’.

Coming back to this week’s meeting and press conference, the ECB will not want to alarm markets further by stoking a fresh taper tantrum. It also does want to add fuel to the euro fire as this will further dampen inflation expectations. Sintra was an important step in preparing markets for the taper, the ECB does not have to do a lot more this month.

Growth v inflation

The ECB’s problem is inflation, not growth. Maybe it should accept this as a pretty classy state of affairs but it will continue to focus on its mandate. Eurozone inflation was softer in June but core inflation managed to pick up. Inflation dropped to 1.3% from 1.4% the preceding month, in line with estimates, while core inflation advanced to 1.1% from 0.9%. Core inflation this year has danced around the 1% mark.

This most recent inflation data supports the case for the ECB to remain cautious. Ignoring the financial market implications for a moment, it cannot justify going significantly more hawkish now with inflation proving lacklustre. Labour market dynamics continue to be a problem. Employment is not as tight as it appears and wage growth is the key unknown that will either spur a sustainable recovery in inflation or mean the ECB has to stay in the market for even longer.

Language

No policy change is anticipated – indeed the reaction of markets to subtle shifts in tone highlights the potential problems facing the ECB down the line. (this is not just a reversal of unconventional monetary policy but also a shift out of a 30-year-odd bond bull market).

The focus this is on the tone and language. At the last meeting it made two small changes to the monetary policy announcement – saying that risks are no longer ‘tilted to the downside’ and that policymakers don’t think rates will be cut further.

The next important baby step would be to remove the option to “increase the [QE] programme in terms of size and/or duration”. Minutes from June show the Governing Council is willing to look at this easing bias again.

Removing this easing bias could be yet another yard on the normalisation marathon. Although the euro has stiffened since late June this would likely be taken by the market as broadly ‘euro-positive’.  Leaving this in would likely spark a plunge in EURUSD on the release of the statement, although it could be quickly corrected by a hawkish Draghi in the presser. However, the bond market reaction to the speech by Draghi last month could play a part and the Governing Council may not want to send any further hawkish signals for the time being.

It doesn’t have to remove it completely: The ECB could remove the commitment to increase the “size” of QE, even if it leaves the possibility to extend the duration of the programme still further (a course that may be a requirement to help ensure an orderly exit from QE anyway – less QE but for longer could be a method the Governing Council views as the most gentle exit).

There is good cause to shift the language here. Strong economic growth certainly makes increasing the size of monthly bond purchases unlikely and an unnecessary addition to the statement at present. Failure to remove any aspect of the easing bias (size and/or duration) may make the ECB have to deliver a more abrupt shift in tone later. It looks like it can remove the ‘size’ element but hold on to some more flexibility by signal it is still willing to prolong QE depending on how inflation progresses.

Caution

The ECB has tightened too quickly twice before and is loath to repeat the mistake. While this may be the first meeting at which there is a proper discussion of reducing stimulus, any word on tapering is likely to be held back until September, when there will also be fresh staff projections. Draghi will face questions on whether tapering was discussed and what the consensus is. He is likely to admit it was discussed but no firm commitments have been made.

The ECB is expected to delay any commitment to taper purchases until the September meeting, when it may outline a reduction starting in 2018. There is absolutely no talk of rate hikes as the ECB wants to pare back stimulus before considering tightening.

The two big takeaways from Sintra is that central banks are eyeing the path to the exit doors and that even the merest hint of removing the punch bowl can still roil financial markets, albeit not quite as badly as when Bernanke sparked his taper tantrum. The ECB could strike a useful compromise this month by removing the easing bias, which is broadly expected by the market. Failure to drop this will require a more abrupt shift in tone later and we note that the ECB is running out of time with asset purchases and with its plans to decide on monetary policy for 2018 by the October meeting.

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