BofA Global Research | We are surprised that markets did not respond to a rather hawkish set of minutes from the last European Central Bank (ECB) meeting. Already in December, confidence in the outlook was improving, before the US-China trade deal and the UK elections. Given green shoots in data and further upside to core inflation, a discussion about the risk balance shiſting to “neutral” could start fairly soon. Combined with increasing emphasis on the need to monitor “side effects” from negative rates, the risk balance for this week is for a hawkish surprise. The risk of hawkish-leaning undertones at the ECB meeting supports our front-end steepener recommendations. We see positive risks for the EUR from the meeting.
The January meeting could be interesting
We initially thought the January meeting would be a strict placeholder event. But data flow, Governing Council member comments and the prospect of some information about the strategy review have increased the risk of a hawkish undertone. The last set of policy minutes from the December meeting already point that way. We will listen to ECB President Lagarde very carefully about the balance of risks, timeline and aim of the strategy review. And we would not be surprised if, aſter the press conference, ECB sources and individual Governing Council member communication add some nuggets that challenge the view (and market pricing) that the ECB is on autopilot this year.
The ECB is gaining confidence in its economic forecasts. That preceded recent comments from Executive Board member Mersch and Banque de France’s Villeroy de Galhau: this transpired in the December discussion. Further improvements in core inflation in line with our forecasts and the growing of green shoots may quickly (too quickly, in our view) spark a debate on a shiſt in the assessment of balance of risks to “neutral”. This is not likely as early as this week, but the tones need watching.
We will probably be told the strategy review is starting, but watch the wording associated with that. Will the ECB communicate the strategy step-wise? Can it conclude on the “current stance” sooner and leave longer-term ESG (environmental, social and corporate governance) considerations for later, for instance? That matters for the intensity of action we can expect this year. Are “side effects” specifically mentioned? If so, markets could get caught on the wrong foot. That the increased emphasis on the issue in the last set of minutes was completely shrugged off by markets has us concerned. The ECB is communicating, but if markets do not respond, that could create the (we think false) impression that technical adjustments to the current policy stance are a no-brainer. We do not expect action this week, but the potential for ECB-induced volatility is high.
Moving in right direction
The ECB’s economic assessment this week could reveal important nuances. The risk balance is very likely to remain negative, but the magnitude of the downside risks may have somewhat abated. The ECB could surprise with somewhat bolder tones on its confidence in the base case. Think about the following elements: the US-China trade deal is now released and the Brexit Withdrawal Agreement is quasi-approved. These are “news” since the last December meeting. We do not think the ECB, like most of us, expected (or should we say hoped for?) a different outcome, really. And consequently, things going as planned does not mean upside risks. But it means two fewer sizeable short-term tail-risks, even if the longevity of the US-China deal and the future relationship with the UK aſter the transition period remain big question marks.
Data flow has been better, with tentative signs of manufacturing stabilisation, a German annual growth estimate for 2019 consistent with 0.1-0.2% QoQ growth in 4Q19, and decent Nov-Dec import data from China. This combination probably increases ECB confidence in its growth forecast of 1.1% this year.
The same applies to inflation dynamics. Core inflation in the Euro area ended 2019 at 1.3% YoY. Not only is that some 40bp higher than when the September package was announced, it is also already at the level the ECB forecasts on average for 2020 (we think it could still grind a bit higher over the next few months).
Although we would expect the ECB to stick to the overall assessment that risks remain skewed to the downside, especially in a meeting without a forecast update, nuances in tone matter. Both Executive Board member Mersch and Banque de France’s Villeroy de Galhau are on record already arguing that the risk balance has improved. The last set of ECB minutes flags more confidence in the December base case, with references to improving inflation dynamics, in particular.
We would not be surprised if, aſter this week’s meeting, and in particular aſter potential further improvement in January and February core inflation, ECB hawks became more vocal on the risk balance (and maybe question the need for QE). An improvement in the risk balance, with even the slightest hint of a potential move toward a balanced assessment, could underpin Villeroy de Galhau’s assessment that interest rates may have to remain low, but not lower. So from our economic assessment perspective, next week’s meeting comes with the risk of some hawkish-leaning undertones.
A strategy for the strategy review?
Just before the blackout period, Austrian Central Bank Governor Holzmann confirmed the strategy review would start this week (and that Governing Council members had been asked not to provide further details, still adding that negative or low interest rates and side effects needed to be discussed). We expected as much. But we hope for a few more details on the content, timeline and goal of the strategy review, ie, a strategy for the strategy review.
A lot of issues could (probably will) be part of this review: the definition of the inflation target, the measure of inflation, ECB communication and voting procedures, ESG orientation, the current policy stance, etc.
It is too early for details on content. But we will be all ears on two elements: the timeline and the motivation for the review. Will there be a provisional end-date or is this an open-ended discussion that could stretch potentially even beyond the end of this year? Will the ECB communicate during the strategy review or do we run the risk of a flurry of individual governing council views and updates? And will the ECB reveal its strategy in parts, ie, could we get communication on the assessment of the current policy mix before the ECB reveals its long-term strategy on ESG orientation, for instance?
The last point, in particular, matters for the ECB’s capacity to change its current policy stance during the strategy review. One of the pushbacks on our view that the ECB would need to start addressing reversal rate matters as early as 2H20 is that the central bank would not do this during the strategy review. That emboldens our view that the first actions would be through tiering, ie, a higher multiple of reserve requirements exempt from the negative deposit rate; the ECB has flagged that it stands ready to adjust that multiple since the inception of tiering. But if the ECB aims to communicate on strategy review elements as each is concluded, we could see adjustments to the current policy stance before the formal end of the review.
We will also be looking for hints regarding the intention of the ECB strategy review. Of course, reviewing the strategy aſter 16 years is justification enough. In December, Lagarde said the European Parliament, academia and civil society representatives would be solicited during the review. In an interview in early January, she flagged that the ECB should get “closer to the people”. This may be about the perception of inflation across institutional sectors, but it may ultimately also be about concerns about negative interest rates among households, corporates or financial institutions.
Our base case is that Lagarde’s choice of words will be neutral. But what if she mentions the need for the ECB to acknowledge “potential side effects” or “unintended consequences”? The reversal rate issue, but also the ramifications for savers, could implicitly suggest the central bank’s awareness that technical adjustments to the deposit rate would be inevitable. Any sign of the need for corrective action to side effects of negative interest rates would probably catch markets by surprise. We are actually somewhat surprised the increased emphasis on the (need for) monitoring of side effects reflected in the December policy minutes has been entirely shrugged off by markets. Although one of our key (out of consensus) calls for 2020, even we would be surprised if the ECB formally opened the debate about technical adjustments to negative deposit rates as early as next week.
