ECB Preview: Stuck in a dovish corner

Q. What will be the main market focus?

A. We don’t expect any change in monetary policy, with the exception of a more cautious tone adopted by Christine Lagarde. There will be mostly three points of interest for market participants: the new macroeconomic projections, any discussion about the euro exchange rate and the latest developments regarding the strategy review. Regarding the economic assessment, in the minutes from the last July meeting, the ECB noted that: “It was generally underlined that, by the time of the September ECB staff projections, more information would be available for a reassessment of this profile and any implications for the medium-term outlook for the activity”. Since July, we have had plenty of indications that the recovery stalled in August and in early September in most euro area countries, that COVID-19 cases are on the rise and that the inflation baseline scenario (with an inflation rate at 1.3% in 2022) is seriously challenged by persistent deflationary pressures (see our note, The inflation shocker). The ECB’s new economic assessment should take into account this more uncertain and difficult environment, and should underline the possibility of a long-lasting and very gradual recovery, in line with Philip Lane’s recent warnings. As it is the case anywhere else in the world, the continuation of economic recovery is contingent on virus developments.

Q. How will the ECB tackle the strong euro?

A. It is likely that a big part of the press conference will be devoted to the euro area exchange rate following recent comments from the ECB’s chief economist, Philip Lane, about the surging common currency. The current level of the euro exchange rate is already uncomfortably high for the ECB. Looking at the widely-watched trade weighted index, the euro is in risk-territory, trading near six-year highs. With falling inflation, the ECB cannot afford the euro to surge further and cross the psychological threshold of 1.20 versus the US on a sustainable basis. A strong euro reduces the level of imported inflation and seriously damages the ability of the central bank to reach its inflation target. It implies major negative ripple effects on the economy, hurting both inflation and growth. Based on the latest calculations from Goldman Sachs, the appreciation of the euro so far might translate into lower growth and inflation by about ¼ percentage point in each of the next two years. We don’t think there is appetite for further rate cuts from the ECB to counter the strong euro. At least for the moment, verbal intervention should do the trick and help containing the appreciation of the currency.

Q. Do you expect any insights about the ECB’s strategy review?

A. The Federal Reserve’s decision to favor an average inflation target is not without consequences for other central banks but we don’t think it will drastically change the ECB’s stance on inflation. The debate regarding inflation targeting is still going on in academic and public circles – with Jean Claude Trichet indicating recently that the ECB should move to targeting core inflation for instance. But we believe it does not have much significance and that a symmetric 2% target, which gives more flexibility to the central bank, is already a done-deal. It is very unlikely at this stage that the ECB will move beyond that. As the strategy review is still at an early stage, with many pending questions regarding the ECB’s “green” role, it is likely that Christine Lagarde will refrain from giving too much insights this week in order to avoid preempting the discussion.

Q. How markets could react to the outcome of the ECB’s gathering this week?

A. With market attention mostly focusing on the euro, any attempt to talk down the common currency could create high volatility on the EUR/USD cross and push it down in the short- and medium-term. Our head of FX Strategy, John Hardy, pointed out earlier this week: “Given often-noted heavy speculative long position in EURUSD, the favoured scenario is some exploration of the key major trend support zone that stretches down toward 1,1500”.

Q. When will the Governing Council make revisions to its asset purchase program?

A. Given the prevailing economic uncertainty, the deflationary environment and the growing risk to face a new drop in economic activity in Q4 this year on the back of a new spread of the virus and COVID-19 bankruptcies, we hardly see how the ECB could avoid expanding further its PEPP. The question is not whether the ECB will use its envelope in full, as it was still the case a few weeks ago, but when it will increase it. We are onboard with consensus expecting a new increase of its asset purchase program by €500bn by the end of the year (probably in December). Our baseline scenario for the coming years is central-bankism and continued support to the economy via asset purchases are the new normal in post-COVID times. That means we don’t see the end of central bank’s asset purchase programs.