Mario strikes…ball now in Fed’s court

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The ECB will almost certainly be delivering an early Christmas present this year. ECB President Draghi could not have made it any clearer that the central bank was planning to step up monetary stimulus in December. This could include an adjustment of the QE programme, but also further policy rate cuts, something which had been ruled out before. The ECB’s signal that it will act also makes it more likely that the Fed will delay raising interest rates until next year. There may be some early signs of that in the statement following next week’s FOMC meeting.

Crucially, all options are now on the table. The ECB could change the size, duration and composition of the QE programme as set out before, but also cut its key policy rates further Nick Kounis Nick Kounis Head of Macro Research

  • The Fed and ECB’s game of currency tennis looks set to continue
  • The ECB strongly signalled it would step up stimulus in December
  • A rate cut as well as a stepping up of QE is on the table
  • The Fed could put a 2015 hike into question at next week’s meeting

Markets cheer

The ECB President’s remarks pushed the euro down towards the 1.11 level and took 2y German government bond yields 6bp lower, to new record lows of -32bp. Indeed, EONIA forwards were pricing in a 60% probability of a 10bp deposit rate cut by year end, compared to 30% before the meeting. The chance rises to 100% by the middle of next year. The prospect of further monetary stimulus also boosted risk appetite, with equity markets surging.

Downside risks confirmed

Mr. Draghi made it clear that the downside risks to the inflation outlook stemming from emerging markets, commodity prices and financial conditions (read: the euro) had been confirmed. As we have noted previously, the EUR/USD has been trading above the levels (of around 1.10) assumed in the ECB’s September projections, while oil prices have been lower than assumed. Those projections were for a medium term under-shoot of the ECB’s inflation target, so recent developments have been suggesting that inflation was set for a bigger undershoot. Another concern for the ECB is that inflation expectations become dislodged, which would make it more likely that inflation gets stuck below the goal more permanently. Market-based measures of inflation expectations have dropped in recent months.

The return of the V-word

Therefore the ECB asserted that it was no longer in a ‘wait and see’ mode but had a ‘work and assess’ stance. Indeed, it would ‘re-examine the degree of stimulus in December’ and committees had been set up to look at the various options. Just to make it clearer, the President brought back the code word ‘vigilance’, which had been used by his predecessor Jean-Claude Trichet to signal that policy action was imminent. Mr. Draghi said ‘we want to be vigilant, as people used to say in the old times’.

All options on the table

Crucially, all options are now on the table. The ECB could change the size, duration and composition of the QE programme as set out before, but also cut its key policy rates further. This would mean reducing the deposit rate deeper into negative territory. It currently stands at -0.2%.The possibility of a further cut in interest rates is something the Governing Council has changed its position on. It had previously stated that the lower bound for interest rates had been reached. The ECB head explained that the situation in terms of inflation risks had changed, while the Council had also seen the experience of other countries (Sweden and Denmark for instance), which had cut rates to significantly negative levels.

Graph: ECB deposit rate and market interest rates

More QE, sharply higher chances of rate cut

Our base case is that the ECB will step up its QE programme by increasing the size of monthly purchases (by EUR 20 bn to EUR 80bn). We also expect it to extend the duration beyond September 2016. Following the ECB press conference, we think the probability that a deposit rate cut will be added to these measures has sharply increased. If the deposit rate is cut, it will most likely be by 10bp, taking it to -0.3%.

ECB needs to strike a balance

The ECB needs to strike a balance in the monetary stimulus package it delivers in December. On the one hand, it needs to do enough to significantly ease financial conditions. An important consideration is getting the euro down. Although as Mr. Draghi noted it is not a policy target, he admitted it has a significant effect on ‘price stability’, which is the ECB’s policy target. On the other hand, the central bank needs to be mindful of keeping its powder dry in case downside risks to inflation intensify in the future.

Fed and ECB playing tennis with EUR/USD

One key aspect in this balancing act might be the Federal Reserve’s deliberations and their impact on EUR/USD. The FOMC will meet next week. It is not expected to change policy, but its statement could give us more of a sense of when it sees the likely timing of its first interest rate increase. It has previously signalled that the first move will be this year. However, the same considerations that have made the case for the ECB to step up stimulus, appear to be also pushing the FOMC towards a delay to 2016. A significant consideration for both central banks is the level of their respective currencies. Market speculation that the Fed would delay rate hikes pushed up EUR/USD in recent weeks. The ECB’s statement yesterday pushed it down.

The ball is now in the Fed’s court

The Fed’s concern that further stimulus from the ECB (and others – the PBoC eased policy further today) will push up the US dollar, will add to the case for it to wait. Indeed, we expect the Fed to delay starting to hike rates until 2016. A more dovish FOMC statement, in line with this view, could push EUR/USD up again. The bigger the upward effect of a Fed delay on EUR/USD, the more aggressive the ECB might then need to be in putting in place stimulus to push it down again. Central bank currency tennis looks set continue.

It is about inflation, rather than economic growth

Against the background of the ECB’s impending stepping up of stimulus, one might ask whether the economic outlook has darkened sharply. That is not really the case. Weaker growth in the global economy led by emerging markets has meant that economic growth in the eurozone (and the US) will be somewhat softer, but the recovery story still stands. Indeed, eurozone PMI data out this morning provided some confirmation of this, with the composite rising to 54 in October from 53.6 in September. Increasing stimulus has much more to do with low inflation.

Mario’s lesson for Janet

President Draghi did a good job yesterday in sounding constructive on the economy, while still announcing more stimulus based on the low inflation outlook. In contrast, in September, the Fed’s decision to delay a first rate hike was seen as bad news as investors worried that it reflected a much weaker growth picture. Fed Chair Yellen could take some lessons from Draghi’s approach, if she does signal that a rate hike will be delayed further.


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