ECB Preview: Arrivederci Mr Draghi, Bonjour Mrs Lagarde

We do not think the ECB's September package will make any material difference in brightening the current inflation outlook, as demand rather than supply side factors hem in the economy. This raises the question whether the ECB should/can do more. The September minutes already revealed widespread disagreement with the latest package, limiting the room for manoeuvre in the near term. Hence we expect the ECB to be side-lined in terms of new policy signals at the October meeting, but the recent fall in inflation expectations raises the probability of further action at the December meeting (or early next year) by the ECB, although it is still unclear what such measures would entail. Fiscal policies are welcomed, however at current stance and judging from the 2020 budgets released, we do not expect fiscal policies to play any meaningful role in lifting inflation.

With the disagreement on the board, incoming ECB president Christine Lagarde will take the hot seat with the challenging tasks of lifting inflation expectations from record low levels as well as uniting an extremely divided GC. We see the first task to unite the two camps in a committed and credible ECB package, and we have already heard a prominent hawk (Weidmann) wanting to put the recent disagreement behind them. We reiterate that we should never underestimate the ECB in its ability to innovate new tools, but at the current stage, 'more of the same' will not do it in our view. Therefore, a lift of the ISIN limits and commitment to expand the asset classes should it be needed could be on the cards, however ECB policies need the support from other policy areas as well. We note that the economic outlook and inflation expectations (both median and probability distribution) will be key. We have observed a small increase in deflation risk probability (see chart on right).

As the tiering system takes effect on 30 October and the ECB restarts its QE programme, Draghi will likely face questions on the impact and limitations of such measures. In particular, we expect Draghi to face questions on the ISSUER/ISIN limits, which we expect to restrict government bond purchases in 15 months' time.

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Bunds under pressure as risk appetite has improved

German 10Y yields have moved 30bp higher from the lows in August and for the first time since July the outright yield is now above -0.40%. Since the last ECB meeting in September 10Y bund yields are some 15-20bp higher. It naturally reflects global sentiment, but also a divided ECB board. Markets have interpreted the September package as the ECB not being ready to yet again do ‘whatever it takes’, which we also have seen in lower inflation expectations and higher real rates.

5y5y real rates (nominal – inflation swap) has moved close to 50bp higher since the August lows. Hence, the market will scrutinize how Draghi addresses the division among the board members, but also how the ECB sees the latest developments in the eurozone economy. However, at the end of the day we do not expect any significant market impact of the ECB meeting. Draghi is after all now leaving the ECB.

We hold on to the view that the market has pushed yields too high over the last couple of weeks and repeat our -0.60% target for 10Y bund yields. The reasons are that (1) the underlying eurozone macro economy is weak, (2) ECB monetary stimulus should not be underestimated in its financial market impact and (3) the market has lost faith in higher inflation. For more see Yield Outlook: Downside to yields remains despite better risk appetite that we published 16 October.

FX: A passive ECB may make EUR/USD go higher

While the meeting may be a ‘non-event’ from a policy perspective, we are less sure if that will also prove to be the case in FX. An ECB which simply commits to its alreadyannounced easing plans and talks about caution in evaluating the effect of these would likely not be enough to propel further optimism in to markets about the long and short-term prospects for the euro area. In turn, a passive ECB could very make EUR/USD go slightly higher on-the-day. The longer-term outlook continues to be heavily dominated by optimism on Brexit and a stabilization in global demand.

Data since last meeting

Bleak European data since last meeting

Since the September meeting news from the economic front has continued to be bleak. Manufacturing PMIs have continued their downtrend and signs of adverse spill-overs to service sector activity have increased (see Euro Area Macro Monitor). On a positive note, money growth picked up some speed, pointing to a slight rebound in the economy in 2020, in line with our view. Still a closer look reveals that the uptick has not been driven by credit to the private sector, but rather by foreign investor inflows.

The main risk factor to the growth assessment is still expected to be the external environment. That said, it is slightly more positive than at the 12 September meeting, with a lower probability of no-deal Brexit, the Phase 1 interim US-China trade war ceasefire as well as a rebound in Chinese data.

ECB’s 2% inflation target as elusive as ever

The September HICP dipped below 1% for the first time since 2016, although slower energy and food price inflation were largely to blame. But even on the underlying inflation pressures, progress remains slight with core inflation stuck at 1.0%. While service price inflation has increased slightly, NEIG inflation continues to ease and stood at a mere 0.3% in September. We think the latter is increasingly becoming a worry for the ECB and a key impediment to lifting core inflation away from the 1% mark it has essentially fluctuated around over the last 2 years. An immediate turnaround does not seem to be just around the corner: import and producer prices are moving south again and, with the manufacturing sector already in recession in several European countries, goods producers remain reluctant to raise prices in the current economic environment.