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ECB Preview: Next stop December

The ECB Governing Council meets on Thursday and we expect no changes to monetary policy. Looking ahead, we continue to expect the Council to upsize and extend the pandemic emergency purchase programme (PEPP) again in December, from the current €1.35 trillion purchases through to end June 2021, as the inflation outlook fails to sufficiently converge towards the pre-pandemic configuration. The Council might use the upcoming meeting to prepare the market for further easing in December.

Investment implications:

· ECB policies support European risk assets but spreads have come in a long way, risks to the macroeconomic outlook are to the downside and a regime of hard fiscal dominance remains elusive.

Additional thoughts:

• Inflation outlook: Inflation remains far below the aim and there has been only partial progress in combating the negative impact of the pandemic on projected inflation dynamics. The September Meeting Minutes saw close to 100 uses of the word “inflation”, around double the frequency of the preceding July Meeting Minutes. Euro area inflation keeps surprising to the downside, with core HICP September inflation falling to 0.2% year over year, the lowest number since the inception of the Euro in 1999. In his Jackson Hole speech, Executive Board member Lane argued that “once the negative shock has been sufficiently offset, the second stage is to ensure that the post-pandemic monetary policy stance is appropriately calibrated in order to ensure timely convergence to our medium-term inflation aim.” There is little doubt that the negative shock hasn’t been sufficiently offset yet, given that the pre-pandemic December 2019 staff projections featured a 2022 core HICP inflation forecast of 1.6%, vs. 1.1% in the latest September projections. The next quarterly staff macroeconomic projections will be released in December, and are unlikely to paint a radically improved inflation picture. They will also, for the first time, encompass an assessment for 2023, which should provide a natural setting for an announcement of additional easing measures. The Eurozone composite Purchasing Managers Index fell for the 3rd consecutive month, slipping below 50 in October. While the baseline scenario of the September ECB staff macroeconomic projections factors in some resurgence of COVID-19 infection rates and tightening of containment measures, current Euro area infection developments and incoming data at a minimum suggest risks to the growth outlook have increased since the September projection round.

• December and beyond: We expect the ECB to upsize and extend the PEPP as soon as the December meeting. An additional €600 billion of purchases, taking the PEPP close to €2 trillion and 17% of Euro area GDP, and extending purchases by six months to end 2021 appear reasonable. We would also look for additional TLTRO-III operations beyond March 2021, as well as an extension of the preferential -1% interest rate period under TLTRO-III from June to December 2021, consistent with the expectation of a PEPP extension over the same horizon. Once the pandemic-related downside risks to the inflation path are sufficiently neutralized via temporary policy measures like PEPP & aggressive TLTROs, we believe more regular asset purchase tools will come back to prominence in order to ease the post-pandemic monetary policy stance further, while interest rate cuts will remain on the back-burner. We continue to believe that, while the ECB will retain optionality and won’t officially rule out deeper negative policy rates, the ECB has a high bar for lowering interest rates further and as such see policy rates unchanged for the foreseeable future. The ECB’s current role is first and foremost to support fiscal policy, a role we believe best served via large scale asset purchases and generous liquidity provision to fund credit expansion.

• Strategy review: President Lagarde might face questions during the press conference on the status of the ECB’s strategy review, after the Fed’s adoption of average inflation targeting and the ECB exercise finally getting off the ground. The ECB aims at presenting the outcome of the deliberations during the second half of 2021, so while questions might come up now and the review increasingly comes into focus over the next couple of months, it is probably too early for Lagarde to disseminate significant insights at this stage. Executive Board member Panetta recently argued that the decline of the natural rate of interest speaks to reduced tolerance for inflation misses, conventionalizing asset purchases and targeted lending to banks, and fiscal and monetary policy reinforcing each other. We continue to expect the review to lead to evolution instead of revolution and don’t expect radical investment implications as a result of the exercise. Review or no review, the ECB will have to remain highly accommodative for years to come.

• Digital Euro: On October 2nd the ECB published a report on a digital Euro. The ECB will now undertake public consultations, and ventures to make a decision on the introduction of a digital Euro around the middle of next year. That makes it a potential topic for questions during the press conference. The lower bound on nominal interest rates is typically considered a result of the physical nature of currencies. If nominal interest rates are sufficiently negative, a natural arbitrage for savers is to withdraw cash from banks and store it elsewhere. Given that cash remains popular in many jurisdictions of the Euro area and the ECB’s intention is to merely complement cash, not replace it, the introduction of a digital Euro ought not to provide the ECB with an opportunity to lower the already negative deposit facility rate much further. Should, at some stage in the digital future, the mood swing decisively away from cash and a Euro area wide consensus builds for replacing it with a digital Euro, the option for much deeper negative policy rates will come into sharper relief. While the disappearance of cash can be considered a necessary condition for deeply negative policy rates, we believe it is by no means assured that it also constitutes a sufficient condition, given question marks about the private sector‘s reaction function in such an environment.

• Tiering multiplier: The ECB introduced tiering in order to mitigate the pressure on banks that emanates from negative rates. However, tiering must be balanced against the desire to keep money market yields near the deposit rate, which in turn requires a large enough amount of reserves at the deposit rate to act as an anchor for the rest of the money market complex. There has been a noticeable increase in the number of ECB references to concerns about the banking system since the start of the pandemic, such as the frequency of reference to the risk of a negative feedback loop between the real economy and the banking sector. The overall trend of concern continued in the September Meeting Minutes, as the full effects of the pandemic had yet to become evident in corporate balance sheets. While recent ECB communication on tiering doesn’t suggest any urgency and political sensitivities probably imply a reactive rather than proactive stance, the ECB is likely to explore whether the current allowance for European banks to put 6x the minimum reserves back at the ECB at 0% remains adequate in light of excess liquidity having almost doubled since the introduction of tiering in September 2019, to now solidly above €3 trillion. We therefore think the ECB will look to increase the amount that banks can leave with the ECB at 0% without jeopardizing a spike in money market rates, and while it’s conceivable that it happens on Thursday, on balance we think a decision to raise the multiplier is more likely to feature in December or next year. A doubling of the multiplier to 12x seems feasible, which should aid banks further and act as an additional anchor for sentiment in the market.

Source: PIMCO, Konstantin Veit, Senior Portfolio Manager Euro Rates

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