Keeping a lid on rate-outlook debate

With the FOMC meeting out of the way, the focus today now turns to the European Central Bank, with a lot of market speculation as to what may happen.

Our central scenario is that: (1) while the ECB will start discussions at today’s policy meeting, details of its plans for QE will not be revealed until the July 26 meeting; (2) ECB President Mario Draghi will in his press conference hint at the tone of the discussions, alluding to a consensus that QE will be tapered slowly, but still ending in Q4 this year; (3) an end to QE will be based on inflation optimism, to which signs of life on wages will form a new ingredient; (4) policy will remain accommodative due to the stock of QE holdings, reinvestment strategy, and negative interest rates and (5) Draghi will be coy on the interest-rate outlook, choosing to highlight patience on the timing of lift-off.

While there is now a consensus that QE will end in 2018, there is still plenty of room for the ECB to surprise. If the ECB were to surprise then this is most likely to take the form of: (1) making a QE announcement and revealing details following the meeting today; (2) announcing an abrupt end to QE when the current programme expires in September and (3) keeping QE open-ended and extending taper into next year.

Overall, we think the room for surprising markets is low as the risk is that any surprises could on balance be misinterpreted as hawkish, and therefore an increased prospect of an earlier lift-off as regards interest rates.

The measure of success following the ECB meeting today will be to keep a lid on a debate over the rate-outlook, and ensure that market rate-expectations do not move toward anticipating an earlier lift-off.

Current market pricing suggests a hike is fully priced in by end-Q3 2019, assuming it’s a 10bps move, while a 20bps hike is priced with a 70% probability by the close of September next year. With QE coming to an end, what markets price for the rate-outlook will become increasingly important.

However, we wouldn’t be surprised to see Draghi ending his eight-year term in office, on October 31, 2019, without having overseen a rate-increase, implying a hike won’t come until December next year at the earliest, as there is no scheduled policy meeting in November.

Alan McQuaid (14/6/18)