ECB Preview: Time for Draghi to shift gears

This week’s ECB meeting on 8th June, the same day as the UK election, may not see any changes to monetary policy, but we believe that the Governing Council will take the first steps towards the normalisation of monetary policy in the currency bloc.

Below we take a look at what we think will and won’t change at this month’s meeting.

Changes:

• Forward guidance: we expect the ECB to drop its forward guidance that interest rates (the deposit rate) could be lowered in future, and rather than include in its opening statement “We continue to expect (interest rates) to remain at present or lower levels for an extended period of time”, we could see this change to “(interest rates) to remain at present levels for an extended period of time”. This may seem like a subtle change but it could have big ramifications for financial markets.

• Growth: ECB staff forecasts may revise the growth outlook higher for this year, while revising the inflation outlook lower. GDP is currently forecast at GDP, with core inflation at 1.1%. The risks to growth could be described as ‘broadly balanced’, with no mention of the downside risks.

No change:

• Inflation: we expect the ECB to reiterate that there is still no sign of a convincing uptrend in inflation figures.

• APP: we don’t expect any change to the ECB’s Asset Purchase Programme, and we don’t expect any announcement on tapering. The ECB is likely to maintain that it will increase the size of its Asset Purchase Programme if the “outlook becomes less favourable”.

• Interest rates: the ECB is also likely to commit to maintaining interest rates at current low levels “well past the horizon of our net asset purchases.”

• These changes appear to be relatively modest, however, tinkering with the wording of the opening statement would be the first step to preparing for a bigger shift in ECB policy such as tapering the Asset Purchase Programme or even stopping it altogether. Thus, the outcome of the meeting on June 8th could pave the way for tapering discussions to begin this summer, and this may get investors excited.

The market impact:

The EUR has already benefitted from a strengthening in the Eurozone economic outlook, and since the start of May it is the joint second best performer in the G10 FX world, just behind the New Zealand dollar. We expect a shift in the ECB’s forward guidance to continue to fuel the uptrend in the euro, and EUR/USD may see back to 1.15, the highest level for 12 months, if the outcome of this meeting is as we expect.

The yield curve and the banking sector

However, we believe that the reaction in the European bond and equity markets could be more interesting. The German yield curve (as benchmark for the Eurozone), has been flattening, alongside the US yield curve, as you can see in figure 1. When the yield curve flattens, this means that longer dated (10-year) bond yields are moving at a slower pace than short-term bond yields (2-year), which is suggestive of a weaker economic outlook in the future and potentially lower interest rates.

We don’t believe this is the case for the Eurozone, thus, we could see a steeping of the German yield curve if the ECB does drop its forward guidance on interest rates this week. In contrast, we expect the US yield curve to continue flattening. Our view on the Eurozone yield curve is essentially a belief that the ECB will play catch up with the Fed in the next year, while the Fed may take a prolonged pause on its rate hiking cycle after its expected June rate hike.

The US yield curve is already a lot flatter than the German yield curve, which reflects the large drop in US 10-year yields in recent weeks. The US yield curve is currently 85 basis points, compared with 98 for the German yield curve. Usually, a flattening of the yield curve weighs heavily on a country’s banking sector, however, in this instance European banks continue to underperform their US counter-parts (see figure 2 below).
This is unsurprising given that the ECB’s negative deposit rate erodes profits at Europe’s largest banks. However, if the ECB drops its forward guidance at this week’s meeting then we expect to see the Eurozone/ German yield curve start to steepen, which may warm investors’ hearts towards the European banking sector.

Why European bank stocks could steal the limelight from the US

Figure 2 shows Deutsche Bank and JP Morgan. This chart has been normalised to show how the two banks move together. As you can see, Deutsche Bank has actually underperformed JP Morgan, even though the US yield curve is flatter than the German yield curve. Thus, a less dovish ECB could see Deutsche play catch up with JP Morgan and other US banks, and we may start to see some life in the unloved Eurozone banking sector over the summer months.