Markets are positioning for a very dovish signal from the ECB tomorrow, amid the multitude of geopolitical risks and weak PMI and inflation data this week.
Overall, the May round of survey data was disappointing and it is now clear that the uptick in headline inflation in April was mainly due to base effects from the later timing of Easter this year, which in particular lifted holiday related prices. National data suggests a sharp deceleration in the overall Eurozone rate with the May reading to far below the 2% inflation rate that originally was defined as an upper limit, but which many now want to see as a symmetrical target. Coupled with renewed concerns over Brexit and geopolitical tensions.
Against that background, the ECB is expected to hold rates steady at the June council meeting, but push the guidance on rates far into 2020. Draghi will also be eager to stress again that the ECB stands ready to use all available instruments if necessary to bring inflation higher, which will keep the option of a new round of QE purchases on the table, although for now the central bank is unlikely to go back there again. The other main item on the agenda is the new round of targeted long term loans (TLTROs), which is set to start in September and it is anticipated with pretty generous conditions, although rate tiering , as has been discussed as a way to mitigate the impact of negative rates for banks, doesn’t seem to have a majority at the moment.
In a way both issues are connected as in the TLTRO II program the interest rate was tied to the main refinancing rate, but banks, whose lending exceeded the benchmark only had to “pay” the deposit rate of -0.4%. So a discussion on the side effects of negative rates, which could also consider a tiered deposit rate system would have an impact on the details of the TLTRO loan program and vice versa. Linking the loans to the ECB’s standard rates means the ECB is not limited in its rate setting options, but if there were a tiered deposit rate, the question is which to apply to the preferential part of loans for banks that exceed the standard.
Meanwhile, the common currency has been the winner along with Aussie this week. However the recent gains have been driven by Dollar weakness, as opposed to Euro strength, and the key to further upside will come on Thursday, when the ECB meets.
Other than ECB meeting, there ate other reasons to be wary of the Euro. Budget irresponsibility in Italy being one, and the risk of a disordering no-deal Brexit scenario being another. More generally, assuming global markets remain plagued by bouts of risk-off positioning in the months ahead, the Dollar is expected to hold up better than the Euro given the attractiveness of US Treasuries, being the highest yielding risk-free investment available.
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