Gains and pains from lower for longer ECB

Summary

The ECB’s decision to bide its time before raising rates after a complete exit from QE is supporting both stock and bond prices whilst crushing the euro.

Tightening timing

Policymakers confirmed the further tapering flagged on the record earlier in the month, including the pace, €15bn from €30bn, before the taps are turned off completely in December. What now looks like a orchestrated surprise was the decision to delay interest rate rises under almost all circumstances for at least a year from now. Given that ECB President Mario Draghi is set to step down in October 2019, a slower than expected return to sufficiently inflationary conditions risks overlapping with the transition, complicating rate timing further. As oil prices continue to fade from last month’s cycle peak,  even before OPEC increases supply as mooted, inflationary inputs from energy will soon fall out of the equation, a potential risk to the small CPI forecast increases policymakers made for this year and next, whilst reducing growth estimates. On the other hand, what Thursday’s policy moves have provided is ample wiggle room should economic hazards springing up along the path to normalisation—e.g., Italy, trade—threaten to lengthen the current economic pause.

Euro faces reality

The single currency quickly priced out froth from volatile gains earlier in the month following senior ECB policymakers’ strong signals that QE was coming to an end. Confirmation came with the central bank’s clearest guidance yet on the timing of higher rates, but by instigating a delay on the heels of the Federal Reserve’s increasing gusto for tightening, the news was taken as an unexpected extension of accommodation. This handed stock markets on both sides of the Atlantic their least equivocal gains of the week, though a reversal for giant U.S. banks kept the Dow flat. Europe’s banking index also closed firmer, but among the region’s weaker performers, suggesting the move may persist in coming sessions. Still, with stock markets having made it through the most intense risk events of a multi-faceted week with plenty of underlying buying interest, major indices should now continue to grind back towards early-2018 highs after last month’s disruptions.

ECB raises stakes for BoE

With the ECB’s moves now out of the way, and after Friday’s Bank of Japan policy decision, the Bank of England will be amongst the remaining pivotal central banks still to update policy in the second half of the year. The ECB’s warning that rates may only rise well into 2019 will tighten focus on the euro’s rate differential to sterling. Indeed, sterling was on course to close with its strongest gain against the single currency so far this year, well into the U.S. session on Thursday. That strength may be a precursor of new difficulties the MPC could face as it tries to stabilise inflation, following signs of rebounding input prices earlier in the week whilst consumer prices came up short. With Downing Street managing to snatch a victory, albeit temporary, by defeating rebel amendments to the Brexit Bill, sterling may even benefit from the absence of pressure on that front, ahead of a critical Brussels Summit on 28^th June. Advantageous fundamental conditions could thereby coincide with relative euro weakness to underpin the pound and put BoE policymakers under further pressure.

Figure 1 - euro/sterling FX pair: 1-day absolute change interval chart, 4pm BST, 14^th June 2018