ECB preview: Monetary exit remains very distant

We expect rates to be kept unchanged, which is in line with the general perception. This week?s meeting will be about the implications of the sell-off in fixed-income markets. Draghi is likely to repeat that an ECB exit is very distant; that rates will rise at some point; while excessive rate rises in the periphery could be dealt with by activating the OMT. No immediate implementation of an ABS programme. That is a slight disappointment to us, but probably not a major issue for the markets. Inflation should be watched carefully during the autumn. It is a lagging indicator, but significantly lower inflation would be an indication that the initial view on the cause of the crisis and the crisis response was wrong, and could prompt much more aggressive ECB easing. Dovish but stopping short of new actions Several Governing Council members gave speeches last week, which should give us some indication of the implication of higher market rates. Based on these speeches, we believe Draghi?s key messages at the press conference will be: 1) the ECB stands ready to ease again and an exit remains very distant, 2) higher market rates per se are not an issue for the ECB and 3) the OMT is the ECB?s weapon against excessive levels of peripheral bond yields, but it requires a bailout request from Spain or Italy or others. The first response by several speakers to the massive sell-off in fixed-income markets was to state the obvious fact that the ECB is no way near the Fed when it comes to monetary exit. C?uré said: ?? at the current juncture, there should be no doubts that our ?exit? is distant and our monetary policy is and will remain accommodative.? And Draghi said that the ECB stands ready to act again if necessary. That is verbal support to prevent market rates from rising further and verbal support for general confidence in a modest Euro-area recovery during the remainder of the year. C?uré also said: ?However, these conditions are not permanent; interest rates will eventually increase, triggered by a tightening of the monetary policy stance, by an unwinding of global risk appetite, and/or by other external events. The recent bout of volatility in global fixed income markets is excessive in view of the current economic conditions, but it can serve as a useful reminder that such developments cannot be dismissed lightly.? And later he continued ?The financial system should however be able to operate under a different constellation of yields. The current period of low interest rates should be used to prepare for it.? This suggests to us that the ECB is not overly concerned about the rise in interest rates per se. It will probably require a weakening of key figures to trigger more ECB easing and not ?merely? rising interest rates. Up to this point, key figures have continued to improve since the June meeting, eg PMIs and other high-frequency activity indicators. Finally, the rise in peripheral yields should be somewhat more of a concern to the ECB, especially if sustained over the coming months. Here the ECB can repeat the threats of bond buying via the OMT, though obviously underscoring that OTM activation requires that eg Spain or Italy asks for a programme. For Portugal and Ireland, OMT activation still requires market access, which will obviously be more complicated if current market conditions are sustained. All in all, Draghi is likely to remain dovish but stop short of concrete actions. No immediate implementation of an ABS programme The conclusions from the first part of the EU summit section 8b call for joint risk-sharing between the European Commission and the European Investment Bank ? which we believe is a prerequisite for an ABS programme with the ECB ? and could be implemented from January 2014. One more time, we have been proved too optimistic when it comes to the timetable for financing peripheral SME loans. With the benefit of hindsight, we do see that Draghi gave some hints at the June press conference that there would be no immediate implementation. That is a slight disappointment to us, but probably not a major issue for the markets. See more about our take on the EU Summit: Banking Union: A small step forward . Start watching inflation more carefully for signs of deflation risks Looking a bit further ahead, we believe inflation will be key to the ECB. We recently did a research note which took a deeper look at deflation risks in the Euro area (see the summary below). Inflation is likely to print higher when the June reading is released today, and for July, but then we expect lower numbers during the autumn. Very low prints for August and September could re-ignite fears of deflation and a Japanese lost decade. Just to summarise our call on the ECB: we expect a gradual recovery with no need for more easing, but see risks tilted to the downside. There are two ways that the ECB could be forced to ease again, in our view. The first is near-term key figure weakness, rapidly falling excess liquidity or excessive EUR strength, which could all prompt a near-term refi rate cut and perhaps even a deposit rate cut. However, the other way, the one where we could see the ECB act much more like we have seen the Fed or the Bank of England, would be in case of increasing deflation risks. The ECB (and the German) view seems to have been that the Euro-area crisis is very structural. Basically, the periphery lived above its means and is now adjusting to a new normal. In this scenario, there is no room for fiscal or monetary easing, austerity is the only way to reduce debt and structural reforms are the only way to return to growth. However, this view seems to be changing. The ECB cut interest rates in May and turned significantly more dovish even though the projection for growth and inflation was more or less unchanged from December last year. And the European Commission has accepted a somewhat slower reduction in structural deficits. In January, Draghi said that if the output gap was as big as some suggested then inflation would have been lower. Inflation dropped significantly in the following months. The ECB turned significantly more dovish. The new view seems to be that at least part of the crisis is due to the lack of demand and the lack of confidence. This scenario is completely different. Fiscal and monetary policy should be eased, the growth potential is still there even without structural reforms, and debt can be brought down by the return of growth rather than austerity. This scenario also means that deflation risks and the risk of a lost decade are real if economic policies are not eased enough. Inflation is a lagging indicator, but significantly falling inflation would be an indication that the initial view on the cause of the crisis and the crisis response was wrong. Increasing evidence of a growing output gap would prompt a significantly more aggressive stance from the ECB, in our view. For that reason, we believe inflation should be watched carefully during the autumn.