ECB October Meeting Preview: Will the ECB turn hawkish?

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Summary:

  • Investors gear up for the ECB’s tapering announcement
  • Expectations are for the central bank to cut its QE purchases by as much as 30 billion euro
  • Scope of the re-calibration to be in effect for at least nine months starting January 2018
  • Majority of the QE re-calibration to come from the corporate bond purchases
  • ECB expected to downplay the tapering decision by reiterating that QE could extend in time if need be
  • Expectations high for the ECB to end its QE purchases by end of 2018
  • First ECB rate hike projected for 2019

All eyes turn to the European Central Bank this Thursday as the much-awaited tapering announcement will mark an end to a few months of speculation. The ECB is expected to announce a tapering of approximately 30 billion euro from its quantitative easing program. Currently, the ECB is purchased a total of 60 billion euro made up of both sovereign and corporate bonds.

In terms of the breakdown, the central bank is expected to cut back more on the corporate bonds first. While the markets may get what they were anticipating over the past few months, a lot of questions remain.

A taper of 30 billion euro will cut the current bond purchases by half to 30 billion euro and will see a reduction of nearly 50 billion euro since the ECB started its QE program in January 2015. The central bank had started its bond purchases at a pace of 80 billion euro.

For one, the newly proposed tapering scope will come into question. As widely expected, the ECB will implement its tapering starting January after previously committing to purchase bonds at the current pace until December.

For how long the next (and reduced) QE purchases will run for remains the big question. The ECB for its part is likely to err on the side of caution and maintain a dovish tone. The markets are currently anticipating that the new tapering will run for at least nine months with the ECB expected to end its QE program by end of 2018.

ECB’s inflation forecasts and forward guidance

The forward guidance will, of course, play a vital role in setting the market expectations. A more upbeat ECB statement could pose the risk of the markets front-running the ECB. This could result in a higher exchange rate for the euro currency which could in turn delay growth and dampen inflation expectations.

Core inflation is expected to remain steady at the current 1.1% levels, although the central bank had previously flagged that inflation could slow into early next year.

Why Do Central Banks Target Inflation?

The ECB will also have to address the topic in regards to the key interest rates. It is quite likely that Draghi will use this as a means to keep the market expectations in check.

Thus, despite the prospects of the ECB ending its QE next year, interest rates are likely to remain low for a longer period after QE ends. There is also the possibility that the ECB will retain its wordings in regards to the QE. Most importantly, the central bank could stress that the option to extend QE beyond current expectations are still open.

Beyond tapering, the markets are expecting the ECB to hike rates no sooner than 2019 with some expecting a one-off rate hike in 2018. However, this is all subjective and depends on the economic developments in the Eurozone.

With the euro already seen surging, the strong rally already suggests that the markets are well prepared to match the ECB’s potential announcement of a 30 billion reduction to its QE program. Thus, the market reaction could be mostly muted on this prospect.

However, the press conference that will be held by Draghi, later on, will prove to be crucial as far as the FX markets are concerned.

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