The last time that the ECB met, there was quite a bit of optimism in the market and among authorities.
Sure, lockdowns were still in effect, and Europe was behind other countries in the vaccination program. But that was before the AstraZeneca and Johnson & Johnson vaccine pauses.
Although, business optimism in the industrial sector is at a record high, the bigger services sector is still wary of when the economy will return to normal.
Meanwhile, the euro has been creeping higher, as investors are less interested in investing in bonds. Both the US and the UK are ahead in the reopening process, providing better investment opportunities for capital.
A stronger euro would have been understood to be a headache for the ECB under pre-pandemic conditions. But with the shared economy facing the prospect of inflation, being able to “wash out” some of it with lower import prices would be helpful.
Getting the economy going
On the other hand, a stronger euro poses a problem for exporters.
With the EU economy already weak, the price of raw materials going through the roof would weigh on the only sector of the economy doing well. Especially when combined with the need to price exports higher.
It was likely partly with that in mind that the ECB announced an expansion of asset purchasing under the PEPP (covid buying program).
It did lower yields for a bit. But the ECB is likely to have to take more stringent measures if they want to actually change the course of yields, and by extension, the euro.
Kicking the can down the road
The consensus among economists is that the ECB will not make any policy changes, and pause after taking action at the last meeting.
Presumably, as time goes on and more people are vaccinated, then there is the expectation of inflation rising as the economy reopens. This would help offset some of the rises in yields. Especially if the ECB manages to effectively communicate that an interest rate hike isn’t likely.
On the other hand, part of the reason why yields could be rising is not related to monetary policy. Typically, bond yields respond to expectations of what the central bank will do. But, the political tensions within the EU block might have a larger role to play.
Italy’s finances are once again under strain. And they might miss a key deadline for their budget. So, as the economy gets back on an even keel, the EU will have to return to demanding more fiscal responsibility of members, and push up the yields on peripheral bonds.
What to look out for
The vaccination program in Europe appears to finally be accelerating to the rate of other developed countries. That said, it’s still at half the rate of the US.
The key to the market reaction is likely to be in the post-rate decision press conference, where Lagarde will have to tread a careful course. Having more experience now, the President has become better at navigating the pitfalls of monetary policy statements. So, we might see a relative calm in the markets.
Points that might shake up the markets is if Lagarde mentions anything about the euro strength being an issue. And/or if she hints at further tightening control of the yield curve.
For example, if she suggests looking at a longer horizon for monetary policy, this could be interpreted as an attempt at Yield Curve Control. And this will bring the euro down.
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