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ECB Policy Outlook: QE2 and Forward Guidance

Core Content Summary

The European Central Bank (ECB) is expected to implement a series of policy measures in the second half of 2019, including:

• Reintroducing an easing bias in forward guidance by the end of 2019.
• Two 10bp cuts to the deposit rate, with the first likely in September and the second in October.
• Tiering to mitigate the negative impact of further rate cuts on the banking sector.
• Resumption of Quantitative Easing (QE), with a monthly purchase pace of EUR35-40bn for six to nine months, potentially extending further if needed.

These measures aim to support inflation and growth, which have remained below target and trend, respectively.

Main Views and Key Information

1. Forward Guidance and Conditionality

• The ECB is likely to revise its forward guidance to make it conditional on the actual achievement of the inflation target, rather than just convergence.
• This shift could mean that rates will remain low until headline inflation reaches and sustains 1.8–1.9%.
• The change is expected to occur as early as July 2019.

2. FX Market Impact

• A resumption of QE is expected to curb EUR gains, even against a weaker USD.
• EURUSD is forecast to peak at 1.20 in Q4, but the tactical outlook remains bullish, with a target of 1.18 in Q3.
• EURJPY is seen as more bearish, with a target of 116 by year-end.

3. Interest Rates

• The ECB has limited room for further rate cuts, with another 40bp possibly feasible, and 20bp expected by October.
• Tiering will be used to reduce the burden on banks, as lower rates increase excess liquidity.
• The impact on net interest margins (NIMs) is a key constraint, as the cash flow effect of negative rates is relatively modest.

4. Equities

• The ECB's renewed unconventional monetary policy may accelerate de-equitisation, particularly in the value factor, due to increased private equity investment.
• The symmetric inflation target and the need for above-target inflation to offset previous misses could signal a strategy review is in the works.

5. Credit Market Implications

• The Corporates Sector Purchase Programme (CSPP) eligibility pool for non-financials is estimated at ~€330bn.
• Banks' Senior Preferred bonds could be included but face legal and conflict-of-interest challenges.
• The ECB is expected to focus on government bonds, with covered and corporate bonds playing a smaller role.

6. QE Timing and Volume

• The QE2 announcement is most likely in December, though September is not ruled out.
• The ECB may wait to exhaust the room for rate cuts before launching QE, to maintain credibility and avoid legal risks.
• The initial purchase pace is expected to be EUR35-40bn per month, with the potential to extend the programme if needed.

7. Cross-Currency Basis Trade

• A EUR/USD xccy basis flattener trade is initiated, targeting a 32bp spread.
• The trade is expected to fall as QE leads to increased excess liquidity, potentially driving down the xccy basis.
• The curve is expected to re-steepen, affecting shorter maturities.

Key Risks and Uncertainties

• Uncertainty remains about the reversal rate and the impact of further cuts on the banking sector.
• Economic and geopolitical risks, such as US-China trade tensions and a no-deal Brexit, could pressure inflation.
• Inflation expectations may disanchor if the ECB fails to meet its targets, leading to more aggressive measures.

Conclusion

The ECB is poised to implement a comprehensive policy response to support inflation and growth, with QE2, tiering, and forward guidance revisions as central components. The timing and magnitude of these measures are influenced by internal consensus, legal considerations, and market expectations. The FX market is expected to respond negatively to the resumption of QE, while the equity market may benefit from a renewed focus on value assets. Investors should remain vigilant of the ECB's policy trajectory and its impact on financial conditions.