This week sees the second anniversary of the ECB’s asset purchase program and an ECB meeting tomorrow with Mario Draghi. He’s under some pressure to sound more bullish about the European economy and discuss a potential taper of this program. Asked in last month’s press conference if the ECB is ready to do less if the Eurozone continues to outperform, Mr Draghi said it was still a ‘high-class’ problem and the ECB hadn’t discussed it.
Of course since then, the economy has continued to perform well. Business surveys have improved to hit multi-year highs and annualised GDP growth should hit 2%. Many participants are also focusing on headline inflation which returned to the ECB’s target last month, the first time in four years. However, notably these gains have been driven mostly by temporary energy base effects as the core measure of CPI is still ‘subdued’ sitting at just below 1% and has not risen above 1% since August 2013. In which light, we should see updated growth forecasts and a slightly higher inflation profile.
What is key going forward for Eurozone monetary policy will be how the projections stack up against the ECB’s key criteria when headline inflation overshoots. The four principal questions are a policy horizon over the medium-term, that it is self-sustained and not temporary. Finally, inflation should be similar across the whole of the Eurozone.
Well, with the pace of wage growth still moderate and uneven inflation across the continent (France 1.4%, Spain 3.1%), we tend to think Mr Draghi will have to remain cautious sticking to the ECB’s commitment to continue QE until December 2017, or longer if needed. It’s noteworthy too that a favourite gauge of inflation expectations used by the ECB has started to turn down below 1.7%.
Amongst this detail, we should not forget that QE was extended in December, albeit at a slower pace as a safety net ahead of the political risks of this year. We have seen these act as a strong headwind already for the single currency and this will dominate its near term direction with the fascinating upcoming French elections. Once these are out the way, we can foresee the ECB becoming more hawkish and the June meeting is then favoured for a potential change in forward guidance. Don’t forget, this will play very well with the German electorate, and their election later in the year.
For the single currency, interest rate differentials (eg. the U.S. 2-Year/German yield spread) are at 17 year highs and the prospect of three hikes by the Fed are now rising above 50% as the market plays catch-up. Market structure reflects this central bank policy divergence which is still firmly bearish with multiple layers of resistance. We will need to see a decisive break of the 1.05 resistance zone to kick on and head for multiple-year lows.