ECB preview: still dovish despite better data

We do not expect a hawkish stance from the ECB, although the latest economic survey indicators have strengthened further and inflation has risen above 1.0% for the first time in three years. President Mario Draghi will most likely argue that the ECB does not react to a single inflation figure, that the latest inflation gains are due primarily to energy prices and consistent with the ECB’s inflation forecast – broadly in line with last week’s comments from the hawkish executive board member Yves Mersch.

The higher inflation is good news for the ECB but it seems clear that the underlying price pressure is most important and here there are ‘no signs yet of a convincing upward trend’. ECB executive board member Benoît Cæuré said recently, ‘we are still waiting for signs that core inflation is on the rise and will clearly exceed 1%’. We expect core inflation to stay below 1.0% for most of this year, while the ECB looks for a rise to 1.1% on average.

Although tapering speculation is likely to be boosted in coming months by rising inflation, the ECB has, in our view, sidelined itself until H2 with the latest QE extension. We expect headline inflation to rise temporarily above 1.5% but to come back below 1.3% and stay there in H2 17. Based on this, we expect the ECB to extend its EUR60bn monthly QE purchases into 2018.

It remains an open question how aggressive the ECB’s buying of bonds yielding below the deposit rate will be, as it has only said it will be ‘to the extent necessary’. We estimate that – in order not to breach the 33% issue limit – 15% of the QE purchases in German government bonds will have to be below the deposit rate in a scenario with unchanged yields on German bonds throughout 2017. If purchases below the deposit rate are postponed as long as possible, the ECB will be forced to buy bonds yielding below the deposit rate in November in the scenario with unchanged yields (note the estimates are very sensitive to assumptions).

Yesterday, the ECB published a legal act on the option to buy bonds yielding below the deposit rate, which revealed this was not possible until 13 January 2017. Previous communication from the ECB had suggested it would be possible from 2 January.

As we expect the ECB to continue its QE purchases in 2018, buying bonds with a yield below the deposit rate could become more pronounced, as the QE holdings will have hit the issue limit aside from new issuance. However, the ECB could also decide to deviate the purchases more aggressively from the capital key distribution – in the minutes from the December meeting, the ECB said it wants to minimise departures from the capital key, thereby also indicating that this is a possibility (see link). Buying a larger share of bonds in periphery countries seems attractive to the ECB when, at some point in time, it will exit the QE programme, as this will avoid material spread widening.

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