Investors are impatiently awaiting the monetary policy update for the eurozone while the ECB has entered a so-called quiet period before the meeting on September 12. In the coming week, no new comments from the members of the ECB’s Governing Council are to be published, however market participants continue to speculate about the possible outcomes of the regulator’s decisions.
The economic environment has essentially remained in the same condition as it was during the previous ECB meeting in July. Inflation numbers released in August remained at the same low level, at 1%, well below the 2% target of the ECB which can be used as the main justification of any new monetary easing. The economic outlook is not improving, especially with weak data from Germany where manufacturing orders are declining more than expected: a drop of -2.7% in July vs. expected -1.5%. Even with the continued strength of the European labor market (low unemployment and stable wage growth), the major discussion of the ECB meeting is expected to focus on downside economic risks.
The main concerns for the European policymakers are the external risks which can materialize in Q4 2019. The protracted trade war between the US and China has intensified further as none of the parties seem to be willing to concede. Brexit, with the current deadline still on October 31, adds to the overall uncertainty, especially if the UK leaves without a deal. As for the internal risks, we see political confrontations in Italy and in Spain as the main sources of market fluctuations. Both countries are set to have new governments before the end of the year and more clarity on the prospect coalitions are expected in the coming weeks.
Tempering the anxiety
After the July speech of Draghi, market expectations were boosted with the indicated willingness of the ECB to act "far and wide" if needed. Therefore, most forecasts on the potential measures are now large-scaled and include using three measures:
- Rate cut. A decrease in the deposit rate is not complex to implement. The implied market probability of a rate cut is close to 100% for the September meeting, in the range between 10 and 20 basis points cut.
- Tiering system. Tiering for banks was mentioned by Draghi in July and is now widely expected. This solution aims to ease the negative effects of the potential rate cut for banks' profitability. This would be a new tool, therefore, the ECB will have to come up with a whole novel framework for implementing it.
- Asset purchase program (APP). Many ECB watchers are betting on the start of the new quantitative easing (QE). The estimated size of the monthly purchases varies in the range of 20-40 billion. The ECB can surprise the market by expanding its list of eligible instruments with new asset types like equities or bank loans.
In the last weeks, some ECB voting members expressed their skepticism, indicating that the decision to start APP is not a done deal and should be treated as a last resort tool. Central Banks' representatives from Germany, Netherlands, Austria, France, and the Executive Board member Sabine Lautenschlaeger have indicated doubts on whether to start a new QE program is the appropriate measure for the current economic environment. This criticism from the ECB officials has weakened the case for the expected restart of the QE in September.
We see a higher probability now that the ECB will need more time to decide whether to start a new round of QE immediately to prevent a recession or to activate asset purchases only if the potential external risks materialize. The absence of the new APP can be a disappointment for financial markets because expectations are high. However, the majority of investors see limited benefits from the new QE for the real economy. For fixed-income securities, the new round of asset purchases means even more negative yields, which would put extra pressure on large investors such as insurance companies and pension funds in their ability to generate returns to cover their liabilities.
Draghi might push for a wider stimulus before finishing his ECB presidency period after 8 years of unprecedented monetary easing in the eurozone. Given his dovish stance and leadership style, he is expected to memorialize his term by accelerating an extensive package to give support to the European economy.