EUR/USD

As widely expected, the ECB announced that it will stop net asset purchases at the end of this month. Today’s highlights are Draghi’s more cautious tone on growth and additional information on the reinvestment policy, including an enhanced reinvestment guidance.

“Continued confidence with increasing caution”, this is how Draghi described the tone of the discussion within the Governing Council. While confirming the Governing Council’s confidence in the resilience of domestic demand, Draghi acknowledged that incoming data have been weaker than expected and momentum has slowed. Increased caution was more visible in the risk assessment than in the new macroeconomic forecasts, as the latter show slight downward revisions to growth and inflation numbers that do not exceed 0.1pp per year. Risks to the growth outlook are still seen as broadly balanced, but, importantly, “the balance of risks is moving to the downside”, mainly in the wake of external factors.

The enhanced reinvestment guidance states that full reinvestments will continue “for an extended period of time past the date when we start raising the key ECB interest rates”. This compares to the previous, more generic, version envisaging reinvestments to last for “an extended period of time after the end of net asset purchases”. What does this change imply in practice? In our view, it suggests that full reinvestments might continue until at least the end of 2020. As a matter of fact, we can try to "quantify" the approximate length of "extended period of time” by taking as a reference the latest change in the ECB’s rate guidance, which happened in June and replaced the expectation to keep rates unchanged for an "extended period of time" with the expectation of unchanged rates "at least through the summer of 2019". Assuming that the ECB did not make any meaningful reassessment of the outlook between April (the last time they used the old rate guidance) and the June meeting, this would imply that the ECB regards "extended period of time" as being at least one year. Therefore, if we add at least one year to the time of the first rate hike currently implied by the rate guidance, say fourth quarter of 2019, we end up with reinvestments lasting until at least the end of 2020. This time frame is broadly in line with what we had expected entering today’s meeting (similarly, market expectations were for reinvestments to last two-to-three years).

The new guidelines for reinvestments published today reveal that the ECB will gradually adjust its PSPP purchases to the new capital keys and preserve the market-neutrality of its purchases (in other words, the ECB does not plan Twist-like operations). The ECB will also aim to keep the size of each individual purchase program constant.

With net asset purchases soon behind us and more details available on the reinvestment policy, the two hot topics in the coming months will be liquidity provision to banks and the timing of the first interest rate increase. In regard to liquidity, we think the ECB will ultimately decide to extend TLTROs, probably by two years, at a less-favorable, variable interest rate (which could be the MRO rate). The rationale behind this extension would be twofold: first, it would allow the ECB to avoid a liquidity “cliff effect” as the residual maturity of outstanding TLTRO money starts to fall below one year in mid-2019, with negative consequences for banks’ net stable funding ratio. Second, it would support the transmission mechanism of monetary policy by easing funding stress for Italian banks. In regard to rate policy, if the coming months do not bring any improvement in the numbers for growth and core inflation, the ECB would feel increased pressure to make a dovish change in the rate guidance that pushes the timing of the first rate hike from after next summer into 2020.

U. S. consumer prices were unchanged in November, held back by a sharp decline in the price of gasoline, but underlying inflation pressures remained firm amid rising rents and healthcare costs.

The strength in underlying inflation reported by the Labor Department on Wednesday supports views that the Federal Reserve will raise interest rates at its December 18-19 policy meeting. The U.S. central bank has hiked rates three times this year.

November's flat reading in the CPI, which was the weakest in eight months, followed a 0.3% increase in October. In the 12 months through November, the CPI rose 2.2%, the smallest gain since February, after advancing 2.5% in October.

Excluding the volatile food and energy components, the CPI climbed 0.2%, matching October's gain. That lifted the year-on-year increase in the so-called core CPI to 2.2% from 2.1% in October.

Last month's inflation readings were in line with market expectations.

Despite the firmness in core consumer prices, the overall inflation outlook is benign amid falling oil prices and signs of slowing economic growth both in the United States and overseas.

A report on Tuesday showed producer prices edging up 0.1% in November after accelerating 0.6% in October.

The Fed's preferred inflation measure, the core PCE price index excluding food and energy, increased 1.8% year-on-year in October, the smallest gain since February, after rising 1.9% the prior month. It hit the U.S. central bank's 2% target in March for the first time since April 2012.

The market expects the core PCE price index to hover below that target for much of 2019, which they say could see the Fed temporarily halting interest rates hikes.

Minutes of the Fed's November policy meeting published last month showed nearly all officials agreed another rate hike was "likely to be warranted fairly soon," but also opened debate on when to pause further monetary policy tightening.

Traders expect no more than one rate increase in 2019. In its last forecasts in September, the Fed projected three rate hikes in 2019.

When the Governing Council of the ECB meets this week, it will be facing a less favorable growth outlook, no signs of core inflation trending higher and nervous financial markets. The truce between the US and China will buy time but does not fundamentally ease trade concerns, while in Italy the situation remains fragile with sovereign spreads still very wide and the economy flirting with recession. Recently, the only unambiguously good news has been the sharp drop in oil prices, mainly supply-driven, which will contribute to supporting eurozone economic activity in the coming months at a time of intensifying downside risks.

This assessment is likely to be reflected in a more cautious tone by ECB President Mario Draghi and in the ECB’s updated macroeconomic forecasts, which will probably show a downward revision to GDP growth for 2019 and 2020 from 1.8% and 1.7%, respectively, to somewhere in the 1.5-1.7% range. The latest data have confirmed that the ECB’s projections for core inflation remain too optimistic; the possibility of a further slight downward revision there, together with lower oil prices at the cut-off date, pose downside risks to the inflation forecast for the next two years, which currently stands at 1.7%. Numbers for 2021 will be published for the first time and they will probably show GDP growth settling at about 1.5% (broadly in line with the estimated potential growth rate of the economy) and inflation at 1.7-1.8%. It should be considered that some of the recent slide in oil prices occurred after the cut-off date used to determine the exogenous inputs to the ECB’s models. Therefore, the new forecast numbers will not fully reflect the scale of the correction in oil prices.

Despite the assessment turning less favorable, the Governing Council is very likely to call an end to its net asset purchases, reflecting the progress made so far in boosting economic growth, closing most of the output gap and stimulating wage formation. With the risk of outright deflation sharply reduced since the inception of QE and with technical constraints increasingly biting, an emergency tool such as net asset purchases is rightly regarded as having run its course.

However, financial conditions will have to remain very accommodative. Therefore, the ECB will probably take the opportunity to enhance its reinvestment guidance, at least by clarifying the timeframe for rolling over maturing assets. The current generic wording, that reinvestments will be carried out “for an extended period of time” after the end of net purchases, might be replaced with a statement suggesting that reinvestments will last for at least two years after QE is terminated – as a reference, the Fed’s full reinvestments lasted for three years after the end of their QE. The ECB’s chief economist Peter Praet recently noted that the market expects reinvestments to continue for two-to-three years. We doubt any change in the ECB’s guidance will challenge this expectation.

Liquidity support to banks will be another topic up for discussion this week, although our gut feeling based on the latest statements by Governing Council members is that an announcement might not come yet. We think the ECB will ultimately decide to extend TLTROs, probably by two years, at a less-favorable, variable interest rate. The rationale behind this extension would be twofold: first, it would allow the ECB to avoid a liquidity “cliff effect” as the residual maturity of outstanding TLTRO money starts to fall below one year in mid-2019, with negative consequences for banks’ net stable funding ratio. Second, it would support the transmission mechanism of monetary policy by easing funding stress for Italian banks.

Given how important timely guidance on liquidity policy is for banks’ funding plans, if the ECB does not make an announcement on Thursday, it will probably not wait any later than March 2019. If Draghi signals his determination to preserve the transmission mechanism of monetary policy, this should be read as an indication that action on liquidity is in the pipeline.

Easing growth and weak core inflation raise the risk of a bold dovish change in the rate guidance, for example one that pushes the timing of the first rate hike from after next summer into 2020. We see a 25% probability of this happening on Thursday.

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