ECB monetary policy braced for a trend reversal

The sentiment indicators in the Eurozone are in a celebratory mood. Both the purchasing managers‘ indices as well as the business climate indicators are signalling an acceleration in economic pace in the Eurozone in the months ahead. The recovery is evidently not just restricted to certain countries, with quite a few EMU member states recently delivering robust economic signals. The upswing in the Eurozone thus appears to be gaining a broader base. This encouraging development might be attributed to a slight acceleration in global economic activity. A slightly higher oil price and a still very stable economic development in China are also contributing towards this trend.

The spectre of deflation, that had kept market players and central bankers in suspense last year, has receded in response to a strong increase in European inflation rates. Inflation pressure remains low, but the latest positive developments regarding the economy and inflation are creating a growing sense of unrest among the monetary decision-makers. The American Federal Reserve has already responded and raised interest rates in March, with two further rate hikes likely to follow in 2017. The ECB is still a long way off from raising key interest rates. But at the most recent meeting of the ECB Council, President Draghi already no longer sounded quite as pessimistic as in the past. In the months ahead, a less expansionary tone will also become gradually perceptible in monetary policy formulations.

But before the ECB can raise key interest rates, it will still want to bring its current asset purchasing programme to an end, at least according to the ECB’s mantra until now. At the September meeting, the ECB can be expected to announce that the programme will be continued into the first half of 2018, along the lines of „lower the dose, extend the prescription“, but with the volume probably being tapered by EUR 10bn to then EUR 50bn per month. The ECB can be expected to end the programme in the course of 2018 provided there is no outbreak of fresh problems at the euro countries. In particular the approaching parliamentary elections in Italy could cause upheavals on bond markets. Were this to happen, the ECB could maintain its asset purchase programme also beyond 2018.

During the course of 2017, however, the ECB should nonetheless tighten the monetary screw. In the autumn of this year, the ECB will likely raise the deposit interest from minus 0.40% to minus 0.25%. As health is gradually restored to the credit channel and the risks of deflation recede, the ECB will then be in a position to signal a further normalisation of monetary measures once symmetry has been restored to interest rates. Overall, however, its monetary alignment will remain unequivocally expansionary.

The central banks in the USA as well as in the Eurozone appear to have bid farewell to their monetary lows and are heading towards a less restrictive monetary policy even if it remains expansionary on both sides of the Atlantic. These developments have already had an impact on bond yields, albeit more strongly so in the USA than in the Eurozone due to the ECB’s ongoing bond purchasing programme. In the USA at least, the bulk of the interest rate expectations has already been priced into yields, thereby limiting any further increase. Yields on 10y Treasuries in the USA are therefore unlikely to exceed 3%. Bunds are unlikely to rise beyond 0.75% by the end of 2017. The days of extremely cheap money are gradually coming to an end, not that money will become all that dear either.

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