January 14, 2019
Peter Wilson , Global Fixed Income Strategist
Outlook for European Central Bank Policy in 2019
- The European Central Bank (ECB) may make its first rise in the deposit rate (currently -0.4%) in September 2019, earlier than the markets expect, and if circumstances permit, take rates back to zero by year end.
- The ECB ended its net bond purchases in 2018 without negative market reaction, as expected. In 2019, we expect continued gross purchases for reinvestment to support bond markets and to moderate yield increases as policy rates start to rise.
What it May Mean for Investors
- While the policy-rate increases from late in 2019 may push eurozone bond yields higher from mid-year, we think these rises should be contained and gradual. If the ECB begins to signal its intention to normalize rates sooner than the market expects, this should support our forecast for a moderate euro appreciation against the dollar in 2019.
The ECB terminated net bond purchases in December. However, in our opinion, this is not the end of Quantitative Easing (QE), and policy still remains accommodative. Importantly, as the U.S. Federal Reserve (Fed) did, the ECB will continue to reinvest principal and interest from its roughly 2.5 trillion euro ($2.9 trillion) in holdings of (mainly government) bonds. At the ECB’s last monetary policy meeting on December 13, the central bank enhanced its guidance on QE reinvestments, stating in its press release that reinvestment of principal would continue for “an extended period of time past the date when it starts raising the key ECB interest rates.”1 The ECB also gave itself more flexibility on the reinvestment timing by widening the time window within which it can reinvest maturity payments: “The reinvestment of principal redemptions will be distributed over the year to allow for a regular and balanced market presence.”2
We believe that, even as net purchases have ceased, continued gross purchases for reinvestment will be supportive of the supply/demand balance in the market and will keep yield rises moderate. The ability to increase the pace of monthly reinvestments, which are allowed by widening the investment window, may permit the ECB to respond to market volatility, and to some extent, counter sharp market-driven yield increases (perhaps in Italy) should these occur. The issues of ending reinvestment and reducing the ECB’s balance sheet will likely not be a concern for the market, at least until late 2020 or 2021—which we believe is how the central bank will want it.
Interest rate policy
Currently the ECB’s key policy interest rate, the deposit facility rate (DFR) stands at -0.40%. The ECB’s current forward guidance on rates, which remained unchanged at the December meeting, states that policy interest rates are expected to remain at current levels “at least through the summer of 2019.”3 Chart 1 shows the current expectations for rises in the DFR based on pricing in the overnight interest rate swaps (OIS) market. If we assume that the first rise in the deposit rate will be in increments of 15 or 20 basis points (0.15-0.20%), then it is clear to us that such an increase is not fully factored into market expectations until the second quarter of 2020. The deposit rate is not expected to exit from negative territory until mid-2021. We believe this view is too cautious, and we anticipate that the ECB may seek, given the right conditions, to “normalize” (i.e., restore to zero or positive levels) the deposit rate by early 2020 or the end of 2019.
There are several reasons why we expect the ECB to begin raising rates earlier than the market foresees. First, the deposit rate is in negative territory and will take at least two rate moves to restore to zero. However, these increases can be credibly presented as “normalization” rather than as the start of a tightening cycle.
Second, the ECB’s governing council make-up will change in 2019 and may assume a less dovish slant. The term for ECB’s chief economist Peter Praet—considered relatively dovish—will expire on May 31, 2019. ECB President Draghi’s term expires on October 31, 2019, and council member Benoît Coeuré’s term ends December 31, 2019. Internal discussions on Draghi’s successor will likely begin at mid-year (around the June 6 monetary policy meeting), but the first rate increase decision could be taken before Draghi leaves office, effectively making the job for Draghi’s successor easier. Under this scenario, we might expect an initial rate increase in the DFR of 15 or 20 basis points (100 basis points equals 1%) during the September 9 policy meeting, and a second taking the deposit rate back to zero on December 12.
Third, the ECB will likely take offsetting measures to continue providing cheap, long-term funding to the banking system. In the first or second quarters of 2019, we expect to see further discussions on a new round of Long-Term Refinancing Operations (LTROs), which provide funds to banks over a period of years (current operations roll-off between June 2020 and May 2021). If new such operations can be put in place by mid-year, then the ECB may begin raising rates without sparking a steep rise in the risk premium for banks or for longer-term bond yields.
Two main risks could derail this scenario. The first is continued economic and inflation disappointment. In our view, a sluggish economy had no impact on the schedule for ending net asset purchases. We expect that gross domestic product growth might need to significantly undershoot the ECB’s 1.7% 2019 projection in order to impact the desire to normalize rates. While an undershoot of the ECB’s 1.4% core inflation forecast for 2019 looks possible, the central bank may still move on rates, provided its longer-run forecasts remain close to target. The bank projects 2021 core inflation at 1.8%, effectively in-line with its price stability target of “below, but close to, 2% over the medium term.”4
The second risk is another spike in bond-market volatility. Italian yields remain elevated, while the European Union’s budget confrontation appears to have been defused for now. Volatility may return after the European Parliament elections in May, particularly if Italian populists are emboldened by electoral success either to intensify their demands or call snap national elections.
As for the markets, if rates do rise earlier in 2019 than interest rate swaps currently anticipate, we believe eurozone bond yields may need to start factoring this in and begin to trend higher from mid-year. However, we also believe that the ECB will successfully contain any excessive increase in risk premium, and rises will be gradual and moderate. We would expect 10-year German bund yields, for example, to exceed their 2018 highs of 0.80% but not by much, potentially reaching 1% by early 2020.
The impact on the euro’s exchange rate versus the dollar is less certain for 2019. Our ECB view tends to support our belief that the dollar will weaken somewhat (around $1.21 versus the single currency by year end) as the policy rate divergence—which has supported the dollar recently—finally turns towards gradual convergence.