Investors bet that the European Central Bank’s new strategy means it will continue to buy bonds for longer, driving yields in the eurozone. But the central bank still has its work cut out to convince markets that it can reach its revised inflation target.
Christine Lagarde is aware of the challenge, and the President of the ECB said the Financial Times this month that the “pudding test will be in the food.”
ECB observers will look at how the new strategy will be implemented Thursday when the central bank will offer new guidance on monetary policy.
Most investors expect Lagarde to indicate that the ECB will strengthen its bond purchase plans beyond the end of its 1.85-tonne pandemic emergency purchase program (PEPP), and will be more patient before it raises interest rates. But I’m not sure exactly how aggressive the new guide will be and what difference it will make.
“The ECB has materially reduced the likelihood of a premature tightening,” said Elga Bartsch, head of economic and market research at the BlackRock Investment Institute. “It is now, when the new strategic framework is put in place, that we could receive forgotten surprises.”
Germany’s 10-year bond yield fell to minus 0.41 percent on Tuesday, the lowest level since February, as growing fears about the Delta coronavirus variant boosted demand for safe havens. But ties in the eurozone have already been tightened since the ECB concluded its 19-month strategy review two weeks ago by agreeing a simplified and slightly higher inflation target of 2 percent.
“Beyond the PEPP there will be a serious buying program, and it’s hard to imagine that they don’t put the emphasis on this message,” said Robert Tipp, head of global links at PGIM Fixed Income. “This is ultimately a link support.”
The ECB’s governing council also agreed that its policy needed to be especially “vigorous and persistent” when operating in a world of low, low-inflation rates – as it is today – which it said could imply moderate oversupply. and transitory of its new purpose.
This does not go until the US Federal Reserve, which decided last year to adopt an average inflation target. However, economists expect the ECB’s updated guidance on state inflation to be temporarily above its target.
Lagarde promised that the new guide would be “clearer and crisper” with less slang. She told the FT: “When we say our response needs to be particularly strong or persistent, I think perseverance is precisely meant to signal that we will not tighten prematurely.”
Luigi Speranza, world economist at the helm of BNP Paribas, said the ECB is “already acting strongly” by covering 80 billion euros of bonds a month via its PEPP, adding: “Now they say it will be stronger for longer to be persistent “.
He said one way he could do this is by saying that higher inflation should be “visibly reflected in the real dynamics of underlying inflation” before considering his new target to be hit – something from ECB executive Isabel Schnabel he said already twice in recent weeks.
This implies that it will also guard against core inflation, eliminating the most volatile energy and food prices, and expect robust proof of its sustainable growth in line with its 2 per cent target. It may also indicate that wages need to grow at a healthy rate before they can react.
“The ECB has opened the door to a more sustainable strategy with the release of its new strategic framework,” said Krishna Guha, vice president of Evercore ISI. “Now she’s going to walk for him.”
The ECB has a powerful influence on bond markets, and since early 2020 has acquired almost all of the new eurozone government bond issue, bringing its holdings to about 42 percent of all debt. sovereign of the block.
Investors should also look for any signs that the ECB’s regular business acquisition program – still running at € 20 billion a month – will be expanded to € 40 billion – € 60 billion and become more flexible to maintain a high level of stimulation when PEPP is liquidated.
Silvia Ardagna, an economist at Barclays, predicts that the ECB will acquire € 700 billion in assets next year, adding: “The key message of the ECB’s revised guidance will be ‘loose for longer’.”
However, the Frankfurt-based institution is unlikely to provide details to finish PEPP before publishing its next economic forecasts in September, when it will have a better idea about the impact of the Delta coronavirus on economic growth.
Meanwhile, there are persistent doubts about the ECB’s ability to reach its higher inflation target given its long struggle with very low inflation. Despite the cut in interest rates in negative territory and the acquisition of trillions of euros of activity, inflation in the euro area is on average only 1.2% since the 2008 financial crisis.
Euro five-year five-year inflation swap – a popular measure based on long-term market expectations of inflation closely monitored by central banks – is currently trading at just 1.56 per cent despite the current inflation recovery while the economy reopens.
“The ECB raises the question of how to achieve this more ambitious goal from such a low starting point while using the same old tools,” said Andrew Bosomworth, CEO of Pimco. “This creates a credibility problem that we think will leave inflation expectations subdued.”