ECB Preview: Wait-and-see with a dovish slant (again) – Rabobank

Elwin de Groot, Senior Eurozone Strategist at Rabobank, suggests that Thursday’s meeting is the ECB Governing Council’s first since the UK’s EU referendum.

Key Quotes

“Although a ‘Brexit’ had been marked as a potentially significant downward risk to the outlook in the June meeting (as per the Monetary Policy Accounts), it would appear that this topic had been discussed only briefly. One of the key conclusions of the June meeting was that the ECB’s focus in the near-term should be on the implementation of recent policy easing measures. Moreover, it was assumed that these measures would support the recovery in a substantial way and that their full impact was yet to be seen. In fact, it was repeated several times that the positive impact of the measures was not yet fully reflected in the official projections published in the June meeting. A wait-and-see stance, albeit with a dovish slant, was therefore warranted.

Whilst ‘Brexit’ likely marks a departure from the generally positive mood at that meeting and the ECB, under Mario Draghi, has often leaned towards activism, we expect the ECB to steer clear from any policy action on Thursday. We expect Mr. Draghi to argue that there is still some policy stimulus from past measures lined up, which may help offset any Brexit-related fall-out. The latter, in any case, remains hard to fathom at this stage. The September economic staff projections will help assess to which side the ledger falls. So any substantial discussion about the need for further easing measures and in what form is likely to be shifted towards the September meeting.

One additional factor in support of a ‘wait-and-see’ assessment at this stage is that the initial market response to Brexit in the Eurozone has been relatively contained. Although ‘Brexit’ unleashed significant market turbulence in the first days after the referendum, non-bank equity prices have more than retraced their post-Brexit fall and financial conditions overall, reflected in a slightly lower effective exchange rate and lower corporate and sovereign spreads, have eased since June 24. Even Euribor-OIS spreads (Figure 1) have hardly moved, despite lingering concerns about Italian banks. The initial downward shift in the core yield curve also added to easier financial conditions, although this has been largely undone over the past week.

More worrying is the fact that, following ‘Brexit’, the 5y/5y forward inflation swap dropped to a fresh record low (1.25%). Although liquidity premiums in the wake of ‘Brexit’ may have affected the break-even rate (safe-haven flows into Bunds leading to a tighter differential with less liquid inflation linkers) and although the 5y/5y has partly recovered over the last week as well, what stands is that its level is still lower than before any of the previous ECB meetings (January 2015, October 2015 and January 2016) in which the Governing Council hinted at further easing measures.

However, this, we would argue, should only be a reason for the ECB to err on the side of caution when it comes to adding even more (ineffective?) stimulus.”