Thursday, January 23, 2020

ECB likely to hold rates and quantitative easing at current levels

Tags
  • Euro
  • Pound
  • European Central Bank
  • Bank of England

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Analysts’ Pick: ECB likely to hold rates and quantitative easing at current levels

  • ECB likely will keep rates, quantitative easing and its economic outlook unchanged from December
  • Tone of the ECB will likely be similar to December, showing optimism on economic recovery while citing downside risks from US tariffs on EU goods and spread of new coronavirus
  • ECB’s framework review likely to be split into inflation objective review and evaluation of its monetary policy tools
  • Friday’s PMI report on UK and EU sectors likely to also drive the EUR/GBP cross pair

Today's ECB decision on monetary policy is unlikely to surprise investors. Rates are expected to remain unchanged and ECB officials are very likely to let the asset purchase program continue through the year. This is due to the aggressive easing that the ECB introduced in September last year, and as economic indicators in the EU continue to show improvement. Inflation in the EU rose from 1.0% in November to 1.3% in December. But headline inflation was driven mostly by transport which in turn was likely driven by higher oil prices during the month. ECB officials have little reason to stop its APP and December's meeting minutes also highlight this. But investors expect this (overnight index swaps imply that a 0.3% probability for a rate cut is priced into the market) and the euro is unlikely to be driven by the decision.

December’s top three contributors to inflation growth in the EU by change in percentage points

 

Nov 2019

Dec 2019

Change

Transport

0.00

0.29

+0.29

Housing, water, electricity, gas and other fuels

0.03

0.11

+0.08

Food and Non-Alcoholic Beverages

0.23

0.25

+0.02

*Source: Eurostat

Rising fuel prices in December likely driver of inflation for the month

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Overnight Index Swaps indicates investors do not expect a rate cut or hike in 2020

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Economic data in the eurozone has also mostly improved since the last monetary policy meeting in December where the ECB had a more positive outlook for the European economy. Coupled with easing trade tension between US and China, the ECB should view global risks reducing. Although it will likely be cautious on the rising threat of US tariffs on EU goods and the most recent virus in China that looks to be spreading across several countries. The ECB should leave its economic outlook mostly unchanged as a result.

Economic data implies the EU’s economy is showing improvement but is still below ECB’s target

Indicator

Actual

Consensus/Previous Estimate

Prior

Dec Inflation (CPI)

1.3%

1.3%

1.0%

Markit Dec Manufacturing PMI (Final revision)

46.3

45.9

46.9

Markit Dec Services PMI (Final revision)

52.8

52.4

51.9

Markit Dec Composite PMI (Final revision)

50.9

50.6

50.6

Nov Retail Sales (YoY)

2.2%

1.5%

1.4%

ZEW Jan Economic Expectations Survey

25.6

-

11.2

*Source: Bloomberg

Focus instead will be on the details for the framework review, which is expected to be released with today's monetary policy statement by the ECB. The review is set to end in around a year and broad outlines are likely to be highlighted at today's meeting. ECB President Christine Lagarde has already confirmed that the main focus of the review will be on all aspects of the ECB's price stability objectives. The central bank's inflationary target is likely to be a main topic for the review as the current target puts the ECB at a disadvantage when inflation starts to rise. Using an inflationary target of "close to but below 2%" sets expectations higher for the ECB to aggressively raise rates when inflation starts to rise towards 2%. A symmetric target is likely to be debated on and investors are likely to look out for a possible hard line 2% target.

Another area that the review is likely to focus on is its APP. The debate on its APP will likely be regarding the duration, composition and type of assets being purchased by the ECB. Climate change, another likely factor to be in the guidelines may however put pressure on the euro. If the topic of climate change is heavily included into the framework review, the timeline of the review may be affected as it will likely be a long debate between officials. Lagarde has suggested that the ECB can consider incorporating climate change into its forecasts through its various outlets. But incorporating climate change into forecasts would imply certain biases, and ECB officials are likely to debate against this.

The final driver for both euro and sterling will be tomorrow's Markit PMI report. For the eurozone, the market expects a pickup in manufacturing PMI, which will drive overall PMI in the bloc. PMI is also likely to improve thanks to receding geopolitical risk as a result of the phase one trade deal between China and the US, and as business sentiment in the bloc looks to be bottoming out.

ZEW survey of economic expectations signal that the EU’s economy appears to be recovering

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The UK’s PMI is expected to rise as well, especially after the UK elections and with trade tensions easing between the US and China. More jobs were also created in December, which is likely to spill over into January's PMI report as an indicator of business sentiment. A better-than-expected PMI should be expected for the UK in tomorrow's report. But tomorrow's PMI is also likely to factor into the BoE’s decision on monetary policy next week. We expect the UK's PMI to beat expectations for both the manufacturing and services sectors but still remain 51 or lower, which will continue to drive expectations for a rate cut by the BoE. Sterling should gain initially thanks to the better-than-expected economic data but retreat over the week as the market starts to price in a higher probability for a rate cut.

Implied probabilities for a rate cut spiked after weak economic data in the UK

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Hence, the EUR/GBP cross should continue to remain little changed with downside risk (as a result of over emphasis on non-mandate considerations of the ECB's framework review) after today's ECB meeting. EUR/GBP is likely to range with an upper bound of +0.17% and lower bound of -0.10% from its current price as a result, with a possible downside potential of roughly 0.18%. Tomorrow, expect the sterling's gains to outweigh the euro's if both PMI reports beat expectations, putting downward pressure on the cross-currency pair of roughly 0.13%. In the medium-term, the sterling is likely to have more room to fall, as the market continues to price in a higher probability of a rate cut by the BoE at the end of January.

 

Scenario

Effect on EUR/GBP after today’s ECB meeting

1

ECB keeps policy and economic forecasts unchanged, splits framework review into two parts

Remains little changed, ranging between 0.8435 and 0.8460

2

ECB keeps policy and economic forecasts unchanged but makes dovish comments on future forecasts

EUR/GBP falls past 0.8435 towards 0.8410

4

ECB keeps policy and economic forecasts unchanged, announcing framework review with emphasis on climate change

EUR/GBP falls past 0.8440 to 0.8435

*Source: ADSS

Technical Analysis:         

EUR/GBP

The euro may have been oversold in the short-term, and the EUR/GBP cross looks to be recovering slightly as traders continue to remain cautious ahead of the ECB’s monetary policy meeting later today. Bears control possession of the euro after breaking the 23.6% Fibonacci retracement level. With more downside than upside potential for the euro for the conclusion of the ECB’s monetary policy meeting later, the bears may be able to pull the euro down towards 0.8410’s level. But there is some risk that the EUR/GBP cross rebounds as a result of being oversold.

Support: 0.8440 / 0.8410 / 0.8377

Resistance: 0.8466 / 0.8485 / 0.8521

EUR/GBP Chart (H4)

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