The European Central Bank (ECB) meets Thursday for its long-awaited policy decision, potentially spelling out the beginning of the end of its asset-buying program in what could be one of the most critical market events in 2017.
ECB President Mario Draghi is widely expected to outline a plan to begin tapering the central bank’s bond purchases, though the details of how much and when have been the subject of much speculation.
Draghi’s main challenge will be to avoid sparking a euro rally. He’s also presumably aiming to avoid a “taper tantrum” in the bond market, such as was seen in the U.S. in 2013 when Ben Bernanke, who was then Federal Reserve chairman, indicated the central bank was preparing to begin winding down its monthly asset purchases.
“Ideally, the ECB would like to announce tapering as noiselessly as possible, limiting any upward movement of interest rates and the euro to a bare minimum,” wrote analysts at ING, in a note.
What is happening?
The ECB first started to buy government bonds at the rate of 60 billion euros ($70.5 billion) a month in 2015 in a determined effort to end deflation in the eurozone. The program was boosted to €80 billion a month in April 2016, and then scaled back to €60 billion in April 2017 in what some people saw as the first attempt to taper. The now €60-billion-a-month program runs through December 2017, but with inflation still below the ECB’s target, no one really expects the purchases to come to an end this year.
At the September ECB meeting, Draghi specifically said an update on the program’s future likely would come at the October meeting, fueling lots of chatter about what will happen on Thursday.
The ECB delivers its rate decision at 12:45 p.m. London time, or 7:45 a.m. Eastern Time, followed by Draghi’s press conference at 1:30 p.m. London time.
What is expected?
Forecasts are a bit all over the place, but most economists expect the purchases to fall to €20 billion -€30 billion a month in January, but then run until September or December 2018. That means the bank could add another €200 billion to €300 billion to its balance sheet. The bond purchases are set to reach €2.3 trillion euros by the end of 2017.
At Société Générale, analysts see a nine-month extension at a clip of €25 billion a month as the most likely outcome, while Morgan Stanley forecasts that the asset purchases will be cut in half to €30 billion without a firm end date. Such decisions have been dubbed the “lower for longer” scenario, where the bank remains accommodative, but to a less aggressive degree.
On the more hawkish side, Rabobank expects the ECB to wind down the program in three steps of €20 billion, entirely ending the program in the second half of 2018.
Why is this important?
The central bank has consistently pledged that interest rates will stay low “well past the horizon of our net asset purchases.” An extension of QE well into 2018 then means the ECB is unlikely to raise interest rates until 2019, according to analysts.
The outlook for eurozone interest rates is crucial for the financial system, including for exchange rates, bond yields, mortgages, consumer spending and bank lending. That’s also why Draghi & Co. are hesitant to scale back on easing until the economy is strong enough to absorb higher rates. While economic growth has picked up recently, unemployment is still high, wages aren’t rising at a fast clip and inflation is stubbornly low.
The main refinancing rate currently stands at 0%, while the deposit rate is at negative 0.4%.
How will markets react?
Euro trading has been a snoozefest over the past month as traders ponder whether Draghi will announce a hawkish or dovish taper. Against the dollar, the shared currency EURUSD, -0.0423% has traded in band of $1.17 to $1.19 since late September. On Thursday ahead of the meeting, the euro bought $1.1826.
But on Thursday, the currency stands to get jolted as the ECB makes it intentions clear, according to ING. Here are the four scenarios the Dutch bank is operating with:
• The dovish surprise: Draghi highlights his concerns about the strong euro exchange rate and says there are still risks to the growth outlook. The bank then reduces QE to €40 billion a month and hints QE could increase in the second half of 2018. The euro slides to $1.16, while 10-year German Bund yields TMBMKDE-10Y, -1.93% remain flat.
• The base case: The ECB sticks to the “lower for longer” plan and slashes QE to €25 billion a month and lets it run until the end of 2018. The euro rises to $1.20 and German yields climb 5 basis points.
• The hawkish surprise: The central bank opts to reduce the monthly purchases, but ends the program altogether in September. That would send the euro to $1.21 and give German yields a 10 basis point boost.
• The very hawkish surprise: QE stops in June, adding less than €200 billion to the overall program. The euro jumps to $1.23 and German yields roar 20 basis points higher.
What are analysts saying?
• “The EUR/USD may be on the verge of a correction, particularly if the Fed-driven dollar simultaneously remains supported. The euro’s weakness may well be telling us that the market is positioning itself for a dovish ECB”—Fawad Razaqzada, technical analyst at Forex.com
• “Central bankers are likely to proceed with caution because they are wary that any bold announcement around QE could trigger an event like the taper tantrum of 2013. Whatever the ECB does, it will not want to undermine the gradual increase in inflation. All the signals of a recovery are present in the eurozone, but the central bank is still worried about the sustainability of rising inflation.”—Charlie Diebel, head of rates at Aviva Investors
• “As ECB tapering will coincide with the Fed’s wind-down of its own balance sheet, it’s likely to put upward pressure on bond yields. But we’d expect this pressure to be contained. So far, the ECB has done a very good job of managing the market’s tapering expectations, and we expect it to continue to do so.”—Darren Williams, economist at AllianceBernstein