By William Watts
Christine Lagarde appeared determined to not spark a taper tantrum on Thursday, but economists said the European Central Bank president still faces a tough challenge later this year in determining the fate of the institution’s emergency bond-buying program.
The ECB, as expected, left interest rates unchanged and made no tweaks to the size of its asset-buying programs at its policy meeting. The important part of the policy statement dealt with the pace of bond buying under what’s known as the pandemic asset purchase program, or PEPP.
The ECB said it expected over the “coming quarter” to continue purchases at a pace “significantly higher” than that seen in the first months of 2021, a continuation of the pickup in pace implemented in the current quarter to around 80 billion euros a month. The move wasn’t unexpected, but some economists had seen the potential for the ECB to instead announce it would slow the pace down.
Lagarde, in a news conference, told reporters the decision on the pace had been subject to debate.
Meanwhile, Lagarde described the risks to the outlook for economic growth in the eurozone as “broadly balanced,” a shift from the ECB’s previous assessment that risk were skewed to the downside. That’s a “big deal,” tweeted Frederik Ducrozet, global macro strategist at Pictet Wealth Management:
The ECB upped its forecasts for economic growth and inflation for this year and 2022, but left its projections for 2023 unchanged.
The unchanged 2023 inflation forecast — at 1.4% — is particularly important, underlining that the ECB, like the U.S. Federal Reserve, sees a near-term pickup in inflation as likely to remain transitory. Also, Lagarde emphasized that core inflation “far away from the ultimate aim.” Inflation has long undershot the ECB’s target of near but just below 2%.
Markets took the ECB meeting in stride, with international investors turning their attention to eagerly awaited U.S. data, which showed another hotter-than-expected inflation reading and a continued drop in first-time jobless claims .
The euro /zigman2/quotes/210561242/realtime/sampled EURUSD -0.1024% was little changed near $1.2180 vers the dollar. Yield spreads in the eurozone were well behaved, with the premium that investors demanded to hold Italian 10-year government bonds /zigman2/quotes/211347230/realtime BX:TMBMKIT-10Y +4.28% over 10-year German government bonds /zigman2/quotes/211347112/realtime BX:TMBMKDE-10Y +9.80% narrowing by 2.4 basis points, according to FactSet.
European equities were slightly higher, with the pan-Continental Stoxx Europe 600 /zigman2/quotes/210599654/delayed XX:SXXP -0.09% showing a gain of 0.1%.
But the improving growth outlook is expected to set up a challenge.
“If the economy evolves the way the ECB expects over the next three to six months, the PEPP will get the ax in Q1 next year,” said Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics, in a note. That move would probably be accompanied by a boost in purchases under the ECB’s other bond-buying facility, known as the asset purchase program, or APP.
“Whatever the ECB does, however, it will involve significantly reducing the pace of QE compared to what have, admittedly, been a very strong pace since the pandemic hit” in March 2020, he wrote. “It’s possible that markets will take this in their stride, but unlikely.”
It’s more likely that markets will test the ECB by pushing government bond yields higher, Vistesen said, noting that Lagarde also said that higher market-based interest rates would be unwelcome.
The forecasts, and shift in language, “suggest that the central bank is ready to stare down markets, at least to an extent. If the economy progresses as the ECB and consensus expect, bond markets should prepare for a world of slower QE from Q4 onwards,” he said.
A rough patch could come as early as this summer, warned Rabobank strategists Bas van Geffen and Elwin de Groot, in a note.
The ECB’s pledge on the pace of PEPP purchases could come in conflict with the usual seasonal pattern that sees the bank’s bond-buying program slow in the summer due to thin liquidity. Asked about this, Lagarde said the ECB would use the flexibility of the PEPP to deal with seasonal liquidity fluctuations.
That raises more questions, the strategists said.
“Will the ECB ignore the thin liquidity, and go against its previous years of pre-emptive slowdown in summer? Has the ECB just pre-committed to a large amount of catch-up purchases in September? Or was this all talk to lull the markets, and will actual Q3 purchase volumes disappoint come September?” they asked.
“We note that there is still some wiggle room between the amounts purchased in Q1 and the higher volumes achieved in Q2. That promises to keep the market squarely focused on the weekly purchase statistics throughout the third quarter of the year, wrote van Geffen and de Groot.
Meanwhile, Pantheon’s Vistesen warned: “ECB watchers and [eurozone] fixed-income investors should prepare for what will likely be a fierce fight in the council between the doves and hawks over the balance between reducing stimulus slowly or quickly, and how to communicate this.”