Given the market reaction to his comments – Italian BTPs rallying, front-end pricing in more ECB rate cuts, break-evens recovering, EUR/USD falling, EuroSTOXX index rising – here is a brief note on what ECB President Mario Draghi actually said in Sintra, and what we make of it.
We infer that Draghi is trying to coax the ECB's governing council into making a conditional commitment to easing policy further – including a resumption of asset purchases – based on the inflation outlook. But investors should be mindful of the fact that the ultimate decision over whether that condition is met (and any action) could easily fall to his successor, who is due to arrive later this year.
Draghi’s speech was not particularly surprising, but it moved the markets. The euro, for example, sank by about 0.5% against the US dollar to a low of USD 1.12, while European and US equities rose (see Exhibit 1 for the USD/EUR rate), with a higher probability now attached to the ECB doing more, both on interest rates and asset purchases. Draghi's key dovish phrases were:
- “In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required”
- “In the coming weeks, the (council) will deliberate how our instruments can be adapted commensurate to the severity of the risk to price stability”
- “Our medium-term policy aim: an inflation rate below, but close to, 2%. That aim is symmetric, which means that, if we are to deliver that value of inflation in the medium term, inflation has to be above that level at some time in the future.”
Exhibit 1: The euro sold off against the US dollar in the wake of Draghi's speech on 18/06/19 in Sintra - the graph shows the euro/USD exchange rate from January 2019 to 18 June 2019
The key ambiguity here is whether the deliberations Draghi refers to are hypothetical in nature – how would we react in a certain situation? – or represent the usual countdown to action, which involves tasking the staff to prepare a package of measures.
When it comes to how the ECB will act, there was a reference to the Amsterdam speech of April 2014 in which Draghi explained how the ECB would react in certain circumstances before the launch of quantitative easing (QE).
Essentially, rate cuts are the appropriate response to an unwarranted monetary tightening (exchange rate appreciation). Asset purchases are an appropriate response to a deterioration in the medium-term inflation outlook (including a de-anchoring of inflation expectations) that obliges the ECB to “increase meaningfully the degree of monetary accommodation”.
No consensus on resuming QE
Investors who know this playbook may have concluded that a resumption of QE must be imminent given that breakeven inflation rates are so low (see Exhibit 2 below). However, those investors should reflect on what was absent from this speech, but did feature in the famous Jackson Hole speech of August 2014 (which marked the real countdown to QE): “Over August, financial markets have indicated that inflation expectations exhibited significant declines at all horizons. The 5-year/5-year swap rate declined by 15 basis points to just below 2% - this is the metric that we usually use for defining medium term inflation”.
The fact that Draghi seemingly felt unable to make such a statement in Sintra suggests to us that there is not a consensus within the council that the extremely low level of break-evens does justify resuming QE.
Exhibit 2: An important gauge of market expectations for eurozone inflation - the 5-year 5-year swap rate - has been trading at all-time lows (graph show changes in the 5-year 5-year eurozone forward inflation swap between January 2014 and 18 June 2019)
In our view, the key section of the speech was the following: “We remain able to enhance our forward guidance by adjusting its bias and its conditionality to account for variations in the adjustment path of inflation. This applies to all instruments of our monetary policy stance.”
A broader easing bias
We have had an easing bias on interest rates before. The implication is that Draghi is considering a broader easing bias on the monetary stance – including a resumption of asset purchases – with a commitment to act that is conditional on the inflation outlook.
That guidance would most likely be expressed in terms of the forecast path of inflation – in particular, if the council no longer sees a “sustained adjustment in the path of inflation consistent with its inflation aim”, it would act – rather than an evaluation of the current level of inflation relative to the target.
In theory, there is a lot to be said for such guidance. However, investors need to conscious of two features of such a conditional commitment to act:
- the ECB will set and mark the test when it comes to the assessment of whether the conditions have been met for, say, the resumption of QE: the ECB produces its own forecast and the ECB decides whether a particular forecast is consistent with a sustained adjustment in inflation consistent with its target
- Draghi will leave the ECB at the end of October, so investors need to think about whether his successor will be so easily convinced that the conditions for resuming QE have been met before concluding more QE is a done deal.
The key signposts to watch in coming days are:
- What other ECB policymakers say, and in particular whether they sound as enthusiastic on the need for action and whether the deliberations that Draghi refers to are hypothetical or a prelude to action in the autumn
- How the European Council summit influences the race to succeed Draghi.
As always, what matters is a view on what the ECB might do relative to what is priced in the market. And more stimuli are priced in today than were priced in yesterday.
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