ECB Preview: The Limits of Dovishness?

Summary

• We expect the ECB will keep its policy rate unchanged with deposit rate at 4.0% this week. The tone will likely be consistent with Schnabel’s recent speech: that inflation has undershot, but it is too early to declare victory.
• Further hikes from here are looking unlikely, but the ECB may also push back on near-term cuts.
• Their updated forecasts will show a lower growth trajectory near-term, with a downward revision to inflation across their trajectory. It would be dovish if their 2024 forecast got close to 2%.
• On PEPP, we see a high chance they signal discussions on its early winddown have begun, but details may be vague before the Spring.
• Ultimately, a full end to PEPP reinvestments is likely before end-2024, which will put more pressure on next year’s heavy EGB net supply .

Market Implications

• Unless there is a serious dovish shift in tone, I see growing value in fading March cuts priced and would watch for an opportunity to fade April cuts too. Given the room for surprises we will revisit these ideas post-ECB.
• The direction of travel in PEPP discussions and is likely to continue. This should support EUR credit spread wideners: we like 10Y BTP/Bund wideners and 5Y KfW/Bund wideners.

Pause Rate Hikes – Little Change to Statement

We expect the ECB will keep its interest rate policy unchanged at its policy meeting on 14 December (deposit rate at 4.0%). The tone will likely shift to  consistent with Schnabel’s recent speech: that inflation has undershot, but it is too early to declare victory, and that while hikes are probably done, cuts are not imminent.

Otherwise, we expect:

• Their updated forecasts will show a lower growth trajectory near-term, with a downward revision to inflation across their trajectory. The amount taken out of 2024 will be important – if it’s near to 2%, then that would be very dovish.
• On PEPP, we see a high chance that they signal that discussions on its early winddown have begun, but there is little rush for them to provide much more information so long before policy framework revisions are completed in the Spring.
  • Ultimately, a full end to PEPP reinvestments is likely before end-2024, which will put more pressure on next year’s heavy EGB net supply .

The market is already pricing 38bp of cuts by April, only a short way from being fully priced for a cut in both March and April (the lower limit of reasonability in our view, Chart 1). Unless there is a strong change in tone from the ECB (something along the lines of looking to ease soon, or rates being too high currently), this looks like a good position to fade, especially given that at least some of this dovishness seems to have been driven by expectations on the Fed, which itself seems strongly overdone (Chart 2).

Careful Not to Over-egg the Hawks’ Shift

The ECB has shifted significantly more dovish in the last few weeks. Schnabel’s most recent comments were probably the most important aspect of this. In brief, her comments were:

• November flash EZ inflation was a “pleasant surprise”. Underlying inflation is now falling faster than expected.
• Further hikes unlikely.
• Cannot declare victory on inflation prematurely – there will be an uptick in coming months.
• Labour market has been very resilient, need to err on the cautious side with regards to cuts. Need to stay restrictive as long as possible to get back to target – need to wait and see if recent disinflation momentum is sustained.
• Services inflation and wage growth (ULC) are an issue as productivity is low.

The market has (probably rightly) made a lot out of the change in tone from probably the most important hawk at the ECB. However, there are always nuances to the situation. We recall that the market was badly wrong-footed at the end of August by reading too much into Schnabel’s comments when she gave a more balanced outlook (the outcome, it turned out of a general agreement not to give hints one way or another on next policy move). There is always a risk of similar misinterpretation.

It feels like Lagarde leans a lot on Schnabel’s opinion, and it seems likely that her comments will roughly reflect the above at the presser. However, first and foremost it seems unlikely that she will want to give forward guidance, and there are data related issues with cutting in April or earlier:

• If the ECB still cares about wage growth as much as Schnabel seems to, they will not yet have Q1 negotiated wage data by then.
• They will not have the full picture of Q1 inflation either by then. Q1 tends to see most repricing in core (Chart 3). The final March outturn is scheduled for release three days after the April meeting. January and March see the most repricing activity: January tends to see big discounting, March sharp price rises. Importantly, a big drop in January does not necessarily mean a big miss in Q1 – March moves tend to counteract (Chart 4). This means it will be hard to extrapolate January weakness/strength in core.
• Near-term inflation trajectory may not remain as deflationary as it did in November. We have warned previously that Eurozone services inflation is looking mild partly on the back of large undershoots in accommodation prices (Chart 5). Recent history suggests December will see this fade that could sap some of (Chart 6). This appears to be what we already started to see in Germany.

ECB Forecasts Likely to be Decently More Dovish

The ECB will need to downgrade their expectations for growth and inflation (Chart 7). 2023 GDP growth is probably c.0.2-0.3ppt lower than it was in September (+ 0.7%),  with the possibility of an even larger downgrade in 2024 (Sep: +1.0%). Meanwhile, in core inflation it is highly likely they will drop the 2023 forecast by at least 0.1ppt (Sep: +5.1%), with probably a return to 2% or lower in 2025. A dovish outturn would be a signal that inflation could reach target in 2024. At this stage we consider this a relatively low probability given the risk that the inflation picture does not look quite as rosy in a few months. That said, the ECB have not been averse to sharply changing key inputs back and forth (as per their unemployment forecasts, Chart 8).

PEPP Reinvestment Conversations to Start Soon

Despite the more dovish tone in rate policy, talk around the ending of PEPP reinvestments continues to gain ground. In fact, if the hawks think hike-talk has no legs, they may step more strongly into demanding a PEPP winddown.

Lagarde recently noted in testimony to the EU parliament that discussion on PEPP reinvestments; ends would occur in the “not too distant future”, and that it would gradually reduce investments. We think it is reasonable for discussions to begin at this week’s meeting. There is little expectation for details now though (the policy rate framework review which will determine ultimate balance sheet size is not due to conclude until Spring). A H1 partial winddown in reinvestments, with a full end to reinvestments in early H2 would make sense in our view.

We have previously covered the market effects of an end to PEPP reinvestments. In brief, while such a policy would probably have the greatest direct net-supply effect on German bonds, it has implications for TPI’s (the ECB’s first port of call for fighting spread widening) effectiveness and would probably drive a bear-widening in EGB periphery bonds.

Watch for Opportunities to Fade April Cuts

Given all of the above, unless there is a serious dovish shift in tone, we see growing value in fading March cuts priced (by which point the ECB will still not have a clear picture on Q1 inflation) and would watch for an opportunity to fade April cuts too. Given the room for surprises we will revisit these ideas post-ECB.

The direction of travel in PEPP (which is a separate discussion to that of depo rate policy) seems more certain, and is likely to continue in its current trajectory. This is likely to continue supporting EUR credit spread wideners (we like 10Y BTP/Bund wideners and 5Y KfW/Bund wideners).