The Euro and July's European Central Bank Policy Meeting: What to Expect

On Thursday the governing council of the European Central Bank (ECB) will meet to discuss interest rates and monetary policy in Frankfurt. What is the impact on the euro likely to be?

“Thursday’s ECB meeting is unlikely to bring any new policy decision,” says Marco Valli, Chief Eurozone Economist for Italian lender UniCredit.

“The spill-over effect of the UK referendum into the Euro-area remains very uncertain, “he adds.

It will take a long time -  longer than a few weeks for the ECB to estimate the impact of Brexit on the Eurozone.

Not until September are we likely to get an assessment of how the shock has affected the Eurozone economy, and what measures, if any, are needed.

“Speaking last week, ECB Governing Council member Luis Maria Linde said the ECB will not provide its assessment of the impact of Brexit on the euro area until September “at the earliest”.  Says Valli.

The bottom line is that the ECB will not have at its disposal sufficient data to make any decisions at its Thursday meeting.

“By the time the Governing Council (GC) meets, it will only have very limited information on the short-term impact of Brexit on Eurozone economic activity. This information will include the German ZEW survey (due tomorrow, but usually this indicator offers little growth insight), Eurozone consumer confidence (Wednesday) and French business sentiment (Thursday, just a few hours before the rate announcement). The PMIs, the first really important data release in the post-Brexit environment, will be published the day after the GC meeting.” Says Valli.

As such the likely impact on the euro to dollar and euro to pound exchange rates are likely to be muted.

Economist Ralf Umlauf, of research and advisory service Helaba, points out that the ECB is highly unlikely to cut rates given the Bank of England (BOE) did not last week.

“All in all, easing by the ECB would seem premature, especially as the Bank of England remained on hold last week and continued stimulus is under way, with the second generation of TLTROs and the existing QE programme.” He said in a recent note.  

Valli makes the same point - the ECB has not even yet finished rolling out the considerable palanquin of measures it has already issued in March, making it even less likely to add more. These include the TLTRO’s -  cheap loans offered by the ECB to commercial banks -  and the unfinished asset purchase programme.

Analysts at Citi think that the ECB will not change policy in July but that September could be 'live':

"Citi Economics suspects that the ECB will play for time and leave policies unchanged on 21 July. However, September meeting is likely live
with a formal extension of QE beyond the soft -end date of March 2017 as well as a small 10bps cut in the main refi rate to -0.1%."

Indeed within the analyst community there appears to be a strong feeling that regardless of the fallout the ECB will take precautionary measures in September.

Alex Holmes, of esteemed London-based advisory service Capital Economics, for example, said he expected the ECB to even go as far as making a cut in the deposit rate in September from -0.4% to -0.5% as well as an extension in the duration of its QE programme:

"We have pencilled in a cut in the deposit rate from -0.4% to -0.5%, an increase in the monthly pace of asset purchases from €80bn to €90bn, and an extension of the programme by another six months.”

With robust measures like these in the pipeline, Holmes sees downwards pressure being maintained on the euro, even if the ECB hold fire on Thursday:

“While the ECB may hold fire on Thursday, we expect it to loosen policy further in September. This should keep downward pressure on the euro, but provide further support to euro-zone equities and core government bonds.”

Bank of America Merrill Lynch's head of research Tomos Rhys Edwards, is in "no doubt" the ECB will make changes in September:

“We have no doubt continuing QE beyond March 2017 is necessary. Beyond the flat inflation outlook, we think financial and political stability risks in the periphery warrant continuous support from the central bank.”

Investors expecting a negative outlook

The market is already expecting a dovish lean from the ECB, according to broker TD Securities, so the meeting statement will have to be especially pessimistic to cause meaningful downside in the euro. 

This scenario, which they assign a 20% possibility of unfolding, would be characterised as follows:

“Signs that the ECB is leaning towards more easing this fall should continue to pressure the EUR lower. A break of the 1.0940 level opens up a test of the Q2 low near 1.09. 10y Bunds to fall further into negative territory to ~ -10bps.”

Their base case, however, which they assign a 75% probability of happeneing, is that the statement will be broadely balanced in its assessment, stating that, there are risks to growth from Brexit - but not elaborating - and also highlighting positives such as the increase in bank lending, as evidenced in the most recent ECB Bank Lending Survey.

Of their 'base case' they comment as follows:

“No need for major changes. Brexit remains a downside risk to growth, with no further elaboration. Inflation to remain very low (no longer ’or negative’) in the next few months. Can mention improvement in this week’s Bank Lending Survey.”

Such an outcome would see EUR/USD at 1.1090.

TD attribute on a very small 5% probability that the euro will strengthen meaningfully, which they would expect if the ECB were to relax the rules around their bond purchase programme.

This could be by allowing a greater share of non-German bonds to be included, as currently the attribution is determined by the relative size of member states economies, or the ‘Capital Key’ as it is known. 

Essentially this means that most of the bonds the ECB buys as part of its QE programme are German. This has kept German bond prices high – and yields low since they are inversely related. Lower yields put more downwards pressure on the euro.

In TD’s euro-positive stance, however, the ECB would reduce the German component, allowing German bond yields to rise, which would support the euro, which they would see rising to 1.1140.

Draghi’s Q&A

In their alternative scenarios for Draghi’s post-meeting press conference TD have as their base case, with an 80% probability, that Draghi will, “downplay the magnitude of the hit (from Brexit) to EZ growth.” Whilst at the same time, “He will upsell the stimulus in the pipeline, with no suggestion of any immediate need to act via either rate cuts or extending QE.”

The add that if he downplays the scope of easing required this should give a lift to the euro, which will probably rally up to 1.1140 on the commentary.

TD then see a 10% probability that Draghi will sound more optimistic than expected, leading to a stronger rally in the euro to 1.12.

This would come about as a result of Draghi, “pushing back forcefully on the need for further easing.”

Their euro-negative scenario, also with 10% chance of happening, is that Draghi will say that the bank lending survey suggests banks are not concerned about profitability and could therefore withstand another cut to the deposit rate.

This would be expected to send EUR/USD down to 1.085, possibly even into the 1.07s id USD strengthens due to positive data or rate rise expectations, gaining a further lift.

Tweaking the Parameters?

Even if the ECB doesn’t change policy there is a possibility they may “tweak” the “parameters” of existing policy according to research from Nordea Bank.

Nordea banks FX Stratgist Holger Sandte says that Brexit led to a sudden spike in demand for safe-haven German bonds which saw their yields fall, sometimes well below zero.

One of the rules of the ECB’s QE programme is that it can only buy bonds which have yields above the deposit rate, which currently stands at -0.4%.

There are now many less bonds which meet the criteria, and according to Sandte the current supply will be exhausted by December.

“The UK’s vote to leave the EU can mean a lot for the ECB. A deterioration of the economic outlook could warrant more easing at some point but more immediately, the decline in bond yields makes the current purchasing targets impossible to achieve.” Says, Nordea strategist Holger Sandte.

Sandte adds:

“Given the current QE parameters and assuming stable yields, the ECB will run out of eligible Bunds by around the turn of the year, according to our calculations. A further decline in bond yields would mean scarcities would occur even earlier.”

One possible way for the ECB to increase supply would be for it to relax the eligibility criteria and allow for the purchase of bonds with lower yields than the deposit rate, however, this is unlikely he says as it will effectively cost the ECB extra money.

Another option would be to change the ‘Capital Key’ which decides the share of bonds from each member bought depending on the size of that country’s economy. So, for example, the Capital Key determines that 26% of the bonds bought must be German and 17% Italian and so on. Reducing the German share might help since the worst shortage problem is with German bonds, but that would meet political resistance, thinks Sandte.

In the end the most likely option for the governing council will be to give up the 33% maximum holding limit for the ECB on any given bond, so that it can purchase a greater share of the bond’s available.

“We think the most likely option is to give up the 33% issue limit on non-CAC holding bonds (generally issued prior to 2013, for details see fact box). This would allow the ECB to buy bonds at the current pace for another 3 months (on top of the turn of the year).”

CAC bonds are those which have ‘Collective Action Clauses’ attached to them, which allows a 26% or more minority to become a ‘blocking minority’ in the event of debt restructuring. The ECB is only allowed to own 25% of these as rule dictate it is not allowed to have a blocking minority.

Non-CAC bonds have no such ‘blocking minority’ clauses and so could be held in greater levels then the current 33% allowed.

ZEW Sentiment Data Unlikely to Inform Governing Council

Key German and Eurozone sentiment data released on Tuesday morning, in the form of the ZEW sentiment survey for July, is one metric the ECB will have at hand, to give them an idea of the strength of sentiment in the Euro-area post-Brexit.

The ZEW is a survey of financial analysts asked if they are optimistic, pessimistic and neither.

The resulting figure is the net balance of positive answers minus negative answers.

The release for June showed sentiment waning substantially, not surprisingly, with the 'Current Situation' component falling to 49.8 when 51.8 had been forecast from over 55 previously.

The Eurozone ZEW Survey, measuring economic sentiment in July meanwhile fell to -14.7 from 20.2 previously.

"The Brexit vote has surprised the majority of financial market experts. Uncertainty about the vote’s consequences for the German economy is largely responsible for the substantial decline in economic sentiment. In particular, concerns about the export prospects and the stability of the European banking and financial system are likely to be a burden on the economic outlook," commented ZEW-President Professor Achim Wambach.