Testing times: Five questions for the ECB
LONDON (Reuters) – Growing concern about the impact of trade tensions on the economic outlook, another spike in Italian borrowing costs, fraught Brexit talks and volatility in world markets make for a colorful backdrop to Thursday’s European Central Bank meeting.
The ECB is expected to repeat that its 2.6 trillion euro ($3.0 trillion) bond-buying scheme is likely to end at the close of the year, with bond markets hoping for details on how reinvestments from maturing bonds will be channeled next year.
Here are some key questions that may come up.
1. How worried is the ECB about growing risks to the growth outlook?
Economists were unanimous in a recent Reuters poll that the ECB will end its bond-buying stimulus by year-end, with a low likelihood of an extension in the face of political and trade worries.
But growing concern about the economic outlook may be hard to ignore as trade wars take a toll. This month, the International Monetary Fund cut its world economic growth forecasts for 2018 and 2019, and Europe’s biggest economy Germany lowered its growth projections.
Minutes of the ECB’s September meeting showed that at least some policymakers debated whether to downgrade their growth risk assessment, which they described as “broadly balanced”.
“Global downside risks, and the possibility of further increases in those risks from here which could formally tip the balance toward downside risks in the statement, are the main things to watch,” said Pictet Wealth Management strategist Frederik Ducrozet.
(Graphic: IMF cuts euro zone GDP growth forecasts – tmsnrt.rs/2Jai7Q8)
2. When will the ECB start discussing rate hikes?
The ECB is likely to repeat the line it has laid out since June: that rates will remain on hold through the summer of 2019.
That’s not to say a question on the rate-hike debate will not come up at ECB chief Mario Draghi’s press conference.
Dutch central bank governor Klaas Knot said earlier this month the ECB will have to start discussing the timing of a rate hike in January.
Draghi also stirred the rate debate with his recent reference to a “relatively vigorous” rise in underlying inflation — comments that have been toned down since.
At the same time, market turmoil in Italy has ignited some caution into investor rate-hike expectations ECBWATCH.
(Graphic: The ECB’s QE program – tmsnrt.rs/2J6CZb0)
3. Will the ECB spell out its plans for reinvestments?
This is the big question for euro zone bond markets, given that reinvestments of funds from maturing bonds held by the ECB will continue to buffer debt once new buying ends.
The ECB has said it will reinvest funds from maturing bonds but has yet to spell out details and there is some talk about whether the bank will target its funds at longer-dated bonds.
Some policymakers have even advocated not rolling over corporate bonds and spending the proceeds elsewhere, Reuters reported last month.
But policymakers also said that any changes to the ECB’s reinvestment policy are likely to be mostly technical, aimed at keeping purchases smooth. For an interactive version of the below chart, click here tmsnrt.rs/2Nqxh3Z.
(Graphic: ECB’s QE redemption estimates – tmsnrt.rs/2NpEjpM)
4. What about the ECB’s capital key, isn’t that due a change?
That’s right – the ECB is due to update its capital key, the amount of capital each member state has paid in, at the start of 2019 to reflect changes in the size of their economies.
Draghi has said the ECB would follow its capital key when deciding how to deploy its reinvestments, so any changes here are potentially key.
Economists estimate that a new capital key would see Germany’s weight increase while Italy’s and Spain’s fall — implying lower reinvestment flows into those countries.
However, while Germany’s weighting is likely to rise, a scarcity of eligible German debt for ECB purchases means there is little if any scope to buy more bonds from the country.
“These are technical issues that usually nobody would care about, but in this instance it is important because for the foreseeable future, reinvestments are the main policy tool that the ECB will use,” said Jefferies senior European economist Marchel Alexandrovich.
(Graphic: New capital key to benefit Germany at Italy’s cost – tmsnrt.rs/2J8lZkv)
5. What is the ECB’s tolerance to Italian risks?
Since the ECB last met, Italy’s anti-establishment government has delivered an expansionary budget — sparking a clash with the EU and sending Italian bond yields up sharply. The bond selloff has rippled into Italian banking stocks, broader share markets and the euro.
Recent correlations between euro/dollar and the German/Italian bond spread have started to strengthen, highlighting the currency’s sensitivity to Italian bond market volatility.
Draghi said this month that Italian officials must stop questioning the euro and need to “calm down” in their budget debate as they have already hurt firms and households.
And not everybody is convinced that Italian risks will remain a localized affair. Alessio De Longis and Ben Rockmuller, portfolio managers at Oppenheimer Funds, have reduced their exposure to European equities in favor of U.S. equities citing growing concerns on Italy.
(Graphic: Italian-German spread widens to highest in 5-1/2 years – tmsnrt.rs/2J4PWSo)
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