In line with other global central banks, ECB communication has turned hawkish recently with Mario Draghi arguing that in a situation where the economy continues to recover, monetary policy tightening could be needed in order to keep the policy stance 'broadly unchanged'. In our view, these comments were intended to prepare the market for a reduction in QE purchases from next year, which is likely to be announced at the meeting in September. We still expect the ECB to continue its QE purchases but at a reduced pace of EUR40bn per month in H1 18, keeping the end-date dependent on the inflation outlook. That said, we believe it is most likely the ECB will taper towards zero in H2 18.
Added to this, the minutes from the June meeting revealed that the ECB discussed whether to revisit the QE easing bias where it signals its readiness to increase the size and/or duration of QE. We expect the ECB to discuss this easing bias at the upcoming meeting but believe it will deliver only a minor twist and remove its readiness to increase the size of QE while maintaining the flexibility in terms of duration. Together with this, the ECB could add that the duration part of QE will be reconsidered at the meeting in September, when the ECB has updated inflation projections.
Despite the hawkish comments mentioned above, the ECB has also expressed concern about an unwarranted tightening of financial conditions. Related to this, Draghi's communication has been that the ECB needs to be persistent in monetary policy in order to be assured about the return of inflation to the objective while any adjustments to the monetary policy stance have to be made gradually.
Finally, we expect the ECB to have discussed tapering at the upcoming meeting after Draghi rejected such discussions at the latest meeting in June. In our view, such a discussion will be in line with the latest communication that monetary tightening could be needed in order to keep the policy stance 'broadly unchanged'.
In fixed income markets, tapering is primarily an issue for Italy as well as the outright level for yields. However, there is plenty of cash in the system and the ECB will have a large reinvestment need in coming years. Hence, any significant widening of the BTPS-Bund spread is not expected to be persistent given the strong domestic investor base in BTPS.
The July ECB meeting will, if anything, probably add to upside risks for EUR/USD. When Draghi started the exit talk at the Sintra conference he in our view opened the lid for the cross, i.e. this was the catalyst for starting to correct its long-standing undervaluation. We still see EUR/USD in a range around 1.13 near term but risks remain on the upside longer term.
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