ECB Policy Focus Set Balance Sheet Further Shift

The key macro event for the financial markets this week will be the ECB monetary policy announcement on Thursday. After raising their key policy rate by 25bps to 4.00% in September, they altered the forward guidance in the accompanying statement. The message that "The Governing Council considers that our key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to target" is very likely to be repeated in the statement on Thursday. This will be no surprise to the financial markets with the OIS market currently indicating precisely zero basis points of tightening by ECB at this week's meeting and a mere 3bps by the end of the year. So, the tone of Lagarde comments and certain aspects of ECB policy management will be the key determinant of market moves in the period following the announcement.

Given Fed Chair Powell's comments in his speech yesterday, market participants will want to know how much emphasis FED might now be placing on financial conditions as a factor possibly shaping our thinking on the level of restrictiveness of the monetary stance. Short-end (2yr yield) rates are unchanged since the last ECB policy meeting, but the 10yr yield is 28bps higher. The Euro Stoxx 600 is down 3.8% currently while the ITRAXX EUR CDSI has jumped to the highest level since May, and the IG Credit spread has widened by about 10bps. The EUR EER-42 has weakened by about 0.6%. Clearly, financial conditions have tightened in Europe as well, and Lagarde may well make a similar comment to Fed Chair Powell that there has been a considerable/significant tightening of financial conditions.

Of course, again like Powell, ECB will also emphasize the fact that inflation remains too high and that more work is required to bring inflation back to target. This is consistent with the updated guidance that rates need to remain at this level for a "sufficiently long duration." But the news on inflation since the last meeting has certainly been positive with the September inflation readings falling more sharply than expected. The headline annual CPI rate fell from 5.2% to 4.3%, 0.2ppt more than expected while the core rate fell from 5.3% to 4.5%, 0.3ppt more than expected. ECB forecast update in September has headline inflation at 5.6% for this year and 3.2% next year (core 5.1% & 2.9%) and with a very favourable base-effect for October, the forecasts from ECB remain achievable. Of course, the developments over the coming weeks in the crude oil market could alter that scenario and remain a key risk. Offsetting that risk though is the fact that the technical assumption for the euro-zone long-term yield is now about 15-20bps higher than assumed in the September forecasts.

The higher longer-term yields ECB face as we meet Thursday will likely underline caution in relation to communicating guidance on balance sheet policy. I already know that under the APP program, all maturing securities are rolling off which on average equates to about EUR 27bn per month over the next 12 months. On top of that, we know that by the end of next year, the outstanding TLTROs will also mature from ECB balance sheet. That equates to around EUR 900bn of further balance sheet shrinkage by the end of 2024 if we assume of the APP average roll-off rate remaining unchanged beyond the 12-month period in which data is available. I suspect ECB will continue to refrain from signalling an appetite for outright sales of securities under the APP program.

What is perhaps more plausible is a shift in guidance on the commitment to continue reinvesting all maturing securities under the PEPP program through to the end of 2024. I don't think ECB will alter their formal guidance on Thursday, but there is certainly a much higher risk that in the Q&A, ECB acknowledge for the first time that a discussion regarding PEPP plans in 2024 took place at the meeting. That mere acknowledgment would raise considerably expectations of a change in PEPP policy to a tiered slowdown in PEPP reinvestments possibly from the start of next year. However, given the rout taking place at the long end of bond markets, it would be a risky strategy and it's plausible this acknowledgment is left until December. If ECB do confirm a discussion took place, we would likely see a clear reaction, in the BTP market. The spread over Bunds on the 10yr broke above 200bps this month to reach levels not seen since December. The EUR 24bn tax cut and fiscal deficit slippage confirmed by Rome is reinforcing upward pressure. Perhaps this could even incentivize ECB to signal a change. I would class BTP market developments as a key downside risk for EUR at present. A three-month rolling correlation of the BTP/Bund spread, and EER-41 EUR is currently at -0.85.

EUR/USD has shown considerable resilience of late despite the move in rate spreads clearly favouring the US. Crude oil prices are higher since the Hamas attack on Israel, and TTF natural gas prices are about 40% higher. Even prior to the Hamas attack, Germany was already suffering from the still elevated natural gas price relative to pre-pandemic levels. A further rise from here would likely put renewed downward pressure on EUR/USD. Record levels of crude oil production in the US underline the favourable terms of trade shift for the dollar. The primary FX downside risk on top of this for EUR would be ECB acknowledging on Thursday that they discussed the PEPP policy guidance for 2024. That would likely fuel a widening of the BTP/Bund spread and would be made worse if there was explicit criticism of Italy and any hint that the TPI is not a tool to be used to protect governments from adopting inappropriate fiscal policies.

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