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ECB preview: sorting out the stance

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It is no secret that data from the euro area continue to point to strengthening of economic activity, therefore the path to deeper ECB loosening seems to be closed. On the other hand, however, for ECB it is still too early to change the stance, especially in the middle of the electoral race in France. President Draghi should remind that the risks are always present (mainly for inflation) and the bank is waiting for more evidence of improvement. For those looking for confirmation of optimism from the March conference this will be a disappointing message and a major risk for the EUR on Thursday.

Since the last meeting in March, macroeconomic data from the euro area have maintained a solid trend pointing to recovery acceleration. After the impressive readings of PMI indexes, hard data are follows suit. On this basis, the market has already built a consensus that the future of ECB policy will be to move away from ultra-loose policy. Even in the accounts of the last policy meeting, it was stated that "a discussion on policy normalization would become warranted".

But not everything on the macro side looks encouraging. The sustainability of the recent rebound in inflation, which has largely benefited from higher oil prices, remains a problem. As this effect began to fade, the return of inflation to the ECB’s target remains under question. Moreover, core inflation remains stubbornly low and unemployment rates stays high in many countries, which means little chances for a wage pressure. Long-term inflation expectations have also started to slow down recently.

Inflation expectations in the euro area are falling again and moving away from the ECB's inflation target ("close but below 2%"); Source: TMS Brokers, Bloomberg

So it is safer for the ECB to do nothing at the meeting this week and cautiously wait for more data from the economy. This is also reasonable approach as we are in the middle of the race for the French presidency. While it may seem as though that Emmanuel Macron's victory is a foregone conclusion, the central bank can not base its policy on election polls. In addition, the Draghi and Co. should try to avoid the communication error that has occurred the last time. In March Draghi's conference was viewed as somewhat hawkish, and this impression has been further fueled by subsequent comments by some members of the Governing Council, on the basis of which the market has begun to build expectations for interest rate hikes later this year. However, much effort has been put in later (Draghi and Praet's interviews and Reuters article based on anonymous sources from the bank) to correct the situation and prove that the market has "way over-interpreted" the ECB's message.

We think that this Thursday Draghi will lead the conference in this direction, repeating its words from last week's speech that risks “remain tilted to the downside”, “a very substantial degree of monetary accommodation is still needed” and “underlying inflation has not shown a convincing upward trend.” Although we believe that the announcement of asset purchases tapering is coming closer (probably in September), the ECB will not start preparing markets for this fact earlier than mid-year.

For the time being, however, we do not expect significant changes in the ECB stance. The market is approaching with slightly hawkish hopes, so the lack of fresh hints from Draghi will be a moderate disappointment. From the perspective of a strong EUR rally in reaction to the outcome of the first round of French presidential elections now the currency is more sensitive to dovish remarks. We see a risk of EUR/USD falling in reaction to the signals from the ECB conference, although move should not exceed 1%. There is a significant risk that a weakening of the euro will be used to close short positions by those investors who want to exit failed hedges related to the risk of the French election.

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