UBS: ECB to take on forward guidance

With the Eurozone’s growth and inflation outlook on track to match the four-pillar concept of the European Central Bank (ECB), and with inflation now around its target, we believe the hawks in the Governing Council will increasingly get the upper hand over time. As a result, we expect the ECB to "tighten" its communication about its monetary policy over the coming months. To be more precise, we think it may tweak the introductory statement to its press conference and its forward guidance on 8 June as follows:

• Acknowledge a sizable improvement in economic data, confidence indicators, and credit and financial markets

• State that risks to the outlook have become more balanced, in contrast to the previous downside tilt.

• Remove the interest-rate easing bias contained in the phrase, "...to remain at present or lower levels for an extended period of time."

• Reformulate its readiness to "increase our asset purchase programme in terms of size and/or duration," while retaining some flexibility to prolong QE if economic, financial, or political conditions worsen.

Having already scaled down its quantitative easing (QE) substantially this April – from EUR 80bn to EUR 60bn in monthly asset purchases – the ECB is likely to maintain the current pace of bond buying until December, in our view. Although we do not expect the ECB to communicate a decision on 8 June, our view is that it will wind down its QE program over a six- to nine- month period starting January 2018, to be communicated on 7 September. We forecast the first interest rate hike in 2019 at the earliest.

As the ECB’s exit strategy becomes more visible, political risks fade, and eco- nomic growth in the Eurozone surprises on the upside, we retain our con- viction for a higher EURUSD exchange rate and moderately higher Eurozone bond yields.Nevertheless, as discussed in detail in our 14 May report, ECB exit – man- ageable for France, Italy and Spain, governments will continue to benefit from locking in low yields for longer, and gradually higher yield curves will not endanger fiscal sustainability in the coming years.

The run up to QE exit

Eurozone inflation retreated to 1.4% year-on-year in May from 1.9% in April, while core inflation fell to 0.9% from 1.2%. Despite the headline rate being very close to the 2% target, we should not conclude that the ECB is in a hurry to normalize its monetary policy. In his January press conference, ECB President Mario Draghi presented the four-pillar concept for a change in policy. According to him, for the ECB to abandon extraordinarily low interest rates and nonstandard measures, inflation must show:
1. a convergence to the inflation target
2. be durable
3. over the medium term
4. across the entire Eurozone

We think all conditions are in the process of being met, although the ECB's confidence in the durability is not there yet. A few months of inflation around the target doesn’t mean the turnaround is sustainable. Given the recent retreat in oil prices, the stronger euro, and moderate wage growth, we estimate that inflation will stay in the 1.5–1.8% range in the second half of the year before gradually rising to 1.9% at the end of 2018. Con- sequently, the ECB should have plenty of time to implement its QE exit strategy, and we see only a low probability that it will be compelled to taper its QE program and hike interest rates earlier than our expected timeline.

ECB will carefully manage communication

The minutes of the last monetary policy meeting on 27 April revealed that the Governing Council was concerned about the potential negative effects of changes in the forward guidance on monetary and financial conditions. We are convinced that the ECB will do its best to avoid a "taper tantrum" in the Eurozone, which could put at risk the prospects of economic recovery and a sustained return of inflation toward the ECB target. As a result, we should expect only gradual adjustments in the ECB’s policy communication, particularly at the earliest stages of QE exit.

Little emphasis on ECB QE purchase parameters and bond scarcity

Draghi has played down in the past the issue of the scarcity of Bunds. We expect that this potential limit to sovereign bond purchases will not be in the spotlight at the 8 June Governing Council meeting and the subsequent press conference. We continue to believe, though, that the ECB is ready to adapt QE purchase parameters anytime, if needed.