Improving growth and the rarity of inflation running ahead of the European Central Bank’s target provide the awkward backdrop to the meeting of policymakers in Frankfurt this week.
After years spent worrying about the scourge of deflation, officials have just seen prices in the eurozone increase at a faster pace than their target of just below 2 per cent for the first time in four years.
However, few investors believe that will be enough to persuade the central bank’s governing council to make any changes to its €2.3tn stimulus programme when they give their latest decision on policy on Thursday.
Instead, ECB president Mario Draghi is predicted to try to tread a careful path between telling a positive story about the region’s economy while insisting the outlook isn’t bright enough to scale back stimulus.
The problem for Mr Draghi is that while headline inflation has jumped, “core” inflation figures that strip out the rebound in the oil price over the past year remain sluggish at 0.9 per cent. There is also little sign of wage growth, which the ECB has suggested is an important gauge of economic health.
“Remember as well that ECB President Mario Draghi set out four conditions the ECB needed to see to be satisfied that inflation was meeting the ECB’s target,” says Cosimo Marasciulo, head of European fixed income at Pioneer Investments. “One of those conditions was that inflation had to be durable, and not just one month’s number.”
With no excitement expected from the ECB’s headline announcements, investors will be left to scrutinise Mr Draghi’s language to divine what conversations are happening behind closed doors about the ultimate removal of the stimulus programme.
Although there has been much attention on the potentially reflationary effect of Donald Trump’s economic plans, the question of when the ECB will begin to end its quantitative easing plan has simmered away for money managers this year.
Even if there is no change in 2017, Andrew Bosomworth, head of portfolio management in Germany for asset manager Pimco, believes QE will come to an end next year.
“Our analysis suggests that the rules it has set itself for the purchase of sovereign debt leave the ECB with no other choice but to taper purchases of government bonds further beginning early in 2018,” he says “In fact, we think it will have to cease buying central government sovereign bonds in some smaller countries altogether in the first quarter.”
Markets are pricing in a 40 per cent chance of the ECB raising rates by the end of next year.
“With tapering off the table, market participants are instead focused on possible changes to the wording of the ECB’s forward guidance and whether it may drop its current bias toward lower interest rates following public calls from two prominent governing council members.” says Cathal Kennedy, European economist at RBC Capital.
Mr Draghi is likely to avoid being drawn directly on the future of QE, but he will be unable to ignore the recent extraordinary moves in short-term government bonds and what they say about the side-effects of the ECB’s programme.
Since the governing council’s last meeting, the eurozone government bond market has broadly followed the trajectory set by US Treasuries — with yields rising as the effects of return-sapping inflation begin to be priced in.
One corner of the market, however, has bucked the trend. As other bonds sold off, short-dated German sovereign bonds experienced a rally that sent the yield down to a record low of minus 0.93 per cent late last month.
While some market watchers put the move down to worries over the French election — with investors moving out of French bonds into German debt as a hedge against the chance of far-right Eurosceptic politician Marine Le Pen winning — others point the finger at the ECB’s bond-buying.
ECB data released this week showed Germany’s Bundesbank is switching its bond purchases to shorter durations, pushing the average maturity of German bond purchases from 8.1 years to 7.5 years.
The Bundesbank already faces headaches finding enough bonds to buy as part of QE — with German debt the largest part of the ECB’s overall programme — and there is an imbalance between supply and demand of short-dated German debt.
This year, Germany’s debt office is expected to cut sales of two-year debt by €1bn. Meanwhile, German bonds are also in demand from investors who need the highly rated AAA-securities for repurchase agreements, or “repos”.
Mr Draghi’s press conference will draw intense scrutiny, but the moment he is finished investors will be reminded that any talk of tapering depends on the region cleaving to the political status quo.
Less than a week from now, the Netherlands will hold an election. The following month French voters will go to the polls. Later in the year a general election is scheduled in Germany, and one may also be held in Italy.
Gains for Eurosceptic parties that threaten the unity of the eurozone are likely to upend any plans the ECB has for removing market support. High-stakes elections are still weighing on markets, says Didier Saint-Georges, managing director at Carmignac. “Political risk in Europe is no paranoid fantasy.”