September ECB outlook: After fueling high expectations, it’s time for Draghi to deliver

Macro

Head of Macro Analysis

Summary: After fueling high expectations, it’s time for Draghi to deliver.

Draghi has created high market expectations, it is now time for him to deliver. If he does not announce a big push, the ECB will need to do much more in December meeting, with little chance of success, and in a more uncertain macroeconomic environment.

The two main arguments in favor of ECB’s new measures are the risk of de-anchoring of inflation expectations and the risk of technical recession in Germany in Q2-Q3 this year. On the bright side, domestic demand remains broadly resilient in the eurozone, as pointed out by recent strong retails sales, and fueled by low inflation and rising wages. The outlook is positive for private consumption in most countries, except for Germany where we start to see a contagion of weakness from the manufacturing to the service sector.

The opposition of 6/7 hawkish members of the Governing Council is unlikely to prevent a relaunch of QE, but it could lead to a smaller package than initially anticipated. Market expectations were for QE2 to be set at EUR50bn per month, but the size could be revised lower between EUR20-30bn per month to reach a broad compromise. The ECB can also play with other QE parameters, such as the duration of the program and/or the removal of capital keys, which is more unlikely.

A rate cut of 20 bps could also be announced but the effect in boosting inflation is rather low. There has been a lot of debate about the introduction of a tiering system, but it is not yet certain it will be announced this week as “some concerns were raised regarding possible unintended consequences” according to the latest ECB minutes.

Risks to growth are growing in coming quarters as the EU could be the next target of Trump’s trade war. Based on real effective exchange rate, the EUR is 25% too weak versus the USD and, on the top of that, US trade deficit with the EU is increasing at fast pace and approaching the level of the US trade deficit with China. The combination of deteriorating US trade deficit with the EU and very accommodative ECB monetary policy is likely to trigger sharp response from the Trump administration in coming weeks or months.

Strategic view: If Draghi delivers, it could appease the market for one week or two weeks at best, betting on the fact that there is no further deterioration on the trade war front. The upcoming FOMC meeting will constitute the next test for euro/dollar sentiment. In the interim, we see further weakness in EUR/USD is likely due to the recent breakdown of 1.1000 and the expected further ECB stimulus.