Obviously, next week’s ECB meeting will be dominated by the Brexit vote. However, as the meeting comes too late for any imminent ECB action to calm markets but also too early to have a real view on the short-term economic damage, we believe the ECB will simply try to buy some time by sounding dovish. Any real action will likely not happen before September.
What a difference a referendum in a non-Eurozone country can make. In the pre-Brexit vote world, the ECB’s main concern was low inflation and a future of another two years of headline inflation below the ECB’s target. In the post-Brexit vote world, even though financial markets have calmed somewhat in recent days, the ECB’s concerns have increased. The economic recovery of the Eurozone is again at risk, inflation could be lower and, above all, the future of the entire Eurozone has never been shakier and more unclear than at present.
Not the time to act. Even though market participants had been speculating about new ECB action at next week’s meeting, we believe that the ECB will keep its powder dry. In fact, the timing of the week is a bit unfortunate. It comes too late for any imminent ECB action to calm markets but it also comes too early to have a clear understanding of how severe the short-term economic damage from the Brexit vote will actually be. The only post-Brexit data available at next week’s meeting will be the readings of the July ZEW index and Eurozone consumer confidence. In combination with the recent stabilisation of financial markets, this is clearly too little information to justify new monetary action – and even more so as the last four months have already seen an enormous amount of stimulus, which will continue to support the Eurozone economy.
Rain check for September. Although we don’t expect any new action from the ECB next week, new measures at the September meeting have become more likely. At least if the Brexit vote has the negative impact on sentiment and economic activity that almost every analyst expected. In September, the ECB will have two entire batches of soft indicators and new staff projections available. This, in our view, could justify an extension of QE until at least the end of 2017. Given the ECB’s increased awareness of adverse effects from negative interest rates on the banking sector, another rate cut does not look likely.
How to tackle the problem of too little supply for QE purchases. Even without an extension of QE, the ECB seems to run out of assets to buy in the next twelve months. In particular, the drop in German bond yields is causing some headaches. As the ECB is only buying bonds with yields higher than the deposit rate, it currently can only purchase German bonds with maturities of seven years and longer. In theory, there are several options to tackle the problem of too little supply: i) increase the issuer limit from the current 33% to 50% or 70%; ii) include bank debt into QE purchases; iii) shift the country distribution of purchases from the current capital key to market capitalisation; or iv) scrap the deposit rate floor. In our view, the first three options are politically too sensitive and controversial as they strengthen the argument of QE being monetary financing. Scrapping the deposit rate floor, therefore, looks like the most feasible and likely option.
Dovish through the summer. The biggest challenge for the ECB president at next week’s meeting should be to sound dovish and open the door for September action, without giving away too much. He might regret that almost ten years ago, the ECB stopped the tradition of a summer meeting without a subsequent press conference.