Rates Spark: Financial conditions targeting

Of the two truisms overused in our line of work, ‘we’ll know more in the future’ was the one most evidently in favour at yesterday’s ECB press conference (the other one is ‘uncertainty is high’, when were we ever certain about the future?). It seems like president Christine Lagarde’s standard answer to questions about the ECB’s many policy tools was: ‘we’ll see in December’. If the aim was to prevent a hawkish reaction to a reduction in PEPP purchases, this was the right strategy. EUR yields ended the day lower.

The ECB could accelerate purchases if financial conditions were to tighten again

To be fair, PEPP purchases continuing at a ‘moderately lower pace’ is hardly a sea change. We may yet find out what monthly rate the ECB has in mind but we would guess that purchases in the last months of the year won’t differ much from the €65bn/m realised in August. Anonymous ECB sourrces quoted by Reuters after the meeting suggested this much. Financial markets also took to heart that easier financial conditions since June were a criterion used to decide on a reduction of purchases. The implication, it seems, is that the ECB could accelerate purchases if financial conditions were to tighten again in the absence of meaninful progress towards its inflation goals. We call this ‘financial conditions targeting’, and we find it strikingly reminiscent of the Fed put.

The problem of course, is that we have only a partial understanding of what constitutes accomodative financial conditions. In addition to the usual market variables (dubbed "upstream" by the ECB) including bond yields and credit spreads, ease of access to and cost of credit for firms and households (downstream) feature prominently. This puts increased focus on the ECB’s lending surveys, with the next and only release before the December ECB meeting scheduled for October 26th (incidentally, two days before the October ECB meeting although this one is widely considered not to be 'live').

Market reaction was telling. We expected this kind of rally but thought it could only be achieved by keeping PEPP purchases at around €80bn/m. This speaks to the hawkish tilt in market expectations, but also to the ECB’s success in communicating its new reaction function. In this context, we think the view that an increase in APP purchases will be announced in December to cushion the end of the PEPP, what our economics team calls ‘a grand recalibration between the PEPP and APP’, will gain in popularity.

Only a further acceleration of inflation can upset this state of play

This is all positive for EUR bond markets. Supply pressure remains of course but the removal of a hawkish risk means they are more likely to tread water, Treasury-style. There is still scope for upward momentum for rates of course, but we think it will have to wait until the US debt ceiling is lifted, and for the current Covid-related soft patch in data to end. The main winners are carry traders in our view, as they can look to a quieter Autumn. Only a further acceleration of inflation can upset this state of play in our view.