Draghi's challenge will be to keep markets tuned into tapering, without causing a 'taper tantrum'
We see the two-step post-French elections EUR/USD rally as fully justified starting with a build-up of QE taper expectations, amplified by Draghi’s Sintra speech, mainly driven by steeper German yield curve. It seems it will only be a matter of time before EUR/USD breaks through 1.15 (as bund yields nudge up), with an overshoot around the ECB September meeting.
We see limited scope for lower Eurozone sovereign yields. While the ECB wants to avoid a taper tantrum bund sell-off, it also seeks to pre-prepare the market for eventual QE tapering via gradually higher yields. Thus, a dovish surprise and sharp decline in bund yields is not desirable. The likely retention of the QE easing bias (the threat of an increase in QE duration and size) may push German 10-year yields lower, but don’t expect a material move below 0.55%. We could see German yields rise hit 0.65% later this year.
Next week's European Central Bank meeting is going to be a double balancing act for President Mario Draghi and his colleagues.
How will the ECB get round a pretty basic conundrum? On the one hand, the ECB wants to prepare financial markets for tapering, without creating a ‘taper tantrum’. On the other hand, in a world without inflationary pressure, the ECB will have to substantiate the tapering preparation with economic arguments that do not leave market participants completely stumped: a balancing act that requires all of Draghi’s verbal acrobatic skills.
This week's ECB meeting may be low on action, but it will be big on words. We highlight and explain the key things you should listen out for in Draghi's speech and what it will all means for markets.