Growth risks less pronounced, but muted inflation still a concern

While interest rates remained unchanged, the ECB’s Governing Council appeared to have a more positive view on growth, in line with the recent stabilisation in macro data, and “less pronounced” downside risks. Inflation, however, is still a headache. Underlying inflationary pressures remain muted, and headline inflation is expected to hover around current levels, with monetary policy likely to remain highly accommodative “for a prolonged period of time”. 

Strategic Review: A long list 

Similar to other leading central banks, the ECB has formally embarked on a review, which will examine every aspect of its mandate and role in a “broad and comprehensive” manner. The review will cover not only the central bank’s inflation target, which remains its core mandate, and its standard “toolbox”, but also how it can best communicate its strategy to the broader public and how best to incorporate sustainability in its monetary policy framework. The review is expected to last until the end of 2020, although Lagarde’s “it will be over when it’s over”, hinted at some flexibility around the end date. 

Tackling climate change

During the press conference, ECB President Christine Lagarde faced several questions on climate change and the ECB’s plans related to sustainability. With climate change seen as a “threat to financial stability”, Lagarde said the ECB would thoroughly examine the role ECB could play in this area. However, it will not be easy to clearly delineate the roles of the ECB and individual European states

A more dovish bias

Looking ahead, investors will focus on what the most likely outcome of the review will be and its implications for markets. Given the perennial challenges that the ECB has had in lifting inflation, and with inflation expectations back to its current target, it is widely expected that the target will shift to a range around 2 per cent (rather than the current “below, but close to 2 per cent”). This would implicitly allow for inflation overshoots if deemed temporary and would cement a more dovish bias going forward. 

The review will also likely see asset purchases formally becoming part of the ECB’s monetary policy toolbox rather than an exception. Lastly, the ECB will no doubt spend plenty of time on its communication strategy, given the challenges and pushback that the central bank is experiencing against its quantitative easing and negative rates policy.

Lagarde’s legacy and implications for markets

Overall, the review will be Lagarde’s legacy at the ECB and will define her mandate to lead the central bank in a new direction. However, we expect the review to reinforce the ECB’s dovish bias, keeping monetary policy on the well-defined path outlined by her predecessor Mario Draghi during his tenure. 

In the near term, the ECB will be relieved to see some stabilisation in European macro data, thanks in no small part to the easing in geopolitical tensions. Still, the central bank will stand ready to act with more stimulus should the rebound run out of steam. We see rate cuts as more likely than additional QE, given the legislative constraints that the ECB faces around the latter, and tiering that appears to be working “extremely well”, as Lagarde highlighted during the press conference.

Further steepening ahead

For investors, the review is unlikely to have meaningful near-term implications, with rates likely to continue trading in well-defined ranges in the absence of any major shock. Considering the challenges of extending the QE programme further, however, we expect longer maturity government bonds to underperform, particularly in core markets, and curves to steepen as a result. However, should an external shock materialise - for instance if the US decides to apply punitive tariffs on European exports, we have little doubt that the ECB will overcome its internal limitations and respond with more asset purchases to support markets and the economy. We would then reassess our curve exposure accordingly; but for now, our base case is for further steepening ahead. 

Priced to perfection

European credit meanwhile appears to be priced “to perfection”, particularly in the higher quality part of the universe, with valuations that are not as attractive as they were 12 months ago. A more neutral exposure to the market is therefore warranted, with room for spreads to widen from current levels. Longer term, however, European credit markets should remain well supported, not only by the ECB’s purchase programme, but also by the strong inflows that the asset class continues to enjoy, as yield-starved European investors venture into credit in search for income.