In his first press conference of 2019, European Central Bank (ECB) President Mario Draghi said risks surrounding the eurozone growth outlook have shifted to the “downside,” versus the “broadly balanced” risks he discussed just one month ago when the bank ended net asset purchases.
Policy changes ahead
We think Thursday’s downgraded growth assessment is a precursor to two changes in the ECB’s monetary policy stance later this year.
First, we expect the ECB to change forward guidance in March 2019, which will validate the market’s expectation for the first rate hike. Currently, market interest rates indicate liftoff – defined as the first 10-basis-point increase in the overnight rate – in April 2020, whereas the latest ECB guidance is for policy rates to remain unchanged “at least through the summer of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term.” We expect the ECB to amend this sentence to read “at least through the spring of 2020 …”
Second, we expect the ECB to introduce a regular long-term refinancing operation (LTRO) with a maturity between 18 and 24 months and a rate linked to the main refinancing operation as part of its standard toolkit. There is a widespread and possibly misplaced expectation the ECB will provide a targeted long-term refinancing operation (TLTRO) in June 2019, when approximately €380 billion borrowed under this facility will lose 50% of its effective contribution to banks’ net stable funding ratios (NSFR) owing to the loans’ residual maturities falling below one year.
The narrative is more nuanced than this, and we think it is important to distinguish between monetary policy operations targeted to stimulate demand by incentivising banks to lend to the private sector (e.g., TLTROs with fixed rates as low as the deposit facility’s −0.4%), and standard LTROs that provide banks with generic funding. We expect the new tool to be of the latter type. Without it, banks that need to raise their NSFR will face increased funding costs as they seek market-based sources of funds.
Low for longer, working longer
With the Federal Reserve signalling a slower pace of tightening, geopolitical uncertainties persistently weighing on economic sentiment and tighter financial conditions since the end of last year, the window of opportunity for the ECB to normalise its policy stance is closing and may have already shut. We amend our medium-term base case outlook for the ECB accordingly to push out the expected timing of the first rate hike and to lower the terminal rate in this cycle. We now think the ECB will postpone its first hike in the deposit facility rate of 15 basis points (to −0.25%) from later this year to the first half of 2020 and that the deposit facility rate will peak at 0% in this cycle.
Europe’s imbalanced economy faces Japan-like structural headwinds to inflation from an aging population increasingly working longer to make ends meet. For the ECB this implies a non-insignificant risk that inflation expectations dislodge from 2%. For investors that implies harvesting what is left of the term premium.
Read PIMCO’s Cyclical Outlook, “Synching Lower,” for insights into major economies and markets in 2019.
Andrew Bosomworth is PIMCO’s head of portfolio management in Germany and a regular contributor to the PIMCO Blog.