Markets expect too much from the ECB – BAML

Analysts at BofA Merrill Lynch explain that ECB’s QE has an expiration date and for a number of reasons, the ECB does not seem willing or capable to increase the issue limit or relax the capital key in its QE purchases.

Key Quotes

“QE will have to end next year. 

However, investors expect a relatively fast pace for QE tapering. Indeed, our Rates and FX Sentiment survey shows that most investors expect ECB QE to be over by mid-2018. Moreover, the market is pricing faster hikes by the ECB than by the Fed for the next three years.”

“We disagree with this consensus for the following reasons:

• Our calculations suggest that the ECB could stretch QE by the end of 2018 and we expect them to do so. Why stop early when they are far from their inflation target and they keep revising their inflation projections downwards?
• The strength of the Euro this year makes us even more confident that the ECB will take all the time it has with QE. It is inevitable in our view that the ECB will have to revise its inflation projection downwards again in September, further away from its target, to a large extent because of the strong Euro.
• Moreover, we would expect strong forward guidance that policy rate hikes above zero will be on the table only after inflation is close enough to the target.
• In contrast to what we see in the US, Eurozone core inflation and the output gap are consistent and are moving in the right direction, but they are not where they should be yet. The Eurozone still has an output gap, suggesting that policies can remain loose without inflation risks—while tightening too early could lead to deflation risks. Although the ECB monetary policy is now loose, it is not as inconsistent compared with the economy’s position in the business cycle as in the US.
• We expect the ECB to have a different view on financial stability concerns than the Fed. First, Eurozone equities are not at a historic high, as in the US, and in any case the stock market is less important for the Eurozone economy, which is bank-based, than for the US economy. Second, fast ECB tightening could lead to higher periphery borrowing costs, bringing back Eurozone debt sustainability concerns and Eurozone breakup risks. Therefore, while financial stability in the US needs the Fed to lean against asset price bubbles, financial stability in the Eurozone needs the ECB to keep supporting periphery assets, or at least to avoid a sharp adjustment."