With the July meetings of both the ECB and the Fed on the horizon, we expect a quiet month for monetary policy, with little chance of surprises. We continue to expect two more hikes from the Fed in 2018, while the timing of the first rate hike from the ECB will be a critical milestone for markets.
The June meeting of the governing council of the European Central Bank (ECB) was rich in information, with the announcement of the end of quantitative easing (QE). Any further major changes are unlikely during the July meeting. We expect the press conference to focus on the evolution of forward guidance and the reinvestment policy for bonds that are set to mature.
That said, the ECB will likely face questions about its forward guidance, particularly regarding rates. Last time, ECB President Mario Draghi said “rates will remain at their current level, at least through the summer of 2019” – a statement that we consider both too precise and too vague. It was surprising to see the ECB tie its hands on the timing of its first rate hike – a critical milestone for market participants.
But once translated, the statement seems to have different meanings in different languages: according to the ECB’s French and German texts, the first hike will be “during the summer”, whereas in English and other languages it reads as “after the summer”.
Certain members of the ECB have publicly expressed the need to focus on incoming data to steer the appropriate timing for the first hike – an opinion which, in our view, is shared by the vast majority of ECB board members.
Achieving the right balance between a hawkish and dovish approach has allowed the ECB to announce the implementation of the end of QE smoothly. But the lack of flexibility around the announcement of the first rate hike could be a problem moving forward.
In terms of credibility, it will be very difficult for Mr Draghi to take a step back now, and therefore we do not expect any changes this month. The deeper, more difficult questions will come later in the year, about how the forward guidance may change, taking into account the evolution of risk, market developments and economic data. The lack of optionality is a source of concern for the future and may have to evolve.
Another important issue for markets is clearly the reinvestment policy for bonds that are set to mature. Sovereign bond reinvestments are set to total EUR 150 billion in the next 12 months. As of today there has been no substantial communication around reinvestment policy. We expect the communication of a transparent framework, likely with some degree of flexibility to diverge from the ECB’s capital key in the short term, and more specifics about the ability to invest in longer-dated securities to counter the loss of duration in the portfolio.
Fed: focused on normalisation
The US economy remains strong: Federal Reserve Chairman Jerome Powell’s recent testimony to Congress was entirely consistent with the latest Federal Open Market Committee (FOMC) minutes, both delivering a clear message of confidence.
Mr Powell remains confident in the ability of the Fed to continue to raise rates as already communicated to the market. It is clear that he thinks a gradual hike in rates to be the best way to maintain inflation close to the Fed target.
Rising protectionism and the threat of trade wars continue to be medium-term risks – worries for 2019 or 2020 when the picture is less certain – rather than short-term concerns. That’s why the Fed’s famous “dot plot” diverges more from market expectations the further you look into the future.
As and when Fed funds rates come closer to the neutral rate – defined by the dots as 2.9% – we should expect more flexibility in the Fed’s market communication to maintain a certain degree of optionality.
For 2018, the focus remains on normalisation, with good visibility for the year ahead. We continue to expect two hikes, which is close to market expectations and we believe that the meeting will not provide any surprises.
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Three factors appear likely to shape the US economy through the rest of 2018: trade tensions, mid-term elections and the Fed’s road to normalisation. In a late-cycle environment marked by the potential for tail risks, investors should take a closer look at small caps, energy, high yield and alternatives.