(27 JULY 2019)DAILY MARKET BRIEF 3：ECB: The return of “whatever it takes”?

The ECB succeeded, but has been less successful in achieving its inflation target. Despite negative interest rates and EUR 2.6trn of quantitative easing, Eurozone core inflation is just 1.1% and is expected to remain low for some time to come. 5 year/5 year inflation swaps, a measure of inflation expectations, were 2.2% in July 2012, but today stand at just 1.3%. Thursday’s ECB meeting provided signals that the central bank may now do “whatever it takes” to try to shift stubbornly low inflation and inflation expectations.

• The ECB has opened the door to further rate cuts, even though the deposit rate is already -0.4%. We expect a 10bps rate cut and deposit tiering to be announced in September, with a further 10bps rate reduction to follow in October.

• The ECB is also looking at options for additional quantitative easing, but given the risks of such a program we think that pressure would have to increase materially for it to be launched. A QE program large enough to be effective would likely require breaking either its capital key or issue limit rules, and could push Bund yields deeper into negative territory.

• The ECB didn’t mention a formal review of its inflation target. But in its statement the usual reference to an inflation target “below but close to 2%” was dropped in favor of a “commitment to symmetry in the inflation aim”. Draghi reinforced the point, stating that, “basically we don’t like what we see on the inflation front and symmetry means there is no 2%cap. Inflation can deviate on both sides.”

We think this low rate environment should be positive for equities and supports carry trades, which help boost portfolio income. In our FX strategy, we overweight a basket of higher-yielding emerging market currencies (Indonesian rupiah, Indian rupee, South African rand) against a basket of lower-yielding currencies (Australian, New Zealand, and Taiwan dollars). Euro investment grade credit spreads should remain supported by an accommodative ECB and we see good long-term value in emerging market sovereign bonds.

If the ECB were to raise its inflation target, and if this were to succeed in lifting inflation expectations, the effectiveness of cash as a safe asset would be further reduced. Both medium-term rate expectations and long-term purchasing power would fall as a result. In such an environment investors would need to ensure their portfolios have a suitable allocation to real assets, such as equities or inflation-protected securities, and are not over allocated to nominal assets like cash or fixed income securities.

BY UBS