ECB Meeting: June Ruled Out - July on the Cards

• Jean-Claude Trichet took the market by surprise, starting three minutes early. Going into the meeting, the market was split on the issue of whether the next hike would be in June or July, but Trichet quickly made it clear that the ECB will not hike at the June meeting.
• Trichet kept a hawkish stance on inflation. There were no signals at all that might indicate that the ECB will not deliver more hikes in this round. We now see an 80% change of a July hike and a 20% likelihood of a hike in August or later.
• Peripherals problems will not keep Trichet from hiking rates. Asked if the fragility of the euro zone periphery was a factor in the ECB's rates decision, he said: "Absolutely not. Our responsibility is for the price stability of the euro area as a whole”.
• Nevertheless, the debt crisis is affecting the ECB's hiking pace. The debt crisis has lowered the outlook for wages and inflation in parts of the euro area and it is an extra downside risk. It is therefore appropriate that the ECB favours a slow hiking speed.
• A three-month hiking cycle is in line with our indicators and also seems an appropriate pace relative to previous hiking cycles. We thus stick to our expectations of further hikes in October and January 2012.
• The market reaction was significant today. EUR/USD declined from 1.484 to 1.46 and the two-year German government bond yield declined some 14-15bp compared with the level before the press conference.

Markets were split but Trichet's message was clear

Maybe it was because today's meeting took place in Finland that the ECB president started the press conference three minutes early. Going into the meeting, the market was split on the issue of whether the next hike would be in June or July. By applying the code “monitor very closely”, Trichet made it clear to all that the ECB has no intention of hiking before the July meeting. We see an 80% change of a July hike and a 20% likelihood of a hike in August or later. Trichet also kept a rather hawkish stance on inflation and specifically said that “we continue to see upward pressure on overall inflation” and “inflation is likely to stay clearly above 2% in the coming months”. There were no signals at all to indicate that the ECB will not deliver more hikes in this round.

A three-month hiking cycle is in line with our indicators and also seems appropriate relative to previous hiking cycles. We thus stick to our expectations of a July hike and again in October and January 2012. We expect inflation to go below 2% again in April 2012.

Peripheral problems not a factor

Asked whether the fragility of the euro zone periphery was a factor in the ECB's rates decision, Trichet replied: "Absolutely not. Our responsibility is for the price stability of the euro area as a whole." The debt crisis does matter for the ECB, but only to the extent that it affects the outlook for overall euro area inflation. At the current juncture it will not stop the ECB from delivering more hikes.

Trichet stated that, “risks to the economic outlook remain broadly balanced in an environment of elevated uncertainty” and, "Downside risks relate to further increases in energy prices". Relative to our projections, downside risks have increased recently due to rising prices and recent disappointing data from Germany.

Fiscal responsibility in focus

The EU/IMF programme for Portugal revealed last weekend was welcomed by Trichet. He also expressed concern about fiscal developments in some countries. He sees a risk that fiscal balances may fall behind targets and emphasised in the press statement that where necessary, “additional corrective measures must be implemented swiftly to ensure progress in achieving fiscal sustainability. The implementation of credible policies is crucial in view of ongoing financial market pressures.”

Fiscal tightening is lagging behind in Portugal, and Greece will most likely have to deliver more measures following the 2010 deficit being revised upwards, while Spain is ahead of the curve. The ongoing debt crisis complicates the ECB's situation. The ECB targets the euro area inflation as a whole, but also has to take into account the significant downside risk that the debt crisis represents. The debt crisis has lowered the outlook for wages and inflation in a not insignificant part of the euro area and is therefore part of the reason why the ECB prefers to hike rates at a moderate pace.

Market reaction

The bond markets reacted significantly to today's ECB meeting. The two-year German government bond yield declined some 14-15bp compared with the level before the press conference.

Ahead of the ECB meeting, a 40% probability of a June hike was priced in. This has now declined to almost zero. Not even a full 25bp hike in July has been priced in. The implied probability of a July hike is now about 75%.

Further out on the curve, hike expectations were reduced more aggressively. The refi rate is now expected to reach 2% around March (if assuming no further normalisation in Eonia). Before the meeting, the market expected this level to be reached by late this year.

Unless economic data deteriorates markedly from here (which is not our macroeconomic main scenario) the market pricing now seems relatively fair given our ECB view. As such, we do not expect rates to continue down. However, with risk appetite under pressure, recent softness in economic data and commodity prices now declining, bond yields are not likely to move much higher either.