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Anders Svendsen, an economist at Nordea Research, in an article titled, ‘ECB: The market is gearing up for a hawkish shift’, explained that when Draghi expects a relatively vigorous pick-up in underlying inflation then markets move.  

Key Quotes:

“We do not read new policy signals from today’s remarks, but Draghi does sound more confident on inflation and the markets are gearing up for a hawkish shift.”

“EUR/USD has bounced to levels around 1.18, albeit the momentum seems a little old in age, after a strong EUR-period. The EUR reaction is certainly not as vigorous as the fixed income reaction, to use the phrasing of Mario Draghi. Maybe investors are contemplating a hawkish FOMC meeting Wednesday evening as well?”

“Draghi’s remarks at the European Parliament has moved the markets quite a lot (especially in the fixed income space). The passage on a “relatively vigorous pick-up in underlying inflation” has sparked debate about another hawkish shift by the ECB.”

“The EURIBOR curve is now pricing roughly two full 25bp hikes over the next 24 months, up more than “half a hike” since just a week ago. The markets are gearing up for a slight hawkish central bank perception shift, especially ahead of the Fed on Wednesday.”

“We read no new policy signals in Draghi’s speech, but rather an ECB president that is somewhat more confident in inflation projections. Indeed, Draghi notes that as a reaction to the new forward guidance in June, “the realignment of market expectations with those of the Governing Council was immediate and smooth.”

“It is also noteworthy that Draghis changed rhetoric on inflation comes only a little more than a week after the ECB staff revised its 2019 and 2020 core inflation forecast down by 0.1% points. Is the harder rhetoric just a reflection of the audience Draghi is catering for?”

“Draghi’s remarks in full length are much more balanced than the headlines suggest. President Draghi emphasizes that the forward guidance remains in place. What we have here is ECB optimism that inflation will pick up, which we already knew. Net asset purchases will end by the end of the year and rates will remain unchanged beyond the summer of 2019, but the path for rates after next summer remains heavily dependent on incoming data.”

“It is important to note that the slight changes to Draghis rhetoric on inflation does not matter for the time-frame that is within the current forward guidance. The rates will remain on hold until after the summer 2019 and the net asset purchases will stop at year-end, but it matters for the prospects post September 2019.”

“The recent hawkish re-pricing suggests further upside in the Bund yield to the 0.60-0.65% range.

Those levels should be within reach, especially if the Italy risk premium abates over an important budget-week in the Italian parliament. If such levels were reached we would tend to fade the move. This small, albeit hawkish, rhetorical shift in the making from the ECB, is not a big game-changer (yet). Especially not for the short-term outlook.

The ECB President is suggesting that the staff projections’ stable profile for core inflation is the result of slowing non-core components and a relatively vigorous pick-up in underlying inflation. This is to some extent reflected in the super-core measure of inflation which has suggested a building momentum for some months, although the very recent August reading seemed a little softer.

Moreover, base effects from the 16% drop in Italian education prices in October 2017 will leave a positive base effect for October 2018 that could push core inflation a few tenths of a percentage point higher and probably to the highest level in three years.

On the other hand, the details of the August inflation print showed a 5% drop in German education prices that will keep core inflation back for the next 11 months. Apart from the nitty-gritty details, underlying inflation momentum is building gradually, though not much new information supports a hawkish shift at the ECB.

“The pick-up in EUR core inflation though seems almost inevitable and adds to the list of relative positive factors for the EUR against the USD. On our barometer, the USD outlook turns ice-cold against the EUR at the latest around November/December. And the relative core inflation picture is one of the factors speaking in favour of the EUR.”