ECB likley under pressure to revise inflation projections lower

Since the 16 July ECB meeting, notable developments in world markets have put downward pressure on the c.bank's quarterly inflation projections. Brent price is down about 25%, and trade-weighted EUR is up 5%. 5y and 5y5y fwd EUR swap breakevens are 45bp and 20bp tighter at 0.66% and 1.63%, respectively. Indeed, 2016 and 2017 market-based inflation expectations of 0.3% and 0.65% are significantly lower than the ECB's current projections of 1.5% and 1.8%, respectively.

The drop in the oil price is threatening the ECB's outlook for higher inflation. Around a year ago ECB president Draghi expressed concern when 5Y5Y inflation expectations declined below 2.0% and the latest decline could very likely result in a more dovish tone from the ECB. 

While the ECB is likely to outline a dovish message at its upcoming meeting on 3 September, it is unclear whether recent developments are big enough to spur action and boost its QE programme significantly at this point. 

"Overall we expect the ECB to sound dovish and slightly worried at its upcoming meeting on 3 September. Currently, we see a low probability of the ECB delivering imminent easing and we believe the ECB will first attempt to improve the inflation outlook by verbal intervention," states Danske Bank in a research note to its clients. 

It is likely that ECB will lower its projections notably in the absence of any new easing measure announcements. In the figure above, each time the gap between ECB projections and market expectations got too big, the ECB had to announce new easing measures to largely maintain its projections and let the market converge towards them.

Board member Peter Praet's interview with reporters in Mannheim indicated that risks for achieving a sustainable inflation path towards 2% have increased recently. He also emphasised that there should be no ambiguity on ECB's willingness and ability to act by adjusting the size, composition and/or length of its QE programme.

Against this, price action in Bunds has been somewhat puzzling: on Monday, the 10y Bund struggled to rally much on the sharp equity market fall, yet it was sold off as much as 13bp on Tuesday and ended the week about 18bp cheaper despite the dovish ECB comments. 

"We see risk/reward favouring dovish-biased trades and recommend long 5y5y fwd France vs Germany and long France in real yields at the long end", says Barclays in a report on Thursday.

EUR/USD failed to sustain hefty gains on the day and is back below 1.13 handle to currently trade at 1.1273.