Draghi Outlook Snaps Euro Interest-Rate Bears Out of Hibernation

  • Money markets at increased risk of pricing higher policy rates
  • ECB discussed removing reference to rates remaining lower

Investors are betting that the European Central Bank will start raising rates before the end of its quantitative easing.

Forward swaps based on the Euro Overnight Index Average are pricing 10 basis points of rate increase by April next year, compared with less than three at the end of last month. Investors are also betting that the ECB will exit from negative policy rates by January 2020. The ECB may taper its bond purchases further beyond the end of this year as it faces increasing limits on its bond-buying program.

While the market is pricing in a rate increase sooner, euro-area headline inflation looks set to have peaked as the base effects from energy prices are fading. Core price pressures remain near 2014 levels when the ECB started quantitative easing.

Stubbornly low core inflation increases complications for policy makers at a time when the ECB is already approaching the limit above which it can’t buy German bunds further. Increasing the ceiling on bond-buying may trigger legal challenges since there are concerns that any change may contravene the Maastricht Treaty on monetary financing. This may force the ECB closer to the exit door no matter what the inflation outlook is.

Expectations that the ECB will adopt a less accommodative policy stance have been building up in the market following improvement in recent euro-area economic data, including purchasing managers’ indexes hovering near six-year highs.

Following the ECB’s policy review on Thursday, President Mario Draghi refused to speculate on the possibility of rate increases before quantitative easing ends. He did acknowledge, however, that the balance of risks to growth has improved and the ECB’s policy committee discussed removing a reference to rates remaining “at present or lower levels.”

• NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

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