04/09/2014: Outlook ahead of the ECB decision

The calm before the storm?

Markets have been predictably dull this morning in the run up to the big ECB monetary policy decision this afternoon. However, this could be the calm before the storm.

Despite a rebound in the first few days of this week, the German 10 year Bund yield remains firmly below 1.0% at 0.94%. That has come as the yield has been sliding consistently ever since the start of the year. Falling yields suggests falling inflation expectations and this chart looks very similar to the chart that the ECB uses to gauge its future inflation expectations on, the 5-year/5-year Forward Inflation Expectation rate. This suggests that the market is pricing in a move towards deflation and the ECB will need to act to combat the slide.

Bund   04092014

The big question for today is that as the market prices in deflation and expects the ECB to act, just when will the action take place? The ECB looks set to disappoint the market. Any expectations of full blown QE which have come about following Mario Draghi’s dovish Jackson Hole speech could be dashed today. Draghi promised to use all available instruments to combat falling prices, but that action is unlikely to be the ECB’s ultimate weapon. Instead expect the announcement of “private QE” or an Asset Backed Securities purchase programme.

If this is the case then expect huge volatility (as traders try to decipher exactly what it means for future action) but ultimately the likelihood of a sizeable short squeeze for the euro which pulls EUR/USD sharply higher. This could also have a knock on impact on the other dollar pairs as the selling pressure on the greenback pulls Cable higher and Dollar/Yen lower.

Any knee jerk reaction on these pairs can be expected to be short-lived though and once the initial shock settles down then the dollar should regain its poise.

Subsequently:

  • Use any technical rally/short covering  in EUR/USD as another chance to sell. There is resistance in the $1.3200/$1.3300 band that would represent a good chance to sell.
  • Use a rally in GBP/USD towards the key downtrend at $1.6590 as a chance to sell, whilst any rally that finds resistance below $1.6700 should ultimately still be a good selling opportunity.
  • Use a correction in Dollar/Yen into the 103.50/104.43 band as a chance to buy.
  • Sell any rally in gold towards $1280 resistance

The trading ranges on the days of the ECB meetings in May (161 pip range) and June (169 pip range), which were the last two times that Draghi announced significant policy changes, show that volatility could be significant today.

Over to you, Mario…

EURUSD   04092014

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