Tomorrow the European Central Bank announces its monetary policy conclusions from the final meeting of the Governing Council of 2015. The market is anticipating that ECB President Mario Draghi will extend the central bank’s quantitative easing program. However to what extent? What is the market anticipating? What is the ECB likely to do, and what will be the impact on the euro? With all that in mind, is this a good time to buy the euro ahead of the ECB meeting?
The market is pricing in a sizable move by the ECB. The German 2 year Shatz yield is seen as a barometer for the market expectations on the ECB deposit rate. The Shatz has now fallen to -0.440%. This would suggest that the market is pricing in a 20 basis point cut to the deposit rate. Consensus expectations suggests that the ECB will only cut by 10 basis points, so there could already be some backlash on the Shatz that the ECB will not go far enough. There is much debate in the market as to whether the ECB will go even more unconventional and split the deposit rate into a two tiered system where the bigger banks pay more for their deposits than smaller banks. This lack of certainty would suggest that the ECB rates decision at 1245GMT on Thursday will generate market volatility.
This volatility is likely to continue into the press conference (at 1330GMT) when Draghi is expected to announce an extension of its asset purchase program as well. The current €1.1 trillion program means that there are €60bn of assets purchased every month between March 2015 to September 2016 (ie. 18 months). Again it is uncertain how this program will be extended, with possibly a further €10bn per month (to €70bn) and lengthening the program by 6 or even 12 months. The program purchases sovereign debt. The table below from The Economist lays out the maturities of European debt and how a large proportion of that debt currently returns a negative yield.
However, when the ECB first announced its €1.1trillion program (in January 2015), the HICP inflation rate for the Eurozone was standing at -0.6%. This morning, Eurozone inflation for December was announced and it remains at +0.1% (albeit this wa a slight miss of the expectation of +0.2%). This is much higher that the nadir of -0.6%, but whilst there has been some progress made on inflation in recent months, the dovish argument is the lack of traction in the recovery.
Also, the “transition mechanism” is all important (ie. how the QE program filters through the system) and with this in mind, Eurozone credit growth has been stalling again in recent months and this could also be an encouragement for the ECB to act.
However, there is evidence that the Eurozone is gradually picking up. For example, the PMI surveys have been improving significantly in recent months. The composite PMI (a combination of the manufacturing and services PMIs) was at 51.5 at the time of the ECB’s announcement in January. This has now picked up and as of last month’s data, the PMI had improved to 54.4. This suggests that economic activity is likely to be increasingly positive in the coming weeks (and possibly months).
So, is the ECB going to throw the kitchen sink tomorrow? My expectation is a small cut to the deposit rate to -0.3%, and a more aggressive asset purchase to €70bn. This would also be flanked by a dovish rhetoric from Draghi once more. However, I also feel that the net result of this could be that the market has gone too far in selling the euro.
Since the last ECB meeting the euro has dropped by around 750 pips. I feel that this could now be set up for a short squeeze on the euro on the disappointment that the ECB has not done enough. The upside risk on disappointment outweighs the downside risk of pretty heavy expectations. The key medium to longer term level that therefore springs out of the chart is the old key support at $1.0810 which is now the basis of resistance. The alternative view would be tha if the ECB meets expectations there could even be a further decline back to test the key March low at $1.0456 and perhaps a move back towards parity. The decision is on a knife-edge.
The question of taking a position in front of the announcement is one of trader risk appetite. This would be a high risk strategy (depending upon the use of stops). My preference would be to trade during or after the press conference as all the information is known. If Draghi does disappoint, there will be plenty of time to make money as part of the short squeeze unwinds the huge short positions the market has on the euro.