Draghi To Deliver or Disappoint…

The market senses there is a strong fundamental case for the ECB to do more at the December 4 meeting. But will ECB President Draghi deliver or disappoint..?

Some of the key considerations being:

  • Inflation expectations continue to fall. The 5y5y inflation swap for the eurozone has been trading in the 1.75-1.85% range recently, down from 2.00-2.10% at the September ECB meeting. Moreover, the ECB‟s own inflation forecast for 2015 are likely to be revised down substantially (see ECB preview, 5 November 2014)
  • The sharp drop in energy prices should lead to very low headline inflation figures in the next few months and this creates further asymmetry around inflation expectations. For reference, this was a keyreason the BOJ opted for further easing at the end of October.
  • The trade-weighted is actually up since the October and November ECB meetings. Not by a huge magnitude around 1%, but this momentum is int he wrong direction, at a point when more and more ECB members are highlighting the exchange rate as a key transmission mechanism for weaker monetary policy into the economy.

The ECB may not be able to agree on full-blown QE at the December meeting. But ECB
Vice President Constancio hinted on November 26 that the ECB is likely to buy
sovereign bonds if it judges that current measures are insufficient to reach the desired
balance-sheet expansion. Specifically he said, “During the first quarter of next year we
will be able to gauge better if that is the case. If not, we will have to consider buying
other assets, including sovereign bonds in the secondary market”. Together with President Draghi‟s stance, which focused on the need to “raise inflation and inflation expectations as fast as possible”, there seems to be a core group within the governing council that is ready to deliver more easing more or less immediately.

Hence, even if a full-blown QE announcement is not possible, the market feels there will be a strong desire to deliver a message that is as dovish as possible. One possibility is to expand the menu of private sector assets being bought to include corporate bonds. It may not be possible to buy more than EUR200-300bn over a one- to two-year horizon. But such liquidity considerations have not stopped the ECB from buying ABS. Hence, the market sees that as a clear possibility. Another option is to spell out a clearer roadmap as to when sovereign bond purchases would be triggered, to provide a “contingent easing signal”.

From a Euro trading perspective, the following are additional important considerations:

  • Expectations for something concrete at this week‟s ECB meeting seem low. For
    example, a recent Reuters poll of money market traders suggested that none (out of a sample of 17) expected additional easing at this meeting. Other polls may show a less unequivocal conclusion. But it is fair to say that the consensus is that the ECB will be in wait and-see mode. Hence, there is potential for a surprise. Even in regard to longer-term QE expectations, there is a lot of scepticism that all governing council members will agree. Hence, there is room to surprise on that front too, although turning such expectations around may take a bit longer.
  • The big drop in energy and importantly gasoline prices is likely to have a bigger
    impact on consumption in the US than in the Eurozone, simply owing to the tax structure (a sizeable portion of high gasoline prices in Europe is because of taxes, which will n
  • EURUSD has been trading in a narrow range for about two months. But it is close to important technical levels around 1.23.
  • Statistically, December is typically a strong trading month for the Euro (that has on average been the case since 1999, even excluding 2008). But the world is changing. 2014 is nothing like 2012 or 2013, when the Euro traded well in December. For example, the capital flow situation is fundamentally different in 2014 than
    in any year since the Euro‟s inception. Hence, the historical seasonality is not a good
    reason to avoid downside exposure.
  • In relation to EURUSD specifically, the market expects USD catalysts, including Friday’s NFP’s and the Fed meeting on December 17, to be potentially USD supportive (EURUSD negative).                                                                                                                                       

2014-12-04 10_12_31-

All in all the risks to the EURUSD are pretty asymmetric heading into the meeting if the ECB is perceived to be aggressively moving towards a sovereign QE path then expect continued Euro weakness to prevail, if no meaningful new measures are announced the market is likely to want to lock in considerable profits ahead of the end of the year and sizeable short positions in the EUR as reported by the COT data likely reduce further on a healthy round of profit taking with most major participants likely to then look to reposition into the New Year. The key areas to monitor post the ECB press conference will be projected downside channel support in the 1.2150/22 if Draghi delivers and the first area of  meaningful resistance on a Draghi disappointment comes in at 1.2450/25 and then the trendline from the summer highs which come in around 1.2750/28.

EURORTRS

ECB: some Institutional expectations for ECB press conference this afternoon:

  • Goldman Sachs: Draghi to signal further possible measures are being discussed. See 2015 inflation revised down to 0.7% vs 1.1%, but 2017 inflation forecast at 1.5% and moving “close to 2%” by end of 2017. Now see “it as more likely than not” ECB will announce a sovereign debt QE programme during the first half of 2015.
  • Barclays: Do not expect ECB to announce further policy easing, but wait at least another month before deciding to purchase government bonds. Expect ECB to lower inflation projection to 0.5% for 2014, 0.9% for 2015 & 1.2% for 2016.
  • Citi: We continue to have a marginal preference for a QE decision on Jan 22 2015, rather than on Dec 4 2014. We also note a much stronger emphasis on direct purchases than on TLTROs. Look for a more dovish message in statement, like “composition” of balance sheet and “pace” of expansion. Staff forecasts to highlight some downside risks to both GDP & inflation.
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