Over the last few weeks we’ve seen am increase in volatility and momentum in the Euro which has been distinctly lacking over recent months. This volatility has been driven by two factors; firstly the possibility of tapering and then secondly the prospect of an extension of QE.
Reports that the ECB were considering tapering their QE program which is due to end in March next year, saw the EUR spike higher initially alongside a spike in 10y yields on German, French Italian and Spanish paper. However, these reports were soon after dismissed by ECB members. Indeed, following the dismissal of those reports analysts are now changing their view and expect the ECB to announce an extension of their QE program beyond the march 2017 end date, hence the sharp leg down which we’ve seen in EURUSD over recent days.
expectations ahead of the meeting have now taken a distinctly Dovish twist. Whilst markets are not expecting the bank to ease further at this meeting they are expecting that the ECB will announce an extension of QE or atleast give a signal that an extension of QE is likely to come.
The bank’s recent reluctance to ease further despite built up expectations are consistent with Draghi’s previous comments about the diminishing returns of further easing and especially moving deeper into negative rates however, with EuroZone growth remaining sluggish there is still a case for further ECB action.
Positioning Ahead of The Meeting
Looking at positioning heading into the meeting we can see that institutional players have once again been building short positions. You can see that after starting to rebound higher here post Brexit, institutions have now started to load up to the short side again.
So clearly expectations are starting to align around an extension of QE, so what is driving this argument and fueling these expectations?
1- Inflation remains problematic
Despite better headline inflation readings, core inflationary pressures in the eurozone remain weak. Stripping out the more volatile component core inflation has actually been on a downward trend this year moving from 1% in January to 0.8% in August. There is little sign currently of any improvement ahead and is likely to remain at subdued levels. Furthermore, below trend growth supports a widening of the output gap and weak wage pressure and subdues input prices point to further benign cost pressure.
2 – Risks of second round effects
Although energy price effects and the prospect of higher headline inflation may slightly reduce the risks of negative second round effects, market based measures of inflation expectations remain extremely depressed. With 5Y inflation expectations lingering around 1.4% despite the recovery in Oil prices. There still remains elevated global uncertainty with ongoing CNY depreciation and thus there is still a case for the ECB maintaining monetary stimulus
Again though key to point out that markets are not expecting further rate cut action by the ECB and ECB’s Mersch commented recently that “Cutting interest rates even more would come with increasing risks as reactions to such cuts might not always be linear. This needs to be taken into account when doing a cost-benefit analysis.” “…interest rates can only stay very low over the short term. The longer they remain low, the more pronounced the negative side effects will become”.
In terms of gauging possible market reaction to tomorrow’s meeting let’s consider some different scenarios that we might see play out which at the moment can broadly be seen as
- No further information
- QE extension – departure from capital key
- QE extension – removal of deposit rate floor
- QE extension – raising ISIN/issuer limit
- Tapering/ increased expectations of tapering
No further clarity
With much attention being given to the path of the ECB’s QE program markets are waiting some clarity on the issue, with expectations now that the bank will announce an extension or indeed signal that an extension is likely to be announced in the near term. However, in light of the ECB’s recent stance there is a risk that they offer no clarity or further detail at all.
With the ECB scheduled to update their economic and inflation forecasts in December there is the likelihood that they will choose to wait until then before making a decision on the path of QE. Markets reaction to recent ECB meeting has been much more subdued given spit expectations and lack of significant information from the ECB which could once again be the situation this time around.
Special attention will of course be paid to the press conference which is likely to be much more market moving then the decision and statement. Of key importance will be questions posed to Draghi regarding the possibility of tapering and QE tweaks. If Draghi refrains from offering info there is a chance that concerns regarding possible tapering could enter the market again leading to an appreciation of EUR. Similarly, if Draghi dismissed claims of tapering or says that the ECB have not discussed such a move then this likely to further the Euro’s bearish path.
Indeed the immediate tightening in monetary conditions in response to tapering talk will likely drive the need for the ECB to ensure a Dovish tone to this meeting.
The next key situation we could see is that of a QE extension or at least a clear signal of intention to extend QE in future. This would put immediate downside pressure on Euro and remove all concerns regarding tapering. Within this scenario of a QE extension there are three separate scenarios we might consider.
1 – Departure from capital key
The first is a departure from the capital key. According to Reuters there is a chance that the ECB could arrive at a compromise which allows for minor, single or temporary needs based deviations from the capital key. If the ECB does point to the potential for a departure from the capital key this would mean the ECB would need to purchase fewer bunds and more peripheral bonds leading to a steeper Bund yield curve and thus a lower EURUSD alongside a narrowing of peripheral Bund spreads.
2 – Removal of deposit rate floor.
If the ECB suggests the potential for removing the deposit rate floor this again would lead to a steepening of the bund curve as the bank would need to purchase fewer super-long term bonds. The impact on spreads would likely be smaller though again EURUSD should be weighed down in this event.
3 – Raising ISIN/Issuer limit
If the ECB suggests raising the ISIN/issuer limit than the bank will be able to purchase more euro area bonds/ This could still lead to a steeper bund curve and lower EUR though the impact on the curve isnt as clear as it is with the first two options.
The reaction of the yield curve and peripheral spreads will simply depend on which/if any, the ECB suggests leading to a mixed outcome for EUR too. Generally, a steeper curve leads to a weakening of EUR if the level of the curve is unchanged as EUR tends to react more to the shorter end of the curve.
Hence, the first two options, which could lower the yield curve with steepening should translate into stronger EUR downside. The likely effect of the third option isn’t as clear, though receding concerns over tapering could still be a mild negative for EUR.
The final scenario to consider, which is the outsider scenario is if the market gets a sense of the likelihood of tapering, most likely as a result of Draghi’s comments during the press conference. Any indication of near term tapering would take markets by surprise and risk sentiment would likely be impacted negatively with widening peripheral spreads further damaging risk sentiment. It is less clear how a steepening of the curve in this scenario would affect EURUSD due to the Euro’s correlation with risk sentiment whereby we have tended to see EUR appreciation over periods of risk aversion.
In sum, it seems more likely that the ECB’s next move will be an extension of QE rather than a tapering of it, leading to a weaker EURUSD rate. However, this time around there is still the likelihood that the ECB refrains from offering any further clarity on the path of QE ultimately leading to a muted market reaction. So, having looked at some different scenarios and discussed the possible market reaction to them, let’s now assess the technical landscape
For an overview of technical opportunities in FX markets ahead of the meeting please see the video below.