Forex Institutional Research: Citi ECB Primer

Forex Institutional Research: Citi ECB Primer

Subject: ECB primer: Improving forecasts help unwind EUR shorts

  •  We expect the ECB to be in wait-and- see mode, with its focus on the CSPP and TLTRO2 programs starting this month.
  • ECB staff forecasts will be raised. Oil prices shift inflation higher. Q1 GDP surpassed most expectations.
  •  Still, Draghi is incentivized to walk a fine line between optimism over Q1, the impact of its new programs, or sounding too cautious but doing nothing.
  • EUR should push higher on short-term optimism – however we don’t see the ECB as moving the needle to far one direction or another. We recently closed our short EURUSD position.
  •  A wildcard is Greece. With its first review successful – it should be a focus of the press conference.

No surprises

Policy expectations for this ECB are low, and we don’t see a challenge to the consensus view. Our economists base line is improving forecasts, but the dovish Draghi stance is here to stay. We expect the

ECB will remain in wait-and- see mode. After a strong Q1, data in the European economies continue to improve and the ECB has yet to release the CSPP (corporate sector purchase programme) and the new

TLTRO2 (June 24 th ). The date of initiation for the CSPP remains unknown – and could be one point of clarification for Thursday.
We suspect the governing council (GC) will want to wait and see their effect on the economy before making any new decisions. Hence Citi’s view is that if policy is expanded, September seems the earliest point it could be expected. From a market pricing, short rates are sanguine, with legacy expectations a small adjustment to policy before end-2016. Our economists call for September 2016.

Staff forecasts to get an upgrade

Taking Mid-May as the cut-off date for inputs to the new forecasts, rates are pretty much unchanged.
EURUSD is slightly higher – and a trade-weighted EUR is slightly weaker – hence FX should have little impact on the forecast changes. The one notable difference is oil, now $8 higher than in March. This suggests a slightly higher path for inflation – however, the ECB must tread lightly here. Too bullish a forecast would imply no need to add stimuli beyond Q1 2017 and EUR would rally, too bearish and it is hard to justify no action by Draghi. Our economists forecasts are below – the EUR neutral outcome is if 2018 forecasts are left unchanged.

Citi Economics: We look for 0.1pp upticks in GDP mid-points to 1.5% (‘16), 1.8% (’17) and 1.9% (’18). For inflation, a higher elasticity to changes in energy prices, and higher GDP growth together with easing measures are likely to lift HICP mid-points by up to 0.2pp to 0.3% (’16), 1.5% (’17) and 1.8% (’18).

Greece is a regional focus, but not a global one

One part we expect the press conference will be devoted to is question on Greece. The ECB could now reinstate the Greek waiver, if the review is fully finalized. If not, they could opt to send a signal it is just a matter of days before this takes place. The waiver would allow Greek assets to be used in liquidity operations as well as posted as collateral. If this isn’t specifically brought up by Draghi, we would expect the press core raise when Greek assets be included in the APP (asset purchase programme, ie QE). There is a degree of uncertainty surrounding this date, as a waiver is not sufficient as debt sustainability is also a pre-requirement. A cautious ECB may by time here, and wait for the IMF conducts its debt sustainability analysis.
This could be in Q3, but there is no set timeline. For Greek assets and Greek banks, the waiver is much more important with the upcoming TLTRO2. The cross over impact on EUR from Greek banks is probably very little.

How much will this ECB move EUR?

As a base case (70% chance): We expect EURUSD mildly higher as short positions are covered (+1%) – although a portion of this flow could pass through markets before Thursday.

Under our economists base case scenario, a forecast upgrade remains the trigger for short covering (this was one reason we chose to close our short EURUSD view this week) – but short covering is very different from accounts getting long EURUSD. We doubt that the market will build short USD positions before NFP (3 June), Yellen (6 June) and mid-June FOMC (15 June). Flow data suggests there has been small pre-positioning ahead of the event, and short rates still have 7bps of cuts priced in for 2016. Euro-area macro data has improved, and surprises have recently pushed back into positive territory.

Hence, we expect small short covering. We suspect the ECB can take its time given the improvement in the macro data, and recent weakness in the EUR. We expect Draghi to walk a fine line between an improving outlook, and sounding too optimistic. Too aggressive a EUR rally (>3.0%) should be seen as a fade ahead of the US risks that follow.

What about a hawkish Draghi (EURUSD >+2.0%, ~20% chance): While not our base case, it would be where a focus on Eurozone improvements while glossing over inflation or growth risks. In April the risks were: “The risks to the euro area growth outlook still remain tilted to the downside,” and “Looking ahead, on the basis of current futures prices for energy, inflation rates could turn negative again in the coming months before picking up in the second half of 2016.” An upgrade of the language to “balanced” would be the hawkish Draghi outcome.

 A dovish Draghi (EURUSD -1%, 10% chance): A dovish ECB would be one where risks remain skewed to the downside, and forecasts are only upgraded for 2016. This would signal that the benefits from Q1 have little carry over in the governing councils view, or that energy market aren’t sufficient to raise inflation medium-term. This lowest probability outcome would encourage rates to add to the view that the ECB may review its policy in September.

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