By Dean Popplewell
The FED has indicated that the “buck does not stop here.” They are not the leader, yesterday’s dovish statement has them wanting to follow the ECB’s lead. The failure of Ben and company to deliver new accommodation has raised the pressure on Draghi and his fellow cohorts to deliver significant measures today. The FOMC statement does nothing but alters contingency to say it “will closely monitor incoming info and will provide additional accommodation as needed.” In June they were “prepared to take further action as appropriate.” As noted by many, the new language is slightly more definite but less active and based on economic developments, like tomorrow’s NFP. Between here and September, the market will be relying on all economic data to outguess the next FOMC decision.
What is Draghi to do to maintain the risk tone and overall position taking since last week’s pro-euro rhetoric? Fundamentally, the ECB is required to deliver some renewed balance sheet support for peripheral sovereigns. The ECB needs to announce that they will resume direct secondary market buying of Spanish debt, perhaps in conjunction with the EFSF/ESM programs. Even more dramatic, grant the ESM a banking license. It’s radical and probably pushing the envelope too far, but certainly deserves attention in the post announcement press conference. The less aggressive approach that would prevent a market negative reaction would “involve reduced haircuts on collateral and perhaps additional LTROs.” What about conventional policy easing? This alone will be not enough to appease the market. Investors would read this as if the ECB has “bottled it.”
For the ECB to maintain the continued risk-on affect requires policy makers to implement significant engaging measures to the central banks balance sheet. By default, this would have a significant affect on the single currency’s risk premium. The record short EUR positions beware. This scenario should see a further right hand squeeze of the EUR against G10 currencies, in particular, the dollar and yen. However, its reaction to EM positioning should remain the same, under performing, as the single unit continues to be viewed as an attractive funding currency. The EUR gains against the core currencies should also be rather limiting as lower yields eventually move against the single unit and as the ECB’s balance sheet continues to expand.
Now, what about the ‘near impossible’ set up by Draghi and company. The radical notion that euro policy makers offer no new measures this week? The Capital Market hatchet appears, bullying the EUR into further submission against the core’s, just like the sovereign market. But its questionable how the EUR will react against the commodity and EM currencies. There is a strong possibility that it could outperform these currencies on “perverse” growth reasoning.
- Notion that the ESM will be granted a banking license- EUR rallies versus G10; underperforming rally against EM
- ECB is to resume Bond buying- EUR rallies modestly against G10 and underperforms commodity and EM
- Reduced collateral requirements and/or LTROs- Overall disappointing, but not enough to see a big sell off
- Traditional policy easing alone- EUR loses ground against the cores, but questionable against commodities and EM
- Going the FED route- pandemonium; aggressive risk off as markets follow a leaderless policy
The market move from yesterday has been rather orderly. Enough so that the retail market has gotten itself small EUR outright long, nothing wild, as they prefer to wait, digest and then react to the impending ECB announcement. It can be too expensive to do anything otherwise. The recent market longs have mostly been taken out by their stop losses near Tuesday’s lows (1.2225-30) to limit investors market exposure through the announcement. Now the market is in wait and see mode.