ECB Meeting: What To Expect And How To Position

Includes: BUND, FXE, ITLY
by: Colin Lokey

With Jackson Hole in the rearview, the stimulus-starved market now sets it sights squarely on the ECB's governing council meeting set for next Thursday. ECB President Mario Draghi was a conspicuous no-show at Jackson Hole this week, as he elected to remain in Europe citing a heavy "workload." The market - which nowadays is conditioned to interpret everything in terms of 'easing' - took this to mean that the ECB was hard at work, hammering out the details of a plan to support Spain and Italy by purchasing bonds in the secondary market.

In this case, the market was probably correct. The ECB's executive board members also elected to skip Jackson Hole. According to the Financial Times, three committees of officials from the region's central banks crafted and presented variants on the bond-buying plan to the board, which in turn will attempt to coalesce them into one comprehensive proposal to be submitted to the governing council.

As I indicated in a previous article, the main point of contention seems to be the issue of the ECB making its purchases 'conditional'. Questions have surfaced regarding whether it would be appropriate (considering the fact that monetary policy isn't exactly a privilege that should be subject to conditions) or indeed feasible, given the thin market for Spanish and Italian sovereign debt. Adding to the drama, reports began to surface Thursday that Bundesbank head and outspoken critic of ECB bond purchases Jens Weidemann had threatened to resign in protest to what he views as the financing of governments by the ECB.

If the ECB isn't feeling enough pressure thanks to the premature promises Mario Draghi made to the market last month, a flurry of bond auctions could crank the heat up a few more notches before the ECB's meeting next week. Notably, Spain will attempt to sell 2-, 3-, and 4-year debt next week in what will be a crucial test of the market's appetite for periphery risk. A weak auction, coupled with an ECB disappointment, could be more than the market can bear.

There will be no shortage of traders placing bets ahead of the ECB's press conference Thursday and if you're the gambling type, you may want to consider Credit Suisse's "Analysis of ECB Scenarios." Credit Suisse contends that there are four possible outcomes:

1) Disappointment,

2) Compromise,

3) Positive, and

4) Extremely Positive.

The "disappointment" scenario involves the further relaxation of collateral requirements, the "compromise" scenario entails both the relaxation of collateral rules and a cut to the repo rate, the "positive" scenario involves the purchase of sovereign debt, the relaxation of collateral rules, and the renunciation of seniority on the bonds the ECB purchases, and the "extremely positive" scenario is an amalgamation of all these features.

For its part, Credit Suisse believes the "compromise" scenario is the most likely outcome and therefore, it does not see the ECB announcing bond purchases at next week's meeting. As for its recommendation on how to play this eventuality, it recommends buying into weakness in short-term Spanish and Italian bonds, as it believes that eventually, the ECB will fulfill its promise and buy at the short-end.

As for the other scenarios, it should be noted that the idea of the ECB renouncing its seniority is far fetched at best. Although in my view, such a move is a precondition for both future PSI's and for the accurate appraisal of the strength of the central bank's balance sheet, there is no indication that the ECB is ready to go down that road, as it would raise the specter that it should take haircuts on its Greek debt to assist in a third restructuring for Athens.

As to the repo rate cut, Credit Suisse correctly acknowledges that a relaxation of the collateral framework (involving reductions to the haircut schedule) amounts to a cut to the repo rate, but nonetheless lists "relax collateral rules" separately from "repo rate cut." To me, it isn't clear that either will be a part of the announcement, but investors should keep in mind that any further relaxation of the collateral framework amounts to a diminished cushion between the ECB and potential losses on dodgy assets posted by banks in liquidity ops.

All in all, it seems to me highly unlikely that the ECB will not announce some derivation of a bond purchase program next Thursday. To fail to do so would be to send shock-waves through the market. Having said this, investors should keep in mind that there is one wild card: the pending German Constitutional Court decision due on September 12. The ECB may decide to wait on that decision before finalizing its new SMP plan. While many seem to believe that it is highly unlikely that the ESM will not pass constitutional muster in Germany, Morgan Stanley sees

"...a probability of up to 40% on the Court granting an emergency injunction against the ESM, forcing the government to hold off until the Court has given its final verdict sometime next year."

Just so there is no ambiguity, if the ECB should decide to postpone the finalization of the bond purchase program until after September 12 on the assumption that the German court will rule favorably and that ruling should disappoint, it would be extremely destabilizing for markets. The ECB likely knows this and I would not expect it to allow the stability of the European bond market to live and die by a German court decision. As such, I believe there will be some watered-down version of a plan next week.

Given all of these considerations, here are a few conclusions and recommendations. The bar is high for Draghi next week and I doubt he will clear it no matter what he says - the ECB would have to hit a home run to maintain the momentum the short-end of the Spanish and Italian curves have seen over the past month. Given this, expect a sell-off in Spanish and Italian short-term debt, a rally in German bunds, and a sell-off in the euro (CurrencyShares Euro Trust ETF: FXE) next Thursday. Expect all of these moves to reverse course later in the month, as the ECB works to refine its plan and the ESM gets the go-ahead in Germany. Position accordingly to play the swings.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.