With less than 24 hours to go before the European Central Bank's monetary policy announcement, the euro is trading marginally higher against the U.S. dollar, after falling to 1.25 overnight. Rumors of what the ECB will or will not do are swirling once again and even though the EUR/USD has rallied the talk is centering on how much of a disappointment the central bank's actions will be. The only reason for the rally in the EUR/USD is short covering, which is probably prudent given the level of event risk on Thursday. The latest tensions in Spain including the bailout of Catalonia and Bankia has put the ECB back into firefighting mode making swift and aggressive action absolutely necessary to prevent borrowing costs from skyrocketing and Europe's sovereign debt crisis from wrecking havoc on the financial markets again. EUR/USD, bond yields and equities stabilized over the past month because investors expect the ECB to take additional steps to reduce borrowing costs in Europe. When the ECB last met in August, President Draghi pledged to do "whatever it takes" to hold the eurozone together and said "believe me, it will be enough." He also added that "it is pointless to go short the euro" and investors have heeded his advice as the EUR/USD's has risen from 1.2250 to 1.26 last month. However the euro's ability to hold onto its gains rests on the ECB's ability to deliver. The bar has been set very high with Draghi's comments tomorrow and an interest rate cut won't be enough to satisfy the market. If the central bank fails to outline an aggressive plan to buy bonds of troubled European governments, the EUR/USD could tumble quickly.
There are six primary questions that investors will look for answers to from the ECB on Thursday and how the central bank addresses these issues will determine how the EUR/USD trades.
1. Will the ECB Cut Interest Rates?
2. What Maturities will the ECB buy under their New Bond Purchase Program?
3. Will they Target a Specific Amount for Bond Purchases?
4. Will there be a Yield Cap?
5. Will Bond Purchases be Sterilized?
6. Will the ECB wait for the German Court's Ruling Before Finalizing their Plan?
Best Case Scenario for EUR
The best case scenario for the euro would be a 25bp rate cut, explicit euro denominated target for unsterilized bond purchases and a yield cap. While a rate cut is normally negative for a currency, in this case, if it is accompanied by a well flushed out bond purchase program investors could end up buying euros on optimism that the ECB's efforts will finally help to control funding costs in the region.
Worst Case Scenario for EUR
The worst case scenario for the euro would be no rate cut and an unfinished proposal for buying short term bonds. If the ECB leaves plenty of room for interpretation, hinges their decision on the German Court's approval of the ESM and indicates that bond purchases will be sterilized, investors could express their disappointment by selling euros. Sterilizing bond purchases is negative for the euro because it offsets the impact that the purchases would have on money supply and hence limit its effectiveness on the economy.
What We Expect from the ECB
While we hope for the best, we have to prepare for the worst because central banks rarely like to be as explicit as investors would like and the ECB in particular may not want tie their own hands with specifics before they know how much support member nations will need.
1. Will the ECB Cut Interest Rates? - Of the 58 economists surveyed by Bloomberg, only 30 expect the ECB to cut interest rates by 25bp to 0.5%. These almost even odds make an interest rate cut a coin-toss but to avoid a disappointment in the lack of details in the bond purchase program, we believe that the ECB will follow through and lower interest rates.
2. What Maturities will the ECB buy under their New Bond Purchase Program? - ECB President Draghi already made it clear that their purchases will be focused on the short end of the curve on bonds with maturities up to three years. We don't expect any surprises on this front but anything short of three years will hurt the euro.
3. Will they Target a Specific Amount for Bond Purchases? - Unfortunately we don't expect the ECB to announce a fixed quantity of bond purchases. While this would be very positive for the euro because it gives investors a target, it is dangerous for the central bank to commit to a specific amount for a variety of reasons. The most important of which is that it strips away any flexibility to adjust the program as necessary and creates a completely new set of expectations in the market by which future monetary policy will be measured. There's no benefit to committing to a specific amount unless it is large enough to shock the market but that would be unlikely because it would raise a host of political opposition. Instead, we expect the ECB to announce flexible and open ended bond purchases program.
4. Will there be a Yield Cap? - While a yield cap would send a powerful message to the market, we believe the ECB will avoid one because of complaints that it oversteps the ECB's mandate.
5. Will Bond Purchases be Sterilized? - According to a report from Bloomberg, bond purchases are expected to be unlimited and sterilized which means that it won't have the full firepower required to stem the crisis but one encouraging aspect is that the report also claims the ECB will be waiving its seniority. This means they won't put themselves first in line for any repayments.
6. Will the ECB wait for the German Court's Ruling Before Finalizing their Plan? - One of the biggest risks tomorrow is whether Draghi will wait for bond purchases to be ratified by the German Constitutional Court before finalizing their plans. If so, it would be a sign that the central bank is not fully independent because the Bundesbank's influence and pressure is affecting the ECB's decisions.
Setting Up for Disappointment?
As we eagerly await the ECB's announcements, it is important to remember that the central bank's number one goal is to get investors to buy and hold the stocks and bonds of Portugal, Ireland, Italy, Greece and Spain. To do so effectively over the long run, they need to leave themselves with ample flexibility even if it comes at the expense of the market's short term dissatisfaction. We expect the ECB to announce a new framework for bond purchases that includes an expansion in the maturities of bonds purchased with an open ended and flexible quantity target. The ECB won't be able to satisfy everyone tomorrow and there's no question that the risk for the euro is to the downside and given the leaks that we have seen so far, there is a good chance that investors will be disappointed by the ECB's announcement. Its also important to remember that the magnitude of problems in each country is different, making it difficult to set specifics before the country formally requests for aid.