ECB's Draghi: Correct Meds - Maybe Wrong Dose?

by: Dean Popplewell

By Dean Popplewell

It's not a surprise to witness euro markets remaining in a holding pattern ahead of the BoE and ECB rate announcement this morning. The "Old Lady's" Governor Carney is expected to stick to his central bank playbook with no changes expected. But for Draghi and the ECB, the market has high expectations of the euro central bank to come out swinging and be aggressive in its quest to rid their region of low inflation and the possibility of deflation while giving further support to its fledgling economic growth. For investors it will be Draghi's post rate announcement press conference that will have the market either singing euro policy makers praises or beating down on the central bank's credibility for not been aggressive enough.

So far, euro policy makers have held out the possibility of a package of measures that could also include liquidity injections conditional on increased credit supply to SMEs. Currently, it's wagered that euro policy makers are debating a cut of -10 or -15 basis points in both the benchmark and deposit rates. Because the deposit rate is already at zero, a cut would push it into negative territory, which is effectively charging banks to park funds at the ECB. Draghi would be making financial institutions "pay to play." A negative deposit rate ploy aims to boost lending between banks and ultimately to the private sector. It would also make euro assets less attractive to investors and weaken the 18-member single currency further (€1.3614), and hopefully boost inflation through import prices.

Table Cheaper funding

Even providing "unlimited" credit for a couple of years would suggest that the ECB will be one of the last G7 central banks to raise rates. The problem that euro policy makers face is that cutting rates and providing bountiful credit may be too little too late to be the complete solution. It will take months for changes in interest rate policies to finally work throughout the economy. Maybe the only concrete option left for the ECB is Quantitative Easing (QE) – the similar policy implemented by the Fed and the BoJ. The ECB could add money into the system by purchasing euro bonds and cease sterilization. But that too has its problems – global bond yields are relatively low and pushing them much lower does not have much benefit. It's most likely a non-starter due to the fact that the euro ABS and corporate markets are currently too small and illiquid to make much of a difference. But look for a commitment to revive the ABS market.

However, "unconventional problems do not necessarily have an unconventional solution." Not many have tabled an established solution, like forex intervention to the euro's problem of low inflation. Making use of the "traditional" intervention technique would be far more direct in tackling the euro's worries of deflation or low inflation without the potential complications of negative deposit rates (first time). According to the fixed income trader's, negative rates will only provide a short-term solution. Whatever is tabled or whatever is done Draghi and company must do it with an aggressive perception; otherwise this market will make the central bank pay one way or another.

Cannot fake perception

For the EUR to extend its recent weakness after this morning's rate announcements, Draghi and company will have to meet investors' high expectations and hint that more easing or even the possibility of QE is on the cards. A market that is not very short cannot be squeezed too far and so far limited price action would suggest that the market is relatively balanced between shorts and longs. Historically, the ECB has an ability to disappoint and a repeat this morning cannot be ignored; a minimal move is a possibility. Cuts to the refi and deposit rates are already priced in – the Euribor, the Eonia curve, and EUR are little changed. The most pain would be felt if Draghi suspended aggressive actions by leaving the door ajar for depo rate cut further down the line. In this scenario, the market could aggressively sell off in Euribor and the Eonia curve and buy EURs-pushing the single currency up close to levels at the last ECB meet (€1.3900-95). An aggrieved and neutral positioned market will be willing to sell most EUR rallies.

In Draghi’s press conference the market will be hanging on his every word waiting to see whether rhetoric and tone can push the EUR lower. As per usual, Draghi will be required to describe the rationale behind the ECB's actions or lack thereof. Will he mix up rate cuts followed by credit breaks and hint at QE? All needs to be done, but it’s the percentage mix that market wants to know about – the when and where. Currently, the EUR remains just above its 3-month low registered last week (€1.3584).

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