Why This Week Is Crucial For The Fate Of The Euro Rally

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Includes: ADRU, DBEU, DBEZ, DEZU, EEA, EPV, EUFL, EUFN, EUFS, EURL, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEE, FIEU, GSEU, HEDJ, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, PTEU, RFEU, SBEU, UPV, VGK
by: Alpha Source

Summary

The upcoming ECB meeting should mark the beginning of a long effort to prepare market participants for what is to come.

As the euro continues to strengthen in the face of escalating geopolitical tensions, it is to time reflect on the sustainability of its appreciation.

The ECB decision will reveal key elements of its strategy going forward, but likely not enough to meet investor expectations.

The market impact of ECB policies tends to be underestimated by many investors. Yet, the European Central Bank’s asset purchases have been arguably one of the most significant factors supporting the ongoing market rally, offering ample liquidity, dampening volatility spikes and bolstering risk-appetite. As a result of Mr. Draghi’s aggressive course of action, ECB currently boasts the largest central bank balance sheet globally, surpassing the $5 trillion dollar mark and still rising.

It is, therefore, critical to evaluate the market implications of the anticipated tapering of its purchases and assess the most probable timetable. While the September ECB meeting should mark the start of a long effort to prepare market participants for the gradual normalization of its balance sheet, investors’ hopes for a “game-changing” announcement will likely be dashed. The policymakers at ECB remain unwilling to deliver a dramatic change and still unable to provide specific details regarding the path ahead. Consequently, I believe that the outcome of this week’s main market event will be underwhelming, as the European Central Bank will strive to maintain its policy options relatively open in the face of increasing uncertainty on multiple fronts.

In recent weeks, we have experienced a combination of acutely unsettling and potentially destabilizing political and geopolitical events, which have made financial markets vulnerable to a sharp downturn, putting the growth and inflation projections of central banks at risk. The twin crises that currently stand out -- namely the Korean nuclear stand-off and the approaching debt-ceiling deadline -- have yet to be fully priced in, despite the minor sell-off we had on Tuesday. Admittedly, the collateral damage of the associated tail-risk would be inherently tricky to quantify, but there is no doubt that -- should it materialize -- it would be of catastrophic proportions.

We have grown accustomed to successfully overcoming emerging crises unscathed, without lingering market setbacks. This is reflected in the remarkable resilience of equity markets across the globe and particularly in the U.S. As an illustration, it has now been more than 10 months since the S&P 500 had a pullback of 3 percent or more, making it the third largest period without a sell-off since the second World War.

This, combined with an unprecedented period of persistently low-volatility, has cultivated a sense of market omnipotence regardless of the severity and the nature of the emerging threats. But policymakers at the helm of ECB are -- hopefully -- cognizant of this market fallacy and aware of the economy's substantial remaining vulnerabilities. They will therefore avoid an aggressive stance, with the aim to avoid endangering the nascent recover, while smoothly deflating excessive market expectations.

One other factor that will force ECB to retain a high-degree of policy flexibility in the months ahead is the need for sufficient coordination with other systemically important central banks. Policymakers are beginning to realize that changing course in isolation, without the necessary follow-up by other major central banks, can prove ineffective or even counterproductive. As such, the need for a more seamless and coherent strategy, especially between the ECB, the Federal Reserve and the Bank of Japan, is becoming increasingly clear.

From a purely economic perspective, the crux of Mr. Draghi’s dilemma lies in the fact that the pick-up in growth within the Eurozone has yet to translate into a durable and sufficiently broad increase in terms of inflation. Hence, the economy remains vulnerable to a possible deflationary shock, triggered by a renewed bout of risk-aversion and market turbulence, should the existing problems brewing beneath the surface become impossible to ignore further.

The pace of appreciation in the euro’s exchange rate will probably be cited by the ECB as a major headwind to economic growth, hurting exports and suppressing inflation. This is why I expect that the central bank will deem that it’s premature to exacerbate this phenomenon by introducing major changes to its current asset purchase program. Instead, the overall presentation of its economic assessment will be balanced, aiming to stem a continued surge in the euro.

What we can reasonably expect from the ECB meeting on Thursday is to acknowledge the progress achieved in its latest economic assessment, signaling that a gradual reduction in the pace of its monthly asset purchases is indeed warranted. This is a view that has already been embraced by market participants, underpinning the ongoing rally in the euro. Nonetheless, the details about the phasing-out process will likely be scarce.

More importantly, the actual unwinding of the European Central Bank's balance sheet is bound to remain a distant goal. However, the underlying risk is that a prolonged reliance on these extraordinary artificial liquidity injections will result in widespread misallocation of capital, further increase in asset bubbles, and -- inevitably -- financial instability down the road.

Disclosure: I/we 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.