Market participants are preparing themselves for the ECB meeting on Thursday with investors speculating that President Drahi will announce a final large package before his departure on October 31. Business sentiment has constantly been deteriorating in the Eurozone economy, with manufacturing PMIs of most of the major economies trading below the 50-line threshold that separate growth from contraction (figure 1, left frame). Germany manufacturing PMI is currently extremely low at 43.5 (July print), its lowest level in seven years. The deterioration in European fundamentals is mainly coming from the uncertainty associated with the trade war (figure 1, right frame) shows that Europe is the most exposed economy to global trade tensions due to its high percentage of exports. Gross exports increased from 39% in 2008 to 46% in 2018 as a share of GDP, which is significantly higher than the 12% share for the US.
The German economy contracted in the second quarter of this year, down -0.1% QoQ, and leading indicators are showing further deterioration in the economic activity. For instance, Germany factory orders have been crashing in the past 18 months, from an annual growth of +10% in January 2018 to -4.6% in July 2019. Figure 2 (left frame) shows that factory orders tend to lead German industrial production by three months. In addition, the ZEW indicator of Economic Sentiment, which is a financial survey that aggregates sentiments of approximately 350 economists and analysis on the economic prosperity of the German economy, has also been plunging; it a is currently standing at its lowest level since December 2011. Figure 2 (right frame) shows that the ZEW indicator leads the German economic activity by approximately six months.
An interesting chart from Oxford Economics (figure 3) shows that the German economy has never performed extremely poorly relative to the Euro area (ex-Germany). Figure 3 shows that the spread between German and Euro area (ex-Germany) industrial production is below -5%, its lowest since 1995. This is really surprising considering the fact that in the late 1990s and in the early 2000s, Germany was often called the sick man of Europe.
Source: Oxford Economics
In addition to the sharp slowdown in the Eurozone largest economy, inflation expectations have also weakened dramatically in the past year; the popular market measure 5Y5Y inflation swap is currently trading at 1.22%, far below the ECB’s 2% target (figure 4, left frame). In figure 4 (right frame), we can notice that consumer prices (CPI and core CPI) have oscillated around 1% in the past cycle despite the ECB running an aggressive monetary policy. The central bank’s balance sheet assets increased by EUR 2.7 trillion since June 2014; they are now standing at EUR 4.7 trillion, 40% of the Euro area GDP. Investors are very skeptical about ECB’s staff projections on inflation HICP, and are expecting prices to increase to 16% by 2021. As a reminder, the CPI index is roughly 7% lower than the early 2013 ECB projections.
As a result, the market is speculating the ECB will go "big" on Thursday, and is expecting a 10bps cut in the deposit rates, tiered system for banks and the announcement of a new asset-purchase program of approximately 300 billion to 400 billion Euros. It seems that the ECB this time is acting to prevent the euro from rising as the single currency is currently dramatically undervalued against the US dollar. Eurostat-OECD prices are in a fair rate at 1.36, implying that EURUSD is currently 20% undervalued relative to its "fair" value. We actually think that the euro may rise after the announcement as market participants are already positioned for the worst. Hence, it could be worth buying some at 1.10 with a tight stop at 1.0890 and a first target at 1.1150.
Disclosure: I am/we are long GBPUSD. 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.