By Dean Popplewell
Draghi and Company are taking a big gamble. After last weeks emphatic verbal position of support for the single currency they are expected to be there again this Thursday behind the EUR for all to see, raising expectations significantly of what’s going to be said and done to save their euro pet project. Last week’s rhetoric appeared prepared to deliver significant support measures highlighting “excessive risk premiums in sovereign markets due to re-denomination risk are disrupting the transmission mechanism for monetary policy.” Is renewed ECB secondary market bond buying under consideration? Perhaps in conjunction with EFSF primary market buying, alongside new LTROs and further rate cuts?
If the euro policy makers fail to deliver a determined, concise, proactive position, they may as well throw in the euro towel. This is not the time to play the conservative eurocrat whose single focus is their own country’s national identity. If they do so, they will have single handily created and guided the downfall of their own EUR currency as lack of action will severely disappoint financial markets and increase systemic stress towards panic levels. Policy makers must be well aware of this, mind you, sure bets rarely exist. Market consensus expects Draghi to deliver a significant bond buying program and further policy easing. According to analysts a “more transformative measure” would involve plans to grant the ESM a banking license. This seems less likely to be delivered this week. Lets start with at least a line in the sand and a bucket full of promises.
If the EUR utopia is finally delivered, the market will be able to quickly price out systemic stress and EUR risk premium. With the market close to a record single currency short, it should lead to a significant short squeeze of these positions. Starting off, the big dollar and the yen would most likely be the biggest losers, however, the EUR would be expected to run into another wall and is likely to continue to underperform many EM currencies as the ECB liquidity provision and low policy rates make it an attractive funding currency once risk appetite improves across the board. Moreover, even gains versus the core currencies are likely to be short lived as yields move against the EUR and the ECB’s balance sheet continues to expand. Many trading theories will be expanded on as the ECB announcement draws closer.
The importance of the ECB’s actions this week certainly is taking some of the heat off Ben and the Fed to deliver their own policy innovation a day before the ECB. The market already believes that further QE3 is on the horizon if U.S. data does not improve. Many believe its down to a matter of timing for when the Fed wants to give the U.S. economy another jolt to increase economic traction. Dealers are probably pricing in only a +30% chance that Helicopter Ben will indicate an AP move on Wednesday this week. The odds would probably double for an official announcement early next month. No decision and the market can expect risk-sensitive assets and currencies to give up some ground gained over the last few trading sessions. However, be prepared that a lack of Fed action on new measures most likely will be cushioned by language signaling more easing is possible and the likelihood of ECB easing the next day.
Draghi better get his “whatever it takes” package together quickly. Monday’s EC release of the Economic Sentiment indicator indicates that the 17-member union is becoming more pessimistic about their prospects this month as the currency areas’s fiscal and banking crisis deepens. The stronger north or core is no longer immune to the long running crisis. The indicator has fallen for the fifth consecutive month to 87.9 and appeared ahead of this morning’s softish Italian bond auction results. Despite bonds rallying first thing, periphery yields may back up again if the ECB fails to deliver on its promises of last week to resolve the crisis. The market bias remains currently on the upside for a retest of 1.2395, and above this, the single currency should have momentum to extend further. With the daily momentum remaining positive the market will have to play the percentages and buy on dips.