ECB’s Draghi: Correct Meds, Wrong Dose

To no one’s surprise, European markets remain in a holding pattern ahead of the Bank of England (BoE) and European Central Bank (ECB) rate announcements this morning. The “Old Lady’s” governor, Mark Carney, is expected to stick to his central bank playbook with no changes expected. But for President Mario Draghi and the ECB, the market has high expectations for the euro central bank to come out swinging and be aggressive in its quest to rid the single currency’s 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 the ECB policymakers’ praises or beating down on the central bank’s credibility for not been aggressive enough.

To date, ECB policymakers have held out the possibility of a package of measures that could also include liquidity injections conditional on increased credit supply to small- to midsized enterprises. Currently, it’s wagered that the ECB is 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. In essence, 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 European assets less attractive to investors and weaken the 18-member single currency further (€1.3614), and hopefully boost inflation through import prices.

To Table Cheaper Funding

Even providing unlimited credit for a couple of years would suggest that the ECB will be one of the last Group of Seven central banks to raise rates. The problem that euro policymakers face is that cutting rates and providing bountiful credit may be too little, too late to be a 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 Federal Reserve and the Bank of Japan. The ECB could add money into the system by purchasing eurobonds 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 European asset-backed securities (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.

With today’s ECB meeting one of the most important in years, 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 eurozone’s worries of deflation or low inflation without the potential complications of negative deposit rates. Given the overall state of affairs, it’s difficult to grasp why the ECB hasn’t acted in an aggressive fashion much sooner. For all the jawboning about the tools it has at its disposal, it’s time for the ECB to put those tools to work in a focused and convincing way. Bold talk and little else simply won’t do this time around and the ECB’s street credibility is at stake.

Draghi: The Man of the Moment

For the EUR to extend its recent weakness after this morning’s rate announcements, Draghi will have to meet investors’ high expectations with more easing and even the possibility of initiating QE. 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 refinancing and deposit rates are already priced in. The most pain would be felt if Draghi suspended aggressive actions by leaving the door ajar for a depo-rate cut further on down the line. In this scenario, the market could aggressively selloff in the Euribor and the Eonia curve and buy EURs, thereby 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.

At 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, he 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 three-month low registered last week (€1.3584).

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