ECB: A Deeply Complacent Market

Published on June 4, 2014
SGH Insight
"We find it difficult to recall a time where there was a more universal consensus among traders and analysts that a central bank’s upcoming actions were fully priced in than there is now for tomorrow’s ECB Governing Council meeting. One would be hard pressed indeed to find an article or commentary not running with the "priced in" theme."
Market Validation
(Market Pulse 06/5/2014) "The euro fell to a four-month low against the dollar after the European Central Bank cut interest rates, as expected, and said it would announce further policy easing measures to tackle the threat of disinflation."

We find it difficult to recall a time where there was a more universal consensus among traders and analysts that a central bank’s upcoming actions were fully priced in than there is now for tomorrow’s ECB Governing Council meeting. One would be hard pressed indeed to find an article or commentary not running with the “priced in” theme.

Ironically, we would also be hard pressed to find any credible assessment of what the actual impact would be of a cut into negative interest rate territory – an unprecedented step to take for an economy the size of the Eurozone. And that is because it is in fact unprecedented, with its ultimate impact, beyond any weak attempts at handicapping the first 50 pip move on the announcement effect, far from determined or known by markets; exhibit one on that front is the head scratching over the “conundrum” of exactly why US treasuries have rallied so strongly alongside European bond markets.

And in addition to the implications of the ECB’s actions being far from determined yet or priced in, there are specifics around tomorrow’s announcement itself which could temper and even turn around some of the pre-positioning of “too little, too late.”

Three points to consider:

–         First, we expect the ECB Governing Council to give serious consideration to a deeper than expected 15 basis points cut as opposed to a 10 basis point cut, especially in light of the forecast revision that will result from the severity of the most recent CPI reading. Our base case is that they may in the end probably lean towards 10, but either of the two options on the size of the cut into negative rates will not be presented as the “end of the road” on rates. While it is indeed difficult to go too far into negative territory without creating distortionary effects such as cash hoarding in the process, the ECB would still have another small tweak left before what we believe to be the effective real “ZIRP” floor of around approximately -0.25% (see SGH 5/29/14, “ECB: Delivering the Right Cocktail”);

–         Second, the ECB will, we believe, address the non-believers who still assume that an actual sovereign QE purchase program (large scale asset purchases as Draghi calls it), is nothing more than a verbal threat; we think Draghi is likely to stress that a European QE program of sovereign bond purchases is a tool the ECB can and may use if the current disinflationary pressures deepen. There is a big difference between QE as a logistically complicated and politically awkward if not controversial measure — which it is — as opposed to one that is impossible, mandate inconsistent, or even illegal as some analysts, amazingly to us, still maintain;

–        Third, and on a more immediate nuts and bolts level, the ECB may choose to introduce a new three or even four year VLTRO (Very Long Term Refinance Operation), a very powerful liquidity backstop in and of itself, especially if offered at ultra-low long term fixed rates, in addition to, and not instead of, a suspension of the sterilization of SMP bond purchases. Three or four years is a very long time indeed for the ECB to provide what is in effect a formal commitment and cap to its already successful forward guidance on low (or lower) rates, especially if the economy and inflation actually do start to gradually recover as expected, and one may be excused for thinking that the US may even have moved further along its zero interest rate interest exit cycle in that period, reinforcing the differential between the two economies – and currencies.

While we usually refrain from market commentary or calls in our reports, and traders have gotten used to historically unprecedented low volatility and ranges especially around the Euro, we ultimately would shy away from any recommendation on the FX side to fight the ECB, a credible central bank, once it starts flooding the system with its own currency simply on the basis of a drop of a mere two or three big figures.

And beyond any attempts to try and pick a short term counter trade to the recent Euro selloff that we frankly do not think is even close to being overly subscribed, we find little reason to believe or encourage any bet on a Euro rally – especially with the markets dangerously sleep-walking through a political backdrop that includes such potential massive shifts, even if as of yet perhaps unlikely, as the risk of a UK exit from the European Union.

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