ECB: Getting on Track

Published on December 4, 2014

Currencies, bonds, and equity markets are reacting sharply to today’s ECB meeting and subsequent press conference by President Mario Draghi, reflecting a much deeper disappointment on unmet expectations than surveys going into the meeting may have indicated.

And indeed beyond the simple survey question of whether the ECB would embark on QE at this meeting or not (most thought they would not), there had been enormous speculation growing in the markets and press going into today over the possible announcement of other measures, and over what exactly Draghi and the ECB meant by responding to the threat of low inflation as fast as possible and evaluating all instruments for potential balance sheet expansion.

Much of this speculation frankly put markets well “over their skis” for today’s meeting (see SGH 11/26/14, “ECB: Preparing Additional Measures”). But with another sharp downgrade in the quarterly staff forecasts and the high probability that the current measures will indeed not prove powerful enough to turn inflation expectations in the Eurozone around, we think the ECB nevertheless remains on track for QE in the first quarter of next year.

Just remember, this is a consensus-driven organization that studied 71 draft proposals on the architect for their new headquarters before settling on the winning design, as Draghi proudly pointed out in his opening remarks.

Looking beyond the first response and market correction, here is what we believe are some key points to note going forward:

–        The most significant question mark for markets after today’s meeting is one of consensus on all three elements of a further expansion of the balance sheet – “timing, pace, and composition.” That very need to build further consensus for a new program has however been at the root of our understanding of why the ECB would wait out this meeting, and has also been why we explicitly pushed back on speculation especially after Draghi’s speech on November 21 in Frankfurt that this meeting would simply be a rubber stamp to QE in the next meeting in January.

–        The downward quarterly staff revisions were nevertheless dramatic, and we continue to expect Draghi to be able to forge “sufficient” consensus for both a sovereign and corporate bond purchase program in the first quarter of 2015. While Draghi firmly, and almost defiantly, reminded reporters that the ECB had and would act without unanimity if need be to meet its mandate, he dodged probing questions on whether a QE program could be launched with a simple majority or would need a “super majority” consensus of Governing Council votes.

–        We believe that speculation to be moot, as we do not expect Draghi to ram a QE program through on the thinnest of majorities only to have it immediately undermined by a cacophony of dissenting voices. Rather we continue to expect that the weak data and some time and patience in observing what is sure to be a slow pace of balance sheet expansion will prove enough to convince a solid majority of ECB members to back a QE program in Q1.

–        On the economy (it is after all about the economy), Draghi, as we expected, did note that the latest sharp drop in inflation was not just in energy, but also in the much more important, and dangerous, services component. And while the ECB (obviously) does not consider a drop in energy prices as a negative for the economy, as some pundits seem to think, Draghi also flagged the potential danger of the transmission of a “good” drop in inflation into inflation expectations and core, that could be dangerous.

–       Draghi also pushed back strongly, and we believe appropriately, on the “moral hazard” argument against purchasing sovereign bonds, namely that the ECB’s job is to do what it has to do to meet its mandate and not to play fiscal policeman or politics with member state finances (ok, well sometimes…). This continues to be an issue within the Governing Council, but one that as we have been writing is fading as an objection given the harsh realities of the Eurozone economy, except among the most hawkish of the GC members.

–        And on the question of what assets to buy, gold simply has never been on the list — sorry to disappoint the gold bugs out there — while foreign securities are too close to currency intervention. And as we also suspected, the ECB has been leaning towards buying, in addition to corporate bonds, sovereign bonds according to the ECB Capital Key, but the final decision on the shape of a program has not yet been made despite suggestions in the press to the contrary.

–        We still do not expect a QE sovereign bond program to be conducted on a risk-weighted basis in order to appease ECB hawks in that a risk-adjusted program is expected to have to help the areas needing the least help with yield compression, while potentially having a negative chilling effect in dampening demand for assets from the Eurozone regions that need stimulus the most. We continue to believe a QE program will be conducted on a “flat” basis, either, most probably, according to the ECB Key, or according to a market weighting.

Try explaining that one to Rick Santelli …

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