ECB: Market Whipsaw

Published on July 25, 2019

European Central Bank President Mario Draghi and team delivered as expected at today’s Governing Council meeting, down to communication details and to flagging a rate cut in September. Yet the twitter world is collectively scratching its 280-character limited head for why the initial dovish reaction in markets has faded, at least for now, across the board in European rates, currency, and equity markets.

The simple answer may be found in the tired but often on the mark adage of “buy the rumor, sell the fact,” but we believe there may be more at play here.

** First, there was, for sure, a residual risk (around 30% in market pricing terms) that Draghi could choose to force action today rather than wait, as much more widely expected, until September. But we do not believe this is a delay that much matters, except for the real short-end pips. For one, the ECB today set a formal easing bias that rates will remain “at their present or lower” levels, and in doing so has all but guaranteed an ease in September that it will not back down from (see SGH 7/12/19, “ECB: The Upcoming Ease”).

** Second, Draghi confirmed that an appropriate tiering system for negative deposit rates will be studied as part of the upcoming package to offset some of the additional cost the soon-to-be lower rates might incur on the European banking system. In other words, it is not a question of whether rate cuts will be delivered, but of exactly how.

** And lest the ECB determination to fight low inflation be in doubt, the Governing Council even agreed to include in its text, as we had predicted, the commitment to a “symmetric approach” to achieving its “below but close to 2%” inflation target – a clever work-around for a more extended and formal discussion and change, if even needed, down the road.

** Where markets may have been disappointed was instead on the QE side, or as formally known, the ECB Asset Purchase Program.

** Draghi, in no uncertain terms, flagged that a resumption of the QE program would be among the key tools to be studied by the working group tasked to formulate an easing package for September. But he stopped short of an explicit guarantee it would be rolled out by then.

** More importantly, assuming it is included as part of the easing package, the real market shrug may be rooted in Draghi’s response to questions over what assets might be included in a new QE package.

** Draghi, wisely, did not get into any actual details on what assets may or may not be included, thus avoiding fanning the flames of speculation, preempting his own Governing Council, or boxing in the task force. But what he did say was that the task force would look at broad options that would not go beyond what the Council had discussed today.

** In effect, this suggests that a resumption in asset purchases could include some revisions to the old program such as a modest increase – we would expect from 33% to 40% – in issuer limits to open up some headroom for sovereign bond purchases and, as we have also written, perhaps some greater focus on corporate bond purchases, as well as potentially purchases of packaged bank loans.

** But what it does not hint at is any discussion or apparent momentum behind the big kahuna markets have suddenly and increasingly been chattering about – the inclusion of equity purchases in a new APP program, which would be a radical departure indeed for the ECB.

** This sudden speculation on equity purchases is, perhaps, a mirror image of the chatter and rising expectations right before the December 2018 FOMC meeting about an end to the balance sheet taper that caught Fed Chairman Jay Powell flatfooted.

** As opposed to the (much more severe) December Fed whiplash, the ECB is at least pointed in the right direction for September. On the other hand, while the Fed was quick to turn on both rates and its balance sheet policy, we do not expect the ECB to follow central banks like the Swiss National Bank and Bank of Japan into the business of equity ownership.

** In the meantime, literally, as Draghi pleaded for an assist from the fiscal side to stretched monetary policy “that may even have diminishing returns,” German Finance Minister Olaf Scholz was on the wires squashing all hopes for fiscal stimulus, denying that Germany was facing a crisis in its sputtering growth and flatly ruling out the need for any stimulus from Berlin. And that is coming from a Social Democrat.

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