ECB Preivew: Draghi to join currency wars? 4 scenarios

The European Central Bank meets on September 3rd to decide on its policy and it has a lot to digest since its last meeting in mid July.  Will we hear a more dovish tone from Draghi? Or will he wait for developments in China and the Fed?

Here is the preview with everything that has changed and 4 scenarios

Update:  Draghi sends EUR/USD down on open door to more QE, low forecasts, downside risks

Previously on the Draghi show

The ECB last met in mid-July, just after a deal was forced on Greece. The focus was on the small indebted nation. Draghi then said that some form of debt relief for Greece is “not controversial”  as he noted a small relief for Greece’s banks.

Regarding monetary policy, it seemed to go on as planned: perhaps  there  was some minimal front loading of QE ahead of the  drier summer months, but the Bank’s bond buying  program, aka QE, was going as planned: there were some signs of better monetary activity, more growth and hopes that inflation will get back  on track.

The ECB continued with its €60 billion / month purchases, with September 2016 set as the intended end date.

Will it change now? So many things have changed since.

Trouble brewing

• Greece: While the Greek parliament approved all the bills, this led to a collapse of the government and the country is going to the polls on September 20th. Yet there is a bigger event beforehand.
• Federal Reserve: A rate hike in from the Fed in September had good chances. This is positive for the euro-zone as a  stronger US dollar, together with the accompanying stronger yuan  both make European exports more attractive. Well, since then we have heard quite a few doubts from the Fed, with  current market pricing standing at less than 25% – low chances.
• Commodity prices:  The  2014 fall in oil prices is still weighing on headline inflation in the euro-zone. Draghi and co. awaited this effect to move on, but despite the recent bounce in prices, oil and other commodities are still too cheap and they  mean that the ECB continues missing its target.  Inflation forecasts could be lowered.
• China:  The world’s  No. 2 economy is the biggest source of trouble for the euro-zone in various manners:
  • Exports to China: With China slowing down,  it imports less, and the biggest exposure is in Germany, with heavy machinery sales to the economic giant. The ECB, which sits in Frankfurt, cannot ignore this.
  • Yuan:  So far, the Chinese yuan traded hand in hand with the US dollar, and it meant a better export environment for  Europe as well as more expensive imports from China, pushing up inflation, as the euro lost  value against the dollar. The recent  devaluation and potentially more along the road, darken the clouds. China is exporting deflation, including to the euro-zone.
  • EUR reaction: This is an own goal from the ECB. Due to the negative deposit rate and the QE program, the euro has become a funding currency and a safe haven. In good times, money is borrowed in euros to take risks abroad, and when trouble brews, money returns to the euro-zone. We have seen it in the its starkest with the Greek crisis. It showed that the euro behaves as safe haven even when trouble is from within. So, with troubles in China, the euro strengthened, and this is not what the ECB wants.
  • Fed: With trouble in markets and with some members of the Fed very keen to stabilize markets (or “work for Wall Street” if you wish), there is a growing chance that the Fed will not raise rates and basically join the currency wars.

Tools

There are more aspects to the global financial woes on the euro-zone, and  the ECB faces its own  dilemma: should it act?

The  interest rate tool is exhausted, but it could certainly change its QE program. so far, the  results of the program are mixed, but there is not doubt that the Bank is good at implementing it: the bond buying process is smooth and it also broadens the tools with more ABS  coming onto the market.

The ECB could:

• Enlarge the monthly buys: Currently at €60 billion / month, any increase would be very powerful.
• Extend the program: Currently intended to end at September 2016, it could be extended to a further date or be indefinite – which  what the Fed did with QE3 and is much more powerful.

4 scenarios

1. Open the door for more action without details: High probability. The ECB could leave policy  unchanged but note the global challenges and say it is prepared to do more. In this scenario, Draghi keeps the tools in the shed and waits for the Fed to move. With this time, he can examine the  manner in which to add more stimulus. The markets are expecting something of this sort, so the apart from the immediate  choppiness, the euro is likely to stay in place.
2. Open the door for more action with clear details: In this case,  he may hope that the details are powerful enough to depress the euro and stimulate the economy without having to really act, at least not immediately. A pre-announcement about an extension to €100 billion / month and no limit, perhaps coming in December, could be very  powerful without a  commitment to real action. This has  a medium chance and would  be euro negative.
3. More QE now: With the current deterioration, this is certainly an option. The chances are medium  and the impact would be  very negative. In this scenario, the euro would plunge, especially if the door is open for even more action.
4. Nothing: The ECB could say it is watching the situation but  doesn’t have any plans to act (in response to a reporter’s question), This has a low chance  due to the  damage done by the strengthening euro and the need to keep up with currency wars. In this scenario, the euro would jump.

What do you think?

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