The stakes are high towards the decision of the European Central Bank. The biggest question is: will Draghi announce outright QE? Will the central bank accelerate its expansion of the balance sheet by buying sovereign bonds?
It could certainly take a leap forward. Where will EUR/USD trade afterwards? Here is a preview with 3 scenarios.
Update: ECB Live Blog – QE or no QE?
Background
The ECB has an inflation target of “2% or a bit below” on headline inflation. This target is being missed month after month for over a year. The preliminary numbers for November hit the cycle lows of 0.3% in headline CPI and 0.7% in Core CPI. Both are the lowest in years, but have already been seen earlier in the year.
The low numbers come despite two big announcements: in June, the ECB set a historic negative deposit rate alongside a cut in the regular rate and an announcement of the targeted loans program (TLTRO). In September, it made further cuts and also announced buying of Asset Backed Securities.
The fall in inflation also comes despite a weaker value of the euro, which is a result of these measures and also to an ongoing rhetoric regarding the exchange rate, including a detailed explanation by Draghi himself.
Reasons for weakness are the tensions with Russia around Ukraine, which have hurt the German economy, lack of progress in reforms in some countries, and recently we had an acceleration in the fall of oil prices.
Tools – a slow start
As rates have reached their lower bound (according to the ECB), the focus is on the expansion of the ECB’s balance sheet. Draghi committed, and later received full backing, for an expansion to the March 2012 levels, which means printing around 1 trillion euros.
An expansion of the balance sheet would lower long term interest rates and make it easier for banks to lend out money.With a more immediate effect, it is also set to lower the exchange rate. This in turn would push the price of imported goods higher, lifting inflation instantly, and it would make European exports more attractive, reviving the very sluggish growth and lifting inflation via demand.
So far, the expansion of the ECB’s balance sheet had a slow start:
- The first tranche of the TLTRO raised only €82.6 billion euros, and this was quite disappointing. The second and last tranche of the TLTRO is on December 11th, one week after the ECB meeting. It will certainly be larger, but probably not large enough.
- Buys of ABS have expanded the balance sheet by only €17.8 billion, and the pace is very slow.
- In addition, banks are paying back those LTRO loans made in late 2011 / early 2012 and they are expected to squeeze the balance sheet by an additional €300 billion.
QE?
On this background, there is pressure to expand the balance sheet by tapping the biggest market: sovereign bonds.
But here, we have a more complicated picture. The euro area is a monetary union of 18 different and independent countries. Each country has its own bonds. There are no euro-bonds. What bonds does Draghi buy? German and French bonds yield under 1% for 10 years. Italy’s 10 year bond yield is around 2% and Spain’s is a bit below. These are the “safer bonds”. Would the ECB buy Greek bonds? Would it be enough.
The issue is not only what to buy, but German opposition: the zone’s biggest country has a very conservative anti-inflation stance. Two German ECB members quit in the past on disagreements, and the country is not really afraid of deflation, but more afraid of monetary financing and specter of inflation.
Germany sees the recent fall in oil prices as a “mini stimulus program” set to boost consumption, while other members might fear that this could have “secondary effects” resulting in a deflationary cycle.
An important meeting
But, there are good reasons to expect action now.
This ECB meeting is special for three reasons:
- Forecasts: The ECB updates its growth and inflation forecasts every three months. A deterioration in forecasts in June led to action, and so did a deterioration in September. It’s this time again. Mario Draghi said that he will do more if forecasts deteriorate. As aforementioned, recent inflation data is bad, the EU forecasts are for inflation are only at 0.8% in 2015 and falling energy prices are set to push inflation even lower. Headline CPI is the ECB’s mandate. And, the fall in the euro hasn’t helped. Not yet.
- Sense of urgency from Draghi: In his November 21st speech in Frankfurt, Draghi repeated his stance about doing whatever it takes to fulfill the mandate, including a mention of bonds. More importantly, he used the word “fast” and in general, sent a message of urgency.
- Change in calendar: This is the last monthly meeting by the ECB. In 2015 it changes to a meeting every 6 weeks, with the next meeting happening only on January.. Will he wait until then?
3 Scenarios
- Draghi says QE will happen dependent on the size of the TLTRO, but not on new forecasts, as there is a need to act. This means that only if the TLTRO take up is huge, perhaps €500 billion euros or more, QE could be avoided. But if it doesn’t happen, the ECB will not wait for more developments and forecasts for a decision, but rather begin buying bonds immediately. This is our main scenario. It is not fully priced into the price of EUR/USD and could cause a slide.
- Draghi says QE is on the cards, depending on deteriorating forecasts: This would be no news, but just a repeat of things we already no. It means a “wait and see mode” in which there is no QE decision now and perhaps not in the future. In this scenario, EUR/USD rises. This has a lower probability.
- Draghi announces immediate QE: This scenario is also less likely before the TLTRO, and if it does happen, it means the situation is even worse than expected and EUR/USD crashes hard.
More: QE is far from being priced into EUR/USD – Goldman Sachs
What do you think?
For more, see the euro dollar forecast.
In our latest podcast, we preview December’s big events, talk about the importance of jobless claims, the crash in oil prices and GOFO going negative:
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