ECB preview: is EUR 50 bn a month enough?

In the last few minutes ECB officials have reportedly leaked that the ECB council will discuss a QE programme that is EUR 50 bn a month through to 2016, the equivalent of EUR 600 bn a year. Below, we look at the potential scenarios for ECB QE and the potential market impact.

On Thursday 22nd January, the ECB will announce its latest policy decision. The market is in full-blown QE mode, and after the Swiss dropped its EURCHF currency peg last week expectations are high that a QE package from the ECB is on its way.

Earlier this month, a leak from the ECB suggested that the Bank would announce a EUR 500 bn package, however, in the aftermath of the drastic actions from the Swiss National Bank (SNB) last week, the bulk of the market now expect a package at least EUR 500bn in size, with some market participants looking for the ECB to announce a EUR 1 trillion programme.

The ECB are notoriously hard to predict as Draghi presides over trying to please 19 member states. We believe that Draghi wouldn’t risk the market’s ire by not announcing QE at this week’s meeting, however, it’s the details of the programme that really matter. Below we lay out a few potential options that Mario Draghi may choose:

1, EUR 500bn QE package

This would disappoint the market. A EUR 500bn one-off QE package may be considered too paltry to make a difference, especially since the Bank of Japan has committed to do more than this each year until its CPI rate rises to 2%.

Market impact: we would expect a sharp knee jerk reaction lower in stocks, bond yields could also rise, which could put upward pressure on the EUR in the short term. Overall, we think a QE disappointment would be a long-term negative for the EUR, as it would increase pressure to take action in the coming months.

2, EUR 600-750 bn QE package

This would be more in line with what the market expects and would suggest that the ECB is serious about combatting deflation. A package of this size would also send a signal to the market that the German Bundesbank is on board with this package, which could be viewed as a long-term positive for the harmonious future of the currency bloc.

Market reaction: We would expect stocks to drift higher, particularly the FTSE 100 (see more below), and bond yields could also fall in the immediate aftermath. The Fed’s example tells us that sometimes the prospect of QE is a more powerful driver of a currency than the actual announcement of QE itself. Thus, after an initial knee jerk reaction higher in the EUR, we could see the EUR drift lower in the days after a QE announcement.

3, EUR 1 trillion QE package

This would be the big bazooka that the market is looking for. Markets love liquidity, so we may see a boost to overall market sentiment as it would signal that the ECB plans to step in and fill the QE void left by the Federal Reserve when it ended its QE programme at the end of last year.

Market reaction: same as above, but larger moves to the upside for risky assets.

Other policy options that the ECB may go for:

• Cutting the deposit rate further into negative territory: it is already at -0.2%, the ECB could follow the SNB’s lead, and rather than expand its balance sheet, opt to cut rates deeper into negative territory. This is unlikely to placate the market, who appear to want QE (or blood) from the ECB. A negative interest rate tends to have a long-term negative impact on a currency; however, it can take a while to weaken a currency, as we have seen with the Swissie.

If the ECB does announce QE:

If he does as the market expects and announces QE, then Draghi’s statement on Thursday, which begins at 1330 GMT/0830 ET, will be the time when he announces the details that will determine the size of the market reaction. Things to look out for from his statement include:

• The size of the package: will it be big enough?

• The timeframe for purchases: Will the ECB opt for an open-ended programme or will it last a few months/ years? The latest rumour suggests that the ECB will announce a package worth EUR 50 bn per month, through to 2016.

• What assets will the ECB buy? Private sector assets will be the riskier end, which could stoke a lot of excitement in the stock market. Public sector assets are less of a concern since government bond yields have fallen so sharply across the currency bloc in recent years.

• How will the ECB split up purchases? Will it buy assets from all member states equally? Will it play it safe and only buy high quality assets from the Eurozone’s largest economies?

• Will there be risk sharing? This is likely to have been the hardest decision around the ECB’s QE programme. Risk sharing could trigger a stock market rally, particularly in Europe’s peripheral countries.

Will QE work in the Eurozone?

An announcement of QE is just the beginning, the questions around the size of the package, and risk –sharing in case of bad debt are key questions that could determine if it will be successful.

Previous studies suggest that QE is more effective than policies such as forward guidance when it comes to boosting growth and inflation, however QE can take time to work its way into the system, and it can take a lot of purchases to have an impact, so this may only be the beginning of the ECB’s QE journey, if it wants it to work.

Where will the money go?

When the Fed embarked on QE after the financial crisis, the liquidity it provided didn’t go straight into the real economy, instead it leaked out to other economies and asset classes. The same could happen to an ECB QE programme. In this instance, we think that the money could flow across the Channel and boost the UK housing market, particularly in London, and the UK stock market; it could also boost the gold price.

Gold could be a big winner from an ECB QE programme. Not only is the market jittery at the moment, which is good for a safe haven like gold, but a large QE programme could also stoke inflation pressures down the line. Since gold is considered an inflation hedge, this could boost the yellow metal.

Takeaway

• The market expects QE – a major shock would be if it holds steady, this could cause a large jump in market volatility.

• The latest rumour is that the programme will be EUR 600 bn in size, with EUR 50bn of purchases per month through to 2016.

• There are still lots of unknowns – what will the ECB buy, where will it buy it from and will there be risk sharing?

• There is still a chance that QE won’t work in the Eurozone and instead the money could flow out and prop up global stock markets, like we saw when the Fed embarked on QE in recent years.

The currency view:

Quantitative Easing is bad for currencies, right? By definition, QE is a policy that seeks to stimulate the economy by increasing the monetary base, or supply of money, in an economy, and as we all know from Economics 101, a greater supply of a currency lowers its value. This framework is undoubtedly true in theory, but as the 20th century baseball legend Yogi Berra once noted, “In theory there is no difference between theory and practice. In practice there is.” In other words, the actual market reaction to a QE announcement by the ECB on Thursday may not be as simple as “sell euros.”

The key to understanding the impact of QE on markets is the “surprise factor,” or the idea that QE programs only have a large immediate impact when they are not anticipated. Recent studies by the Federal Reserve and other central banks have shown that unexpected changes to monetary policy tend to have much more significant market impact than announcements that were widely anticipated.

The Federal Reserve’s experience with QE1 and QE2 clearly show this concept in action. Flashing all the way back to late 2008, the US mortgage market and broader economy were in disarray, prompting the Fed to announce that it would start buying mortgage-backed securities on November 25, 2008. Because this announcement was widely unexpected, the dollar fell 5% over the next month (the red arrow in the chart below) before actually rallying to new highs once the purchases began (green arrow). Astute traders will note though, the long-term impact of the QE program was dollar weakness (black arrow).

A similar situation emerged in the period around the QE2 announcement two years later. Fed Chairman Bernanke heavily hinted that the central bank would soon announce another iteration of quantitative easing in his Jackson Hole speech in late August, stating that the Fed would “do all that it can” to support the economy and that “The Committee [was] prepared to provide additional monetary accommodation through unconventional measures if it proves necessary.” With this transparent signal, traders sold the dollar in anticipation of QE2 (red arrow), and when the program was actually instituted, the dollar saw an immediate bounce before eventually continuing lower.

As William Shakespeare once wrote, “What’s past is prologue.” The ECB has been alluding to a new QE program for months, driving EURUSD to an 11-year low around 1.1500, similar to the red arrows in the above chart. Especially after last week’s SNB decision,expectations are for a massive QE announcement from the ECB on Thursday, potentially even in excess of the rumored EUR 500B program from two weeks ago. If Draghi and company fail to clear this formidable hurdle, a kneejerk rally in EURUSD seems likely.

Technical View: EURUSD

Turning our attention to the EURUSD chart, the pair is now deeply oversold after its prolonged downtrend, with its 14-period RSI indicator now around 20. Rates have broken through support level after support level over the last eight months, and those previous support levels may now provide resistance on any bounces. Accordingly, it would be prudent for EURUSD bulls’ traders to see whether the pair can recapture the November 2005 low at 1.1640, potentially opening the door for a short-term recovery back toward the June 2010 trough at 1.1880. On the other hand, a larger-than-expected QE announcement on Thursday could still lead to more weakness in the single currency; the next support level to watch to the downside is last week’s low around 1.1460, with potential for more downside toward the long-term 61.8% Fibonacci retracement around 1.1200 if that floor is broken.