ECB Preview: Will Saint Draghi bring a present to expectant bears?

'Twas the night before Draghi, when all through the market
Not a trader was trading; they were waiting for their targets
The trading plans were hung by the monitors with care,
In hopes that a tradable trend soon would be there…

Much like a child on Christmas Eve, traders are eagerly awaiting tomorrow’s massive European Central Bank decision and press conference, but it’s still an open question whether St. Mario will bring a shiny new gift or a lump of coal for expectant bears.

After a series of dovish signals over the last few weeks, the key question is how, not if, the ECB will ease policy tomorrow; traders are expecting the ECB to be extremely accommodative tomorrow; in fact, pinning down the market’s exact expectations will be critical to the reaction in the euro, European equities, and fixed income in the wake of the announcement. The ECB’s toolbox of potential easing measures is vast, stretching from traditional interest rate cuts deeper into negative territory to expanding its ongoing QE program to more esoteric ideas like a two-tiered deposit rate or buying bundled credit risky loans.

Logistically, there are some constraints that the ECB will have to navigate in order to expand its ongoing non-traditional easing measures. Under current rules, the central bank is not allowed to buy bonds with yields lower than its deposit rate, nor is it allowed to own more than 33% of any specific bonds total supply. Of course, there are two potential workarounds here: either lower the deposit rate or just loosen/abolish the restriction itself. As of writing, EONIA futures are pricing in a 10-15bps cut to the ECB’s deposit rate, which would open up more bonds for purchase in and of itself. Given the clear signals of late and entrenched market expectations, a deposit rate cut of at least 10bps looks likely, with a more aggressive 0.20% cut potentially on the table as well.

In terms of the bank’s QE program, it may also opt to change the duration, quantity, or composition of monthly asset purchases. An extension of the current “soft” deadline of September 2016 (say, to March 2017) would be among the least aggressive moves the ECB could make and if accompanied by only a small deposit rate cut, could lead to a “sell the rumor, buy the fact” reaction in EUR/USD (in other words, EUR/USD could bounce back toward the 1.07-1.08 zone).

However, the central bank could also opt to act more aggressively with a “big bazooka” style easing. In addition to a 10bps+ cut to the deposit rate, this would likely entail increasing the monthly volume of bond purchases to €70B or €80B from the current €60B pace. In this case, we could absolutely see further downside in the euro, and likely upside in European equities and fixed income. In the past, we’ve noted Draghi’s propensity to take bold actions when required, and with euro positioning well below the extreme bearish levels seen when QE was first announced in January, the odds are shifted toward the downside for EUR/USD in our view.