Is the ECB ready to finally accept the inevitable and engage QE this week?

Macro Outlook

What are the chances of the ECB finally pulling the trigger on QE on Thursday? Flash August inflation data may just give Mario Draghi some further wriggle room. Although Eurozone inflation fell to 0.3%, Spain and Italy beat forecasts, whilst some regional beats in Germany did not paint such a dark picture. Furthermore, the core Eurozone inflation reading picked up from 0.8% to 0.9%. The ECB recently appointed asset manager BlackRock as its advisor on the development of a programme to buy asset backed securities (ABS). In June, Draghi announced the ECB’s intentions to purchase ABS and although it may come a touch too early for him to announce a firm plan on how this will be undertaken, he appears likely to talk about it. Purchasing ABS is seen as “private QE” (full blown QE would likely involve purchases of sovereign government bonds) and would be designed to help inject liquidity into the system. However, with sovereign bond yields continuing to plummet in the Eurozone, the market is fast pricing in deflation and the “big bazooka” QE necessary to combat it. If Draghi simply continues to jawbone, this could disappoint the market and this could drives the possibility of a short squeeze on the euro. Thursday’s press conference will be another volatile one for the forex markets.

Must watch for: ECB Monetary Policy and press conference

Impact: The flash inflation from last Friday leaves the door slightly ajar for Quantitative Easing, but it is unlikely at this meeting. The ECB is expected to keep rates flat (main refi rate at 0.15% and deposit rate at -0.10%). However, the fun (i.e. increased euro volatility) could come during Draghi’s press conference. It is possible that he could announce measures of how the ECB will begin the purchase of asset backed securities. Also, after his dovish speech at Jackson Hole, Draghi may also begin to lay the ground work for future QE too. This could mean another spikey day for the euro.

Foreign Exchange

Expectation of euro weakness is well documented and is a crowded trade, but is there room therefore for further downside? One signals is the yield spread between the German 2 year Shatz and US 10 year Treasury (see Commodities and Bonds section). There is a strong correlation between the direction of EUR/USD and the yield spread (calculated using Shatz minus the 2 year Treasury). So watch for further retreat into negative territory on the Shatz and/or further upside in the US 2 year Treasury yield which could drive further euro weakness this week. Central Banks are back on the agenda once more. With the Bank of England set to release a statement with its announcement there will be added focus for Sterling trades. The debate over when the BoE will raise rates is growing ever more heated, with arguments over lack of wage growth (and latterly CPI inflation) and the degree of spare capacity in the economy appear to be holding the hawks at bay. We will get more of a clue this week. Mario Draghi is likely to continue to try to jawbone the euro lower in his press conference, however, if the market views QE as necessary the this may not be enough to drive a lower euro.

WATCH FOR: A raft of central bank policy decisions (Australia, Canada, UK and Eurozone) will drive major pairs. Add in manufacturing PMIs and of course the key US labor market data (i.e. Non-farm Payrolls, participation rate and average weekly earnings growth) should ensure a much more volatile week.

Indices

With reports that Russian troops with armoured vehicles have moved over the Ukrainian border, is the conflict in eastern Ukraine about to move into a whole new phase? The European equity better hope not. The last couple of weeks have seen a fairly reasonable state of calm engulf trading sentiment in Europe and this has allows investors to focus on the positive earnings season. Perhaps with a sense that bad economic news is now good for markets (i.e. helping to usher in QE from the ECB), markets have been taking the deteriorating data in their stride. However, key resistance levels have stopped the bull recovery in its tracks, with the DAX stalling at 9600, the FTSE unable to breach 6834 and the CAC at 4415. The rejection has coincided with the renewed geopolitical tensions and as tradition has seen fit in recent months, it has been the DAX which has been hit the hardest. Russia appears to be the biggest downside risk to gains on German equities now. The S&P 500 remains fairly well insulated from the conflict (in a geographic, economic and corporate sense). However the psychological resistance at 2000 has yet to be decisively overcome and could induce some profit-taking. After a strong run higher, perhaps there is room for a near term correction which would give yet another chance to buy.

WATCH FOR: Monday is Labor Day but the manufacturing PMIs should ensure an active day. A raft of central bank decisions through the week with special focus on the ECB will also keep activity high. A hectic week ends with Non-farm Payrolls.

Other Assets: Commodities & Bonds

Precious metals prices seem to only really be able to push higher on the news of escalating geopolitical tensions in Ukraine now. This means that trading remains very difficult to predict. Theoretically the jump higher in gold and silver at the end of last week should be another chance to sell. The strength of the dollar has resulted in a drag in prices in recent weeks with a series of lower highs and lower lows. The strength in the dollar shows little sign of abating quite yet and this should continue to heap the pressure on gold and silver. The oil price appears o have stabilised and support has formed at $101.11. This comes as high ranking officials in Iran and Saudi Arabia (the two largest producers in OPEC) suggest the weakness in the oil price would not last long, whilst higher margin supplies would underpin prices.

Eurozone sovereign debt yields continue to plummet in front of the crucial ECB meeting and although there has been a slight rebound following the in-line Eurozone inflation, there is little suggestion that further downside pressure will not be seen. The spread between the yield on the German Shatz (2 year) and US 2 year Treasury is the widest since July 2007.

WATCH FOR: If geopolitical tensions remain elevated precious metal prices will be supported, but could be balanced by dollar strength. Easing measures from the ECB on Thursday could see bond yields fall further.