There are two parts to Thursday’s ECB meeting that investors should watch out for: 1, the rate cut, and 2, a potential announcement by President Draghi of unconventional monetary policy action. On balance we agree with consensus and believe that the ECB will cut rates on Thursday, however we think there is a 30% probability that some hawkish elements within the ECB (most notably the German Bundesbank) may vote against a rate cut due to the rise in German CPI in July. If the hawks are out-voted as expected then a rate cut should be negative for the euro as its yield differential with other currencies will have been eroded. Thus, we may see broad-based euro if the ECB cuts interest rates at Thursday’s meeting. The biggest declines could be against the Swedish Krone, the Aussie dollar, the pound and the US dollar, as these currencies’ central banks are expected to keep rates unchanged for the medium-term.
Draghi saves the day?The second thing to watch out for is the unconventional monetary policy that may be announced during the press conference. Draghi pledged to “do what it takes” to protect the Eurozone at a meeting in July. At the August ECB meeting he said that the Bank would work on a new sovereign bond-buying plan to try and protect Spain and Italy from the bond vigilantes during times of sovereign stress. Since the August meeting there have been some clues about what to expect. We know that Draghi told a meeting of EU officials earlier this week that ECB purchases of sovereign debt with a maturity less than 3-years is not the same as government financing. However, we also know that that Germany remains against any type of government financing through bond purchases and media reports suggest the head of the Bundesbank has threatened to quit on the back of a potential new programme of support from the ECB. Thus, the outcome of Thursday’s meeting is not clear cut. We need to wait to see what the ECB has hatched, however market expectation for some type of plan is high. Draghi’s fateful speech in July has reduced the tail risk of a Eurozone break-up and contributed to the rally in risky assets this summer. The markets seem to be prepped to expect a “big bazooka” at this month’s ECB meeting to obliterate the sovereign debt crisis and restore calm to peripheral bond markets.
What to expect: three potential outcomesThe first outcome: the disappointment. Draghi can’t persuade the Bundesbank to agree to a bond-purchase scheme and instead the two factions agree on a rate cut to try and placate the markets while essentially passing the baton on to the politicians to try and sort out this crisis. We think there is a low probability of this happening because if the ECB doesn’t deliver on Draghi’s pledge to protect the currency bloc then its credibility would be damaged.
The second outcome is a middle road. The ECB agrees on a broad outline of a new bond-purchasing scheme that is more robust than the original SMP programme. It will allow the ECB to buy short-term bonds to ensure the effective “transmission of monetary policy”. Thus, after more than two years, steps have been taken to give bond-buying a home within ECB monetary policy, which is a move towards the ECB becoming the lender of last resort for the currency bloc and more like the Fed and the BOE. However, we would expect the ECB to state that the plans won’t be finalised until the outcome of a German Constitutional Court ruling on the legality of the Eurozone’s long-term bailout fund the ESM. The initial reaction for European stocks and the euro could be mild disappointment, but we believe that EURUSD could find good support above 1.2455 – the top of the daily Ichimoku cloud, and this level could attract further buying interest back towards 1.2640 and maybe 1.27. We believe there is a high chance this will happen, and we call this the middle road.
The final outcome that we foresee is one where the ECB announces all the details of a bond buying plan and says it will buy unlimited amounts of bonds until Spanish and Italian yields reach a certain level. Although there is conditionality attached, Spain agrees to a formal sovereign bailout so the ECB can start buying bonds immediately. This would be euro positive, but we think there is virtually no chance of this happening on Thursday.
Overall, we don’t see the September ECB meeting as being a game changer. We believe the ECB will lay out the broad strokes to further involvement and a new bond-buying programme, but that it won’t commit until the outcome of the German court ruling. We think the most important meeting will be the October meeting, when the ECB will announce in detail its plan to purchase bonds and also, crucially, a start date for the purchases.
We do see some initial selling in the euro on Thursday. One to watch could be EURSEK, which has reached a key resistance level at 8.4310 – the 50-day moving average. It may be difficult for this pair to break above this level in the near to medium-term, so we could see some profit taking and a return to 8.40 then 8.35 could be on the cards.