ECB: Go Big or Go Home

Forex News and Events

The European Central Bank gives policy verdict today and is expected to announce the much expected Quantitative Easing (sovereign bond purchases) in order to fight the deflation and help the union to step out of recession. The expectations are running high regarding the size and the content of the program. It seems there will be more room for disappointment out of today’s meeting, simply because the expectations have gotten well beyond the ECB’s objectives, partially thanks to Swiss National Bank’s surprise removal of the EUR/CHF floor on Thursday of last week.

The ECB’s balance sheet has been expanding since September 2014, since the ECB decided to gradually put in place two rounds of TLTRO lending and private debt purchases. The Bank’s balance sheet advanced to 2.2 trillion euros as of January 16th, meaning there is still an important potential for expansion given the policymaker’s desire to expand the total assets to roughly 3 trillion euros. The markets expect the ECB to announce a package worth 500 billion euros to, at least, meet the consensus. This number extends to 750 billion to 1 trillion euros as there is growing expectation that the National Central Banks (NCBs) will be involved in the bond purchases program. There is also talk of open-ended, monthly 50 billion euro purchases until the target balance sheet size is achieved (as Dow Jones reported yesterday). Finally, it is worth noting that we also hear rumors in favor of an operation exceeding the trillion euro. All in all, the expectations are very high and the ECB need to come aggressive enough to meet expectations. This is where we see risk of disappointment during the ECB President Draghi’s press conference following the verdict.

Frequently asked questions…

There are important uncertainties vis-à-vis the potential ECB QE today. The leading ones are clearly the size of the operation, whether the ECB action will be a one shot move or an open-ended program and whether the ECB will share risk with the NCBs - where the latter would buy only their own countries’ debt and carry the idiosyncratic country risk alongside with the ECB.

Another important unknown is the distribution of the purchases. The rational expectation is a distribution with respect to each member’s capital key (weighting of EZ members respective capital at the ECB). Yet other possible scenarios include the use of other metrics/factors, as bond ratings, percentage of debt-to-GDP ratio, etc. Should the QE involve only the AAA-rating and investment grade bonds – in which case the Germany will be the biggest beneficiary while being the last EZ country to need such help – or should the priority be given to those most in need?

Finally, the duration of the bonds. The purchases should involve longer-term maturities, mostly 5 to 10-year bonds, in order to lower the corporate borrowing costs and give time to cash to reach the real economy. A shorter duration operation can only end up in market dissatisfaction.

Expect higher volatilities as Draghi speaks today

All in all, the list of pending questions is non-exhaustive. The ECB President Draghi’s speech will likely trigger important price action in the EUR-complex. We stand ready for two-sided volatilities. EUR/USD rallied to 1.1679 yesterday amid Dow Jones reported that the ECB would propose 50 billion euro QE per month. News had no official confirmation yet triggered heavy price action, warning traders the high tension in the EUR market pre-ECB/ Draghi.

High EUR volatility on the wire