ECB Will Give 2018 QE Policy Update On October 26th

This year, the two monetary policy aspects we've been focused on the most are President Trump’s decision on who the Fed chair will be and what the ECB will do with the CSPP (corporate sector purchase program) and the PSPP (public sector purchase program). The big decisions are both going to happen in the next few weeks, just as earnings season gets going. That’s quite the trio of events for the market to digest. There could be volatility in the end of October. If Powell is picked, the QE is extended for longer than expected at a high rate, and earnings growth is 6% or better with good guidance, stocks will do well. A Santa Clause rally could finish out the year on a positive note making it the first year without a 3% correction since 1928. The current streak is at 233 days which is 8 days fewer than the longest streak. The 22% gain is the second largest gain (largest is 30.4%).

The expectation is for the ECB to make the decision on guidance for the 2018 QE program on October 26th. The chart below shows the baseline expectation for the policy. As you can see, it shows the program shrinking to 40 billion euros per month for the first 6 months of the year. Then it slows to zero by the end of the year. I’m worried about volatility in the stock market when the QE starts heading towards zero in July. At that point, the Fed will be nearing the peak of its unwind.

There has been a narrative shift in what QE means for the stock market. The bears have been saying QE has boosted stock prices. The bulls were happy to go along with that argument because the bears were actually making a bullish case for stocks in the near term (and bearish in the long term). Now that this unprecedented QE policy will end for the ECB in 2018 and the Fed is doing an unwind, the bulls need to take the stance that QE never caused the rally in the first place. The narrative is that QE was a placebo effect for the market which got the animal spirits going. If that’s the case, unwinding the balance sheet and the ECB tapering won’t affect stocks. That’s a tough case to make, in my opinion, because this year has had the most QE ever when you add up all the major central banks. As I mentioned, this year is about to be the first year without a 3% correction. That calmness is occurring despite weather catastrophes, political unrest in America, and a sharp earnings growth deceleration in Q3.

The counterpoint to that argument is the market should have priced in the expectation of the ECB’s tapering since it’s widely expected. In response to this, bears will say the decision is still uncertain. The current 60 billion euro purchase rate per month is the same as what was in place in 2015, so we haven’t seen what the tapering can do to the market yet. The chart I showed earlier was the baseline expectation. The slower for longer scenario would be 9 months of QE at 30 billion euros per month. Then over a 3 month period, it’s shrunk to 0. The initial shock would be more substantial, but there would be 2 months were the QE would be larger. It’s only 2 months larger because the 1st month of slowing from 40 billion to zero is about 30 billion euros. The third scenario is the open ended extension. That’s when the ECB does QE of 20 billion euros for 12 months. Then it slows to zero in the first few months of 2019.

The 4th possibility is the most favorable to the stock market. This QE status quo extension plan would be extending the 60 billion per month in purchases indefinitely. This doesn’t seem probable given the Bundesbank’s desire to end the program. If it continued forever, the ECB would run out of assets to purchase. There would be a wide divergence between the Fed’s policy and the ECB’s policy. It would cause the dollar to increase such an amount that would cause systemic risk to increase.

The 5th possibility is fast and furious tapering. This would be like the unwind plan the Fed is doing in the sense that it’s changing every 3 months. The plan is for 3 months of 40 billion euros, 3 months of 20 billion euros, and 3 months tapering to 0. The final plan is the change in composition plan. This plan is for the total purchases to decline to 40 billion per month for 12 months or more. The decline in purchases would only come from the sovereign debt purchases while the corporate purchases remain stable. This would be the second most bullish option for stocks as the corporate purchases have more of an impact on stocks, in my opinion.

The chart below shows an interesting new trend in the assets acquired in the PSPP. As you can see, the bonds of Italy and France are being purchased more while the bonds of Germany and the Netherlands are being purchased less. This might infuriate the Bundesbank, further angering them about continuing the ECB’s purchases. As a reminder, the Germans don’t like the idea of QE being a proxy bailout for the periphery European countries. They’re also angry about the increased inflation they are seeing.

Conclusion

I laid out the decision the ECB will make in two weeks. It’s possible for one of the biggest earnings periods of the quarter, the ECB decision, and President Trump’s decision on Fed chair to all occur in the same week. The more bond buying, especially of the corporate variety, the more bullish it is for stocks. The worst case scenario for stocks would be bad earnings reports, a substantial reduction in QE with the program ending in 2018, and the President picking Warsh. That scenario isn’t likely, but if it happened, I’d expect a 10% selloff.

 

 

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Don Kaufman: Trade small and Live to trade another day at Theotrade.