ECB meeting outlook: EUR falters as we get closer to QE

This week’s ECB meeting is likely to be less eventful compared to the last ECB meeting in January. Back then the ECB announced its first ever QE programme, at this month’s meeting we expect no such bomb shell, instead we expect the latest round of ECB staff economic forecasts and more information on what QE under the ECB will look like.

Although we don’t expect anything new to come out of this meeting, Mario Draghi’s press conference at 1330 GMT on Thursday could be illuminating as the market has a few unanswered questions including:

1, When will the QE programme start? Some are saying 9th March, others are saying 13th March. A later date could spook the market and lead to some questioning the ECB’s commitment to the QE programme. If its commitment is questioned then we could see a sharp reversal in the EUR.

2, Is the QE programme going to be open-ended? The statement from the January meeting was ambiguous; it said the programme would last until “at least September 2016”. If the programme is likely to end in September next year, then the market may doubt its effectiveness, as open-ended QE appears to be expected by the market, hence the weakness in the EUR and the low level of Eurozone bond yields. However, some reports in the press have spoken about the “scarcity” of some European paper in the future. There is a chance that for some maturities there may not be enough assets to satisfy the ECB’s EUR 60bn a month demand, and the ECB’s programme could cause some major disturbances to the European bond market. We expect to hear details about how open-ended this programme actually is and how the ECB will try to avoid disrupting the market, as we mention above.

3, Will the Eurozone buy bonds with negative yields? The average bond yield for the Eurozone is a mere 0.67% for bonds of 7-10 year maturities. For some bonds the yields will be negative, which means that the ECB won’t earn anything for holding say 5-year German yields, which currently yield -0.05%. There could also be a risk that the ECB is buying at the high (yields move inversely to price), which could become a credibility issue and hurt its balance sheet down the line. However, the ECB has committed to EUR 60 bn of asset purchases per month, which is a sizable amount, and could add some significant downward pressure to bond yields in the coming months.

What about the growth outlook?

At this meeting we will also get the ECB’s latest forecasts for growth and inflation. These come at an interesting time when the Eurozone economy is showing signs of life and when the pace of price declines has finally started to slow. Even though there have been signs that spring is coming to the Eurozone we still expect the ECB to cut its inflation forecast for this year to -0.1% from 0.7%, while the growth forecast could be upgraded to 1.2% from 1% in the last round of forecasts.

Crucially, we don’t expect the ECB to cut its longer term inflation outlook for 2017, which would put less pressure on the ECB to expand its QE plan or announce any new measures to try and ward off deflation in the coming months.

The EURUSD view:

The single currency has made a fresh 11 year low versus the dollar on Wednesday. Interestingly, the EUR navigated last month’s Greek bailout crisis without any problem and EURUSD consolidated. However, it has since broken below prior support at 1.1098 as we lead up to the ECB meeting. Any better than expected US data, particularly labour market data, has proven to be more damaging for the EUR’s performance than domestic problems. Although US economic data has mostly missed expectations so far this year, the labour market has managed to hold up well. The ADP private sector payrolls report for Feb showed a healthy 212k, which has increased expectations for another strong payrolls number on Friday. This is helping the dollar index break to a fresh 11-year high on Wednesday.

From a fundamental perspective, as the market focuses on the prospect of Fed rate hike the relative monetary stance of the ECB vs. the Fed should be negative for EURUSD for the foreseeable future. Yields are also a key driver of FX and as you can see in figure 1, the spread between the US and German 10-year bond yield is close to its highest level since 1989. This spread has an inverse correlation with EURUSD, so unless we see the yield spread change, then EURUSD could remain under downward pressure.

From a technical perspective, Wednesday’s break below 1.1098 – the former low of the year so far – was a bearish development that opens the way to potential further downside. The break of 1.1098 is also a break below the symmetrical triangle pattern, which suggests that the downtrend may now resume. Key support lies at 1.10, a psychological level, then 1.0765 – the low from 3rd September 2003. If the ECB delivers a hawkish surprise then we could see some volatile price action in EURUSD, with 1.1679 a major level of resistance and the highest level since 21st Jan.

Takeaway:

• The ECB meeting on Thursday is unlikely to be as exciting as the January meeting, when the ECB announced its first QE programme.

• However, the ECB staff forecasts will be illuminating and we expect to get more detail on the QE programme.

• Key questions we think Draught could answer include: when will the plan actually start, is it actually open-ended, and will the ECB be happy to buy bonds with negative yields.

• The EUR has been under pressure in the lead up to the meeting, as the market focuses on the positive US labour market data.

• EURUSD broke below key support on Thursday at 1.1098, which could mark a resumption of the downtrend.

• Below 1.10 opens the way to 1.0765.

• Unless Draught shocks the market by taking a less dovish stance than expected, we think the EUR could struggle from here.