More Thoughts on the ECB

It was ECB President Draghi's speech in the central bank conference in Portugal on June 27 that began the current market phase. He seemed to acknowledge the obvious, which that ECB officials may be as surprised as any one with the market's dramatic response to the assessment reflationary forces are at play.

The day before Draghi spoke, the 10-year German Bund yield traded near 23 bp.  It peaked a week ago near 62 bp.  The yield has eased a bit in what appears to be consolidation ahead of the ECB meeting.  This is part of the overall tightening of financial conditions was the market's reaction function to Draghi's comments.   The Bloomberg measure of financial conditions has tightened by 50 bp this month.  Conditions are the tightest since the end of 2014.

Macro-fundamental conditions have not changed much in recent weeks.   The euro area is enjoying a cyclical expansion, and growth continues to exceed trend.  However, inflation remains lower than desired, and wage growth remains modest.  If last month, the ECB's analysis allowed Draghi to conclude that the movement to price stability required continued extraordinary accommodation, then nothing since suggests otherwise.  If anything, the tightening of financial conditions and would suggest less, not more future inflation.

Draghi has a particularly difficult job.  On the one hand, the ECB wants to prepare investors that asset purchases are not permanent and the economic conditions that warranted the unorthodox measures are not as intense as they were previously, and the downside risks to growth and inflation have been neutralized.  On the other hand, it is premature to conclude that an exit is at hand, or that the patient, the eurozone economy, and prices, can be taken off life-support. 

The ECB's balance sheet has not peaked.  Leaving aside the remainder of this month, the ECB's balance sheet is likely to expand another 300 bln euros over the last five months of the year.  The ECB has not announced what it will do next year.  We expect that decision to be announced in September. 

What we do know is that the ECB is most unlikely to halt its purchases suddenly.  And that means tapering.  For back-of-the-envelope purposes,  grant reasonable and conservative assumption about tapering.  Assume that the 60 bln a month pace is cut in half for the first six months of 2018. Under that scenario, the ECB's balance sheet would expand by another 180 bln euros in the H1 18.

At the same time, it seems reasonable to assume that the Fed begins to allow its balance sheet to shrink.  We suspect it will begin in Q4, which at $10 bln a month, would reduce the balance sheet by what we think is an inconsequential $30 bln.  In Q1 18, the pace is $20 bln a month, and in Q2 18, the pace would accelerate to $30 bln a month.  If our analysis is correct, from the beginning of next month through June 2018, the ECB's balance sheet will expand by 480 bln euros, while the Fed's balance sheet would shrink by $180 bln.

Although there had been talk earlier in the year, seemingly pushed by officials from eurozone creditors, that maybe interest rates could rise while the asset purchases were continuing.  Draghi and the ECB's leadership argued against an early rate hike. Still, the German two-year note yield has rallied from a record low of just beyond minus 95 bp in late February to minus 55 bp at the end of June.

The rise of the German two-year yield may be cited as evidence that the market is pricing in an ECB rate hike, but that seems like a stretch, especially given that is still in deeper negative territory that the deposit rate.  Interpolating from the OIS, it appears the market has not priced in more than a 50% of a 10 bp hike until the middle of next year.  It seems reasonable to us that between now and that potential ECB hike that the Fed would raise its Fed funds target two or three times.

Draghi is attending the Fed's Jackson Hole confab in late August (August 24-26).  He does not always attend it and the fact that he is, a fortnight before the ECB's September meeting, suggests to some that he will have something to say.  As the date approaches, look for speculation to increase.  It is also a date to keep in mind for risk management and option dates. 

A press report, citing an unspecified official,  suggested that the ECB wants to keep its asset purchases open-ended.  If it is, this would be seen as dovish even though no one believes it will be exercised.  It would be seen as a sign that the tapering and fuller exit may be more protracted than currently anticipated.  Barring an offset, we suspect the euro may be sold on such a development. However, given our reading of market sentiment, the real money flows that still seem to see European equities as better value than the US, and the diminished US interest rate premium, especially at the long-end of the curve, suggests the participants are inclined to buy the euro on pullbacks.

We suspect that a pullback toward $1.1370-$1.1400 would be bought.  On the upside, last year's high near $1.1615 is the nearby target.  The euro did not rise above the previous year's high in 2015 or 2016.   Based on current implied volatility, there is about a 75% chance that in a week's time, the euro will be trading between $1.1375 and $1.1665.