Thoughts about the ECB and Euro

Mario Draghi's term at the helm of the ECB is winding down. He will step down in October. It has not been an easy job. The light at the end of the tunnel in 2017 turned out to be another train in 2018. The eurozone enjoyed 0.7% quarterly growth every quarter in 2017. The ECB was able to outline an exit from its asset purchases. The debate began over sequencing and when the first rate hike could be delivered.

But alas, the cyclical recovery fizzled and in the second half of 2018, the German and Italian economies contracted. Price pressures eased. At the last meeting, the concerns had reached a point that the ECB took unprecedented action and downgraded its risk assessment before the staff provided updated forecasts.

The staff has to make good on this at this week's meeting. In December, the ECB forecast 1.6% CPI and 1.7% GDP growth. Both will likely be revised lower. We suspect that CPI projection will be shaved by 0.1%-0.2% and the GDP to be marked down to 1.2%-1.4%. It is, arguably, preferable to have to lift the forecasts in the future rather than cut them again. The extent that the 2020 forecasts are revised, however, may offer more insight into the mood of policymakers and their level of concern of the risks this slowdown does continue to evolve into an outright contraction.

Even if the cart was before the horse, the combination of the changed risk assessment and the updated forecasts require a policy response. The policy response will more nuanced than a change in rates. There are two levers. Forward guidance and a new loan facility.

Forward guidance in this context refers to the ECB's pledge not to raise rates until after this summer. The market long pushed the first rate hike into 2020. The ECB could confirm and validate these expectations. However, it might not be in a hurry given that the market has already done the heavy lifting and it touches on a sensitive issue, and that involves pre-committing Draghi's successor. Recall that at Draghi's first meetings, he unwound Trichet-led hikes.

The new loan facility is no panacea for growth or inflation. It simply would avoid an unwanted tightening of financial conditions. The Targeted Long-Term Refinancing Operations, which consist of four-year loans, are the main focus. The previous loans are due next June. That means that in this June they will be counted as short-term funding and run afoul of new regulations (ratios). In order to avoid the consequences, new loans to refinance these are likely to be provided. The issue seems to be when not if. Committing to it in March (even if details will be announced later) may give the ECB an advantage by having the market discount it, that is getting the benefit before it actually does it. To some extent, this may have already happened.

The euro fell every time the ECB held a monetary policy meeting last year, except in September and it fell at this year's sole meeting in January. Sentiment seems particularly bearish toward the euro, which could not catch much of a bid even when February's Composite PMI was revised higher. As of the middle of February, speculators in the futures market had the largest net short euro position since late-2016, more than doubling it since mid-January. The gross short position stands more than 220k contracts, a 20% surge in the last few weeks. The euro is at the range that has confined over the past four-month. During this span, it has not spent much time beyond $1.13 or $1.15. In the wide, the range is extended in both directions by about 3/4 of a cent.

The fact that the US jobs report will be released around 24 hours after Draghi's press conference begins further complicates the market's response to Draghi. A fairly healthy jobs report is expected, though the headline payroll growth is bound to fall shy of last January's 304k increase. Anything close to 200k must be considered good. There is scope for the unemployment rate to slip below 4% and for average hourly earnings to edge up to 3.3%, which would match the cyclical highs.

Outside of the very short-term traders, the key question is whether the divergence of ECB dovish signals and a firm US jobs report be sufficient to break the euro out of its range or has the news been discounted already and the ranges, while maybe fraying will hold. The February low was set near $1.1235. There is an option for 1.4 bln euros at $1.1250 that expires on the March 7, shortly after Draghi's press conference likely concludes. Technically, the $1.12 level corresponds to a key retracement of the euro's 2017 rally. Although I argue that renewed divergence will allow the dollar to resume its rally, with the prospects of a potentially very weak Q1 GDP, and the FOMC meeting in a fortnight, I lean against a sustained break now.