ECB’s Draghi Cannot Afford to Lose Street Cred This Week

Rate divergence is a major trading theme for 2015. Yet no one expected the imminent impact of varying rate policies so early in the new calendar year. For months the market has been focusing on the Federal Reserve or the Bank of England to hike interest rates, but both banks have pushed the timing to do so further out the curve. Now there’s a real possibility that the European Central Bank (ECB) will introduce its own quantitative easing (QE) policy. In light of these events, investors have to broaden their horizons to include Tier II central bank policies, the proactive measure undertaken by the Swiss National Bank (SNB) last week, and the impacts that the Swiss action may have on other national central banks in the euro region. Currently, Scandinavian banks are joining the Danish government in trying to persuade offshore investors that the Nordic countries will not copy the Swiss and drop their euro pegs — the diverging rate storyline has gotten far more interesting.

Markets Await ECB Decision on QE

The next five trading sessions will be dominated by central banks, as various governors, presidents, and policymakers remain front and center throughout the week. While the Banks of Japan and Canada take the lead in the first half of the week, investors will be focusing intently on President Mario Draghi and the ECB on January 22, when the possible introduction of a sovereign debt-buying program tops the bank’s agenda.

Although the consensus is for ECB interest rates to remain unchanged, the market has been pricing for expectations that it will extend its program of asset purchases to include sovereign as well as corporate bonds. Let’s hope so, especially after the SNB’s costly action that did away with the CHF currency cap last week. It was a non-transparent policy move, and the repercussions will be felt for many months to come. The surprise Swiss decision indicates that investors cannot afford to be complacent with central bank rate decision announcements any more.

SNB’s Damage Control Ongoing

Investors were sideswiped not once, but twice last Thursday when a number of central banks altered their policies. The Reserve Bank of India (RBI) eased monetary policy by -25bps to +7.75% just two weeks before its regularly scheduled meeting, and has set off expectations of more cuts to come. At the same time, the SNB removed the three-and-a half-year-old currency cap of €1.2000. President Thomas Jordan’s actions (an about-turn from all the public rhetoric) shocked markets and it had a massive global impact. Swiss officials have been in damage control ever since, but they expect markets to stabilize, adding the cap on the franc was no longer justified as the Swiss economy was improving. Jordan also said the “exchange-rate situation will remain under consideration in future decisions, and the minimum rate risked loss of monetary conditions through an inflated balance sheet.” Can anyone safely decipher this cryptic message?

The SNB undertaking was an historic outcome and move, which both dealers and investors will be tallying for weeks to come. The lack of transparency by the SNB’s decision has unnerved investors and possibly changed the central bank rules for the lesser knowns. The SNB has lost much street credibility and its actions still raise the possibility of future unanticipated moves by other central banks.

Draghi to Follow through on His Pledge

The ECB faces a crucial test of its resolve to do “whatever it takes” to preserve the EUR when it decides this week on buying government bonds to combat deflation and revive the economy. Last week, the European Court of Justice smoothed the way for QE, but opposition from Germany’s Bundesbank, German politicians, and the German public may yet derail the ECB’s best intentions. At issue is how the program is designed and whether it is seen as credible and sufficient?

The QE announcement is expected following Thursday’s meeting, supported by German policy members (optics), as well as dovish ECB members. This market requires at least the perception of consensus. Compromises will be made behind closed doors — the details of which the markets will never be privy to.

The announcement is not expected be an open-ended QE, but at least €500B. Do not be surprised to see Draghi use the post-meeting press conference to talk about the size and whether it’s fixed — a good politician will talk up an open-ended solution. There is a possibility that the ECB might go for a mix with the program containing corporate and government bonds. On Thursday all will be known.

How will the market react? No matter what, everyone should be expecting plenty of market volatility, with the risk that the market has “bought the rumor and will now want to sell the fact.” Follow Bund yields as they may experience a major correction just like the Fed and BoE announcements did to their sovereign debts. If at current levels, the single unit (€1.1598) looks oversold outright, a crowded and tired trade. Nevertheless, there is the risk that the downside could still support the pace for further EUR weakness, down to the revised technical levels just ahead of €1.1000.

Investors will not be able to rest on their laurels for long. A Greek election in six days is threatening to hand a share of power to a party wanting to renegotiate the “austerity measures” on which the nation’s bailout is based. The political voting outcome will have a direct impact on other peripheral eurozone countries like Portugal and Spain, potentially reviving the talk of a euro exit there, too.

Will China Come in from the Cold?

Europe is not the only region in investors’ crosshairs. Asia will be required to brace for more volatility this week as the world’s second-largest economy, China, releases a string of monthly indicators, alongside keenly anticipated central bank policy decisions in Japan. China is due to release a plethora of data tomorrow, including retail sales, fixed-asset investment, and industrial output data for the month of December. But the focus will fall on the country’s fourth-quarter gross domestic product details. Analysts expect Chinese fourth-quarter economic growth to have slowed to +7.2%, year-over-year (+7.3%), which would be the slowest reading since the first quarter five years ago. On Wednesday, it’s the Bank of Japan’s turn to face the music. No disrespect to Governor Haruhiko Kuroda, but most of the market will be focused on Draghi and his press conference.

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