It’s no surprise to see tight trading in capital markets ahead of this week’s main events – the European Central Bank’s (ECB) supposedly telegraphed solution to the eurozone’s low inflation problem, and the U.S.’s most influential economic release, the monthly nonfarm payroll (NFP) report.
A move is expected by the ECB tomorrow at its scheduled rate-setting meeting, but how aggressive it will be is anyone’s guess. Euro policymakers have a decent track record in disappointing the market, making it a market prerequisite to consistently price in that possibility as well. No matter what, the ECB Governing Council are required to be firm, and bank officials must walk away giving the market a perception that they are not done; that any interest-rate cut this week will not necessarily be the final one. Otherwise, and very quickly, the ECB will lose a fair bit of street credibility. Thus far, the market’s assumption is that ECB chief Mario Draghi will probably reiterate his commitment to keeping borrowing costs at present or lower levels. And though the May NFP is expected to be less spectacular than last month’s tally, most economists expect solid returns. That could easily muddy the waters for the ECB’s policymakers.
The ECB’s Limited Options
The ECB is battling a prolonged period of low inflation that threatens to derail the euro area’s promising economic recovery. So far, the ECB has held out the possibility of a package of measures that could also include liquidity injections conditional on increased credit supply to small- to midsized enterprises (SME). Currently, it’s wagered that euro policymakers are debating a cut of -10 or -15 basis points in both the benchmark and deposit rates. However, “unconventional problems do not necessarily have an unconventional solution.” Not many have tabled an established solution, like forex intervention to the euro’s problem of low inflation. Making use of the “traditional” intervention technique would be far more direct in tackling the euro’s worries of deflation or low inflation without the potential complications of negative deposit rates (first time). According to the fixed-income traders, negative rates will only provide a short-term solution.
The EUR’s contained range, especially after yesterday’s weak price data supporting an ECB move, would suggest that the market’s speculators, who have toyed with short-EUR trades, have not committed to large positions. Otherwise, we would have witnessed more intraday volatility. A market that is not very short cannot be squeezed too far. The ECB has the uncanny ability to disappoint markets and a repeat on Thursday cannot be ruled out, thus a minimal move is a possibility. Cuts to the refinancing and deposit rates are already priced in – the Euribor, the Eonia curve, and EUR are little changed. But, if the single currency happens to rally, it will not take much to unwind the “net” short positions. The most pain would be felt if Draghi and company disappoint and leave the door open for a depo-rate cut later in the year. The market would aggressively selloff in Euribor and the Eonia curve and buy EURs.
High Stakes for Draghi
It’s all down to Draghi’s press coverage and his tone during the post-meeting grilling – will he be able to push the EUR that much lower? Or will it be time to book some profit from the remaining short-EUR positions against most Group of Seven trades? Draghi will be required to describe the rationale behind the supposed rate moves. Investors will want to know if ECB policymakers will support credit via another Long-Term Refinancing Operation (LTRO) program. The market has been speculating that the ECB would borrow the Bank of England’s funding-for-lending scheme to support credit. A supposed four-year LTRO of around €40B has been suggested and would be used for SME lending. If so, and for this to work more effectively than the first LTRO program, banks must be “made” to lend credit, rather than have the opportunity to enter numerous “carry” trades. What about quantitative easing (QE)? It’s most likely a non-starter due to the fact that the euro asset-backed securities (ABS) and corporate markets are currently too small and illiquid to make much of a difference. However, Draghi may make a commitment to revive the ABS market and this will be seen as a precursor to QE further down the line.
Panic Selling May Ensue
Be prepared to see some of the nervous short-EURs lighten their positions ahead of Thursday’s rate decision. A EUR break below €1.3560 will provide the market’s next bearish trigger (€1.3475). But, does the EUR have the momentum? Resistance now appears topside at the 200-DMA at €1.3645. Even today’s disappointing eurozone purchasing managers’ index services data (53.2) has caused minimal market reaction. With European business activity having slowed more sharply in May than first estimated, it is seen as a sign that weak prices were undermining the area’s recovery from its debt crisis. The ECB cannot afford to mess about tomorrow. Currently, the EUR/USD remains just above its three-month low registered last week (€1.3584), and with Federal Reserve tapering added to anything the ECB does, it should strengthen the “sell-EUR!” rally cry.
EUR: Sell The Mystery, Buy The History