The ECB meets tomorrow. Few, if any, are expecting fresh
action. The economy has progressed broadly along
the lines that ECB anticipated. Growth is stable near trend levels.
While deflationary pressures have eased, price increases remain minimal. At
0.4% year-over-year, eurozone CPI, officials cannot be content with the
progress.
Moreover, the latest bank lending survey was disappointing. Credit
conditions have weakened for the third consecutive quarter. The Composite
Index fell to 12.67 in Q3 from 12.75 in Q2 and off from the 16.4 high in Q2
15. Despite the access to cheap funds via TLTRO II, bank lending to
households has slowed from earlier in the year. The growth of loans non-financial businesses also appears to have
lost some momentum recently.
If the ECB did not seize upon the window of opportunity last month to
provide more support, it most likely would not
do so now. The most likely scenario is that while Draghi may lay some
groundwork, any fresh action will likely wait until December when the staff
forecasts are updated.
What is difficult for many investors to come to grips with is that Draghi
and many other ECB officials, even if not all of them, support the combination
of orthodox and unconventional policies, and regard them as effective.
That is an important recognition. It means that ideas that the ECB will
call an end to its efforts because they are ineffective are probably a non-starter from an intellectual and investment
perspective. The issue is not really whether the ECB runs to
the exit, but rather what it does next. The lens is not what it ought to
do, but what it is likely to do.
Although the talk of tapering ran through the market like pink eye in a
grammar school, few truly think that is a realistic scenario now.
A Bloomberg survey found 97% of the (50) economists surveyed expected the asset
purchases to be extended beyond the soft
March 2017 end date. Nearly as many (90%) expect the announcement at the
December 8 ECB meeting.
Almost three-quarters of the Bloomberg survey expect the ECB to soften
its self-imposed rules to ease the potential securities shortage by increased
the issue and issuer limits. This
raises questions. If the former limits reflected prudent risk
management, what does the dilution of those safeguards mean? How will
more concentrated purchases impact the transmission mechanism?
The prohibition against buying securities that have a lower yield than
the ECB’s minus 40 basis points makes sense. However, given
the size and duration of the purchases, it also would make sense to maintain
that floor not for individual securities but for
the average purchase. This too eases the potential shortage of securities. Also, it would preserve the sanctity of the
capital key
To be sure, these decisions are for December,
not tomorrow. Tomorrow, Draghi can lay the groundwork by saying three
things. First, he will likely anchor discussions of the trajectory of
policy to inflation and the legal need to work toward its mandate.
Second, Draghi will likely emphasize the ECB’s flexibility and the numerous
tools it within that mandate. Thirds, he will likely stress that there
are no technical constraints that cannot be
overcome.
In December, we expect the ECB to extend asset purchases for another six months and suspect that it may begin slowing
its purchases (tapering ) in H2 17. There seems to be little
appetite to take the deposit rate into the deeper
negative territory.
Another consideration that seems to be noticeable by its absence in
discussions about the ECB’s course is the tightening bias that has emerged
through the exchange rate since the end of H1. From the UK referendum
through last week, the euro appreciated 5% on a broad trade-weighted
basis. This is roughly tantamount
to 50-75 bp of tightening. The euro has pulled back over
the past week, but it remains near levels not seen since
early-2015. In some ways, the more sterling depreciates, the more that the euro needs to
weaken against the dollar to cushion the impact.
The euro has fallen nearly 2.4% against the dollar this month after
rising 0.7% last month. It has risen 2.8% against sterling. The
euro has risen by more than 12% against sterling since the UK referendum, and October may be the fifth
consecutive month of appreciation. The last such streak was from
August 2012 through February 2013 when the euro’s appreciated for seven
consecutive months.
The euro’s uptrend against the US dollar off the January lows (and through
the June and July lows) was violated in
the middle of last week near $1.1040. That area now serves as
resistance. Today the euro eased to its lowest level since the late-July
low near $1.0950. The spike low in the immediate response to the UK referendum
results was nearer $1.0915. A break of that could spur a move toward
$1.0800-$1.0820.
Incidentally, IF the euro goes to $1.08 and recovers to GBP0.9000, that puts cable at $1.20. If my
longer-term view of the euro is accurate (return toward record lows), as big as
that if may be, it would likely put cable below $1.00.