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. 
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.  
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.
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. 


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