Draghi Speaks, Euro Softens

Draghi escalated his rhetoric regarding future ECB action; recall that in his tenure, Draghi has more often than not surprised on the dovish side

A collateral development from the widening policy divergence has been a sharp increase in the demand for dollar funding, but this is probably not a sign of stress in the financial system

The PBOC announced a rate cut for its Standing Lending Facility (SLF) for local financial institutions across several maturities

Argentina holds the second round of its presidential election on Sunday

Mexico’s FX commission tweaked its intervention program slightly; Mexico reports Q3 GDP

Price action: The dollar is mostly firmer against the majors, but trading within narrow ranges. The Aussie and the yen are outperforming, while the euro and the Swiss franc are underperforming. The euro is trading back below $1.07 after Draghi’s dovish comments, while sterling is trading just below $1.53. Dollar/yen is trading flat around 122.80. EM currencies are mixed. MYR and IDR are outperforming, while RUB and RON are underperforming. MSCI Asia Pacific rose 0.4%, with the Nikkei up 0.1%. China markets were higher, with the Shanghai Composite up 0.4% and the Shenzen Composite up 1.3%. The Dow Jones Euro Stoxx 600 is up 0.1% near midday, while S&P futures are pointing to a slightly higher open. The 10-year UST yield is flat at 2.25%, while European bond markets are mixed. Commodity prices are mixed, with copper up around 1%.

 

The US dollar is rebounding today after yesterday’s correction. Those losses seemed to have been a function of some profit-taking after the seeming confirmation in the FOMC minutes that the Fed was set, barring a significant surprise, to raise rates next month. The dollar bulls were already beginning to buy the dip before Draghi spoke.

Draghi escalated his rhetoric regarding future ECB action. The market took Draghi’s comments as a signal that the ECB take aggressive action when it meets on December 3. The euro was sold back to yesterday’s lows (~$1.0660) before a bid was found. Draghi said the ECB will “do what it must” to lift inflation as quick as possible. He pushed back against ideas that with the core rate at a two-year high (1.1%), there was no need for such urgency. The central banks in Germany, Slovenia, and Estonia have argued against the need for new action. Draghi is still pushing forward. It is predicated on the staff cutting its growth and inflation forecasts.

In his tenure, Draghi has more often than not surprised the market with his dovishness. His comments today are important. Taken together, they suggest that Draghi is pushing the ECB toward broad based action. There are four moving parts: pace, duration, composition, and rates. What participants are contemplating now is not tweaking one or two of these, but all of them: Stepping up the pace of the purchases from the current 60 bln euros, to be extended beyond September 2016, including more agencies and possibly sub-sovereign instruments, and a cut in the deposit rate.

Draghi’s comment today that a lower deposit rate strengthens the transmission of the asset purchases is the strongest signal to date that this is on the table. Many people were looking for a 10 bp cut in the deposit rate, some 20 bp. However, with the German 2-year yield at record lows near -40 bp, to really get ahead of the curve, a larger cut would be needed. There is some speculation that the ECB may be considering a 50 bp cut. In this environment, it is difficult to envision a sustained euro bounce between now and early December.

An interesting collateral development from the widening policy divergence between major central banks has been a sharp increase in the demand for dollar funding. This shows up primarily in the widening of cross currency basis swaps, which measures relative interest rates of funding across currencies. The EUR/USD cross currency basis swaps rates are now back to levels not seen since 2012. The 3-month rate, for example, is at -45 bp compared with -20 bp for most of 2015 and between 0 to -10 bp for most of 2014. For comparison, during the 2011 crisis in Europe, the rate fell to nearly -160 and even more in 2008 as European banks faced a severe shortage of USD funding, which forced the Fed and ECB to step in with their swap agreement. Basis swap rates are widening for other currencies as well, always in favor of higher demand for dollar funding.

The reasons the widening of basis swaps now seem more prosaic, and not reflective of systemic risks. They probably have more to do with normal supply and demand factors of funds on the corporate side. For example, US companies have sharply increased their euro-denominated bond offers to a record EUR87.7 bln according to Bloomberg data, including the likes of Apple and McDonald’s taking advantage of the lower rates in Europe. Once they have the funds in euros, they can use cross currency basis swaps to re-denominate the cashflows into dollars, thus creating a demand for dollar funding. Another explanation is that European banks (and Japanese too) are growing their US loan books as they become more confident in the US economy, and for that they first need to get dollar funds.

The PBOC announced a rate cut for its Standing Lending Facility (SLF) for local financial institutions across several maturities. The SLF for overnight maturity was cut to 2.75% from 4.50% and the 7-day maturity to 3.25% from 5.50%. This seems to be more about liquidity and market functioning rather than economic stimulus. It could help, for example, the PBOC control the policy rate by strengthening the upper limit of rates. Seasonality also plays a role, as we approach the end of the year. Either way, the move can only help sentiment in China.

During the North American session, the only US data point is the Kansas City Fed manufacturing index. Fed speakers today include Bullard and Dudley. Canada reports September retail sales (0.1% m/m consensus) and October CPI (1.0% y/y consensus for headline, 2.0% y/y consensus for core).

Argentina holds the second round of its presidential election on Sunday. The most recent polls suggest that opposition candidate Mauricio Macri will prevail over ruling party candidate Daniel Scioli. Obviously, Macri is the market-friendly candidate, and Argentine bonds and equities have been rallying of late. However, we caution that polls were wrong in the first round vote on October 25, which tipped Scioli to win. And it’s not just Argentine polls; polls in the UK and Turkey were dead wrong this year, for instance.

Mexico reports Q3 GDP, and is expected to grow 2.4% y/y vs. 2.2% in Q2. The central bank sounded somewhat less hawkish in its minutes, with some board members wanting to wait until after seeing the impact of the Fed lift-off before deciding on a rate hike or now. We think that the bank will err on cautiousness, and the discussion about hiking rates before or just after the Fed seems premature to us. Inflation around 2.5% is at all-time lows, and there appears to be no pass-through from the weak peso.

Mexico’s FX commission tweaked its intervention program slightly. In extending the program to January 29, the central bank will continue its daily auctions of $200 mln at a set price of the 1% above the fix rate of the prior day. However, it suspended the auctions of $200 mln with no minimum price and replaced it with a second daily auction of up to $200 mln at a set rate of 1.5% above the fix rate of the prior day. The commission added that it “will continue to evaluate operating conditions in the foreign exchange market, in order to be able to adjust the cited mechanisms in the event that become necessary.” We don’t want to read too much into this, but the move seems to suggest a slightly less aggressive stance on intervention. Some speculate that falling foreign reserves are becoming a concern.