Draghi’s Day to Deliver


  • There are four moving parts for what the ECB can do today: the deposit rate, duration of the program, pace of purchase, and a change in the composition of purchase
  • We anticipate corrective upside pressures on the euro to be held in check by the anticipation of a US employment report
  • A lot has happened in the last couple of days for Brazil, we summaries the main developments

Price action:   The dollar is mixed in narrow ranges. The euro is trading at $1.0560 and the pound at $1.4930. The Australian and New Zealand dollars are outperforming, up marginally, along with the Canadian dollar. The dollar is at ¥123.50 against the yen. In the EM space, RUB is underperforming along with IDR, while TRY and MEX are outperforming, though moves have generally been modest. Most EM Asian indices closed lower but the Shanghai Comp was 1.3% higher, up every session this week so far. The Nikkei was flat. EuroStoxx is up 0.6% ahead of today’s crucial ECB meeting and US are up 0.5%. Oil futures are up about 2.0% following sharp losses yesterday.

  • The much anticipated ECB meeting is at hand.   Yesterday’s disappointing eurozone CPI figures only fanned the anticipation.  Today the service PMI was softer than expected at 54.2, down from 54.6. What will Draghi do?  There are four moving parts.
  • The first is the deposit rate, which currently stands at -20 bp.  When first adopted in September 2014, that rate was said to have exhausted the scope for interest rate policy.  Of course, we know factually it is not because other countries, like Switzerland and Sweden, have gone further.  Negative interest rates are a new development, and no one knows how far they can go.   Ironically a cut in the deposit rate now seems among the less contentious things that the ECB will likely do.  At least a 10 bp cut is expected, and the market may be disappointed with less than 15 bp.   There is some talk of a tiered system that links the bank’s deposits with the deposit rate.
  • A second element is the duration of the program.  It also does not appear particularly contentious.  The September 2016 end-date was always soft and conditional on the proximity to the inflation target.   The staff’s forecast for inflation appears to require more than a three-month extension.  The market may be disappointed with less than a six-month extension.
  • A third element is the pace of purchases. It is currently at 60 bln euros a month.  Some acceleration from here is likely though it is more contentious.   Most participants appear to expect a 15-20 bln euro increase.  This would have the ECB buying more bonds over a longer period.  Under the current dimensions, the ECB would buy 540 bln euros of assets in the first nine months.  Under the revisions, assuming 75 bln a month for the entire year, it would buy 900 bln euros of assets.
  • The fourth dimension of ECB policy that can be changed is that assets it is buying.  Currently, bonds yielding less than the deposit rate are not included in the asset purchases.  The anticipation of ECB easing has seen more instruments trade below the minus 20 bp deposit rate.  This is a self-imposed rule that the ECB can suspend or modify.  It can also include more assets into the program. There have been suggestions of sub-sovereign (e.g. local and state) bonds.  There has also been some talk of increasing the state-owned entities, including agencies.  Moving too far from sovereign credits may also be controversial.  It is harder to quantify what has been discounted here.
  • Arguably, for many investors, how the markets respond may be more immediately important than precisely what the ECB does.   The euro has been stuck in its trough, mostly straddling the $1.06 level.  The sideways activity in recent days has not alleviated the technically over-extended condition, and there are some minor (bullish) divergences.    The price action recently suggests that some short-term momentum traders have been quick to take profits on the substantial short positions that have been established since mid-October when the euro slips to even marginal new lows.  We expect that pattern to continue.
  • At the same time, we anticipate corrective upside pressures on the euro to be held in check by the anticipation of a US employment report.  Following the ADP estimate yesterday, the risk of a significant downside surprise has lessened, and Yellen’s comments suggest confidence in the underlying economy even though the Atlanta Fed’s GDP tracker has been cut to 1.4% for Q4.  We note that the premium the US pays on two-year borrowings is at new cyclical highs over Germany and Japan. The premium is less than a single basis point above the nine-year extreme against sterling set yesterday.  It is within half a basis point of the multi-year high against Canada recorded in August.
  • Market participants are broadly cognizant that interest rate hikes do not always trigger currency strength.  To be sure, every Fed tightening does not spur a dollar rally.  However, each of the previous two significant dollar rallies  (Reagan dollar rally, in the first half of the 1980s and the Clinton dollar rally in the second half of the 1990s) were preceded by Fed hikes, with an understandable even if not fully predictable lags.    Our contention is that we are in the middle of the third significant dollar rally.  This one is driven by policy divergence, and the duration of that divergence can be best measured in quarters not months.   Moreover, that divergence not peaked in duration nor magnitude.
  • While the ECB is the main game in town today, there are a few other developments to note.   First, the Caixin PMI readings for China suggest some stabilization of the economy may be taking place. The composite PMI for November stands at 50.5 from 49.9.   It is the first time since July above the 50 boom/bust level and it is the highest reading since June.  Since the yuan’s inclusion in the SDR was announced on Monday, the dollar has traded tightly against CNY6.40, having finished last week near CNY6.3945.  The offshore yuan is also little changed just below CNY6.45.  One implication is that the gap between the onshore and offshore yuan is relatively wide, leaving the market susceptible to direct or indirect official action.
  • Second, the third PMI is the charm for the UK.  Recall this week, the manufacturing and construction PMI readings disappointed.  Today the service sector generated a pleasant surprise.  It rose to 55.9 from 54.9.  The consensus was for a small tick up to 55.0. However, in the current context, it meant very little for sterling.  Sterling was pounded yesterday, closing below $1.50 for the first time since last April.  In fact, it also briefly traded below $1.49 yesterday.  Today it is bouncing along yesterday’s trough and has largely been confined to about a half cent above $1.49.   Perhaps what is helping sterling steady today is purchases of it against the euro.  The euro was squeezed above GBP0.7100 yesterday, and this provided an opportunity for some operators to sell it at its best level in three weeks.
  • Third, we note that the dollar-bloc currencies remain resilient.  The Australian dollar  is back above $0.7300 after dipping to $0.7285 in Asia earlier today.  Iron ore prices have continued to fall.  Nevertheless, there is potential for the Aussie to push toward $0.7375-$0.7400.  The Canadian dollar was resilient in its own right to the brief drop in oil belwo $40 a barrel yesterday.  The sideways movement of the US dollar against the Canadian dollar pushed it briefly below the 20-day moving average (~CAD1.3320) for the first time in a month.
  • A lot has happened in the last couple of days for Brazil. (1) Congress approved the lower fiscal target for 2015 of R$119.9 bln, despite strong opposition. This is a positive development and a small step towards cleaning up the fiscal mess, as well as preventing a cut of funding to some government services. Markets reacted positively to this yesterday. (2) The speaker of the lower house, Eduardo Cunha, accepted the impeachment process, taking the route of accusing the president of violating fiscal rules in the 2015 budget. The process now goes to a sub-committee in the lower house then to the floor for a vote, where it needs two-thirds of support in order to move the process to the senate. (3) This was a retaliation following the decision of the ruling party PT to vote against Cunha in Ethics subcommittee following corruption allegations. The final vote will be on December 8, and it should go against him. Possibly, Cunha’s new strategy to avoid charges is to barging with the opposition by offering a hard push towards the impeachment process in exchange for their political support in defending him.  This will be a turbulent end of the year for Brazil with a lot at stake amid hard to predict variables. All we can say at this point is to expect higher volatility.