ECB Preview

The ECB meets Thursday and is widely expected to stand pat until the next meeting. Macro forecasts won’t be updated until the December 10 meeting, but the bank will have to acknowledge the deteriorating outlook now. There’s a small risk of more jawboning against the stronger euro, but it should otherwise be an uneventful meeting. We expect the ECB to increase QE in December but another rate cut seems very unlikely, as does activation of OMT.

POSSIBLE NEXT STEPS

  1. Jawbone the euro weaker – POSSIBLE NOW, POSSIBLE IN DECEMBER. Madame Lagarde downplayed concerns about the strong euro at her September 10 press conference, only to be immediately corrected by several of her senior colleagues, including Chief Economist Lane. While the ECB professes not to target the exchange rate, that never prevented Trichet or Draghi from making comments that worked to weaken the euro. Of course, without any underlying shift in relative monetary policy stances or economic fundamentals, jawboning typically has limited impact. In any case, Madame Lagarde has started to incorporate the exchange rate into her official commentary since the last meeting and she will surely get lots of questions about the euro this time around. That said, the euro has traded sideways since the September meeting and has yet to test that month’s cycle high near $1.2010. As such, there is likely to be a bit less urgency about the euro this time around.
  2. Tweak macro forecasts – VERY LIKELY IN DECEMBER. The ECB updated its forecasts at the September 10 meeting, with baseline forecasts for 2020 and 2021 GDP revised to -8.0% and +5.0% from -8.7% and +5.2% in June, respectively. Baseline forecasts for 2020 and 2021 inflation were revised to 0.3% and 1.0% from 0.3% and 0.8% in June, respectively. Even though official forecasts won’t be changed this week, we think the ECB will signal downside risks to the economy and inflation are building followed by changes to the official forecasts in December. September headline inflation came in at -0.3% y/y and core at 0.2% y/y. October data will be reported this Friday and both readings are expected to remain steady.
  3. Further increase and extend Quantitative Easing (QE) – UNLIKELY NOW, LIKELY IN DECEMBER. The ECB increased its PEPP at the June 4 meeting by EUR600 bln to EUR1.35 trln, slightly more than the expected EUR500 bln. In addition, PEPP was extended beyond this December until at least June 2021. The ECB’s balance sheet stood around EUR6.7 trln ($8.0 trln) in mid-October, up from EUR4.7 trln ($5.17 trln) at the beginning of this year. This 45% increase pales in comparison to the 72% increase in the Fed’s balance sheet this year.
  4. Tweak Pandemic Emergency Longer-Term Refinancing Operations (PELTROs) or Targeted Longer-Term Refinancing Operations (TLTROs) – UNLIKELY NOW, POSSIBLE IN DECEMBER. The ECB introduced PELTROs at the April 30 meeting and the take-up to the first one on May 20 was disappointing, coming at only EUR851 mln. However, due to more favorable rates, the take-up for the June 18 TLTRO was robust, with banks securing EUR1.3 trln of funding for three years. The take-up at the most recent September 24 TLTRO was considerably lower at only EUE174.5 bln. As evidenced by the current -0.553% for the Euro Short-Term Rate (ESTR), the eurozone is awash in liquidity and so further measures to boost it seem unnecessary now. Eurozone September M3 accelerated to 10.4% y/y vs. 9.6% expected and 9.5% in August. This is the fastest rate since April 2008 and reflects both aggressive ECB balance sheet expansion and liquidity provisioning via TLTROs and PELTROs. On the other hand, the ECB said that European banks tightened lending standards in Q3 and expect further tightening in Q4. This will blunt the central bank’s stimulus efforts.
  5. Cut rates – VERY UNLIKELY NOW, VERY UNLIKELY IN DECEMBER. While the bank has left the door open to take rates more negative, it’s clearly reluctant to do so due to the potential for doing further harm to the banking sector. Many at the ECB (as well as the BOJ and SNB, it would seem) question the efficacy of negative rates and whether the costs of going more negative outweigh the benefits. WIRP suggests nearly 60% odds of another cut by April 2021. If it eventually does cut, however, we expect the ECB will increase the so-called “tiering” that allows banks to avoid some of the increased interest charges on their deposits at the ECB.

 

INVESTMENT OUTLOOK

Our long-standing bearish dollar call remains in place. The fundamental story is still negative, with an ultra-dovish Fed, a faltering US economy due to the pandemic, and the risk of a very large fiscal stimulus package after the elections. Once this current bout of risk aversion settles down, we expect the weak dollar trend to resume, eventually leading to a clean break above the $1.2010 cycle high from September 1. After that, there really aren’t any significant targets until the April 2018 high near $1.24, followed by the February 2018 high near $1.2555. With the rising virus count leading to increased restrictions across Europe, the pace of euro gains is likely to be much slower than it was over the summer. However, the fact that Europe succeeded in crushing the curve in the past gives us hope that it will do so again. Here in the US, we are already seeing a third peak in infections that so far shows no signs of abating. Pardon us for sounding grim, but investors will ultimately be trading virus-differentials.

Our dollar-negative view seems impervious to the US election outcome, at least over the short-term horizon. There are two scenarios that would likely lead to fiscal expansion. Biden plus a Democratic Senate would most likely lead to very aggressive stimulus, which we think will be dollar-negative given the greater twin deficits and accelerated Fed balance sheet expansion needed to mop up record UST issuance to prevent a spike in long-dated yields. Trump plus a Republican Senate would likely deliver fiscal stimulus but on a smaller scale. This would also be dollar-negative over the short-term, but both would set the table for a dollar recovery if the US can start to outperform again. The last potential outcome of a split government (Biden plus a Republican Senate or Trump plus a Democratic Senate) would likely lead to gridlock and forced austerity, translating into a weaker dollar though a worse growth outlook (perhaps after a knee-jerk risk-aversion dollar rally).

Euro positioning is not as overextended as it’s been in the past. The latest CFTC data shows net euro longs for non-commercial accounts stand at 166k contracts for the week ended October 20, down slightly from 169k the previous week and well below the record high of 212k from late August. As a result, we believe further euro gains won’t be as tough from a positioning standpoint.

Since July 1, the euro has gained about 5.5% vs. the dollar, 2% vs. the yen, and is basically flat against sterling.  All three currency pairs have traded largely sideways since the September 10 ECB meeting. Overall, the moves have been neither excessive nor “brutal” but eurozone policymakers will remain vigilant. Draghi often pushed back at euro strength during his tenure, let’s see how Lagarde approaches it going forward. A significantly stronger euro is the last thing the eurozone needs as it flirts with deflation again. However, it is often more about the pace than the level and so recent price action would seem to warrant limited concern.

Looking at various asset classes, the behavior on ECB meeting days this year has been mixed. So far in 2020, the euro has weakened on 4 of the 7 decision days. However, it has strengthened on 3 of the past four. STOXX Europe 600 has fallen on all 7 ECB decision days so far, while STOXX Banks has mirrored the euro and fallen on 4 and risen 3. Both MSCI EM and MSCI EM FX have fallen on 5 of the 7 decision days, suggesting that risk assets typically perform poorly on those days.