ECB Preview

The ECB meets Thursday and is widely expected to add stimulus. Macro forecasts will be updated and the bank will likely acknowledge the deteriorating outlook. We expect the ECB to increase PEPP by at least EUR500 bln and we see a high chance of an upside surprise. A rate cut is very unlikely but there’s risk of more jawboning against the stronger euro.

POSSIBLE NEXT STEPS

  1. Further increase and extend Quantitative Easing (QE) – VERY LIKELY NOW, POSSIBLE IN 2021. We look for an increase in the PEPP of at least EUR500 bln, but we think there is a high chance of an upside surprise, in part because of the euro’s recent strength. Given the building downside risks, why shouldn’t the ECB go big now? The window to deliver a decisive dovish move is narrowing as the vaccine approaches. The ECB last increased PEPP at the June 4 meeting by EUR600 bln to EUR1.35 trln, slightly more than the expected EUR500 bln. In addition, PEPP should be extended again, this time through at least end-2021 and perhaps even to June 2022 from June 2021 currently. After this slug of stimulus, we assume the ECB will move back to wait and see mode to see how 2021 develops.
  2. Tweak Pandemic Emergency Longer-Term Refinancing Operations (PELTROs) or Targeted Longer-Term Refinancing Operations (TLTROs) – VERY LIKELY NOW, POSSIBLE IN 2021. 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. With liquidity remaining plentiful, the take-up at the most recent September 24 TLTRO was considerably lower at only EUE174.5 bln. As such, the ECB may need to sweeten the terms once again to keep the liquidity flowing. Indeed, the ECB reported that European banks tightened lending standards in Q3 and expect further tightening in Q4. This will blunt the central bank’s stimulus efforts and so for now, the taps will be kept open.
  3. Jawbone the euro weaker – VERY LIKELY NOW, POSSIBLE IN 2021. We’ve always felt that the ECB is more concerned about the pace of euro gains than any particular level. From July 1 to September 1, the euro gained 7% and that got the ECB’s attention at the September 10 meeting. Up until last week, the pace was pretty restrained but recent price action suggest the move is starting to snowball. Since just early November, the euro is up nearly 5%. While we think this will lead to more pushback from the ECB this week, there’s really not much it can do about the exchange rate. Without any underlying shift in relative monetary policy stances or economic fundamentals, jawboning typically has limited impact. In any case, Madame Lagarde has incorporated the exchange rate into her official commentary since the September meeting and she will surely get lots of questions about the euro given its recent strength.
  4. Tweak macro forecasts – LIKELY NOW, POSSIBLE IN 2021. The ECB updated its forecasts at the September 10 meeting, with baseline forecasts for 2020, 2021, and 2022 GDP revised to -8.0%, 5.0%, and 3.2% from -8.7%, 5.2%, and 3.3% in June, respectively. Baseline forecasts for 2020, 2021, and 2022 inflation were revised to 0.3%, 1.0%, and 1.3% from 0.3%, 0.8%, and 1.3% in June, respectively. The ECB will add 2023 to the forecast horizon in this week’s forecasts and we think the bank is likely to signal ongoing downside risks to the economy and inflation. Headline inflation has come in at -0.3% y/y for three straight months through November and calls into question the 2021 forecast of 1.0%. Will the ECB forecast further progress in meeting the 2% target in 2023? Stay tuned.
  5. Cut rates – VERY UNLIKELY NOW, VERY UNLIKELY IN 2021. 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 25% odds of cut this week, rising to nearly 60% by April 2021. We think this overstates the case for cutting but if it eventually does cut, 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 as the US economy falters due to the pandemic and the lack of fiscal stimulus. On the other hand, eurozone ZEW expectations rose to 54.4 in December from 32.8 in November. What could be driving this? Simply put, it appears that targeted lockdowns in Europe have been working and virus infections have been falling across Europe since the mid-November peak. While there is a long hard winter ahead for the world, Europe has shown once again that when push comes to shove, it can bend the curve. We have yet to do that here in the US as our third wave shows no sign of peaking yet. In a nutshell, this is why we think the dollar continues to underperform. The ultra-dovish Fed and likelihood of further fiscal stimulus are short-term negatives for the dollar but are medium-term positives once the virus has been controlled here.

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 139.9k contracts for the week ended December 1, 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. That said, it’s hard to find anyone not bearish on the dollar out there.

Since July 1, the euro has gained over 7% vs. the dollar, 4% vs. the yen, and 1% against sterling.  These moves are neither excessive nor “brutal” but eurozone policymakers will remain vigilant. Both Trichet and Draghi pushed back at euro strength during their tenures, so let’s see how Lagarde approaches it if gains continue to accelerate. 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 only limited concern. The ECB will be much more concerned about delays to the EU budget and recovery fund, in our view.

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 5 of the 8 decision days. STOXX Europe 600 has fallen on all 8 ECB decision days so far, while STOXX Banks has mirrored the euro and fallen on 5 and risen 3. Both MSCI EM and MSCI EM FX have fallen on 6 of the 8 decision days, suggesting that risk assets typically perform poorly on those days.