ECB Meeting Promises Fireworks

Fasten your seat belts.  The ride is going to get bumpy.   Economists may differ on what the ECB will do.   Investors may differ on the market response.  This uncertainty ensures a strong market reaction.

The euro is off about 0.25% after recovering in the North American session yesterday.  The euro has spent this week thus far mostly within last Friday's trading range.  It has finished the North American session in the last four sessions between $1.0999 and $1.1014 according to Bloomberg.

The other major currencies are little changed.  The Canadian dollar is consolidating yesterday's strong gain.  The New Zealand dollar has steadied after extending the RBNZ-inspired decline.

Asian equities were mixed, leaving the MSCI Asia-Pacific Index little changed.  Japan, Korea (rates were left unchanged at the central bank meeting), Taiwan and Malaysia saw equity gains, while the rest of the region, including China, slipped lower.

China's inflation data stands out in the relatively light news session.  Consumer prices rose 2.3% in February.  The 7.3% surge in food prices may be linked to the Lunar New Year.   Non-food goods and services prices eased.    Producer prices fell 4.9% year-over-year, compared with a negative 5.3% pace in January.  Producer prices have been falling for a full four years.  Separately, Japan reported its February producer prices fell 3.4% in February.  The recent negative reading began last April, which was the outright decline since March 2013.

The ECB is center stage.  The larger context of the meeting is the political leadership vacuum with Merkel exhausting much of her political capital on the refugee challenge.  There are also growing doubts among investors of the efficacy of negative interest rates and QE itself.   The scar tissue from the December disappointment is still fresh.

The economic backdrop is one of renewed deflation, fragile and uneven growth (though Germany and France have reported stronger than expected January industrial output figures).   As Draghi noted previously, fiscal policy may be marginally relaxed due to refugee-related spending.

There are several moving parts in the ECB's unorthodox stance.  To the extent, there is an agreement among economists it is that the cuts in the staff forecasts for inflation and growth will allow the ECB to cut the deposit rate another 10 bp to minus 40.  There are some who think that to get ahead of the curve of expectations the ECB will cut 15-20 bp.  The OIS market shows rates bottoming near minus 50.

There is also anticipation of a tiered system so to mitigate the pressure on banks.  Note that last year, net interest revenue actually rose for banks, according to Bloomberg, as lending volumes offset the lower price.

There is also a loose consensus that the ECB will increase the pace of its purchases.  Most expect a 10 bln euro increase (to 70 bln euros a month).  Some look for a larger 15-20 bln increase.  There is some thought to suspend the capital key as the determining element but is highly contentious.  If it is announced, it would be supportive of peripheral markets.

There are also some economists that look for a new asset class to be included, like corporate bonds or senior tranches of systemically important banks.  Most do not expect the duration of the asset purchases to be extended beyond the current March 2017.  Lastly, there is some speculation of a new long-term repo operation.

The more aggressive the ECB is the better for the peripheral assets.  The one exception is Portugal.   DBRS is the last of the rating agencies that recognize Portugal as investment grade.  It reviews it at the end of next month.  If DBRS joins the others and cuts Portuguese sovereign rating, the government bonds would no longer qualify for purchases under QE. 

Denmark is the most likely to respond to the ECB's action.  The Swiss National Bank meets next week.  One of the implications of negative rates in Europe (and Japan) is that it makes US yields more attractive.  This is one of the considerations behind our contention the long-end of the US curve may not be pulled higher by Fed tightening.  This is a return of the so-called Greenspan Conundrum.

The euro fell from $1.1375 on February 11 to $1.0825 last week.  The $1.08 area remains important support.  On the upside, we draw your attention to the $1.1060-$1.1070 area.  If disappointment with the ECB today pushes the euro through there,  we suspect the single currency would have legs toward $1.1300.