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ECB Preview: What Wall Street Thinks Mario Draghi Will Say Tomorrow

In many ways, the task facing the ECB’s Mario Draghi is the most daunting of all central bankers. On one hand, the ECB head has to keep financial conditions as loose as possible to stimulate the lethargic credit pathways in Europe, on the other European banks and insurance companies have been the most severely impacted by the ECB’s Negative interest rate policy. Which is why some have suggested that pursuing a BOJ-like policy of “curve manipulation”, where the 10Y is pegged at a certain level and allowing the curve to steepen while pushing short rates even lower may be the best approach for the central bank. However, due to the peculiarities of the joint European bond market, where political considerations make such an experiment particularly complicated complex, it is unlikely that the central bank will be able to mimic the BOJ’s exercise in progress.

Making matters worse for the ECB is the intertwined nature between depressed European bank equity prices and local lending. As Deutsche Bank suggestively cautioned earlier, “our view has been that, in what is predominantly a bank dominated market, lending standards (and then actual lending) could soon be hurt by the depressed nature of European bank equity prices as bank equity prices have led lending by 12 months since the Euro commenced (updated graph included in the piece). The tightening seen yesterday is still way below GFC levels but given recent equity trends it is a potential worry in the quarters ahead. Perhaps this is another sign to central banks that current monetary policy could hurt lending in so far as it hurts bank equity prices. It is not clear that the ECB has any inclination to change direction but it feels increasingly unlikely that they can ease further without causing collateral damage.”

As DB concludes, “the path of monetary policy is becoming more and more complicated.”

Still, Draghi has to say something, and as Bloomberg notes, the ECB meeting on Thursday may boil down to Draghi’s communication about asset purchases, with market watchers focusing on just one key aspect: any hint of QE tapering would spur a large scale sell-off in the rates market, according to most of the sellside strategists.

Here is what the prevailing consensus of what Draghi may and should say tomorrow looks like:

  • Rates markets are pricing a dovish outcome
  • Draghi will need to put the tapering discussion back in the box to avoid an adverse market reaction, according to BofAML
  • Any euro move triggered by ECB could be short-lived as the outlook for the currency remains linked to the market pricing of a Fed rate increase this year
  • ECB is expected to stay on hold this week for many reasons, including risk events such as U.S. elections and the constitutional referendum in Italy; staff economic forecasts will be released only in December
  • Outlook for any technical changes to QE such as issue limit and deposit rate floor for purchases as well as any indication of by how long the buying program would be extended, if at all, will be watched

Below is the full breakdown by bank of what Wall Street’s strategists believe will happen tomorrow:

BofAML (Gilles Moec, Athanasios Vamvakidis, Ralf Preusser)

  • Expects Draghi to sound dovish and reject talk of early tapering; central scenario sees ECB announcing in December that it will prolong QE until September 2017 at the current EU80b pace
  • EUR may weaken; still, the impact is unlikely to be sustained as a QE extension expected; sees EUR/USD below 1.1000 if Fed hikes rates and the ECB extends QE in Dec.
  • Draghi will need to put the tapering discussion back in the box to avoid an adverse market reaction in rates
  • The QE discussion seems to have moved on from tapering to technicalities; tweaking QE parameters reduces the risk of further bull flattening in core rates

RBS (Giles Gale, Ross Walker, Clement Mary-Dauphin)

  • Importance of meeting has increased as it will be a difficult communication exercise for the governing council while markets are betting on a volatile outcome
  • A communication mistake could spur a large sell-off in EUR rates, peripheral spreads widening and curves steepening; still, expect the magnitude of the move to be somewhat smaller than during the “bund tantrum”; sees ~50-70bps upside in 30y rates
  • If ECB sends a strong signal that QE is going to be extended, announces issue and issuer limit relaxations, reiterates its accommodative stance and addresses taper concerns, investors should expect lower rates, bull flattening and tighter peripheral spreads
  • Base-case scenario is for a nine-month extension with unchanged EU80b monthly pace and a relaxation of issue- issuer limits at December meeting

UBS (Reinhard Cluse, Nishay Patel)

  • Base-case scenario remains that ECB will announce a six- month extension of QE in December, with ongoing purchases of EU80b per month
  • Still, given the resilience in growth, the pick-up in inflation and concerns about the negative side effects of low interest rates and bond yields, believe a tapering decision in December shouldn’t be dismissed easily
  • Rates markets seem to be pricing in a fairly dovish outlook for ECB monetary policy and euro zone fundamentals, setting a high bar for the ECB to deliver a more dovish outcome than what is already priced in
  • If expectation regarding technical changes to the ECB’s QE program materializes (above all, higher issue limits for non-CAC bonds and scrapping the deposit rate floor in December), euro zone yield curve should steepen materially
  • Foresees German 10-year yields rising further and reaching 0.15% by year-end and 0.50% by end-2017

GOLDMAN SACHS (Dirk Schumacher)

  • Draghi will stress that the timeline for QE will be decided based on the inflation outlook, and that technical constraints will not stand in the way of an extension
  • Continue to expect the ECB to extend the QE at December meeting beyond March 2017 — at least initially– at the current volume of EU80b
  • While ECB may have arguments for why it may consider tapering the purchases, a large majority on the Governing Council probably still view the net effect of the ECB’s policy measure on growth and inflation as positive
  • Says there is probably a broad agreement among the Governing Council that there would be no sudden stop, but rather a gradual decline in the monthly volumes purchases, once it decides to end the QE

CITIGROUP (Harvinder Sian, Guillaume Menuet)

  • This week’s meeting has some asymmetric bear steepening risk as there may be some news on the technical PSPP shifts, which could remove long-end negative convexity support
  • Draghi may not be hawkish but he will probably also not be as dovish as the consensus expects when asked about taper risks; says it’s hard to see a bullish inference
  • Baseline scenario for this month is ECB announcing an increase in the issue/issuer limit from 33% to 50% and a relaxation of the rule that prohibits purchases of bonds with a yield below the deposit facility rate; this should be enough to address any scarcity concerns well beyond March: MORE

JPMORGAN (Greg Fuzesi, Mika Inkinen,Paul Meggyesi)

  • Doesn’t expect changes this week; decisions about extending QE and changing modalities are linked and will likely be taken together in December
  • Says ECB is almost 100% certain to extend QE beyond March, and sees only a 20% risk of a reduction in the pace to EU60b/month; as compromise with the hawks, expects the extension to be only for six months, rather than nine
  • Recommends paring back on bearish duration exposure; close shorts in 15Y Germany, and take profit on 3s/5s steepeners
  • Front-end swap spreads already price in ECB buying below the depo floor; fade the richness in Schatz swap spreads via Schatz/Bund OIS swap spread curve steepener
  • Take profits on short EUR/JPY straddles; ECB meeting could prove reasonably inconclusive about the ECB’s policy intentions and so partially reverse the recent downward pressure on EUR/USD

BARCLAYS (Cagdas Aksu, Huw Worthington)

  • Decision on QE extension or parameter changes will likely be on hold until December
  • If there are any announcements, they are more likely to be on technical parameter changes than the extension of the program
  • Base case is for QE to be extended at the December meeting by six-nine months beyond March 2017, seeing a reduction in size also possible at the March meeting next year
  • Stick with a portfolio of trades that have a term and credit premium increase bias in EGB peripheral curves and spreads; in core, continue to favor being long belly ASWs outright, as well as versus longer-end ASWs
  • Trades include long 10s/30s Ireland steepener, short 30y BTPs vs Germany, long 7y France ASW and short 5s/15s Finnish ASW box

NOMURA (analysts including Jordan Rochester)

  • Stronger indications of a QE extension would keep EUR/USD on its current depreciation path, while steepening curves with stable risk sentiment would also sustain the momentum of USD/JPY appreciation
  • If ECB communication further increases market concerns over near-term tapering, curves may steepen and risk sentiment deteriorate; this would challenge the recent trend of EUR/USD depreciation and USD/JPY appreciation, though not Nomura’s main scenario

DEUTSCHE BANK (Francis Yared):

  • ECB likely to wait until December before announcing the technical changes to QE, but Draghi may give some indications about the range of possible outcome
  • Maintain the same strategic bias toward a bear steepening of the curve; make tactical adjustments to portfolio to reflect current valuations and a slightly less favourable macro backdrop
  • In Europe, exit the Bobl-Buxl ASW spread; among other trades, maintain the 10s30s steepener which somewhat lags in the repricing of QE expectations

UNICREDIT (Marco Valli, Vasileios Gkionakis)

  • Sees upside risks for EUR as its underperformance suggests that some market participants may be gearing up for some sort of announcement at ECB meeting
  • It would be premature for the ECB to do so now, without updated economic projections
  • Central scenario remains that the ECB will announce a six-nine-month extension of QE beyond March 2017 in December

Source: Bloomberg