The Inside Story Why The ECB Decided "The Markets Needed To Be Disappointed" And How It All Fell Apart

On Wednesday morning, less than 24 hours before the historic, and grossly disappointing ECB announcement, one which sent the EUR soaring the most since the Fed's announcement of QE1, we warned that Mario Draghi may underdeliver, although in doing so he would face the risk of appearing quite weak before the ECB's governing council where in recent months the schism between European doves and hawks has grown to epic proportions.

As MNI noted, "Thursday's meeting will not only be key for the euro area's economic outlook but also decisive for the nature of Draghi's presidency as he starts the second half of his tenure. If he gets his way without sparking a revolt, it hard to conceive a situation in which Draghi won't prevail" to which we add that this is "correct, but the moment ECB decision-making devolves into a pissing contest, Europe has a big problem."

After all if Europe's monetary politics become nothing but a contest of egos, a tragic endgame is all but assured. We concluded by saying that "the question is whether Draghi will listen to logic and reason, or if he will continue his campaign to isolate the Hawks on the ECB governing council and in the process make Europe's monetary situation unfixable. If Draghi does relent, the EURUSD can soar as high as 1.09 tomorrow according to some estimates."

The next day not only was the warning of underdelivery prescient as Draghi did not prevail, but the EURUSD did soar as high as 1.09 as the ECB unveiled a "stunning" package which left Goldman's FX strategist reeling .

But just as we were almost ready to congratulate Draghi on "relenting" and acting rationally, we read a Reuters piece which explains that not only did Draghi not relent from his endless confrontation with the ECB governing council, he actually lost. This is what Reuters just reported:

One source with direct knowledge of the situation interpreted Draghi’s public stance ahead of the meeting as trying to pressure the Governing Council to take bigger action.


"Draghi raised expectations too high, on purpose, and attempted to paint the Governing Council into a corner," the source said. "This was problematic and he was criticized for this by several governors in private."

He failed, and in doing so may have emboldened the Weidmann-led hawks at the ECB whose opposition to Draghi's ultra-easy policies has been duly noted.

How did they win?

Reuters says that "unlike last year, when opponents of quantitative easing made their stance public before the decision, the hawks mostly worked behind the scenes. Opponents worked to curtail proposals coming out of the ECB’s committees that prepared the decisions, ensuring that some of the more radical measures expected by market players never made it onto the table."

The huge market disappointment took place following weeks of public statement by Draghi which convinced traders that the Italian would unleash something short of a neutron bomb, and as a result markets also expected a 25 percent increase in monthly asset purchases and possibly even a deeper rate cut. More radical options under discussion included the purchase of corporate debt or a split deposit rate that would punish banks parking too much cash with the central bank, sources told Reuters earlier.

None of that happened.

Reuters then explains that the smaller than expected move is seen by some as a disappointment for Draghi, who has established a track record for promising and delivering big, as he did with his July 2012 pledge to "do whatever it takes" to preserve the euro and pushing through bigger than expected QE earlier this year.

"Like the Fed earlier this year the ECB has now managed to confuse markets and the public. From now on, markets will treat hints dropped by ECB president Mario Draghi and some of his colleagues with much more scepticism than before," brokerage Berenberg said.

Here, however, is where the narrative breaks:

"the European Central Bank President and his chief economist Peter Praet stoked expectations with dovish speeches in the weeks before the meeting but the ECB’s Governing Council concluded that markets needed to be disappointed this time because the economic outlook has improved and new inflation forecasts were not as bad as feared, the sources said."

Now that, unfortunately, makes zero sense because as we reported, the very next day the US stock market had its biggest one day gain entirely due to Draghi appearance in New York, where he reassured the market that there is no need at all to be disappointed, when he said that "QE there to stay", could be "calibrated" if needed and the ECB can use "further tools" if needed as there is "no limit" to the "size of the ECB's balance sheet."

What happened next was a tremendous surge in the S&P which soared to pre-ECB drop levels, even as the EUR, which is at least in theory the monetary policy transmission mechanism did almost nothing.


Ironically, the market's first reaction was of course correct: yes, Draghi may have resumed his jawboning as the market breathed a sigh of relief, but what will actually happen if the Fed does hike on December 16 without a major increase in ECB liquidity, is that as much as $800 billion in liquidity will be soaked up by the Fed's 25bps rate hike as calculated previously. The impact of a move which is the equivalent of unwinding one and a third of QE2 overnight, will certainly have dramatic consequences on risk prices unless there is a more than offsetting injection of liquidity elsewhere.

Finally, confirming that Reuters' attempt to smooth Draghi's mistake is nothing but an urgently hashed out fiction meant to goalseek the deeply flawed conclusion to a broken narrative, is what Draghi said during yesterday's Q&A.

Recall that as we reported previously, Mervyn King asked Draghi if "today's speech deliberately designed to try offset some of the reaction yesterday?" to which Draghi responsed shockingly honestly: "Not really... well, of course."


Here is what really happened: the ECB tried to engineer a modest market selloff because the "market needed to be disappointed", coupled with a modest rise in the EUR to give the Fed some rate-hike breathing room. Instead, since everyone was positioned exactly the same - wrong - way, the dramatic overreaction in stocks and FX forced Draghi to not only panic but to publicly come out and admit that the only purpose of his Friday speech was to offset the damage from his failure to defeat the opposition at the governing council and to send markets surging. Which they promptly did. 

And while the markets rejoiced at this latest verbal intervention, the question is now that Draghi has challenged the governing council and lost, and furthermore, once again relented to markets, how will the hawks on the council react to any future demands by Draghi to push the S&P even higher? Lastly, if Berenberg is wrong and the ECB has lost a major portion of its credibility, how will Draghi jawbone next time when not even "whatever it takes" is sufficient any more?