ECB Preview: The Market's All-In But "There's A Significant Chance Draghi Disappoints"

Blackrock's chief multi-asset strategist summed up tomorrow's anxiously awaited ECB meeting best by noting that "what’s priced into markets is a fully fledged extension of the [bond-buying] program," but warns that, thanks to a muted reaction to the Italy vote and recent encouraging data, "there’s a significant chance the ECB disappoints markets." As bond traders bet on a six-month QE extension, Citi warns, anything less will be seen as hawkish and send EUR surging.

The ECB has a recent history of disappointing investors expecting more stimulus, and as The Wall Street Journal reports, with the bond-buying program scheduled to end in March, the ECB is running out of time to inform investors of its plans.

Just last week, Bunds had a mini taper tantrum when rumors spread...


And, even as investors expect more stimulus on Thursday, the debate with some analysts is moving to whether the ECB could start tapering its stimulus program in March.

Like other investors, Edward Farley, head of European corporate debt at PGIM Fixed Income, expects a six-month extension to the ECB’s asset purchases. Still, he says he has been avoiding securities like southern European corporate bonds that look most vulnerable “if there is any accident with central bank policy.”


There is little sign investors expect that on Thursday. Peripheral government bonds and corporate debt has rallied this week despite the “no” vote in Italy’s referendum which outgoing Prime Minister Matteo Renzi had presented as a way to revitalize Italy’s stuttering economy.


Investors seemed unfazed by Mr. Renzi’s resignation after the vote even though it could bolster the fortunes of the populist 5-Star Movement which has called for a non-binding referendum on Italy’s membership of the euro.


The gap between 10-year Italian and German bond yields has narrowed by around 0.1 percentage point this week to around 1.54 percentage points. Media reports that the Italian government was ready to take a controlling stake in troubled lender Banca Monte dei Paschi di Siena seemed also to fuel the rally.


The spread to Germany, the bloc’s largest economy, also narrowed for Portuguese, Spanish and French bonds.


As far as the actual policy decision goes, the biggest problem for the central bank remains, as Bloomberg points out, that underlying inflationary pressure is too weak and shows no signs of picking up. Headline inflation accelerated a little in November, broadly in-line with the ECB’s forecast of 0.5% for 4Q, but it looks to have done so thanks to movements in food prices. Core and services price inflation are stuck at 0.8% and 1.1%, respectively. And even though unemployment continues to fall, the wages data bring little cause for optimism. There’s unlikely to be much movement in the core inflation forecasts, but revisions downward are more likely than upward. It will also be the first time forecasts for 2019 will be published -- how the ECB marks its own homework may help with understanding risks to the policy outlook.

There remains no sign of underlying cost pressure building. Until there is, further easing looks inevitable. The Governing Council has faith in its tools -- it thinks inflation would have been lower if they had not been deployed -- and there is reason to keep using them. BI Economics therefore expects an extension to the program of asset purchases.

Economists seem to be split between those expecting the ECB to announce an extension by three or six months.

And with doves outnumbering hawks still on The ECB, it seems six months is more likely...

Economists highlight good reasons for the ECB to keep buying bonds. The central bank has an inflation target of close to 2% but consumer prices in the Eurozone were only 0.6% higher in November than the same month last year.

Others argue further stimulus isn’t warranted. The eurozone’s economic picture is brighter, with business activity growing at its fastest pace this year in November, according to a survey of manufacturers and service providers.

As Citi strategist Steven Englander notes, nearly half of survey respondents expect ECB to extend QE by 6 months at current EU80b purchasing pace, writing that anything less than that outcome likely to be seen as hawkish and drive an “immediate EUR buying outcome."

  • 20% expect ECB to engage in “serious but limited” tapering
  • Two-thirds of respondents see ECB as being unaffected by Italian referendum

Which confirms Bloomberg's consensus...

  • An announcement that asset purchases will continue until June 2017, or beyond if necessary, at the present pace of 80 billion euros a month (risk: tilted to longer)
  • An increase to the issue limit to address bond scarcity (risk: balanced)
  • No commitment to taper asset purchases (risk: balanced).

And beyond December...

  • A further three-month extension of the asset purchase program to be announced in March 2017 (risk: tilted to longer)
  • Tapering of asset purchases to begin from September 2017 and for the program to end in March 2018 (risk: tilted to longer).

However, the market’s subdued reaction to the Italian referendum may show that investors have become too reliant on the central bank to smooth over the eurozone’s probelms, a factor that may concern some ECB officials.

“I don’t think that [argument] will win the day, but it’s a risk,” said Stefan Isaacs, deputy head of retail fixed income at M&G Investments. It would be “dangerous” for the ECB to pull back before it has succeeded in boosting inflation, Mr. Isaacs said.

As a reminder, last December, the euro jumped more than four cents against the dollar, stocks tumbled and the price of riskier bonds fell after the bank delivered a smaller-than-expected package of stimulus measures.

Finally, as we detailed previously, there is another problem: with the US tightening at a time when demand for US debt will have to stay constant or rise to fund Trump's fiscal stimulus, it would be up to Japan and Europe to provide the "helicopter money" to fund US economic growth as DB explained. Even a small hint that this is going away, and suddenly the Trump stimulus is looking very shaky.

Sure enough, as Reuters admits, some proponents of the extension fear an ill-timed signal about reduced buying in future could heighten market volatility, potentially undoing some of the benefits of the scheme.

To be sure, it is not a done deal yet:

Extending the asset buys would require the ECB to ease some of its self-imposed restrictions, a sensitive debate as most options on the table raise legal or political concerns, facing varying degrees of opposition within the Governing Council.


Still, ECB President Mario Draghi seemed to dismiss those concerns this week, arguing that the program was sufficiently flexible, suggesting that parameter changes would not stand in the way if policymakers opted for the extension.

However, givem the current spate of economic and political events, it just may be that a tapering announcement by the ECB is the catalyst that finally blows over the house of cards market that has soared since November 8 on nothing but hope and lack of concrete news.