Ahead Of The ECB

January Meeting

The ECB’s January monetary policy meeting saw rates remain unchanged, as expected, though the press conference following the decision saw ECB president Mario Draghi delivering a message that was more Dovish than many expected.

Draghi noted that inflation was still well below the ECB’s target and that the expected 2016 inflation path is now significantly lower than projected in December due to continued declines in oil prices. Downside risks to both inflation and growth were cited, with the slowdown in emerging markets listed as prominent among the contributing factors.

Draghi confirmed that the ECB will review its policy stance at their March meeting, stating that the Bank’s credibility would be harmed otherwise, and reiterated also the ECB’s willingness to act, saying that there were “no limits” to how far they are willing to go in employing their resources to achieve their mandate.

What’s Happened Since

Data and developments since the January meeting have done little to suggest that the ECB would refrain from further easing and indeed market expectancy is heavily built on the side of further easing, the only questions remains to what extent will the ECB provide further stimulus.

January CPI came in at -0.2% vs expectations of 0% , marking the lowest print since March 2015, whilst Core CPI also fell short of expectations at 0.7% vs 0.9% expected. This disappointing inflation reading underscores the necessity of further easing as the European Central Bank fight to keep the Eurozone out of deflation.

The downside risks from the slow-down in emerging markets that the ECB cited in January are alive and well. Concerns for the slow-down in China have continued to remain prominent with the latest Chinese Manufacturing data marking the seventh consecutive monthly decline and the PBOC acting to reduce domestic RRR levels yet again alongside cutting its 2016 growth forecast.

One positive development has been in energy prices. Oil, which plumbed fresh multi-year lows in February, has since managed to recover and stabilise above $30 per barrel as optimism grows for a production freeze among major producers, fueling a covering of short positions.

Since the January meeting EUR has fallen sharply lower against all major counterparts with the exception of USD and GBP which are hampered by diminished rate-hike expectations and Brexit concerns respectively.

Expectations For This Meeting

As was the case in the run up to the December meeting, with the ECB having clearly signaled further easing and data continuing to support the case for such action, market consensus is calling for further action on Thursday.

Market Base Case Scenario

• In terms of forecasting what policy adjustments the ECB is likely, consensus is built around a 10bps+ rate cut and technical adjustments to the QE program. Beyond this base case, expectations vary and the different outcomes become increasingly technical.

With Inflation running so low and inflation expectations hitting new lows, it is clear that the ECB will need to take decisive action and traders are expecting that the ECB will not repeat the mistake it made in December where it essentially over-promised and under-delivered. Notably, ECB members have been far less vocal about forthcoming stimulus this time as they try to keep expectations contained. Indeed reports emerged last week from ECB sources stating that was no consensus on action beyond a 10bps deposit rate cut, which some players suggest is the ECB attempting to bluff markets into lowering expectations so as to achieve greater impact when measures are announced and avoid the consequences seen in December.

Some analysts are forecasting a similar disappointment to that which we saw in December whereby the ECB do too little and markets react adversely. The base of this view is built around two themes

1. Oil has recovered more than 40% off 2016 lows and looks set for further recovery which will feed back into higher inflation
2. Going further into negtiave rates could be detrimental to the already shaken European Banking sector, a concern noted by ECB’s Couere last week

However, given yet another negative inflation print in the latest reading, a year after the ECB announced its huge QE program, it feels as though the greater risk is that the ECB will take more aggressive measures than markets expect, fueling EUR downside. Whether this be a greater than anticipated rate cut, expansion of QE, tiered interest rates or other measures, it seems unlikely that the ECB would allow room for market disappointment given the reaction in December. Key to delivering an effective outcome on Thursday will be not only the announcement of immediate measures but also the scope left for further easing in the coming months. To avoid the wrath of expectant markets, Draghi is going to need to convince markets with affirmitive action and a clear signal that more can be done.

This meeting will also include an update of the ECB staff macroeconomic forecasts which will now for the first time reflect the outlook for 2018. These updates will also be key a driver of market reaction.

Trade Ideas

If the ECB are successful in delivering EUR lower with the policy adjustments announced on Thursday we are likley to see a sharp move to the downside. Looking at EUR/GBP breakout traders could enter shorts on a break below the immediate .77 area support that has underpinned price over the last month.

I would be interested in fading a downside move if we got as far as the 1.7480 area breakout zone. Brexit concerns still hang heavy over the UK economy and are likely to weigh further on GBP as we head into the June referendum date which could bring EUR/GBP back up to around .77