London Open Update: Markets Await Draghi and the ECB Liquidity Machine

The ECB couldn’t have orchestrated it better themselves: Italy and Spain easily managed to sell debt this morning and they saw the price they had to pay for it tumble. And all of this happened without the ECB who can still can only buy debt in the secondary markets not in the primary markets. This has boosted investor sentiment, EUR/USD is back above 1.2750, which has weighed on all of the dollar crosses, and the dollar index is back at its lowest level of the day.

Spain sold nearly twice the amount of2015 and 2016 debt it had initially offered and yields fell to 3.912% for 2016 debt. Likewise, Italy also has a good auction selling 6-month and 12-month debt with yields of 1.644% and 2.735% respectively. This is a lot more expensive than Germany, whose 6-month debt auction earlier this week saw investors actually pay to hold Bunds as interest rates were negative, and however, yields in these at-risk nations are falling and thus moving Spain and Italy away from bailout territory. Cue the notable sigh of relief in the markets causing positive reactions in stocks, the euro, GBP, Aussie, as well as gold and oil, which are also benefitting from a weakening in the dollar.

So the first major debt auctions of the year have gone off well, but will this sentiment persist when Italy and Spain try to auction the rest of the EUR 150bn of debt they need to refinance by the end of March? We shall have to wait and see. Also, we aren’t out of the woods yet as we still have the ECB and BOE meetings to get over in the next couple of hours and the main event of the day: the Draghi press conference at 1330 GMT/ 0830 ET.

Our expectations for the two meetings are as follows: the Bank of England will leave rates unchanged at 0.5% and will refrain from adding more QE to the economy until next month at the same time as it releases its latest round of growth and inflation estimates in its Feb Inflation Report. We expect the Bank to forecast a large inflation undershoot this year and prices should start easing from January when the effects of last year’s VAT increase fall out of the index. There were some worrying economic signs for the UK today when industrial and manufacturing data showed weakness in this sector. Industrial production fell for the second consecutive month. Although some of the fall in manufacturing production was due to weaker energy use on the back of warmer than average winter weather, we still think this points to a slight contraction in the economy in Q4. This may persuade the BOE to act in February and it could expand asset purchases to the tune of GBP 50-100bn depending on 1, how sharply it expects inflation to fall over the next two years and 2, how deep the Q4 contraction may be.

None of this is impacting the pound today, which has staged an impressive rebound. It has rallied from near 17-month lows at 1.5284 earlier to a high of 1.5384. The decline in the pound this week was on the back of a rumour that the Bank could do more QE in January, however as this gets priced out the pound could continue to rally. Above 1.5350 then 1.5400 and 1.5500 come back into view, although we think that a continuation of this pound-friendly sentiment will depend on the ECB later today.

Expectations are for Draghi and co. at the ECB to stay pat on interest rates since the December LTRO auctions have already massively expanded euro liquidity (although most of it is parked at the ECB…). There seems to be some consensus building that the Bank could cut rates further in March, possibly by 50 basis points. However, 1% is the all-time euro-era low for interest rates in the currency bloc, so the ECB may want to keep its powder dry and continue to provide bank liquidity rather than use all of its ammunition and cut interest rates too far.

We are going to be listening closely to Draghi to gear his thoughts on 1, the prospect of official QE and support for sovereigns in the coming months (unlikely to be too much support for this from the Bank, and Drgahi could use his “not in the spirit of the Treaty” re-buff to any journalist brave enough to ask if QE is coming) and 2, how successful he believes the LTRO has been in light of the fact that deposits parked at the Bank have been rising in recent weeks and are now close to the same levels of LTRO demand.

Obviously banks aren’t happy to lend to their peers, hence why they are dumping money with the ECB, but will some bright spark eventually think that putting cheap borrowed money in interest-poor deposit accounts at the ECB is a wasted opportunity? Could the expectation that eventually banks will put this money to work elsewhere be enough to drive the current rally we are seeing? Stocks have perked up in 2011 as have commodities. Even base metals are out-performing precious metals on the back of 1, improved sentiment in the markets and 2, expectations that the global economy will avoid a recession. Emerging market FX is also higher today. EURHUF, after reaching a record high in recent days, has fallen back through its 50-day sma at 308.44, so too has EURTRY.

So the prospect of feasting on ECB liquidity could be one factor boosting markets today, but we need to wait to see if Draghi plays ball. If he says liquidity is here to stay then cue a risk rally. The euro may rally initially, but essentially this is euro negative as it takes over from the dollar (where the Fed is not offering stimulus) as the global funding currency of choice. If he doesn’t offer more support, or sounds too hawkish, cue a collapse in sentiment and possibly a small bounce in euro crosses in the medium-term.