FX Daily: Market is set to profit take ahead of ECB decision

3rd June 2014

  • Calls from the EC for the UK to amend its economic policies got short shrift from the Treasury. A Treasury source responded to the calls, saying “the UK will continue to work through our long-term economic plan, which is bringing down the deficit, creating jobs, cutting income taxes and controlling welfare and immigration.” (The Times)
  • BoJ Governor Kuroda told a parliamentary committee that the BoJ stands ready to cope with an “untimely interest rate rise or fluctuation.” He added the BoJ will conduct monetary policy in an appropriate manner, while keeping a close eye on developments in market interest rates. (MNI Market News)
  • Abe’s latest reform plan contains scant details as to how Japan will deal with its toughest issues. Markets primary concerns such as the GPIF overhaul, labour reform and companies owning farm land have not been addressed by the draft report. (Reuters)
  • Japan Business Federation plans to work closely with the government to combat deflation and push for a corporate tax cut to 25%, according to its new chief Sadayuki Sakakibara. (Nikkei)
  • Investors used the recent sell-off in Japanese equities to buy companies that will benefit in a rising inflation environment. (WSJ)
  • The targeted reserve cut announcement by the State Council last Friday, as well as reserve cut for county-level rural banks in April, may release around CNY300billion in rural and small enterprise sector, according to deputy chief of Bank of China. (China Business News)
  • China’s HSBC May Final Manuf. PMI was downgraded marginally to 49.4 from its 49.7 flash estimate.
  • Japan April Labour Cash Earnings YoY rose 0.9%, beating expectations for a 0.4% gain. 0.7% previous.
  • Australian April Retails Sales gained 0.2% on the month, up from 0.1% previous but underwhelming expectations of 0.3%.
  • The RBA held their policy rate at 2.5%, as expected.

Another day, another record high on the S&P 500. The headline read isn’t as bombastic is it sounds. The US headline index gained a mere 0.07% on the day to 1,924.97, consistent with general price action of slow moderate gains. The US 10 year yield inched above the 2.5% level overnight, having been confined to a 26 basis point range for the last month. Euro-dollar moved below the $1.36 level yesterday as soft German CPI increased bets that the central bank would ease policy. The currency cross is now in the regions of a three month low. CFTC positioning data put euro shorts at their highest level since July 2013. The market is set to profit take ahead of the ECB announcement. The risks that the central bank could underwhelm are stacked high and what they do announce will change the direction of markets for the rest of the year.

A further jawboning on the euro lower is out of the question after Draghi came just short of precommitting himself to easing with the line “the Governing Council is comfortable acting next time”. They only held off acting in May to wait for the staff projections of inflation. With four out of the five countries which have already reported inflation readings for May recording weaker price growth, the Eurozone aggregate is set to show a decline today and raise the stakes for the ECB to ease. Draghi has been pretty explicit about his intentions, outlining a scenario play-by-play at the recent ECB central banking form. The central bank president knows that markets are heavily positioned for his announcement and is spelling out policy action to try to rein in expectations. After Bernanke’s serial miscommunication blunders of last year, Draghi now faces the same fate.

The ECB Governing Council has been consistent. There is no deflation in the Eurozone. This is the only scenario is which QE as we now it would be rolled out for, meaning QE is not on the cards at this policy meeting. Instead the ECB is adamant that the exchange rate is the reason that inflation is below target, accounting for 80% of the fall in the last 2 years. In fact, Draghi mentioned the exchange 13 times in his last press conference. His response to a high exchange rate exacerbating disinflation is conventional policy alone. 10 to 15 basis points of cuts to the entire rate corridor, including negative deposit rates, is now almost a given. The third scenario is that a lack of credit supply could constrain the recovery and limit the full effects of monetary policy. This is a reality as banks seek to slim their balance sheets before the ECB asset quality review this summer. The consultancy PWC estimated that European banks have €80 billion of loans to shed this year, of which almost 20% are in southern Europe. In these circumstances there is very little scope for banks to extend loans to the periphery and especially their neglected SMEs. This comes at the worst timing as credit demand is finally set to re-emerge after 4 quarter of a gaining Eurozone recovery. Thus we expect the ECB to complement rate cuts with either refinancing operations or purchases of asset backed securities of loans to SMEs. ABS purchases is Draghi’s preferred option as he wants to capitalise on the global investor appetite for Eurozone assets. The market is small meaning as little as €50-60 billion in purchases as well as Draghi’s personal backing of the market would be enough to have an effect. The only hindrance is the market isn’t yet fully developed meaning this option may have to wait to be deployed.

Despite Draghi’s explicitly clear breakdown on policy, we still think markets are betting on QE. This explains the paradox of a rally in equity markets during a bull bond market. Peripheral bond markets continue to see substantial inflow and ETF on emerging and frontier markets have outperformed year to date. We watch the VIX index which is now marking its sixth week below the 15.0 level. Historical a prolonged period of low volatility proceeds financial crisis. Financial markets are set to profit take on Thursday’s announced and nothing short of full blown QE can prevent this. Although an ABS programme could lead to a slower market shake out. We expect the euro to snap back higher on an underwhelming policy announcement and look to play this against the CEE currencies HUF, PLN, CZK whose central banks are likely to be more dovish in reaction to ECB easing.