How Would The EUR React To ECB's QE Extension?
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ECB: Balancing act:
We argue the ECB cannot keep its options open until December. With macro data still weak and high market expectations after a dovish July meeting, we believe a commitment to continuing QE after March 2017 is the least markets expect. While the ECB is aware of the adverse consequences of its unconventional policies, we think its communication is still consistent with a full commitment to deliver on its price target, even if the other branches of policy are not as helpful.
Our preference would be for a “full package” in September, with announcements on both the principle–buying beyond March–and the technical details. However, we recognize a majority of the Governing Council may need more time, as we are getting into increasingly controversial territory. The ECB has repeatedly disconnected the “what” from the “how” in the past. From a technical point of view, the ECB can continue QE for now without hitting the “scarcity wall”. Taking the time to get the relevant staff committees to explore all options may be palatable to a majority of the Governing Council.
The risk to our call is that a majority of the Governing Council will have taken so much comfort in the decent data flow this summer that the decisions on both the principle and the technical configuration of QE will be pushed back to October or December. While from a fundamental point of view this would not necessarily change much, we think markets will be disappointed. At the very least, next week we believe the ECB will have to provide a clear deadline for the final decision to continue QE and signal, in no ambiguous terms, that a “reflection has started”.
FX: Hard to weaken the Euro:
We do not see a large EUR impact from the ECB QE extension. The distance from the ECB’s inflation target is so long that we do not believe there is any investor who does not already expect the ECB to continue QE after March 2017. The market impact will depend more on the length of the extension and the technical changes to the QE program to allow extending it. As we expect only a six-month QE extension, with the technical details left for later this year, and no changes in the depo rate, we do not see a sustained EUR move from this meeting. Once we know the technical details, the impact on the EUR will depend on how much more room, if any, the changes to the QE program will create beyond the QE extension.
Moreover, the risks to the Euro from the meeting may be to the upside. If the ECB does not announce QE extension in this meeting, markets could take it as a signal of strong disagreements within the ECB on how to extend QE. We are surprised we have not heard any ECB officials referring to scenarios for policies ahead, in contrast to what happened ahead of previous policy changes. This could suggest the internal debate has not progressed much. FX positioning suggests the market does not expect any surprises from the ECB.
The market is actually slightly long EUR/USD, according to our aggregate positioning indicator. The market was short EUR/USD late last year. This position got squeezed, reaching the longest EUR/USD position after the very weak May NFPs. Positioning became neutral by July, but the market is now slightly long EUR/USD, following the recent loss of momentum in US data.
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