May 27

ECB Expectations on the Rise

The fact that Mario Draghi is ‘comfortable’ acting next time seems to equate with markets being comfortable pricing in less volatility. The VIX dropped to a recent low of 11.36 on Friday, levels not seen since early January’s bout of equity market complacency. Much has been made of the wider lull in volatility across bond, equity and currency markets. This was already apparent before Draghi’s promise, but the ECB definitely seems to have compounded the phenomenon of falling rates and falling volatility.


                                                                                                                                                                                   VIX Since Last ECB Meeting(May 7th)

The German 2 year bund yield fell to 0.05% today from around 0.14% before Draghi’s pledge. Short term Spanish and Italian bonds are also rallying this morning, with 2 year yields reaching recent lows. Emerging market currencies have seen inflows from Europe, as EUR losses have coincided with EM gains in recent weeks. Days of pronounced weakness in EM currencies (May 15th) seem to have occurred simultaneously with EUR gains. This relationship was most prominent against the Turkish Lira and South African Rand, two EM nations with wide current account deficits that are heavily dependent on external liquidity(easing). This implies that EUR is being used as funding currency for EM carry trades.

Mario Draghi and the Governing Council have a huge test of ahead of them. Market expectations are running wild for a range of broad easing measures, including everything short of outright quantitative easing. It is clear that most of these options are priced in at this point, and the entire ‘game’ will come down to the questions after Draghi’s opening statement. The journalists in the crowd will undoubtedly dog Drahi to give more clues on when QE is coming, and the answer to these questions will determine if markets are over their skis.

Probable June ECB Easing Measures:
1. Rate cuts in the overnight cash rate( @0.25%) and Deposit rate (@0.00%). Deposit rates will be lowered into negative territory. This has been well telegraphed for months, and a 10-15 bps cut is likely already priced in.

2. A funding for lending style LTRO(Long Term Refinancing Operation). The ECB will offer collateralized loans to banks. In exchange banks must increase lending to small and medium sized enterprises (SMEs) by the corresponding amount that they borrowed from the ECB. This move has been also been elaborated on in recent months but it is harder to measure if it is priced in because we don’t know anything about what the demand for loans would be from banks.

3. Ending sterilization of the Securities Market Programme. The SMP was enacted in Fall 2011 during the Italian debt crisis. The facility amassed about 160bn Euros in periphery debt. These purchases were sterilized by the ECB auctioning off weekly deposits elsewhere to drain the 160bn from the money supply. Ending this sterilization would effectively result in an instant 160bn Euro QE program. Keep in mind that varying amounts of the 160bn have been going unsterilized as the ECB tries to keep overnight interbank rates stable at low levels. Draghi has stated in recent months that most of the bonds in the SMP will mature in less than 9 months or so, making this a short term measure at best. It is hard to gauge whether this is priced in, it has not been mentioned much lately.

4. Extending fixed rate full allotment. This program sees the ECB offer unlimited secured weekly funding to banks. It is due to expire in mid 2015. This is probably irrelevant in terms of being additional easing, as it was a near impossibility that banks would be able to fund themselves by mid 2015 anyway. This was going to be extended at some point.

The period between telegraphing a new bold policy change, and the actual enactment is a delicate exercise of managing expectations. Markets are not exactly sure what to price in for the June ECB meeting, and there are even more questions about future easing. If QE isn’t on the table for now, measures taken at the June meeting may be seen as the Governing council’s best shot as fighting low inflation. Mario Draghi and the ECB will have to repeat prior acts of central bankers surprising the market if he really wants to make waves.