ECB Calibration is the new tapering

Mario Draghi spent most of the press conference trying to convince the audience that tapering doesn’t actually exist, and even if it did it wasn’t on the ECB’s table. Draghi and co. at the ECB is reducing the size of its asset purchases to EUR 60bn a month from April, even if it is extending the length of time it makes purchases through to December next year. Nice try Draghi, the ECB has tapered – except tapering is now called calibration, and calibration isn’t nearly as nasty as tapering, so the euro fell, stocks rallied and German bond yields backed off their earlier highs.

The key message from Draghi is that the ECB will be in the market for a long time to come, all we know is that they will be there until at least December next year. This increase in the ECB’s balance sheet, especially in the face of a Fed rate hike next week, is mildly euro negative, however, today’s decision is probably not enough to send EUR/USD back to parity.

The ECB: A financial version of Alice in Wonderland

The ECB had to change its standards for bond purchases to ensure that its QE programme did not disrupt the debt markets. It will now include bond purchases below its own deposit rate, which is already -0.4%. Thus, the ECB will be paying to hold some bonds that will be included in its QE programme. The craziness doesn’t stop there, some of those bonds have a negative yield because of the ECB’s QE programme in the first place. This meeting has been like a financial version of Alice in Wonderland.

The ECB has had to buy negative yielding bonds because it has bought all the eligible higher yielding stuff, so it has no choice. Essentially this is the market-moving news as it may mean lower yields for longer, which could be bad news for banks, who see their profitability dip in a negative yield environment. Thus, the rally in European bank stocks in recent days, could be cut short at some stage on the back of this meeting.

Other takeaways from this meeting included:

• Draghi admits that there is a limit to what the ECB can do to assuage political risks.
• The growth outlook is broadly unchanged: 1.7% for this year, 1.6% for 2018/19.
• Inflation is expected to rise only to 1.7% by 2019.
• Draghi continued to put pressure on Eurozone governments to reform to boost growth.
• The ECB’s QE programme remains flexible.

The market impact:

• The initial reaction is euro negative, EURUSD has dropped to its lowest level since Monday, and is currently testing 1.0650. We don’t think that this meeting is enough to push EUR/USD to parity, in fact, we continue to think that if the market changes its view that calibration is a form of mild tapering then we could see a turnaround in EURUSD, and it may test 1.0930 – the 38.2% retracement of the May – December decline in EURUSD.
• But, the upside for the euro could be limited as European bond yields may struggle to push significantly higher from here due to the ECB’s plan to accept bonds that yield lower than -0.4% going forward. This suggests to us that the era of negative rates could be with us for some time yet.
• A fall in the euro should be good news for stocks. The Eurostoxx index has risen sharply since Draghi started speaking, even Deutsche bank has rallied on a wave of QE-euphoria. We are not sure that Europe’s banks can sustain this rally, even if the Eurostoxx banking sector is at its highest level since January. Overall, a negative interest rate environment is not conducive for bank profits next year. But, you can’t be hasty to ditch European banks, as the strong bullish market in the US is a powerful force, and the prospect of more liquidity than expected from the ECB could keep banks buoyed for longer than is fundamentally justified. But, any signs of weakness in Europe’s banks could lead to a sharp sell-off in the coming weeks.

Overall, 2017 will usher in a new era for ECB policy, one where it has admitted it wants a long-term presence in financial markets to depress yields. Unless we see a sharp upturn in growth and inflation, then the Eurozone is likely to remain in second place to the buzzy US economy. It remains saddled with debt, bad banks and political risks, which could make it a tricky environment for some time to come. This makes it hard to get too excited about the euro, and is another reason why the dollar should keep its crown as the King of FX and the world’s most important reserve currency for some time to come.