Market participants knew that volatility would rise today with the ECB meeting. What they got was far worse than could have been anticipated.
It started with a report from the Financial Times a few minutes before the ECB's official announcement claiming, disappointingly, that there was no rate cut. The euro took off, spiking to almost $1.07 from around $1.0550. A few minutes later the ECB announced the ten bp cut in the deposit rate (to -20 bp). The euro pulled back but then rallied again to $1.0740 before dropping a cent. And all this before Draghi's press conference began, and the details of changes in QE were announced.
Ultimately, and profoundly, the ECB disappointed, which this has rarely been seen in Darghi’s tenure and hit a market that had amassed a significant short euro position over the past several weeks. As it became clear that the ECB was simply going to deliver the smaller-than-expected rate cut and extend the program for six months (at least), the shorts ran for what must have felt like a small exit, lifting the euro to almost $1.09.
The ECB announced the inclusion of regional bonds, but the telling disappointment was in not increasing the size of the monthly purchases. The small tweaks in the staff projections suggest the ECB means to keep expectations low for follow-up action in March. The euro has retraced 38.2% of the decline that began in mid-October. It is found just below $1.09. The 50% retracement is a little above $1.10.
Relative to market expectations, and what was discounted, the ECB tightened policy. It spurred a sharp backing up of European interest rates and a substantial narrowing of the 2-year interest-rate differential that had been widening with the dollar’s rise.