European Central Bank to do “What it must” by Adding Stimulus
The European Central Bank (ECB) is expected to announce further easing measure to boost the economy as the ghost of deflation still lingers. Eurostar released its advance estimate of inflation and it came in at 0.1 percent, lower than the forecasted 0.2 percent. The core reading excluding energy and food also disappointed, with a 0.9 percent versus an expected 1.1 percent.
The ECB President has pledged to do what “he must” which many feel has signalled further easing, to be announced on Thursday. The market reacted to his words by depreciating the EUR which could head lower ,the deeper the commitment to easing turns out to be.
There are three main scenarios for the European Central Bank (ECB) policy announcement on Thursday, December 3 at 7:45 am EST.
- Do nothing.
- Kitchen sink.
- Mixed bag.
Do nothing. The ECB has not been historically the most proactive of central banks. Owing to the union formed by the 19 nations in the EMU, the final decision can take time. This is not the ECB of old, but it could still suffer from decision paralysis, although it has to be said that the biggest voice against further quantitative easing, Bundesbank Governor Jens Weidmann, has not been as vocal of late. There is a low possibility that the ECB will keep rates and the stimulus program unchanged. President Draghi has made clear that he prefers action to rhetoric and would rather act proactively to avoid falling into deflation. The ECB could still wait for the Fed to come to the rescue and hike rates, but the market is optimistic that European policy makers would rather have more control of the fate of their economy.
Kitchen sink.The ECB has three tools it can use to stimulate the European economy. It can lower the discount rate deeper into negative territory, extend the timeline of the current bond-buying program and finally increase the amount of the program. There is a possibility the ECB will use all the tools at its disposal on Thursday, but it’s not the most likely scenario. It would send a strong message, that much is true, but there can be a potential cost by using all the ammunition when it already knows the Federal Reserve will likely finally make its move by raising U.S. benchmark interest rates in December. The Fed is not expected to have a fast pace of tightening which is why the ECB policymakers would be wise to save some stimulus for when the American central bank takes its foot off the pedal.
Mixed bag.Given the commitment that ECB President Draghi has expressed in his latest interviews and press conferences, action is expected from the ECB. The exact mix of monetary policy decisions is up for debate as some of the tools would require internal rules to be modified. The QE side is more heavily expected to be modified on Thursday. An increase of EUR 20 billion to monthly purchases and a possible extension to 2017 is likely. The QE actions could be announced without a deeper negative discount rate. The current rate is -0.2 percent and could be pushed lower to -0.4 percent. Given the situation the ECB finds itself in, the central bank will probably do more rather than less to avoid losing the confidence of the market.
The biggest risk for investors becomes that too much information might already be known in advance, leading to a crowded trade. Monetary policy divergence is being fully realized in December as the ECB will ease as the Fed gets ready to tighten—which will lower the EUR versus the USD. The fact that the reasons why are well known has led to large short EUR positions. The fact that the world is not as binary could derail the efforts of the ECB, as was shown during the Chinese stock market rout this past summer. Even the second part of the EUR/USD divergence equation could back down as Fed members forecasts signal a slower rate of tightening.
Mario Draghi has made clear he will use all the tools at his disposal and in this uncertain and volatile market he just might be forced to.
Euro events to watch this week:
Thursday, December 3
7:45 am EUR Minimum Bid Rate
8:30 am EUR ECB Press Conference
8:30 am USD Unemployment Claims
10:00 am USD Fed Chair Yellen Testifies
10:00 am USD ISM Non-Manufacturing PMI
Friday, December 4
8:30 am USD Non-Farm Employment Change
8:30 am USD Trade Balance
10:00 am OIL OPEC Press Conference