More Than Just The ECB

The ECB meeting and details about the asset purchase plan is the key event of the day. However, there is something else happening. A string of disappointing US data and the sell-off in equities have sparked a bond market rally that again has caught many participants wrong-footed.

The U.S. 10-Year yield had reached 2.62% on September 19. It fell back to 2.38% yesterday and is only a little above that now. It is not just the long-end. The U.S. 2-Year yield was near 60 bp two days ago and is now flirting with 50 bp.

This has sapped some of the greenback's strength. The main beneficiaries are those currencies that arguably are interest rate sensitive; namely the dollar-bloc and the yen. These currencies were also beaten up, with significant losses last month.

The dollar had been briefly and barely traded through the JPY110 level yesterday. It reversed lower, posting a large key reversal in its wake. There has been follow through dollar selling today. It neared the 20-day moving average (~JPY108.00). It has not traded below this moving average since mid-August.

There have been several comments from officials, former officials and Japanese companies that have suggested that a weak yen is not an unmitigated favorable development. We suggest there are three considerations behind such pronouncement, which the market had been quite happy to shrug off. First, ahead of the upcoming G20 meeting, the Japanese government took preemptive action to head off possible criticism that it was manipulating its currency. Second, Japanese officials may also be concerned from the backlash as well from the US Treasury, which is likely preparing its next report on the foreign exchange market. Third, we recognize some merits of the concern in their own right. Here we suggest the pace of the yen's depreciation may pose an adjustment problem for some businesses.

On the other hand, BOJ's Kuroda has not objected to the yen's weakness. A weakening yen may be boosting inflation more than the asset purchases and expansion of the monetary base. After all, between April and August, while the dollar was confined to a JPY101-JPY103 trading range, amid QQE,  Japanese price pressures eased. The sharp depreciation of the yen is likely to rekindle price pressures in the coming period.

A disappointing US jobs report tomorrow, which is precisely what we have been warning about could spark a deeper dollar correction. The first important retracement of the dollar's August-September rally comes near JPY106.80.

The dollar-bloc currencies are also firmer. It helped that Australia reported a smaller trade deficit (A$787 mln down from A$1.36 bln) and better building approvals. However, the 1.5 cent bounce off yesterday's lows is not so much about Australian fundamentals. New Zealand, which has actually seen some negative news, has also traded higher. It also bounced 1.5 cents off yesterday's lows, though the upticks seem more vulnerable. Fonterra dairy prices fell 7.3%, and powdered prices fell 10% at yesterday's auction. And without much data itself, the Canadian dollar also rallied. The US dollar had traded around CAD1.1220 before slumped to almost CAD1.1070 earlier today.

The UK reported a better than expected construction PMI. It rose to 64.2 from 64.0 in August. The consensus had looked for a decline. Sterling, however, is trading a bit lower. It appears that the bounce in the dollar-bloc, especially the Australian dollar, has spurred some unwinding of cross positions.

There seems to be something else at work as well. The March 2015 short-sterling futures contract has rallied. This has pushed the yield lower, matching the lows for the year. Although the many participants have been fickle, and the temporal inconsistencies with forward guidance have often confused, we have been firm in our expectation of for a Q1 15 rate hike. It seems that participants are having second thoughts (again). In mid-September, the March short-sterling contract implied a 92 bp yield. Today it is implying 77 bp.

That brings us to the ECB meeting. We make three key points. First, we do not expect any hint of sovereign bond purchases, though Draghi is unlikely to rule them out. Even the Bundesbank’s Weidmann has conceded that they could be appropriate under certain (but unspecified) conditions. This may disappoint some.

Second, we expect the ECB to maintain the maximum amount of flexibility and may not provide the amount that it will be purchasing. Third, the program is likely to dovetail with the TLTRO facility, which means a 2-4 year operation. We see risk that the market is either disappointed with what may appear to be a lack of shock and awe or “buy the rumor, sell the fact” type of behavior. This could see the euro strengthen, but peripheral bonds pare some recent gains.