Yesterday, we asked whether Saint Draghi would bring a shiny new present or a lump of coal to expectant EUR/USD bears. Today we learned that the bears must have been much naughtier than they had thought, as all they found this morning was two particularly small and unimpressive lumps of coal in the bottom of their stockings.
After a bit of a fiasco where the Financial Times errantly “leaked” that the ECB was leaving its deposit rate unchanged, we learned that the central bank would in fact be cutting the deposit rate by a less-than-expected 10bps to -0.3%. Ironically, traders who bought EUR/USD on the false leak actually benefited, because the halfhearted deposit rate cut still led to a bounce in EUR/USD.
As we noted yesterday, the deposit rate cut widens the universe of assets that the ECB can buy under its QE program, but not by nearly as much as a 20bps-or-larger cut would have. Despite this disappointment, EUR/USD bears still hoped that Draghi could deliver a big surprise at its upcoming press conference.
Alas, these hopes were quickly dashed as Draghi did the bare minimum to retain the ECB’s credibility, falling well short of taking the sort of bold action that traders had expected. The central bank did opt to extend its ongoing quantitative easing (QE) program by six months until “at least” March 2017 and broadened the assets available for purchase to include regional debt, but these actions had already been discounted by the market. The “big bazooka” of expanding the monthly QE purchases by say €20B a month was nowhere to be found, leading to a panicked stampede out of the crowded short euro and long Eurozone fixed-income trades.
While today’s developments seem apocalyptic for many traders, it is worth noting that Europe’s economy is not necessarily on the type of life support that would have necessitated an everything-but-the-kitchen-sink action from the ECB. The Eurozone’s November flash Manufacturing PMI recently came out at an 19-month high of 52.8, whereas the accompanying Services PMI report was even more impressive at 54.6, a 4.5-year high. As Draghi was at pains to note in his press conference, the central bank can still adjust its QE program as needed to accommodate developments in the economy and fight deflation. In other words, Draghi decided that discretion was the better part of valor and opted to keep his powder dry in case its (more) desperately needed in the future.
Market Reaction
As we noted above, the market reaction has been swift and violent. EUR/USD surged over 350 pips in just 75 minutes to peak near 1.0900, though rates are now edging back down toward the 1.0800 level as of writing. Meanwhile, the crowded long trades in European fixed income were immediately unwound, taking many short-term yields out of negative territory. This is either a tremendously fortunate coincidence or brilliant maneuver on the part of the ECB, because it broadens the universe of assets available for purchase at least as much as a more aggressive deposit rate cut would have.
Predictably, equities fell across the board, with major European indices dropping as much as 2.5% on the day and US equities fell at the open.
Pin Action
In terms of the likely pin action from today’s ECB decision, the biggest implications will be for negative-interest-rate-policy trading partners of the Eurozone (notably Switzerland) and for US monetary policy. After waking up fearful of aggressive ECB action, the Swiss National Bank can now breathe a big sigh of relief. The SNB will likely not be forced to intervene aggressively ahead of its monetary policy meeting next month and will likely only need to cut its own main interest rate slightly in response to the ECB.
As for the Fed, today’s big surge in EUR/USD, and therefore broader drop in the value of the US dollar, removes a potential risk from raising interest rates in two weeks. Recently, Fed policymakers noted some concern with the rising value of the US dollar, which tends to suppress inflation and economic activity in and of itself. With the dollar now trading nearly 2% lower against one of the US’s most important trading partners, this concern is not nearly as pressing and the only major hurdle left for the Fed will be tomorrow’s NFP report (stay tuned for our full preview later today)