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What Are ECB's Policy Options?

Published 09/08/2016, 05:31 AM
Updated 04/25/2018, 04:10 AM

The European Central Bank (ECB) will meet today and is expected to maintain the interest rates unchanged. Half of investors expect an expansion in the ECB’s asset purchases program as soon as today, while the remaining half expect to hear more about the future options the ECB would consider to further loosen the monetary conditions in the Eurozone.

Given that we are approaching the end of the ECB’s Quantitative Easing (QE) program, which is due on March 2017, the ECB will sooner rather than later announce the next step

Today’s meeting could basically be about discussing the future options, while a concrete action is more likely at October, or December meeting.

The most likely and the easiest to implement measure is an extension of the QE program. September 2017 could be a satisfactory revision, as it would give the ECB six more months to deal with the post-Brexit turbulence in the Eurozone economy, the Italian banking crisis, and Spanish, French and German elections.

Per se, the possibility of additional monetary boost is not sufficient to convince investors, as the pool of available bonds is drying at a visible pace. The ECB’s massive bond buying program injected an unpleasant distortion in the Eurozone’s sovereign market. As of today, the two-thirds of German bonds are no longer eligible, because they offer a yield below the ECB’s deposit rate limit of -0.40%. In a similar way, the 30% of the Eurozone bonds could not be added in the ECB’s balance sheet.

Given the constraints and distortions in the Eurozone’s sovereign market, the ECB had recently announced to extend its QE program to Eurozone corporate bonds. As a result, Henkel (DE:HNKG) and Sanofi (PA:SASY) have been the first corporate bonds to issue debt with negative yield this week.

As the risk-to-return distortion spills over the corporate bond markets, the ECB is left with the possibility of removing the lower limit rules for bond purchases and allow buying bonds that yield below the deposit rate, or simply lowering the deposit facility rate.

It could also consider changing the capital ratio. This measure is among the least preferred ones on the list of possible actions, given that it would have serious political implications. In fact, changing the capital ratio would favour countries with high debt levels, and would be hard to digest for countries like Germany and Austria.

Finally, the ECB could potentially enlarge its scope and consider buying overseas bonds, which could not only release the pressure in the Eurozone's sovereign and corporate bond markets but could also cause a suitable depreciation in the single currency.

Today, investors in the Eurozone will be seeking more clarity in this jungle of possibilities. As the Bank of Japan (BoJ) Governor Kuroda said, the monetary policy is not about limits, yet about the costs versus the benefits as all public services.

Of course, the ECB meeting and President Mario Draghi’s press conference should trigger decent price volatility in the euro markets in the afternoon. The dovish ECB expectations should keep the gains limited heading into the meeting, while the ECB decision should give a clearer direction to the euro in the short-term. Breaking above the 1.1340, the EUR/USD could gain enough momentum to target 1.1500, before 1.1616 (2016 high). Clearing the 1.1122-support (Aug 31st low), the EUR/USD could extend weakness to 1.1045 (Aug 4th low) before 1.1000.

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