Record Bond Rally Hinges on Draghi Delivering a Full QE Package

(Bloomberg) -- Mario Draghi needs to go out with a bang if he’s to renew a surge in bond prices that sent yields to unprecedented lows.

Markets have factored in the European Central Bank’s president slashing interest rates and restarting quantitative easing, so it will take a multi-faceted stimulus package in his penultimate meeting Thursday to impress investors. Bond gains have faltered and the euro has staged a recovery from the weakest since 2017 this month after opposition from some officials raised doubts over the size and timing of any new asset purchases.

Money markets are still betting on a 15-basis-point interest rate cut on Sept. 12, a bigger drop than the 10 basis points forecast by economists. Those expectations for policy easing to revive inflation have depressed the euro to $1.10 and driven German bund yields well below the ECB’s minus 0.4% deposit rate.

“I think that the ECB will struggle to exceed the already dovish market expectations,” said Valentin Marinov, head of Group-of-10 currency strategy at Credit Agricole (PA:CAGR) SA. Any failure to mitigate the fallout from even more negative rates on banks and to lift limits on the bonds the ECB can buy could spur euro gains to $1.12, he said. “Without them, people will conclude that Draghi is done and that the ECB may not have the courage for more once he is gone.”

Goldman Sachs’ strategists have stopped recommending bets on the euro’s decline against the yen ahead of the announcement, while Morgan Stanley (NYSE:MS) has scaled down its estimate for the size of future asset purchases.

That caution led European bonds to fall Monday, the latest in a series of pullbacks from the rally. Longer maturities have been worst hit, following poor demand in a 30-year German auction, as they would benefit the most from renewed ECB asset purchases. Allianz (DE:ALVG) Global Investors has warned of a bigger sell-off in German bunds.

Here are further views by analysts:

Credit Agricole (Risk of Euro Rebound)

• “Lot of negatives” are in the price of the euro -- a 10-basis-point rate cut is fully priced in and investors attach a 45% chance to a 20bps rate cut: Marinov
• Euro could “squeeze higher” versus the yen and Swiss franc and to a lesser degree the U.S. dollar
• Euro-dollar estimated fair value has been reduced from $1.1234 to $1.1186 on the back of a flattening in the European bond curve relative to the Treasury curve
• This variable is the strongest driver of the euro’s fair value at present, especially in the run up to this week’s ECB meeting with the market anticipating a fresh round of QE
• If the European curve bear steepens on Draghi, the euro’s fair value could bounce again

Morgan Stanley (Bund Steepeners, Euro Rally)

• ECB to deliver an easing package of 10 basis points of rate cuts and restart QE at a pace of 30 billion euros per month for nine-12 months, according to strategists including Chetan Ahya
  • “However, markets could be disappointed by the timing and size of the QE programme”
• Suggests investors put on positions in 5s30s bunds steepeners -- as they see 10- and 30-year bund yields ending the year higher
  • Continues to recommend investors short two-year German bunds at minus 90bps and/or pay March 2020 ECB meeting OIS
• The euro should rally post the ECB decision “as sentiment is already bearish and a more hawkish ECB outcome that leads to a steeper yield curve will push the euro higher and dollar down”

NatWest Markets (Flatteners Attractive for Bond Bulls)

• “ECB expectations got too aggressive this summer. They may have more to correct,” according to Giles Gale, head of European rates strategy
• “Flurry of hawkish rhetoric was more of an attempt to dial-back over-ambitious market expectations and give some headroom for a dovish surprise, rather than a sea-change at the Governing Council”
• Would be “surprised if no QE were announced” -- sees 10-basis-point rate cut (accompanied by tiering) and a re-start of QE at 30 billion euros a month for six months (accompanied by increases in the issue and issuer limit to 50%)
• Steepeners don’t look like the ideal bearish trade right now, while if bullish, 5s30s flatteners (with positive carry) look attractive

Commerzbank (DE:CBKG) (Fleeting Euro Impact)

• Commerzbank still expects a “substantial extension” of QE purchases despite the hawks’ opposition and this could weigh on the euro“Any immediate euro-negative reaction to the ECB could prove short-lived,” according to Esther Reichelt, a currency strategist
• Expects growing political pressure on the Fed to continue rate cuts, in particular if we see (temporarily) lower euro-dollar levels
• Sooner or later the market should become aware, that the bigger the ECB’s easing package this week, the less the ECB will be able to do in the future, which could actually support the euro