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John J Hardy
What next for the US dollar after Janet Yellen's comments on Tuesday led to a weakening of major dollar pairs? Saxo's John Hardy explains.
Article / 05 June 2014 at 7:09 GMT

FX Update: All the fallout from all ECB scenarios

Head of FX Strategy / Saxo Bank
Denmark
  • Market already prices in new LTROs
  • QE announcement unlikely
  • Hawkish outcome: EURUSD at 1.38
By John J Hardy

Clearly the European Central Bank (ECB) is virtually the sole focus today, so today’s FX Update is an ECB preview.  There are several elements to pay close attention to at today’s ECB meeting, and we also have to consider the odd setup of ECB meetings in general, in which the basic decision on interest rates will be announced first at 1145 GMT, and the market is left hanging until Draghi’s opening statement at 1230 and then we get the additional guidance that occurs during the extensive Question and Answer session.

1145 GMT Interest rate announcement

Base case: the ECB cuts the deposit rate 10 basis points to -0.10 percent and the main refinance rate by 15 basis points to 0.10 percent. Market reaction: Nervous sideways action with possible minor new lows as we wait for Draghi’s opening statement at the press conference.

Quite possible dovish surprise: ECB cuts the main refinance rate to 0.00 per cent or 0.05 percent or a range (like the Fed) of 0.00-0.10 percent. Market reaction: It's not used to dovish surprises from the ECB and EURUSD heads significantly lower and not far from 1.3500 ahead of the opening statement.

Extremely unlikely hawkish surprise (very low odds): ECB cuts refinance/deposit rates by only 5 to 10 basis points each (low odds – too incremental) or not at all (highly unlikely – EURUSD immediately rips 300 basis points higher in the latter case – I don’t think it is possible to see this latter development after expectations have so clearly been laid for a cut.

Draghi’s opening statement: Here the market will be focusing on the ECB’s inflation (primarily) and growth forecasts and the mix of actual new easing programs announced.

Inflation/growth forecasts: Here, watch for a lowering of the Harmonised Index of Consumers Prices inflation forecast and whether only the 2014 forecast is lowered (ie, only lowering the 2014 forecast would suggest that the ECB continues to believe that there is no threat of deflation risks becoming entrenched and extending beyond the near term). The dovish surprise would be any lowering at all of the 2015 and even 2016 forecasts. The March ECB forecasts for 2014-16 were +1.0 percent, +1.3 percent and +1.5 percent. Growth forecast lowering is secondary.

Credit easing programs and the magnitude/terms thereof

New LTROs with possible linkage to a BoE-style “funding for lending scheme”. The market has priced in new long-term refinancing operations (LTROs) – the longer the LTRO (baseline being another 3-year one) and the more generous the terms (full allotment, fixed rate, etc), the more dovish this is – not to mention the potential expected size of the program. Linkage to some sort of “funding for lending” will be a possible feature.

ABS (Asset-backed securities) market – this is another potential route towards relieving banks of taking additional risk on balance sheet (and repackaging and off-loading currently on balance sheet loans) and there has been considerable noise on this front from the ECB and in the media (an article in the Wall Street Journal recently even suggested coordination on this front between Bank of England and the ECB). So there are reasonable odds that something is announced, but possibly a program of modest size or an expression of the intent to do this in the future rather than at this meeting.

Important wildcard: suspension of the Securities Market Program sterilisation. This would be an important element of any dovish surprise, after it has been talked about for a long time with no action taken. It would add more than EUR 170 billion in liquidity.

Quantitative Easing. We are very unlikely to get any announcement on this now. But I wouldn’t be surprised to hear Mario Draghi mention during the Q&A that quantitative easing is a policy tool that the ECB can take up at a future date if necessary.

Q&A
Anything can come up here, but look for discussions of what was discussed and how “unanimously” or “firmly committed” the ECB is to whatever is not contained in the opening statement, or for which little forward guidance is provided in the opening remarks.

Overall outcome and market reaction :

Most likely dovish outcome (preferred scenario) – EURUSD to 1.3500/1.3450 fairly quickly and then to 1.3250 eventually,

To get here, the ECB cuts rates as expected or slightly more than expected and leans heavily on guiding the potential for rates to fall further in the future. Inflation forecasts for both 2014 and 2015 are lowered by more than 0.1 per cent each (minor GDP inflation adjustments are an additional potential factor). The Securities Market Program sterilisation is suspended and a large LTRO with Funding for Lending scheme on generous terms is announced. Heavy hints of an ABS programme in the works are thrown about and

Most likely hawkish outcome (alternative scenario) – EURUSD to 1.3800 and above very quickly and then falls further out.

EURUSD pops higher if the ECB only cuts by the consensus amount and the forward guidance on further cuts is not convincing, the ECB only cuts the 2014 inflation forecast. An LTRO is announced, but the SMP sterilisation is not.

Chart: EURUSD
The pair is in a nervous tight range between 1.3585-1.3650 ahead of today’s ECB press conference and technicals aren’t of much use when it is about an important event risk.

EURUSD

Source: Saxo Bank

Final thoughts
I have made the argument before that the huge trade in EU peripheral assets (equities and sovereign bonds) that was so instrumental in driving the EUR higher last year and early this year even as the interest rate spread with the USD (for example) collapsed, may be largely over with now. We are likely to get some further spread compression on a strong new ECB easing initiative, but we also have to consider that significant easing measures are going to bring massive liquidity back into the European financial system, making carry trades attractive (particularly with those negative rates) and likely eventually encouraging heavier consumption in the periphery and the core and bringing down the EU’s now enormous current account surplus (as the depression at the periphery saw current account deficits of 10 percent or more of GDP in 2006-07 become modest surpluses by late last year).

The other interesting developments to watch will be how risk appetite and the bond market deal with a dovish or hawkish surprise. EURUSD should trade up on hawkish surprises and down on dovish ones. But what do you do with EURJPY, for example, if the ECB is more dovish than expected and yet risk appetite is strong (relatively monetary policy suggests the pair should sell off, but strong risk appetite would offer some support.). It is more clear that the likes of EURAUD and EURCAD might rise sharply in the event we get a hawkish surprise and risk appetite weakens.

Regardless of what happens, stay careful out there!

Economic Data Highlights
  • Australia Apr. Trade Balance out at -122M vs. +510M expected and +902M in Mar. 
  • China May HSBC Services PMI out at 50.7 vs. 51.4 in Apr. 
  • Germany Apr. Factory Orders out at +3.1% MoM vs. +1.4% expected 
Upcoming Economic Calendar Highlights (all times GMT)
  • Euro Zone Apr. Retail Sales (0900) 
  • UK Bank of England Rate Announcement (1100) 
  • Euro Zone ECB Announces Refi and Deposit rates (1145) 
  • Euro zone ECB’s Draghi holds press conference (1230) 
  • Canada Apr. Building Permits (1230) 
  • US Weekly Initial Jobless Claims (1230) 
  • US Weekly Bloomberg Consumer Comfort Survey (1345) 
  • Canada May Ivey PMI (1400) 
  • US Fed’s Kocherlakota to Speak (1730) 
  • Australia May AiG Performance of Construction Index (2330) 
  • New Zealand May QV House Prices (0000) 

- Edited By Adam Courtenay

John J Hardy is head of FX strategy for Saxo Bank. Read more of John's commentary here.

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