The market can return to one of its favourite games later today: guessing what Mario Draghi can say to either talk up or talk down the euro. The ECB decision will be released at 1245 BST, with the press conference starting at 1330 BST. We don’t expect any change to policy, which makes the latter event more important from a market perspective.
To taper, or not to taper, that is the question yet again
The key question for the financial markets is when will the ECB begin to taper and recalibrate its QE programme to reflect the pick-up in the Eurozone’s economic data? While we don’t expect any change to the ECB’s forward guidance at today’s meeting, or any announcement that the ECB will scale back its Asset Purchase Programme (APP), Draghi could take the first step at today’s meeting and set the stage to announce something bigger at the next meeting in June.
It’s all in the statement…
The first clue that the ECB will announce a taper to the APP in the coming months could come in the first few paragraphs of the ECB’s introductory statement. If the ECB drops the wording that the economic risks are tipped to the downside then this could be perceived as a move towards policy normalisation, albeit a very small one. Even the smallest change to the introductory statement can cause a big movement in financial asset prices. At the ECB’s last meting in March, Draghi said that although there remained risks to the economic outlook they were now less pronounced, which was pounced on by euro bulls. This has been reiterated in the lead up to today’s meeting; with Draghi’s close confidante Benoit Coeure saying that the risks are now neutral during a recent speech.
The second clue may come in the Q&A, We expect him to be asked outright if the ECB discussed tapering, or if they have simulated tapering scenarios. While we expect Draghi to remain tight-lipped, if he lets slip that the Bank is looking at ways to unwind the APP, this could be another bullish signal for the euro.
Why the ECB is right to be cautious about tapering
Overall, we expect Draghi to remain restrained in this meeting, after all, the risks to inflation - CPI dipped in March - are still tilted to the downside and this could be one reason to delay tapering. The other reason is the precarious state of the Italian banking sector. Its banks hold the largest amount of bad debt in all of Europe. If the ECB reduces the amount of liquidity in the European financial system too quickly then it is hard to see how these banks can recapitalise themselves, and avoid selling off some of their bad debts at a book value so low that it hits their capital position. This could ultimately cause a much bigger problem for the ECB and the wider European banking sector.
Thus, bringing the APP programme to an end is a complicated process, and one that requires delicate handling. While the ECB does need to address the APP-sized elephant in the room at today’s meeting, any signal that the end is nigh for the APP is likely to be modest and delivered in a softly, softly way, so as not to spook Europe’s troubled banking sector. We don’t think that the ECB will go into any detail about the fading of the French political risks after the first round of the French Presidential election saw Macron cruise to victory. Instead Draghi is likely to say that all European governments should concentrate on economic reform.
What next for the euro?
To assess the potential impact on the euro from a change to the wording in Draghi’s introductory statement as mentioned above, it is worth looking at how the euro performed at the last meeting on March 9th when there was a very slight alteration to the wording of the statement. EUR/USD rallied more than 1.5% on the 9th and 10th March, which kicked off a longer rally back to 1.0900 on the 27th March, a total move of nearly 400 pips. Thus, this meeting could trigger a further surge in the euro that may lead to a sustained move higher back towards the 1.12/1.13 highs from November last year in the coming weeks.
Side note: Nafta shambles
Last night we wrote that the potential market impact of the US leaving Nafta could be negligible for the markets, as the US has been one of the most protectionist countries anyway in the last 10 years. This was further confirmed to me this morning when I woke up to headlines saying that Trump had switched course and was now going to renegotiate Nafta. Overall, this suggests that both communication and policy decision making are a shambles at the White House right now, with extreme and more moderate forces vying to get Trump’s attention. Overall, this Nafta issue highlights that policy implementation risk is surging under the Trump administration, and could stoke volatility if it continues.