Position: Short EUR/USD (etf FXE); Short France (EWQ)
All eyes are on Thursday’s ECB press conference at 8:30am EST – ECB President Mario Draghi has all but officially told the world that he’ll issue sovereign QE. Below, we present a brief case for being short the EUR/USD, with no crystal ball to guide us on timing, sizing, or composition of a QE package.
Shorting The EUR/USD: Head’s You Win; Tail’s You Win
Summary: We see Draghi coming up short in his pursuit to wave the QE wand and inflect the Eurozone’s rising tide of #deflation. Our view has not diverged over past years: Draghi remains in a box as he doesn’t have unified support from his country level lieutenants to carry out the necessary (remaining) “structural reforms,” and a sole inflation target to govern highly diverse economies is misplaced. Here’s our scenario analysis heading into Thursday:
1) Should Draghi deliver (and/or under-deliver) on current QE market expectations of €500 Billion (which themselves are highly speculative), we believe the EUR/USD is set to burn lower at least until he can better “fulfill” newly set expectations.
2) Should Draghi over-deliver on QE, we expect the EUR/USD to burn on the back of an expanded balance sheet and against an environment of strong USD and weak oil. Grounding our call remains the fundamentals of #EuropeSlowing.
3) Should Draghi not deliver QE on Thursday, expect the EUR/USD to remain weak as deflation and abysmal growth prospects remain center stage for the region.
The EUR/USD remains broken across our TRADE, TREND, and TAIL durations.
Timing – Central Bank Hints: A week ago, Draghi told the German publication Die Zeit that the ECB is ready to buy government bonds on Thursday in order to fulfill its mandate on price stability. Can we believe him?
- The Swiss National Bank (SNB) thought so. In an emergency decision last Thursday morning (1/15) ahead of its expectation for the ECB to launch QE (which would weaken the EUR and encourage piling-in to the safe Swissy safe haven trade) it discontinued its 3 year running policy of a minimum exchange rate at 1.20 vs EUR and cut its main interest by 50 bps to -0.75%
- The Danish Central Bank thought so. To limit currency appreciation, the Danish central bank over the weekend cuts its deposit rate to -0.2% from -0.05%
- ECB. Since its December meeting, Draghi has talked of a QE announcement falling in Q1 2015. While there’s been strong pushback, especially from the German camp against QE, since the New Year, Draghi’s public remarks on QE have not wavered and in fact increasingly suggest announcement at the 1/22 meeting
Timing – Economic Hints!
- Under Draghi’s QE logic to ignite inflation, there’s no sense in delaying QE as the ECB is well off its mandate of price stability based on CPI at or near 2.0%
- CPI is currently at -0.2% and has tracked lower for 3+ years (see chart)
Timing – Legality Roadblock Passed?
- As an initial indicator for the legality around the ECB issuing QE, The European Court of Justice Advocate General said last Wednesday that the ECB’s bond-buying scheme – the Outright Monetary Transactions (OMT) Program – is “compatible in principle” with EU law.
- While not a Final decision of the ECJ, and only a proxy for a pending round of QE, this decision appears to be a key “tell” that will positively influence Draghi’s decision making on QE
- We expect the Germans in particular to cry a loud foul unless the terms and conditions of the QE meet their needs
Size – A Game of Expectations!
- The market got a hold of an ECB draft proposal for a €500 Billion QE package.
- Since last year, Draghi has indicated the willingness of the ECB to tack on another €1Trillion to its balance sheet.
- What’s the magic number? We don’t purport there to be one as we have little conviction that “this time around” Central Bankers can fix deep seated economic competitive issues with magical financial-based incentives.
Composition – Getting Ducks in Order:
- We suspect Draghi and ECB may well be waiting to get past the Greek election on January 25thuntil it decides on adjusting the composition of QE
- Therefore the “details” may not come until March 5th when the ECB convenes its next press conference
- Currently, the Greek anti-austerity party Syriza maintains a 4% to 6.5% advantage in three polls ahead of PM Samaras’ New Democracy government.
Composition – The Devil is in the Details:
- Some big unanswered questions remain:
- Will QE involve risk sharing among the National Central Banks, mandating them to buy up their own countries’ bonds?
- Will the ECB take on the full risk/exposure in buying sovereign bonds?
- Or will there be some mix between the two?
- Also, will ECB purchases be excluded to only AAA rated paper?
- The Germans remain the loudest cohort that still stands against QE and therefore is most interested in National Central Banks sharing risk in any QE program
- As it relates to Greece, based on the election outcome, the ECB may have to alter its QE program. A couple examples:
- Should Syriza win, the ECB may exclude Greek bonds from its purchasing program for fear the country may try to restructure the bonds after the ECB has purchased them.
- Should Syriza win, it may influence the ECB to put more emphasis on the National Central Banks to fulfill QE purchases. This too would appease the Germans.
The days ahead could bring some monster swings across global markets. We’re positioned to stay short the EUR/USD, and today added a perennial country favorite to the short side, France via the etf EWQ. We’ll be along for the ride.