Markets Are More Wary of a Surprise ECB Cut Than Bond Pundits

(Bloomberg) -- For currency and bond strategists, this week’s European Central Bank meeting is all about laying the groundwork for September. Yet traders are more wary of surprise action.

Money markets are pricing in a 35% chance of a 10-basis-point rate cut at Thursday’s meeting, while debt markets have surged to records since President Mario Draghi raised the prospect of fresh stimulus last month. Most analysts, however, expect the ECB to hold fire this week to see the extent of a predicted cut by the Federal Reserve next week and whether economic data recovers.

Subdued inflation expectations mean that for markets it’s just a question of when the ECB unleashes a wave of easing that may include an interest-rate cut and a re-start of its asset-purchase program. Investors will also be watching to see whether the ECB raises its limits for the buying of bonds, or alludes to any further plans to tier the deposit rate to ease the squeeze on bank profits.

“We even think there might be some more substantial measures in the ECB’s pipeline to maximize its effect by surprising the market,” said Esther Reichelt, currency strategist at Commerzbank AG. “It might be worthwhile for the ECB not to wait until September and potentially face adverse currency effects.”

The euro fell for a third day, reaching a seven-week low of $1.1176 Tuesday. The yield on 10-year German bunds was little changed at minus 0.34%, halting a four-day decline.

Draghi has surprised markets before, saying on June 18 that action will be needed “in the absence of improvement” in inflation. That was different from the ECB Governing Council’s meeting only two weeks earlier, when he said action would be needed in the event of “adverse contingencies.” He reversed rate hikes at his first meeting in November 2011, extended quantitative easing longer than expected and looks set to end his tenure with more easing.

Those expectations have driven yields across the continent into negative territory, with Belgium the latest to persuade investors to pay to lend it money for a decade this week, and Spain a favorite for QE bets. On the euro, options have turned mildly positive for the next six months as the Fed is expected to outdo the ECB’s easing, yet the wide range of forecasts shows that the main thing needed is clarity.

Here are views from strategists on the markets and the ECB:

Goldman Sachs (Favors Spain, Portugal)

• Goldman remains positive on peripheral debt in the run-up to the ECB’s meeting on Sept. 12, given it expects double the amount of QE anticipated by markets
• “The ECB will ultimately over-deliver relative to these expectations and see more room to price QE -- long Spain and Portugal are our preferred expressions,” write strategists led by Praveen Korapaty
  • Expect a 20-basis-points cut and tiering in September and a renewed asset purchase program, including sovereigns; QE to start at 25 billion euros per month for nine months, within existing restraints over issue limits
• The euro may still appreciate though due to the region’s favorable balance of payments surplus and Fed easing likely to outpace the ECB, according to strategist Karen Reichgott

Commerzbank (Preemptive Strike)

• Commerzbank foresees a risk that the ECB could “go big” and cut deposit rates by 20bps this Thursday, to preempt any potential Fed easing
• It predicts the euro will appreciate to $1.16 by end-2019, as even with a 20-basis-point cut by the ECB, the Fed could “overcompensate” with a 25-basis-points cut on July 31
• The ECB doesn’t “have much leeway left, so a big preemptive move that hopefully prevents them to have to do more at a later stage could seem attractive to them,” Reichelt says. “That would have an impact on the euro -- but I doubt that it would trigger a euro depreciation trend”

Credit Agricole (Upside Euro Risk)

• Euro-dollar likely to be broadly range bound, with the pair expected to trade closer to $1.12 by end-September
• Increased short-positioning, coupled with the ECB refraining from acting as early as this week, could “trigger upside risk related to euro-position-squaring this week,” said strategists Manuel Oliveri and Valentin Marinov in a note to clients
• Speculative-oriented investors may still continue selling the euro on rallies as the ECB might “prepare markets” for policy action in September

JPMorgan (Take Profit)

• Favors taking a tactical approach in the near term and lightening QE-friendly portfolios by taking profits on spread trades in long 10-year Spain versus France bonds
• “Our call is for the ECB to change language in the statement with ‘policy rates at present levels or lower’ to open the door to further rate cuts, with 10-basis-point cut in the deposit rate to be delivered at the September meeting,” write strategists Fabio Bassi and Antoine Gaveau
  • Half of JPMorgan’s clients in a survey expect the ECB to reinstate QE purchases by September

BMO Capital Markets (Short Euro)

• Bank currently prefers a short position in euro-dollar, and anticipates levels south of $1.12 will be tested prior to Thursday’s ECB decision; they might trim that exposure by mid-week, says Stephen Gallo, the head of European currency strategy
• The odds of a 10-basis-points reduction this week are much higher than what is priced into the OIS curve, according to Gallo
  • “At the very least we expect EUR/USD offers in the 1.1240/1.1250 range, barring any last minute ECB sources or leaks that could drastically alter the outcome of Thursday’s rate decision and press conference”
• BMO are among the most bearish on the euro’s prospects, predicting it at $1.10 in three months and then even lower at $1.09 in the next six to 12 months

NatWest Markets (Summer Restraint)

• Recommends buying 10-year Spain versus France given the former is not overbought, while the tenor looks a safer place to be long than five-year
• Strategists led by Imogen Bachra expect a 10-basis-points rate cut and a restart of QE at 30 billion euros per month for six months to be announced in September
  • A delay this week retains optionality for the ECB for little cost in the form of risk of disappointing markets, while a mid-summer move risks volatility due to lower liquidity, and there is also a risk that the message is less forceful if shouted into a market cleared by holidays
• ECB is unlikely to accompany any rate cut with tiering of the deposit rate, with potential communication issues and negative side effects
• NatWest believes that the ECB will raise the issue and issuer limit to 50% during its QE restart

©2019 Bloomberg L.P.