ECB preview; will 2016 slump force its hand?

With market expectations arguably higher than ever for ECB action, we take a look at what changes have occurred since the December meeting and where we could see markets move from here.

Next week’s European Central Bank (ECB) meeting is one of the most highly anticipated events of 2016; will a global slowdown and a continued disinflationary environment expected force the committee’s hand once more? There is no doubt the expectations for action are at their highest since the infamous December meeting, which saw the euro rally heavily despite a raft of measures from the ECB.

To understand the mindset of the ECB committee, it is important to recognise what changes have occurred to the data available to the ECB between the two meetings.

From an inflation front, the most recent headline CPI figure stands at -0.2%, which is some 0.3% lower than the 0.1% reading in December. However, a great deal of this disinflation will be attributed to the downturn in energy prices, which is why the core reading is also hugely important. Currently core CPI stands at 0.7%, which is also lower than the 0.9% level seen in December. Finally, perhaps the measure which is favoured most by the ECB members is the Eurozone 5y5y inflation swap, which is a measure of what average expectations are likely to look in five years.

Once more, this reading points to a significant deterioration in inflation expectations, with the December reading around 1.7% falling down to the circa 1.4% figure today. With headline CPI, core CPI and the 5y5y inflation expectations all down between 20-30 basis points since December’s meeting, members are likely to be willing to act in a bid to reflate the eurozone.

The eurozone economy as a whole continued to stutter along at 0.3% in Q4 2015, which matched the Q3 growth rate seen by the ECB in December. One positive is the fact eurozone unemployment fell fairly consistently from 10.6% to 10.3% over the December-March period, yet looking at the economy, fears remain.

One noticeable measure of economic progression which has deteriorated since December has been the PMI surveys, with both manufacturing and services highlighting a clear slowdown in economic expansion. This has been reflected in actual business activity, with both industrial and manufacturing production dropping into negative growth recently. With business confidence at the lowest level since 2013 and consumer confidence at a 13-month low, there is no doubt we have seen a significant economic deterioration since the December meeting.

December saw the ECB meeting preceded by a two-month rally in the DAX, gaining around 20% in that time. Meanwhile EUR/USD suffered heavily in anticipation of further easing, losing over 8% in the 50 days leading up to the meeting. Whether the ECB would act to prop up equity markets is arguable, yet the importance of the euro is undoubted, given that a weaker euro will make their goods more competitive and can impart inflation.

Given the US represents the biggest export destination and third largest import market for the eurozone, EUR/USD is the pair the ECB are likeliest to watch. The past 20 days have seen the pair fall 4.75%, yet it is currently 2% higher than at the time of the December meet.

The daily timeframe shows that while we remain within a clear three-month uptrend, the pair is approaching not only a key support zone at $1.0777 and $1.0808, but also the critical January swing low of $1.0710. A move back below $1.0710 could undermine this uptrend and would likely bring back calls for $1.0520 and even parity.

However, until we see a break through $1.0710, this uptrend remains intact and thus another move higher is possible, with $1.1059 the first major resistance level in view. Today’s gains are pointing towards a possible return of the uptrend which was instigated by the December meeting.

Looking at the DAX, the potential impact of ECB action can be seen with the big red weekly candle in early December following the meeting on 3 December. Expectations of ECB actions are growing by the day and there is a good chance we could extend the recent rally into the announcement.

A break through 9928 would provide a bullish indicator that further upside could come into play, with the 50% (10,065) and 61.8% (10,388) retracements coming into view. However, be aware we remain within a downtrend and unless we break through 11433, another big leg lower cannot be ruled out. 

There is no doubt that Mario Draghi wants to do more easing, just as he did back in December. However, this was also the case in December, but it was the apparent hesitancy of certain other members of the committee which held back the final stimulus package. On this occasion there is a feeling that some of the more hawkish members are also starting to turn. The RBS chart below shows a rough guide regarding who stands where, with the most influential members clearly sitting in the dovish camp.

Interestingly, the most influential hawk, Jens Weidmann, will be unable to vote in the March meeting due to the rotational voting rules. This would point towards a greater likeliness of substantial action at this meeting.

There is no doubt the data backs up the need to take action, with business activity and sentiment slumping heavily. However, this will no doubt have been influenced by the equity market sell-off which has dominated the beginning of 2016. Inflation will be a key concern, with all three major measures falling heavily. They cover a measure for total inflation, one excluding energy price impacts and another covering future expectations. There will be little resistance behind the notation this is a situation that needs to be fixed.

Markets have been preparing for action, with the euro devaluing and indices rallying in anticipation of further easing. It would be no surprise to see these moves extended as we approach the meeting. Yet be aware of the impact high market expectations make for a release such as this. Much like in December, when a great deal of any action is already factored into price, you can often see sharp reversals rather than another move in the same direction.

Ultimately it will be down to the details. Will the ECB increase the amount of monthly QE? Will it begin to buy corporate bonds? Will we see interest rates cut once more? It is clear previous measures are making little impact, so we could see some creative policy changes this time around.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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