Is Draghi ready for QE?

The last European Central Bank meeting put the cat among the pigeons, and we saw a final admission from Mario Draghi that fighting disinflation was necessary.

Mario Draghi, president of the European Central Bank
Source: Bloomberg

The lack of volatility in all markets has been something to behold lately, but the fact that this anomaly has extended to forex – usually the most volatile market – has been more difficult to conceive.

Data from the eurozone today showed that quarterly GDP is still nothing to write home about and, while most PMI data from the member states has been decent, producer prices remain under pressure, declining 0.1% on the month against the gain of 0.1% expected.

Previous meeting

The actions announced by Mr Draghi after the last ECB meeting included the following:

1. All three main ECB interest rates were reduced

2. Targeted Longer Term Refinancing Operations were introduced

3. Sterilisation of Securities Market Program (SMP)*, worth up to €119 billion, ended

This is essentially a form of mini-quantitative easing, as it will increase liquidity in the system thus making the negative deposit rate more effective.

4. Preparatory work on Asset Backed Securities (ABS) purchases to begin

This is an area one could expect to feature heavily in the press conference tomorrow. The progress made on the plans to buy up business loans and repackage them as asset-backed securities will likely be questioned. Equally, one could expect to see a degree of scepticism; if this was solution, wouldn’t it have already happened?

5. Full allotment for ECB operations was extended from mid-2015 to end-2016 

6. The possibility of more easing

This was all very well, but has since left the markets wondering, a) will it be enough, and b) if not, when can we expect to see full scale QE.

In the press conference, Draghi acknowledged that almost all of policy makers’ conventional tools were exhausted and left the door open to more action, by saying, ‘Are we finished? The answer is no’.

Tomorrow's meeting

If inflation remains low – and it will – the ECB will expand its balance sheet, by scaling up TLTROs and, if needed, launching a QE-like large-scale program of asset purchases. The market appears to be waiting to hear exactly when this level of easing will take place, but one has to wonder whether the ECB’s mandate will permit such a move.

Having peaked at 1.3994 in early May, the speculation surrounding the necessary actions from the central bank alone was almost enough to send the euro on a downward trajectory against both the pound and the dollar. The announcement of the actual measures to be taken then took hold, with EUR/USD falling to 1.35 in the immediate aftermath. The pair has since recovered, adding as much as 200 pips before settling back around 1.3650 and consolidating around the 200-DMA.

The liquidity differential ultimately puts the bias on euro strength. The ECB package, due to start in September, cannot contend with the real liquidity being pumped into the markets every month by the Federal Open Market Committee.

The French Prime Minister Manuel Valls also made his concerns clear regarding the overvalued currency earlier this week; ‘The euro is overvalued, which is bad for our industry and our growth.’ Look to sterling too; the six-year high accomplished against the dollar certainly suggests that the Bank of England will act first in terms of tightening monetary policy.

From a trader’s perspective, the positive correlation (0.91%) between GBP/USD and EUR/USD cannot be ignored, and the higher highs in the pound may well translate into a similar trajectory for the EUR/USD. The 1.3740 level is the line in the sand for me, and I think this will be pivotal in showing direction. A puncture and daily close through here would target 1.3820 in short order. While below it, there is an argument for a move towards 1.35 once again and this area remains the key level of support. Only a move down through 1.3470 would negate the 11-month up-trend.

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