ECB recalibration amounts to diluting the punch bowl, not removing it – Add to strategic short EUR

ECB recalibration amounts to diluting the punch bowl, not removing it – Add to strategic short EUR

  • Strategy implications – short EUR, short CEE-EUR, short SGD-CNH, long CAC: The ECB’s ’30 for 9’ QE recalibration (‘30bn euros less in bond purchases for 9mths’) amounts to diluting the punch bowl, not removing it. If you consider ECB reinvestment of maturing bonds as well as the open-ended nature of the end of QE, this ‘30 for 9’ recalibration is even less dramatic – closer to ‘15 for 9+’ (‘15bn less bonds for 9mths possibly more’). Post-ECB meeting, we’re even more inclined to express our strategic long USD bias via short EUR, among others. Our strategic long USD view is premised on a Powell-Taylor Chair-Vice Chair Fed, a December rate hike and a GOP tax plan passed by year-end.

  • Strategic FX: In our strategic FX portfolio, we add to short EUR (target 1.125 – or -3.2% from current 1.1625 – by December). We also add a small short EUR-JPY position, which is attractive given that yen short positioning – and BOJ policy options for further easing – are exhausted.

  • Cash-Plus #1: In our low-beta ‘Cash-Plus’ portfolio, we add to short Hungary HUF-EUR, Poland PLN-EUR and to a smaller extent Czech CZK-EUR. Post-ECB decision, these CEE currencies underperformed the EUR. In the case of Hungary, FX weakness is welcome. Poland’s economic cycle is mature, which could delay NBP tightening. The Czech CNB may also be inclined to soften its hawkish stance in response to ECB’s dovish taper and amid some domestic political uncertainty. We explore adding short Sweden SEK and Norway NOK vs EUR. We note that among the euro-linked FX, only the Swiss CHF outperformed, which could make it an attractive RV long (risk-adjusted for possible SNB intervention).

  • Cash-Plus #2: Also in our ‘Cash-Plus’ strategies, we are maximum short SGD-CNH, which not only benefits from EUR weakness but also from a likely strong-to-stable RMB policy (vs CFETS basket) ahead of Trump’s China visit in 2wks (SGD is our proxy for China’s trade-weighted basket). We expect to reduce this after Trump’s visit.

  • Strategic Equity: We add a small long France CAC, which not only benefits from EUR weakness but also set to outperform Euro Stoxx if Macron tax cuts gain traction.

  • Strategic Fixed Income: We reduce short Euro High Yield. We explore shorting EM local currency bonds. A bearish EUR outlook almost necessarily implies a strong USD view, which will be negative for EM FX.

Based on our Conviction-Correlation model, our EUR year-end forecast: 1.125

Forecast coincides with this chart from technical analysis gurus at Bloomberg (26 Oct-17):

  • What’s new?: The ECB’s soft taper was a letdown for euro bulls and rates-payers. Purposefully vague/open-ended on details, Draghi succeeded in simultaneously communicating QE exit while spurring a >1% drop in the euro and 4-8bp fall in Bund yields’ (and wider Bund-UST spreads) in the aftermath.

  • QE duration was more important than size: The 30bn-taper from EUR60bn to 30bn in monthly bond purchases was on the hawkish side of the consensus (20-30bn), but investors focused on a later-than-expected/open-ended QE end date of September 2018 (vs consensus range of Jun-Sep 2018).

  • ECB optionality: ECB maintained it has the option to increase the size or duration of QE as needed. The balance of CPI/growth risks (we think to the downside) – coupled with political uncertainties – suggest that any/next recalibration is more likely to be on the easy - rather than tighter - side. Nevertheless, we watch any signs of impatience/urgency from ECB hawks. While there was probably a broad consensus in the ECB committee on overall policy, it is not unreasonable to think there were/remain internal differences of opinion on specific items (eg unwind pace, sequencing and tools). QE flexibility provides optionality to accelerate/decelerate pace of unwind: Draghi stressed the QE program's flexibility even though 'the ECB did not discuss parameters, limits (eg capital key constraints), QE composition and alternative scenarios'.

  • No hike anytime soon: Rates will stay ‘well past’ end of QE. No guidance on definition of ‘well past’.

  • ECB reinvestment dilutes the taper: ECB highlighted reinvestment of proceeds from bond maturities as a key feature of QE. ABN Amro estimates that maturity proceeds from ECB-held bonds amount to EUR 15-20bn per month. Draghi comments implied that reinvestment could be a policy lever for any potential recalibration if needed (‘reinvestment will help deliver the right stance’). ECB plans to reinvest maturing debt through the end of QE.

  • Downside risks to CPI ...: On inflation, Draghi cautioned that headline CPI will decline towards the turn of the year on energy px base effects. While underlying CPI is moderately picking up, core CPI has yet to show convincing upward trend. Wage growth somewhat increased and core CPI to rise gradually over MT.

  • ... and probably to growth: On growth, Draghi commented that risks are broadly balanced but outlook still relies on ECB support. Global recovery supports exports. Downside risks include FX. If/when the current synchronous global growth turns to coordinated global slowdown, expect EUR to bear the brunt.

Our Twitter poll flagged to us that QE duration may be more important (to EUR outlook) than QE size:

ECB QE recalibration was on the dovish side of economist expectations - Bloomberg (26 Oct-17). Marginalia ours.

  • What’s next?: Now that an ~11mth-plan has been communicated, EUR is unlikely to receive support from the ECB anytime soon. For that, it would require renewed urgency/impatience from ECB hawks, which in turn needs evidence of a pick-up in economic/inflation momentum (little acknowledgement of these from the ECB statement anytime soon).

  • Watch for the main risk to EUR-bearish view: Some renewed sense of urgency to unwind QE faster than the '30 for 9' plan that was communicated. This could come from hawks inside or outside the ECB. Note that Germany CDU’s Brinkhaus commented that the ECB must follow with more steps and signal rate changes.

  • ECB step towards exiting QE welcome. ECB must follow with more steps, signal rate changes - CDU's Brinkhaus (26 Oct, as ECB decision details were in the news wires)

  • Bundesbank Weidmann may support extending ECB bond purchases as long as it ends program soon – Handelsblatt (24 Oct)

  • EUR is exposed to the downside from any slowing of economic momentum. Europe’s cyclical recovery is mature relative to US/Japan and – unlike the US (and now Japan) – there are no plans for significant fiscal stimulus (except perhaps in France). Expect Draghi to increasingly urge EZ govts to spend more. More fiscal stimulus would breathe confidence/flexibility to remove monetary accommodation more quickly.

  • Any signs of Eurozone slowdown just in the early stages of the QE unwind could give rise to whispers of an ECB ‘policy mistake’, which would be negative for ECB credibility – and for the EUR.

  • Finally, EU faces political stresses that may be small individually but significant in aggregate.

Reference/Visuals:

EUR (inverted) vs Eurozone Citi economic and inflation surprise indices (Bloomberg, 26 Oct-17):

Eurozone inflation - Still below target (Bloomberg, 26 Oct-17):

ECB balance sheet (Bloomberg, 26 Oct-17):

This article's author attempts a selfie with the ECB - back when EUR-USD was ~1.10 (Frankfurt, 27 Jun-16):

#eur #eurjpy #jpy #huf #pln #czk #sek #nok #chf #rmb #cnh #cac #ecb #eurozone #draghi

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