ECB Provides More Questions Than Answers

The ECB certainly delivered on all fronts at last week’s meeting, although a little underwhelming in some areas. We saw a rate cut, the restarting of QE, the tiered deposit system to mitigate the impact of negative rates on banks, easier terms for targeted long term refinancing operations (TLTROs), and strengthening of its forward guidance. Overall, the ECB did follow-through with the promise of supportive easing measures, however, the adequacy of the package along with the introduction of a tiered system has left the rates markets bewildered. The 2s10s Bund curve bear flattened by over 8bps on the day, while on the OIS curve side the market removed the near term possibility of cuts. 

For us, the most important question is regarding QE. The ECB will be buying €20 billion of bonds every month from November until inflation expectations come “sufficiently close to, but below, 2%.” 

Talk about taking a risk, this is likely one of the biggest gambles I have seen from a central bank in quite a while. Considering that the target is very unlikely we have just essentially witnessed the announcement of unlimited QE. If inflation continues to weaken as it has been, the markets will now believe that the ECB has nothing left in its policy tools to combat it. In this case, confidence in the ECB and the Eurozone economy will vanish. 

The two charts below show inflation expectations for Germany and the Eurozone core inflation rate. 

What does this mean for us as traders in the near term? Not very much. It will certainly have a longer-term impact on the EUR, but in the short term our long EUR idea still stands now that the ECB meeting is behind us and the market spent a good amount of energy selling off the single currency heading into that meeting. Perhaps the most important detail for us right now is that the OIS market is pricing out expectations for another near term rate cut. This alone should relieve some of the selling pressure on the currency.

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