Friday, February 26, 2016

ECB March Meeting: Front Running

The expectations are high for March 10 ECB (Fed and BoJ will come in quick succession in the following week as well). ECB President promised action (or consideration to be precise) in the last meeting. And ever since inflation breakevens have nose-dived. This week's inflation data almost takes away the last bit of uncertainties around some action at least.
However, the major question this time is not if, but what. In the face of an unrelenting fiscal pressure, the ability of central banks to surprise and exceed expectations are increasingly under pressure. The limits of negative rates are already in mainstream discussion. Policy rate cuts are easy, but they are already on the brink. A tiered negative depo rate can be viewed positively (even for bank stocks), but that avenue is not really a surprise. Market was half expecting it back in December anyways. Any other combination of policy rates adjustment will hardly be exceeding expectation.
On the other hand, QE has more potential in this regard. For one, extending asset based (say equities) will be a really large surprise. But it is highly likely that such bazooka will be reserved for a real crisis. Not now. Other options include increasing the QE timeline (already done once), and increasing the monthly purchase amount.
We have discussed before what left in the central bankers' toolkit. For March, the most potent and practical option is the second one in the above paragraph - upsizing monthly purchase. Here it has to be both credible and effective. Given the outstanding amount of sovereign issues (I think Germany will be the limiting criterion), hitting the balance is tight. A sizable increase puts in to questions the achievability of the plan, given the current capital key ratio rule of purchase. On the other hand, a token increase will most likely be a dud. The most effective thing for now will be to hint a possible reevaluation of the capital key constraint. That will give way to a very credible QE in future from Europe perspective. This is especially true as we have seen a recent increase in peripheral spreads. The crisis has moved a little closer home already.
Here is a quick recap of last few ECB actions.

25bps cut in key rates
1. Main refi from 75bps to 50 bps
2. MLF from 150bps to 100bps
1. Main refi from 50bps to 25bps
2. MLF from 100bps to 75bps
1. Main refi from 25bps to 15bps
2. MLF from 75bps to 40bps
3. depo from 0 to -10bps
4. TLTRO announcement
1. Main refi from 15bps to 5bps
2. ABS/ covered bonds purchase program
3. depo from -10 to -20bps
4. MLF from 40bps to 30bps
Details of ABS purchase program
1. QE 60b till Sep 16
2. TLTRO pricing change (flat from 10bps over MRO)
Announcement of QE details
Increase in QE issue share limit (33% from 25%)
1. Depo from -20bps to -30bps,
2. QE from Sep 16 to Mar 17
3. reinvestment principal payments

And here is how the markets reacted historically to ECB meetings. The charts show the movements in corresponding markets over a period of 5 days before and 2 days after the ECB meeting, measuring the move in terms of number of standard deviation (then prevailing).
Observing from the graph, we see a strong positive bias for euro to respond to ECB (positive bias used to mean a rally during 2012 euro crisis and a sell off in more recent time!). At the same time  risk assets like Euro Stoxx also shows a positive skew. On the other hand, the response from rates world is much more nuanced, and has been mostly disappointing for rates levels (failure to sustain rally), and less so for less slope (sustained steepening on the back of policy easing).
This pattern is validated when we look at the relative rates spreads. These charts below shows the USD to EUR 10y swap rate spread and 5s30s steepener spread (USD less EUR). In relative terms, the slopes performed even more consistently.
Given this back ground the asymmetric tactical trades are:
1) shorting euro and long equities
2) positioning for a steepening in 5s30s.
3) And hedge the position with a short rates on the long end.
This is especially attractive given the recent risk rally in euro and flattening of the euro curve. Fine tune this based on the degree of surprise you expect. This is a tactical positioning. With little fiscal support, a monetary response will probably be still wanting in the face of deeper issues that remains. And following week can unwind the whole thing, especially after BoJ.

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