Intakes From The ECB Meeting: Stay Long The Euro

As expected, the ECB cut its deposit rates by 10bps to 0.5% and announced that it will restart its asset-purchase program in November, buying EUR 20bn of sovereign and corporate bonds as long as the Euro area economy needs, and will end the program ‘shortly before rising the key policy rate’. In addition, it dropped the calendar-based forward guidance and replaced it with inflation-linked guidance as we saw that inflation expectations have been falling in the past year. Figure 1 (left frame) shows that the 5Y5Y inflation swap is currently trading at 1.22%, down from 1.75% 12 months ago, diverging significantly from the 2-percent target. Policymakers also introduced a tiered deposit rate to banks that would exempt a portion of excess reserves held at the ECB from the deposit rate.

Figure 1

Source: Eikon Reuters

As expected, the Governing Council reviewed the economic outlook to the downside, lowering real growth projections to 1.1% and 1.2% in 2019 and 2020, respectively, down from 1.2% and 1.4% in the June projections (figure 3). The risk still remains high due to the persistence of global uncertainty impacting the international trade growth and the vulnerabilities in some EM markets due to the high US dollar. Figure 2 (left frame) shows that the annual growth in world trade has slowed down significantly since the beginning of 2018, down from 1.2% in January 2018 to slightly lower than 1% in June 2019, its lowest level since February 2016. As Europe is the most exposed economy to global trade tensions due to its high percentage of exports, the downgrade in growth expectations has been largely associated to the elevated uncertainty. Figure 2 (right frame) shows that gross exports increased from 39% in 2008 to 46% in 2018 as a share of GDP, which is significantly higher than the 12% share for the US.

Figure 2

Intakes From The ECB Meeting: Stay Long The EuroSource: CPB, Eurostat

Euro policymakers also reviewed inflation projections to the downside, lowering the HICP to 1.2% and 1.0% for 2019 and 2020, down from 1.3% and 1.4% in June (figure 3). It is clear that Euro policymakers have constantly been very optimistic on the inflation outlook (figure 4, left frame), and Draghi admitted that the stimulus package announced on Thursday was done mostly to bring the inflation closer to the 2-percent target. Figure 4 (right frame) shows that the CPI and core CPI inflation have anchored between 0.5 percent and 1.5 percent in the past few years, which is non-acceptable for the Governing Council. Therefore, the ECB will run the EUR 20bn monthly APP program as long as needed in order to get the inflation back to target.

Figure 3

Intakes From The ECB Meeting: Stay Long The EuroSource: ECB

Figure 4

Intakes From The ECB Meeting: Stay Long The Euro

Source: WSJ, Eikon Reuters

One important comment from the conference was that Draghi was calling Euro government to act as well in order to get a more efficient and rapid response from the current monetary policy, implying that fiscal stimulus could be the next step. It is clear that it takes time for European governments to loosen their fiscal conditions, especially very indebted nations such as Italy or Greece. Even though most of the EU nations have a deficit below 3% (as a share of GDP), most of the countries have seen their debt-to-GDP ratios increase in the past few years. Figure 5 shows that most of the core economic nations run a debt-to-GDP ratio well above the SGP 60-percent limit. For instance, France remains the only core country where the debt-to-GDP ratio has continued to increase since 2014; while the debt-to-GDP ratio decreased from 91.9% in 2014 to 86% in 2018 in the Euro area, it increased from 94.9% to 98.7% in France (it has even stabilised in Italy). Hence, even if the Euro area needs a fiscal relaxation now, it will certainly take government leaders a considerable amount of time before adjusting to the current economic environment.

For example, with a manufacturing PMI at 43.5 and sentiment surveys at their lowest level in the past decade, Germany is very close to falling into a recession and definitely needs a fiscal relaxation to stimulate growth in the medium term.

Figure 5

Intakes From The ECB Meeting: Stay Long The EuroSource: Eurostat

We went long EURUSD at 1.10 before the meeting as we thought that the market participants were already positioned for the worst. To the exception of QE-infinity, we did not think that the meeting was that dovish and therefore we could see some euro appreciation ahead of the Fed meeting next week. US policymakers have actually much more room to ease and therefore could surprise the market in the next few meetings, which could lower the US dollar in the short run.

Intakes From The ECB Meeting: Stay Long The Euro

Disclosure: I am/we are long GBPUSD, EURUSD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.