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ECB Has High Burden of Proof to Weaken Euro Today

ECB Has High Burden of Proof to Weaken Euro Today

Talking Points:

- ECB meets for last time this year with several changes expected to its QE program.

- Failure to address market's 'Christmas List' of policy changes could see the Euro rally, regardless of an extension.

- See the DailyFX Economic Calendar for Thursday, December 8.

Join me today at 07:30 EDT/12:30 GMT in the DailyFX Live Trading Room for coverage of the ECB rate decision and trade setups in EUR-crosses.

The ECB meeting is expected to bring about significant changes to the ECB’s bond-buying program. At a minimum, the ECB will announce a six-month extension, extending the duration of its QE operations from March to September 2017. Any downside from this announcement has already been priced-in to the Euro, by our estimates; the formal recognition of this policy adjustment itself should have little impact on the Euro.

To ensure “smooth implementation” of its policies, the ECB will likely make an adjustment to its deposit floor threshold or capital key allotment. As a reminder, the ECB allots its bond buying based on the capital key. What is the capital key? The capital of the ECB comes from the national central banks (NCBs) of all EU member states. According to the ECB, the NCBs’ shares in this capital are calculated using a key which reflects the respective country’s share in the total population and gross domestic product of the EU.

As such, it's no surprise that Germany - as the country with the largest capital key contribution - has seen the belly of its yield curve (3Y-7Y) drift into negative territory at points over the past six months, below the ECB's -0.40% deposit level - the threshold at which the ECB no longer purchases bonds in its QE program. While scarcity is not a concern now, the fear of liquidity issues down the road are significant enough that the ECB wants to act now to eliminate said speculation.

Likewise, beyond extending its QE program, the ECB will either: remove the limiting parameter of -0.40% on its bond buying; or discard the capital key variable. In the first case, German yields would like move lower the fastest; in the second, peripheral yields like in Italy and in Spain. The latter move would be particularly welcomed in Italy, where the banks are under pressure after the referendum result.

The market's 'Christmas List' of things the ECB needs to accomplish today is steep - 1) extend QE; 2) alter implementation; 3) reassure markets taper is far away; and 4) show willingness to help Italy after the referendum result. If the ECB doesn’t make changes beyond an extension, the odds of the Euro rallying will increase as markets speculate that the ECB isn’t delving deeper into its extraordinary policy-loosening toolkit and moving closer to ending is crisis efforts.

Read more: December Forex Seasonality Sees US Dollar Weakness into End of Year

--- Written by Christopher Vecchio, Senior Currency Strategist

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.