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How to Be Ready for the ECB

How to Be Ready for the ECB

- Tomorrow’s ECB meeting is looking to be one of the more significant European announcements in months, if not years. Expect heavy volatility tomorrow.

- The expectation for an increase in bond purchases may be mostly ‘baked-in’ to current price action in EUR/USD, but the bigger factors of volatility will likely come from modifications to the deposit rate, or changes in the structure of European QE.

- Traders can use sentiment to attempt to time EUR/USD, and we’ve made real-time SSI completely free on our new, updated DailyFX 4.0. Click here to take a look.

The meeting that everyone around the world has been waiting for is now less than 24 hours away. The European Central Bank meets tomorrow for their December meeting after warning markets that the bank would re-examine their QE policy at this meeting. This was largely inferred to mean that the ECB was going to step up their stimulus program to offset persistent deflationary pressure that still persists despite being over a year deep into their current program. The Euro has been seeing massive selling across markets over the past six weeks, and we’re seeing an extension of that selling this morning just 24-hours ahead of tomorrow’s ECB meeting.

Created with Marketscope/Trading Station II; prepared by James Stanley

The current program purchases €60 Billion of bonds per month and most analysts expect this to increase tomorrow. That doesn’t really even seem to be up for debate at this point. But increasing QE isn’t as easy as simply typing in a larger number on the calculator every month, as the ECB has set a framework which they must operate within in an attempt to avoid losing money on Quantitative Easing, which was an important point, politically speaking, to get support from Northern European states to enable QE in the first place. The ECB will only buy bonds that have higher yields than what the ECB is paying to commercial banks that are depositors. The current ECB deposit rate is -.2%, so this means that any bond that’s yielding less than -.2% would not be applicable under the ECB’s QE program. So, those really attractive 2-year German Bunds that everybody in the world wants wouldn’t apply under the current form of the program because the yield on that paper is currently at -.434%. And it’s not just 2-year German Bunds sporting a negative yield of less than -.2%, as some estimates peg approximately 10-12% of the €5 Trillion trove of potential of bonds as carrying a sub -.2 yield.

So, it may make sense for the European Central Bank to cut their deposit rate to further open up the possibilities of bond purchases without having to carry too much risk in the ECB portfolio (like being forced to stuff the portfolio with Spanish, Italian or Portuguese debt merely because it’s some of the only debt that applies). This would increase the negative rate that the ECB is paid from commercial banks, and this would open up considerably more bonds to be applicable to this QE program while also further encouraging commercial banks to lend (by charging them more money with even more negative rates). But that impact would likely be short-lived, as the ECB ratcheting the deposit rate lower would likely see the secondary market continue to bid up that debt (bid up = higher prices = lower yields for bonds) to the point where yields decreased even further, which would essentially nullify the impact to QE of a lower deposit rate within a few months.

So, cutting the deposit rate may not be a panacea here. We also may see the ECB attempt to restructure their QE program by relaxing some of the rules that they had instituted when initially triggering in July of 2014. One possibility is cutting the deposit rate floor altogether. The Federal Reserve didn’t have a deposit rate floor during their multiple QE programs, and by setting the rate floor previously as the maximum yield that the bank would purchase bonds in the open market at, all that the ECB did was telegraph to the market where resistance would come in. As in – if the largest Central Bank in the world tells you that they’re buyers until yield hits -.2% (with the implication that they will continue to hold the position) – that is like the best support that an investor can get. If yields are .4% at the time, and the ECB announces that they’re buyers until yields move to -.2%, that means that buyers can, essentially, take a free ride on the ECB by front-running their expected future bond purchases.

So, scrapping this altogether may make sense, but this could raise the ire of certain countries within the Euro-bloc as the threat of QE becoming a costly endeavor could increase massively with the bank taking on all of that negative yield (which essentially paying a sovereign government for the right to deposit money with them). The ironic part of all of this is that the economies that do not need capital flows (like Germany with already negative yields), are the ones that will get the most. And the countries that do need capital (Spain, Italy, etc) won’t get as much.

So this may bring on another structural change to European QE in the form of shifting bond purchases away from Germany, or by the removal of the rule that mandates that the bank cannot purchase more than 1/3rd of any individual bond issue. These changes likely would face political pressure from a number of European member-states.

How to Trade This

First and foremost – I need to point out; you don’t have to trade this. Cash is a position too, and tomorrow will likely be volatile. This is one of the most important announcements for EUR/USD in months, if not years. Volatility will be likely. Direction will be uncertain, and what the ECB actually does will remain a mystery until Mr. Draghi takes the podium at 8:30 AM ET tomorrow morning (the statement is issued at 7:45 AM ET).

Given the moves that we’ve seen in EUR/USD since Mr. Draghi had originally announced the bank’s intentions at their October meeting, we can probably say that a good portion of the expectation for an increase in bond purchases is priced-in, at least to some degree, as EUR/USD has lost over 750 pips since that October 22nd meeting. As we had outlined just a month before that meeting, traders had the opportunity to sell EUR/USD before it put in a bearish break of the bear-flag that spent over 7 months developing. But a really strong NFP report just 24 hours after the ECB had pledged to re-examine QE put EUR/USD in full-on lurch mode, broke the bottom of the bear-flag, and has continued to see aggressive price action since.

But what likely isn’t priced-in, and what will likely provide the biggest potential for volatility tomorrow would be a decrease the deposit rate, or any significant structural changes to the current form of European QE, at least more so than a simple increase in monthly bond purchases.

But what you have to expect is the possibility for an event like we had in June of 2014. We discussed this prospect last week in the article, The ECB Fires a Warning Signal, but Will They Deliver in December. Most signs point to ‘yes,’ but it’s the delivery of ‘what’ that will shape upcoming price action in the Euro.

But with such a dire situation in the Euro-zone, there is really only one way to approach the Euro right now, and that is to look for ways to sell it. The fundamental situation for Europe and the technical situation for most European assets all point to the fact that continued pain is not yet being offset by current stimulus policies. And as Mr. Draghi has said, the European Central Bank is willing to do whatever it takes, or whatever it must to get this situation turned around.

So, longer-term trajectory on the Euro seems to be fairly clear right now; the only question at that point is the timing of the trade, and profit targets. The very obvious profit target level is parity, but with everyone in the world looking for the same figure, it would make sense to adjust one’s approach.

Created with Marketscope/Trading Station II; prepared by James Stanley

--- Written by James Stanley, Analyst for

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