Bar Is Set High and Risk for Disappointment Remain High

As we head towards the last meeting of the ECB, the risk of a disappointment is really high. The market is expecting another jolt of life from the president of the ECB and if he fails to provide one, the outcome could be bloody.

If you look at the overnight volatility of the Euro against the dollar, you can see that the people behind smart money have been busy hedging their bets. The volatility has spiked to its second highest point ahead of any ECB meeting this year.

It is widely expected that the ECB will announce the extension of its QE programme, however, the market is divided about whether it will be a 3-month or 6-month extension. Given that we have had a "No" vote in the Italian referendum and the German elections are also going to present some headwinds next year, we anticipate that the ECB may actually announce a 6-month extension.

They can always scale back if likened be and change their flight path. However, revisiting the same issue in another 3 months’ time will create trouble for them. Having said that, the ECB is used to facing troublesome situations. One of the major ones which they need to address is the scarcity of eligible funds to buy.

Therefore, we are expecting the bank to announce some technical changes to their monthly bond purchase programme. This could involve increasing the issue limit to 50%. In our base case scenario, one path the ECB will not venture down is the lowering of the interest rate. Removing the floor for deposit rates to increase the pool of eligible funds also remains a distant option.

The recent moves in the bond yields which we have seen since Donald Trump's victory has relaxed some of the scarcity issues for eligible funds, but the bank needs to make some changes if they want to continue their programme beyond their current deadline.

Apart from Mario Draghi's decision on the QE, markets will also react to the bank's latest growth and inflation forecast. What we expect is that their inflation forecast for 2019 (1.8%) may still remain below their target level of 2%. The bank may also axe its inflation forecast for 2017 from 1.6% to 1.5%.

Therefore, we think that the bar for disappointment is really high and the bank really needs to deliver on all angles to satisfy the markets. Hawks must remain shackled because any tapering talks before September 2017 could bring about a catastrophe for markets. Let’s buckle our seatbelts and get ready for the ride. Hopefully, it won’t be too bumpy.

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