ECB Cuts Rates, Boosts QE & Murders Euro Shorts

Read that again. Does the title make any sense? Just how did the ECB murder euro shorts with even more easing?

The ECB has made its move this week. Even lower negative interest rates, more QE, and rhetoric that should all else equal send the euro tumbling to new lows.

But exactly the opposite happened an hour after news hit the wires. Baffled yet? Well, most traders were. The stupendous volatility this single event has brought to the financial markets is difficult to overstate.

  "A very wild and extremely volatile (painful) day for traders across most asset classes. After dropping just over 160 pips from pre-ECB highs, the euro (EURUSD) rebounded almost immediately after Draghi toned down his rhetoric on further interest rate cuts (which was exactly what markets have been discounting since January's meeting). The euro is now up a staggering 390 pips from its intraday lows! Global equities are all trading significantly weaker, while gold has resumed rallying on the heels of a weaker dollar (massive euro liquidations).    Lesson of the day? Know what you wish for!"    Business Of Finance on Facebook, 11 March 2016

"A very wild and extremely volatile (painful) day for traders across most asset classes. After dropping just over 160 pips from pre-ECB highs, the euro (EURUSD) rebounded almost immediately after Draghi toned down his rhetoric on further interest rate cuts (which was exactly what markets have been discounting since January's meeting). The euro is now up a staggering 390 pips from its intraday lows! Global equities are all trading significantly weaker, while gold has resumed rallying on the heels of a weaker dollar (massive euro liquidations).

Lesson of the day? Know what you wish for!" 

Business Of Finance on Facebook, 11 March 2016

Contrary to intuition, the euro (EURUSD) is some 420 pips north of Thursday's lows, making this one of the largest and most brutal intraday reversals we've seen in a long while. Yields on core European sovereign debt are all higher, instead of lower. Such moves make little sense considering how much looser monetary policy is now in the Eurozone. Or does it? Let us explain.

The facts

€80bn, that's how much assets the ECB will be monetizing each month going forward. The ECB announced Thursday, to heightened expectations, that it was lowering all 3 of its main interest rates on top of increasing the size of its asset purchase program, technically know as the PSPP (Public Sector Purchase Program).

Specifically, the bank cut its main refinancing rate by 5bp to 0%, the rate on its marginal lending facility by 5bp to 0.25%, and most notably the rate on its deposit facility by 10bp to -0.4%. Yes, banks now pay the ECB up to -0.4% on overnight deposits parked with it. In addition, the scale of asset purchases will be expanded by €20bn/month (from €60bn to €80bn) while covering more eligible assets than it had ever before.

These changes have not technically been effected yet, but will be made later in the month.

 Note: This is a snapshot prior to Draghi's press conference.   "The ECB did not disappoint today, at least for now.    Full ECB statement below:    Monetary policy decisions    At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:    (1) The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.    (2) The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, with effect from 16 March 2016.    (3) The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March 2016.    (4) The monthly purchases under the asset purchase programme will be expanded to €80 billion starting in April.    (5) Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.    (6) A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility."   Business Of Finance on Facebook, 10 March 2016

Note: This is a snapshot prior to Draghi's press conference.

"The ECB did not disappoint today, at least for now.

Full ECB statement below:

Monetary policy decisions

At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:

(1) The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.

(2) The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, with effect from 16 March 2016.

(3) The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March 2016.

(4) The monthly purchases under the asset purchase programme will be expanded to €80 billion starting in April.

(5) Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.

(6) A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility."

Business Of Finance on Facebook, 10 March 2016

Consensus forecasts were indeed met on paper (qualitatively and quantitatively) as analysts expected both a reduction in borrowing costs and an expansion of the PSPP.

We abstain from going too much into the motivations of the ECB's decisions but it is mostly accurate to reason those decisions with continued deflationary pressures due to low energy prices, fragility in the Eurozone's economic recovery (assuming there even is one), and external factors such as the slowdown in global economic growth.

The motivations, we feel, are very similar to those when the ECB held its previous meeting in January, where the prospect of renewed rate cuts and more aggressive asset purchases was earnestly raised. Herein lies the problem, but more on this later.

Fundamentally speaking, there is nothing much that has changed since January to warrant fresh discussions.

One could perhaps view the exacerbations of the crisis with regards to migrants, or the situation with Britian's proposal to exit the European Union, or significantly higher crude oil prices as new developments. Nothing particular noteworthy apart from developments in the energy space and political contentions in Germany.

Size and scale of QE increased

We know that the ECB will now purchase €80bn instead of €60bn a month worth of European debt securities. The targeted end date of the PSPP is still unchanged at September 2016.

What is however less discussed and is perhaps the most important bit of fact in this entire revision is that the ECB will broaden the list of eligible securities it can monetize under the current program.

In short, apart from increasing the size of QE, the ECB now has the ability to purchase European debt securities it couldn't have in the past. Before we get into why this crucial chance was made, it is key understanding some of the limitations the ECB has previously imposed on the PSPP.

There were five major constraints rigut before the latest ECB meeting, as summarized by Bloomberg:

  1. Bonds are purchased in proportion to a country’s capital key, a measure of the size of each economy and population.
  2. The ECB won’t buy more than 33% of any individual bond issue.
  3. It won’t buy more than 33% from any individual issuer.
  4. The bonds purchased must mature in no less than two years, and no more than 30 years.
  5. And it won’t buy bonds that yield less than its deposit rate.

Under the old framework, the ECB was only allowed to purchase euro-denominated government bonds of Eurozone countries subject to the aforementioned capital key limits and criteria. It was also purchasing government-secured agency debt securities, but the bulk of monthly flows was still into government debt.

  "Euro shorts (and correlation trades) have capitulated in earnest after Draghi pulled way back from promising further rate cuts in the coming months. Not only is the euro 140 pips higher that pre-ECB levels, European risk assets (and globally for that matter) are selling off hard.    And of course, European rates are rallying in convergence to where the ECB's o/n deposit rate currently sits. This isn't the first time Draghi has noosed euro shorts."   Business Of Finance on Facebook, 10 March 2016

"Euro shorts (and correlation trades) have capitulated in earnest after Draghi pulled way back from promising further rate cuts in the coming months. Not only is the euro 140 pips higher that pre-ECB levels, European risk assets (and globally for that matter) are selling off hard.

And of course, European rates are rallying in convergence to where the ECB's o/n deposit rate currently sits. This isn't the first time Draghi has noosed euro shorts."

Business Of Finance on Facebook, 10 March 2016

All 5 aforementioned restrictions greatly limited the ECB's maneuverability. Unlike the U.S. treasury market, the euro sovereign bond market is much smaller. For each day that passes, the amount of eligible securities (under the old framework) the ECB is allowed to purchase decreases, and by a relatively substantial amount. Here's why:

  1. The largest euro government bond markets are of Germany and France. Yields on German and French government paper have been on a downtrend, with the front end of the yield curve dipping below 0% and even under the then ECB's deposit rate of -0.3%. Refer to Point 5 above. Bunds under 5 years of maturity have consistently yielded below -0.3% (the old deposit rate). This makes a LJ increasingly large portion of the German government bond market ineligible for monetization. Germany is also the largest single market for government debt in the Eurozone.
  2. The very fact that the ECB's purchases are draining massive amounts of liquidity from the already stetched euro sovereign bond market, has accelerated the down trends in bond yields of the respective countries, creating a negative feedback loop which will overtime handicap the ECB's ability to meet its targeted monthly asset purchase amount.
  3. Capital key restrictions mean that once most (if not all) of eligible German bunds have been monetized, again subject to Points 2 and 3, the ECB has to find other bonds to purchase, which is again limited by Point 1.

As you can see, the ECB realized this mounting issue when it contemplated maintaining the size of its PSPP, let alone increasing it. It would therefore make absolutely no sense had the ECB increased the monthly purchase target amount without broadening the scale of the securities it can purchase. In layman's terms, the ECB needed a bigger basket from to monetize, and that was what it did on Thursday.

 This infographic illustrates the relatively tiny size of the Euro IG (investment grade) corporate bond market (EUR denominated securities). At €1.6trn, EUR IG is only slightly larger than the HY (high yield) corporate bond market in the U.S. (USD denominated securities). About 40% of EUR IG debt are from financials (ineligible under the current updated PSPP framework). That leaves about €900bn of non-financial EUR IG securities for the ECB to potentially monetize.  Interesting to note that about 5 hours into the ECB's policy decision announcement, European IG CDX is diverging strongly from higher government bond (and financials) yields, in what is obviously the market's attempt to front run the ECB bidding for liquidity in the already thinning sea of IG debt.   Chart courtesy of Goldman Sachs

This infographic illustrates the relatively tiny size of the Euro IG (investment grade) corporate bond market (EUR denominated securities). At €1.6trn, EUR IG is only slightly larger than the HY (high yield) corporate bond market in the U.S. (USD denominated securities). About 40% of EUR IG debt are from financials (ineligible under the current updated PSPP framework). That leaves about €900bn of non-financial EUR IG securities for the ECB to potentially monetize.

Interesting to note that about 5 hours into the ECB's policy decision announcement, European IG CDX is diverging strongly from higher government bond (and financials) yields, in what is obviously the market's attempt to front run the ECB bidding for liquidity in the already thinning sea of IG debt. 

Chart courtesy of Goldman Sachs

Under the new framework, the bank will be allowed to purchase debt securities of non-financial euro-denominated corporate bonds of private entities in Eurozone countries.

This move significantly broadens the list of elibigile securities, and lessens the pressure placed on the liquidity situation of the euro sovereign bond market. It also marks the ECB's official entrance into the private sector; by opening the door to directly monetizing bonds of private companies, the ECB now acts as creditor to private corporations within the Eurozone

Not aptly so; the term PSPP or Public Sector Purcahse Program would become off. While the full details of this change have not yet been publicized, we reckon that private sector purchases will fall under the bank's EAPP (Expanded Asset Purchase Program) framework.

Most encroaching of all, this venture into the private sector opens up an entirely new dimension for both the ECB and European markets. In the short to medium term, we are expecting non-financial credit to starkly outperform banks and to perform slightly better than sovereigns. The market has already started to front run the ECB in its private sector purchases.

But why did the euro explode so violently? 

This is what everyone was asking during the first few hours after Wall Street opened for trading on Thursday morning. Thankfully, it's not a hard question to find an answer to, honestly.

In most cases, there are no simple answers to questions surrounding very complex subjects such as the financial markets. But in this rare occurrence, we dare say it is as simple as logic would have it.

One line summaries it: Expectations were betrayed.

  "Draghi just trolled the markets in his presser, once again. Euro erases all its post rate cut losses and clears the 1.11 figure! This is insane volatility."   Business Of Finance on Facebook, 10 March 2016

"Draghi just trolled the markets in his presser, once again. Euro erases all its post rate cut losses and clears the 1.11 figure! This is insane volatility."

Business Of Finance on Facebook, 10 March 2016

What has not been reflected in consensus estimates was that the markets were expecting the ECB to stay on the side of even looser monetary policy beyond its March meeting. That is, even more rate cuts down the line (following Thursday's cut). We've read analysts expecting the deposit rate to be at -0.75% by year's end.

Unfortunately, that is going to be an extremely unlikely outcome, as proclaimed by Mario Draghi himself. Refer below to our screen capture of the exact moment the President uttered the words he did; and that was the few words which utterly crushed any euro shorts. 

 Note: This is a snapshot of the news flow during Draghi's press conference. The time stamps are viable.   "Uh oh, Draghi has hinted that there will not be further rate cuts... Euro snaps higher instantly, dragging risk lower."   Business Of Finance on Facebook, 10 March 2016

Note: This is a snapshot of the news flow during Draghi's press conference. The time stamps are viable.

"Uh oh, Draghi has hinted that there will not be further rate cuts... Euro snaps higher instantly, dragging risk lower."

Business Of Finance on Facebook, 10 March 2016

Besides commenting that he did not anticipate rates to head lower in the future, Draghi also commented that the ECB did not have the leeway to bring interest rates as negative as they wished, even if the board wanted to.

This sent a very strong message across trading desks worldwide, and that was the market's expectations of renewed easing in the future were rendered obsolete.

It's a case of fundamental weakness and technical strength. We can't be more bearish the euro on a fundamental aspect. But we also can't be more bullish the single currency from a technical point of view. 

What we saw on Thursday was a classic capitulation where an overly eager and one-sided market suddenly tips over and flings everyone on the side of the consensus overboard. Expectations were betrayed by the man who inspired them in the first place. It's irony on the finest level.

We might do a separate piece in the future talking more about our views as this piece has been more factual than opinionated. Meanwhile, do throughly enjoy the wild ride!