Sunday, January 18, 2015

Markets pricing in substantial QE operation by the ECB

Evidence continues to mount of the ECB's impending quantitative easing announcement. Here are some indicators:

1. The European Court of Justice in effect cleared the way for such a program (see story). Furthermore, there are options on the table that may avert major hurdles for Germany (see post).

2. The SNB's action last week suggests that the central bank is preparing for new inflows of euros it can no longer stomach.
Deutsche Bank: - ... the timing of the SNB’s decision suggests that they do expect the ECB to deliver next week.
3. The Eurosystem consolidated balance sheet (chart below) is expected to begin declining again, as the area's bank deleveraging results in repayments of loans to the ECB. The TLTRO program and the current securities buying activity (ABS, covered bonds) remain insufficient.

Source: ECB

4. The CPI is in the red (see chart) and there is no improvement in the swaps-implied inflation expectations. This is something that Mario Draghi and team watch quite closely.

Orange = swaps-based euro 5yr forward 5yr inflation expectations. Purple = the same for the US
Source: @Schuldensuehner

5. Short-term rates in the Eurozone are moving deeper into negative territory. The German 3-year government yield is now at negative 15bp (see chart). The overnight interbank rate (EONIA) is also falling.

Source: ECB

In fact the term structure of the overnight rate expectations has shifted sharply lower - with negative overnight rate expected to persist well through the end of 2016.

Source: Deutsche Bank

The market expects the banking system to be flooded with liquidity generated by quantitative easing for a long time. The area's banks will therefore prefer lending to each other at negative 8-12 basis points to depositing with the ECB at negative 20 basis points - as they play "hot potato" with new infusions of liquidity.

With this in the background however, it's important to point out that the ECB has been known to disappoint. Many of the Eurozone periphery bond yields are at or near record lows anticipating this action from the ECB (priced to "perfection"). The euro is at multi-year lows (see chart) - also expecting the ECB to act. A substantial QE program is now priced in. Anything but a "bazooka" announcement will send shivers through the markets, resulting in a volatility spike. The bet is on that the ECB will come through with "shock and awe".

10-yr Italian government bond yield had a record low close last week

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