The big day arrives

After all the disappointment, all the foreshadowing, all of the big talk and hawkish talk and frankly confusing talk, the big day is finally upon us.  If there were any lingering doubts that the ECB would do something, they surely took flight after this week's raft of uber-low CPI prints across the Eurozone.

The question now, of course, is "what will they do?"  There are essentially four streams of potential easing that the ECB could pursue:

* Interest rates.   This is the most orthodox stream of the lot, if one can call taking deposit rates negative "orthodox".   A move of 10 or 15 bps lower on the refi and depo rate are assuredly in the price.

* Liquidity.  This issue needs to be addressed if the ECB expects to have any impact on market rates (and frankly, it's not altogether clear that they do.)  There are really two options here: more LTROs or non-sterilization of the SMP.  One of these increases the volume of transactions that banks have with the ECB and the other decreases it.  In an AQR world, it would therefore seem that non-sterilization would be a preferable option.  The major demerit of doing so is likely to be a potential legal challenge from German monetization hawks.

*Asset purchases.  Although the ECB has done asset purchases before (SMP, covered bond program), they've never engaged in the galactic sizes performed by each of their G4 counterparts.  The major risk of doing a sovereign purchase campaign in aggressive size is that a) EZ sovereigns have done nothing but rally this year already, which hasn't spurred nominal GDP growth and b) the ECB would probably need to rent a block of flats in Karlsruhe to house the staff required to deal with the raft of cases brought before the German constitutional court.  As such, Macro Man is sceptical that this is likely alternative at this juncture.

* Credit easing.  At this point, the primary problem with credit transmission in Europe is not the threat posed by peripheral sovereign weakness, but rather the exorbitant rates charged to companies in those countries, particularly SMEs.   Readers familiar with Europe will know that bank lending is the primary credit channel in the economy, so this is a very serious issue.   Part of the problem is that while the monetary policy portion of the ECB wish to kickstart bank lending, the regulatory side is applying pressure to clean up balance sheets, reduce leverage, and increase capital buffers.   While this problem is hardly unique to the Eurozone, at this point it seems to be most acute there.  Following on the from the joint BOE paper, it seems likely Draghi will discuss ways to boost securitization, which would naturally disintermediate banks from the process, perhaps making them more likely to extend loans in the first place (just ask US mortgage lenders a decade ago!)

As noted last week, Macro Man feels that the balance of risk to Euro rates is tilted to the downside.  While euribor looks well-priced, that didn't stop some plucky punter from buying a strip of 99.87/100 call spreads, and even the 100 calls outright in December.   Of course, those are pretty wing-nut trades of the "I'll pay a tick for anything" variety.  Digging a bit deeper, it looks like positioning in 'bor is actually quite modest, at least judging by the aggregate open interest (the lower graph on the chart below.)

As you can see, the generic third euribor contract has actually traded as high as 99.90, all the way back in December 2012 when the ECB first broached the possibility of negative deposit rates.  It was for this reason that Macro Man thought it unwise to go full-hog short these contracts ahead of the announcement; he sees a decent risk that the market makes a half-hearted attempt to rally after the decision, particularly if there is some relief on the liquidity side.

Positioning does look a little more extended in Bunds, where your author continues to favour shorts against TY.

As for the euro....they can bitch and they can moan, but without intervention it may be a little tricky to get what they want.  The problem for the ECB is that their very success in fighting the peripheral fire and maintaining the euro as a reserve currency has contributed to the EUR's strength.  D'ya think they ever wondered how the dollar remained so strong for so many years despite current account deficits ( a problem that the Eurozone doesn't even have!)?

In any event, the EUR still looks fairly priced according to Macro Man's model, so while it may do whatever it wants today, colour him unenthused about the prospects for a proper macro opportunity.

Bonne chance, tout le monde....