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Assuming that we will not trade off US reflation and rising US bond yields, which we recently have, trying to figure out if this week’s ECB QE tapering decision is bullish or bearish for the EURUSD and the yield curve is not easy. The response will depend on a number of QE parameters that are under ECB review. The length of the QE program extension in 2018 should take precedence over the new monthly amounts the ECB plans to buy from January. That is because the ECB wants to avoid markets pricing in a first rate increase before 2019. Sequencing, or a transition between QE and rate increases, will become a more important driver in 2018.
Probable scenarios:
1. A short six-month extension and reduced purchases would be bullish EUR and bearish for rates as this would help markets bring forward a first rate increase.
2. A nine-month extension is the SG forecast and the consensus. This is probably most neutral (market positioned), but the reaction will then depend on forward guidance. The devil will be in the detail. The ECB retains the option to extend again after September 2018, but what message does it send on sequencing (first rise in interest rates), and reinvestments of maturing bonds?
3. A 12 month extension is the most bearish scenario for the EUR even with lower amounts, and favours a steady/flatter curve as the timing of the first rate increase is pushed further out than in a 6m or 9m extension scenario.
1. Programme duration extended by at least nine months, with the best case for EUR bears 12 months until end-2018. Purchases are open-ended (“at least or beyond”), i.e. the ECB retains the option to extend into 2019 if headline and core inflation numbers continue to disappoint.
2. Programme size: the higher the better as this would keep bund yields and the IRS curve flatter relative to the US, keep the EURUSD from rising and maintain wider EU/US rate spreads.
The ECB can tweak the reinvestment amounts to keep purchases at a certain level or reduce them over time. The constraint of a shrinking bond universe is gradually diminishing the ECB’s QE powers and puts greater emphasis on the maturity of reinvestments to anchor longer end yields.
The Rsq of EURUSD and 10y IRS is 0.44 and puts fair value at 1.1710.
3. Forward guidance: interest rates are to stay at present levels at least until bond purchases are completed. Clamping down on speculation of an earlier rate increase can allow US/EU 1y2y forwards to widen. The Rsq of EURUSD and 2y IRS is 0.33 and puts fair value at 1.1690. Courtesy: SG
