It is difficult to pin down what is exactly priced for today’s ECB meeting. Rate cuts and ABS purchases aside (the impact of which is too small to matter), we think markets expect Draghi to signal that large-scale QE has become an even probability by the end of the year. Our expectation is that he delivers – but this notwithstanding, we see four factors that have changed versus H1 that suggest the outlook for the euro remains bearish independent of an ECB-induced squeeze.
(1) Russia has disturbed the baseline. The normative case for more ECB easing has always been strong – it is needed to risk-manage a fragile baseline susceptible to external shocks. The fresh news is that an external shock has materialized. The magnitude is still unclear – but the fragility of the baseline has been exposed.
(2) Equity inflows have stopped. The biggest euro flow story over the last twelve months has been equity inflows. Over the summer we have seen a large bout of outflows however. It is difficult to say if these continue, particularly if QE is around the corner. But we have a fair degree of confidence that this episode exposed the maturity of the inflow, and they are unlikely to return in as big a size.
(3) Fixed Income outflows have started. The third change over the summer is the huge rally in Euro bond markets that has coincided with a rise in fixed income outflows. There may be threshold effects here – the exceptionally low level of European yields versus the rest of the world should at some point prompt a reach for yield abroad. We believe we have crossed this threshold, and that the potential for fixed income outflows is exceptionally large given the large European underweight abroad.
(4) A new Draghi put. Finally, we consider Draghi’s Jackson Hole speech to be a material evolution to ECB rhetoric. The stability of market-implied inflation expectations has been elevated as the defining variable to further ECB action. This means that the scope for disappointment has become more limited. A hawkish outcome today may force bigger action down the road if inflation expectations sell off.
In sum, we acknowledge that euro positioning over the last few weeks has built up significantly. But there is more to recent weakness than speculative flow. We would sell EUR/USD on a Draghi squeeze and can see a move down to 1.25 by year-end.
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