Otmane El Rhazi from
The Bullion Desk.
All eyes will turn to Frankfurt tomorrow for the highly anticipated ECB press conference where president Mario Draghi is expected to announce the implementation of a full-blown quantitative easing (QE) programme in a last-ditch attempt to stoke inflation creation and prevent the bloc’s slide into a deflationary spiral.
Market speculation for QE rose to fever pitch following the European Court of Justice’s (ECJ) decision that the Outright Monetary Transactions (OMT) programme was legally permitted within the ECB’s mandate under certain special conditions. This was seen as opening the way for Draghi to make good on his promise to “do whatever it takes” to protect the euro.
This ruling effectively removed the final potential road block to beginning QE – the legality of creating a liquidity allocation programme within their mandate, something the Bundesbank had already questioned.
Germany, considered by many to be the engine of Europe, went on record to register its dislike of this policy, seeing it as a blank cheque to the rest of the eurozone.
Its reservations are due to several factors: the divergence between Germany’s relative strength and the periphery’s weakness makes it feel it is directly bailing out countries that have failed to make the tough decisions and stick to their austerity programmes, leaving Germany on the hook should any country subsequently default.
The country also has a deep-rooted fear of inflation due to the run of hyperinflation after World War 1 – it wants the level and size of any QE to be limited and strictly controlled to prevent a reoccurrence.
The idea of a liquidity allocation programme to be run in a currency union created from several sovereign states, some of who are already reneging on their current repayment obligations and timelines makes this apprehension understandable; however, with non-conventional monetary policy already at play, there is no alternative.
Market speculation for QE turned to certainty following the Swiss National Bank’s (SNB) decision to remove their currency peg of 1.20 francs to the euro, allowing their currency to free-float for the first time in three years, causing the franc to rapidly appreciate, rising 40 percent initially to below 0.86 to the euro.
The peg was introduced to lower price volatility and to allow a stable relationship with the neighbouring currency union after currency appreciation eroded its global competiveness.
Its removal is therefore highly significant – it implies that the SNB believes that the fallout from removing the peg was the preferable option to trying to maintain it, implying that it expects a significant move in the euro.
This was taken by markets as a clear signal that the SNB expects a large QE programme to be launched this month that would pressure the euro lower, which would also force the bank to print francs to substantially weaken the currency to sustain the peg. This implies that it expects such a large move in the euro that it would be more detrimental to the Swiss economy to sustain the peg than to abandon it.
The market has already pricing in a bond-buying programme of around 500 billion euros; the SNB apparently believes that Draghi’s QE program me is likely to be significantly bigger than this, raising speculation that total purchases could be closer to 1 trillion euros.
This is not unlikely – with monetary policy already incredibly accommodative and several unconventional measures already having been put into place, such as negative deposit rates, a QE programme is seen as the ECB’s last resort, the bazooka in Draghi’s arsenal. It is now effectively a case of go big or… go big – there is no alternative.
The ECB is therefore expected to err on the side of caution and either make more funds available to the programme or signal to markets that -like the US Federal Reserve – it will implement a form of ‘QE infinity’ by leaving the end date open to show markets that it will run this programme until it works, making a total closer to 1 trillion euros highly likely.
If an open-ended policy is confirmed, indicating the total could be twice the size current consensus of 500 billion euros, we would expect enough of a shock to markets to drive the euro even lower to around 1.12 to the dollar.
Confirmation of euro weakness should bolster dollar strength, putting metal prices under growing downside pressure in dollar terms.
This would normally be bearish for the precious metals, especially gold, but we believe that an announcement of a larger-than-expected package would cause the US dollar and gold to break their inverse relationship and trade in tandem.
If so, it would signal that gold is not trading as an out-and-out commodity but as a store of wealth as investors rush to safe havens while uncertainty about currencies increases – something we have already started to see to some extent as QE is priced into markets.
The real question now is how much the ECB is likely to buy, how long for and where. Rumours of purchases at 50 billion euros per month for one or two years are now making the rounds, stoking speculation that the package is likely to be bigger than consensus.
But while Draghi’s QE is likely to be similar to the US programme, these should be some very key differences that will determine its direction and chances of success. The main one is that the eurozone, unlike the US, is a currency union composed of several separate sovereign states all in different stages of recovery, making a one-size-fits-all methodology unlikely to be successful or accepted.
Since different countries will require different levels of intervention, we would expect the ECB to tie each central bank to its country’s bond-buying requirements, creating effective backstops to their expenditure. The outcome of any QE programme implemented is therefore likely to be country-dependant.
Investors are likely to position themselves in European equity markets, as was the case in the US, to benefit from the additional liquidity that is expected to flush through the system, knowing that any trade is backstopped by the ECB, effectively removing the risk.
Still, as mentioned, much will depend on which countries’ bond markets the ECB decides to enter as to where the strongest gains will be made.
The largest gains are therefore likely to occur in the countries that are most in need. This could start to reduce the divergence between the core and peripheral countries, which has been reinforced and widened by investors moving into German bunds – seen as the most secure, which is highlighted by the country’s move into negative rates.
This is a situation likely to be thrown almost directly into contention – Syriza is expected to gain control at elections in Greece on January 25. This would be dangerous for the eurozone because the party has campaigned on renegotiating the terms of the country’s bailouts and a slashing of Greek debt, threatening a ‘Grexit’ should it not succeed.
But the Troika is unlikely to yield to its demands because this would set a precedent for the rest of the eurozone that debts do not have to be repaid.
This poses a significant risk to the eurozone’s recovery – despite 74 percent of Greeks saying they would like to remain in the eurozone, a ‘Grexit’ that nobody wanted could occur should political brinkmanship come into play.
As the eurozone was designed never to be reversed, a Grexit would severely weaken it and possibly spur other extremist parties – predominantly on the right – in countries under the Troika’s thumb to threaten to pull out of the union as a bargaining tool for reduced repayment terms.
We would not be surprised if the ECB signals that it is likely to delay the start of purchases somewhat, providing time to react to the outcome from this vote and any potential fallout built in or accounted for. This will also probably bolster safe-haven demand, lifting gold prices while investors look to hedge currency risk but also potential contagion.
Increased liquidity and a further weakening of the euro should also spur Chinese consumption as European service demand rises and US consumption, taking advantage of the stronger dollar, which would further bolster the European manufacturing sector.
(Editing by Mark Shaw)
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