In the aftermath of this weekend's disappointing G-20 summit in Shanghai in which the much anticipated "grand Chinese devaluation" was not only not discussed, but any abrupt devaluation was taken off the table (if only for the time being), the market has shifted its attention to the next big policy event, which is the March 10 ECB announcement where much more easing is already priced in.
As we added following our G-20 summary, "the next big move in the market is now entirely in Mario Draghi's hands" citing Citi's Israel Englander, who said laid out the possible outcomes as follows:
The ECB is in focus. EZ is undershooting on growth and inflation, and ECB President Draghi has been impassioned on the need to provide more stimulus. If they lowball or grudgingly meet expectations, we could face another December 4 move because market participants will see it as the equivalent of a ‘last ease in the cycle announcement’, basically ECB throwing in the towel. If they move aggressively (and take measures beyond vanilla QE and 10bps on rates), they will catch market off guard and unwind the view that policymakers see themselves as powerless.
We think it will be the former, which brings to mind the warning we posted on December 2, when citing MarketNews we wrote that "Mario Draghi May "Under-Deliver" Tomorrow, MNI Warns":
Draghi has been priming markets for action since October, saying the ECB will do what it must to raise inflation as quickly as possible, and investors are betting that the probability of a deposit-rate cut is 100 percent. Now, even with some officials voicing misgivings, his Governing Council may find that only a rate reduction combined with increased bond purchases and possibly as-yet unannounced tools will prove convincing enough.
The December 3 "shock" in which the ECB ended up doing almost nothing, and which unleashed the biggest EURUSD move higher since the announcement of QE1, while Bunds and and macro hedge funds P&Ls plunged, is still fresh in all traders' minds.
Which is why the ECB may be trapped.
Having not only set expectations sky-high once again, but also forced to cover for the G-20 disappointment, Draghi will have to unveil a massive bazooka, one which combines both more QE with even more negative rates. Only in the aftermath of the BOJ NIRP fiasco, will the ECB dare to push rates lower yet again to -0.40% or more, having seen the dramatic reaction by the financial sector in both Europe and Japan following the recent rate cuts?
According to one hedge fund, Francesco Filia's Fasanara Capital, as a result of the high expectations ahead of the ECB meeting next week, there is potential for disappointment, especially on banks as the fund's CIO believes the advent of even more NIPR will unleash the next leg lower in European financials. Here are his thoughts:
Market recovering strongly ahead of ECB meeting next week, possibly a déjà vu’ of December meeting, potential for disappointment.
Market discounting ECB to intervene boldly, via a combination of increased QE, LTRO, depo rate cut, without collateral damage caused on banks by deeply negative interest rates.
As banks performed strongly in recent days, market may think the recent complaining about negative rates by top banks’ executives across Europe has been heard.
On the contrary, we believe deeply negative rates are coming, and are an inescapable negative for the banking sector, leading to overall weak equity markets post ECB.
ECB remains committed to continue on path of negative rates, as today’s communication by ECB officials confirms:
ECB’s Cœuré defends negative rates
2016-03-02 . From JPM Research: this morning, the ECB governor gave a speech in which he defended negative interest rates. He acknowledged a possible drag on bank profits if lending rates fall more than deposit rates (which are sticky at the zero bound). He added that the ECB is well aware of the issue and that it is "studying carefully the schemes used in other jurisdictions to mitigate possible adverse consequences for the bank lending channel." But, he then pushed back against the "narrative that banks' challenges flow largely from our monetary policy." He argued that banks have been able to offset declining interest revenues with higher lending volumes, lower interest expense, lower risk provisions and capital gains. For example, he said that the net interest income of Euro area banks increased last year as they refinanced high-yield liabilities at low rates. And he said that negative rates complement the ECB's QE programme, which has been positive for asset prices, credit risk and lending volumes. He finished by saying that banks would be worse off if the ECB does not respond to global growth uncertainties, as stagnant output and falling prices are bad for their profits ECB’s Lautenschlaeger defends negative rates
2016-03-02 . From Bloomberg: ECB Encourages Banks to Diversify Revenue Pool on Low Rates. Banks struggling to make a profit in an environment of low interest rates should diversify their revenue pool, European Central Bank Executive Board member Sabine Lautenschlaeger said. “It’s not my task to find a viable business model for each and every bank,” but “having a diversified revenue pool is always very good,” she said in an interview in New York late Tuesday. “You can see that banks are increasing their fee income right now, that they change their business model to shorter maturities when they lend in order to be able to change faster when the interest-rate environment changes again.”
Which brings to mind the report Deutsche Bank wrote less than a month ago, on February 6, when its stock was plumbing record lows, and in which it begged the ECB to stop cutting rates. Recall:
The BOJ surprised with a move to negative rates last week, while ECB rhetoric suggests additional easing measures forthcoming in March. While a fundamental tenet of these measures, in particular negative rates, has been to push investors out the risk spectrum, we remind that arguably the impact has been exactly the opposite.
This in turn reminds us of what was the biggest catalyst for the February swoon: the fear that central bankers have run out of ammo since their preferred method of intervention, namely negative rates, has direct and immediate downward consequences on financial assets, which then spread contagiously (and instantly) to all other sectors.
Since absolutely nothing has changed since then, we are confident Fasanara will end up right, and the entire rally over the past two weeks which has been predicated first on hopes of a massive G-20 stimulus, and which then was "transferred" to hope that Draghi will somehow pull a rabbit out of his hat, will be unwound, resetting the entire cycle, especially with the March FOMC meeting fast approaching and this time threatening not with more easing but with another 25 basis point of tightening following the recent "strong" economic data... at least according to Reuters' revised headline.
How to trade this?
For those who are worried about shorting stocks, that leaves two possible trades to bet on disappointment: one is to go long the EURUSD ahead of the ECB, and the other is to short the German 2Y Bund. As the chart below reminds us, what happened in the December disappointment was the 2Y yield soaring by 15 bps to the ECB's discount rate in milliseconds. This time around the spread is 25 bps, a spread which will be closed instantly the second Draghi once again fails to present the much anticipated bazooka.