While hardly a surprise after yesterday’s Reuters trial balloon, which killed any speculation that Draghi would use the Jackson Hole podium to announce ECB balance sheet tapering, sending the EUR sliding, moments ago the EUR dumped to fresh session lows after the highly anticipated ECB minutes were released, noting that “concerns were expressed about the risk of the exchange rate overshooting in the future,” confirming what we speculated last week, namely that for all the pseudo-hawkish rhetoric from Draghi since Sintra (and before), the ECB simply will not tolerate a Euro which approaches 1.20 and threatens to dent European corporate earnings.
The immediate kneejerk result sent the already sliding EURUSD to session lows:
There were also a few clues on future policy:
- “On the other hand, there was a risk that financial conditions could tighten to a degree that was not warranted by the improvement in economic conditions and the outlook for inflation. In this context, the point was made that, looking ahead, the Governing Council needed to gain more policy space and flexibility to adjust policy and the degree of monetary policy accommodation, if and when needed, in either direction.”
- “Measures of underlying inflation, while showing some tentative signs of a pick-up, still needed to show conclusive evidence of a sustained upward trend. Therefore, a very substantial degree of monetary accommodation was still needed…”
Among the other highlights from the minutes, which were initially read as dovish across most Wall Street desks, were the following observations:
- “The appreciation of the euro to date could be seen in part as reflecting changes in relative fundamentals in the euro area vis-a-vis the rest of the world” but “concerns were expressed about the risk of the exchange rate overshooting in the future”
- “Looking ahead, the Governing Council needed to gain more policy space and flexibility to to adjust policy and the degree of monetary policy accommodation, if and when needed, in either direction.”
- “The overall degree of accommodation was determined by the combination of all the monetary-policy measures”
- “The asset purchase program would continue to be a key instrument if the Governing Council assessed the sustained adjustment of inflation at risk”
And perhaps the key quote, confirming what we have said since 2012, namely that it is the flow, not stock, that matteers:
- “In this context, it was also suggested that the stock versus flow effects of the asset purchases be considered.”
This suggests that Draghi is well aware that stocks will tumble once the ECB stops buying various bonds, or simply reduces the monthly purchases, even if it ultimately keeps its balance sheet constant.
And yet, the ECB itself admits it is trapped, because the longer it waits, the more it will have to do in the future to reverse the current dovish path, especially once the ECB hits the red line where it runs out of (German) bonds to buy:
- “A suggestions was made that some consideration be given to an incremental adjustment in the language on forward guidance, because postponing an adjustment for too long could give rise to a misalignment between the Governing Council’s communication and its assessment of the state of the economy, which could trigger more pronounced volatility in financial markets when communication eventually had to shift”
In kneejerk reaction to this latest slide in the Euro, European shares have reversed losses, with the Stoxx 600 rising as much as 0.1% after the minutes, paring an earlier loss of as much as 0.5%, while Germany’s DAX rose up as much as 0.2% before trading little changed. Meanwhile in bond markets, Bund futures spiked higher in kneejerk reaction to the ECB minutes release fueled by the Euro slump to session lows. However, this jump too was quickly retraced, after a read of the the rest of the ECB’s July meeting was deemed to be “more balanced”, with “incremental” changes to forward guidance discussed, and some concern over potential financial market volatility if policy adjustments are postponed for too long.
As a reminder, when Draghi meets the press after the governing council’s next vote on September 7 he will have to explain why the bank is holding discussions on slowing down the pace of its bond buying in 2018, while at the same time presenting forecasts for weaker inflation. As the FT notes, a decision on tapering is expected at the council’s October meeting. Further recall that it is none other than Draghi to blame for the recent surge in the Euro, and the near record number of spec shorts in the currency: the EUR rose sharply after Draghi’s Sintra speech in late June in which the ECB president mentioned “reflationary” forces were emerging in the eurozone economy, and again after his press conference following the July vote.
Today’s minutes put the currency’s rise down to two factors: the removal, following the election of Emmanuel Macron as France’s president, of the political uncertainty that erupted in the wake of the Brexit vote and market expectations over US interest rates. “These two factors were now largely priced out, leaving the euro back around the levels prevailing before the UK referendum.”
Of course, the real reason why the market has been so convinced that the ECB will have to accept a higher Euro – and launch balance sheet tapering 0 is because over the next 3-6 months the amount of bonds the ECB can monetize at the current purchase pace will collapse to virtually nil.