Chutes and Ladders: Preview of BOE and ECB Meetings

The Bank of England and the European Central Bank meet this week. There is much speculation that both can alter policy. We suspect there may be risk for disappointment, but that disappointment with the BOE, could trigger a bounce in sterling, while disappointment with the ECB could see the euro sell-off.

The outcome of the Bank of England meeting will known first. Based on the dovish cast to the Sept BOE minutes and some recent comments, within the context of generally soft economic data, there is speculation that the BOE can resume its asset purchases program with a GBP50 bln purchase over the coming few months. This seems to be the consensus.

The risk of disappointment is three-fold.

First, the Sept meeting saw only Posen wanting to resume QE. To go from 8-1 to 5-4 seems like a big shift, given that--the second risk to disappointment is the data has not been too poor, including employment, mfg PMI (Sept) and non-manufacturing PMI (Aug) and the uptick in inflation in the most recent report (Aug) from 4.4% year-over-year to 4.5% on the headline. The core rate rising to 3.1% from 3.0%. The headline rate matches the cycle high. The third risk to disappointment is the BOE preference for using the cover of its quarterly inflation report to make such announcements and the next one is due in November.

Sterling recorded the year's lows, thus far in late Sept near $1.5330. It bounced up into month end, but has run out of steam near $1.5700. The net spec position at the IMM switched to short 64k contracts in late Sept from +11k contracts in late-Aug, suggesting short-term momentum players and trend followers have built a substantial short sterling position.

Some of this reflects the general US dollar strength as a safe haven. The failure of the BOE to resume its asset purchases could prompt a bout of position adjustment. We also note that end the end of last week, sterling's 50-day moving average crossed below the 200 day for the first time since early Sept 2010.

Such a short covering bounce will provide longer-term investors a better level to hedge or reduce sterling exposures. We look for sterling to finish the year near $1.50.

Sterling's response to the BOE move or lack thereof, will be influenced, at least in part, by the reaction to the ECB's moves. This week's ECB meeting is the last of Trichet's presidency.

The ECB's critics worry that the central bank is blurring fiscal and monetary policy, but the ECB itself draws a clear distinction between liquidity measures and monetary policy proper. The ECB's focus is likely on liquidity measures. This will likely include another 6-month refi and re-introduction of a 12-month facility.

The ECB may also announce a resumption of its covered bond purchases. It previously bought 60 bln euros of covered bonds in a year-long operation that ended in the middle of last year. The size of the European covered bond market is estimated at roughly 2.5 trillion euros. This market has come under stress in recent weeks and this is reflected in the lighter issuance schedule and widening spreads. If the ECB does resume its covered bond purchases, speculation has centered around 50-100 bln euros. Rather than easing monetary policy per se, covered bond purchases are likely best understood as another way to inject liquidity.

There had been some thought that the ECB could also widen its corridor (deposit and emergency lending rate), which currently stands at 75 bp and 2.25%. However, European contacts suggest that it would not make sense to re-widen the corridor by cutting the deposit rate without reducing the repo rate.

The ECB is most likely to provide new liquidity measures. A rate cut is more controversial. There has been much speculation. At first some were talking about a 50 bp cut. However, M3 and private sector lending, coupled with higher than expected preliminary euro zone inflation (including an uptick in Germany) have seen many scale back the call to a 25 bp cut.

With the euro zone flash composite PMI for Sept coming in below 50 and no real improvement in the final mfg PMI, the risk is that the euro zone stagnates or worse. ECB officials should also have confidence that with the dramatic pullback in commodity prices, headline inflation pressures should ease.

Lastly, another wild card is the politics. If the ECB does not cut rates, and Trichet did not use the code words in Sept to suggest a Oct rate cut, the pressure falls to the next ECB president to begin the easing cycle. Draghi, the first ECB President from a peripheral country, for which the ECB is already buying its sovereign bonds in the secondary market. It is far from ideal for Draghi to have to begin cutting rates at his first meeting.

If the ECB does cut rates this week, the euro may respond positively as it may be associated with boosting risk appetite, especially ahead of the US jobs report, where the private sector is expected to have created about 90k jobs, half of which may be accounted for by returning strikers. A failure to cut rates may be euro negative on grounds that the crisis in the periphery is likely to worse, without easier monetary policy. Indeed both the ECB rate hikes this year triggered new widening in peripheral spreads over bunds.

The net speculative position at the IMM has swung from long 2.5k at the end of Aug to short 82.4k at the end of Sept. The stalling of the euro's downside momentum could prompt to late shorts to cover, in which case the $1.36-$1.37 area should cap such upticks. On the downside, $1.3150 is our next target, which corresponds to a retracement of the euro's rally since mid-2010, the last time it had traded below $1.20. We look for the euro to be near $1.29 by the end of the year.