Great Graphic: Draghi Pushes Back

ECB President Draghi sent an unambiguous signal to investors. Although the economic data from the region has been largely stable, the downside risks have grown, and the ECB will take action at its next meeting, which is in early December.

In the past, Draghi has indicated that the negative 20 bp deposit rate exhausted the scope for rate cuts. However, he did reveal that the possibility of another cut in the deposit rate was discussed. The key takeaway point is that the "degree of easing" would be re-examined at the December 3 meeting in its entirety.

It was not only that Draghi was more dovish than the market expected, but his comments made it appear that the ECB was closer to a consensus than many expected. He revealed that some members wanted to take action immediately. Still, even if the ECB announces its intention to provide more monetary stimulus in December, the launching of the new effort is unlikely to start until early 2016. That said, it would not be surprising if in the coming days, the less dovish ECB members like the Bundesbank’s Weidmann, resist the push.

Most observers have been focused on extending the length of the asset purchases. We have been skeptical of the effectiveness of extending a program that is not even half complete. It essentially concedes that the current purchases are insufficient. Increasing the size of the current operations seems to be the more logical course. That is what the Bank of Japan did last October. However, there is a concern that it might exacerbate a shortage of some instruments, like German bunds. This has been a concern since the asset purchases plan was announced, but thus far there is only marginal evidence of this. Consider that 10-year German bund yield has risen 33 bp over the past six months.

Still, under the ECB's program, instruments yielding less than the (minus 20 bp) deposit rate cannot be included in the official purchases. After yesterday's rally, German yields from one through four years are lower than -20 bp. The two-year yield set new record lows near -32 bp. Reducing the deposit rate further would free up more instruments that can be bought, theoretically.

The ECB can also tweak the composition of the assets it is buying. The Bank of Japan has shown that a wide range of instruments, including ETFs, REITS, corporate bonds, commercial paper can be bought. The focus in Europe is on increasing the agency bonds that are included in the program.

Although we too were surprised by the dovishness of Draghi, it supports our emphasis on the divergence of monetary policy as the key macro force driving the capital markets, and what we argue is, the third significant dollar rally since the end of Bretton Woods. Divergence was not just about the Fed tightening, but what made this force so potent is that others are still moving in the other direction.

The first phase of divergence is precisely that. Other countries are easing policy while the Fed prepares to begin normalizing monetary policy. The second phase begins with the Fed's lift-off. Like many in the market, we have struggled to time the transition from phase one to phase two. Yet, with the four-week average of US weekly jobless claims making new cyclical lows, we continue to believe that the second phase will materialize.

The dramatic euro drop in response to Draghi’s dovishness saw the single currency test the seven-month uptrend drawn from the year's low set in March near $1.0460. The Great Graphic posted here from Bloomberg depicts this. The trend line connects April, July and August lows. It comes in near $1.1075 now. That area (~$1.1085) also corresponds to a 50% retracement of the euro’s rise off that March low. The 61.8% retracement level is found near $1.0940. Below there is the $1.08 level that held in May and July. Given the magnitude of yesterday's move, which pushed the euro to its lower Bollinger Band (a little below $1.11), players may be reluctant to be aggressive ahead of the weekend.

Some observers have argued that the dovishness of the ECＢ make a BOJ move next week more likely. We are less convinced. We link the yen's weakness to 1) the broad dollar strength, 2) the rally in equities, and perhaps to a lesser extent 3) firm US yields. The reasons why many economists look for BOJ action next week is the specter of deflation and the risk of a second contracting quarter. In our conversations with Japanese officials, they seemed to play down such concerns. They want to look past the sharp drop in energy prices. They recognize that given the low growth potential, normal GDP variance can produce negative growth from time to time. Officials seem willing to do more if necessary. They are not yet convinced it is necessary.

The dollar was at the lower end of its range last week when it tested the JPY118 area on October 15. With yesterday’s gains and the bit of follow through in early Asia, the dollar is approaching the upper end of its current narrow range, which we see as JPY121.25-JPY121.35 area. However, it takes a move above JPY122 to signal anything of significance.