Bank of America / Merrill Lynch on what to expect from the European Central Bank and President Draghi this week, and on the EUR/USD:
Our base case is that the ECB will confirm that tapering "has not been discussed" and we expect President Draghi to emphasize, as he did at the IMF press conference last weekend, the ECB's intention to preserve the ECB's" necessary" and "very substantial" amount of monetary support. We also expect him to highlight that inflation has to return to target "without undue delay" - an expression which is already in the prepared statement but should get more prominence. The tightening in monetary conditions since tapering talk began provides an insight on what would happen if the ECB actually decides to taper from March 2017 onwards. This is why we expect Mario Draghi to be quite dovish this week, though action will likely have to wait until December 8.
We don't expect Draghi to elaborate much on the instruments, because we think the Governing Council is not through its review of the various options. We still expect the ECB in December to prolong QE until September 2017 at the current EUR80bn pace, and we also think that this will entail tweaking the capital key. Indeed, we think it's the only credible way to deliver on what seems to be the apparently conflicting twin objectives of the ECB at the moment: keeping long term rates in positive territory without reducing the overall degree of stimulus. A weak form consists of getting the Bundesbank to buy more substitution assets (supras) and less Bunds, which, combined with raising the issuer limit to 50% would be enough to bring us until September. A stronger form would allow the purchasing allowance of NCBs hitting scarcity walls to be redistributed across the other NCBs. The strong form is our base case at this stage, but with a low level of confidence. We see a significant risk that all we get is weak form, given the politically controversial nature of such move.
Looking ahead, the ECB is clearly facing "stimulus fatigue". It is frustrated by the lack of support from the fiscal and regulatory authorities and is probably more worried than it lets out about the long term consequences of ultra-low interest rates on financial stability. This is probably tilting their instincts towards starting to remove the full force of the stimulus as soon as data permits. Our chief concern is thus that a discussion on tapering starts in earnest in the summer of 2017 with a higher chance than today of winning. Then whether or not fragile sovereigns like Italy will have become more sustainable without monetary policy crutches will become the key issue. This brings us back to the fundamental ambiguity of QE, which in the European context is not just a monetary policy tool but has also become a corner stone of the Euro area institutional survival.
FX: Buy EUR Dips Vs JPY
A dovish tone should be negative for the Euro, but we don't see a sustained impact. Markets already expect QE extension, but will wait for the details that will be clear only in December. EUR/USD has been weakening recently, but this has been a USD move. If the Fed hikes and the ECB extend QE in December, we would expect EUR/USD to stay below 1.10. However, we would see the dip as an opportunity to buy the Euro, particularly against the JPY.
