ECB Meeting amidst messy Italian politics and gas flow fears

So what do we know for Thursday? We know we’re definitely getting a rate hike (the first since 2011). What we don’t know with certainty is the size of that hike. A Reuters sources article came out Tuesday morning stating that ECB policymakers will discuss whether to raise rates by 25bps or 50bps. Many are now thinking could the ECB be floating a trial balloon via Reuters similar to what the Fed did via WSJ for their 75bps hike. This could be a way to escape the straitjacket of their own inflexible forward guidance for a 25bps hike at this meeting. There is a cost, however, in that it damages their communication credibility going forward, but I suppose when weighed up with maintaining inflation fighting credibility it is the lesser of two evils. The rates market is pricing in 35.6bps (71% chance of a 50bps move).The market is pricing in just shy of 100bps of hikes over the July and September meeting (see graphic below - look at the Imp. rate Δ column & 2nd row) meaning 25bps in July and 50bps for September are well discounted. Over the remaining four meetings for this year, 167bps (not far away from 175bps) of hikes are priced, which could be delivered as follows 1) 3x50bps hikes and 1x25bps hike or 2x50bps hikes and 1x75bps hike and then a hold at the December meeting potentially. The bar for a hawkish surprise is now higher and we would need to see a 50bps hike at this meeting followed by a 75bps move in September (that would deliver 125bps vs market expectations of 97bps). I do think the euro could pop higher on a 50bps move by the ECB, but gas flow news could quickly reverse this. The euro would likely dump lower if the ECB stick to 25bps, now that expectations have been priced in for a larger move. 

(Source: Bloomberg ECB OIS)

What could make the ECB move by 50bps on Thursday?

• The SNB moved by 50bps – could this affect the psyche of the ECB?
• Broad based weakness in the euro, exacerbating the inflationary pressures, a hawkish surprise could help put a temporary floor under the euro
• Downside risks to growth are accelerating rapidly (gas supply fears, etc), meaning the window for more aggressive front-loaded rate hikes are rapidly closing
• The hawks could negotiate a deal whereby they get a larger rate increase and less conditionalities attached to the anti-fragmentation tool
• The Q3 survey of professional forecasters could make the ECB uncomfortable with their inflation projections (available to the public only Friday)

The other major policy announcement expected is more details around the anti-fragmentation tool, Transmission Protection Mechanism. There is a chance we may not receive any more information as the tool may not actually be ready by Thursday. If we do, the factors I’ll be on the lookout for are 1) conditions attached 2) size 3) duration 4) trigger/spread levels for its use. The conditions have to prevent moral hazard and irresponsible fiscal behaviour to avoid political uproars, but not so onerous that countries such as Italy refuse it outright. The Reuters sources piece, stated that European Commission rules on reforms and budget discipline looks to be the guiding criteria. On the topic of size, will it be open-ended or have a ceiling on the number of purchases? The duration of the tool – will it be used in very specific and limited cases (i.e temporary) or will it become a longer lasting policy tool? I want to know what warrants an unnecessary widening of spreads and what levels would be problematic. I doubt the ECB will be too specific, but I would say a BTP-Bund spread of around 250bps is a pain point for the ECB.

The ECB meeting coincides with the key 21 July end of Nord Stream 1 pipeline maintenance. We’ll get an answer as to whether gas flows will come back online (this is the biggest risk factor for the euro). It’s a binary event - no gas flows -ve euro or gas flows +ve euro. Additionally, the Italian political scene is become increasingly messy. On Wednesday Mario Draghi will face a confidence vote. There are 3 permutations as to how it could go 1) he wins and stays on as Prime Minister 2) he loses and a new coalition is formed to replace him 3) he loses and a snap election takes place. The most bearish for the euro would be option number 3. The prospect of early elections could paralyse government and stymie the implementation of necessary reforms in order to access EU recovery funds. This would likely exacerbate concerns around Italy’s fiscal situation and feed through to a risk premium being discounted into the BTP-Bund spread. Italian bond volatility would also ramp up.

1-week implied volatility for EURUSD is significantly elevated as it captures all these euro risk factor inputs. Liquidity has deteriorated and this has the potential to cause disorderly, non-linear price moves if big orders hit the market. Looking at the chart. Potential resistance levels for rallies are at 1.027 (21-day EMA) and 1.035. On the downside, parity is obviously a key support zone to monitor on further sell-offs. The RSI has made a strong move out of oversold, but needs to get back above 50 for bulls to have more confidence in the move. There was some minor divergence too on the recent parity low.