DE30: What the ECB has to do to reach what it needs?

Summary:

• European equities start higher on Thursday
• Showdown has just arrived, the ECB has to beat market expectations to avoid tightening of financial conditions - get the most out of our preview outlined here
• Wirecard’s issue of 500 million EUR in 2024 bonds has been oversubscribed

The beginning of trading on Thursday has brought widespread gains across European equities, though they have been limited thus far. Riskier assets were already on the rise during Asian trading hours following a message from US President Donald Trump regarding a two-week delay of a tariff increase on Chinese goods worth of $250 billion from 25% to 30%. Initially this move had been scheduled for October 1, however, at the request of the China’s Vice Premier this data was pushed back to October 15. That boosted sentiment and resulted in decent gains in Asia with the NIKKEI closing 0.75% higher and the South Korean KOSPI adding more than 0.8%. In Europe, this exuberance has so far been shared among investors, however, everything will hinge on the ECB today. The European Central Bank needs to deploy substantial measure to avoid tightening of financial conditions which would be a highly undesirable scenario at a time when Europe's economy is witnessing a deepening economic slowdown (concentrated mostly in manufacturing). We present our take before this event later in this article. 

After the successful start of trading, the German DE30 is coming back toward its flat line. Notice that bulls could have faced a bit of fatigue given the unprecedented six-day long rally. Of course, expectations ahead of today’s ECB meeting have been among reasons why stocks in Europe have surged so heavily recently. On top of that, we have got some reassuring information from the trade front which has also soothed investors’ concerns regarding a further trade war escalation. Either way, this outperformance we have seen of late can backfire later today (if the ECB fails to top market expectations) given that space for a reversal is notable. Source: xStation5

What the ECB has to do to top expectations and thereby avoid tightening of financial conditions? We would like to divide our preview into several points:

• A deposit rate cut: The consensus indicates at a 10bps rate reduction, but there are also some calls the central bank should cut by 20bps. Thus, it pure and simple that a 10bps reduction is a minimum the ECB needs to deliver to reach its aim. We would also like to underline that, in our view, further rate reductions are likely to be less effective (and they could be even counterproductive once further cuts do not come along with alleviating measures for the sake of banks), therefore we reckon the ECB should rather resort to other measures like QE or LTRO/TLRO-like programs.

• A QE resumption: Expectations look also for a relaunch of bond purchases by at least 30 billion EUR per month. We think that here is a hard nut to crack for the ECB to beat expectations given the fact that this scale of purchases look quite noticeable given how much of debt has left in free float. Of course, the ECB could also decide to lift issue/issuer limits and this is a very likely scenario as it would free up a plethora of new government bonds for the ECB. We also do not rule out the ECB will hold off on relaunching bond purchases, and instead will decide to offer a much more substantial TLTRO program which would be a cure-all for beleaguered European banks.

• Tiering: Once the ECB chooses to slash its deposit facility rate, it is clear that this would have to come with implementing a tiering system to ease pressure on banks’ profitability (banks’ shares are likely to dive if the ECB omits to implement thereof). Of course, the devil is in the details, and those details could play a major role in how banks’ shares will respond to an ECB’s offer.

• Forward guidance: Along with the statement we will also get a set of fresh staff macroeconomic projections. They are likely to be trimmed for both GDP and CPI to justify a need to act. Last but not least, the ECB cannot let itself to give markets even a grain of hope that it is running out of ammo. Hence, its forward guidance has to include a strong commitment to act further if necessary with a pledge that rates will stay at the current or lower levels for an extended period of time, well beyond after the ECB will end its QE program that has even yet to start.

In terms of marker reactions we expect classics: Hawkishness should see the euro rising, short-end rates going up and yield curves steepening, while dovishness should see the euro tumbling, short-end rates moving down and yield curves flattening.

Meanwhile, looking into the German DAX one may notice that Wirecard is among the largest losers. This underperformance has come despite the fact that Wirecard’s issue of 500 million EUR in 5Y bonds (with a coupon of 0.5%) was oversubscribed, as the company said in its statement. Source: Bloomberg