‘Draghi Delivers His Classic’: One Bank’s Take On The ECB And How To Trade It

Right, so my ad hoc assessment of Draghi on Thursday was that he masterfully pulled off what by all accounts should have been impossible.

He somehow managed to pull a dovish rabbit out of a hawkish hat (how’s that for wordplay?) by pairing calendar-based rate guidance and a taper to €15 billion/month starting in September with the announcement that APP will end in December.

The June ECB meeting was fraught with peril considering the political turmoil in Italy (which manifested itself in a goddamn 15-standard deviation selloff in the Italian front end a couple of weeks ago) and the notable deceleration in eurozone economic activity in Q1.

The “transitory” characterization of the lackluster incoming data and the fact that new elections were averted in Italy notwithstanding, today’s announcement could have gone all kinds of wrong were this anyone but Draghi.

But this was Draghi and so, he managed to announce the end of ECB QE while simultaneously engineering a rally in European stocks (thanks in no small part to the euro’s worst day against the dollar since Brexit) and bonds (thanks to the extension of APP through December and more importantly, thanks to the new short rate guidance).

There’s a full breakdown of this in “Draghi Sticks Impossible Dismount, Puts Dovish Spin On QE Expiration Date While Simultaneously Adopting Date-Based Rates Guidance“, but the bottom line is that, for now anyway, he’s managed to keep the ECB on pace for slow normalization while setting the stage for a prolonged period of suppressed vol. Or at least that’s the way I see it and if you read that linked post, it’s the way a lot of other folks see it too.

Obviously not everyone agrees and I don’t claim to be some kind of fortune-telling guru, so it could very well be that a further reduction in the flow of asset purchases starting in September and the cessation of the “flow” effect (reinvestments notwithstanding) could end up doing exactly what common sense dictates – namely, reversing the favorable supply/demand distortions that have suppressed yields and spreads across the eurozone on the way to driving up volatility.

But for the time being, folks seem pretty impressed with today’s performance.

Take Barclays for instance, who is out on Thursday evening with a note recommending a a tactical long in Italian spreads (specifically, long 5Y Italy vs. Germany) and in the note, there’s a section called “Draghi delivers his ‘classic'”. Here are a couple of short excerpts:

The dovishness of the announcements came from a variety of angles. First, the Governing Council decided to end QE at the end of December after a mini-taper of €15bn per month in purchases in Q4 18. However, dovish flexibility was kept on this decision through added conditionality “subject to incoming data confirming the GC’s medium-term inflation outlook”. On the QE front, reinvestment forward guidance was kept unchanged.

The real dovish surprise came from the short rate forward guidance: “The GC expects the key ECB interest rates to remain at their present levels at least through the summer of 2019”. The market had interpreted the previous guidance “well past the end of net asset purchases” as six months after, while the new forward guidance indicates this is likely to be nine months. The GC made this even more dovish by moving the statement “in any case for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations of a sustained adjustment path” from QE to short rates. This essentially makes the gap between end of QE and first rate hike nine months at a minimum. The final dovish emphasis President Draghi used during the Q&A session was the unanimity of all these decisions.

As ever, the risk is that by the time rate hikes get going in earnest and the ECB gets out of NIRP, the economy will have rolled over, leaving them with little in the way of counter-cyclical ammo either in rates or on the balance sheet (especially in light of self-imposed issuer cap constraints).

But in the meantime, Barclays thinks the scope for bunds to sell-off is limited (sorry Bill Gross) and in terms of the trade mentioned above, the bank simply think that between more balanced near-term political risks and the fact that Draghi mentioned Italy, means there’s room for tightening in Italian spreads, especially if folks find the newly attractive yields too tempting to resist.