What to expect from the ECB and Draghi?

As long as it moves, there is opportunity, and it’s this that the forex asset class has been good for lately. The return of FX market volatility has taken the world’s most coveted currency, the US dollar, on another wild ride in the overnight session ahead of ECB’s rate and press conference this morning. According to the recent CFTC reports, investors have made a $35-billion bet that the dollar is to remain supreme for some time backed by a “less” dovish Fed and the potential for G10 interest rate differentials sooner rather than later. Nevertheless, there will be the odd occasion, similar to the overnight action preceding the ECB decision, when ‘overextended’ USD-long positioning squeezes the market to swing the other way.

Event risk heightens

Following on from the disappointing Euro PMI’s, a soft US Manufacturing ISM yesterday and a growing sense of disinflation has allowed for some short-term repricing of the Fed intentions by the weaker “long” USD. As US interest rates fall so does investors appetite for dollars. With global debt product aggressively rallying (lower yields for treasury’s) over the past session has dollar lovers re-calibrating a portion of their portfolio. The market is also increasingly cautious ahead of this morning’s ECB decision and press conference, the Hong Kong Occupy Central deadline for CY Leung to step down, and the US non-farm payrolls on Friday, not to mention the broader economic headwinds from US Ebola scare.

Dollar volatility steps up

For “carry” trade lovers, they could have only been breathing a sigh of relief with the AUD’s overnight move. The antipodean currencies have been in a vortex of late, with the respected AUD and NZD been walked lower by their own CBank rhetoric and backed mostly by softer commodity prices. Nevertheless, the AUD/USD managed to climb nearly 100pips from its lows to above the psychological AUD$0.8800, in part helped by a smaller than expected trade deficit and a rise in building approvals. The Aussie trade balance narrowed from AUD$1.36B to AUD$787M. Among the notable components, exports to China rose nearly +10% (AUD$8.3B), while shipments of iron ore and coal were also up +20% and +5.6% respectively. Not to be outdone, the Kiwi dollar has been particularly volatile with its own +150pip rally to just shy of NZD$0.7920, while USD/JPY is down -70pips, trading under 108.50, while sending the Nikkei225 down nearly -2%. Fears over the global economy are prompting an adjustment of the greenback following the rapid gains of recent days. However, the dollars downside against the yen continues to show some support from Japanese imports and others looking to pick up USD’s on dips. After having broken 110.00 and now facing such a rapid pullback may suggest that the dollar’s upward momentum may be dwindling and should be put on hold for the time being.

The market still needs to see how serious the current support is before writing that particular argument off. Nevertheless, global investors should remain weary of the Hong Kong situation. With the uncertainty remaining elevated, and with the China state media announcing the government will “not give an inch” of compromise over the Occupy Central protest could shepherd investors towards the mighty dollar once again. If not, then the market will need to digest in context both the ECB meet and press conference and tomorrows NFP for some market conviction.

What to expect from the ECB?

Many market participants believe that Draghi and company are underestimating the ECB’s ability to be dovish during the meeting. Whether it’s buying Mediterranean debt products in their ABS program or stating that they are prepared to “expand” their balance sheet should be considered dovish enough. Consensus is not anticipating that today’s meet will provide any significant new insights. With interest rates unlikely to move any lower, expect most of the attention will be on details of the ABS/CB purchase program. The market is already aware of the potential inclusion of the safer tranches of Greek and Cypriot debt. Draghi will surly highlight the ECB’s aversion to buying mezzanine tranches unless government guaranteed. Expect Draghi to shy away from talking about size, but instead focus on its aim of returning the size of its balance sheet to early 2012 levels.

Finally, investors should be looking out for comments on FX and the recent value of the EUR and a “reiteration that EU policy makers are open to additional unconventional measures.” After yesterday’s disappointing manufacturing PMI’s, especially Germany’s, the ECB will need to be very proactive and very innovative to overcome stagnant growth and potential deflation.

A regurgitation of the script should not be capable of turning around the EUR’s one directional summer play. A lower EUR (€1.2629) continues to be supported by lower Bund and peripheral bond yields. Nevertheless, during times of uncertainty there will be a squeeze on the weaker ‘long’ USD positions. Nevertheless, with the ECB’s intention to expand its own balance sheet, and potentially introduce QE, these actions alone will only allow any market correction to remain brief for the foreseeable future. The market is setting itself up that way. The EUR’s relatively mild reaction to yesterday’s disappoint data could be pointing to further losses for the 18-member single currency.