Eight months into his term and it appears that ECB President Mario Draghi is nothing like his predecessor Jean-Claude Trichet. The former head of the European Central Bank’s word was as good as gold. We use to call him the Godfather of the FX market because if he promised more action, he would deliver. Yes, Trichet can be blamed for missing the housing bubble and probably an assortment of other problems but the one thing he knew was that confusion meant volatility and he sought to avoid it by preparing the market properly for any change in monetary policy. Two weeks ago, ECB President Draghi pledged to do everything in his power to protect the euro. This sent the currency sharply higher by creating expectations for greater activism. Unfortunately on Thursday, the ECB failed to deliver, which not only hurt the credibility of the central bank President but also the euro. Draghi set the market up for disappointment and did not say anything to temper expectations when German Chancellor Merkel and French President Hollande backed his pledge- a mistake that Trichet most likely would not have made.
A New Set of Expectations
Now we are left with a new set of expectations. While the ECB left monetary policy unchanged last week, Draghi laid the foundation for a big announcement in September. The most importance sentence that was said in his post monetary policy meeting press conference was the following:
“The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective.”
This sentence basically said that the ECB may engage in large scale bond purchases to drive yields lower. Draghi then went on to say:
“Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.”
This basically means that they want to introduce new measures but need time to figure out the details, which includes the appropriate course of action, limits, tenor etc. From the Q&A session we know that any bond purchases would be focused on the short term part of the yield curve but exactly which tenors still need to be determined. Once these details are defined, the Governing Council of the ECB would take a vote and act if there is a majority.
The recent decline in European bond yields clearly reduced the pressure on the ECB to act and this plan for asset purchases can only proceed if a country such as Spain or Italy asks the EFSF for help. Until that happens, the ECB is in planning stage but the according to Draghi, the framework for intervening in the bond markets should be developed in the coming weeks. Many economists have interpreted this to mean action at the September meeting but once again, bond purchases would be activated at the request of a sovereign and so far Spain and Italy made no mention of their plans to activate the EFSF. Another LTRO or a reduction in the deposit rate is also a possibility that could turn into reality if European bond yields rise again but Spain and Italy refuse to ask for help.
ECB President Draghi has now created expectations for large scale asset purchases and hopefully he’s not setting the market up for another disappointment because the price action in the EUR/USD suggests that investors believe that the ECB will provide an effective liquidity backstop for Europe. While Draghi is still a novice when it comes to managing expectations, hopefully he is learning quickly because if he disappoints the market again, traders may not be so kind to the euro.