ECB Front and Center: Can Do Little, but Disappoint?

Today is the most important ECB meeting in several months. Nervousness ahead of it has encouraged some modest position adjusting across asset classes. Given that the Irish aid package failed to stabilize the markets, many are looking at the ECB step into the breach. It seems that there are only four potential courses of action. The first is simply not to take any new initiative and continue with its plan to continue to normalize operations. Currently the ECB provides unlimited amount of 3-month funds at a fixed rate of 1%. The next step would be to auction the three-month money, which if done in sufficient size could still be fairly generous in terms of liquidity. This would like see a strong against the euro and European bonds.

Second, the ECB could signal that market conditions do not yet allow it finish the normalization process. This also risks a negative market reaction on disappointment.

Third, the ECB could re-introduce a longer-term repo, like a 6-month or 12-month repo. Although this would provide extra liquidity, the market likely see it as a subsidy for insolvent institutions. However, what would banks do with that extra liquidity ? Likely buy their sovereign bonds, like they did before.

Fourth, the ECB could buy more sovereign bonds. Reports indicate that Spain, Portugal and Italy have been pressing this case. Some comments suggest the French are sympathetic. German officials clearly are not. Trichet does not seem to be and his reference to it recently probably needs to be understood in the context over what happened in May, when he said it was not discussed, only to reverse himself shortly afterward. His citation of the size of the broad governing board could be read as a note that more than Germany decides ECB policy or that Trichet did not want to stick his head out. The latter seems more likely.

In the absence of a fiscal transfer, which is politically untenable, especially given the German constitutional court challenges, QE has certain merits. However, we are concerned that it would not solve the real problem. Banks in some peripheral countries have not access to funding outside of the ECB.

Recall what Portugal's central bank reported within 48 hours of the Irish package: sovereign difficulties had forced banks into a "permanent and large scale" dependence on ECB funding that is not sustainable. If the ECB were to buy more Portuguese bonds, for example, would Portugal banks be more welcome in the wholesale funding market ?

Large-scale ECB bond purchases would also look a lot like a fiscal subsidy (which is part of Germany's objections). Spain--federal government, regional government and banks need to roll over 253 bln euro of debt next year and likely raise a 60 bln more. Italy--government and banks--have to roll over more than 300 bln euros next year (concentrated in Q1). Meanwhile, other potential courses, like increasing the EFSF or issuing euro bonds, like Junker has suggested is not in the ECB's domain.

On balance, I suspect that the market will be disappointed with what the ECB does and with the short-term momentum studies over-stretched on the 2-day bounce.    Other indicators I find helpful, like the 2-year US-German interest rate spread is also edging more into the US favor.  Lastly, I think that the prospects for a respectable US jobs report tomorrow will also limit dollar losses.