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ECB Will Avoid A Taper Tantrum Today, But It's Running Low On Ammunition

Following up to our earlier preview of today's critical ECB announcement, here is Bloomberg macro commentator Tanvir Sundhu, who says not to sweat what Draghi says today as the ECB will be able to avoid a "taper tantrum" (for now) and as a result the risk isn’t that the ECB is going to set off a sustained bond bear market, but - due to the shortage of monetizable assets - "it’s that it might find itself low on ammunition if the economy or prices suddenly turn south."

From Sundhu's latest Macro View:

No Taper Tantrum In Sight, But ECB Ammo Running Low

 

Markets will avoid a taper tantrum when the ECB announces its well-telegraphed plan for reducing QE today. 

 

Bond spreads and volatility are well-behaved, supporting carry trades in the near-term.

 

Lower QE purchases for longer has become consensus: 30 billion euro per month for nine months beginning from January. This will strengthen forward guidance and may limit moves higher in the euro.

 

Given the need to buy more time, Mario Draghi’s caution about any tightening of financial conditions amid low core inflation means that policy won’t stray too far from the middle ground.

 

Within its self-imposed limits on QE purchases, the ECB needs to be able to further ease at any point while keeping bond-market volatility contained.

 

Cross-asset volatility hasn’t repriced materially ahead of the meeting. The persistent low realized-volatility environment may push investors into carry-positive trades.

 

Effective ECB communication has helped push long-end EUR rates implied volatility to record lows this month. The three-month option on 10-year swap rates only prices in 2.7bps per day of movement.

 

Carry trades, via systematic short gamma strategies, can still perform well. Although, depending on what’s announced, there may be a need to adjust buckets. An increased emphasis on forward guidance would lead to an out-performance by short-volatility positions in the front-end.

 

Bund yields may gradually shift higher in 2018, helped by strong PMIs. But they probably won’t deviate too far compared with forwards, with the 1-year forward rate at 0.77%. That’s in advance of a likely year-end squeeze due to scarcity issues that may force closing of short duration positions that carry negatively.

 

The inflation distribution has narrowed and moved to the left in recent years, with wage indicators showing little sign of a convincing upswing.

 

While the inflation market has unwound the deflation premium, it’s reluctant to price inflation much higher, with the EUR 5-year inflation swap at 1.3% against core CPI of 1.1%. The option premium for the 3-year 1.5% inflation cap (used to hedge against rising inflation) remains just above its all time lows.

 

Against this benign environment, the key risk isn’t that the ECB is going to set off a sustained bond bear market -- it’s that it might find itself low on ammunition if the economy or prices suddenly turn south.