"Markets stop panicking when policy makers start panicking" - BofA strategist Michael Hartnett

All eyes will be on Mario Draghi on Thursday as expectations for something big from the former Goldmanite have grown over the past two weeks. More specifically, some now think the odds of QE expansion have increased considerably in light of recent events. Here's what we said on Wednesday:

Why would the ECB expand QE you ask? Well, first because if we're going by inflation, PSPP really hasn't worked as evidenced by collapsing expectations.

And second because the only thing that can offset the synthetic inverse QE that China and/or the rest of the EMs embarked on, is more quite tangible QE conducted elsewhere, ideally at the ECB (which is currently 6 months into its first QE episode), or Japan (although the ceiling to debt monetization there may have been already hit with the BOJ already monetizing more than 100% of all gross issuance) but not the Fed, whose rate hike intentions are what started this entire global reserve liquidation fiasco in the first place.

So in short, the deflationary bogeyman still lurks, as does more than a $1 trillion in expected EM FX reserve draw downs spearheaded by China with Saudi Arabia right behind Beijing. That will serve to remove liquidity from markets and put upward pressure on core rates, effectively working at cross purposes with DM central bank easing.

And then there's the outright turmoil in China's financial markets, the confusion wrought by the yuan deval, heightened volatility across the globe and chaos in emerging markets from LatAm to AsiaPac. Put simply, Draghi's famous jawboning might not do the trick this time especially with everyone casting a wary eye towards the Fed.

Bottom line: nothing calms the market like a panicked central banker.

On EUR/USD via Bloomberg:

• EUR/USD is little changed at 1.1225 within tight range today as traders wait for ECB rate decision at 1:45pm CEST and press conference afterwards. 
• Traders currently in wait-and-see, headline-trading mode, and they aren’t pre-committing to cash positions
• All eyes on whether Draghi will talk down the euro and/or signal a possible expansion of ECB’s QE if needed
• Dovish stance will see EUR testing 21-DMA support at 1.1194 ** Pair has been trading above that lvl since Aug. 10
• Next support at 1.1102/07 21-DMA/Aug. 20 low
• Bids seen at 1.1185/90 and 1.1150, a trader in London says
• Should Draghi disappoint EUR bears, pair may test offers at 1.1275/80: trader
• Daily trendline resistance since Aug. 27 at 1.1308 and 1.1364 high on that day may cap reaction initially
• Any knee-jerk response might be short lived as all important NFP data expected tmrw
• Probability of a Sept. Fed liftoff now at 32%
• Below, find some color on today's pivotal ECB decision from everyone you might care to hear from.

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From Bloomberg's Richard Breslow:

With China closed, global equities are having a calm up day which perhaps gives some insight into the broader view of risk without Shanghai panic, Bloomberg’s Richard Breslow writes. By and large it has been a quiet day as we await the ECB and nonfarm payrolls. No one is looking for the ECB to move on rates. The market is looking for the staff projections to be cautious with any outlook change and the heavy lifting to be done by Draghi at the press conference with a ready-to-act statement on unwarranted tightening. Any sign of cautiousness could be a mistake as global markets need bold actions. The economy needs it, the currency needs it.

• The five year/five year inflation gauge that Draghi has said the ECB watches very carefully remains at very depressed levels. There is no sign from the swaps market that inflation is expected to hit target as far as the eye can see. Say what you will about the market being wrong, but the market has had a better track record on predictions than many central bankers. Germany is not the euro zone. Isn’t that the message we are meant to have learned throughout the financial crisis? I would certainly ask Draghi if this swap still figures highly in their forecasts
• At the other end of the spectrum, bund yields are staying elevated. (Yikes, I can’t believe I am calling 80bps elevated.) Much has been written about why bund yields are higher despite the equity turmoil, but the reality remains. From a technical level 80 bps has been interesting. The ECB wouldn’t want yields to break higher. And the last thing the rest of Europe needs is higher yields. This week three euro- zone countries will have sold bonds at yields that have been moving higher since their last go rounds
• The euro remains in the middle of its YTD range with the USD. As long as EUR/USD remains above 1.1100-1.1150, let alone its 55-day moving average, technicians view it as a buy. The euro zone, again Germany aside, can’t afford a strengthening currency. This includes the rest of the core as well as the peripherals. It’s not currency war to get the EUR down, it’s economics if they want to strengthen the economy. EUR/GBP poking its head above the 200-DMA won’t have gone unnoticed
• The IMF which has continued its serial downgrading of global growth forecasts has said so again. After cutting its growth forecasts in July, IMF Managing Director Lagarde said earlier this week that, “the global expansion outlook is worse than the lender anticipated less than two months ago,” with advanced and Asian economies growing more slowly than expected. Ahead of this week’s G-20 meeting the IMF argues that “Advanced economies should maintain supportive policies. In most advanced economies substantial output gaps and below-target inflation suggest that the monetary stance must stay accommodative”
• Global equity markets have been in a panic. Volatility has spiked. A strongly dovish ECB will help. If volatility is the supposed enemy of a central banker then here you go. The PMIs have not been spectacular. Even the Spanish economic miracle took a breather this week with employment data described as showing a deceleration in the economy by Miguel Cardoso, chief Spain economist at Banco Bilbao Vizcaya Argentaria SA.
• This really isn’t the time for the ECB to go small. It is an opportunity for them to exert some leadership

From Deutsche Bank:

We expect the ECB to respond to recent events with verbal intervention. Our new market-based Financial Condition Index (FCI) has tightened sharply in the last couple of weeks. But the ECB sees gradual spillovers from its accommodative policy stance into bank credit counterbalancing tighter financial market conditions. Euro area GDP growth expectations remain largely static, with lower oil prices and easy credit conditions offsetting a stronger euro and slower global growth. This facilitates a “steady hand” on policy. However, we expect the ECB staff inflation forecast for 2017 to be revised marginally lower. Although we believe that fears of a hard landing in China are overdone, capital outflows could put upward pressure on the euro or — through falling FX reserves — on long-term government bond yields. We expect the ECB to reiterate its readiness to act, if necessary.

From Citi:

The review of financial, economic and monetary developments is likely to highlight some growing uncertainty about the state of health of the global economy at a time of increased financial market volatility related to the deterioration in Chinese economic prospects and possibility of a first rate hike by the US Federal Reserve. The assessment of the euro area economy will likely be similar to previous iterations, in our view, acknowledging an ongoing but moderate recovery. From an inflation perspective, we suspect that the ECB will take heart from the slight increase in core inflation rates. However, we expect that the probable lowering of inflation mid-points, and of the longer-dated estimates, together with the sizeable correction in market-based inflation expectations, could lead to some strengthening in the ECB’s language about the need to maintain an accommodative monetary policy stance.

From Goldman:

Compared with the July meeting, the immediate risk of a systemic event on the back of developments in Greece has declined significantly. However, the external risks for the Euro area seem to have increased. In particular, questions regarding the momentum of the Chinese economy are likely to weigh on the minds of Governing Council members. Judging from the accounts of the last meeting, the Governing Council was already concerned in July about the negative impact on the Euro area from a potential slowdown of the Chinese economy.    

We think the sharp decline in the oil price (around EUR10 since the July meeting) will be another focal point of the discussion in the Governing Council. While a lower oil price is clearly positive for the growth outlook of the Euro area, the negative short-term effect on inflation - given the still low overall level of annual inflation rates - will be a cause for concern, at least for some Governing Council members. The decline of around 20bp observed in 5-year-forward inflation-linked swap rates to below 1.7% since the July meeting will add to these concerns. After all, the rationale given for the introduction of the expanded asset purchase programme in January this year was the risk that the oil price decline "could adversely affect medium-term price developments" and that "this assessment is underpinned by a further fall in market-based measures of inflation expectations over all horizons and the fact that most indicators of actual or expected inflation stand at, or close to, their historical lows".

Overall, we expect the Governing Council (GC) to acknowledge the continuing uncertainty regarding the economic and inflation outlook. We also expect a signal similar to the July statement that the GC is willing to act should clear evidence emerge that the ECB's baseline scenario of a moderate recovery is at risk: "If any factors were to lead to an unwarranted tightening of monetary policy, or if the outlook for price stability were to materially change, the Governing Council would respond to such a situation by using all the instruments available within its mandate."

From BofA:

Events colliding with the ECB's yearning for plain sailing In an interview with Boersen Zeitung last week, ECB board member Benoit Coeuré stated that “we do not wake up every morning and look at the economic indicators in order to decide whether to raise or lower interest rates or whether to stop or expand QE”, conveying a sense that QE should be allowed time to work through the economy and is not designed to “micro manage” the cycle. The decision to reduce the frequency of the Governing Council meetings – announced in July 2014 – also signalled the ECB’s willingness to wean the market off speculating on how the central bank would react to short-term “noise”. Finally, we also believe that with QE, as it was designed in January, the central bank has found a delicate internal compromise, and that the bar for any material tweaking is quite high. Still, the ECB has been “asymmetric” for quite some months, firmly dismissing any tapering of the programme before September 2016, but open to more action. Draghi noted in July that it was ready to do more “if any factor were to lead to an unwarranted tightening in monetary conditions or if the outlook for price stability were to materially change”. The issue then is whether the China-related turmoil would qualify as a “material change”. We believe there is enough room for more dovish talking, but not – yet – for action, even if the latest developments sit well with our view that the ECB, by year-end, will have to make a continuation of QE after September 2016 a baseline and not a possibility, given a deteriorating inflation outlook.

During his July press conference, Draghi mentioned in the prepared statement that “market based inflation expectations have, on balance, stabilised or recovered further since our meeting in early-June”. This no longer holds with “5 year/5 year” down to 1.62%. It is always tempting for central banks to dismiss market-based inflation expectations, given their tendency to over-react to the latest developments, but even before the materialisation of the Chinese turmoil, we had reservations about the ECB’s inflation trajectory. On the basis of the move in oil prices alone, we estimate the central bank will have to revise down its forecasts by 0.3 pp in 2015 and by 0.2 pp in 2016. Because of the quirk in the slope of the oil futures curve, the central bank should be able to claim that 2017 will still be consistent with their definition of price stability, but this comes at a cost in terms of price level gap. 

From Credit Suisse:

The ECB will present its new staff projections for inflation and growth. Our economists expect that the ECB will lower its 2017 inflation forecast from 1.8% in the March and June forecasts to 1.7% in the September forecasts. This could indicate that QE is unlikely to end before September 2016 and run potentially longer. However, our economists do not expect a firm extension. We believe the market will take the lowering of the 2017 forecasts as moderately dovish and we would expect a small rally on this. If the ECB only lowers its forecasts to 1.7% for 2017, it would still be significantly more optimistic about inflation than our economists or the market (see Exhibit 22). Our economists' baseline scenario for inflation is an increase to 1.5% by year-end 2017 and an average inflation of 1.35% for the same year. While they expect 2016 inflation to be significantly driven by oil and currency moves, the 2017 number is approximately unchanged in each of their risk scenarios. The market, however, is significantly more bearish on inflation for 2017. The market based average inflation in 2017 is approximately 0.75%, which would still be close to 1% below the ECB's new forecast.

From Credit Agricole:

The ECB should worry in our view about a potential China-induced global demand shock which could hurt the Eurozone recovery (exports account for more than a quarter of Eurozone’s GDP) and inflation outlook (the recent EUR TWI appreciation and lower commodity prices should drag the Eurozone headline inflation lower still).

There are several ways in which the ECB could telegraph its dovish message:

1/ Downward revision of inflation and growth forecasts - of particular importance will be the new HICP mid-point projections for 2016 and 2017 (that stand at 1.5%YoY and 1.8%YoY currently). A forecast downgrade seems widely anticipated by now and the real question is more about the magnitude of the correction. A significant downward revision (eg a new inflation forecast of close to or below 1.2% for 2016 and 1.5% for 2017) would signal that the current QE program could extend beyond September 2016. In addition, indications that the Governing Council is now less optimistic about the Eurozone growth over longer term (GDP growth forecasts are 1.9% for 2016 and 2.1% for 2017) should be seen as a dovish surprise, strengthening the ECB’s commitment to QE for longer.

2/ Verbal intervention in EUR – EUR has been one of the biggest beneficiaries from the China-induced market turmoil with the TWI index at one point appreciating by more than 5%. The ECB President is fully aware of the fact that if the latest FX appreciation is left unaddressed, EUR could extend its gains broadly. We therefore think that EUR could feature prominently during the press conference with Draghi highlighting the importance of the currency as driver of inflation in the environment of persistent downside pressure on global commodity prices.

From Barclays:

Since the last policy meeting in July, there have been several macroeconomic and financial factors that have reduced the near- and medium-term inflation outlook and tightened overall financial conditions. The ECB staff macroeconomic projections are likely to show a downward revision in inflation forecasts for both 2015 and 2016, resulting from a stronger euro and weaker oil price futures. Therefore, we expect President Draghi to maintain an accommodative stance during his introductory statement, likely insisting that the Governing Council still has tools available should monetary and financial conditions tighten further. We now expect further easing to be announced before year-end as we believe inflation is unlikely to return to levels consistent with the ECB’s objective of price stability over the next two years. A time extension of the asset purchase programme to beyond September 2016 is the most likely option, in our view, and we think it could be decided as early as next week. Other options include an extension of the size and the scope of asset purchases and a cut in the deposit rate – the latter would be the most effective against a strong euro, in our view, but we do not expect such announcements next week, although the Governing Council will probably start discussing these options. 

Bonus: Barclay's QE tracker

And one more thing: Can the ECB actually do anything to offset FX reserve drawdown when EM flows only seem to track the Fed?