After EUR/USD enjoyed a spectacular rebound after the Italian referendum, the next big event is the ECB. Here is the view from Morgan Stanley:

Here is their view, courtesy of eFXnews:

We believe the reaction of the EUR over the ECB meeting will ultimately depend on the probability of tapering in the next 12m. In particular, EURUSD will rely on the short end rate differential between EMU and the US.  Our economist’s assumption is that the ECB will keep rates on hold at next week’s meeting but add a 6m extension to its QE purchase program.

What is the market expecting?

Rates – no cut is priced for the December meeting and only 3.5bp by the end of 2017. The first hike is now 38 months away in 2020 instead of 60 months away as was priced at the end of October.

QE – the level of a bond yield is unable to give us an accurate measure of what the market is “pricing” regarding further government bond purchases. Our only estimate is via speaking to our clients. Recent discussions suggest the majority of macro investors are not assuming the ECB will taper in 2017, indicating another extension would come in September.

Potential Scenarios and EUR response

1) Extends QE purchases for six months beyond March at the current pace of 80bn/month. Expected by many market participants, already hinted at by ECB members speaking to MNI news, wouldn’t be surprising for markets. Limited EURUSD impact. To extend purchases and leave an expectation in the market that they could extend again, the ECB would need to make some tweaks to its current program that limits the scope for purchases. Here are some tweaks that the ECB could make and the potential EUR impact.

-a) No longer using the capital key to allocate purchases. As this approach could be bearish for the German bund but bullish for the periphery, we think the EUR could react positively. Note that the ECB doesn’t necessarily need to explicitly express it is moving away from the capital key, they could indicate that they plan to be more flexible, in which case the EUR reaction should be limited. The market impact would be more volatile if they are explicit.

–b) Buy bonds below the deposit rate. Would be bearish for the EUR on the day given that this measure should put downward pressure on front-end German yields in particular.

—c) Change the maximum limit on buying per issuer/ISIN. This approach would generally be bullish for the whole German bund curve. For EURUSD to fall we would need to see a larger decline in bund yields than US Treasury yields, pushing down the yield differential. EURUSD is more sensitive to front-end rates (2y) than long end rates (10y).

—-d) Scarcity to be addressed (Bundesbank repo facilities enhanced) We have to assume that the ECB will either discuss or be asked about the lack of bonds, specifically about short end bonds being used for repo purposes. Any rise in short term rates as a result of reduced worries about bond availability would strengthen the EUR, but we wouldn’t expect more than a 1% increase.

2) Cuts rates by10bp Extremely unexpected. Markets price in no probability of a cut next week and only a 3bp by the end of 2017. EURUSD would fall by 2-3%, driven lower by front end rates (Exhibit 15).

3) Extends QE purchases by more than six months. This would be unusual for the ECB to extend for more than six months as they haven’t done that before so this measure would surprise markets. We would expect EURUSD to weaken.

4) No change in policy. EUR would rise as markets are expecting some form of easing. The magnitude of the increase will depend on the explanation given by the ECB and how it intends to scale back QE purchases. This would see German yields rise substantially, while Italian spreads likely widen out, pulling the EUR in opposite direction.

5) Extend corporate bond purchases but not government bond. 10% of the current monthly purchases are in corporate bonds. Reaching this sector and not government bonds would imply a tapering of bond purchases. This scenario is highly unlikely and would be the most bullish of the scenarios considered here.