Draghi, a Rabbit, the Euro and the Magic Trick Traders Envision

  • Euro has 70% chance in options market of matching 12-year low
  • Even with exchange rate falling, inflation remains just 0.1%

Mario Draghi needs to come up with something to surprise currency traders next week or risk a euro rebound that would threaten his efforts to boost inflation.

The good news for him is that strategists are gaining confidence the European Central Bank president will pull it off and exceed the market’s expectations for monetary easing at the Dec. 3 policy meeting.

Forecasters are cutting their year-end and first-quarter euro estimates at the fastest pace since March, when the start of the central bank’s bond-buying program sent the currency tumbling to a 12-year low. Options signal there’s a 70 percent chance the euro will match that low this year, up from 18 percent when the ECB last met in October.

“He’s going to pull a rabbit out of the hat -- we’re just not sure what that rabbit will be,” said Steven Bell, London-based chief economist and director of macro strategies at BMO Global Asset Management, which oversees about $244 billion. “The euro is going down heavily.”

Bell predicts the shared currency will drop below parity with the dollar next year, after it sank to $1.0566 on Wednesday, its weakest level since April and approaching this year’s low of $1.0458 reached on March 16. It was little changed on Thursday at $1.0619 as of 10:05 a.m. New York time.

Ways that Draghi might exceed investors’ expectations include lowering the ECB’s minus 0.2 percent deposit rate by 0.2 percentage point, Bell said. Futures prices compiled by Bloomberg suggest that only a 0.1 percentage-point cut is fully priced in.

The ECB chief may also expand the bank’s quantitative-easing plan to include assets such as corporate and local-government bonds or remove the rule preventing it from buying securities that yield less than the deposit rate, according to Bell.

Turbulent Year

A weaker euro is key to the ECB’s ambition to boost inflation to 2 percent. Yet even after a 12 percent slide this year as policy makers increased the money supply, prices are barely rising across the 19-nation economy. Part of the reason is the euro’s mid-year rally as a meltdown in emerging markets prompted investors to unwind riskier trades funded in the currency.

The risk for Draghi -- and the euro -- is that he fails to live up to the growing speculation that he has a surprise in store.

While the ECB chief has been dropping hints about extending stimulus since the central bank’s Oct. 22 meeting, he’s been vague about the details. Further euro losses are by no means assured.

Since the October gathering, strategists surveyed by Bloomberg have cut their median year-end euro forecast by 3 U.S. cents to $1.07, and their first-quarter outlook by 2 cents to $1.06. Those predictions still put the shared currency slightly stronger by Dec. 31.

Start Button

“For the euro to continue going further, it needs something more than the spin,” said Neil Jones, the London-based head of hedge-fund sales at Mizuho Bank Ltd. “If Draghi actually does come with some decent measures, then we can still get a sharp move lower. We need something physical now. We need the start button to go on further QE.”

Jones said he’s confident Draghi will either cut the deposit rate by as much as 0.25 percentage point or widen the scope of the 1.1 trillion-euro ($1.2 trillion) QE program, and sees the euro falling below $1.05 before year-end and less than $1 in 2016.

Not everyone’s convinced Draghi will do enough to satisfy markets. Some officials have argued that incoming data show they have no need to act next week. And speculation the Federal Reserve is preparing to raise U.S. interest rates later in December, which should boost the dollar, is just as priced in as ECB easing.

‘Already Baked’

“I don’t think they’ll be able to drive the euro much lower,” said David Bloom, global head of currency strategy in London at HSBC Holdings Plc, Europe’s biggest bank. “They’ve already promised a rate cut, they’ve already promised more QE. How can you over-deliver if over-delivery is priced in? It’s already baked in the cake.”

Bloom sees the euro rebounding to $1.10 by Dec. 31, and $1.20 by the end of 2016.

That’s a break from the growing consensus that Draghi can’t afford to under-deliver. Last week, he said officials will do what they must to get inflation rising.

“Since euro-dollar has already depreciated in response to Mr. Draghi’s statements in recent weeks, it will be difficult for the ECB not to follow through on Dec. 3 in order to prevent another retracement,” said Stephen Jen, co-founder of London-based hedge fund SLJ Macro Partners LLP and a former economist at the International Monetary Fund. “The ECB will not disappoint.”

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