European Central Bank May Surprise with Size of New Stimulus

Frankfurt: Christmas is coming - and investors are already convinced they will unwrap an early present Thursday in the form of more economic stimulus from the European Central Bank.

ECB head Mario Draghi has signaled clearly that action is coming this week when the bank's governing council meets. So clearly, in fact, that the challenge - as for parents with overexcited children - may be simply to avoid disappointing expectations.

That means that this week's meeting could bring surprises. Draghi may seek to exceed expectations by expanding its bond-buying stimulus program or cutting interest rate more than analysts foresee.

One consequence of such action could be a weaker euro against the dollar. Currently, the euro is hovering around $1.06. Some think it could head down toward $1.00, so-called parity; others, that Draghi may have to over-fulfill expectations just to keep it where it is.

The weaker euro - or, to look at it another way, the stronger dollar - would mean cheaper European travel for Americans. But it could also hurt the profits of American companies doing business in Europe, because the currency shift will shrink euro earnings in dollar terms. More broadly, a weaker euro would help eurozone exporters by making their goods more competitive in major trade partners including China, the U.S., Britain and Japan.

Starting from the ECB's Oct. 22 meeting and in subsequent speeches, Draghi has indicated action is likely in December. Through its stimulus actions, ECB aims to make credit cheaper for companies to support growth, which is still weak at just 0.3 percent in the third quarter. Most of all, it is trying to push inflation higher from 0.1 percent toward its goal of just under 2 percent annually. Price stability is the bank's chief goal; low inflation suggests the economy is weak and makes it harder for indebted countries such as Greece to recover.

To achieve that, the ECB is currently buying 60 billion euros in government and corporate bonds a month, up to a total of 1.1 trillion euros. And Draghi mentioned that the current rate on funds deposited by banks could be cut further. That rate is already negative at minus 0.2 percent.

Here's what investors expect from the ECB - and where the central bank could surprise on Thursday:

BIGGER BOND PURCHASES, FOR LONGER

Right now, markets are expecting the ECB to either extend the bond-buying program beyond the current end date of September 2016 or increase the purchase amounts. It could also increase the list of eligible bonds beyond government bonds and limited types of very secure private-sector bonds.

To exceed expectations, Draghi may have to do several of those, or all three, and/or exceed the amounts.

Holger Schmieding, chief economist at Berenberg Bank in London, looks for the ECB to raise bond purchases to 75 billion a month; lengthen the minimum duration of the purchases by six months until March 2017; and add new types of bonds excluding corporate issues. Ben May at Oxford Economics says a longer purchase program duration is likely but expects no increase in monthly purchases.

LOWER INTEREST RATES

Markets are already expecting a cut in the deposit rate by around 0.15 percentage point, says analyst Carsten Brzeski at ING-DiBa in Frankfurt. Estimates range from 0.10 point to 0.20 point.

So to exceed expectations, Draghi would need something like a cut of 0.20 percentage point, or more.

Speculation about a deeper cut into negative territory has been fed by experience in Switzerland, Denmark and Sweden, which have negative rates and have seen fewer unintended consequences than some had feared. Switzerland has its key rate at negative 0.75 percent. That has supported the idea that the ECB might be able to go even deeper into negative territory than it has.

A cut in the deposit rate has several effects that could help stimulate the economy. It would increase the amount of safe bonds available for the ECB to buy, since currently the central bank cannot purchase bonds yielding less than its deposit rate. It would push banks to lend money instead of hoarding it at the ECB.

Perhaps most important of all, the negative deposit rate is seen as tied to the euro's exchange rate to the dollar. That is because the lower rates go in the eurozone, the less people want euros to buy fixed income investments. That lessens demand for euros - and sends its exchange rate lower. It helps exporters and helps the ECB raise inflation by making imports more expensive.

And that's particularly so against the dollar, since the U.S. Federal Reserve is widely expected to make its first rate increase in years at a Dec. 15-16 meeting.