ECB's Forecast Torpedoes the Market

Major Moves

Traders soured on the market, sold stocks and bought bonds following a surprisingly pessimistic announcement from the European Central Bank (ECB) this morning. As I mentioned in yesterday's Chart Advisor newsletter, the ECB was expected to downgrade its economic forecast for the Eurozone in order to justify additional financing for European banks; however, the extent of the central bank's pessimism today was surprising.

Unfortunately, the adjusted estimates from ECB President Mario Draghi detailed an expected growth rate of 1.1% this year, which is down 0.6 points from the last estimate. Geopolitical risks such as trade protectionism were to blame for most of the adjustment, which is the lowest estimate since the Greek financial crises prior to 2014.

In the following chart, I have used one-minute candles to illustrate the reaction traders had to the ECB's announcement on the value of the euro. If you are unfamiliar with the way currencies quotes work, it is important to understand that if the euro is falling, the dollar is rising.

As I have mentioned many times over the last few months, a rising dollar is a problem for U.S. equities because it makes U.S. exports more expensive and discounts international profits earned by U.S. multi-nationals, which could extend the current correction.

EUR/USD rate

S&P 500

What the ECB is essentially planning to do is ease monetary policy by providing more capital to banks in the form of loans from the central bank. Like quantitative easing, this should lower short-term interest rates, which should be a positive for asset prices, but the ECB's negative tone probably shocked traders a little today.

At one point during his press conference, Draghi said, "The risks surrounding the euro area growth outlook are still tilted to the downside." Comments like that hit banks in the region hard, with some, like Deutsche Bank AG (DB), down more than 5% by the close of market. After a short-lived recovery in the middle of today's session, the S&P 500 closed at a new short-term low.

It is important to note that today's announcement wasn't entirely new information. It may feel like that from reading the headlines, but traders were already aware of the ECB's plans for bank loans and lowered forecasts. I will argue that the tone in the news is as much a reaction to stock prices that have already been declining since hitting short-term resistance than any fundamental changes. A worsening Eurozone economy is a risk to the market in the long run, but the pace of the decline is representative of a normal technical correction that happens to coincide with some bad news than a major retracement.

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Risk Indicators – ECB Pessimism Hits EM

In his statement to the press, Mario Draghi also suggested that "vulnerabilities in emerging markets appears to be leaving marks on economic sentiment," which may have contributed to additional selling in emerging market indexes. This was unfortunate because one of the areas we have seen surprisingly strong investor sentiment recently has been in emerging markets – especially China.

One day does not make a trend, but emerging markets had already failed to make any headway after the double bottom breakout in January. As you can see in the following chart, the iShares Emerging Market ETF (EEM) is challenging its breakout point near $42 per share again after failing to break to new highs last week.

I wouldn't assume that, if emerging markets break support, the rest of the market will follow; however, weakness in this asset category is a signal for caution. On the other hand, emerging markets frequently provide an early sign that stocks have hit a bottom when they rally. I recommend that traders keep their eye on the asset class for signs of support in the short term to avoid missing out on a new buying opportunity.

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Bottom Line: Labor Still an Unknown Risk

In tomorrow's Chart Advisor newsletter issue, I will discuss what we learned from the labor report that will be released before Friday's open. I expressed some concerns in yesterday's issue that traders were being set up for a disappointment when the data is released. However, one advantage of the selling today is that it relieves some of the pricing pressure before the announcement. Lower prices today mean that the market is less likely to fall tomorrow, and buyers may find the low prices attractive once the labor report has been released.

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