Trading is a tough game. Even when your analysis is correct, the Market Gods find ways to take your hard earned money. I have been banging the drum on the fact that the ECB has been too tight for quite some time. I have correctly forecasted that the European economy was going to under perform. The ECB’s balance sheet has continued to shrink at a time when both the US and Japan are expanding.
This has resulted in a European economy that has been mired in a deflationary spiral downward. By not keeping up with the other Central Bank easing programs, the ECB is importing all the world’s deflation. This has had an excruciating effect on the European economies. They are already suffering from way too much debt, and deflation only makes the real cost of this debt all the larger. It also makes it practically impossible for the European economy to grow out of their problem.
Europe is caught in a massive balance sheet recession. And just like Japan did in the 2000s, Europe has attempted to fix it by changing the price of credit instead of the amount of credit. Mario Draghi has boldly pushed European rates to negative levels. But in a balance sheet recession changing the price of credit has minimal effects on the economy. The private sector certainly appreciates the lower cost of carry for their massive debts, but there is no demand for credit at the lower price so therefore the lowering of the rate does very little to stimulate the economy. The Central Bank is pushing on a string.
This policy decision has some interesting effects on financial asset prices. Let’s start with the easiest and most obvious one. If the economy is stuck in a deflationary spiral and the Central Bank is pushing short term rates to negative levels, bonds are the biggest beneficiaries of this policy. Although there is some credit risk in European sovereign bonds, for the most part the bond prices are made up of inflation expectations and the expected level of future interest rates. A deflationary spiral with a Central Bank that is focused on trying to fix the problem by lowering the price of credit (even going to negative levels) is bond nirvana. And that is why the European bond markets have experienced one of the greatest rallies of all time. The ECB is making a huge policy error and bonds have correctly sniffed out that this is not going to help.
Some analysts will claim that European bonds are rallying so hard because they are anticipating a large QE program. I couldn’t disagree more. The European bond market has been rallying like a banshee for six months. QE programs are inflationary, the exact opposite of the condition that bonds thrive in. In fact, I think that if Draghi actually goes through with a large scale QE program, that will be the signal to sell bunds short. In the mean time, don’t be like Bart.
Remember that absence a massive expansion of the ECB’s balance sheet, they will be trapped in a balance sheet recession. Their economy will suffer a similar fate to the Japanese lost decade of the 2000s. Bond yields will stay low and equities will under perform other more expansionary countries.
Which brings me to my trading. I had correctly forecasted that the European economy would be stuck in a funk, and I chose to short sell European stocks to express that view. Although they are indeed under performing, they have by no means sold off hard.
The massive lowering of long term interest rates have kept European stocks better bid than they deserve.
This is why trading is so hard. I correctly forecasted that the European economy would be terrible, and although I was aware of the possibility of a big bond rally, I was too worried about the fact that bond prices were priced with such skinny real yields to get long. Instead I sold short the expensive asset, European stocks, in the hope that they would get dragged lower in the deflationary spiral.
Instead of doing the hard trade, buying European bonds, I took the easier way out and shorted European stocks. I was correct in my deflation forecast, but didn’t have the wherewithal to do the trade that would make me the most money. I lacked the courage to do the hard trade. Even though I was correct, I didn’t really make any money and at the end of the day, that is all that matters. The Market Gods are always ready to remind you how very tough this game is…
Where do we go from here?
What does this mean going forward? The overwhelming consensus is that bonds have rallied because of Draghi’s recent commitment to QE. My suspicion is that at this point, market participants are much too long both European fixed income and European stocks. There is a lot of hope priced into European financial asset prices.
I don’t think that Draghi is going to be able to live up to that hope. I suspect that as usual, the ECB will disappoint at the coming meetings. There is not a lot of support for a QE program that is large enough to actually move the needle.
Therefore in the coming weeks, I expect European stocks to under perform and at the margin, European bonds to continue to be relatively better bid as compared to other global bond markets.
Many strategists are suggesting that US bonds are cheap when compared to European bonds. I think this logic is flawed. In the 2000s Japanese bonds traded at absurd prices when compared to other global bond markets. Yet we still experienced some large bond bear moves in US bonds during this period.
Remember the immortal words of Jesse Livermore – “The market can do anything.”
The spreads between US and German bond yields are hitting new highs, but there is nothing saying that they can’t go even higher.
Don’t get sucked into the trade of buying US bonds and shorting German yields because spreads are “too wide.” Until you see the ECB actually expand their balance sheet, this trade will be a sucker’s bet. The European economy is stuck in a balance sheet recession. If you think that Mario will disappoint, the much better trade is to short the European stock market. With everyone so bullish on equities, this feels like the “harder” trade.
I did make some small changes to my portfolio in the couple of weeks I didn’t update this journal. Although I would love to say that I covered all my bad trades at the perfect time, that seems to be something only traders active on twitter are able to do. I did cover my gold and other precious metals early on my break, but otherwise I mistakenly hung tough with way too many of my losing trades.