Well, my trading continues to be ugly.
Yes, I am talking that sort of ugly…
A couple of days ago, I wrote this piece on why Draghi and the rest of the ECB were going to disappoint. Then what do they do? They pull a rabbit out of their hat and exceed market expectations with both a rate cut (all three rates by the way), and also toss in a pledge for a large QE program.
Regardless of the fact that the Euro had set up with a massive speculative short position going into the meeting, the market beat the Euro like a red headed step child.
We fell through 3 different big handles on the news.
I had been betting on the ECB disappointing, so I had a small long position in the Euro. Well the only thing worse than whiffing on your analysis and being on the wrong side of the market, is keeping that position. Too often traders let their position dictate their opinion, and not the other way round. As Todd Harrison likes to say, “good traders know how to make money, but great traders know how to take a loss.” I am far from a great trader, but I will take Todd’s advice to heart. Given that the landscape changed dramatically with the ECB’s bold moves, I have adjusted my positions accordingly.
Yesterday I sold my Euro long position. There is no sense keeping a position that is pushing to new lows. Although the crowd is overwhelmingly short, Draghi wants the Euro lower. It very well might be one of those trades that is plainly obvious and easy.
My main thesis was that the ECB was not going to engage in QE – instead trying to influence the economy with the price of credit. I was right that they were going to try to influence the economy by lowering the price of credit, but they also threw in a big QE commitment to boot.
There is a lot of confusion about what the ECB actually committed to during yesterday’s meeting. I have seen comments that German Bunds sold off because the ECB did not pledge to buy sovereign debt. This analysis is wrong. The German Bunds sold off precisely because the ECB committed to a large QE program. Don’t forget that QE programs are bond bearish. Too often market pundits think that QE program send long term interest rates down. There is absolutely no proof that this is the case. In fact, the during each of the three big US QE programs long term interest rates rose materially. At the end of the both QE1 and QE2, when the Fed stopped buying bonds, the bond market exploded higher – the exact opposite reaction that the pundits will tell you is expected. Don’t forget – the goal of QE programs are to create inflation. Inflation is a bond investor’s worst nightmare.
Let’s get back to yesterday’s ECB announcement. Draghi did not come out and pledge a QE infinity type program like Bernanke did with QE3. That program was open ended with Bernanke pledging to keep expanding the Fed’s balance sheet until their economic objectives were met. The ECB does not have the luxury of committing to such a blatant program of quantitative easing. There is still a huge problem under EU treaties of monetizing the deficit financing of countries that are not balancing their budgets. The Germans are reluctant to simply go balls to the walls ala Bernanke/Yellen.
Yet at the same time, even the Germans realize that Europe is sinking into a deflationary morass that has the potential of dragging their economy into another depression. The European Central Bankers realize that given non-EU countries’ massive balance sheet expansions (US, Japan, UK), a failure to match would result in Europe importing everyone’s deflation. That is why although Draghi did not come out and say that he was outrightly engaging in QE, he did commit to expanding the ECB balance sheet to the levels seen in the summer of 2012.
This commitment is all that matters. If the market believes him (and his credibility does seem very high), then it doesn’t matter what he buys. He has to figure out how he is going to get around all sorts of legal issues regarding circumventing the prohibitions against monetizing deficit financing, but as long as he succeeds in expanding the balance sheet, then the game has completely changed.
Some very smart guys like David Tepper believe that Draghi is serious:
“What the ECB did today was very important. They want growth, an increase in the money supply and inflation. Basically what it all means for the markets is higher equity prices and a beginning of the end of the world bond market bubble…We are done.”
That comment also demonstrates that Tepper subscribes to the theory that QE programs are not bond friendly.
The trouble with Draghi’s plan is that he is expanding the balance sheet program even before the last balance sheet expansion program implementation has even started. Last meeting he committed to the LTROs (long term repo operations), but they have not yet been executed. In the meantime, the ECB’s balance sheet continues to shrink (which is partly why the European economy has been so poor).
This delay in implementing the balance sheet expansion is why Draghi & Co. also cut all three benchmark over night rates by 10 basis points.
In a crazy move, Draghi pushed rates deeply into negative territory. Although some thought he would cut one or two of these rates, few thought he would cut all three by 10 basis points. But Draghi wanted to show that he was serious about arresting the disinflationary spiral.
The net affect of the ECB’s move is that they probably did about as much as they could have done given their legal constraints. I agree with Tepper that this shows a seriousness for dealing with their problems.
What then to do?
So then the question is how to trade it? I am still coming up with my plan, but I am leaning towards shorting German bunds. I think we very well might look back at the sub 1% ten year bund as the “obscene number.”
I know that many would argue that buying European equities is probably the preferred trade, but I worry that there has already been a fair amount of front running the announcement.
And don’t forget that the ECB meeting euphoria marked the top during the last LTRO announcement.