After two years of the most boring, unnatural, continual grinding higher action in the equity markets, we have finally returned to a more normal environment where stocks move both up and down. I continue to stress that you shouldn’t get too bearish on the dips, nor should you get too bullish on the rips.
You should play it cool like this guy.
Who hasn’t brought their own bananas to a rock concert but being too afraid to eat them in public? Not this guy. He is not afraid to stand out in the crowd eating his banana, and I am going to follow his lead.
While everyone else is chasing momentum, either proclaiming we are headed for a 2008 style crash or going to rocket back up to new highs, I am going to stand alone in my forecast that we chop around this level for some time to to come.
At these prices I definitely think that financial assets are set up to deliver poor long term returns. But I don’t feel that the big correction will come until the bond market revolts. Every modern day equity bear market has been ushered in by the Central Bank raising rates and inverting the yield curve.
Although I cringe as I write this next sentence, I am sympathetic to the argument that this time might be different. The Fed’s withdrawal of QE might be tantamount to a tightening, and that the highly indebted nature of the economy makes it much more susceptible to a tightening. But I don’t think that this is the right bet. It very rarely (if ever) is different this time.
The world’s central banks are going to stay easy until the bond market takes away the printing press. Risk assets won’t have the really big correction until that happens.
What’s happening then?
In the mean time as we try to understand the day to day squiggles, I think the action of the past month can best be explained by the actions of the ECB.
The ECB’s continual shrinking of their balance sheet has been weighing heavily on their economy. It has also had the effect of dampening the global expansion by the other Central Banks. Have a look at this chart that shows net liquidity injections by the four large Western Central Banks.
During 2013 the Fed’s QE program was running full tilt so the contractionary ECB policy was offset. But over the last year as the Fed has wound down its QE program, the effect of the ECB’s balance sheet shrinking has become more pronounced.
This has resulted in Europe sinking into a disinflationary spiral. Have a look at the German 5 year break even inflation rate chart.
It has been steadily sinking.
For some reason the ECB loves to use the five-year/five-year-break-even swap rate as their preferred gauge of long term inflation expectations. This rate has also been plunging over the past year.
In late August, Draghi’s Jackson Hole speech stopped the decline. He seemed to understand what was needed, and the market was hopeful that the decline could be arrested.
And this is when Draghi over played his hand. He convinced the market that the turn was right around the corner.
With visions of an American style QE balance sheet expansion in their heads, the hedge funds piled into “risk on” trades. Josh Brown’s Reformed Broker summed it up best with this September 7th post:
“Here are my best trades, ordered from easiest to hardest,” said one of the top ranked macro CIOs, exchanging ideas. Draghi’s fairy dust had finally settled; he’d been pleasantly surprised, and killed it. “Buy European curve steepeners now, buy European risk assets, buy 5yr/5yr Spain versus short 20yr Germany,” he explained. “Maybe these trades last a few weeks, maybe longer, doesn’t matter – get this right, add some smart convexity, and you could make your year by the end of October.”
These are all trades betting that Draghi would follow through. This sort of positions were rife in the hedge fund community. Famed hedge fund trader David Tepper’s comments echoed this sentiment:
“Draghi wants inflation in the Euro zone. He will not stop,” said Tepper.
The problems arose when Draghi was not able to back up his words with deeds. His TLTRO program came in well below expectations, and then continuing conflict with the Germans has made expanding the ECB’s balance sheet problematic.
As these difficulties became clear, hedge funds started bailing out of their positions. Their “Draghi has our backs” trades were suddenly causing a lot of pain. It didn’t help that the Fed was winding down QE, and that risk assets were severely overbought. Before long it started feeding on itself and the selling became scary.
ECB finally starts buying
But here we are today, and the ECB has finally started buying the assets that Draghi promised a couple of months ago. This morning the ECB announced that it has bought French and Portuguese covered bonds. The market is not in a trusting mood, so most of the traders’ comments are centred around the smallish nature of the purchases. They simply don’t believe that the ECB can ride to the rescue anymore.
However, I remember that during the European sovereign debt crisis of a few summers ago, the initial reaction to the start of the program was also rather muted. But as the ECB followed through, the crisis was slowly brought under control. I suspect that this time will be similar. As the ECB continues buying, the ship will eventually be righted.
My plan was to wait until the ECB actually started with their balance sheet expansion to short sell bunds (remember, balance sheet expansion is bond negative – not the opposite as widely believed). Well, here we are – it has started today and I am going to follow through on my plan.
I am already short as I luckily took a punt into the big spike up during last week’s panic buying. It has been hard, but I have stuck with the short, hoping that I had somehow managed to short sell a buying climax.
This morning, I am going to increase the position.
German 10 year yields hit 75 basis points in the panic buying. If Draghi follows through with promises, then this will prove a truly “stupid” price.
I don’t think the hedge funds were wrong when they all piled into their European trades in September. Their predictions could still prove bang on correct. It would be just like the Market Gods to first shake them all off before the real move starts.