A few days ago Reuters broke a story about the growing dissension within the ranks of the ECB. Titled “Central bankers to challenge Draghi on ECB leadership style”, the article detailed how the national Central Bankers were furious with Mario’s “secretive management style and erratic communication.” They were especially angered that Mario committed publicly to expand the ECB’s balance sheet to levels seen in the midst of the last European sovereign debt crisis.
“This created exactly the expectations we wanted to avoid,” an ECB insider said. “Now everything we do is measured against the aim of increasing the balance sheet by a trillion (euros)… He created a rod for our own backs.”
In the days following the story there were even rumours that Draghi was going to be forced to resign.
This all added up to an ECB meeting that held even more drama than usual. Was Draghi going to be shamed into backing down from his commitment to expand the balance sheet? Were the ECB board members going to press their advantage and neuter the freewheeling Draghi?
It turns out that Draghi’s bold gamble to make public the balance sheet expansion commitment worked. Instead of rolling back that statement, the ECB affirmed it within yesterday’s press release.
Based on our regular economic and monetary analyses, and in line with our forward guidance, we decided to keep the key ECB interest rates unchanged. Following up on the decisions of 2 October 2014, we last month started purchasing covered bonds under our new programme. We will also soon start to purchase asset-backed securities. The programmes will last for at least two years. Together with the series of targeted longer-term refinancing operations to be conducted until June 2016, these asset purchases will have a sizeable impact on our balance sheet, which is expected to move towards the dimensions it had at the beginning of 2012.
The Maestro strikes again! Mario ended up getting exactly what he wanted. He came out during the press conference looking very much like a man in control.
I will admit that during the Q&A he might have referred reporters to the ECB statement a little more than usual, but there is no doubt that Mario won the battle.
Mario even went so far to answer a question about the level of balance sheet expansion with amazing precision.
The other clarification, you always make reference to the beginning of 2012. This has been interpreted in different ways, because of course, the beginning of 2012 can be quite an extended period, so there was a time when the balance sheet was at its peak. It was about €3 trillion, and another time when it was slightly lower than that. People have said between €750 billion or €1 trillion above what it is now. Could you clarify that?
Draghi: On the second question, the beginning of 2012 means March 2012, that is to say right after the second LTRO.
I looked it up and that was pretty close to the highs in terms of the ECB’s balance sheet size. It was a little over €3 trillion in March of 2012.
But are they going to be allowed to do QE?
At this point you might be saying to yourself – “great Draghi won the battle within the ECB, but that isn’t the end of the story. There is still the legal labyrinth of EU regulations for Draghi to jump through before he is allowed to execute QE.” And if you said this, you would be in good company, for even the ever helpful former Federal Reserve Chairman Ben Bernanke has opined about this matter recently.
Former Federal Reserve Chairman Ben Bernanke predicted that the European Central Bank (ECB) would have a rough time implementing U.S-style monetary easing.
Speaking Wednesday at the Schwab IMPACT conference, the ex-central bank chief said the ECB faces political barriers to enacting such an aggressive program.
“The barriers to doing it are not really economic,” he said. “The legal and political barriers being thrown up are going to make it very difficult to do that.”
I am sure that Draghi was especially pleased with those helpful comments from his former peer. But he was ready for the question when it was asked at the ECB meeting Q&A.
And then my second question would be on the comments by Ben Bernanke. He was saying at an event that the euro zone would face legal and political hurdles or problems when implementing QE. So do you share his view, at least until the European Court of Justice comes up with a final ruling on OMT?
On the second point: no. We think that if we act within our mandate we can use a variety of instruments. And the important thing is to always stay within our mandate. We believe that if it’s not monetary financing, it’s in our mandate.
We know that Draghi is a great poker player, so who knows if he is bluffing or not. But it certainly sounds like he has a plan to push ahead with QE if it is needed, regardless of the legal roadblocks. He is in the process of carving out a framework for executing QE under the guise of it falling under his monetary authority.
The risk reward is now much more favourable
The last time Draghi made these sorts of promises the markets exploded higher. Hedge fund traders like David Tepper got all bulled up on the idea that Draghi would follow through and create the growth (or at least nominal growth) he promised.
At the time I said that the Europeans would disappoint with their infighting. I didn’t realize how correct that comment would end up being. However, I also said that eventually Europe would get there.
I think we have now hit the point where it makes sense to trade with the idea that Draghi will achieve his balance sheet expansion. It was always going to take longer than the market expected, but we now have the added benefit of the recent scepticism creating a much more favourable risk reward.
Remember this quote from the reformed broker in the midst of the Draghi induced euphoria of September?
“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.”
Well, these trades didn’t work out at all as the hedge funds had gotten way too optimistic about the prospects of Draghi’s “fairy dust.”
But my guess is that the time to put on all the European reflation trades is upon us. This top ranked macro CIO is probably going to be right – he just fell prey to some poor timing. The Market Gods never make this easy, and it would be just like them to make his call spot on, but not before he has been made to look completely wrong.
As for me, I bought a little gold priced in Euros. I am also leaning harder on my German Bund short position. I know that everyone believes that QE programs are bond friendly, but I am of the opinion that balance sheet expansions are inflationary and bond negative.
I also shorted a tiny little amount of EURJPY.
Japan is dialling up the pressure
This recent move by the ECB is just another step along the road to more and more competitive stealth devaluations via QE. The recent Japanese QE expansion has dialled up the pressure on the rest of the world.
It was one thing for the Japanese to engage in aggressive QE during 2012 and 2013, but to expand it at this point is rubbing salt in the wound.
I am betting that the EURJPY levels seen at the end of 2013 are going to hold. I think that the Europeans cannot afford for that cross rate to go any higher. I don’t know how, but I think they are going to keep it below that level.
I have argued that the aggressive action by the Japanese is going to force the rest of the world into QE. But I recently read a great article by a really terrific writer that argued that China’s response might be more nefarious than simply engaging in monetary expansion. Ben Hunt’s article Mike Tyson: Master Game Theorist is a must read. I don’t know if he is right, but it certainly got me thinking…