It’s tough slugging for the bears these days. The ECB QE driven dash to zero yield is lifting all asset classes across the board. At the fore front of this bull market run is the German bund. Yesterday the 10 year hit a new low yield, with the trend showing no signs of abating.
The entire German curve is slowly slipping more and more below zero.
This yield compression is making it difficult to be a bear on risk assets. It is forcing investors out the risk curve, putting an incessant bid to stocks and other bond alternatives.
The ferociousness of the rally in the long end of the European bond market is perplexing. Contrary to popular belief, longer duration yields in the US rose during the various Fed QE programs.
Yet there has been no signs of a similar reaction in the German bund market. The entire curve has just been steadily dropping lower in yield.
The ECB has so far failed to ignite the inflation expectations that usually accompany a massive expansion of a Central Bank’s balance sheet. Have a look at the most commonly used long term inflation expectation indictor:
The crash lower in the second half of 2014 was the trigger for the ECB’s QE program, and although the ECB has managed to stop the decline, this indicator is still sitting at depressed levels. Yes, it seems to be slowly grinding higher, but slow is the operative word.
The market is unconvinced that the ECB will return inflation back to levels they were expecting just six months ago. Even though they have pledged to expand the balance sheet enough to achieve their goals, the market has become weary of their constant internal bickering.
The market believes that the moment inflation perks up its head, the Germans will insist the balance sheet be reduced, which will instantly bring back the deflationary vicious circle. Therefore the ECB’s balance sheet expansion is not achieving its goals because the Central Bank lacks credibility. As the liquidity is shoved out into the system, instead of the banks lending it out, it is simply sitting on their balance sheet, in the process driving all rates to zero (and below). The Germans’ previous reluctance to engage in QE is actually causing the program to be less effective.
The ECB needs to be credibly irresponsible. That is why Draghi is so insistent that he will not lift up his foot from the accelerator. He needs to convince the market that the balance sheet expansion will be completed and will not be immediately withdrawn.
In the mean time, the ECB keeps shovelling out the liquidity. The market will soon realize that Draghi means business and will not deviate. At that point, the German bund market curve will reverse its flattening trend and steepen. I still hold that eventually the ECB QE program will have a similar effect as the US programs. If it doesn’t, and Draghi is forced to push short rates even more negative, then lord help us.
All the smart guys are bearish
Although I have recently stopped fighting the stock market rise from the short side, I have taken solace that my cautionary stance has some mighty smart company. Every time you turn around, there is another wise old cagey veteran warning about the increasing risks in the financial markets. Druckenmiller, Grantham, Singer, Einhorn or Gundlach; they are all preaching caution. It made me feel like I was on the right side of the trade to have such distinguished company.
But then it hit me. These guys aren’t issuing these dire warnings and then stuffing their book with longs. No, if they are openly worrying about the risks to the system, they are already set up with relatively bearish positions.
I have no doubt that these guys will be right in the long run. I agree with all of their concerns. This will end badly, there is little doubt of that.
Yet, as one of my buddy’s loves to say, “I am never wrong, my timing just sucks sometimes.” What if these “smart guys’” timing sucks? What are the chances they will all be issuing warnings at the top?
I am not advocating getting long because too many “smart” guys are warning about the stupidity of the markets. But I am keeping an open mind to the possibility that this could get even more stupid-er before it is all through.
The retail investor left the stock market during the 2008 credit crisis and never returned. Since then the markets have increasingly become a bunch of hedge funds and other professional investors sitting around in a circle shooting at the target in the middle. It used to be that the hedgies were the smart money that you wanted to tag along with. Now the hedge funds are the dumb money driving “good ideas” to levels that make zero sense.
When the hedgies all agree about something, it is time to look the other way.
US dollar correction?
This preponderance of hedge funds to take trades too far is why I am leaning against the US dollar. I have spoken about this at length, so I will not spend too long reiterating my point, but the hedge funds are all stuffed to the gills with long US dollar positions. It was the trade of 2014 and these guys don’t give up easily.
But have you noticed how many USD cross rate charts are looking quite US dollar negative lately?
First let’s look at the US Dollar index. It seems tired and ready to roll over.
And one of the favourite hedge fund shorts, the Canadian Dollar is actually breaking out to the upside.
The much anticipated Loonie weakness is failing to materialize as all the hedgies have predicted.
Even the usual steady JPY short has not been adding any positive P&L to the sheets lately.
Anyone who has been calling for the US dollar strength to abate has looked foolish over the past year. Yet for the first time in a long while, the US dollar chart is looking heavy. The hedgies are still long US dollars, and if the correction finally does happen, then this could surprise a lot of traders. Be careful if you are trading from the long side with all the other “smart guys.”
Thanks for reading,
the Macro Tourist