Draghi and his merry crew at the ECB met today, and to no one’s surprise, policy was left unchanged. Although Super Mario seemed to have an off day (he fumbled with his words at the press conference and did not live up to his “mythical” reputation), Draghi still managed to deftly steer the market in the right direction.
The Euro rose slightly, Eurostoxx rallied and bunds sold off. On the whole, in terms of Central Bank meeting reactions, this was an awfully good outcome.
Draghi accomplished this by expressing some optimism about the direction of the European economy.
*DRAGHI SAYS BALANCE OF RISKS TO GROWTH HAS IMPROVED
*DRAGHI: ECB REMOVED REFERENCE TO SIGNAL SENSE OF URGENCY GONE
Yet even though Draghi admitted European economic conditions were quickly improving, Draghi was not ready to declare victory. From the FT:
The ECB president cautioned that while “the risks of deflation have largely disappeared”, he was not yet ready to “pronounce victory on the inflation front”. For that to happen, Mr Draghi said, pay for the region’s workers would need to grow at a faster pace.
“Wages growth is the linchpin of a self-sustaining rise in inflation . . . that is the key variable,” he said, later adding: “It’s not the only point, but it’s an important element of our assessment.”
When Draghi spoke these words I couldn’t help but cough out a muffled “bullshit.” Let’s face it, inflation is quickly approaching the ECB’s target, and Draghi is looking for excuses to hold off tapering his extraordinary stimulus.
I stumbled upon this terrific chart from Jeroen Blokland that clearly shows the absurdity of the ECB’s inflation forecasts.
Somehow inflation will stop just underneath their target and spend the next three years there. Yeah, right…
Draghi is scared shitless to pull back on the stimulus for fear of stalling the recovery. Over the past few years, he watched the Federal Reserve repeatedly guide towards tighter policy, only to rescind it once the economy faltered from the tighter monetary conditions.
Super Mario seems determined to not make the same mistake. His policy is more akin to Paul McCauley’s mantra that to escape a deflationary vicious cycle a Central Banker needs to be “responsibly irresponsible.”
Not only that, although he is loathe to admit it, the French election also looms heavy. The last thing Draghi needs is to set the ECB on a tapering glide path only to have to reverse it if Le Pen wins and causes a market disruption.
So we have a situation where fear from previous tapering episodes, and the upcoming French election, are stopping the ECB from withdrawing stimulus as would typically be called for at this point.
Given the fact that the ECB is in essence “too easy”, what should be the expected result? While many market observers would say that since the ECB will be buying more bonds, we should therefore expect them to rise, I contend the opposite.
The ECB is applying too much stimulus, risking higher future inflation. Inflation is a long term fixed income investor’s worst nightmare (apart from default). A Central Bank that is too easy should cause the yield curve to steepen and actually cause long term bonds to fall in price.
And that’s exactly what happened today.
The German bund 2/10 year yield spread blew out to new highs for the move.
And the 5/30 spread pushed out to tickle the previous highs.
It’s interesting that the German curve is steepening at the same time the US yield curve is flattening on the Fed’s hawkish guidance.
So let me get this straight. Draghi is expanding the ECB’s balance sheet at a record pace, in the process cheapening the Euro and steepening the yield curve. While at the same time, the Federal Reserve is attempting to normalize policy, sending the US dollar higher and flattening the yield curve.
Yet everyone is all bulled up on US equities and thinks Europe will be dead money? Mario Draghi is making a policy error by continuing with all this stimulus at this point in the cycle, but that only means the opportunity for us will be all the greater. He will cause the yield curve to get even steeper and European equities to rally even more.
This is non-consensus call. I know all the arguments of the animal spirits Trump is unleashing with his deregulation and tax cuts. The trouble is - so does everyone else. A lot of the good news is already priced into the US market.
But the European equity market is hated with a vengeance brought on by decades of underperformance.
During the period from 2009-2015, most money managers also hated US equities. Yet as Bernanke kept feeding more and more QE into the system, US equities defied all skeptics and rose on “nothing but Central Bank money printing.” Europe is simply a few years behind.
Don’t over think it. European equities will climb that very same wall of worry (especially when Mario keeps making policy errors on the side of too much stimulus).
Thanks for reading,
PS: I hope to write tomorrow, but it is unemployment day, and you never know if trading might become too busy. In case I don’t write, I wanted to let you know that I will be leaving this weekend for two weeks of spring break with the family. I won’t be back until March 27th. Thanks!