John Lennon once said he believes in everything until it’s disproved. Rumour has it Lennon was a big seller into yesterday’s crazy Euro rally. I also heard rumblings John was writing some pretty big blue tickets into the EuroStoxx futures close. For Lennon, the market’s conclusion Draghi’s aggressive ease would not work was premature. The failure of quantitative easing has yet to be disproved.
Although Lennon was smart enough to fade yesterday’s manic moves, in the heat of the moment, most investors were panicking about Draghi’s abysmal failure to weaken the Euro and rally risk assets. The “buy the rumour sell the fact” reaction was epic.
Have a look at the trading in the Euro currency:
An initial move lower was quickly met with ferocious buying. The drop of almost 200 pips was quickly replaced with a 400 pip rally. This was some crazy volatility.
The same pattern occurred in the Eurostoxx equity futures market:
Market pundits were quick to proclaim Draghi’s plan an utter failure. Smart guys like Mohamed El-Erian were sounding the alarm bell (from his Bloomberg opinion piece):
Here are the three big surprises on yet another notable day for central banks and markets, and what they may imply for the future:
- The European Central Bank went beyond expectations by deploying a full range of policy instruments, including a more negative deposit rate and increased asset purchases.
- After the initial favorable response to the larger-than-expected policy stimulus, asset prices started to sell off, with notable moves in oil and stocks.
- To make things even more uncomfortable for the ECB, the depreciation of the euro that immediately followed its announcement isn’t holding. In a counter-intuitive move, the currency has now strengthened after the central bank’s steps.
All this speaks to the consequential issue I discussed in Tuesday’s article: That the ECB risks moving closer to the point where unconventional policies are less effective and possibly counterproductive. After all, neither the appreciation of the euro nor the selloff in stocks will help efforts to counter deflation and improve economic conditions.
Although I am sympathetic to the view Central Bankers are having more difficulty achieving their economic goals through monetary policy, I am hesitant to immediately proclaim Draghi’s program a failure because the market snapped back from the initial reaction.
Yesterday’s action was actually behaving perfectly in line with expectations until Draghi made one huge error during the question and answer period of the press conference. He made the disastrous decision to state:
DRAGHI DOESN’T ANTICIPATE MORE RATE CUTS BASED ON CURRENT VIEW
As Zerohedge so eloquently put it, “you never close an open-ended monetary stimulus package…” It was at this exact moment markets reversed hard. The move was violent, swift and relentless.
PIMCO’s Paul McCulley has stressed over the years, Central Bankers need to be “responsibly irresponsible.” The comment by Draghi gave the impression this was the ECB’s final move.
I understand why Draghi made the comment. He is desperately trying to shift the ball back onto the fiscal side of the field. In essence, he is trying to bluff the politicians. But in doing so, he made his own policy less effective.
But do you really believe the ECB will not do even more QE or take rates even more negative if deflation continues? We have learned time and time again Central Bankers will do whatever it takes to reflate this enormous debt bubble they have created.
Crazy bold move
Overnight as markets have digested the details of Draghi’s program, they have correctly deduced it is a crazy bold move. The Euro has sold back off, and European risk assets have rocketed higher.
Most importantly, the stress on the European financial system is alleviating. Only a month ago hedge funds were piling in shorting Deutsche Bank and the other European banks on worries the “CoCo” bonds would create a self fulfilling negative feedback loop. For a little while there was lots of talk about the possibility of DB or some of the other European banks failing. But have a look at the trading in these infamous bonds:
Draghi has managed to stop the bleeding, and that is hugely important.
Was the package leaked?
Risk assets have been rallying hard for three weeks. During this time there was no real news to account for the rise. I had toyed with idea it was maybe the result of increased Chinese monetary accomodation, but I am now wondering if Draghi’s plan was leaked to the plugged in crowd.
The ECB’s easing package is a complicated affair with many different parts. Yesterday the ECB actually had a second press conference to go through the details of all the new programs. This was not some simple decision to just turn on the taps a little more. The ECB must have spent weeks organizing all the specifics. Therefore it would not surprise me one bit if some large market players knew (or at least got a wink) about the program. This would also help explain the “buy the rumour sell the news” reaction.
Don’t over think it
Upon reflection, I have come to conclusion to not over think Draghi’s move. It is large. Stupid large. Will it work? I don’t know. But I know the risks being short stocks have risen astronomically.
During the Federal Reserve’s quantitative easing era (2008-2014) there were plenty of skeptics convinced it would never work. Although you might argue the Fed only made the ultimate adjustment worse, there can be no denying the Fed was successful in rising the price of risk assets. The same thing will happen in Europe. There will be lots of pessimism, but at the end of the day, the money printing will work. If a Central Bank is determined, they can move almost any asset over the short term.
It’s not imminent
Although I am confident Draghi’s crazed buying will affect the price of many assets, I am not sure they will all be positive. My main mistake during the 2012-14 period was my inability to forecast the Federal Reserve’s ability to solely lift the price of benign financial assets with their balance sheet expansion. I just didn’t believe the printing could be contained to things the Fed wanted to go up in price. I thought if they were successful it would eventually leak into other aspects of the economy that would ultimately cause havoc. But I was wrong. The Fed printed and magically, only financial assets went up.
However those days are gone. Central Banks are having more and more problems directing the price of assets. And this where my belief reconverges with Mohamed El-Erian’s:
This raises some unpleasant realities that have yet to be internalized sufficiently. For investors and traders hooked on liquidity, global central banks are becoming less reliable at suppressing financial volatility and boosting asset prices.
What’s more, if politicians in Europe and the U.S. continue to falter on fiscal reforms, fail to increase infrastructure spending and decline to strengthen labor markets, central banks could find themselves going from being part of the solution to being part of the problem.
Eventually Central Banks will lose control. As they become more desperate, they will take more extreme measures (as evidenced by Draghi’s announcement and Kuroda’s recent move to negative rates). At that point things will come unglued and volatility in currency and fixed income will explode higher. Make no mistake, there is a huge disaster in the making. It just isn’t imminent because the markets didn’t immediately react positively to Draghi’s move.
I stole this idea from one of my favourite guys Martin Enlund from Nordea Bank. Martin highlighted yesterday’s rise in the Euro was not met with a corresponding move in the German/US 10 year yield spread:
Most traders will look at this chart and immediately want to short the Euro. Although I am sympathetic to that argument, part of me wonders if the better trade is to short German bunds and buy US notes.
I know that seems crazy, after all the ECB is buying bunds and the Federal Reserve is in tightening mode. But stop and think about both policies.
What is a bond investor’s worst nightmare (except for default)? Inflation. What is the ECB trying to do? Create inflation. What is the Federal Reserve trying to do? Stop inflation. Why would you want to own the bund at its minuscule yield when the ECB is actively trying to devalue your asset? Why not buy the positive yielding US fixed income with a Central Bank that is (mistakenly) worried about inflation. In the mean time you can pick up almost 165 basis points of carry.
I know this is a hard concept for many investors to accept, but Quantitative Easing is NOT bond friendly.
Thanks for reading and have a great weekend,
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