Theresa May has finally shed her European Union shackles. This morning she delivered her “I like you and we can still be friends, but I am just not that into you” letter to the EU Council President Donald Tusk. A teary Tusk responded that “we already miss you,” but has vowed to make the best of the difficult breakup.
Although Tusk responded with grace, it didn’t take long for the ECB to take the gloves off. Minutes after Tusk’s comments, the ECB “leaked” a story that the market misinterpreted their March 9th meeting’s intention. From the Reuters’ article “Spooked by yield rise, ECB wary of changing message again - sources”:
European Central Bank policymakers are wary of making any new change to their policy message in April after small tweaks this month upset investors and raised the spectre of a surge in borrowing costs for the bloc’s indebted periphery.
One ECB source said the bank has been overinterpreted by markets at its March 9 meeting.
Taken aback when markets started to price in an interest rate hike early next year, policymakers are keen to reassure investors that their easy-money policy is far from ending, suggesting reluctance change message before June, six sources in and close to the Governing Council indicated.
While the current level of bond yields remains acceptable, a further increase would be problematic, particularly in places like Italy, Spain and Portugal, where debt payments are a major cost item and rising yields would curb spending and thwart growth.
With the euro zone economy on its best run in almost a decade and conservative policymakers# keen to start winding down stimulus, the ECB gave a small nod to improvement with a tweak of its guidance in early March, axing a reference to being ready to act with all available instruments.
But that message did not come across as hoped.
“We wanted to communicate reduced tail risk but the market took it as a step to the exit,” one of the sources said. “The message was way overinterpreted.”
It’s hard to believe it is a coincidence this story hit the tapes minutes after the official BREXIT announcement. After all, the ECB meeting that the unnamed ECB officials are “so worried has been over interpreted” was twenty days ago.
There was no need to leak the story in minutes following Britain’s withdrawal from the EU. They had almost three weeks to deal with this problem. And not only that, but the problem had already somewhat gone away. Although yields had initially backed up on the ECB meeting announcement, over the past couple of weeks, the decline in European bond prices had been largely made back.
It is therefore only logical to assume the ECB planned this leak to coincide with the BREXIT official announcement on purpose. But why?
One possibility is that the ECB was worried about markets selling off on the BREXIT news. Although I think most Central Bankers are boneheads, even I can’t believe they are this stupid. This announcement was fully expected, and if the ECB thinks they need to cushion the market from this sort of development, then they have much bigger problems than BREXIT. Let’s give them the benefit of the doubt and put this option aside.
ZeroHedge had another theory that made me laugh:
I like his cynicism. And there was certainly a lot of reasons in the Reuters article to point to this possibility:
The sources also argued that the market may not be accurately pricing risks related to the new U.S. administration, like the possibility of trade wars, protectionism, financial deregulation or President Donald Trump’s difficulty in pushing his agenda through Congress.
Although I don’t doubt Trump’s inability to complete his much hyped reforms is weighing on the minds of the ECB collective, this doesn’t explain the timing of the leak of the story.
I contend the ECB was trying to send a message to Britain with the timing of their leak. Last year the Euro/GBP cross rate rose from 0.70 to 0.92. That’s a devaluation of more than 30%.
In this day and age of limited global growth, the EU simply cannot afford to have their currency rise at this rate against its competitors.
Over the past week the Euro has also broken out versus the US dollar. The ECB is worried that by allowing the “ECB is about to tighten” narrative to develop, the world will export all their deflation to Europe. From this morning’s Reuters’ article:
“Inflation has peaked for now and the oil price is down 10 percent so we are far having to worry about too much inflation,” a third source said.
While the sources acknowledged unexpected strength in the underlying economy, they said it was difficult to communicate this through its policy statements, especially with underlying inflation showing few signs of moving up.
“A small change in the wording can easily be blown out of proportion,” one of the sources said. “There is a communication risk and I would argue for stability.”
The ECB does not want the Euro to rise. I think it is that simple.
There are many ways to play this. The pound is cheap and shorting EUR/GBP might be a way to capitalize on the ECB’s reluctance to ease off the accelerator. Given the bad news about BREXIT is probably fully baked in, the pound is probably a long term buy anyway.
Or you could buy European stocks versus selling US equities. The Fed is tightening too much while the ECB is most likely way too easy (and showing no signs of shifting).
Although I like both of those trades, my favourite trade is to sell bunds versus buying US 10 year notes. I know most investors believe an overly easy Central Bank is a reason to buy fixed income, but I view the ECB’s commitment to creating inflation as a great reason to be short bunds.
The spread between the German 10 year bund and corresponding US t-note had moved in our favour during the past few weeks, but today’s announcement by the ECB has pushed the spread down to attractive point to add to the trade. And don’t forget, we get paid to own this trade with the positive carry.
However you choose to play it, be careful about underestimating the ECB’s willingness to inflate regardless of the cost.
Thanks for reading,