Last Thursday was significant to the markets. So much so, it will come to be viewed as an inflection point in our post Financial Crisis world.
I watched the Euro weaken in the hours leading up to Draghi’s announcement. I watched Draghi announce to the world that the ECB is going to throw everything that is not nailed down at the Eurozone’s slowing economy.
Then I watched the Euro start to find a floor and begin to move its way higher. By the end of the day, despite the ECB’s best effort to burn the Euro like a Salem witch, the market had spoken loudly. All the while, I could only run an old Doors tune through my head, “This is the end. My only friend, the end.”
Now before you picture me sitting in my office, wearing aluminum foil on my head and writing articles about the need for bunkers, canned food and ammunition, let me make one thing clear. I’m not calling for the end of the financial system nor am I calling for a market crash that will make us wish we could transport ourselves back to the Great Depression.
What I am saying is that no matter how you contextualize the market’s reaction to last Thursday’s ECB announcement, something died last Thursday. The ability of central bankers to manipulate “free” capital markets without consequence has ended. Central banks around the world saw what happens when free markets flow where they want despite a central banker’s best effort at forcing markets in a particular direction.
“Of our elaborate plans, the end.”
I’m not sure who coined the phrase “everything but the kitchen sink,” but it aptly describes the ECB’s new elaborate plan. The only difference is they included the sink.
The ECB announced several major enhancements to their current policy. The ECB cut the deposit rate further into negative territory (now at -40bps) and it made a cut to the refinance rate (now 0%) and the marginal lending rate (now at 25bps).
Despite already purchasing almost $800B Euros of assets since October 2014, it will step up monthly purchases to $80B Euros a month beginning in April. The ECB also announced a new series of longer-term refinancing operations, which have interest rates that mirror the -40bps deposit rate.
The math on this last policy enhancement means that the ECB is actually going to pay banks to borrow money! You might want to re-read that last sentence.
Lastly, the ECB announced that it will now include investment grade Euro-denominated corporate bonds in its monthly asset purchases. The addition of IG bonds into the growing list of securities is important because it shows that the ECB is willing to go out further on the risk curve.
80% of the ECBs purchases so far have been government bonds. The fact that they are willing to buy unsecured assets can’t be overstated. The only stop left is to go full Bank of Japan and start buying Eurozone equities and exchange traded funds (ETFs).
The ECB’s elaborate plan is massive and unorthodox, and whether it will work remains to be seen. One question to answer is: why did they go full bazooka with these action steps? I firmly believe that there only 2 long-term drivers of asset prices: the trajectory of growth and inflation.
Those two data series, either for an individual economy or for the globe, are the signal. Everything else is just noise.
Which two metrics are the ECB targeting with their elaborate plan? Draghi believes that this latest iteration of easing policy will “accelerate the return of inflation to price stability” and that the “stimulus will reinforce the momentum of the recovery.” The ECB is trying to improve the trajectory of growth and inflation upward.
The keyword being “trying.”
The ECB has been “trying” since the Crisis and now, 7 years in, they feel the need to unveil this massive enhancement to their current stimulus plan. It feels like they are throwing good money after bad. But the real question is how to we play this development?
“Of everything that stands, the end.”
The standard playbook for an economy whose central bank is actively easing is to short the currency, all things being equal. And the playbook for the Euro has been no different. As I mentioned earlier, since October 2014, the ECB has purchased almost $800B Euros worth of assets.
Over that time, the Euro has fallen 15% and at its lowest point, the Euro was almost in crash mode falling just over 18%. Everything works until it doesn’t.
In the Euro’s trade commentary a week ago, I shared that the Euro was priced for perfection and that the ECB would not be able to do enough to satiate the markets.
Even I was surprised by both how much the ECB is going to do and how violently the Euro reversed course. The Euro had an intraday range north of 350 basis points following the announcement. That is a monster range for a currency.
Do you think that’s the “price stability” Draghi had in mind?
Bottom line: The future path of the Euro is no longer a foregone conclusion.
The only clear Eurozone winners are the banks. They’ve been beaten up for the better part of the last year. I’m not sure that the ECB’s plan will be enough to negate the downtrend that began in early 2015, but It will certainly be enough to push most banks up to critical lines of resistance.
I’ve never traded this security, but one ETF that has decent daily volume and a reasonable amount of assets is the iShares MSCI Europe Financials, EUFN. ECB policy could easily push this ETF up another 6% from Friday’s close, to around the $19.90 area. If it closes above that level for 3 consecutive days, the next area of congestion is $21.50, or another 8%. If you do initiate a trade, your risk price should be just below $18. Close all trades if EUFN closes below that level.
“The snake is long, seven miles, ride the snake…he’s old and his skin is cold.”
While I’ve been intently focused on the implications of the ECB’s plan, I felt obliged to spend a brief moment on the US. This week the Fed will meet, update its forecasts and Yellen will have a presser.
At the end of last year, the Fed suggested that March might be a good time for a second rate hike. The probability of a March Fed rate hike has bounced all around this year. As it stands now the March Fed Futures contract is pricing in 0% change of hike this week.
For the 3 primary US asset classes we don’t need to know the Fed’s decision to know how to trade. Despite USD’s recent weakness, how does a rate hike decision impact the greenback? It doesn’t.
The Fed hikes that’s USD bullish, all things being equal. If the Fed doesn’t hike, it's still holding pat, while the rest of the major central banks are just ramping up. That’s USD bullish. Either outcome points the way to further USD gains.
As for Treasuries, we’ve already seen that the long-dated bonds can be massively bid despite a rate hike. Global growth slowing is driving that train, and a Fed hike decision doesn’t change the current trajectory of global growth.
I’m not calling Jim Morrison a prophet, but we are 7 years into the post Financial Crisis recovery this month. Doesn’t this US stock market rally feel a bit “old” and “cold?” Whether the Fed hikes or not, there is not a legitimate catalyst to sustainably push the S&P past its previous all-time highs.
US equities are the snake and while you can certainly choose to ride the snake to the ancient lake, I wouldn’t. Why not trade markets that are more immune to the antics of central bankers? Certainly a Fed rate hike has implications but for simplicity sake the high probability trades are to remain long the US Dollar and US Treasuries.
Last Thursday’s events are only the beginning. There will be more attempts by central banks to manipulate what used to be free markets. And more and more of those attempts will be met with the markets and capital flowing where it wants, even if it flies in the face of central banks. “It hurts to set you free but you’ll never follow me. The end of laughter and soft lies.”