Summer is drawing to a close, and the scent of blossoming flowers and sweet seaside air is being replaced by slightly less sweet City aromas and a desire to own cardigans. To be blunt, porridge is back on the agenda. This back-to-school feeling usually means taking a fresh look at the market and hunkering down into Q4. Unfortunately, determining the driver for the months ahead is complicated. We started look at the ongoing tussle between three candidates before the summer began, and we are still no closer to one emerging as the victor. Is it carry? the economy? or politics?
The free money game is up! The ECB were supposed to be lining up their taper by now, courtesy of a dramatic flourish from interloper Mario Draghi at the annual Jackson Hole central bank symposium. Oh, but what’s this we see from Reuters yesterday? “ECB sources” are having a little chat are they?
‘Rapid gains by the euro against the dollar are worrying a growing number of policymakers at the ECB, raising the chance its asset purchases will be phased out only slowly, three sources familiar with discussions told Reuters…. “The exchange rate has become a bigger issue,” one of the sources told Reuters. “It is now less favorable for an exit and a stronger argument for a muddle-through option.”’
This, hot on the heels of the ECB’s official July Minutes:
“The appreciation of the euro to date could be seen in part as reflecting changes in relative fundamentals in the euro area vis-a-vis the rest of the world” but “concerns were expressed about the risk of the exchange rate overshooting in the future”
It turns out that they’re not in quite such a rush to take back their easing after all, what with the almost 10% rally in the Euro against the USD since June. And, we might add, what with the German election becoming a snooze fest. The start of the year had seen some explosive headlines in the German press about how the ECB needed to remove stimulus ASAP, partly given the pain inflicted by negative interest rates onto savers, but also partly because inflation had returned with a vengeance to 2%. Until the most recent print, however, inflation had ebbed away, removing an argument for the ECB’s hawkish critics to use against it:
2. The Economy
So the ECB no longer need to be in a rush to cut back on their extraordinary stimulus. [Aside from that whole “running out of bonds to buy” / “distorting the usual norms of finance” type stuff, of course.] The general trend lower in inflation is happening globally, and is keeping the Fed from getting too carried away themselves with their exciting shiny new rate-hiking cycle. Janet Yellen herself may only have 4 FOMC meetings left (of which only two are accompanied by a press conference and the summary of economic projections) – meaning just two chances to decide where she would like the top of this ‘cycle’ to be. It’s as if the whole Fed is hoping just to see out those meetings without too much drama. After all, her replacement could be someone entirely unexpected, what with the rate that DJT is churning through his appointees (#IvankaForFedChair). While they wait, equities rally, spreads tighten, and financial conditions become easier. While the ECB wait, the Euro rallies as domestic Euro-area investors stop their mad dash out of European bonds into higher-yielding assets. No need for that if the ECB are about to start tightening, and when foreign bonds no longer offer such a juicy extra pick-up in yield. The summer speech from the ECB’s Coeure had some great charts on this flow dynamic:
This is now starting to reverse. Money doesn’t sleep, as Gordon Gekko v2.0 warned us, and while the central banks believe economic conditions can leave them on the sidelines, the players are still on the pitch running around.
Those self-same central bankers deliberately mandated the death of volatility, didn’t they? By making the risk-free rate negative, they darn well told us to go out there and buy-buy-buy anything risky. So, as those players on the pitch buy Euros and sell USDs, they’re also happily snaffling up any spike in volatility. Selling volatility has become the winning strategy. So much so, that the NYT profiled a guy they describe as a former manager in a Target Store, for ditching the day job to trade the VIX, and make 12 million dollars in the process. In the two weeks after that article came out, the two ETFs that make money from going short the VIX both took in $1.2bn of assets:
This was reported just after North Korea sent a missile over Japan. The juxtaposition of these events caused much head scratching (or hilarity from the more unkind section of finance followers). Guys, we could be facing nuclear war here, and you’re sitting at home clicking “add to basket” for a leveraged sell-vol ETF? Hey and just ahead of the ECB taking back its stimulus programme? And hey what about this whole Brexit negotiations already potentially collapsing on round 3 of the talks? Liam Fox, Trade Minister, this morning is warning the EU not to blackmail the UK over the divorce bill. He hasn’t had his porridge.
So we’ve got less divergent monetary policy, meaning less carry to be earnt…
We’ve got somnolent economies, growing but without much inflation…
Investors selling volatility and picking up yield where they can…
And politics sending us onto the edge of nuclear war / US impotence / UK breakdown.
Which one do we think will win in the end folks?