Not all Tapers are Created Equal

Much head scratching and teeth gnashing after the Euro staged a significant rally out of thin air yesterday. Sure, it was kicked off by stellar German GDP and confidence data but that was offset by lower Spanish core inflation, but the bid in the Euro lasted persistently throughout the European day. Every single hour saw the price rally, and it’s the same story today since London opened at 7am:

Interesting that it only saw respite in the Asian trading session where it paused in those choppy red and green bars overnight. For those trying to construct this into some kind of greater theme of “risk off across all assets”, that doesn’t chime too well with the Nikkei down 1.5% as EUR/USD treads water. No, this kind of price action suggests an ongoing and persistent flow.

For consideration of the culprit, let’s take a step back from whether it was Professor Sovereign Plum with the Lead Euro Piping in the Library. It doesn’t really matter exactly who or where. The why is what counts, and for this we need to look again at that lovely speech that the ECB’s Coeure gave in July. He proffered some fab charts that proved just how turbocharged the ECB’s QE really was. Just look again at how large the net outflows from the Eurozone became once they announced their asset purchase programme:

This gave them a double whammy: domestic investors went into foreign debt, and foreign investors went into Eurozone equities. The upshot of that is that it led to a significant depreciation in the Euro. As Coeure flagged, these flow effects were huge. Records were being broken all over the place: “At their peak around the middle of 2016, net capital outflows – measured here in terms of 12-month moving sums – reached nearly 5% of euro area GDP. Never before in the history of the euro area have capital flows been so high‘ …. ‘By the end of 2014, shortly before we announced purchases of government bonds, annual inflows into euro area stock markets by non-residents had reached 4% of euro area GDP – the highest on record’.

But now the big QE programme is going into reverse. The greatest Jedi master of all managed to sell it so well that on the day he announced the ECB would be making fewer asset purchases each month, the currency and interest rates both fell. Mario Draghi can indeed give himself a congratulatory pat on the back – and may well be doing so right now at the ECB Communications Conference. He can even sit back with a smile and say, if the currency is rallying now, at least it started from closer to 1.1500 than 1.2000. In fact as of right now, we have got back to where we were in the Euro before that fateful October ECB meeting. Go on son! Another round of high fives for the M-Dawg!

One of the curious aspects of the ECB’s communications is how they have managed to wrongfoot stabilise the markets in this way ahead of their big announcements. They announced QE in January 2015, the Euro fell a bit, but only really started depreciating once they were actually in the market in March of that year. It follows that we are now starting to see the portfolio effects of their taper, even though they announced it on October 26th.

Futhermore, the level of yields matters. Blondemoney flagged in July how the negative yield euphoria couldn’t carry on forever:

But as that 2 year yield edged towards -1%, maybe something clicked. Maybe the ECB accidentally revealed the Emperor’s New Clothes when they announced in December that they would allow QE buying to take place at prices through the deposit floor level of -0.40%. This was really a technical change that meant they could continue to buy German bonds…It set off a rational drive down in the German bond yields, because extra demand came into the market. But maybe around -1% all the demand ran out. Fast forward a few months and now the ECB are openly rumoured to be discussing a taper of their programme, even as they’re not explicitly discussing it at meetings. If the mere discussion of a discussion can arrest the bond rally, then what happens when they actually discuss it and then actually do it?

The ECB’s Coeure is evidently a reader as in his speech he concluded:

‘In addition to yield differentials, the absolute yield level may also matter for investors, particularly if rates are negative. It may be no coincidence that net bond outflows were among the largest when ten-year German Bund yields hit a low of nearly -20 basis points last summer. In a recent survey among foreign central banks, 70% of the respondents reported that negative interest rates in the euro area had encouraged them to adjust their allocations to the euro.’

So wouldn’t it follow that a reversal of policy from the central bank might also encourage an adjustment to their Euro allocations?

This is significant, and not just for FX geeks. If rebalances are taking place, this means investors are now factoring in the long-awaited reversal in the decade-long monetary expansion experiment. It has been feared for so long, but without anything bad happening, that we would be forgiven for missing it. The taper tantrum was four years ago. The fear was over the Fed hiking rates. But it turns out the ECB were just passed the baton. Global central bank balance sheets have gone on increasing.

But no more. Why else did Coeure make that speech in the summer? The second half of it explains what a great favour they did to the world with their turbocharged global QE. He was preparing us for when the methadone would be withdrawn, telling us what a lovely time we had on it, but if we go painfully cold turkey now then it’s not their fault, right?

So keep an eye on the rally in the Euro. It’s not “risk-off”, it’s “liquidity-taps off“. Hence high yield and equities starting to get hit at the same time. Bonds will not be immune. If we are about to undergo The Great Repricing then curves cannot stay this flat. And that’s before we add in a political risk premium to US Treasuries…

The market is still in its slumber. Even after the 150 pt move in EUR/USD yesterday, the option market is only pricing a breakeven of 55 pts over tonight – even in a period including the US CPI release.

There have been many false dawns in calling for a return to volatility over the past few months. But now the stage really is set, with bears having all but given up, and risks increasing. The monetary taps are being turned off; political risks are rising (Zimbabwe joining the action today with a potential coup). Just as we enter the most illiquid time of the year (Thanksgiving next week). This is likely not yet The Big One, but it should be a significant tremor.

 

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