Market Insights

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.

 

Elections a-go-go

At the start of the year, the European elections were the big event risk ahead. Fast forward nine months and this weekend’s German election is met with barely a shrug, thanks to the victory of an oedipal ingenue into the Elysee Palace. The threat of Marine Le Pen has receded so much that one of her closest aides has just quit the National Front, and with it, one of the key architects of their Frexit policy. The Eurosceptic knaves have been vanquished. Even a country that has voted to leave, will today see its Prime Minister lay out a policy for its exit that means it won’t exit for 2 years after it’s technically exited. Geddit?

Blondemoney forgives you for EU-fatigue. At some stage, the Brexit shambles negotiations will produce an almighty bout of excitement, but for now it’s just so earth-shatteringly nuanced as to be eminently forgettable. Hand us an instant-result FOMC meeting any day.

At least politics this weekend should provide a binary outcome.

First up it’s the German election. Although no-one really much seems to care about that, with Merkel consistently riding high in the polls, rarely troubled by the opposition’s Martin Schulz. The bookies have her party emerging as the largest at an eye-wateringly certain 1/100. Even as the largest party she likely has to enter a coalition, however, with the following potential scenarios that could emerge:

Given the market is totes not both’d, we might not get much of a reaction to any of those scenarios, but things to watch out for would be:

  • FDP joining a coalition – as they are the most “anti-Euro” of the larger parties
  • AfD gaining any kind of representation – or indeed, if they don’t, despite polling almost twice what they were in the last election, thus suggesting the anti-establishment vote is dying off

Next up it’s the New Zealand election. This had looked to be hanging in the balance with polls showing the charismatic new young (female) leader of the Labour Party driving them into the lead in the polls ahead of the incumbent National party. “Jacindamania” is now ebbing away, however, with the most recent polls giving National a clear lead of 7-10 pts. Again the market doesn’t seem too worried, probably because the New Zealand Dollar is most often used as just a proxy “risk on / yield hunting” currency. But there are potential pitfalls ahead. The Labour Party want to change how the RBNZ works, and introduce a Fed-style dual mandate; while coalition partners could include the anti-immigration party the NZF. Admittedly, the NZF have already been in government, and a new mandate for the RBNZ might not change much in practice.

Either way, we will have a sense of the result by 8am BST Saturday morning when the exit polls come out…
And for Germany, by 6pm BST Sunday evening.

(Although for both, coalition forming could mean the final government isn’t in place for a few weeks yet).

You might wonder why everyone is so relaxed, given how unreliable polls have become recently. Blondemoney would argue that polling accuracy is proportional to the proportionality of the voting system. In other words, if it’s a proportional representation system, then it’s easier for the polls to capture. The more it’s “first past the post”, or an electoral college, then it’s much harder to predict.

Both the German and NZ elections use a fairly proportional system – a mixture of PR and FPTP. For the election geeks amongst you, both countries actually use the relatively unusual ‘Webster/Sainte-Lague‘ method for determining seats from vote share. (And if that’s not your weekend reading sorted, I don’t know what is). So the polls should be decent at predicting the result. (Famous last words??)

Either way, from this point on, Merkel in charge of Germany means she can get on with taking the EU forward. That may be marginally Euro positive. For New Zealand, its currency can get on with being the favourite of those who like to trade EM without being able to invest in EM!

 

 

Will the Fed end the Truman Show?

We have talked before about how the market is sailing with unsurpassed ease towards the inevitable brick wall at the end of the Truman Show. At some stage, we will wake up from the low volatility, lowflation, low rates environment. The tricky part, as ever, is picking the tipping point. So let’s just consider these charts:

1. The last real bout of volatility came at the start of last year, when China was blamed for market turmoil that ended up with a rout about CoCos. Since then, global equities have had a very lovely time thanks, up 40% in almost a straight line (h/t @HayekandKeynes):

2. And as we know volatility has concomitantly collapsed. Here’s another take on that with a look at the 1 month volatility on the Russell 2000, which is in single digits for the first time (h/t @DriehausCapital):

And just a reminder of how mad this is, historically speaking, with @charliebilello flagging up that the last 5 days have been ‘the most peaceful in the history’ of the S&P:

I flagged up before to keep an eye on the AUD, and if it can stay above 0.8000 then that’s a good indicator of euphoria continuing to trend. It’s managing it, but Blondemoney is now concerned about that perennial canary in the coalmine, the South African Rand. That’s fallen almost 5% against the US Dollar in the past two weeks. Now, some of that really is because of issues specific to South Africa (with President Zuma still under a corruption cloud). But we know that when there’s a mad dash for yield, those pesky political issues are pushed aside. The euphoria cannot be all pervasive if the Rand is weakening.

So, it’s over to the Fed. Tonight they have the platform to provide quite a signal of their intentions. It’s Janet’s penultimate FOMC meeting to include a press conference. If her term isn’t renewed, that means it’s her second-to-last chance to make her legacy stick. She was handed the poisoned chalice of removing policy accommodation into a weak and uncertain economy, and she will want to make sure she is considered to have gotten the job done. Equally, she wouldn’t want to leave a trail that could implicate her in whatever the next crisis may be. So, she needs to stick to her guns. They’ve hiked, but not in such a way as to destabilise the markets. Have they done enough to prevent another financial bubble emerging? Or have they done too much, and squeezed out inflation before it got any momentum?

That’s the line she has to walk tonight. USD/JPY overnight straddles are priced around 95 pips, suggesting a big figure move could be on the cards. But with most markets comfortable with no volatility at all, yet a divergence occurring between the high yielders, there is the possibility for a much bigger move. Look out for a higher USD from here.

 

Politics v Economics

The battle between these two ancient disciplines is hotting up. Well, I say ancient, it’s hardly Latin v Greek, but in terms of what is driving the market there’s certainly a face off emerging between old-school central-bank economics and fresh-eyed-newcomer politics. Viz.:

Central banks are taking away the punchbowl

…it’s just they’re trying to do it very very quietly, so as not to disrupt the party too much.

  • The ECB have already tied themselves into explicatory knots as they battle a stronger currency, telling us that it’s OK as long as its caused by ‘exogenous’ factors, because then its impact of bearing down on inflation can kinda be ignored.
  • Then last night we have the Deputy Governor of the Bank of Canada telling us that “each decision is a live decision” but also that “as the Canadian dollar is strengthening, we’re certainly watching that closely and we’ll be taking that into account pretty strongly in making our decisions“.
  • And the RBA Minutes revealed again that while they’re happy with good jobs growth, and aware that super-low rates may contribute to excessive household debt, a strong AUD ‘was weighing on domestic growth and contributing to subdued inflationary pressure. A further appreciation of the Australian dollar would be expected to result in a slower pick-up in growth and inflation’.
  • Meanwhile Mark Carney lived up to his politician reputation with his speech last night, where he attempted to refine last week’s hawkish comments from his BOE. He appears to have taken a leaf out of the ECB’s songbook, by attempting to re-frame the argument using economic terminology. Rather than ‘exogenous’, he gropes instead for the trendy concept of “r*”, or ‘the natural rate of interest’ arguing that ‘The case for a modest monetary tightening is reinforced by the possibility that global r* may be rising, meaning that monetary policy has to move in order to stand still‘. This is classic Carney, using the language of the doves to turn hawkish… hey, we’ve got to raise rates otherwise they won’t stay low, yeah? All else being equal?

Thanks guys. Deliberate obfuscation is never helpful, even though you think you’re doing it so as not to frighten the market’s horses into another taper tantrum. Falling over yourselves not to worry people just means there’s not enough clear information for those people to make decisions. Hence both GBP and CAD sold off after those comments, only to rebound hours later. The long-term upshot is understood though: interest rates are turning.

  • The Fed could put the kibosh on this in their meeting tomorrow, of course. Just how worried are they about inflation? Did last week’s stronger than expected reading give them an opportunity to exhale? Or are they just marking time while Trump appoints their new leader (and around half of the rest of the Governing Board)?

Politicians are preparing for a punch-up

….or at least they are doing so more openly.

  • The power vacuum since Theresa May’s shock election miscalculation is now blowing up into open warfare. The only surprise is why it took so long. She is Leader of the country in name alone, fatally wounded but propped up by a team of warring puppet-masters who are merely biding their time before plunging their knives into one another to emerge as her successor. This Caesarian tragedy has only just begun. Ken Clarke popped up this morning as the wise narrator, with a telling off for Boris Johnson’s weekend article on his vision for Brexit: ‘Sounding off personally in this way is totally unhelpful and he shouldn’t exploit the fact she hasn’t got a majority in Parliament. He knows perfectly well that normally the foreign secretary would be sacked for doing that’. And while the Tory Party squabbles, the clock ticks down. The next round of Brexit negotiations with the EU has been pushed back, due to ‘Britain’s political calendar’, or rather, we are heading into the Conservative Party Conference, they’re all back from the summer recess, and now they’ve got to decide on a common direction. This, 6 months after Article 50 was triggered, and 3 round of ‘negotiations’ have already taken place. Forgive Blondemoney’s scepticism that this isn’t going anything other than badly.
  • –> The upshot is that, despite the about-turn from the BOE, the politics of Brexit and its potential impact on the currency is about to get ugly. Could it be a sign of a top in GBP/USD that HSBC have just thrown in the towel on their forecast of it heading to 1.2000?
  • On the other side of the globe, Japan’s Prime Minister is looking to shake things up by potentially calling a snap election. This news has been greeted with a fresh round of Yen selling, with an expectation of a renewed focus on Abenomics, which was basically a policy of depreciating their currency, but making it look nice by describing the use of Arrows. Or something. It would indeed be a good opportunity for Abe to call the election now, with the opposition on their knees, and before a new party can be formed by Tokyo Governor Koike after his recent shock win in Tokyo. And the North Korea missile launches have seen approval for the PM rebound. Oh that pacifist constitution could be ripped up very soon indeed.
  • –> It’s all very well that the market thinks “more Abe” means “more Abenomics” means “more selling of the Yen”. But what if his priorities have changed? What if there’s a reassessment of what Abenomics actually achieved? What if Kuroda doesn’t get reappointed as BOJ Governor when his term ends next April?
  • And then in the US, just as Trump had to turn to the Democrats to get the debt ceiling raised, he also says his “ears are open” to find the “right conditions” to stay in the Paris Climate Agreement. The Republicans fire back with a leak that they’re open to putting together a $1.5trillion tax cut which may not have to be exactly revenue neutral. In other words, all sides are becoming clear on the new reality. Consensus has to be brokered for each grouping to gain power – including DJT himself.
  • –> Does this break the deadlock in the US and mean that reflationary policies are back on the agenda? Or is the realisation dawning on DJT only very slowly?

In conclusion…

The market has followed central bank meetings religiously for the past 10 years – after all, they’re the guys who brought the post-financial crisis madness to an end. They spoon fed us a calmer outlook. They mandated us to take risk, and compress volatility in the process. So it’s no surprise that all the focus is on them. Their unclear language can be frustrating, but at least we understand that they’re trying to turn the low rates supertanker around, even as they try to prevent an excessively speedy appreciation in their currency. Usual stuff then.

But the politics? No, that’s messy. One minute Trump can’t get anything done, the next he gets the debt ceiling raised. One minute the UK are progressing nicely through Brexit negotiations, the next their government is self-immolating. One minute Japan can’t reflate for love nor QQE money, the next its leader calls a snap election to reinvigorate his economic programme.

This back and forth is common in the political world, but entirely unclear to the financial world. In the battle of economics v politics, it’s 1-1 going into half time. Fresh oranges please!

Mr. Big is Back

Yes that’s right, the unreliable boyfriend is back. Just when you thought you’d got rid of him, there he is, waiting for you outside your flat with an overzealous bouquet of flowers, cigarettes and a bottle of vino. The first few times your heart leaps even though you know it shouldn’t; but by this stage you just sigh and wonder why he bothered. Did he really think the leather jacket and naughty smile would cut the mustard??

And so, before the metaphor entirely tires itself out, we turn once again to Mark Carney’s pronouncements on interest rates. There he is on Sky News warning the British Public that the possibility of a rise in rates has ‘increased’.  *wink*

I know, I know, we have heard this many times before. Most laughably in the summer, when one minute it was “now is not yet the time to begin that adjustment” of raising rates, then the next minute – or to be precise, 8 days later – it was “Some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional“.

Sterling enjoyed a delightfully painful flip-flop as a result of those comments, but Blondemoney dealt the unreliable boyfriend a fair hand back then. He merely saw the way the wind was blowing for the MPC and was giving himself the flexibility to ensure he wasn’t in the minority when the eventual rate hike decision is taken.

The wind has been blowing even further in that direction since the August inflation report, as the MPC noted themselves in the Minutes yesterday:

‘the relatively limited news on demand had pointed, if anything, to a slightly stronger picture than anticipated in the August [Inflation] Report’

‘If anything, recent developments had suggested that the remaining spare capacity in the economy was being absorbed a little more rapidly than had been expected’.

Pretty optimistic stuff. Even in paragraph 32 of the Minutes, which outlines the argument for leaving policy unchanged, they comment on ‘some signs of growing momentum’: ‘in particular stronger employment data, signs of a pickup in the housing market, and a partial rebound in new car sales’. And that’s in the paragraph arguing for unchanged rates! Oh the little tinkers. It’s in that paragraph that they give their biggest hint of when the rate rise could come, concluding:

‘More generally, the Committee could undertake a full assessment of recent developments, and the data released over the next couple of months, in the context of its November forecast round.’

So – November is when they’re itching to go, and a 70% chance of a 25bp hike is now priced in following comments from dove Gertjan Vlieghe this morning that:

‘Until recently, I thought the appropriate response of monetary policy was to be patient, given modest growth and subdued underlying inflationary pressure. But the evolution of the data is increasingly suggesting that we are approaching the moment when Bank Rate may need to rise. If these data trends of reducing slack, rising pay pressure, strengthening household spending and robust global growth continue, the appropriate time for a rise in Bank Rate might be as early as in the coming months

A little bit more than 25bps is now fully priced by February next year. The reason for the disconnect in timing is partly because of that whole unreliable-boyfriend, lack-of-credibility thing, and also that yield curves have become so flat that hardly any central bank is expected to do anything ever. Never ever. Like, ever.

Oh but another curveball was thrown into that lack of curve pricing yesterday, with US inflation data beating expectations at almost 0.3% month-on-month. Maybe that December rate hike from the Fed might come after all? Either way, these are reminders that central banks are not flatlining.

Blondemoney knows from experience that when you’ve been let down and disappointed by Mr. Unreliable, it’s easy to believe he aint changed. But the whole corpus of the Bank of England is starting to sing from the same hymn sheet. When uber-dove Haldane flipped towards rate hikes in June, he noted:

‘“Provided the data are still on track, I do think that beginning the process of withdrawing some of the incremental stimulus provided last August would be prudent moving into the second half of the year”’

This argument to withdraw the ‘insurance’ cut post-Brexit vote was cited again in yesterday’s Minutes:

‘A withdrawal of part of the stimulus that the Committee had injected in August last year would help to moderate the inflation overshoot while leaving monetary policy very supportive.’

Just like the Bank of Canada, they’ve decided the time is right to remove the insurance policy, and they’re just going to go for it. And why not? There’s certainly a window of opportunity for the BOE to get it done before Brexit talks get complicated.

This time, it’s not just Mr Unreliable at your door, it’s him and his best mates turning up with banners, loudspeakers, a song, and a script to deliver a clear message of why This Time, He Means It. Are you gonna take him back in, girlfriend? For once, you should.