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Market Insights
Remember the ECB?
There’s a lot happening tomorrow, from the UK election to Comey’s testimony, so let’s spare a thought now for the ECB. (Particularly as Comey is expected to stop short of saying whether Trump obstructed justice, as reported overnight, and that the UK polls have become almost entirely irrelevant through their variation). The market doesn’t seem that interested in the ECB, with overnight EUR/USD volatility pricing a move of only ~75 USD pips. Yet it’s more than likely that Draghi will have to use this meeting to offer something to the hawks, not least with only 3 months (and 2 more monetary policy ECB meetings after this one) to go until the German election.
The hawks have reason to be bullish. Eurozone inflation expectations are steady but not stellar, while the PMIs are booming:
Meanwhile, Draghi’s second line of the statement has read as follows for a while:
‘We continue to expect [interest rates] to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases’
You would have to imagine that the hawks would like to remove the words “or lower levels”, as well as “extended period”, and then do something about the expression “well past the horizon”. In other words, expect the first lines of the statement to be significantly amended.
After all, this is what has happened to German inflation ever since the rubicon to QE was crossed in January 2015:
The plunge in the oil price kept it in the depths for a while longer but there is no mistaking that lovely rally up to the 2% point over the past year. Meanwhile German 2 year yields headed ever further into negative territory. Negative interest rates and QE were already leading the German press to scream at the ECB at the beginning of this year, with headlines running from “Raise Rates Now” to “Change Course Mr. Draghi!”. What will they think now that the inflation target has been reached even as the 2 year yield almost hit -1%?
Of course, the ECB create monetary policy for all the Eurozone members, not just Germany. But then not every Eurozone member has a significant election taking place, is one of the biggest economies in the Eurozone, and is facing an existential battle with Britain leaving the EU. It’s no surprise that the next ECB President is expected finally to be a German, after Dutch, French and now Italian incumbents.
Yet we can always rely upon ECB press conference days to take the Euro in directions different from what might be expected. And so it may prove tomorrow, with the market apparently quite long of Euros. The IMM positions are the longest in several years:
One loyal BM reader has pointed out that IMM positions are growing because the open interest on the IMM is growing, so we have to be careful in reading too much from the history of such charts (unless you’d like me to Z score it, but I haven’t had my cup of tea yet…). The fact remains however that the Euro has rallied against almost all currencies since the French Presidential Election was concluded on 7th May:
The winners against the Euro have been the bigger carry currencies although not, somewhat bizarrely the Japanese Yen. Until Friday the yen was also a loser against the Euro, but that has shifted in the past couple of days. Perhaps some of the ECB related “Buy rumour/sell fact” is happening ahead of the event. (If markets keep discounting themselves like this, we’ll be taking off positions before we’ve even put them on…!!)
There are other events tomorrow though, and part of the reason for the yen’s rally is the decline in US interest rates. With Japanese yields stuck due to the BOJ’s Spanx-like Yield Curve Control policy, USD/JPY moves lower as US rates move lower. So with the world now looking rather skewed towards risk-on once again, what with higher stocks, easier financial conditions, and low implied volatility, it’s worth keeping an eye on the downside in EUR/JPY. We had a gap after the first round of the French Presidential election around 119.00 that might come lurching into view if the market finds out it’s got too much risk on for the political risks ahead:
Mind the gap…?
Being pulled in different directions
We are still thrashing out the driver for markets. As discussed in “It’s volatility Jim, but not as we know it”, we are now rotating between carry, politics, and the economy. The next two weeks provide us with something juicy for each of them.
- Carry
We start with the ECB this Thursday and move onto the Fed and Bank of Japan next week. The detail doesn’t matter as much as the sense of direction. And for the first time since Blondemoney starting asking “Hands Up If You’re Not Easing”, central banks have changed course from cuts to hikes:
It’s quite remarkable how this has occurred while stock markets keep on pumping up to new highs. This withdrawal of stimulus was supposed to hurt wasn’t it? Ah, but then you see this chart, which shows that even if the future path withdraws stimulus, right in the present time it’s still ploughing on:
In other words, the ECB and BOJ have been doing enough to replace the Fed’s withdrawal. Enough to have a self-reinforcing impact on flatter yield curves: since the Fed last hiked in March, the US 10 year yield has fallen 0.35bps. Effectively the Fed hikes are being neutralised by the ongoing wall of money. There was a slight dip in the total central banks assets in the final quarter of 2016, but then fortunately we had a US election that returned a clean sweep for pro-business anti-regulation Republicans, and the world got all excited about reflation. The reflationary dynamic was genuine, with Chinese PPI having emerged from 5 years of deflation last September. The market only made a small political miscalculation, failing to spot that the separation of powers alongside a President disliked by his own party might not quite deliver the reflationary boost they initially hoped.
- Politics
Investors think they’ve put that mistake behind them, however. Only to make a second one. They moved from anticipating an omnipotent Republican administration to deciding the President is impotent and therefore irrelevant. He is neither. He’s constrained, sure, but so are all the other branches of government. That’s how the separation of powers works. Trump is blustering around trying to find the levers of power. At some point, he’ll find one. Note that the decisions over who to appoint to the Fed board are gathering momentum, with news today that one candidate is the chairman of a bank in Vice-President Pence’s home state.
Then we come to the UK Election. Those of you outside of the UK seem to regard this as almost a non-event. The polls have become so divergent as to have lost all predictive power, along with a rational belief that no Prime Minister could have possibly called an election if they genuinely were to lose it. That may be true, but let’s pay heed to polling guru Nate Silver’s point that the conventional wisdom is exactly what went wrong in the last 18 months of elections (including an outsized fear of Le Pen):
Either way, the risk of a Corbyn government – or even a Government of National Unity – is not zero, and it could happen in just 3 days’ time.
Meanwhile, the VIX plumbs the depths once again. As @selling_theta flags, there have only ever been 14 times the VIX has closed under 10, and six of those have happened in the past month:
Putting these first two points together we can see why volatility is so compressed. As JPMorgan point out, over one-third of the world’s government bond markets are now owned by central banks, and HALF is held by them plus commercial banks:
These guys are buying and holding these bonds. Add this to the increase in passive equity investors, and trading volumes are plummeting:
This isn’t anything new, you might think. We know central banks are crowding out private investors. We know they’re driving volatility lower. We know they’re still indulging in QE but that’s ending soon and hasn’t caused a problem yet, has it?
Carry on carrying. Friday saw the biggest one-day inflow of the year into the largest Emerging Markets Debt ETF:
Markets are indeed supposed to be fully rational and price in all future expectations. That chart about future rate hikes should be in the price already right?
- The Economy
What if it’s not? What if, at the exact moment we realise the QE is ending properly, at say, a couple of central bank meetings in the next couple of weeks, we also realise that reflation isn’t quite as robust either? And not just for political reasons?
Blondemoney is usually sceptical about charts where one line is progressed forward to make it sit nicely on top of another line. Surely if some data had such predictive power, we would know about it and already discount it? But this chart is from the usually reliable Capital Economics and there is a pretty tight relationship between two variables that should correlate:
In conclusion:
- The Carry Trade hasn’t come under any pressure yet as the Central Bank wall of money continues
- The compression of volatility means that when it does unwind, it will be violent
- Reflation is under threat, both politically and economically
Firewood? Check.
Tinder? Check.
Matches? Ready.
Just wait for the spark.
It looks like we need to have another word…
It looks like we need to have another word about GBP. The pollsters are once again making waves, this time with YouGov forecasting a hung parliament. Their central scenario is for the Conservatives to lose 20 seats, and Labour to win 30. With other polling agencies still predicting anything up to a 100 seat majority, is this YouGov sticking their necks out looking for glory, or does it reduce the information content of all polls to zero?
We can know this: all the polls have behaved similarly in relative terms. They all started with an increasing Tory majority, as UKIPpers mostly went back to the Tories. Then after the manifestos were released they showed a resurgence for Labour, who offered well telegraphed freebies against the Tories mixed messages on social care. We can conclude that when this was “The Brexit Election”, the Conservatives benefitted, with even many Remain voters now thinking it just needs getting on with. However when the manifestos reminded voters of specific policy concerns, old tribal habits die hard, and disgruntled anti-Corbyn voters returned to the fold.
Voters are realigning themselves. There’s a shakedown in the UK political system and the pieces of the puzzle are still mid-air. This happens after huge economic shifts that change the social landscape. The reality is that the politicians are behind the times. Across the world, voters want new faces. But then their loyalty to those new faces is untried and untested. Does the UK really want just to decide between Theresa May and Jeremy Corbyn as PM? It has been said by the great veteran psephologist David Butler (follow him on Twitter if you’re not already!), that he’s never seen such a volatile electorate in the run up to an election. What are the Conservative and Labour parties and who do they represent? What are the big issues of the day, when 52% of the electorate ripped us out of a network with our closest trading partner? We want change, and the current system is straining to cope.
That’s the reason why this is such a bizarre election. And the big unknown factor is how will this volatile electorate turn out? Will they bother to vote at all? As Brenda in Bristol put it, when the election was first called: “Oh no, not again!”. The main reason for the wildly different seat predictions from each polling agency lies in their voter turnout filters.
For markets, the reality is that the Conservatives losing seats must now enter the scenario analysis. Or even if they fail to achieve even a majority of, say, 50, it will leave Theresa May looking weak for having gambled by calling an election in the first place. As discussed, this is the phoney battle ahead of the Brexit negotiation war. These polls suggest that the probability of a disorderly outcome is rising.
Just a thought on GBP
The past year of how GBP/USD has traded could be characterised thus:
* Sell it on Brexit vote
* Sell it on Theresa May “Hard Brexit” conference speech
* Buy it on govt having to consult parliament on Article 50 trigger after losing court case
* Buy it on rebellious House of Lords
This could be called Stage 1 of the grief that a “Remainer-mindset” market felt after the UK apparently took leave of its senses by voting to Leave.
Then Trump turned up, Article 50 was triggered, and The People had to be heard. As they had said they wanted to Leave, well then, the market had to accept it. GBP/USD then turned into this:
* Don’t sell GBP as the economic data looks good, but wait to sell rallies instead, as the data will eventually turn
* Buy GBP for long-term hedges around 1.20-1.25 as it’s good value
Which led to a fairly narrow GBP/USD range. Until…. Theresa May calls an election! Given the massive lead for the Tories in the polls in the months prior to that decision, and the self-immolation of the Labour party, this could only mean one thing…. She would win, win big, and reduce the risk of a disorderly exit as her hand would be strengthened in negotiations. All that faffing with the court case wouldn’t happen again. The country would be set on its Brexit path. We entered a new phase:
* Buy GBP as Brexit is now going to happen in a “strong and stable” fashion
* Sell GBP if Conservative poll lead wobbles
This is somewhat ironic. Those opposing Theresa May have argued either for a 2nd referendum (the Lib Dems) or less hardline Brexit stance (Labour). Back in Stage 1, the thought of Brexit itself took GBP lower; anyone preventing it took GBP higher. That has now reversed. This is because the market has reconciled itself to Brexit actually happening. The first stage of grief, Denial, has passed.
This means that the default impulse to be short GBP has passed. Indeed, some degree of certainty from Theresa May’s increased mandate, along with the improving economic data, suggests the natural inclination might be for a slightly long position. Or at least a neutral one. Certainly volatility in GBP/USD has been falling:
This opens the way for the Second Stage of Grief: Anger. Once we proceed to June 19th, when the negotiations truly begin, we will see a lot of heat and light from politicians on both sides. Theresa May could go into negotiations with a stronger hand; but David Davis seems to want to use that hand for an early knockout punch, threatening to walk out if the EU27 don’t play ball. The EU27 have been remarkably unified thus far, likely united by the dawning realisation that the UK’s money is coming out of the pot. No-one wants money to walk away without a fight. Hence their obsession with a large headline figure for the divorce bill. Who cares about who gets the cat when you realise you’re not getting the same income?
If the market thought the UK have been irrational, let’s see how they feel about the EU27’s position. If the market still has the mindset of the UK being the guilty party, then EU27 intransigence may be considered more rational than the UK’s.
The point of all of these musings is that the moves in GBP are strongly sentiment driven. It can be no other way, as we are about to enter a period of non-linear political risk. If investors felt that the risks for GBP died with the announcement of the election, they are about to receive a significant shock.