Market Insights

A little reminder

This morning provided a nice juxtaposition of news stories that deftly explains why we are where we are.

First up we have the fish-finger-loving, partial-to-a-glass-of-vino-or-ten, EU Commission President Juncker. He was giving his State of the EU address, and unsurprisingly called for an end to individual country vetoes, along with introducing a single European President, and every member state to be in the Euro and Schengen. ‘Ever Closer Union’ writ large indeed.

At the same time, the ONS released UK employment data. Yet again, unemployment fell, but yet again, wages remained stagnant. Real wages are now 3.2% below their peak in 2008 (h/t @Rupert_Seggins):

Oh, and what’s happened to asset prices since then? Up, a lot.

So those who own assets have become a lot richer. Those who own more assets, have become richer than those with less. Inequality between all segments is rising, even before we take into account that salaries are falling in real terms.

To put it bluntly, if you wanted to trade up from a one bed flat to a 3 bed starter home, even with two incomes and super-low interest rates, and banks falling over themselves to lend, it can’t be done. Stagnant wages alongside exponential asset growth have stymied people’s progress. Or at least, their perceived progress. Meanwhile “the rich”, “the elite”, “the 1%” appear unscathed. And worse, uninterested. Jean-Claude Juncker believes the answer to people’s concerns about the establishment, is to create a more powerful and isolated establishment. Or at least, that’s how his speech today could be conceived. If you were, say, a powerfully disenfranchised electorate looking for someone to blame.

Amongst Remainers, there has been and continues to be astonishment that people would vote for something that could be so economically crippling. After all, those real wages aren’t doing very well following the currency-depreciation-induced bout of inflation in the UK, induced by that whole Brexit vote. However, sometimes Turkeys do vote for Christmas, if they’re sick and tired of their current situation. As YouGov report, a majority of Leave voters consider economic damage to themselves or the country to be a “price worth paying” to leave the EU:

I know, you’re tired of this aren’t you? You roll your eyes at the loonies who voted to Leave, or who voted for Trump, or maybe even who voted for Macron, now that he’s spent 26,000 Euros on makeup as he smashes up the Unions. In any case, as a humble market investor, you think this is all a depressing sideshow. Your conundrum is how to get yield in such low volatile times. Here’s how compressed spreads are these days (h/t @BarbarianCap):

But it’s those pesky politics that make these spreads look so unsustainable. The People Have Spoken but goddammit they just Keep On Speaking. Juncker’s speech is a reminder that the anti-establishment mood will persist until The Establishment make some changes. And eventually they’ll be forced to. And in such ways that will make the future path of the economy look quite different from those of the past. Market-based spreads will need to reflect this risk premium at some stage.

Just a small reminder, though, as for now it’s carry on carrying mixed with a dash of stop-hunting (GBP being the current such target). Keep an eye on the AUD above 0.8000 – if that starts moving higher then we are in return to euphoria form, with stocks even higher, spreads even tighter, and the rest.

 

The future is a foreign country: they do things differently there

What the ECB and the Fed wouldn’t give to have the UK’s inflation eh? Core CPI came in at a joyful above-target 2.7%. The cost of raw materials went up to 7.6% in the year to August from last month’s reading of 6.2%. Just in case there was any doubt as to what was driving it (clue: the Great British Pound), here’s a chart showing the marked upswing since that Brexit vote came upon us:

So, it’s pretty simple for Mario and Janet. If you want to hit your inflation target, engender an unexpected vote on the future trading power of your nation. Janet’s lucky, she got an unexpected vote on her political leader, but it took the market a while to catch up to his prospects of reform and thus re-rate the currency accordingly. Oh, how those central bankers must laugh (here they are at Jackson Hole):

But then poor Janet, because despite the significant loosening in US financial conditions this year, there still isn’t much inflation. Maybe that will improve on Thursday, right? When we find out the latest US inflation data? Small fly in the ointment – the next couple of months inflation data is going to be very messed up by pesky natural disasters. The hurricanes, as dreadful as they are, will ultimately prove reflationary, what with the rebuild and supply shortages. But they’re also going to confuse the hell out of the data. Here’s what happened to inflation readings after Hurricane Katrina:

That means it’s going to be very hard to tell what the underlying inflation rate is for the economy, absent these temporary shocks. Markets have to try to price the future regardless, and they’re doing a jolly good show of it too. Here’s the latest outlook for what’s priced into interest rates:

Not a lot, basically. The most excitement over the next 12 months lies in Canada, where a full 50bps of hikes is priced. That’s two whole rate hikes people! Wooohooo! I hope you’re screaming because this rollercoaster is going fast. More notable is one hike from the Bank of England in that time. Although that would only take back the post-Brexit vote August 2016 insurance cut. Not exactly what Kristin Forbes had in mind for her parting speech upon leaving the BOE this summer, where she warned:

‘Many of the factors that have justified keeping interest rates at emergency levels over the past few years have become less potent, and sterling’s depreciation has fundamentally shifted underlying inflation dynamics in a way that makes it more pressing to begin this voyage soon

The majority of the BOE are (yet?) to agree with her. The rise in inflation should be ‘looked through’. Just as it was when it was running at 5% following the financial crisis. (Is there much use in a target if it is either completely missed or completely ignored??) Even if the BOE were to start to pay attention, and start a hiking cycle, would that be good or bad for the economy? No wonder longer term rates remain low.

Somewhat surprisingly, the ECB’s Coeure quoted work by Forbes in his speech yesterday about the pass through effects of the currency onto inflation. Forbes uses a lower currency to argue for rate hikes; while Coeure uses “exogenous factors” to argue that a higher currency can be compatible with rate hikes. Here’s his chart of what’s driven the appreciation in the Euro:

He explains:

‘there are three forces, of roughly equal strength, that help to explain the euro’s marked appreciation in recent months: improved euro area growth prospects, an exogenous component and a tightening in the relative monetary policy stance vis-à-vis the United States.’

In other words, it’s OK for the Euro to rally due to higher domestic growth, as that allows European companies to pass on the higher costs to the consumer and preserve their margins. It’s also OK if it’s exogenous because they can’t do anything about that. And they can’t do anything about US interest rates so that’s basically exogenous too. So, it’s all OK.

He goes on to wax lyrical about the joys of a flat interest rate curve, suggesting that this also means it’s OK for the currency to appreciate, because long-term monetary policy is still loose.

So the stage is set for the ECB. Any time they get a bit edgy about the appreciation in the Euro, they can shout that it’s NOT EXOGENOUS and it should fall accordingly, as the market pares back expectations of the taper. If they’re fine with the currency rising, say it’s exogenous, and let it fly.

In summary, we have central bankers approaching inflation and the exchange rate in whatever way they like, to make the argument for the monetary policy path they’ve already chosen to take. It’s no wonder so little is priced into those curves. The market knows as much as the central bankers do. Not much, basically. We like to think we understand the future. But it is truly the unknown country.

Throw into the mix that Janet Yellen may only have four more meetings left as Fed Chair, and all bets are off. Although… overnight we heard that Ivanka Trump met with Janet in the summer, just before her father went on to say Yellen was still in the running and told the WSJ  ‘I like her. I like her demeanor. I think she’s done a good job…I’d like to see rates stay low. She’s historically been a low-interest-rate person‘.

If Janet Yellen doesn’t want the poisoned chalice then could it be #IvankaForFedChair?

Standing up for central bankers

Blondemoney is no blind central bank groupie, despite the eccentrically detailed focus on their pronouncements. In “Beyond Inflation Targeting“, the BM editorial begins:

Global imbalances, bankers’ bonuses, light-touch regulation: all have been blamed for causing the banking crisis and ensuing recession. But one potential villain lurks in the background, hidden behind technical jargon and protected by tradition: the central banker. We all know that the build-up of risk in the system precipitated an almighty bust, but let’s not forget who controls the key determinant of the price of risk: the central bank through its monetary policy

Written in 2009, that paper argues the central bank obsession with hitting inflation target mandates helped to precipitate the financial crisis. Eight years later, and we have had the ECB turn to negative interest rates and QE to stave off lowflation. Except now, of course, without stoking another bubble-bursting crisis. So it’s time to stand up for Mario Draghi, applauding his attempt to reverse Alice in Wonderland monetary policy even as the inflation target prize might be scuppered.

That’s why on Thursday he didn’t blink in the face of an appreciating Euro. It’s the price to pay to return to some normality. There is talk of a policy error. There is the undoubted instability that it will cause. But really, there aren’t many options left open to him. Domestic money flows out of the eurozone are coming back home as growth returns and yields fall on foreign assets; the Euro was going up anyway.

Let’s not feel too sorry for him, however, as his apparently irrational approach is going to throw up some unhelpful market movement.

The ECB may not appear too concerned about the level of the Euro but they are darn well concerned about the pace of its appreciation. The key phrase is “financial conditions”, which he mentioned four times in his press conference:

This autumn we will decide on the calibration of our policy instruments beyond the end of the year, taking into account the expected path of inflation and the financial conditions needed for a sustained return of inflation rates towards levels that are below, but close to, 2%.

In other words, if the Euro rallies too far too fast, that will tighten financial conditions, so they won’t tighten policy so quickly. So, a higher Euro means lower Bund yields, which is quite nice for the ECB, as it means they can taper into a rising market. It’s not so nice for investors, because it becomes a cat-and-mouse game. The rise from 1.0500-1.1500 was a repricing that ECB QE was coming to an end; 1.1500-1.1800 was a repricing of the Fed as inflation headed lower; this last spurt higher in the Euro was a reprice of ECB apathy towards the currency. The ECB are now OK with a higher Euro, but not too much too fast. That means a very jagged future path for the currency: up two steps, back down one or even two or three.

It means correlations will become unstable. Bund yields and the Euro won’t rise together, they’ll oppose one another, as they have in the past 6 weeks. But that may not hold, either, because at some stage higher inflation could come back and mean a faster taper ahead. Last night we found out that Chinese PPI inflation, a key indicator for global CPI, beat expectations, turning higher for the first time in 3 months.

Positioning has certainly shifted significantly over the summer. This chart from Citi shows that shorts in the USD have been increasing for both hedge funds and real money – but there has been a big divergence in the Euro, where the typically longer term money has been buying it as hedge funds sold it:

The risk now is that the short-term money decides to be the bull to Draghi’s red rag. You don’t care about a higher Euro hey Mario? OK, we’ll give it to you… only for him to pop up with a few shouts of “calibration”, “financial conditions”, and “endogenous”, which would smack the Euro back down again.

N.B. Endogenous is also one of his faves – apparently it’s OK to ignore a higher currency if it comes from endogenous factors. If they were exogenous, that would mean a higher pass through effect onto inflation, meaning a higher euro would make the ECB less likely to hit their inflation target. But as BNPP’s Chief Market Economist Paul Mortimer-Lee has pointed out, the higher Euro hasn’t done much at all to the 5y5y inflation swap:

There is always volatility around turning points. For the Bank of Canada, they had decided to take back their insurance rate cuts and just get it over with. They must have been aware that would strengthen the currency, but decided it was a price worth paying to rip off the plaster and get it done. And in any case, why is a stronger currency so bad? If you want to tighten, then a stronger currency gets some of that done for you. The last few years of the currency wars, designed to prop up ailing growth, are not so relevant any more.

So yes, let’s stand up for central bankers. Even as they are deliberately throwing a hand grenade of volatility into the market. We started this year thinking Trump reflation plus Le Pen might take EUR/USD to parity. Right now we are approaching the peak of the exact opposite view: Trump can’t get anything done plus Eurozone reflation. These final few big figures higher in EUR/USD might be the last, and the most volatile.

Have a good week ahead folks!!

 

Taper me up buttercup

Today at 12.45pm, Enter The Draghi. Actually, this morning there were even some doubts over that, with headlines springing up that the monetary policy decision would come “after” that, before the ECB denied it. Perhaps they need a little longer for their lunch to digest, with the big shift in their super-easy monetary policy that’s thought to be just around the corner. Hence the Euro’s 50 pip rally just on those rumours – and a reminder of how jumpy it is out there.

That’s just the way Mario likes it. Over the years he has become the King of Keeping Us Guessing. This affords him maximum flexibility to allow the market to operate as a pressure valve while he curries the consensus around the ECB table. He can leak that he would like looser or tighter monetary policy, then bond markets and the currency can price him accordingly. But if on the day of the ECB meeting he can’t quite get what he wants, those markets will reverse… but then giving him the perfect opportunity to get on the ECB What’s App group and say “I told you so guys LOL”. Which ultimately gets him where he wants to go.

Today, he has managed to create a finely balanced set up:

  • Having expected a signal on the taper to come in this meeting, perhaps presaged by a Draghi speech at Jackson Hole, it’s now expected to be presented in the next meeting in October
  • …And then start happening in January
  • …With Euro strength delaying matters

Bloomberg has an article on economists’ thoughts, with a nice pic of the taper plan here:

Which is amusing, because it suggests that there’s some clear expectations about what the ECB does next. There are not. There cannot be. It was complicated enough when the Fed tried to row back their stimulus, but now you’ve got 19 Eurozone countries trying to agree, just as the biggest one is about to have a fresh election on its head of state. Now, we know it’s almost certainly going to be Merkel (because the polls are always right, ja??), and that, along with the election of Macron, has allowed the ECB to breathe a sigh of relief that they haven’t been drawn into the politics this year. This means they can get on with the economics.

June’s ECB Staff Forecasts had HICP at 1.5% this year, 1.3% next, 1.6% in 2019; and GDP at 1.9 / 1.8 / 1.7%. That was however based on an appreciation in the real effective exchange rate of only ~1%, with EUR/USD set for simple assumption purposes on where it was at the time of the June projections, around 1.0900.

This is the cause of today’s uncertainty. The Euro is up around 5% in trade weighted terms since the ECB last set those forecasts. Draghi said in March 2014 that ‘each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points‘.

The ECB hawks aren’t worried. Nowotny last week said he “wouldn’t over-interpret or dramatize” the rise. Meanwhile the doves, of course, are somewhat concerned, with Constancio saying “The strong worldwide reflationary phase that seemed likely at the beginning of the year has not materialised…Therefore, the tasks of normalising inflation and unemployment to acceptable levels continue to be difficult“.

The upshot is this:

  • Ever since an ECB taper came onto the table, there have been several leaks that Euro appreciation might delay its implementation.
  • Even the official ECB Minutes notably mentioned the currency for the first time
  • But a taper is a-coming, and so the currency will appreciate, not least with the Fed having hit the pause button on their hiking plans

So how worried are the ECB really?

  1. A higher currency can do their tightening for them
  2. There is now no need to worry about what this might do to them politically (they don’t want to be blamed for voter discontent)
  3. But they don’t want to worry about being blamed for building the next bubble either
  4. They have to cross the taper rubicon eventually

That means the only question for today is: 

Either – Swallow the fact the Euro is going higher and just kitchen sink it today

Or – Manage the Euro’s inevitable appreciation by kicking the currency down today and letting it rise from a lower level

Draghi is the master of market positioning (as Blondemoney’s painful post-ECB PnL burns can demonstrate). CFTC data still shows specs are relatively long of EUR/USD. But then every stop-induced move in the currency of the past few weeks has been to the upside, suggesting it’s not that long. Or perhaps rather that the option structures used to play for a higher euro have been those which sell volatility (no-one can afford to be long vol in Target-store-manager-sell-vol world of today), triggering these stops.

The Bank of Canada were bold yesterday, and with good reason. If you’re going to flip, just do it. The market is long Euros but the leaks from the ECB have done enough to keep the market from being one-sided. Draghi has set up the poker table nicely. The cards are dealt. What will you do next? Blondemoney plumps for the kitchen sink. Or, in a less gender stereotyped way, rip off the plaster, get the Euro higher, and deal with any fall out later.

The deflation bogeyman is back

…for some, it may be that he never went away. To be fair to central bankers, following the Lost Decade(s) of Japan, the deflationary demon has been their ultimate fright night. They all know the answer to fighting too much inflation, but too little and the jury is still out. The financial crisis provided their ultimate beta test, what with it being the end of civilisation / brink of anarchy and all. With the velocity of money at zero and banks frozen and failing, they had to pull some kind of deflation-zapping weapon out of the bank.

This mindset continued as countries’ debt spiralled out of control, and then as oil prices collapsed. A punch of QE here, a smack of negative interest rates there. It was a deflation-busting free for all.

This insight into the central banker mindset is relevant once again, what with higher growth failing to translate into higher inflation. Or more specifically, higher wage inflation. Let’s not bore on again about flat Phillips Curves. We are in the midst of a decade long technological revolution, it should be no surprise that worker productivity and the wages they are paid have been affected by the rise of the internet. Looking at kittens, Tinder dates gone faecally wrong, and an Irish family trying to catch a bat trapped in their kitchen all have their impact. (OK and AI, big data, driverless cars, Uber, Deliveroo, Amazon and the rest). ((Definitely watch the bat video though)).

The point is, there’s growth around, but not in wages.

So up pops a couple of Fed speakers yesterday:

  • Kashkari: ‘We at the Fed might be making one of two fundamental mistakes: Number one, we might be overestimating how tight the labor market is. And number two, we at the Fed may have allowed inflation expectations to drift lower. Both of those, if those really happened, could explain the low wage growth, the low inflation, and the seemingly tight labor market’
  • Brainard: ‘We should be cautious about tightening policy further until we are confident inflation is on track to achieve our target,’ [If inflation continues to fall short of the central bank’s 2 percent target] ‘it would be prudent to raise the federal funds rate more gradually.’

Yes, that deflationary demon is back. What if the Fed rate hikes to date have summonsed him, in a kind of FOMC ouija board way? Kashkari has been so worried that he has been formally excusing himself from the séance by dissenting to the official rate hike decisions since March. He may also, what with his political past , be gearing up for the nod from President Trump after Yellen’s term ends. Brainard is more credible, although also a notable dove. The US 10 year decided to hit fresh lows for the year anyway, at just 2.07%. There’s a certain flight to safety taking place, what with North Korea and the news that Irma is now the most powerful hurricane ever recorded in the Atlantic. But central bankers remain preoccupied with their inability to generate inflation.

We will see just how much that’s really worrying them with the Bank of Canada meeting today and the ECB tomorrow.

In Canada, a 25bp hike is priced at 50%, and if they don’t go today the market pricing expects they will next time. And then to pause, with this characterised as taking back the two “insurance” 25bp cuts that a panicked Poloz executed in 2015 in response to the oil price fall. Their January 2015 cut came as a surprise, on the day before the ECB surprised with their QE package, at a time when everyone was falling over themselves to cut. The question now is whether everyone falls over themselves to hike but in the most dovish way possible? Or, given the strong global growth data we looked at yesterday, can they have the courage to hike properly?

Ah but what of inflation! It’s so pesky! The inflation rate in Canada is now at very similar levels to where it was when they got on their 2015 cutting bandwagon:

But don’t worry. As we remarked about the BOC’s cut in Jan 2015, ‘when a central bank starts talking about excess supply of cattle, you know the jig is up. They want to cut rates and they’ve found their argument’.

In other words, these guys can make any argument they want. That’s why understanding their mindset is so important. FWIW, Blondemoney believes the Canadian economy is doing well enough for Poloz to be bold today. If he isn’t then it’s a sign that central bankers are having nightmares again. Which means another turbocharge for risky assets, as cheap money plus global growth equals Fun Times.

Will Draghi be spooked by currency strength tomorrow? Or is he a man who always sleeps soundly, no baseball bat under the bed? We will soon find out.