Market Insights

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.

If you can meet with Triumph and Disaster and treat those two impostors just the same…

Roald Dahl’s mighty poem contains much useful advice to be passed down from father to son, but to the humble investor, Triumph and Disaster feel very different indeed. What is the future path of financial markets if not a constant journey to navigate towards one while exerting every sinew to avoid the other? If they’re the same, then why do we bother? Fear/Greed, Hope/Despair, these outcomes are reflected each and every day in asset prices. Those prices are the current equilibrium based on our expectations (rational or otherwise) of future outcomes including all current known information. And, as discussed yesterday, even as the US ambassador to the UN describes North Korea as “begging for war“, the next step will be to get the UN to vote on (that magic panacea) sanctions. So, no need for despair, panic, or fear. We have chosen the path to Triumph.

As it turns out, there are sound fundamental reasons to feel that way about the global economy. The JP Morgan Global Manufacturing PMI is at its highest in over 6 years:

And global GDP in general is also up at multi-year highs:

So growth is good, money is cheap, our favourite risk indicators offer no sign of any woolly mammoths on the horizon… suggesting that we haven’t quite hit peak exuberance yet. Yes stock markets are at all time highs, but if manufacturing is rebounding as strongly as it looks like it is, then risky assets like commodities can get even more of their mojo back. Copper is at 3 year highs, although given Blondemoney is now writing about it, it’s no surprise to hear that the long position on the CFTC is already at a record high. Maybe it’s not quite time to short the Australian Dollar just yet…the world can embrace Triumph at an exponential rate.

But what of its cousin, Disaster? We already warned that risk indicators are unable or unwilling to pick up the political risk premium that still abounds. Aside from nuclear war, we have a much more live war of words developing between the UK and the EU. Brexit fatigue means it’s being ignored as posturing for now, but if you knew two of the largest economies in the world were unable to strike a deal on trade, with one country currently lacking any real or effective government whilst also nursing a sizeable deficit, you would understandably be concerned. Political risk is not going away.

Indeed, as growth expands, the forces which blew apart decades-long political consensus will get stronger. Macron’s election didn’t end ‘the rise of populism’; it reaffirmed ‘the rise of anti-establishment-ism’. Trump and Macron have more in common than some might comfortably imagine, and it’s not just their make-up bill. Both have benefited nicely from being inside the establishment (real estate mogul / investment banker), but portrayed themselves as outsiders, as a new force in the political system. We see the same effect now taking place in New Zealand, where a 37-year-old woman no less (the audacity of it!) at the helm of the opposition Labour Party has seen them surge 20 pts in the polls to draw level.

An unequal recovery, where the asset rich benefited at the expense of the austerity-imposed poor, created these political shocks. With more growth out there, this is only going to cause more fissures, and not just of the nuclear kind.

For a less than 10 minute wrap on those two imposters, Triumph and Disaster, please click here…



Thus far, the market’s reaction to North Korea’s missile launches has been predicated on the (allegedly) rational view that it’s sabre rattling and neither side will really let this turn into anything significantly awful. That leads to the logical conclusion that it provides a great opportunity to buy the dip in risky assets; or if you want to get cute, in Defense ETFs. After all, the cheap money party keeps on rolling, what with the Fed’s hiking almost entirely neutralised by equities rallying and credit spreads narrowing. Here’s a nice St Louis Fed chart of how mortgage rates have come down at least 25bps since the start of the year:

Same story in the Eurozone, even with the currency at two-year highs. Here’s Citi’s Financial Conditions Index – printed alongside GDP just in case we were in any doubt that growth is always and everywhere a monetary phenomenon (!):

So why should some posturing between two men with remarkably unusual haircuts give us any cause for concern?

Firstly, those haircuts are sitting atop some potentially irrational brains.

The Cold War’s M.A.D. doctrine taught us that annihilating one another was, as the name suggests, mad. Even a computer called Joshua knew that. But what if the men with their fingers on the nuclear button were less than fully rational; or if there were a miscalculation? If instead of playing noughts and crosses they thought they were playing battleships? After all, Trump, in relentlessly optimistic mood, just described the relief efforts after Hurricane Harvey as “a wonderful thing… I think even for the country to watch and for the world to watch”. He is not the Reality TV President for nothing. Always setting the scene and talking up the ratings. Meanwhile the North Korean leader has been described as “a little unhinged” by no less than former Sec of State, Condoleezza Rice. She has also been adamant that if North Korea even look like they’re getting close to being able to launch an ICBM, they must be blown off the face of the planet. And that’s from a woman with decades of experience in national security, including non-proliferation talks in the 2000s with the North Koreans themselves.

The theory then goes that the US clearly know what they’re doing behind the scenes, the North Koreans can easily be crushed, and no need to worry as we go back to buying those cheaply-funded risky assets. If you’re worried, maybe buy a safe haven for portfolio protection. But please do not under any circumstances miss out on buying the dip. As we have previously discussed, ‘We Are All Passive Now’ and the wall of money into index products is just multiplying the effect from the cheap money party. As CDOs once provided the vehicle to leverage up debt upon debt, now ETFs provide the vehicle to leverage up liquidity upon liquidity. Central banks made the price of money negative, so use that liquidity to buy more something even more liquid.

Unfortunately this propagates the mispricing of risk through the system. Where once the VIX was an indicator of risk, it’s now an asset in itself. So if North Korea accidentally sets off nuclear war, and the VIX spikes, that’s just another opportunity to sell it. It no longer represents “a forward looking indicator on volatility”, but instead just another number that mean reverts. And the mean of the past few years, ever since central banks popped up to smooth down volatility, is that nothing much happens. OK, there were little weird one off flash crashes and stuff like Brexit, but that was just over in a heartbeat, right?

There is talk of sanctions being put into place for N Korea. This is a country that ranks at 213 out of 230 on GDP per capita, just below Haiti. The population is already starving and beaten into submission. The wealth of the few is already likely to be stored below the radar. Sanctions might look like a nice next step before the pre-ordained military response kicks in. But we will hear the word “sanctions”, and decide again that we are reverting to the mean, everything is fine, nothing to see here, please move along.

We like to think we are smart. That we learn. That we wouldn’t repeat the mistakes of the past. That setting off nukes is so insane as to be impossible, rather than just highly improbable. That we wouldn’t rely so heavily on mathematical models to become trapped in a “six sigma” event. That we wouldn’t use a volatility indicator like, say, the VIX, to model future expectations of volatility.


Let’s just take a look a little more closely at what constitutes that financial conditions index we saw above:

The light blue bars are the period of the Great Moderation. Unsurprisingly they’re almost all moving in the direction of loosening. But now look at the dark blue bars, which represent the first half of this year. Some of the classic credit indicators, like 3month Euribor-EONIA (at the bottom), have reduced far more this year than they ever did in the big credit boom. The impact of the rally in the Eurostoxx has also had a bigger loosening effect. Corporate spreads have narrowed similarly. Quantitative Easing is the culprit.

Let’s leave aside whether that’s good or bad – hey at least the bar representing a mad house price boom isn’t quite as large this year, so another credit crunch looks unlikely. And instead turn back to North Korea. We can conclude:

  1. Market-based measures of volatility are no longer providing a signal for future volatility
  2. Market-based measures of credit risk are no longer providing a signal for future volatility
  3. Equity prices and credit spreads therefore fail to incorporate a risk premium
  4. Equity prices and credit spreads therefore no longer provide a signal for future volatility
  5. Equity prices, credit spreads, and volatility prices are all still being used to indicate loose financial conditions that implies piling into risk

So, are we deciding the sabre rattling is irrelevant because of market prices?
Or are market prices telling us to ignore the feeling in the pit of our stomach that there may be a policy mistake ahead?

Our rumbling stomachs suggest that we should be careful on the extent of risk within our portfolios.

To keep on top of North Korea from here, check out the following:

  • An account of what happened last time N Korea fired a missile over Japan, in August 1998
  • @StevenJGibbons on Twitter who is a seismologist monitoring underground nuclear testing – here’s his chart on how the weekend’s test measured up
  • @CSIS on Twitter, the Center for Strategic & International Studies – here’s their chart on missile launches to date


Welcome back! Take off your shoes, pull up a chair, put the kettle on and…. go to sleep

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?

1, Carry

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.

3. Politics

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?