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!!

 

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