Monday, April 28, 2008
Today may, in the fullness of time, be seen as a key turning point for financial markets in 2008 and beyond. Not because of any particular market price action or earnings announcement, though both could perhaps be meaningful. No, the font of significance in today's newsflow comes from humbler origins, in data that is rarely at the top of traders' agendas. Ultimately, the most significant news of the day could spring from the usually inconsequential womb of Germany's state CPI data.
Market observers may recall that last November, ECB president Jean-Claude Trichet alluded to a temporary "hump" in inflation that would have to be scaled before the ECB could contemplate changing policy course. Readers of a certain vintage will recall the late 80's Digital Underground hit "The Humpty Dance"; one wonders if Trichet and co. have been waiting until inflation decelerates before performing this jig. If so, it's perhaps time to cue up Shock G. and co., as this morning's state CPI data have shown a marked deceleration in y/y inflation. Perhaps we're about to ride the downside of the hump!
The chart below shows the y/y inflation rates in three of the German states reporting this morning: North Rhine-Westphalia, Hesse, and Brandenburg. As you can see, there's been a sharp deceleration from recent peaks in all 3 states; indeed, NR-W's rate is almost back to the ECB target!
Should the sharp fall in CPI be mirrored for Germany and indeed Europe as a whole, it coud represent a significant turning point for the ECB. While Macro Man stands by his view that current growth data is insufficient to warrant an ECB easing, it would be foolhardy to ignore the sharp decline in business confidence, ostensibly a leading indicator. And given that uncomfortably high (and accelerating) inflation is basically the sole reason that has kept the ECB in hawk mode, signs that inflation is moderating back towards the ECB target will be greeted with relief in Frankfurt.
Will it prove sufficient to generate a rate cut, near-term? No. But insofar as the ECB has been clear that they are focused on inflation, a change in circumstance should, in the fullness of time, prompt a change in tack from the ECB.
And what would the market implications of an ECB capitulation be? The euro, obviously, should lose some its luster....assuming that Voldemort and others don't step in and bid for "your amount" at these lofty levels. The CBs seem to have taken a break from their activities over the last few days, perhaps wishing to give the market a break after jamming EUR/USD up to 1.60. The true test will come on any further dip below 1.55. Will these chaps keep their hands in their pockets or will they be tempted to fill their boots with "cheap" euros? Inquiring minds want to know!
Perhaps the more interesting trade is in European rates. The euro steepener has been a P/L graveyard recently; indeed, the 2-10 swap curve inverted last week for the first time since the inception of the euro. However, it is clear that the euro curve has lagged its traditional follow-on from the US steepening; ex-post, it would seem clear that the high level of inflation, and concomitant ECB hawkishness, is the reason. However, if inflation is easing back and the ECB relents, then the curve should steepen from here. Conveniently (for those who avoided the bloodbath of the last few weeks), positioning in the curve is cleaner than its been for some time.
In the near term, the back end of Europe may be supported by month-end index extensions, which are relatively large this month. However, there would appear ample scope for the front end to rally; not only have German 2 year yields rallied 45 bps this month, but they are now only 17 bps lower than the ECB refi rate. Before the front-end carnage of the last week, which has pushed US 2 year yields above Fed funds, the last time that US 2's were that close to the official Funds rate was thee middle of 2006.
So for the near term, buying the front end of Europe outright could be a better way to play a shift in ECB policy; assuming the rest of the curve follows, the back end could be sold Thursday or Friday morning at better levels to leg into the curve trade.
Front end Schatz vol looks pretty cheap relative to the moves of the last few days, so Macro Man has spent a bit of premium on low-delta calls in the event that today really does mark a turning point in the history of this economic cycle.