What is the ECB smoking?

As the Greatest Financial Crisis Since the Depression (TM) rolls on, complete with continued carnage at the front end of most major yield curves, the divergent views of prominent central banks is coming increasingly into focus. While Fed policy remains extremely easy (as measured by real rates) and the Bank of Canada cut rates yesterday, seemingly not a day goes by without a hawkish comment from an ECB member. Given the apparently universally held view that a) the European banking system is buggered, b) that stuff like Spanish property is in free-fall and requires attention, c) weak sisters like Italy are being crippled by the strength of the euro, and d) as a result, European growth is headed for a massive slowdown, a constant refrain that Macro Man hears from colleagues and counterparties is "what is the ECB smoking?"

Macro Man did a bit of digging to find out. We should recall that the ECB's mandate is to ensure price stability, with the primary definition of this defined as CPI inflation close to, but not exceeding, 2%. Regular readers of this space, or indeed observers of financial markets, will know that the ECB has not achieved this goal in a long time, as demonstrated by the chart below. Now obviously, headline inflation (the object of the 2% target) is being higher by energy prices, and frankly there's not a lot the ECB can do about that in the short term. That having been said, we should recall that the ECB dialed down the rhetoric late last year on the expectation that inflation was experiencing a temporary "hump". Nothing that we've seen so far this year, least of all $119/bbl oil prices, suggests that we're about to coast down the downside of that hump.

More worrying, from the ECB's perspective, is the potential for second-round effects- namely, rising wages that then fed through into broader price rises. In fairness, macroeconomic data on wages has been pretty muted this far. Worryingly, however, core CPI has risen steadily over the past couple of years, and now rests at the ECB's 2% target for headline! If that isn't evidence of incipient second-round effects, Macro Man isn't sure what is.So will second-order effects intensify? One place to look is labour markets to get a gauge of tightness. And there, the message is that European labour markets are very tight indeed. In Germany, the "anchor" or "daddy" of the Eurozone, has seen its unemployment rate fall to the lowest level since immediately after unification.
And what of serial moaners France, who can almost always find something to complain about- be it the level of interest rates or the level of the euro? As one of Macro Man's colleagues observed this morning, the chart below looks like a classic head-and-shoulders formation: a bearish pattern suggesting that the line should head lower. In point of fact, it's a graph of France's unemployment rate, which is at 25 year lows. That bears repeating: French unemployment is at 25 year lows! You can just imagine the memo that Trichet and co. composing a memo to the French Finance Minister. "Dear Mme. Lagarde: Shut the f*** up!"
But enough of the core: what of the periphery? The market is replete with stories of collapsing prices for Spanish coastal properties, which inevitably drag the economy down with it. How valid are these fears? As far as Macro Man can see, not nearly enough to alter the ECB's calculus. Spain's own house price index , recently updated for Q1, has yet to show a quarterly decline this decade. Sure, the price of some coastal properties is falling.....but its hard to see the ECB (whose own Frankfurt homes haven't budged in value over the last few years) having much sympathy for British owners of vacation homes, who in any event are benefiting from the currency move!
And finally, what of Italy, particularly now that Signore Berlusconi, his fake hair, and fake tan are back in charge of Italy's government? It's taken as gospel that Italy is getting squeezed by the strength of the euro, and indeed that Berlusconi will moan about it. On the latter issue, Macro Man has no doubt that Berlusconi will indeed raise a stink. On the former, colour Macro Man unimpressed. The chart below shows the rolling twelve month sum of Italy's trade balance. He cannot help but notice that despite the sharp rise in oil prices over the last couple of years, the trend in Italian trade (supposedly crippled by the euro) has actually improved. Cry me a (Tiber) river, Silvio.

So what are we left with? Prices that are too high and threatening to stick. Historically tight labour markets. Few obvious signs of macroeconomic stress in supposedly vulnerable Club Med countries. Rather than asking what the ECB is smoking, Macro Man can't help but wonder what the market is smoking for thinking the ECB shouldn't hike.
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Anonymous
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April 23, 2008 at 11:22 AM ×

Hi MM,

will you please help me solve my personal “cheap gamma conundrum”? On Monday, April 14th, 2008, you seemed to be expecting an increase in equity markets volatility, due to a number of earnings reports coming due in the following days; on Monday, April 21st, 2008, I read you were instead long a butterfly centered on 1360 on SPX. Now, if I’m not wrong a long butterfly is an approach designed for a low volatility environment, isn’t it?

As per today post, my daily job as a credit analyst allows me to state the followings: a) 4Q-2007 Italy’s official GDP is still going through statistical revisions, but such a figure is likely to set in the range –0,2% and -0,5%, on a quarterly basis; b) many small and medium sized firms are having a really hard time servicing the outstanding debts, both financial and account payables. I really think that Mr. Berlusconi has chosen the wrong time to become Prime Minister for the third time in the last fourteen years…

Read you later AT

PS - I know you’re busy building up your real portfolio and the blog portfolio is therefore suspended (for the time being, I hope…), but a brief resume of trading strategies currently held might at least prove helpful while assessing your current views on the markets. As far as I know you’re the only blogger out there who has so far been willing to openly and consistently accept putting his views at stake, making your blog a refreshing oasis in the desert of financial and trading blogosphere. We’re not here to passively replicate your strategies, but the old P/L was an easy way to test your views; there’s no need to update any trade on a daily basis, since you could just attach a brief resume of positions held.

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Macro Man
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April 23, 2008 at 12:49 PM ×

AT,

a few weeks ago I took the view that the "pain trade" in equities was a drift higher, so I put on the call butterfly on the SPX, which is indeed a short vol position. However, as earnings week approached and with vols lower, it seemed like a good idea to buy some optionality back in some market. As it turned out, I got screwed on the gap in the S&P on Friday, and after a lot of work broke even on my long gamma position.

That Italy has yet to release its Q4 national accounts data even as the UK and US are about to release Q1 is a succinct example of why interest rates and the currency are not the biggest problem facing Italia.

As for my current positioning, I am short dollars against a panoply of currencies (the dollar is toast trade), which is working well; long the front end of the US yield curve, which is not; long large caps/short small caps through futures, which is doing well; and have tried and failed to short sterling and go long yen, so I've given up for now.

All in, moderate profitability whilst running low to moderate risk; not a bad first month, I think, in this environment.

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"Cassandra"
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April 23, 2008 at 1:19 PM ×

1. au contraire, mssr MacroMan, Il Dulce Berlusconi's tan is most real.

2. Euro-Yen has again marched back to near-previous highs, though this looks like the outside of a correction on longer-term trend (weekly DMI) indicators and probably divergences on some daily technical indicators. This is probably a reasonable place to take a whack at it (or nearer to the end of the month). A$ vs Euro also looks like it could return to explore the upper reaches of its range while earning positive carry...

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Anonymous
admin
April 23, 2008 at 1:34 PM ×

Thanks for the attached summary; what you trade is actually what you’ve been writing on, nothing more and nothing less…

As for problems facing Italy: you’re darned right, but now Mr. Berlusconi is here to fix it all (laughs admitted…). Please refer to latest developments in the talks between Alitalia and Air France-Klm for gauging what’s expecting us: are we going to be bailed out by Aeroflot or Gazprom? That would be the real “socialization of risk” Steen Jakobsen has been writing a lot of lately: is Italian economy on the path to be rescued by a former KGB official?

AT

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Macro Man
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April 23, 2008 at 1:46 PM ×

Cassie, unfortunately I've already made my donation to the Church of EUR/JPY this month, and have little appetite to make another. I suspect I am not along, wwhich is why you may be right and it will work this time. As for EUR/AUD, I concur, and alas narrowly missed being filled on an offer that would have been one of my first trades.

AT< given that the Russkies are one of the regular buyers of EUR/USD, the least they could do is provide funds for some sort of a bailout...just like Roman Abramovitch provides pleasure to all the Chelsea fan FX spot traders that the Russkies run over on a regular basis.....

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April 23, 2008 at 1:53 PM ×

Cassandra, sorry but our nice Cavaliere (Knight) Berlusconi wears more make-up than Amy Winehouse and now his head seems paved with asphalt.. a little bit embarassing (for me as Italian..)
however I know well spain, i've come back from Valencia in these days and you can see more "Se vende piso" than usual but the economy in general seems to keep up relatively well.. the real problem is the finance linked to buliding sector.
For example now real estate mgmt firms earn a rent rate of 5% but they're paying euribor+, losing money also with depreciating assets.
Also in italy things are going bad but not dreadful.
Economic data in europe surprise everyday, probably there's a lot of inertia. But we will have huge problems ahead..
The real problem is that inflation comes from abroad and ECB can't solve this problem with rates. They risks only to burn real wages.

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April 23, 2008 at 2:51 PM ×

Hi M,

The solution to the French and German labour market is the huge number of less-than-fully legalized Romanians that are getting on the bus back home from Spain as we speak. This coincides with the year in which they no longer have to be illegals, BTW.

The same movement will also put a bit of spin on the relationship between Spanish unemployment statistics and macro numbers. Most of the positions immigrant labour is vacating were under the table, and will continue to be so. Pogey is collected on the surface, however.

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Anonymous
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April 23, 2008 at 4:59 PM ×

Hard to fault your logic MM other than you seem to have selectively highlighted the data that suits your view. I see yesterday € 2x10's swap curve inverted for the first time ever.....caution with those backward looking indicators. All is not well in euroland.....

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Anonymous
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April 23, 2008 at 5:09 PM ×

Great post, MM! One of your best yet.

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Macro Man
admin
April 23, 2008 at 6:07 PM ×

Anon @16.59

Naturally the data is cherry-picked to a degree...though I think in the case of inflation and labour markets, it does represent exactly what the ECB is looking at when they speak hawkishly. As to the Spanish and Italian datapoints, yes they are well-chosen examples, but they do represent factual counterpoints to the oft-expressed but rarely-quantified pronouncements of doom for Club Med.

I am not suggesting that the ECB should hike per se....merely observing what some of the data has to offer when one removes the blood-tinted spectacles...

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Anonymous
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April 23, 2008 at 8:24 PM ×

18:07- Fair enough. However I fail to see why the ECB should be applauded. They have failed to fulfill their often proclaimed sole responsibility of their single needle compass- controlling inflation. As for growth, we'll see soon enough....

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Anonymous
admin
April 23, 2008 at 10:14 PM ×

Great post,

Here in Espana, the brits are having a really hard time as the xchange rate is so-oo bad.E1.24 or so.last year E1.42 or so, Commercial activity is really low,Se vende signs?? The company making these signs is the only one making money. Spain and other EU countries are very slow to comment on their problems,,, We all know there is a banking problem, but ask the bankers to comment??? NO Way,

We all, ( Friends etc. think we have more BIGGG problems than is being admitted right now.

Best regards, Keep up the good comments.

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Anonymous
admin
April 23, 2008 at 11:11 PM ×

I completely agree with Charles Butler. Foreign analysts like Macro Man work with partly fake data; Spain has 700K to 1M illegal immigrants, who do not show up at stats, most of them will get unemployed in the next 2 years and many of them will then migrate to France and Germany. The effect will be the same as de-regulation in the labour market.

This will hopefully turn out to save the day both for Spain and the rest of Europe.

Greetings from Madrid,

Diego

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Anonymous
admin
April 24, 2008 at 12:50 AM ×

Don't care what they are smoking but I wish the FED would light up a bowl full. These bastards are almost assuring a depression in the US with each rate cut.

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Anonymous
admin
April 24, 2008 at 4:51 AM ×

You take the data convenient for your conclusion. i can give some facts: increasing spreads of italian sovereign bonds over german ones, spain´s current account of 10% and a construction sector weighing 15% of gdp (vs 6% average eurozone countries), you forgot to mention irish and greek real estate bubble, retails sales data for february was awful outstanfing germany with an annual decrease of 2,4%. While ECB kept rates at 2% absurdly not so far ago, the eurozone growth was below potential and last year was the highest in the last 10 years despite a 4% rate fund. Maybe in those years some reforms have been taken and now are payng off. Nonetheless, i dont think ECB can keep rates at this level , sooner or later they will have to lower.

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Macro Man
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April 24, 2008 at 11:16 AM ×

Anon @ 8.24

While it's true that they have not met their target, I do feel that they chosen a more appropriate course between microeconomic solutions and macroeconomic solutions than the either the Fed or the BOE.

My anecdote from Spain comes courtesy of my buddy from Barcelona, with whom I dined on Tuesday night. He runs a small IT consultancy, and I was surprised to hear him say that business is actually improving after a slow 2007. He also noted that "for the past few years, any Spaniard who wanted to work could find a job" and confirmed that immigrants were performing a large number of tasks...not all of them low value added. He also complained about rising consumer prices.

Meanwhile, if the ECB wanted to set rates for Ireland, they should take 'em to about 7%. CPI inflation there has been rampant, and housing is still depressingly higher than it was when Macro Man flogged his Dublin residence four and a half years ago.

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