A couple of weeks ago the world seemed pretty sure of how Ben, Abe and Dr. Aghi were playing their hands.
Ben's crowd were going to be tapering off on QE whilst Abe was going to do the heavy lifting from here on out and Dr. Aghi, having surgically removed the tail risk, was on look out and even preparing the ground for further easing and potentially negative interest rates to counter a dire European outlook. To that effect the obvious trades were to be long USD/JPY and Nikkei, gently short Euro, be long Euro Equities and to be starting to lighten up on US equities.
Then things started to go a little off course. US data become steadily poor enough for tapering of QE to be reconsidered and see the dreadful term "detapering" introduced - Here we would like to remind you of TMM's rule of ISMs - "Every time the ISM dips below 50, the Fed follows with an ease (rates or QE) "
To this end equities stopped sliding (temporarily) and started to respond inversely to bad US economic news and the Usd started to drift off, most noticeably in that most QE of crosses, Usd/Jpy.
But hope was at hand as the market waited for Abe to come to the rescue with Arrow 3, which was becoming all the more important because shake-downs in everything "Abish", though still being termed "healthy and corrective profit taking", were just starting to introduce elements of doubt as to the immediacy and uni-directionality of Jpy and Nikkei. If this slippage hadn't started occurring probably less necessity would have been attached to the potency of his 3rd arrow comments but as it was, the market didn't get a speech worthy of a Churchill or Eisenhower and as TMM alluded to in the last post, have started to worry that the all powerful Wizard may just be a small man playing around with levers, smoke and mirrors. So down we went again in Nikkei and USd/Jpy, already weak, was given another kicking.
But on the sidelines something else was happening. Carry trades in general had started to catch fire and the lack of guaranteed Japanese action set that nightclub without adequate fire exits that TMM have been warning about for a while, High Yield Emerging Market, alight and the few exits were getting more than a little busy.
So it now fell to the ECB where Dr Aghi's reputation for cool creativity has remained at "David Bowie" levels.
However expectations for a dovish ECB were smashed today. In particular, Draghi’s statement that “price developments should remain in line with price stability” sounded neutral and this sent EUR carry trades, especially Euribor contracts, south sharply, with a concurrent rally in the EUR. Meanwhile this was like a bucket of petrol over EM Bonds and the slits of exits couldn't cope. Italy and Spain were caught in the ECB / EM crossfire and both 10yrs put on 20+bp.
With it now looking as though the QE baton has been passed back to the US, Usd/Jpy and associated NKY then melted in the flames.
No wonder we have had such large movements with perception of CB policy in all three major areas changing within the space of a few days, leaving people worrying that Abe might not be Superman, Dr Aghi might not be Super Mario and Popeye Bernanke may have to go back on the Spinach.
But lets look at them one by one, first the ECB.
Now, TMM is puzzled by Draghi’s statement. Because despite Draghi’s proclamations, EU Inflation expectations are NOT close to the ECB mandate. Below is a chart of 5y EU inflation expectations. We are now at levels from last summer, and before that 2010. At 1.5% for 5 years, TMM thinks any rational observer would conclude that the ECB is missing its inflation target of ‘close to, but below 2%’ by a sizable margin.
A possible explanation is that the ECB is trying to exert pressure on EU politicians to continue fiscal reform efforts, which has eased of late. In the final paragraph of Draghi’s statement, he said: “the Governing Council considers it very important that decisions by the European Council to extend the time frame for the correction of excessive fiscal deficits should remain reserved for exceptional circumstances”. Whilst TMM remain comfortable that data in Europe IS bottoming and that tail risk is not there (despite the sudden resurgence in European periphery yields), perhaps we should be concerned that the ECB, without immediate emergencies (tail risk) to deal with could be back to operating within their normal confines of inflation targeting and, comparatively to OMT swift action, may be perceived to be becoming sluggish in response.
As one wit posted to us.. "*S+P DOWNGRADES DRAGHI BAZOOKA TO WATER PISTOL"
But TMM think that the usual oscillation in expectation and outcome for ECB meetings will result in a swing at the next event with Draghi producing a "more Dovish than expected" result.
So what about Abe? It's all about confidence and TMM have been wondering just how much of the past few months rallies in Nikkei and USD/JPY have been the result of expectation and how much due to real action. Because if he lets this one slip and confidence of success vanishes, then so will the expectation and we will retrace all of that component. Which we feel is most of it. So with that in mind TMM really don' t think he will drop the ball right now and he will put on a show next week.
And the US? We have been throwing around all sorts of arguments and analogies, most of them medical ranging from tearing off the plaster of QE as quickly and painlessly as possible, to continued methadone prescription, to amputation and stem cell therapy. Once again, as with Japan, it all rests on continued confidence and here we have a balance between confidence in the continued supply of liquidity if the economy needs it against confidence in long term Fed policy, the two being slightly different. The other point of confidence is who follows whom. the market the fed, the fed the data, the market the data or the Fed the market. We would prefer to think that the Fed will, as they keep stating "do what is necessary" (as the ECB also keep saying) to which point they will try and play the Goldilocks scenario of just the right amount for any situation.
We would like to remain confident that despite the wild oscillations in central bank expectations the central bank Governors are indeed Governors - Those big Brass Balled governors on the steam engine of the World's economy and they can’t afford to choke off what confidence may finally have emerged.
One could argue that if this is the case then the medium term outlook for equities is pretty flat as the governor functions operate, so selling 1650 straddles in S+P, particularly during this recent high vol may not be as mad as it may currently appear.
The fly in our ointment is Emerging Market fixed income, where positions are being burned alive. Could this become contagious? Well the most encouraging sign we have is that the countries suffering bond grief, such as Mexico actually had positive out comes in equities as that was happening. We are positioned for more grief in the likes of Indonesia and other structurally worrisome emerging markets that have been recipients of blind yield hunting, but don't think that the developed markets, with their brass balled governors are going to fall. In fact European equities are tempting us again.
Finally, to cap off a week of mayhem, we have the NFP lottery today. TMM won't put in a prediction other than to suggest it will "surprise".