ECB: The Force Re-Awakens

If you're reading this, you probably don't need Macro Man to tell you what happened at Draghi's press conference yesterday, nor how markets reacted.  The ECB president left little room for interpretation; the only way he could have been more dovish is if the ECB had actually eased policy.  In fact, he was probably even more dovish that that; in many cases, the anticipation and build-up resonate more than the event itself.    Consider yesterday's press conference as a trailer for ECB: The Force Re-Awakens.

One comment that Macro Man would like to make is to commend Mr. Draghi's manner of communication.  Throughout his tenure at the ECB, he has generally taken pains to speak fairly clearly and with the impact he has upon markets at the forefront of his mind.   He has clearly not always liked the message that he's had to convey, but in general he's endeavoured to leave the market with a  clear picture of the institutional mindset.

In this, the Italian is far superior to his native English speaking colleagues in Washington and London.   While they waffle and flip-flop, Draghi will admit that he has changed his mind and clearly enunciate the factors that drove him to that decision.   Macro Man cannot ever recall his taking recourse in the word "model", which is such a favorite of the current Eccles Building incumbent.  The ECB is "working and assessing".....the Fed and Old Lady are "waiting and seeing."   'Nuff said.

So.....the zillion dollar question is "what now"?  The euro, which was referenced by Draghi on several occasions, predictably fell out of bed at the prospect of more QE and/or a deposit rate cut in December, taking it down to fairly critical support.

So....do we chase or do we wait for a pullback to sell?  Back in the good old days, the answer would be easy.   You'd sell every day for a week, usually at lower prices each time, and then pause to assess the state of play.  In fact, that strategy worked very well during ECBQE1, where the market clearly didn't have enough of a short position and had to chase it down.  That move, however, was notable for two things:

* It actually bottomed at the same time the ECB actually started enacting the QE program announced in January

* The Fed was still in the "teaser trailer" mode for Liftoff, leaving markets almost rabid with anticipation (remember when some people thought they might go in June?!?!)

With the power of hope working on both sides of the trade, small wonder that it worked so well in the first couple months of the year.  Since then, however, trying to momentum trade the euro (or most other non-EM currency pairs, for that matter) has been an exercise in futility.   Not that that can't change, of course, but one also needs to consider the Fed's reaction function in all of this.

To be fair, there isn't that much priced for December...just a 30% chance.  However, given that the Fed seems to take its cues from the market rather than giving them, and with the small likelihood of meaningful progress emerging on the inflation front in the next couple of months, there still remains room for Fed expectations to ratchet down...potentially undermining the dollar.

This is admittedly a tricky one because it seems likely that different measures of the threefold mandate will be delivering different signals.   The Fed, like the ECB today, has noted the strength of the currency and its impact upon inflation.   Given the likely trajectory of ECB policy, will this Fed have the cojones to deliver a liftoff in the same month that the ECB throws more gas on the monetary fire?  It seems dubious.

On the other hand, it now seems possible that with favorable seasonality approaching swiftly, we could see equities make a bid to ramp into year end, which would assuage some of the concerns that emerged (whether they'd admit it or not) when equities dumped in August/September.   Stocks on both sides of the Atlantic have breached their September highs, suggesting that we've put in a double bottom.

Macro Man would note that European stocks dramatically outperformed their US counterparts in the first quarter of the year when QE fever was rampant; given his views on the relative values of the two markets (even with US technology having it off, apparently), readers will be unsurprised to hear him bang the drum once again for European stocks.

Finally, it's perhaps worth putting into context the scale that the ECB (and BOJ) could ease to bring them into line with other central banks.  The chart below normalizes CB balance sheets (denominated in USD) to 100 in January 2007; observe that the two CBs currently engaged in QE lag far behind the Anglo-Saxons who've finished with it.   (The PBOC balance sheet largely reflects FX reserves, which is a form of quasi-QE insofar as the money is deployed into foreign asset markets.)

So the Force is re-awakening (not that's it's been asleep this year), equities are breaking out, and the euro is right on support courtesy of the second highest volume day on EBS over the last four years.  Macro Man reckons you have to have at least a small EUR/USD short on (say 20% of desired), just in case it dumps with no let-up.  Hope for a bounce to sell more but be prepared to watch it go straight down, particularly if real money and macro throw their weight behind the position.

Somehow (and he cannot believe he's saying this), Macro Man finds a European equity long easier to stomach psychologically, both outright and against the SPX.  If the Fed jellies, the outright will perform well, and if they somehow actually do put rates up, one would posit the spread will do well...in fact, the spread should do just fine even if they don't go.

One can only hope that the sequel to the current episode isn't Return of the Screw-Job....