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The most significant event for the markets last week was Draghi
disappointing markets that were eager for an increase in ECB QE. Instead, the
ECB President cut the deposit rate by 10 basis points to -0.30% and extended
the current easing measures to March 2017, and beyond if necessary. Markets
saw this action as insufficient with expectations across the board being that
the ECB would sizeably increase their current easing measures, rather than
just extend them. This was shown be clear declines in both stocks and bond
prices, as well as a significant rally in the Euro.
Whatever It Takes
This is the key reason why the markets reacted so viciously to the lack of
an increase in monetary easing by the ECB. In July 2012 Draghi famously made
the “whatever it takes” comment regarding the preservation of the Euro. Since
then markets have interpreted the remark to mean that the ECB will not
disappoint on matters of monetary policy, that is, that they will act as
expected. However, this interpretation should be used more carefully as it is
easy to confuse “whatever it takes” with “whatever the markets want” when
considering the ECB’s actions, which it appears markets have now done.
The comment was originally made in the context of stopping a breakup of
the Eurozone during the midst of multiple debt crises that threatened to end
the Euro. However at present, we are not on the verge of a crisis. While
economic data, particularly regarding inflation, is poor in the Eurozone, it
is not nearly as severe as situation faced when Draghi originally made the
comment. Therefore, the response from the ECB was always likely to be more
measured than “whatever the market wanted”.
Furthermore, the market had reached an almost excited state about a
massive increase in ECB QE. Expectations had begun around the deposit rate
cut that was actioned, but as this was priced in markets anticipated that
further measures would be required. The consensus became that an extension to
the current QE program would be put in place. Then some began to speculate
that an increase in QE would be made, which in turn became widely expected.
In short, the markets got ahead of themselves.
Draghi is prepared to do “whatever it takes” to ensure that the Eurozone
does not break up, but given that we currently are far from that situation we
cannot expect the ECB to act as if we are on the verge of a crisis. The
action taken was that which the ECB deems as being required, which was not,
and will not necessarily ever be, what speculators want.
Draghi Is Not A Day Trader
Taking a step back, we will consider the action that was taken: a deposit
rate cut and an extension of the current QE. This is still a strong response
and a further increase in the highly accommodative stance of the ECB. The sky
high expectations of investors were not met and the market has responded
negatively to this, but the reality is that the action taken will very likely
be sufficient for the ECB’s goals to be met.
The mandate of the ECB is not to satisfy market expectations. If central
banks simply looked to take whatever action the markets had priced in they
would effectively be making policy on public opinion, which would likely have
dire consequences. Instead the ECB’s goals are price stability, full
employment and balanced growth. This means that Draghi must look to the
longer term.
Although day to day market reaction and confidence in policy making is
important, the medium and long term response is far more so. As the ECB
targets economic health, if the action taken last week sees this health improve,
then markets will respond positively to that economic data. This reaction to
economic data is the effective medium and long term response to last week’s
announcement. Therefore, it is the actual effect on the economy that the
market will react to in the long term, which also the target of Draghi’s
latest measures. Accordingly, it makes sense that the ECB target longer term
goals, as these are in fact far more important.
Conserving Ammunition
In our view the action taken last week is a tactical win for Draghi.
Market expectations were too high, which means that a negative reaction would
likely have been seen if anything short of a massive increase in QE was made.
Given this and that the Draghi did not want to massively increase QE, the ECB
had the option to take the minimum level of increase in their accommodative
stance. This means that they still have a considerable amount of easing left
to use when they believe it will be more effective.
This month we will see the Fed hike rates. This tightening of monetary
policy could push the USD to make new 10 year highs, and over the longer term
will further increase its strength. This will likely undo the 2.6% rally in
the Euro seen on the day the most recent ECB meeting. As external factors are
therefore likely to weaken the Euro, there is less need for the ECB to
directly intervene and take action for the same effect.
Using an increase in QE in early 2016 would also likely have a greater
impact. This will allow time for the effects of the rate cut and QE extension
by the ECB, and the rate hike by the Fed to begin to flow through to the
economy. During this time the markets will move past the initial negative
reaction seen last week. If more QE is then required, the ECB can act as
such. If it is not, then the ECB has not wasted valuable economic stimulus
that was unnecessary.
Trading ECB Policy
The Fed hiking rates later this month is now all but guaranteed, which
makes trading ECB policy more of a story for next year. We were long European
equities in anticipation of more QE last week. However, we also sold topside
protection on equities via out of the money call spreads when expectations
became more extreme. We have since exited each of these positions for a
profit.
From here we will look to establish trades based around the next
significant ECB policy move. This is most likely to in early 2016 once the
initial effects of the Fed rate hike have been felt. Therefore we will look
to position our portfolio to take advantage of this through the rest of
December and early next year before the action is fully priced in.
To take advantage of the ECB’s actions ahead of this, one must look to US
markets and the Fed. The December Fed hike has been sealed by the strong
payrolls print on Friday. This hawkish action will have a bearish effect on
gold, causing it to continue to move lower over the long term. We have
discussed in depth how fresh
ECB QE would be bearish for gold, so the lack of it will likely have a
bullish effect on the metal in the near term.
Therefore we will look to trade ECB policy by taking advantage of any near
term rally in gold prices and shorting gold above $1125, before resistance at
$1150 sets in. These short positions will appreciate as the ECB approaches
the next big move, but will also gain value as gold falls towards $1030 on
the Fed hike.
In addition to our trades on gold, we will also look to trade volatility.
The highly accommodative stance of central banks had created the Global
Central Bank Put that we have taken advantage of on multiple occasions.
However, with the Fed tightening and the ECB taking a less accommodative
stance than previously expected the effect of this put is decreased. This
means that volatility has the potential to increase as the calming assurance
that this put provides is diminished. Therefore the VIX is susceptible to a
move higher outside of its current 15 to 20 range, which we will look to take
advantage of.
We will signal our subscribers when we open these positions, providing
them with the exact trades that we open in our own portfolio. We will also be
publishing our regular market updates with further analysis of the future
action for the ECB, the December FOMC meeting, and how we are trading gold,
volatility, and other markets to our subscribers only. So for more
information on how to become a subscriber, please subscribe via either of the
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