The Cult of Draghi
With a view that Thursday’s important policy developments and market reactions are best not expunged from our analytical consciousness, it’s worth a brief market recap. Beyond the wild moves in now highly unstable currency markets, European market vulnerability was again on full display. Core euro-area equities indices suffered their biggest selloff since September.
Thursday’s session was also notable for the simultaneous declines in both stock and bond prices, an atypical dynamic especially problematic for so-called leveraged “risk parity” strategies. Ten-year Treasury yields jumped 15 bps (to 2.33%). Bond carnage was worse in the eurozone. German bund yields surged 20 bps (66 bps), with yields up 21 bps in France (99 bps), 25 bps in Italy (1.64%), 24 bps in Spain (1.72%), and 22 bps in Portugal (2.47%).
Despite Friday’s rally, it was a disconcerting week – in global markets, in geopolitics and for a darkening of the “social mood.” It’s worth noting that crude (WTI) traded below $40 on Friday, ending the week down 3.8% to a near 11-year low. Turkish equities were down another 1.8% this week, increasing three-week declines to 9.3%. Further selling pressure in Russian stocks pushed two-week losses to 3.9%. The Russian ruble dropped another 2.4%, ending the week at the lowest level since early-September. Brazilian stocks have dropped 5.8% over two weeks, trading near September lows. Mexican stocks dropped 2.8% this week to the lowest level since early-October. Dropping 3.1%, the Colombian peso traded near August lows.
Former Bank of England governor Mervin King (in a Friday panel discussion at the Economic Club of New York): “Just over three years ago in London, you made that magic phrase, ‘We’ll do whatever it takes and, believe me, it will be enough.’ And it had tremendous effects – a great success. Yesterday (Thursday) it didn’t seem to have quite the same effect…”
ECB president Mario Draghi: “It was not the same words.”
King: “Why do you think the market reaction was presumably to move the exchange rate in a direction that you wouldn’t have approved of. And are you concerned of that?”
Draghi: “Well, as I was saying before, they were not the same words. Let me just tell you how the whole story developed, really. It started in the last governing council [meeting], so about a month-and-a-half ago. We decided to make an assessment whether our monetary policy stance was adequate. And so we basically decided that by December we would decide what to do. Basically, we asked all the economists of the 19 central banks in the euro-area and the economists of the ECB, who actually meet in specific committees, to reflect on this. The assessment was, first, that some things were actually improving, as I just said. On the real side, the recoveries continued, though the levels of growth are still low. But it’s continuing; it’s gradually improving. It’s driven mostly by consumption. And the drivers of this recovery are monetary policy, oil prices and a certain stance of the fiscal policy which is between being neutral and mildly expansionary.
However, on the inflation side, we still see very subdued dynamics. The inflation projections that were delivered in December, yesterday, had a minor downward revision for 2016. But this is one of many downward revisions – one of a series of downward revisions. And these projections actually already contained the improvements in the markets until, say, mid-November. So that was a factor. And right after the cut of these projections, we also had other inflation data that was again slightly weaker than expected. So given this broad description of reality, what the committees did was to propose a package – a package of measures which is the one you’ve seen. This package was basically endorsed by the board and proposed to the governing council. And the governing council approved this package with a very, very large majority. Basically, there isn’t any story like I’ve seen written the last two days. What this package says is what I mentioned during the speech, it was a recalibration of our monetary stance which, incidentally, is the word I used in a speech I gave just before the last governing council [meeting] in Frankfurt. It was not a revolution. It was not a novel monetary policy change. So that is basically the story. And we consider the package that’s been proposed by the committees as exactly the right one.
It was clearly, as the markets have abundantly demonstrated, not a package that was meant to address market expectations. It was a package that was meant to address the reaching of our objectives on inflation. That is to be kept in mind. So the process was pretty robust. The approval process was, as I said before, a large majority of the governing council supported it. It was based on a broad proposal. So, again, some of the commentaries I’ve seen in the past two days dwelled on the presence of some dissenters – and what this could imply as far as the future monetary policies concerned. Like all central banks we have some dissent. I think if there’s one who has shown that unanimity is not a constraint to our monetary policy decisions, it’s me. The bottom line of what I’m saying is [that] QE is there to stay. And if needed, it could be recalibrated. Like, by the way, any of our other instruments – like it happens to all monetary policies everywhere in the world.
In the end, let me say one particular thing about what’s becoming the main policy instrument today – namely our balance sheet. Often people ask, ‘What’s the level – what’s the maximum expansion in your balance sheet?’ Well, the balance sheet of a central bank is a monetary policy instrument. As such, it should be utilized to the extent that is necessary to achieve the objective that our mandate asks us to achieve – namely an inflation rate that’s below but close to 2%. There isn’t any specific limit in using this. In conclusion, I think that we have the power to act. We have the determination to act. We have the commitment to act.”
King: “Your words just now, and also in your speech this morning, which if I remember correctly, towards the end you say, ‘There can be no limit to the extent to which the balance sheet can be used to meet our mandate,’ that is the key thing – meeting the mandate. Was that deliberately designed to try to offset some of the reaction yesterday?”
Draghi: “The speech today? No, not really. Well, of course. Let me say this, that’s why I said ‘not really’ and ‘of course’ because it has two parts. It’s actually a well-designed speech because it gives the whole thinking process… The first half is an explanation of why we react with our monetary policy to shocks that seem to have nothing to do with monetary policy – like oil price shocks for example. The second part, which is more closely linked to our recent decision, of course takes into account what we did and has been a fantastic opportunity for clarifying our objectives, our mandate, the process whereby we reached these decisions and give to you, here in New York City, a sense of how the European Central Bank in Frankfurt, a far distant place, actually works.”
Amazingly, he leapfrogged even Ben Bernanke back in the Summer of 2012 with his machismo “do whatever it takes.” Along with the BOJ’s Kuroda, the ECB grabbed the QE baton from the Fed and haven’t looked back. Unlike Kuroda and Yellen, he’s a “market guy,” even serving a stint as a Goldman Sachs vice chairman and managing director.
Market participants began falling out of love with Mario Thursday. Until then, he’d been the central banker equivalent of the Wall Street darling growth stock CEO that reliably always beats earning estimates. For the first time, Draghi was a major disappointment. Only two weeks ago he confidently assured the markets he had the quarter (oops, the meeting and QE growth) in the bag.
November 20 – Financial Times (Claire Jones): “Mario Draghi has dropped his clearest hint yet that the European Central Bank is about to inject more monetary stimulus into the eurozone economy, brushing aside staunch opposition from Germany’s powerful Bundesbank. The ECB president said yesterday that ECB policymakers would ‘do what we must to raise inflation as quickly as possible’. The remark echoed a promise Mr Draghi made during the region’s debt crisis in 2012 to do ‘whatever it takes’ to save the single currency.”
Thursday’s wild market reaction to Draghi recalled the many instances over the years when growth stocks were obliterated on an earnings miss. How many times have we heard some variation of, “How could the stock drop 15% when earnings only missed a penny? This is an obvious market overreaction!” Usually, however, those selling down 15% don’t regret exiting.
The single penny earnings miss tends to be a harbinger of worse things to come. It often marks an inflection point in the “story” – the beginning of the end of the game. With company management no longer able to “manage” predictable earnings growth, the sophisticated players and momentum speculators want out. While down big on misses, at least there’s usually big trading volume to accommodate sellers.
Draghi has been playing a dangerous game. He shot from the hip in 2012 and then forced his radical policy course down the throats of the ECB governing council. He stoked a historic Bubble in European bonds and equities, then essentially dared the ECB hawks (certainly including the Germans) to crash the party. Over recent years he’s become the Alan Greenspan of global central bankers: The hero and clever maestro. Mario the policy and market genius. In the nineties, the speculator world was content to bet on the Greenspan market backstop. These days, why rely on Kuroda or Yellen when Super Mario’s got your back.
Along the way, he’s attracted quite an adorning crowd – or at least a crowd of Crowded Trades. Euro devaluation has been one of the greatest ever gifts to financial speculation, ensuring the euro short has become one massive Crowded Trade. ECB QE and the resulting historic collapse in euro-zone yields have spurred Crowded Trades throughout European bonds and equities. Draghi’s “whatever it takes” has been an albatross around the necks of the Swiss National Bank, ensuring ultra-loose monetary policy and a Crowded Trade short the Swissy.
Similar pressures on the Scandinavian central banks have ensured similar consequences. Only God knows the amount of leverage that has accumulated throughout European fixed income.
For that matter, how much liquidity (and leverage) has flowed from Europe into U.S. securities markets? How much to Eastern Europe and EM more generally?
I have serious issues with contemporary central banking. Somehow, it has become accepted policy to openly manipulate and inflate securities markets. It’s the role of central bankers to dictate “market expectations,” just as over the years they’ve seen a crucial role in shaping so-called “inflation expectations.” Crucially, monetary inflation these days feeds “inflationary expectations” throughout securities markets. And as “money” has continued flowing into global market Bubbles, central banks have lost only more influence on inflationary dynamics in real economies.
In the face of Trillions of QE over recent years, commodity prices have collapsed and general consumer price inflation throughout much of the “developed” world has drifted downward.
Global central bankers have nonetheless adopted Draghi’s “whatever it takes” to ensure “inflation” reaches their “mandate.”
After the August “flash crash” – global market dislocation – central bankers again convinced the markets that they were willing and able to do “whatever it takes”. And as energy and commodities have come under further pressure (along with consumer price indices), expectations grew that more shock and awe was on the way. It’s a fool’s errand. Draghi, Yellen, Kuroda and others talk “inflation mandate” and markets hear endless “money” to inflate securities markets. And the more global Bubbles have inflated the more emboldened financial players have become of QE Indefinitely.
Draghi promises to ‘do what we must to raise inflation as quickly as possible’ – and then delivers no increase in the size of monthly QE purchases. There was no awe – only shock.
Tellingly, markets cared little about negative rates or an extension in the QE program. Flashing indications of latent market vulnerability, participants were demanding more “money” and they wanted it now. Draghi’s Friday talk of a “no limit” ECB balance sheet must have Weidmann and responsible members of the ECB at their wits end.
It’s the nature of monetary inflations that there’s always a need for more. Throughout history, it’s been ‘just one more round of ‘printing’’ or ‘just one more year and then we’ll rein things in’. But things spiral out of control – and there’s a lot of currency with a lot more zeros. It can end in hyperinflation, at least when monetary inflation is afflicting the real economy. Today’s strange variety is inflating securities market Bubbles. It will end with Bubbles bursting and confidence collapsing.
Integral to the bursting Bubble thesis is that policymakers are losing control. Granted, such analysis has about zero credibility when markets are in melt-up mode. But perhaps the markets’ response to Draghi is a forewarning.
A headline from Friday’s Wall Street Journal: “Crowded Trades Collapse: U.S. stocks, bonds and the dollar all tumble as popular trading positions are hit by the ECB.” And Friday evening from the WSJ: “Macro Hedge Funds Caught Off Guard by ECB’s Move.”
I’m sticking with the view that unstable markets will continue to pressure de-risking and de-leveraging. With currencies moving 3% in a session and the bond market succumbing as well to wild volatility, it seems obvious that players will have to respond by ratcheting down risk and leverage. It remains a self-destructive backdrop with way too much “money” chasing limited securities market opportunities. Popular trades now come with unfavorable risk versus reward.
I believe global markets are back in high-risk territory, and fragilities wouldn’t be as extreme if global policymakers had allowed an overdue market adjustment to run its course back in August. Markets rallied on notions of QE forever, while the fundamental backdrop continued to deteriorate. The commodities rout has worsened. Brazil has taken a turn for the worse.
Meanwhile, fragilities continue to fester in China. Efforts to stabilize a faltering Chinese stock market Bubble have stoked even greater bond market excess. Authorities are cracking down hard on the securities industry with troubling ramifications for faltering financial and economic Bubbles. Here at home, an acutely imbalanced economy beckons for (an inauspicious) “lift off.” The geopolitical backdrop turns more alarming by the week. And now, with only about four weeks left in the year, inflated confidence in global central bankers has sprung a leak.