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The comment was originally made in the context of stopping a breakup of the Eurozone during the midst of multiple debt crises that threatened to end the euro.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particularly regarding inflation, is poor in the Eurozone, it is not nearly as severe as situation faced when Draghi originally made the comment.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 of 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.
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