Ok, so as noted on Sunday, Mario Draghi is probably going to thread the needle today. Here’s what we said:
This telegraphing was itself telegraphed (remember: there’s now forward guidance for the forward guidance – that’s how absurd things have gotten) earlier this month when Bloomberg reported that the ECB is set to cut QE in half starting in January while extending the program for at least 9 more months. As we put it, “the ECB is going to cut QE in half, but you and Draghi can still ‘Netflix and chill’ for another nine months.” Good luck scrubbing that from your mind.
If you’re looking for market turmoil around this announcement you’ll probably be disappointed. Draghi will thread the needle. He always does. Sure, the program itself is absurd and CSPP has created all manner of ridiculous distortions (see € HY for example), but once you accept that the whole thing is ludicrous on its face, Draghi has become a master of getting the messaging “right.” Maybe this time is different, but we doubt it. Over the longer-term, there are obviously questions as to what the taper will mean in terms of putting more of the onus on the market when it comes to filling the gap left by the taper, but that’s more an existential question about what happens in the post-QE era. Actually testing Draghi while the program is still in place is a dangerous game to play.
Who knows, that could end up being entirely wrong, bund yields could spike, and chaos could ensure, but we doubt it and besides, it wouldn’t be the first time we’ve been wrong this year, so fuck it.
But the overarching point is that between the market already knowing what to expect and with asset purchases to continue albeit at a reduced paced, it’s difficult to see this creating much in the way of near-term volatility.
Of course as we never tire of reminding you, this is always just a race against the clock: can you normalize in time to replenish the ammo ahead of the next downturn? That is, with the post-crisis policy response having clearly created the conditions for yet another bust (remember, untethered systems create rolling boom-bust cycles), it’s all about how much counter-cyclical breathing room can be restored via normalization prior to things turning south again.
With all of that in mind, here’s Bloomberg’s Tanvir Sandhu with some further color ahead of Draghi…
Markets will avoid a taper tantrum when the ECB announces its well-telegraphed plan for reducing QE today.
- Bond spreads and volatility are well-behaved, supporting carry trades in the near-term
- Lower QE purchases for longer has become consensus: 30 billion euro per month for nine months beginning from January. This will strengthen forward guidance and may limit moves higher in the euro
- Given the need to buy more time, Mario Draghi’s caution about any tightening of financial conditions amid low core inflation means that policy won’t stray too far from the middle ground
- Within its self-imposed limits on QE purchases, the ECB needs to be able to further ease at any point while keeping bond-market volatility contained
- Cross-asset volatility hasn’t repriced materially ahead of the meeting. The persistent low realized-volatility environment may push investors into carry-positive trades
- Effective ECB communication has helped push long-end EUR rates implied volatility to record lows this month. The three-month option on 10-year swap rates only prices in 2.7bps per day of movement
- Carry trades, via systematic short gamma strategies, can still perform well. Although, depending on what’s announced, there may be a need to adjust buckets. An increased emphasis on forward guidance would lead to an out-performance by short-volatility positions in the front-end
- Bund yields may gradually shift higher in 2018, helped by strong PMIs. But they probably won’t deviate too far compared with forwards, with the 1-year forward rate at 0.77%. That’s in advance of a likely year-end squeeze due to scarcity issues that may force closing of short duration positions that carry negatively
- The inflation distribution has narrowed and moved to the left in recent years, with wage indicators showing little sign of a convincing upswing
- While the inflation market has unwound the deflation premium, it’s reluctant to price inflation much higher, with the EUR 5-year inflation swap at 1.3% against core CPI of 1.1%. The option premium for the 3-year 1.5% inflation cap (used to hedge against rising inflation) remains just above its all time lows
- Against this benign environment, the key risk isn’t that the ECB is going to set off a sustained bond bear market — it’s that it might find itself low on ammunition if the economy or prices suddenly turn south