On Thursday, Mario Draghi pulled off a magic trick.
He convinced markets to look through the omission of the reference to further rate cuts and the more rosy assessment of the economic outlook by lowering the ECB’s inflation forecast.
Ultimately, the market read Draghi (and the presser) as dovish. The result: a fresh June low for the euro.
Here’s Bloomberg’s recap:
EUR/USD fell to a fresh low for June, slipping to 1.1166 with little fanfare in morning trading, then briefly rebounded back above 1.1200. Macro and model-driven accounts continue to trim EURlong positions after the shared currency extended its drop following its failure to breach its post-election high at 1.1300. Remarks from ECB’s Nowotny that there is “risk that inflation rates come in even lower if I assume a further increase of the euro exchange rate, which would be inflation dampening” added to the cautionary tone aired by Draghi Thursday. On that day, the ECB trimmed its inflation outlook while acknowledging recently robust economic data, a step that weighed on the shared currency.
Was this a mis-read by markets? You’ll recall what we wrote earlier this week in “Josephine Witt’s Reign Is Over Or, Central Banks May Actually Mean It This Time“:
Recently, you kinda get the impression [central banks] are going to try and dig themselves out of this for real. Because it’s getting increasingly difficult to deny the market distortions they’re causing whether it’s absurd equity valuations, credit spreads that are increasingly detached from fundamentals, bonanzas for carry traders and vol sellers, etc.
“For good reason, we’ve gotten used to taking everything with a grain of salt,” Bloomberg’s Richard Breslow wrote on Wednesday, referencing central banks’ multiple hawkish bluffs. “It’s probably better to err now on giving them a serious dose of the benefit of the doubt.”
Well either markets didn’t give Draghi the “benefit of the doubt”, or Draghi intentionally put a dovish spin on an otherwise hawkish statement. More likely: it was a little bit of both.
Whatever the case, we didn’t see much of a freakout following the shocking result of the UK elections. Sure, the pound reacted and yes, we did get a tech selloff in the US, but consider this from Bloomberg’s Friday credit wrap:
Election? What Election?
- If the synthetic iTraxx indexes are to be believed, then the surprise result from the U.K. election is an isolated affair. Sterling cash credit spreads pushed out to the wides of the week today but Main and Xover both pursued their grind tighter, with the latter hitting levels last seen in September 2014.
- That said, the macro and Brexit challenges facing the U.K. government over the coming days and weeks are likely to fuel persistent investor uncertainty and may dampen market activity
- But no meaningful negative consequences seen for the GBP primary market so far as several issuers are said to be eyeing funding opportunities in the sector
- EUR secondary cash indexes appear becalmed as the week draws to a close, in the wake of earlier volatility; Banco Popular and Liberbank
- EUR IG and HY straddling unchanged at 47.60 OAS (+0.86bps) and 243.55 OAS (-0.05bps) respectively as of 3.40pm London
With all of the above in mind, consider the latest from Citi’s Hans Lorenzen who notes that “the most obvious missing element [Friday] morning was simply any semblance of a ‘normal’ market response to extreme political uncertainty in the UK.”
Lorenzen’s simple explanation: the “magicians” are still pulling the strings.
If the mark of a true magician is to make objects disappear just when the audience felt sure it was observing them.
- It’s a kind of magic – From the surprisingly muted reaction to extreme UK political uncertainty to the vanishing hope of any hawkishness from Draghi, central bank action is allowing markets to maintain their remarkable ability to ignore almost any amount of political or economic uncertainty
This week has felt magical to us on multiple fronts. The most obvious missing element [Friday] morning is simply any semblance of a “normal” market response to extreme political uncertainty in the UK. Then there’s the amazing vanishing act carried out by what merely weeks ago seemed an unassailable Conservative majority. And to complete the hat trick, any hope that Draghi might actually sound even slightly hawkish while announcing the ECB’s turn away from an easing bias on rates seemed yesterday to go up in a puff of smoke.
The common theme uniting the three remains the remarkable ability of the market to shrug off seemingly any amount of political or economic uncertainty – provided the central banks keep promising to work their magic. As such, to us the spread outlook in both € and £ therefore depends much less on the rather intractable complexities of the political and economic outlook than it does on the minutiae of whether and when central banks remove some of their currently extreme accommodation.
As such, we think it would be a mistake to ignore the, albeit very minor, steps the ECB took in a less accommodative direction. Not only were references to downside risks to growth removed from the statement along with any reference to lower rates, but the rise in GDP forecasts also speaks to an ECB that is less concerned about the outlook going forward. Yes, that was partially obscured by the fact that inflation forecasts were revised down, but much of this has to do with moves in oil prices – rather than, as Mr Draghi himself admitted, any fundamental changes in the economic backdrop. Contrary to prior speculation of an across-the-board reduction in inflation forecasts to 1.5%, the reduction for next year (from 1.6% to 1.3%) was far larger than the cut to the 2019 forecast (1.7% to 1.6%). And even there, the ECB’s quarterly forecasts show inflation on a steadily rising trajectory from the first quarter of next year, hitting 1.7% by the end of 2019. Given that it’s mostly the 2019 forecast that the ECB looks to as its reference for its medium-term inflation target, taken together [Thursday’s] shifts imply a modest move away from the previous status quo.
As we’ve argued previously, the market faces a substantial change in the supply-demand balance in 2018. In terms of € IG credit specifically, we expect net supply that will need funding from private investors to increase from about €70-80bn in 2017 to €150-170bn next year. With credit so tight to fundamentals (as indicated by our credit valuation report) we find it hard to see where the marginal demand comes from without an adjustment in spreads. More broadly, the European fixed income market will see a massive shift in the supply-demand balance when the ECB tapers. For now, with the punch bowl (or is it a magician’s hat?) still full of liquidity, the high opportunity cost of not investing is helping to sustain the status quo. But that doesn’t mean that asset prices have actually managed to decouple from central bank balance sheet expansion.
And if this is starting to sound dangerous to you, “do not be alarmed, what you’ve just seen is considered safe“…