Yields rule

Outlook:

Today will be horrible, with everyone trying to read the tealeaves of no fewer than six Fed speakers. We have Yellen, Evans, Bullard, Lacker, Dudley, and Fischer, whose topic at a conference is “The Transmission of Exchange Rate Changes to Output and Inflation.” The conference itself has the theme of “Monetary Policy Implementation and Transmission in the Postcrisis Period.” Yellen gives the opening remarks. We expect the usual double-talk and incomprehensible jargon.

What we need instead is some plain talking. Today even our hero Draghi confused some listeners with a two-word comment that core inflation is “somewhat weakened.” According to Bloomberg, Draghi was speaking to the European Parliament and he said "Signs of a sustained turnaround in core inflation have somewhat weakened. While the recovery will gradually strengthen the impulse underlying the inflation process, the protracted economic weakness of the past years continues to weigh on nominal wage growth, and this could moderate price pressures as we move forward.''

Bloomberg notes that it’s headline inflation that has been soft while core inflation has not been waning. “So where does ‘somewhat weakened’ come from? Does Draghi know something we don't?” Well, a great deal of this is Bloomberg trying to drum up readers, a new habit of late that is quite annoying since you never know what’s good perspective and what’s carnival barker overstatement. Bloomberg goes on, more reasonably, that maybe Draghi does know something. The next batch of inflation data is only a few days away (Nov 16) and presumably he gets it ahead of time. Eurostat has already estimated Oct CPI at zero and core at 1% (from 0.9%). Bloomberg deduces that if a revision is in the cards, the ECB will certainly go for more stimulus at the Dec meeting.

At a guess, Draghi is laughing his head off. While it’s not impossible he was giving a secret signal, it’s just as likely he made a mistake and didn’t intend to say “core” but rather just inflation generally, both headline and core. Even first-rate speakers make mistakes. Besides, we don’t need to parse down to the last word and punctuation mark to have already been given the message—the ECB intends to enlarge and extend QE at the Dec meeting, and probably cut the deposit rate to a deeper negative in order to widen the asset range it can buy. We have no reason to suppose that Draghi was blowing smoke when he made the announcement or that he is blowing it now.

If we assume that risk aversion is a function of uncertainty and we now have a lot less uncertainty from the two major central banks, the carry trade becomes a lot more appealing. The FT has a tortured article on the mystery of why the euro is not already the leading carry-trade currency. Two factors are preventing the carry-trade strategy these days—high volatility in the higher-yielding targets (like Turkey or Brazil) and acknowledgement that a fast change in the euro FX rate can wipe out the gains in a day. The carry trade has long been called “picking up pennies ahead of the steamroller” and this time the steamroller is Draghi. Any retreat from the more dovish stance would drive the euro up by a lot and very fast. A Nomura analyst told the FT “He [Draghi] needs to deliver. If he under-delivers, there will be a lot of disappointment in the FX market and you’d see a decent-sized rally in the euro.”

We say the implication is that traders are more cowardly, or perhaps that new regulations are restraining carry trades these days, or that the long-held bias in favor of the euro is still working its magic. We are inclined to favor the last one—the market remains bedazzled by the euro.

All the more for us when the market finally acknowledges that it’s not in Mr. Draghi’s nature to play games with the press and the market. He does not blow smoke. We would bet $10 that he disapproves profoundly of the Greenspan comment “If you understood me, I must have misspoken.” This is not to say Draghi is not capable of the most Machiavellian trickery, just that he must be painfully aware that the ECB is the only major functioning EMU institution and all eyes are on it. This is super-serious stuff. The ECB must be above reproach. So, bottom line, we give a 99.9% probability that the ECB delivers the wider/deeper QE at the next meeting. This “should” push the euro down another big notch, since the market seems to unwilling to price it in.

Let’s say the carry trade does come back. Who benefits? We hear from a Reader in Germany that it could well be Asia. “It is worth noting in the current leg up of the US dollar bull market, Asian currencies on the whole are outperforming developed market currencies like the euro and the yen. From the mid October lows, the Asia Dollar Index (ADXY) has fallen a modest 1.8% versus the almost 5.5% move in the Dollar Index, which by way of reminder, the DXY index is primarily skewed to the euro, with a 57.6% weight, followed by the yen with 13.6%, and the British Pound with 11.9%. Furthermore, it needs to be considered that despite record outflows from emerging markets, severe macro pressures in the likes of Russia, Brazil, and to a degree in China, plus commodities plummeting 50%, a remarkable lack of corporate casualties have emerged. Perhaps they will emerge, perhaps they don’t exist on the scale feared, or perhaps we won’t know, as a carry trade will mask over the problems if they do indeed exist.”

Whew. Does this mean borrowing cheap euros to buy Ali Baba or Sony?

And finally, we have more craziness from Bloomberg. The last time the Fed was hiking while Germany was cutting was May 1994, before the euro even existed. The US rate advantage over the Continent failed to lift the dollar—it continued to fall almost another full year, until April 1995. Gavekal’s Kaletsky, who can find a flaw in every diamond and is hardly ever right, says history may well repeat itself. “… it is far from inevitable that the dollar will strengthen.” Well, maybe, but not likely, magic or no magic. Yields do rule.

Note: We are the “expert” of the day at FX Street, here.