Not real QE until sovereign paper is on the table

Outlook:

We were shocked and pleased that Draghi fired the cannon he has been claiming to hold in reserve for a long time—from the Spanish crisis in 2012 or last spring, depending on how you count. The rate cuts plus the ABS and QE announcements were precisely what was needed to jolt the comatose patient back into consciousness. Nobody really believes banks are going to start lending madly or that monetary policy alone will goose economies back to health, but the measures show (1) the ECB is no longer disastrously behind the curve, i.e., it can be responsive, and (2) the ECB can once again wear its credibility halo.

That’s if the banks cooperate and start creating assets the ECB can buy. If not, and the process will prob-ably not proceed at an American-style pace given the asset-quality and stress tests, it won’t be long be-fore we hear about the ECB needing to buy sovereign paper. That would be “real” QE and as far as we can tell, Germany continues to oppose it, despite the occasional conciliatory word. Notice that Draghi’s status is so high that hardly anyone is saying the emperor has no clothes, and yet the WSJ naming it “quasi-QE” is perfectly accurate. It’s not real QE until sovereign paper is on the table.

Curiously, we think the structural reform aspect of Draghi’s Jackson Hole speech is where we should be looking for the real growth-drivers. Draghi was not very clear for obvious political reasons, but encom-passed in structural reform are words like tax cuts, unions and red tape. “We can provide as much credit as we want. But if the person who plans to use this credit for a new business has to wait eight months before he or she can open this new business, and then she has to pay lots of taxes, this person will not apply for credit.”

Italian PM Renzi is a prime example of the structural reform problem—Italy is technically in recession, and Renzi faces an impossible political situation and a nearly hopeless fiscal one (debt over 130% of GDP vs. the Stability Pact’s 60%). He can’t do infrastructure projects because there’s no fiscal wiggle room. That leaves drastic action on state pensions, unions and red tape. Renzi (who also became the 6-month rotating president of the European Union Council in July) has met with Draghi and sometimes at length. It seems obvious that one of the things they are cooking up is a massive overhaul of labor lawsand the vast public sector generally. Maybe Alitalia will become the poster child—it was bailed out to the tune of €500 million last year and Renzi has already said to the unions they must accept job cuts or the company will be dissolved instead of being sold. He doesn’t want to privatize Eni and Enil, the crown jewels of the state-owned industries, but he wants to get rid of others and wasn’t shy about selling fancy government cars (some on eBay, no less).

Renzi is the ideal case for structural reform—up against the fiscal wall, scrappy, and with one hell of an ally in the form of Mr. Draghi. Now that Ireland, Spain and Portugal are on a recovery path, Italy should be the new focus. Besides, there is chatter that Draghi seeks Renzi’s job when he leaves the ECB. Suc-cessful Italian reform would arguably be the biggest achievement, bigger by far than what is passing for QE at the ECB. Forget Greece and France—they are incorrigible.

Here’s the problem--markets don’t like complexity and nuance. Traders prefer stockbroker economics and responding to headline events and sound-bites. Traders are also weary of following Italian politics. Berlusconi wore us out. That probably means the usual jumping to conclusions and delusional position-ing. We can suggest that the euro sell-off is already vastly overdone. It’s on the same scale as the sell-off triggered by the sovereign debt crisis, and nobody thinks the ECB actions deserve to be considered com-parable. The sovereign debt crisis entailed questioning the continued existence of the eurozone member-ship. The latest ECB stories are piddling in comparison—mere tweaks.

So, while Draghi has achieved considerable change in the context of the usual degree of ECB activity and responsiveness, it ain’t gonna work without more. More QE, more reform. At a guess, the diagnosis of “too little-too late” means the post-Event consolidation period will be sheer hell. We can have periods of hopefulness followed by periods of acknowledging ineffectiveness. We must never forget that mar-kets forgive the eurozone failings and shortcomings that would fell a lesser currency. Besides, some-thing can always come out of left field that we are not factoring in today. Oil prices could go to $150 (on Russia or the Middle East). The US could sink back into recession from what looks today like a momen-tum-full recovery. US GDP could be 1% instead of the newly expected 3%. We could have another 9/11 or somebody could get assassinated. China could get a hard landing. The number of things that can go wrong—and make the ECB appear puny—comprise a long list.

We won’t start mulling over the longer-term consequences of the ECB actions until after payrolls this morning. Estimates are 220,000 to 225,000, with ADP’s 204,000 for the private sector something of a disappointment. Bottom line, the number has to be over 200,000 or we will see a dollar sell-off. In fact, it will probably take a number at the high end (over 225,000) for the dollar to escape the usual Friday position-squaring. We have two conflicting cases of buy on the rumor/sell on the news. One entails prof-it-taking in the short euro position and the other entails taking profit on the long dollar after payrolls. We don’t expect a blow-out, but you never know.

Also, note that futures roll on Monday, with many exiting the September contract today (as we will). By definition this means closing long dollar positions that are very big. Normally the same positions get placed at the same time in the next contract (December) but in lesser amounts, since the preparation for the ECB was extreme. We often see a one-time, short-lived reversal at the rollover and we should proba-bly gird our loins for a sizeable one this time, too.

And yet the divergence between the US and Europe is crystal-clear. Divergence is one of those key words that traders love to hang their hats on. It’s not going away. We continue to think the Fed is not in any hurry to hike after ending QE next month, but never mind. Traders want to speculate on an early hike (before “summer”). That provides a broad dollar base.

Getting annoyed at a two-handed economist? It’s all in the timing. We predict a minor pullback in the dollar today that has the potential to get sizeable on Monday/Tuesday next week, but a dollar recovery going into the Fed meeting on Sept 16-17. The problem with this scenario is that it’s untradeable. You would be going long the euro (and the yen), against trend. Fading the trend can be fun and profitable, but trend-following is still the prudent strategy. That means sticking to the trend but either close stops (that will get hit) or really wide ones (that can easily get hit, too). Guerilla entries hardly ever work under these circumstances. So, weirdly, the right course of action in the face of pullback risk is to get out and stay out. This is very hard to do when a new trend has appeared so clearly.