Everyone loves ECB day. The set up for this one was particularly good – I like to think of it as ‘Peak Draghi’. Everyone knew what the setup was, and most people were pretty much on the same page. The market confidently expected:
– A 10/15bp cut to the deposit rate
– An increase in the pace of QE by 10bio
– An extension of the length of QE
– Expanding the scope of QE to include corporate bonds, munis
– An extension of TLTRO
But on top of that, as though they felt that it’d give them some kind of edge, most pundits and market participants also felt they needed to tack on some additional, more esoteric announcements. It’s almost as if everyone was stepping over themselves to predict the most surprising dovish thing. On the table was:
– He might hint at eventually buying equities
– Might make the program totally open ended
– Might introduce a two tier depo rate (a penalty rate for excess reserves)
The market moved in the weeks preceding the meeting as each of these ideas was digested, or widely broadcast. I saw tier 1 hedge funds gunning for all kinds of outlandish scenarios in this vein – and not just putting on a wingy option, paying a few cents for a small chance of a big payoff, taking big directional bets in illiquid markets. I was as guilty of this hubris as anyone – and the two tier depo rate business seemed pretty plausible to me – a neat way to get around the issue that by lowering the main refinancing rate, the ECB would pay people money to borrow money from them – which looks a bit too much like helicopter money for people’s taste! The biggest positions were in currencies – where the world and his dog were short Euros anticipating a dovish ECB and a hawkish Fed. In my world, people got long of ASW spreads (partly because of the implications of the two tier thing), and paid 10’s30’s, as well as buying a tonne of short dated calls on Euribors and Schatz, and receiving front end EONIA.
And we all know what happened next. Huge moves in all of those things, against the speculative community. A noticeably downbeat and nervous looking Draghi gave us only 10bp of Depo rate cut, included Muni bonds in QE (which just serves to alleviate the bund shortage, hence arguably a tightening!), and extended the program by 6 months. With staunch opposition from the rest of the governing council, which Jens Wiedman was crowing about on the wires in the immediate aftermath, and no change in the ECB staff forecasts – Mr Draghi had little wiggle room to deliver the knockout blow markets needed. Still this on its own would not have been enough to deliver the carnage we saw, the real issue here was the market pricing in a reaction function that simply wasn’t there.
What do I mean by this? Well, the market had persuaded itself that Draghi was ‘Its kind of guy’. Everyone anticipated that the ECB would perceive what the market expected, and do more. This simply isn’t a stable equilibrium in terms of pricing an event. Market participants with that belief about draghi would like at ANY level of rates – and imagine they must go lower. Ie, whatever is priced now – they would believe the ECB would exceed. They would always buy bunds – no matter what the level. I’ve often observed amongst my colleagues, especially on the trading side, a tendency to have a kind of unhealthy relationship with central bank governors – like some super fans have with celebrities. The reality is, it’s not a two way street. Draghi is not trying to make the Bund go up, or the Euro go down. Those things may help his cause, but he’s not trying to change those things – rather he’s trying to change the real economy. Forgetting that cost a lot of people dear today. In any case – Peak Draghi has been and gone.