QE Is Dead. Long Live QE

Includes: FXE, GLD, IEV, UUP
by: Francesco Checcacci


While the Federal Reserve is engaging in more restrictive (or at least ending easy) monetary policy, Draghi has fired the bazooka, while the Swiss decided they had enough.

The obvious beneficiary will be the USD, while there might be a positive effect also for euro area banks.

However, in case of shock the dollar should keep benefiting while banks could tank.

Gold has started to behave as a currency again as a reaction of the ECB money printing, Swiss peg exit and overall uncertainty.

With this backdrop the wisest trades are probably going to be tactical positions on volatility and correlations at least until the smoke clears, and it might take a while.

Between drums rolling and trumpets playing, and a sideshow of the Swiss National bank announcing it cannot take any more pain, Mario Draghi has announced the firing of the famous bazooka: a round of quantitative easing comprising bond purchases, including sovereigns, to the tune of 60 bln euro per month. Markets duly cheered, without getting too worried about the details. And there lies the devil.

The detail, which should have worried traders, is that 80% of purchases is going to be carried out by the national central banks. Not a problem in itself, if it wasn't getting in the way of the ECB's stated aim in the last year or so: separating bank risk from sovereign risk.

This is not just a detail for geeks: monetary policy works through the so-called transmission mechanisms (read the banking system). It should be obvious that if banks in a certain euro country pay for their funding a lot more than their counterparties in another country the effect of, say, a decrease in interest rates will be different in the two countries. What this means in the current situation is that loser monetary policy benefits most those who do not need it (the 'core') and doesn't do much to those who do need it (the periphery).

Now either Draghi trusts the reform process in most peripheral countries to take its course to the point where the Germans accept closer, if not joint, fiscal responsibility or the party is spoiled.

Enter Greek elections. The party leading polls has promised a fight to cut its debt obligations. Traders are not losing their sleep on this one, but eurozone governments should. In fact they are the biggest holders of Greek debt at the moment. Essentially another Greek default would cost only Italy about 10 bln euros. Didn't Virgil warn them? 'Timeo Danaos et dona ferentes', which loosely translates as ' (I)beware of the Greeks, even when they are bearing gifts'.

The real problem, however, is not so much a debt restructuring, but what Mr. Tsipras is thinking of doing after that. He has promised not to get the Greeks on track with the world in terms of technology and efficiency, but to increase the salaries of Government employees. Is it a surprise that most of the many civil servants want to vote for him?

Trouble is Greece would keep living beyond its means, which means in a few years it's back to disaster, following the scheme of Greek tragedies, where hubris is invariably followed by nemesis.

But Greece is a small country and trouble there might be manageable.

What if populists all over the eurozone start back-tracking on reforms and winning elections?

I suppose the country most at risk is France. In fact the narrative of reform there has never really taken hold, while it has in the rest of the periphery. Spain and Portugal have already done their share. This leaves Italy and France still to implement growth-enhancing reforms.

The difference between Italy and France, as far as I can see from my vantage point (I am based in Tuscany, central Italy, and besides Italian and English also speak fluent French; further, I lived in Paris for 1 year), is that the average Italian wants change, while the average French does not: witness the showing of Renzi's pro-reform party (faction within a party would probably be more correct, but that would start a long digression) at the recent European elections.

I can see Renzi trying to frame the idea of reform in a way your average citizen understands, and people buying into this would go a long way towards seeing a real economic revival here, as other politicians and interest groups would be, although for the most part reluctantly, forced to agree on a new course.

Now will Renzi deliver? And if he doesn't, is it possible that anti-euro populists gain the upper hand? Honestly I see a higher probability of that happening in France through M.me Le Pen's Front National. A French exit from the euro, however, is unlikely to benefit France especially if it comes with a platform advocating everything people like you and me know is bad for growth.

I guess that would be enough to let hell break loose, but France would pay the highest price for it.

Now: this is not my central scenario but everyone would be wise to consider the possibility of it happening, especially since I doubt the markets are pricing it at the moment.

In the meantime gold has started to behave as a currency again as a reaction of the ECB money printing, Swiss peg exit and overall uncertainty. It is reasonable to expect that it might move tactically even higher in case of a Greek tragedy, but strategically it should be on its way to go back to fundamentals, i.e. lower from here.

Oil and gold rebased at January 2000

The dollar and eurozone banks are benefiting so far, but if some unexpected geopolitical stress (of the kind I talked about in my previous article here) were to happen will this last? The dollar should go higher in this case, thanks to its safe haven status, but banks could tank.

The other fact is that correlations and volatilities have gone completely crazy since the Swiss National Bank's announcement. It is obviously currencies which have decoupled from pretty much everything else. Implied volatilities have overshoot the times of the Lehman crisis. This is a bit too much.

Z-cores of implied volatilities and asset class correlations since 2005

With this backdrop the wisest trades are probably going to be tactical positions on volatility and correlations at least until the smoke clears, and it might take a while. In other words for the next few months it should be profitable to teat both volatility and correlations as an asset class while making asset allocation decisions.

Unfortunately most retail investors lack the mathematical base and trading skills to profit from volatilities and correlations, so it would be wise to trust an advisor.

So long, and trade carefully.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.