Mario Draghi and the ECB dominated proceedings this week as they often do. Just before we discuss their rate cuts and stimulus package, a word about the Bank of Japan meeting which occurred earlier in the week.
The Bank of Japan made no change to policy, a decision that we found disappointing. There is little doubt that the sales tax inspired economic reversal seen in Q2 was worse than most feared, and the evidence is that structural reforms are making snail like progress. We continue to believe that the Bank of Japan will eventually announce even more stimulus and we had hoped that strong hints would be given this week.
With both the USDJPY and Nikkei 225 testing resistance this week, we are taking profits on our long positions and moving to the sidelines. We very much hope to re enter these positions but feel that, without further assistance from the Bank of Japan, the so called "Japan Trade" may just lose momentum in the near term.
The big surprise this week was the new stimulus announced by the ECB. It was especially surprising given that they haven't even implemented the Targeted LTROs announced in June. We had thought they would delay any QE announcement until late this year or 2015 and we frankly can't really see the point in cutting rates any further. So why did Draghi decide to fire another bazooka now? It may simply to boost the impact that June's stimulus may have or that something over the summer spooked him. The answer is unknown but two things seem clear to us at this stage. First, Draghi, along with nearly every politician, desperately wants a weaker Euro, and second, the fact that the vote was not unanimous indicates a split that could become very interesting.
The ECB policy mix is indicating that interest rates will remain at the zero lower bond for a number of years with the promise that more QE (probably via Sovereign bond purchases) can be used if necessary. It is likely that anything with a safe or even semi safe yield will be sought after, especially by European investors. What is debatable is whether non European investors chase European yields lower as they have done since Draghi's "I'll do whatever it takes" in August 2012. We think it unlikely with periphery yields lower than US and UK already and European equity valuations not obviously cheap. With support for European assets more likely from domestic rather than overseas investors, the outlook for European bonds and equities is modest in our opinion.
As we have discussed in recent weeks, our main takeaway from the current economic malaise in Europe and the ECB policy response is that the Euro will weaken quite dramatically in the months ahead. We speculated last week that the long-term target for Euro/Dollar could be 1.20 and last week's ECB announcements have only reinforced our beliefs. There is no doubt that the Euro is oversold and we would not be surprised if some consolidation is seen quite soon, perhaps in the 1.2750 area. But the big trend is down and we expect to remain bearish on the Euro for some time.
One final thought on the ECB. In the past, new stimulus had always been a unanimous decision whereas this time round, there was only a "comfortable majority". We assume that the Bundesbank's Jens Weidmann voted against the new stimulus, perhaps with some of the other Northern European council members as well. We also know that German Finance Minister Schauble believes monetary policy has already gone far enough, even before the new stimulus, and Merkel was less than happy with Draghi's incursion into fiscal policy at Jackson Hole.
Simply put, Europe is in a big enough hole already. If investors think that policy makers are divided over future policy, then the whole European project could be open to question again. This would clearly not be a good outcome for European asset prices or the Euro. We would say that any divide would probably not be fully apparent for some time yet but it is interesting that the first occurred at the first announcement of QE from the ECB.
If we are correct that the impact of ECB QE on European assets will be modest combined with the Fed about 7 weeks away from ending QE plus a potential split opening up between Germany and the periphery, we continue to believe that equity markets are vulnerable IF sentiment were to shift to negative. This has not happened yet, and so we wait patiently until it does before we press the bearish case in our portfolios. In the meantime, short Euro trades have been performing very nicely indeed.