After over 2 years of dragging, pardon the bad pun, the market by the nose, ever since his “whatever it takes” speech in July 2012, Draghi finally folded and launched QE. This, as Credit Suisse warned last week, and as stocks are starting to realize, may have been the longest “sell the news” build up in history. Of course, CS worded it more poetically: “the QE Dream becomes reality” and far more importantly, as it also adds: “the dream may prove far more powerful as a market driver than the reality.”
What happens next? Well, finally some very unpleasant questions will have to be answered, such as this one from CS: “current valuations, however, beg the question of when does the periphery take notice of price action in other markets” and more importantly, “If QE does little to move the needle on inflation expectations, then there will come a point in time when the market questions the tightness of spreads…. we think this question will be asked once QE happens.”
Thank you Draghi: the market will finally demand – and get – some answers.
Key sections from last week’s Credit Suisse report:
…if the ECB isn’t in a position to announce a purchase programme, then at the very minimum we would expect Draghi to firmly keep the QE dream alive.Arguably, as we discussed last week, the dream may prove far more powerful as a market driver than the reality, but importantly as we’ve seen in recent months, it is very hard to trade against the possibility that QE may well be coming down the pipeline in the near future. So while an announcement is clearly not now expected, it probably wouldn’t have a lasting market impact unless the messaging is very muddled.
The resilience of peripheral spreads in the latest round of equity and commodity volatility has been remarkable. Spreads shrugged off volatility in 1) EM last year, 2) in crude oil this year and 3) in recent equity volatility. We attribute this to the power of the “Draghi put” and the threat of ECB QE. The question is whether the same phenomenon can continue once the “QE dream” becomes reality.
We expect there will be a tipping point (as we saw in 2013) where negative sentiment in other asset classes (EM, credit, European equities – especially bank stocks and inflation breakevens) will start having an impact on sentiment in the periphery. Obviously, if the ECB delays the QE decision, the feedback loop between the periphery and other risky assets should return; but calling that timing is complicated as we expect that if the ECB does not deliver QE in January, it will still keep the QE dream very much alive and kicking for the next meeting.
The market is differentiating between 1) what the ECB buys versus what it doesn’t and 2) economic versus financial asset valuations. There was a time when weakness in peripheral equities and/or bank stocks would feed through to peripheral yield spreads (see Exhibit 16), almost immediately and vice versa. But the grab for yield environment and the ECB’s backstop for spreads has broken this relationship.Current valuations, however, beg the question of when does the periphery take notice of price action in other markets.
We expect this “tipping” point to happen either when:
1) the ECB does QE but the market remains skeptical of the reflationary impact of QE or 2) the ECB delays QE and the market goes into Greek elections without tangible ECB support. As shown in Exhibit 17, peripheral spreads have diverged significantly from inflation breakevens. If QE does little to move the needle on inflation expectations, then there will come a point in time when the market questions the tightness of spreads. We are not saying that time is now – we share the consensus that ECB QE will initially be positive for the periphery and in fact, below add to our peripheral exposure – but we think this question will be asked once QE happens.
There is even a case to be made that once QE is announced and the exact details on implementation are revealed that the periphery could then become more sensitive to risk sentiment in other asset classes. While the ECB keeps the “QE dream” alive, it is harder for the market to short the QE option, but how and when that dream crystallises into reality will affect the sensitivity of Italian and Spanish yields to other risky assets. We keep our positive view on the front end (i.e., out to 7y) of the periphery, but are more cautious on extending further out these curves.