Financial markets have enjoyed a very robust recovery in the last three weeks. In our opinion, the rally has not been driven by any fundamental improvement in economic growth or corporate or emerging market prospects. The mid-February lows had clearly created an oversold condition that has now been alleviated, and the improving sentiment has coincided with a downgrading of imminent economic and geopolitical concerns. After a 10% rally in equities in three weeks, what happens next?

The big event of next week is the long awaited ECB meeting, at which Mario Draghi is widely expected to announce another round of stimulus. There are some who are concerned that he may under deliver, similar to what happened in December. There are others who believe he has learned from that mistake, and will over deliver a sort of nuclear response in his battle against deflation. For our part, we think he has set the bar quite high, but we will just have to wait to see what he does. Of greater interest to us will be the market reaction. If financial markets react negatively (as they did recently when the Bank of Japan cut rates into negative territory), then Draghi’s credibility takes another hit, as will the global ultra-easy monetary policies of QE/ZIRP/NIRP.

So, let’s have a look at what’s priced in by the markets. It appears to us that the bond markets are expecting something quite aggressive, such as a tiered deposit rate allowing a deeper cut into negative territory. In this scenario, it is easy to see a headline deposit rate cut to minus 0.50%, or in a really funky move, perhaps even nearer to minus 0.75%. With German 2 year and 5 year yields currently at minus 0.54% and minus 0.34% respectively, anything less than at 15 basis point cut to the deposit rate (currently at minus 0.30%) could be seen as a disappointment, see chart 1 below.

Chart 1 – German bond yields versus the ECB deposit rate

In the FX markets, it would appear that investors are pricing in less than bond investors. Chart 2 below shows the EURUSD exchange rate alongside speculative positions of traders on the futures market. We have also marked on the chart the December ECB meeting. Clearly, traders are holding a significantly reduced short Euro position heading into next weeks’ ECB meeting compared to December.

Comparing the current position of the FX and bond markets, someone is wrongly positioned. Either Draghi over delivers and pleases the bond markets, and the FX guys are not bearish enough on the Euro. Alternatively, Draghi under delivers, proving the FX guys right and the bond market wrong. For what it’s worth, we think that the odds are slightly in favour of Draghi disappointing, and Government bond yields may jump higher like they did in December, which could easily help the Euro spike higher as well.

Chart 2 – The EURUSD exchange rate and traders positioning on the futures market

What about equity markets, and other risk assets? Well, let’s assume that developed equity markets all move roughly together as has been the case in recent months, and we’ll take a look at the European equity market in chart three below.

First of all, we have marked what may be an important resistance zone which capped European equities before QE was announced and has acted as first support and then resistance since last August. In the lower panel, we have also shown the 15 day rate of change. This may be slightly cherry picking as this 15 day period starts with the February low, but it is rare that an index can continue to advance so rapidly for longer periods, and at the least, the rate of advance will slow. If the ECB disappoints, equity markets in Europe (and perhaps globally) will reverse some or all of the recent gains.

Chart 3 – Eurostoxx 600 Index

So, as we see things today, fundamentally not much has changed in recent weeks. Equity markets and other risk on assets have rallied strongly from the oversold condition apparent three weeks ago, and are now overbought. It will take a very positive market reaction to any ECB stimulus this Thursday to keep the party going. We expect a sideways market at best now in the short term, with the risk that the last few weeks have been nothing but a robust bear market rally that is set to end shortly.

Stewart Richardson
Chief Investment Officer