Divergence trades, depression trades
“It’s one of our big themes,” said Kathleen Hughes, head of European institutional sales at Goldman Sachs Asset Management, talking about central bank policy divergence over meet-the-press drinks in early September, four hours after European Central Bank president Mario Draghi had taken the deposit rate further into negative territory and announced plans to purchase covered bonds and asset-backed securities. The euro had a terrible day; Goldman Sachs had a pretty good one.
What might a ‘central bank divergence’ strategy look like? First of all, let’s not get carried away. In 2012, the ECB’s balance sheet was the size of Japan’s, at a shade over 30% of GDP, and 14% ahead of the Fed’s. It has since come down by 10% while the Fed’s continued to expand, to just over 25% of US GDP. Needless to say, the Bank of Japan is halfway to Saturn by now. Draghi sees his purchases expanding the ECB balance sheet by €750bn-€1trn, taking us back to 2012 peaks.
Nonetheless, for investors it’s the direction of travel that’s important. This is why Draghi managed to knock 5% off of €/$ this summer with hints and innuendo. There could still be a long way for this to go, so using the euro as a funding currency would be good place to start your strategy.
Euro-zone sovereign bonds have trended for much longer, and Draghi’s latest announcements seemed to push half of Europe’s two-year yields negative. You get 60 basis points from Portugal now. Unless you have to, buying euro-zone sovereigns looks like madness – and at 150 basis points the spread of US 10-year Treasuries over German Bunds also looks stretched. On the other hand, few would have predicted a US 10-year yield as low as 2.5% 10 months ago: a weak US jobs release the day after Draghi’s press conference caused a wobble but it feels like Treasuries have peaked. Again, there’s a carry trade in there somewhere.
One place a successful ECB loosening has not been priced in is equities. The Dow Jones STOXX 600 index enjoyed a good run against the S&P 500 after the Fed’s tapering announcement but, since the beginning of 2014, Europe’s stocks have lost ground badly. Given the Europe index also trades at a lower price-earnings ratio, now might be time to make it an overweight.
Big questions loom over these strategies. What if equity markets are right about the outlook for Europe’s companies, and bond markets are not pricing in targeted longer-term refinancing operations or quantitative easing but the perception of deflation terror at the ECB? For now, take comfort from the pricing of European high-yield bonds and the fact Draghi was not panicked into full QE. Longer term, we must hope this liquidity provision comes in time to free up banks and backstop significant new lending and securitisation – and that there are companies confident enough to take the money and invest it. Otherwise, the point will come when central bank divergence becomes simply euro-zone depression – lucrative for some of these strategies, destructive for others.