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This afternoon, European Central Bank boss Mario Draghi has his legacy moment.
At 12:45pm (apologies to Money Minute viewers – the times quoted there were Central European time, not UK time, we’ll make sure that doesn’t happen again), we find out what’s going to happen with eurozone monetary policy.
Then, 45 minutes later, Draghi stands up and explains it all in detail.
Is it going to be his crowning glory? Or a damp squib?
I don’t know. But markets are certainly betting on the former.
The market believes in the Maestro of the eurozone
I don’t want to try to second guess what European Central Bank boss Mario Draghi will do this afternoon.
He’ll cut interest rates, almost certainly. So the eurozone interest rate will go down from minus 0.4%, probably to minus 0.5%. And he’ll probably restart quantitative easing (QE) in some way or other.
Lots of economists think that this is futile, and that the ECB is “out of ammo”. Other economists think that a central bank can never be “out of ammo”, just lacking in ambition. I tend to side with the latter – where I differ is that while I think central banks can always do more, I’m really not sure that they should.
But all the quibbling about whether any of this will actually help or not is not particularly relevant. Markets respond to genuinely looser monetary policy in a Pavlovian manner. It’s just what they do.
So the question is just: can Draghi surprise markets sufficiently? Can he be dovish enough to make them rethink their recent bout of panic?
My gut feeling, if I’m honest, is that he probably can. Expectations are high, but Draghi has a record of managing expectations exceptionally well.
The only risk is that it’s pretty clear that the market has bought into that idea as well. Investors expect to be pleasantly surprised. Which makes it a lot harder to deliver a pleasant surprise. (Google “Keynesian beauty contest” for more on how markets really work).
So what’s changed?
August was rife with fear. Bond yields collapsed to unheard-of levels and gold soared. Investors were suddenly fretting that a recession was nearing, or that it might even upon us.
This was a rapid reversal that most of us wouldn’t even have noticed, but it really startled the “quant” community (at the risk of massive oversimplification, the quants are the ones who program the algorithms that everyone worries are taking over the market).
This all suggests that investors are starting to think that the collapse in interest rates has been overdone. (Again, to put it simply, value stocks do better when rates are rising, growth stocks do better when they are falling.)
And I suspect this is at least partly about a belief that Mario Draghi can indeed, do “whatever it takes” before he steps down.
Paving the way for a market melt-up – maybe
I pointed out earlier in the summer that, for all the talk of trade wars, the real factor intimidating markets was Europe. If one thing had freaked out markets more than anything (in my view, at least), it was the idea of the eurozone slipping into another recession.
If your mind is still on financial “contagion” and 2008-style risks, then the eurozone is where it is most likely to be unleashed. The contradictions inherent in using a single currency across multiple countries with diverse economies have never really been addressed. That means the necessary political compromises have not been made, or even put to the population.
You can get away with that while the economy is pottering along and no one is really keen to kick up a fuss. The rise of populism helps, oddly. As long as you don’t get a critical mass, then the sight of Brexit and outsider political parties helps to shore up the resolve of the “mainstream” (look what’s happened in Italy, for example).
But when growth collapses and unemployment rises again, you get even more discontent, you get rising bad debt, and you get risks to bank solvency. All of the problems you skated over last time rear their ugly heads again and it’s back to square one.
However, a couple of things have changed. Germany’s economic data has been bad, but that’s partly about the slowdown in China. China is now trying to stimulate its economy again, which suggests that economies exposed to the slowdown in global trade might get a reprieve.
More importantly, investors reckon Draghi will work out a way to prop up bank profits, while simultaneously making monetary policy a lot easier. And he’ll also be able to get past the objections of many of the more hawkish members of the eurozone monetary policy committee in order to do so in a resounding manner.
How will we know if he’s pulled it off? I think the most obvious “tell” will be the eurozone banking index. If eurozone banks bounce today, it’s a sign that Draghi has convinced markets that they’re safe, at least until next time.
Counter-intuitively, we also need to see the euro strengthen. It’s hard to have a proper “risk-on” market while the US dollar is this strong. The most obvious route to a weaker dollar index is for the euro to appreciate. Although looser monetary policy typically means a weaker currency, if Draghi restores confidence in the eurozone with his actions, the euro could very well strengthen.
So at a guess, that’s what we’re looking for – a bounce in eurozone banks and a bounce in the euro. A sufficiently convincing package might even clear the way for a climactic market melt-up, leading to a market top where we get the IPOs of WeWork, Saudi Aramco and that stupid scooter company, all within a couple of months of each other.
But let’s not get ahead of ourselves. All will be revealed in a couple of hours.
By the way, another reminder to get your ticket for the MoneyWeek Wealth Summit on 22 November – I’ve just been talking to our organisers about a very special guest who I’m hoping I can reveal in tomorrow’s Money Morning. Book your ticket now!