The euro ripped higher last week after Mario “Whatever It Takes” Draghi dropped the European Central Bank’s deposit rates to -0.30% and extended QE deep into 2017. Everybody said the market was disappointed, as it was expecting more – nothing new in that story. So why did the market expect more? I have seen the answer in only a few places.
First, the story was not just the euro’s moving by four big figures in just a few hours. The German DAX plunged 4.5% and interest rates rose, not just on German bonds but across the European Union. It was total carnage. So why did this happen?
The basic reason is that prop desks and hedge fund traders had piled onto the same side of the boat. They expected a rate cut deeper into negative territory. They didn’t get it.
A standard trading rule says “the first loss is the best loss.” Doubling down on a losing trade works out sometimes, but the wisdom behind the rule is that it doesn’t work that often. The way you avoid a 20% loss is to cut the loss at 5%.
The selling didn’t come from retail investors: it was all traders and hedge funds. Some sold immediately, triggering more losses, which triggered more sell signals, which spun into more losses and resulting sell signals. Soon the market was experiencing severe whiplash.
Why was everybody on the same side of the boat? They mistakenly believed what the ECB (read Draghi) told them.
“Wait a minute,” you say, “what do you mean Draghi told them?”
I mean just that. The ECB conducts regular private conferences with what they call “market participants.”
The ECB has a special relationship with hedge funds and banks that includes closed-door meetings where it hands them privileged information, allowing them to trade in advance of ECB moves. When this popped on the front pages, Draghi, rather than pretending to be shocked and appalled, defended the practice: “Direct exchanges with … specialised audiences form an essential part of the ECB’s communication policy,” he wrote. They were “integral to its transparency policy.”
The ECB has enriched hedge funds and banks every way it could over the years since the euro debt crisis and bailouts. Stocks and bonds started selling off even before Draghi spoke at the press conference, as hedge funds were reacting to the ECB’s statement)