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)

The ECB did in fact cut rates and increase the amount of QE it would deliver. But I’ll bet you a dollar to 12 doughnuts that, in the “private communications” the ECB had with various “specialised audiences,” they indicated even deeper cuts.

Why would hedge funds buy 10-year German bonds at very low rates using extraordinarily high leverage unless they thought rates were going lower? They expected rates to fall another 10-20 basis points when they bought those bonds. Depending when they bought the bonds, they may even have had open gains to protect. Furthermore, traders clearly expected the ECB to increase its €60 billion QE pace, not merely extend it.

I have sat with traders in Europe who were deeply confident about what the ECB would do. Now we know the reason why: they are getting the straight poop from deep within the bowels of the ECB.

Except that this time, Draghi could not get enough ECB board members to go along with him. I am sure he could have gotten a majority of the vote, but weak support would have raised too many eyebrows. Imagine the FOMC’s approving a new policy with five dissenters. People would say, correctly, that the Fed was in disarray.

I fully expect to see deeper cuts in Eurozone interest rates – perhaps even cuts into negative territory on the refinancing operations as well as the marginal lending facility.

The ECB under Draghi has been willing to hype its moves and then, when the moment comes, deliver more than it promised. This meeting tells us that there is now considerable resistance to taking rates even further into negative territory. It is clearly not just the German Bundesbank saying “Nein!”

I still think the euro will reach parity against the dollar, but the timeframe has been pushed out. Once-bitten, twice-shy traders and hedge funds may hesitate to go all-in against the euro, allowing the euro to rise even further. I expect this unless Draghi musters a surprise announcement that fulfills expectations at the March ECB meeting.

Draghi has to be frustrated: he lost some credibility last week. Now, when he re-utters the words “We will do whatever it takes,” the market will stay skeptical until he actually delivers. They will no longer believe he can deliver on whatever he promised in his “private consultations.”

Europe faces great difficulties generating any real inflation, and it won’t be long before another nation begins to have Greece-like troubles. The ECB must step up as the euro again comes under pressure.
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