Listening to the ECB

 | Jun 03, 2014 | 4:00 PM EDT  | Comments
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When, as a young lad, I started in the interbank foreign exchange (forex) market, there was one thing that always intrigued me. The head of the cable (GBP/USD) desk that I started on was the most powerful man around. He spoke to many of the biggest accounts, but among all of these giants of the sterling market with their swagger and aggression was one anomaly. He also spoke to a small Scandinavian bank whose normal trade size was one or two million pounds.

One or two million pounds may sound like a lot, but I can assure you that for a leading interbank forex broker, it is just a nuisance. Yet, despite that, Dave persisted with this tiny account. I assumed that it was because of some personal connection with the mild-mannered trader at the bank, but when he disappeared from the market six months later never to be heard of again, I learned the truth.

"I bet you're sorry to see him go," I said to Dave. "Yep," he replied, "that guy was the best contra-indicator ever." It turned out that the reason Dave valued this small account was because the trader there had an uncanny knack for being wrong. Dave's position management skills came largely from doing the opposite of whatever the guy did. The problem, of course, with a reliable contra-indicator in a dealing room is that it isn't useful for long. By necessity, they either start to get it right or they get fired. When your contra is an institution, however, it can go on seemingly forever.

My favorite contra-indicator these days is the European Central Bank (ECB), or rather its members' words. The ECB members love to talk, and this often produces a market reaction. But they are slow to actually act. In some ways, this isn't their fault. Attempting to set monetary policy for 15 disparate nations as if they are one entity is a nearly impossible task. As long as the market keeps reacting, talking your way to a desired end is far less risky and complicated than actually doing something.

With the ECB rate decision due on Thursday, it is starting to look like the market is falling for it again. Talk of lower rates and quantitative easing (QE) have resulted in a drop in the euro to a three-month low and a surge in European stocks. This is based on the assumption that the ECB will be aggressive about cutting rates and/or embark on a program of asset purchases. Don't hold your breath. It could do either or both, but a half-hearted attempt is more likely.

This is in part due to historical factors. Deflation is a worry in the area, especially considering that some of the peripheral eurozone members are still deep in debt, but European policy makers are inherently more scared of inflation, no matter how remote that possibility looks. It is hard to forget that the last time that became a major problem millions died as Hitler rose to power in Germany.

Three months ago, as the expectations of action started to build, I recommended staying short the euro through CurrencyShares Euro Trust (FXE) and long European equities through Vanguard European Stock Index (VGK). That has worked out OK, if not spectacularly. It's time to reverse that position. Eventually, the ECB could be forced to take aggressive action, but if history is any guide, it will only do so when forced.

The fact that the ECB is talking the euro lower certainly suggests that that will be the case. The ECB's talk is a lot more powerful than a small, unsuccessful Scandinavian trader, but as a contra-indicator it seems to be just as reliable.

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