QE in Europe shows signs of life

Behavioural finance has a lot to say about confirmation bias, the human tendency to put greater weight on evidence which supports one's existing opinions. Even true believers have been finding it hard recently to find support for the idea of a stronger dollar, though - rather concerning when the bet on a rising greenback and weak euro has become the most crowded in the world.

On Wednesday, figures showing a weak US economy in the first quarter also suggested an inventory hangover will hold back second-quarter growth.

The reaction was strong, but strongest in Europe. The euro had its second-best day since October 2011, leaping 1.9 per cent to above $1.11, the strongest since the European Central Bank announced it would start full-blown quantitative easing, buying government bonds. True believers who did not close out their bet against the euro were slammed. The euro fell back somewhat after the US Federal Reserve's less than dovish statement.

In Europe something else was already under way: the unwinding of the bonkers bond bet.

Bonds in the region fit one common definition of a bubble, with widespread negative yields offering a return only to those who expect to sell them on at a profit to a greater fool. The supposed greater fool is the ECB, but it may be that QE is finally starting to work.

If QE is seen as boosting the economy, expectations of eventual tighter monetary policy should boost yields, offsetting the downward pressure of the ECB's purchases. Exactly this happened with US and UK QE, with yields rising (so prices falling) as the central banks bought more.

Wednesday's sell-off in the German 10-year bond was awesome. Yields might have risen only 12bp, itself the most in more than two years. But they were so low to start with that the price fall was equivalent to seven years' worth of yield. That has to hurt.

The equity market provided no place to hide. The rising euro hammered the shares of exporter-heavy Germany, leaving the Dax down more than 3 per cent - a one-day loss seen only twice since its recovery began in July 2012.

The adage suggests selling in May. Perhaps this year investors are getting in early, trying to beat the rush. Whatever the trigger, it offers a handy confirmation for bears. We will find out soon enough if this is bias or reality.

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