After the record setting highs of the US markets last week, the futures look to be closing the gap to start this week on a positive note as well. This has the VIX index back near multi year lows. Couple this with a light week in terms of US economic news and you have the markets at the whims of politics. With more news sure to come out from the repeal of Obamacare, and talks of an ambitious tax plan to follow, it will be interesting to get the market's likelihood of a meaningful deal.
The lack of greater economic news will provide a clearer link to the talks of a revised tax deal and the removal of Obamacare legislation to how much the market is still pricing assets to a deal. Political exhaustion will come at some point, but as seen in the VIX it looks like strong economic news may take over as a driver in the near term. one thing that investors can be sure of is that low volatility makes bets on larger swings in asset prices less expensive to hedge against. Not a bad idea given the conditions.
Crude oil has been struggling to maintain its gains since the start of the year, nearing the lows that it has seen in early March. The rise we have seen in oil was from the OPEC members (and others) agreeing to output cuts to shore up prices. This has faded over time as inventory levels started to creep back up, but not all of this is to blame on the Cartels.
The US onshore producers have increased production with the rise in oil prices making many of their fields profitable again. This spike in production can stop almost as easy as it started. Longer term, many oil companies are locking in contracts for oil, sacrificing price for stable cash flows. Should this trend continue it could be the start of major oil companies starting to put more of their revenues into longer term offshore projects and exploration.
This could be a good thing for ETFs like the SPDR S&P Oil & Gas Exploration & Production (XOP), which have been underperforming along with the oil market. As oil contracts get locked in prices and we see a stabilization in prices from a lack of investing in replacement wells, the yield on this ETF could start to justify higher prices in the future.
On Tuesday the Reserve Bank of Australia (RBA) will meet for an interest rate decision and have a meeting. Many are expecting no change in policy and in light of some recent economic numbers, some investors are expecting the debate within the bank to start to hinge towards the possibility of rate hikes and less away from the timing of the next cut. The shift from a loosening to tightening policy will depend more on the outlooks from China and their needs for commodities than domestic growth in the country.
China will come out with their manufacturing numbers early Tuesday followed by Europe and the UK (the US numbers are today). Watchin these numbers, coupled with Australia's reliance on the commodity sector growth (and inflation) it would be wise to track these numbers, especially in the APAC region.
The RBA mentioning in their meeting about the recent rise in inflation could spur the Aussie dollar to strengthen back down to levels seen after the US elections when the reflation trade was in full swing. The anticipation of higher interest rates would make the currency more attractive and could help stem the growth in debt levels that are keeping many investors on the sidelines in terms of longer term investment in the country.
Global markets started the week on a down note from US political dysfunction and rallied in hopes of tax reform. In global affairs the markets seem to be discounting (or have priced in) the official invoking of article 50. Given the dramatic shifts in US politics, it is easy to understand why there is less emphasis on an event that will take 2 years to sort out. This is why it will be important to understand what could be over the horizon and find opportunities or risks while others worry in the near term.
The Pound remains at a post-brexit low and seems to have a lot of bad news baked into it. It would make sense from a longer term point of view to look for opportunities in certain asset classes (such as Gilts) that will provide some upside potential and favorable exchange rate movement. With elections in France and Germany this year there will be plenty of volatility and headlines to create some buying opportunities in the UK market and being prepared for those opportunities will be important. It should be good to have a base case scenario and list out what is expected bad news vs unexpected. Below is a good start to this list.
The Fed will speak in a few hours and the almost no one is expecting rates to remain the same. As discussed earlier the markets seem to be taking this rate hike in stride because the Fed seems to have waited to the very last minute to leave make sure there was nothing that could support a delay in rate hiking. What will be important to look for is the language at the conference. How the conference manages the expectations of the Fed going forward will play a large role in the markets going forward.
Should the Fed get more aggressive in their language, and appear to want to head off inflation, the markets could take a pause and revalue equities on that assumption. If the Fed instead keeps the appearance of only raising rates in the absence of any data giving a reason to hold, then markets will feel the economy can expand without much interference from higher borrowing costs.
It will be important watch the Fed futures for June, which is slightly to the advantage of another rate hike, and the end of year overall projections. Should these tick towards more rate increases because of an aggressive fed it will no doubt introduce volatility and readjustment in the equity and currency market.
With nonfarm payrolls coming in at 235K, they beat most expectations. This leaves very little in the way of a rate increase this month by the Fed. What will be important to look out for is how aggressive the Fed seems to look in terms of future rate hikes. Like the ECB coming out stronger than expected in their remarks, a similar tone could spark rallies in yields and currencies here in the US. A quick drop in the dollar is now being reverse (with the exception to the Canadian dollar due to their strong job numbers) as people digest the news. This also led to a rally in the US market futures.
This mixed signal of wall streets whisper number seeming to be higher means very little in the face of the Fed who was looking for bad numbers as the only hindrance to a March rate hike. So should these trends in the dollar and the markets keep in this direction all day, it could just be a traders opportunity to bet on the reversal, but nothing more.
An interesting correlation was seen in the markets yesterday. With the Federal Reserve coming out with hawkish sentiment for a rate increase this month (now over 80% likely), the markets rallied. In the past this was a good reason for the markets to sell off, re-valuing equities to higher discount rates. Now the opposite has occurred and it is tough to understand what to think of rate increases going forward. The best way to make sense of this seemingly reversed trend is to look at where the markets feel the Fed is in terms of combating inflation.
In the past the Fed has been reluctant to increase rates at the cost of the fragile recovery. This caused one rate increase per year over the last two because of concerns with brexit, elections and a lack of inflation. This put the market in the mindset that the Fed would like to see a very strong sign on recovery before taking action on inflation alone. During the end of last year inflation creeped up and now the Fed is changing it tune to raising rates despite Trumps tax and regulation plans. In the near term this expresses that the Fed seems to be a bit behind the curve, due to their caution, and have pushed up their rate hike to this month. This gives the market a signal that the Fed feels things are better than their previous expectations. If the Fed looks to try and correct this mistake with taking action with less external factors in consideration, the market could perceive future rate hikes differently in the future.
Should the Fed start to look at inflation rates alone and not worry as much about political and market turbulence in their decisions, the pace of rate increases could become less accommodating to markets. This drive to get ahead of inflation could lead to rate increases while the markets stagnate and bond becoming more attractive with an introduction of volatility.
That isn't to say that a rate hike is going to reverse the post-election rally, but it will certainly start to move independently of market expectations and could travel a path not aligned with high stock valuations. At a minimum it will make alternatives to stocks a more attractive prospect in the future.
With the Fed minutes today, we are seeing more evidence of the policy and inflation being intertwined. The Fed mentioned that while markets are looking at lower taxes and more fiscal expansion, it is difficult for them to asses the inflation levels that will come through 2017 and beyond. The minutes have shown the vast majority of Fed officials wanted more information on the policy front before taking action in January.
It will be interesting to see if inflation expectations create a self fulfilling cycle and the Fed is forced to raise rates into an environment that doesn't see fiscal stimulus come. This would no doubt see a re-pricing in the markets, specifically commodities and emerging markets which are participating in this broad rally perhaps unjustly.
On the other side of the spectrum, which the minutes seem to have alluded to, is the Fed holding back on rates due to the uncertainty. This could cause inflation to get ahead of the 2% target and see the Fed either have to aggressively increase rates, shocking the markets, or being seen as behind the curve. This could explain the rise in gold along side the S&P500 along side the markets in 2017.
The Dollar is down to the pound and euro from better than expected inflation numbers out of the UK and upbeat remarks from the ECB. In about 30 minutes Theresa May is set to outline her Brexit plans which could send the pound back in the other direction.
We have seen the inflation pick up in many regions that were plagued with slow growth and low inflation since the crisis, which has allowed the Fed to raise rates and the look to do so more aggressively this year. But the political landscape it talking about some policies that could derail these early signs of normalcy.
The hard Brexit speech coming up within the hour will be the first we can see the headwinds that the UK might face over the coming years and how this will affect growth.
Chinese President Xi Jinping has also make some strong comment at the World Economic Forum in response to Trumps trade talks. The rhetoric isn't the main reason for concern, but the fact that Xi is at the forum is a sign that China looks to take a more active role in the global economy. If America starts to isolate itself now it will be ceding regional power and economic potential to countries that are looking for a more outward role.
Through this week's inauguration and the months beyond we will see if the politics of the Eurozone, UK, and US will have the same effect that the November elections did for the reflation trade or if the skepticism of trade and globalization start to pull back growth expectations.
Eurozone inflation numbers came out higher than expected which gave the ECB signs that their stimulus is working. The bank now believes they will reach their goal of 2% inflation by 2019. While this is a welcoming sign of the Eurozone returning to normalcy Germany might not be as welcoming to staying the course to 2%.
Inflation in Germany is out pacing that of the greater Eurozone, the government will have to make a choice to absorb higher inflation for the greater good of the Eurozone, or push for a dampening of stimulus. What Germany decides is an important part of the equation because their lack of leadership in the fight to stem inflation will prevent the transfer of the debt burden off of the southern countries to the bond holders (namely Germany). Failure to do so will create a greater rift in the two speed Eurozone recovery and put strains on periphery budgets and growth.
It will be interesting to watch the Euro and how it reacts to news of Germany not willing to accept more inflation for the greater Eurozone. What should come to strengthen the currency through a more unified economy would start to unravel, with talks of a t class euro and Germany or other leaving the bloc starting to pull the currency down. Spreads on Eurozone debt will also tell the story, with a rise in German Bunds narrowing the spreads with other countries being a sign of markets feeling the country is in lockstep with the measures taken by the ECB.