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.
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.
Good data out of China last night and the highest inflation rate in 2 years in the US pushed pre-markets higher. The lack of a slowing Chinese economy does help with the global economic sentiment, but higher inflation will prompt the Fed to take action in raising rates. Inflation was one of the last excuses the Fed had to remain dovish on rate increases in the near and longer term. Should the rate keep going up it will force the hand of the Fed even in the face of slowing global growth.
There are some signs of a lack of demand in the economy that will be exacerbated when rates increase, and more importantly, when longer term rate expectations start to increase and the longer end of the curve prices this in. One of the only causes of the rising markets could be the decline in the dollar whose strength has become a concern with investors recently. This trend should be watched.
After Friday's sell-off in an "all down" day we look to have our confirmation continued by the opposite occurring. By having a down day and an up day in your portfolio you can better see what asset classes, and what market factors, are moving your portfolio. Looking at what moved the markets up and how that resulted in gainers in your portfolio (and then again in the opposite direction) to see if the market is confirming your theory or there are other factors at play outside your current understanding.
Friday was a near perfect up day for the US Divergence play in the Inflation space. The dollar rose to the yen while bonds, commodities, and stocks declined. Today started off mixed with the yen up, bond yields up (prices down) and stocks up. Brainard then spoke and came out dovish which the market (at least half of it) didn't expect. Markets quickly came back into line with stocks continuing the rally, the dollar continuing the weakening and a sharp reversal in the short end of the bond curve. Commodities also came back from their lows making the latter half of the day a 'perfect up' day in terms of the Divergence theory.
No one likes red in their account (unless you are trading in China) but having a good confirmation of being perfectly right and perfectly wrong lets you know that the theory and your asset selection is in line with the events you are looking to play. If you do not have perfect up and down days it helps you look at how you can adjust. For example if you were short 30yr treasuries Friday you made money along side the rest of the market but you would have been slightly up as well today. This could be from the inflation expectations that lower rates for longer will have in the future. Either way this play might not be the best for the US divergence trade as other factors are affecting the price movement (inflation expectations in the longer run).
Nothing unusual about the dollar rising in the wake of a market sell-off, today should be no exception. But looking at asset classes across the board it seem cash will be the winner for the day. The stock markets are down substantially, given recent low volatility and the Yen is selling off to the dollar as well. Taking a look at yields, the US Treasuries are up the same percentage across the curve.
The move of all asset classes lower is interesting because it shows a smaller version of what could come from a Fed becoming less accomodative. The increase in yields on us treasuries will force all other asset classes to be re calculated, including the equity markets. The dollar increases as a result and hits commodities as well. This divergence in policy (which is just being priced into the markets as of recently) could make allocating between asset classes more difficult and the costs of holding cash much lower in the near term. there will no doubt be more 'all down' days ahead and having the cash on had to take advantage of mis-pricing seems to be a smart bet.
Inflation, specifically wage inflation, could take center stage today leading into the employment report in the US on Friday. A good number will convince the markets that the Fed is going to raise rats as soon as September and put the possibility of a second hike by year end into focus. This could create the gap between countries monetary policies and bring back the concern, and volatility, of divergence. While the world looks to America to see if and when policy will start to diverge, other countries should start of think of their own divergence strategies.
Lower unemployment in Germany has the country diverging from Italy, which still has above 11% inflation, which could spark inflation differentials between countries as well. Unlike the US, Germany cannot raise rates to counter higher wage demand. This will result in the government having to try other means in order to keep wages (and overall) inflation tame while other countries in Europe still need easing. The inflow if immigrants proved promising until political backlash started to stem the willingness of the government, and private business, to welcome more workers. Continuous QE within the Eurozone combined with inflation could result in a deeply negative real yield and cause a selloff in the safe haven of Europe.
News feeds are littered with anticipation about Yellen’s speech on Friday at the Jackson Hole summit. Will she be more hawkish and talk of rate increases in 2016, or will she cede t the ‘market risks’ that caused the Fed paus in the past? The big trades from this are somewhat expected, that a hawkish fed will boost the dollar, spike yields on government bonds, and hurt commodities.
Looking at the relationship between longer term bond yields and the markets you will see that yields create the floors for the equity market and also dictate where new highs reach their limits. And market slump where bond yields dropped (priced of bonds rallied) the downturn was acute and quickly recovered. Where the yields rose (prices dropped in the above chart) the S&P suffered a greater downturn and subsequent recovery.
Much of this is due to the market expectations of Fed action after any market shakeout where the expectations of bond yields going up are less and less likely. This correlation has increased since the start of the year, linking stock and bond prices together. Should Yellen’s speech come out more bearish and rates start to rise in anticipation, stocks will be forced to look at their own fundamentals again to determine fair prices. After earnings season this may not be a good sight.
This week the Fed is going to have its annual conference at Jackson Hole and the financial world will be watching. Many are looking for sign that the Fed could tighten policy by the end of this year while hoping they keep things as they are. A hawkish tone out of the conference could be the start of the US divergence trade and see market turmoil come back.
Looking at the precious metals markets they already seem to be pricing in this type of uncertainty with Gild down 65bps and silver down almost 200bps. Oil is also following the trend lower yet the dollar index is not up as severe. This could be the start of a week of wait and see (albeit with some intraday volatility) and the news at the end of the conference will no doubt shape the trend for the rest of the year.
News that Japan will fall short on stimulus has strengthened the Yen back below 105 to the dollar. Market expectations are looking for more to be done in terms of Fiscal stimulus. While the BoJ is expected to ease policy further at the end of its meetings, there isn’t too much that can be done without the fiscal side stepping in.
This issue is not unique to Japan (though more urgent). European countries are in need of direct stimulus to their economies and banking sector but are prevented from doing so by Euro regulations. The UK post referendum will most likely see a slowdown and depending on the severity, may have to see more than rates cuts to spur growth again. Japan is beyond the point where it will need government spending to pick up. Shocks to the currency after the introduction of negative interest rates was unexpected and there could be more uncertainty with a deeper cut into negative territory. Therefore it will be a better bet to have a coordinated effort, greater than expectations, which show investors and retailors you are serious about starting the economy back up.
Until these issues get fixed in Japan you can use the country’s economy as a sign of things to come for the EU. Doing too little too late diminishes the shock value of the moves and will put businesses and investors into wait and see mode before taking action after stimulus does occur.
The BoE governor Weale came out saying that bank officials need more evidence before a rate cut and the August cut many expect is not a given. This is one of a latest string of trends where officials are seeing resiliency in the markets after Brexit. What this will do to expectations and the markets has yet to be seen.
In the near term the talk of things not being as bad as many feared can be a good thing. An overreaction by officials could bring about even more uncertainty and become self-fulfilling to the greater economies. Many central banks are now in a ‘wait and see’ mode in order to assess what the real toll of the Brexit to employment, spending, and inflation. In some countries in Europe this has exacerbated some issues that were already present and has no doubt put business investment on a slower path. But overall there is some hope that the new UK government, dialogue between the UK and EU, and central banks monitoring the situation will keep the economy moving along.
In the longer term the language out of the BoE and elsewhere could again raise the question of whether the markets are expecting too much accommodation from central banks as a result of the market shocks. Not taking into account the mandates that central banks have to look at could expose a disconnect between market interest rates and even equity prices. Equities have seen a rise from the post Brexit lows from the classic self-reinforcing assumption that market turmoil will lower rates as investors run to safety, then lower rates or more stimulus will keep rates lower, boosting the attraction of equities.
As rates go into negative territories in Europe and Japan, the desire for central banks to stay at these levels will wear thin. Any outlook to the contrary of the doomsday scenarios that the markets priced in could be dashed by the data coming out in the coming months as well as central bank speeches.