Markets look to open to the downside after US holidays with risk off plays back in focus. Brexit news is still causing the markets hold on to safe haven assets and add to them in the form of Silver and German Bunds. There is little reason to expect this trend to stop without some decisions made by the UK in terms of leaving the EU officially. It seems that all party members will wait until the autumn elections to make a decision, and possibly the end of the year before starting article 50 proceedings. This will cause uncertainty as businesses will no doubt delay investments into the country’s economy and possibly start moving parts of their business out. There are some hoping that a turn of events will change the minds of the British people to elect someone who will have another referendum on the subject of leaving and make this all a bad dream. While this could be the case for the UK the mindset of the European Union and the Eurozone as a viable entity will still be in question. This will not be as easily reversible.
The Brexit has already brought Italian Banks and the far left parties into focus as major threats to the Euro. Not to mention Greece. As spreads in the Eurozone widen across countries you will be able to see if the European experiment is starting to look shaky in the eyes of the markets. As long as German Bunds stay at negative yields out to the 10yr mark while Italian and Spanish yields continue to rise, it is safe to assume the markets are pricing in the two speed Europe or worse.
Britain votes to leave the EU, now what. Markets naturally went to risk off with the Pound taking the majority of the hit. We now know that the out come is but there is no clarity on how things will play out going forward. The Brexit gamble is over and money was made or lost, now investors need to look at the bigger picture to see what, if anything, has changed.
Near term, the world will be on high alert. Risk off trades and shifts to US and Yen denominated plays. Also on alert will be the Central banks. One sided bets on currencies could see intervention back on the table. It would be a good excuse for the Bank of Japan to undertake direct market intervention in the markets. The bank of England could try to stabilize the pound if the slide continues next week. The rally in the dollar could even pressure China to take measures to weaken their currency, in this environment the markets would not turn an eye to potential issues across the globe.
Longer term, things will be more measured. The formal exit from the EU is a two year process and more clarity will come through as time progresses. Trade deals and contracts will not cease to exist in immediately. That being said look ahead there will be changes to the way Britain is looked at in terms of investment and banking. Shares of major banks in the UK are already down about a 3rd on the news, which could be an over-reaction or discounting of the future prospects of the city of London outside the EU.
It is important to take this information and compile it into the global story and not let it simply shape it. The lead up to the Brexit vote kept other global factors on the back burner and the out vote will no doubt take precedence in the near term. This should not take attention from the fact that other global factors are occurring and could be the the next 'black swan' event to hit the markets. Not because it was a rare unpredictable event, but rather no one was looking.
All eyes are on Janet Yellen’s speech. Futures are in a waiting pattern, the Dollar is giving back some of its gains over the past few days and news is filled with what might be said. While this moment is going to have a significant play in the markets new found rate rise expectations for June, it is masking the longer dated but more significant events.
The talks in Greece about debt relief are old hat compared to the second rate hike in a decade for the US, but this time could be different in the nature of the bailout terms. In the past the unity of the troika would pit against Greece and come to the conclusion to kick the can down the road. This time one of the members of the troika, the IMF, is making demands for debt relief which Germany doesn’t want to look at (at least not until after 2018 elections).
This will work until the fall when the issue of debt relief will be brought up again by the IMF which is looking to have Greece’s debt ‘sustainable’ to continue to participate in the bailout. The exclusion of the IMF may not seem like a big issue but it will put more of the power into the hands of finance ministers like in Germany and add more of the fracturing political situation in Europe to the bailout talks. Without the IMF you could expect to see these debt negotiation that go to the brink before being resolved become a lot less certain.
Talks over the weekend about China and its debt crisis to loom large and is warranted. Many of the smaller undercapitalized banks would need (and are advertising) backing from the government in the event losses are incurred. This is not too far from what is going on in Greece at the moment.
With more funding needed by June to make debt payments, the Greek government has to show regulators that it is following through with reforms and terms of the bailout. This is causing anther game of chicken which will most likely end in the same fashion, a last minute deal. Where the concern should come in of that over the past few years the political landscape in the Eurozone has become less cohesive. Whether from the Migrant crisis or plain Euro-skepticism from austerity, the governments of the EU are going to make it harder for coordinated action. This doesn’t cause too many problems on its own, but does increase the risk of ‘mistakes’ in the way negotiations have worked in the past. As the games of chicken continue more leaders want to hold the wheel and might not all be pulling in the right direction at the right time.
Chinese regulators are forcing banks to provide provisions for loans that were sold as investment products. This is a win for transparency but could cause ripples in the markets as well. By stopping the flow of cash into these “investment products” from the wealth management arms of the banks will reveal how many of these loans values were based on the constant cash inflows from investors.
China’s increasing debt load has been used to generate growth in the past year. Without as easy of a flow of money, which is off balance sheet, the ability to continue the higher growth rate will wane. Longer term, China is relying on growth to shrink the percentage of non-performing loans, so by kicking them down the road in these ‘bad banks’ until they are less of a percentage of GDP will only work if GDP grows or the bad loans decrease. Since growth is now relying on risky loans to continue, a self-reinforcing cycle has been created, but the velocity is getting harder and harder to keep in motion. The stemming of off balance sheet debt just might be enough to pull this Chinese economy back to earth.
The result of Central Banks meetings do not seem to have gone well from a market prospective. While the US meeting did not mention the global risks as a reason to delay an increase, there was little said in terms of forward guidance in when an increase will come. Perhaps June. The BoJ was another story. The clear evidence of a need for more stimulus did not prompt the committee to add more stimulus. This has caused the expected reactions in the Yen and stock market.
What the central banks are saying to the markets at this point is they are in a wait and see pattern. Looking at the health of the economy on its own to see if it will be able to perform without a safety net. This will adjust the expectations of the market in terms of where bad news will take the markets and how much volatility can spike. The market will also have to use data to estimate when a rate hike (or cut) is most likely to occur. With US GDP coming out in a little over an hour, positive news will help to solidify the estimates of a June hike or push them further. As the markets are left to walk on their own more, it can be expected to experience a few stumbles and wobbles. The question is how many falls until the bank step back in.
A busy day with the Fed and Boj coming out with policy statements and interest rate decisions. For the Fed no change in rates is expected but rather the language of when the Fed looks to raise rates is going to be important. What will be important to look for is if members note global risks to the downside, such as China, in their statement. In the past this is what was looked at by the markets to determine if a rate increase was on the horizon. Things have changed in terms of growth in China and the numbers being presented are looking better than the start of the year. However this is due to large amounts of borrowing that was enacted to boost the Chinese economy. It will be interesting to see if the Fed looks past the headlines ad talks of continued weakness towards China of takes the numbers for what they are and talks a more hawkish note towards inflation.
The Bank of Japan will take some of these cues from the Fed statement, but has mentioned recently that they are satisfied with the results of negative rates. With more of the numbers in Japan starting to turn negative and the Yen up to 111 to the dollar the trend does not match with the recent language of the central bank and some are expecting more stimulus in the coming months, perhaps even at this meeting. If the outlook is still displayed as rosy and optimistic, you will no doubt see continued strength in the Yen as others look for safe havens in the Asia Pac regions.
Today will see some insights from central bankers in Europe with the ECB having its interest rate decision and the Bank of England Carney speaking. With talks of the Brexit and slowing global growth it will be interesting to hear if this is brought up in either of the Governors speeches. Many are not expecting to see any major moves from the ECB at this meeting, more of an assessment on the previous moves and their effectiveness. I some terms they are, lending has increased and the Euro has remained low despite a bit of a dollar selloff. Inflation could still use more attention and the bank will likely address the need to see more inflationary trends to feel comfortable with current policy being the end.
The BOE governor Carney will most likely talk about the state of the UK economy and touch on the implications of the Brexit vote that is taking place in June. The vote produces a lot of unknowns for the country and the Eurozone, the concern that the central bank expresses could add and increasing market focus on the vote and add volatility to the GBP as the deadline approaches. While it is hard to measure the actual moves from a policy event, knowing the amount of concern that it is producing in the markets can help in dealing with, or taking advantage of, volatility as different sides of the policy debate publish views and reports.
Policy seems to be setting the standard in the markets as of late. Oil is going up on talks of coordinated cuts across OPEC and Russia. Iron Ore and other china related commodities spiked because of the People’s Congress meeting and the hope of stimulus as a result. Japan’s economy is confirmed to have shrunk in the 4th quarter of 2015, which will have many speculating more simulative measures from that government there as well. With the ECB meeting on Thursday expecting more stimulus and the only question is the method(s) taken this week will be shaped by the events of the ECB (or lack of them) that will set the mood in terms of rates, bank stocks, and commodities. The current speculation of negative rates not having the same effect as asset purchases did when first introduced has caused some concerns among investors that the ECB will have to try and quell. Whether this means taking more asset purchases on, or extending the existing scheme, or both, will he weighed.
In Japan however the markets have given a clear sign that they are not pleased with the negative rate decision, seeing the Yen spike off the announcement should be looked at by the BoJ as a sign that investors will want a more comprehensive form of stimulus as opposed to negative rates on selective deposits. This measure did more to hurt bank shares and instill panic into the market (causing a flight to safety) than convince the markets that inflation will pick up.
Remember the end goal of all of these simulative measures is to boost inflation expectations, which is changing how market participants think. The difficulty lies in implementing unconventional measures and expecting a rational result in the wake of irrational market volatility. A tall order.
China is the latest to kick off more easing with another cut in the reserve ratio. Japan just released PMI numbers that missed estimates and tomorrow will see PMI and unemployment come out of Europe. This lackluster performance could cause the central banks to have to add more stimulus, with the Eurozone’s as early as this month. With rates in the Eurozone and Japan in negative territory how much more the central banks can do will certainly become a concern. The market will have to shift its attention to the possibilities of fiscal stimulus from these regions for further growth.
Some governments are able to step in, like China, Japan, and the US. The Eurozone is a bit more complicated in the sense that there is no fiscal policy at the level that monetary policy is trying to help out the region. This is going to put most of the strain on the central bank which will try to prop up the economy on its own. This will be the place that monetary policy will be tested in its purist form, with little outside help available. Add to this the prospects of tighter border controls in response to the refugee crisis and you will see growth continue to disappoint and the ECB try and remain accommodative.