This week started out with an early example of how much the markets will dictated by US elections. With news that the FBI stood by its previous decision to not charge Hillary Clinton over her E-Mails, markets have spike considerably. The Dollar has also gained some ground. This goes to show the amount of volatility that will be seen in the next couple of days, not to mention after the results of the election.
The results of the election could move markets significantly, especially with a Republican win of Donald Trump. This will be due to the uncertainty that a Trump presidency will bring, look at the reaction of the Mexican Peso as a clear example of market participants ebbing and flowing around this prospects. But more importantly is to look longer term, into the next year, where the markets have not been too busy to look. There will no doubt be winners and losers in the immediate aftermath of the election, but how does the next year look in terms of global growth, politics in Europe and Japan, and Debt concerns in China.
The election could change the market paradigm, but if we get the status quo, markets will look to a new paradigm. Many pundits and hedge fund managers are talking about the valuations of the market being too high or having room to grow. The reality of the market's current valuation will be judged from the view of the landscape after the fog of the election is gone.
In the past few days there was news of Chinese banks restructuring bonds and tightening mortgage criteria to slow lending. US banks are also piling into ultra safe bonds and curbing lending throughout the year. Brexit has fractured loan availability across European countries, especially in Italy, including Germany.
Markets have not seemed to care, with market up from the years lows and only about 5% off the highs of the year. This should worry investors that in the medium term the lack of lending due to poor prospects could become self reinforcing and bring about the decline in economic numbers lenders are anticipating.
US election worries are front and center in the news, but after the election and the immediate smoke clears, markets will have to face year end and 2017 prospects. This is to include a rate hike that is still seen as more likely than not to be in December. The dollar has been rallying in light of that which is supposed to be a negative for the markets, but correlations have broken down throughout the past few weeks. the bond market is seeing yields spike from their summer lows on safe bonds, and even TIPS are getting a lot of attention. Market signals are looking like a rate hike is expected, while inflation will rise, and the economy continues to grow. All the while banks continue to buy more bonds and lend less. Hopefully the banks are waiting on the side lines for higher rates to start lending, but if they keep their purses tight, the economy will struggle to find the capital to keep its growth going.
The ECB rate decision is up and but the conference is where the action is going to take place. The markets are expecting policy to remain unchanged but the Language of the ECB will be of more concern to the markets. The fear is that the ECB is not doing enough to boost the growth of the Eurozone with an extension of the purchase program or additional stimulus measures. But the abilities of the ECB to take more stimulus actions are where the issues are starting to come forth.
The Eurozone has not been fully integrated with fiscal measures, and the guidelines of monetary policy are in a grey area at the moment. The problems that are slowing growth in the zone (low growth, high debt, high unemployment, etc.) need to be solved politically. With the rise in right wing politics across Europe and major elections across the continent within the next two years, very little is expected to come from the current political climate, possibly even less in the future.
It would be interesting to note in today's speech by Draghi if these needs for fiscal stimulus and political action are brought up. One thing is clear, that Draghi will have to continue to convince the markets that more measures can be taken to boost growth and inflation even without the help of the fracturing governments of the Eurozone.
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.