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.