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.
Revisions to Japan’s growth forecasts and inflation prospects have helped give the Yen a much needed decline. Many investors believed that the successful election results and an upcoming meeting with Former Fed chair Ben Bernanke means that more stimulus is on the horizon. This would be a welcome addition for the economy, which has been suffering from the strength of the Yen and would experience more pain from the post Brexit highs reached recently.
One point that holds some promise if the ability for the central bank and the newly elected parliament to coordinate fiscal and monetary stimulus. This will be needed to turn around the falling growth and inflation forecasts. With many in Japan becoming more skeptical of Abenomics and its ability to succeed, the timing of stimulus should be sooner. Many businesses and consumers are paring back their spending because of the recent turmoil brought on By Brexit and the rest of Europe.
Jobs numbers will be the big new event of the week with analysts thinking a rebound is in order after May’s poor numbers. I would agree that moves in the dollar and interest rate prospects in the US will be linked to this report more than usual. Market participants are looking for a safe haven that has a positive return with no prospects of capital loss. The rise in gold prices seem to show how little there is of these other assets to go around.
On the other end of the spectrum a jobs report that comes out better than many expect; sharp upward revisions, higher wage growth, higher participation rate, you could see the looming prospects of rate increases coming back into the picture. In either of these scenarios you will see the Dollar and yields in treasuries re price as the last bastion for safety or the next country moving towards lower for longer.
The Bank of Japan left rates unchanged and did nothing to address the rise in the currency over the past weeks. This led to the natural rally in the Yen to the 104 range against the dollar. While the governor of the BOJ did say he would not hesitate to take additional steps towards easing, the lack of action in combination with flight to safety conditions from the Brexit kept the currency near lows not seen for almost 2 years in dollar terms.
There is more to the overall assessment of Japan at this time. As discussed in earlier posts the demographic shifts are working against the Japanese economy and the threat of the country losing its safe haven status is slowly increasing with inaction. Fitch warning of a credit downgrade with the delay of the tax hikes will cause international investors to look at these negative yielding securities with a lower credit rating as un-investable. This will leave the BOJ on the hook to continue to be the sole buyer of JGBs and it will be difficult to find buyers at the right yields to replace them.
After the shock in jobs numbers on Friday all eyes will be on Yellen today at 12:30 est. as she will provide more clues to the Fed assessment of the recent drop in jobs numbers. What she says will be particularly insightful into the way the Fed will treat the data over the coming months regardless of whether there is a rate hike in July or not.
Should the Fed stick to their prior comments that one data point doesn’t signify a trend, it will mark the Fed as more committed to the longer term trend in low unemployment and rising wages being a precursor to inflation. By getting ahead of the trend they will be able to keep the inflation rate from getting out of hand while normalizing the interest rate curve. This will allow for cyclical rate increases/decreases to start to take shape.
The other side of the equation is that the Fed has been looking for an excuse, which would fit within its mandate, to not raise rates. This would make the case that the Fed is concerned about global growth and the spillover effects it may have on the US economy. If this happens I would assume that the Fed will seek to delay any real rise in rates until later in the year and look for inflation to hit the 2% target, or even over, before feeling confident in starting a normal rate hiking cycle.
Abe has delayed the tax hike until 2019 and this has caused the Nikkei to go down over 1.5% yesterday. Today in Japan it seems to be more of the same (this time because of the stronger Yen according to news sources). The new of the delay in the tax hikes was not what most economists were looking for and the markets are in agreement. As stated earlier the delay in the tax hikes is going to be a slow erosion of confidence in the government’s ability to manage the longer term budget. In the meantime the measures taken to stimulate growth could speed up this process as the Government spends more and increases the deficit.
Source: Yahoo Finance
The Central bank is now a major player in the bond market, owning around 37% of the market. As demographics works against the country the BOJ will have to take over the purchasing of bonds from the retirees that become spenders as opposed to savers. This fine balance must be maintained due to the face that there are higher yielding alternatives to make JGBs less attractive to outside investors.
Source: Japan Macro Advisors
The issue with the lack of growth and more stimulus being added to the economy could be a greater budget deficit that will make it harder for the BOJ to absorb the bonds left by the slowing domestic demand and the growing needs to bonds, forcing the bank to increase stimulus alongside budget needs. This would take the monetization of debt a step further to monetization of the budget gap, and potentially turning the Yen and JGBs into the least safe haven.
Looking to the G7 summit for potentially market changing news is front and center on many analysts’ minds. The summit ending might be where the big news is going to come in. After the summit Japan will be out from under the direct scrutiny of other rich world countries and may look to add more stimulus to the economy by weakening the currency as well as delay the tax hike from 8% to 10%. This is going to be a large factor in the future because it will break down the fundamentals of the JGB market over time.
USDJPY Spot rate (Source: bloomberg.com)
There are three major points in the Japanese economy that must be overcome to have to robust economy and fiscally sound budget. One is the slow growth of the economy, which arguable is being addressed with the first and second arrow of Abenomics. The second is demographic which will no easily be addressed, and the third is structural changes to the economy.
The last point will require investors to have confidence in Japanese government bonds as a safe haven and store of wealth. With the removal of the tax increase another factor in the safe haven mix is being taken away. This puts the government in a weaker position as less and less pensioners buy JGBs (due to demographics) and more debt is required for the deficit and to cover higher interest rates. This will leave the BoJ with little choice but to continue to monetize debts, spurring more inflation, less confidence, and the cycle continues.