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Daily Market Analysis
Chicken Little

September 26, 2016

– Fed Fake Puts Pressure on Greenback

– Curve Control Confuses

– Domestic Weakness Plucks Loonie’s Feathers

While last week didn’t have the bravado we had been expecting given two major central bank announcements were on the docket, the minutia of the decisions from the Bank of Japan and the Federal Reserve should continue to shape overarching price action in the macroeconomic space in the near future.  Looking at price action in the yen and the broader USD basket, it would be hard to blame someone for missing the fact that there were two major central banks meetings last week, yet the lack of perceived action by market participants should not be taken for granted, as the continued reliance on accommodative monetary policy continues to coil overall risk sentiment, and the resulting melt-up in the hunt for yield does little to structurally support a fundamental rally in risk.

We have suggested previously that from an asset class standpoint global equities are still preferred by investors on the hunt for yield given the unattractive properties and conditions in the fixed income market, though the current state of the equity space does seem frothy on a short-term basis, especially considering the overall level of volatility.  The crumbling of the VIX can be attributed to the resumption of the “Fed Feedback Loop” as market participants continue to question the Fed’s credibility and assume that despite the relative hawkish interest rate statement from last week, there will be some event between now and December that spooks the Fed into delaying the normalization of monetary policy further.  As such, the melt-up of equities appears to be the path of least resistance, along with a reinvigoration in the carry-trade, with high-yielding currencies like the loonie and the aussie getting a chance to spread their wings.  The upcoming week of high-frequency economic data is unlikely to shake the weight from the greenback, with the monetary punch bowl still in place until what is likely at least December.

Even with the soft dollar environment evident throughout the investment landscape, the commodity space looks vulnerable, and is lucky to have the weak USD as somewhat of a buffer from greater pain points.  Everything from grains to cattle have been through some tough times as of late, and much like the oil market, active participants are having to contend with greater supply than had been previously expected.  In regards to the shifting dynamics within the oil market, we have been vocally skeptical that any sort of production freeze or cut with OPEC and major non-OPEC producers would be reached in the short-term, and even more pessimistic that there would be any major agreement in Algiers at the end of this week.  The market seems to have caught up with our thought process late last week, and the unlikely nature of the Saudis and Iranians making any sort of concessions in regards to either freezing or reducing supply, has forced the weaker long positions chasing momentum to capitulate.  Along with the overall soft tone that corresponds with the slim chance of any major action at the informal OPEC meeting this week, the Federal Reserve proposed legislation at the end of last week that would limit and put restrictions on physical commodity trading of financial institutions, effectively making it more expensive for financial corporations to engage in the trading and storage of commodities.  While the headlines risk associated with the informal OPEC meeting this week will dominate the newswires, the increased restrictions on financial firms which engage in the commodity space will likely raise levels of volatility throughout the landscape, potentially putting further pressure on markets that are also reeling from oversupply, and dealing with sharp corrections in price.

Also trying to deal with price issues is the Bank of Japan, releasing a revision to their monetary policy framework last week which the market initially shrugged at, but over the longer-term will likely have huge consequences for financial markets.  As a way to try and reignite inflation expectations, the BoJ decided that along with an expansion in the monetary base and their balance sheet, they are going to try to control the yield curve for sovereign debt, aiming to keep the 10-year yield on JGBs at (or near) current levels of 0%, while still keeping negative rates on short-term deposits.  Though the intentions of the BoJ are to keep borrowing costs low and monetary policy accommodative, trying to control the yield curve at one inflection point in our opinion seems dangerous, and will likely cause distortions on other areas of the curve further out.  More specifically, we feel this potentially sets the stage for greater fiscal stimulus efforts from the government, as the BoJ is now committed to keep the 10-year yield at 0%, and is one step closer to what would be considered “helicopter money.”   The dangerous aspect of this scenario is that should massive fiscal stimulus from the government result in greater supply of JGBs coming to the market, the BoJ’s commitment to keeping the 10-year yield flat at 0% will cause the bank accelerate their monetary base expansion, and compound the increasing inflation expectations that would come from fiscal stimulus, along with distorting the long-end of the yield curve so you see much steeper yields past 10-years as investors dump their sovereign Japanese bond exposure.  The resulting steep back-up in rates that could potentially materialize may spark a flight to safety around the globe, and thus strengthen the yen as opposed to weaken it as carry trades are unwound.  It is unlikely that the Bank of Japan will have much luck trying to fix the shape of the yield curve over the long run, as yield curves tend to act like a tube of toothpaste, in that if you squeeze one area, it pushes the product into different areas of the tube.  In addition, should there be a negative shock to the financial system that naturally increases demand for JGBs, the yield curve control component would result in the BoJ purchasing less JGBs to remove some of the downward pressure on yields, and thus slow down balance sheet expansion and add to disinflationary pressures.

It would seem that the potential outcomes that would result in the BoJ achieving their goal via yield curve control is slim, and does suggest we’re seeing somewhat of a white flag being raised by a major central bank, ultimately wanting to pass the growth baton from monetary to fiscal policy.  Realistically, monetary policy isn’t something that can shape the long-term growth potential for an economy, and if Japan wants to increase long-term growth potential, it needs to conduct a structural shift, and kick the third arrow of ‘Abenomics’ into overdrive, ramping up the fiscal stimulus efforts.  Therefore, we would suggest that ‘new normal’ is not quite that easy to pinpoint, and in fact, it is unlikely to assume that governments around the world are going to accept sub-par levels of growth in the coming years, and not do anything to try and structurally alter longer-term growth projections.  The result we would suggest is that the relative attractiveness of carry trades and the ‘fade the Fed’ mentality becomes a harder bargain to drive, and that we’re getting close to seeing a turn in global yields, though if it materializes,  it will likely be a grind higher as opposed to a spike.


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