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Dog Days of Summer

Scott Smith, CFA August 3, 2016

Although the dog days of summer are upon financial market participants, there have been some recent economic events that are threatening to awake bears from what was set to be an otherwise peaceful slumber over the summer months. Instead of expecting a submissive international economic landscape over the course of August, we would suggest the lack of carbon-based traders for the latter half of the summer has the potential to heighten volatile swings in the market, lifting the VIX off its subdued levels after ebbing lower over the course of July.

It is apparent that like us, market participants are skeptical that the new spending measures announced by policymakers in Japan will be sufficient to achieve the necessary objectives of boosting domestic demand, specifically when it comes to household spending. Not only is the fiscal multiplier hard to adequately estimate, but reports are suggesting that approximately only a quarter of the newly minted plan will be ‘net new’ fiscal spending, and likely to only provide a short-term bump to economic activity. The market reaction to the marginal tweaks to the Bank of Japan’s balance sheet expansion and the lackluster government spending plan illustrates that a more comprehensive plan to shorten the gap in reaching the BoJ’s inflation target, along with stimulating consumer spending and export growth, will require bazooka like measures, something which the BoJ hasn’t unveiled in quite some time. As a result of the disappointing package from policymakers, the Japanese yen is honing in on highs not seen since the Brexit result at the end of June, and 10-year government bond yields have risen from -30bps at the end of July, to make a run at edging into positive territory, something that hasn’t been seen from March of this year.

The backing up of yields on Japanese government debt and the rising value of the yen has weighed on overall risk appetite in financial markets, with the VIX ticking up slightly after trading heavy throughout the course of July. While disappointment with both monetary and fiscal stimulus in Japan has provided some of the narrative for the shaky overall sentiment in global equities, that is not the whole story. Since last Friday the DXY has given back all of the gains registered in July, as market participants have again started to pare back expectations for monetary policy normalization from the Federal Reserve in 2016. Prior to Friday’s first estimate of second quarter GDP growth for the world’s largest economy, we had highlighted the outside risk of a September rate hike from the Federal Reserve, and instead put odds the greater likelihood that if lending rate was going to increase, December would be where the Fed would feel comfortable re-embarking on further normalization. While the first estimate of GDP growth did catch us by surprise, the overall make-up of the numbers is interesting. Specifically, consumption accelerated an inspiring clip over the second quarter, and further tightening in the labour market over the course of the third quarter might help drive consumers to continue to ride the consumption wave into the end of the year. The key piece for market participants to watch in the coming months will be any upward revisions to the number that was so clearly a drastic disappointment, along with ongoing consumer spending patterns. Vehicle sales in the month of July rebounded from the slower pace witnessed in June, coming in well above median estimates and hit levels not seen since November of 2015. While we expect Friday’s non-farm payroll report to have an asymmetric result for the USD in that a softer than expected print is likely to be exaggerated by participants further paring back expectations for future rate hikes from the Fed, while an as expected or slightly better than expected number will be insufficient to fully repair the recent technical damage done to the American buck, a positive number will be critical to expectations that second quarter GDP numbers aren’t indicative of how overall growth is tracking for the balance of 2016. If consumer demand continues to hold up in the face of ongoing tightening in the US labour market, the drawdown in inventories and business investment will then need to be replenished over the course of the third quarter, and subsequently push the lost GDP growth in Q2 into the latter half of 2016. We would still caution a December rate hike from the Federal Reserve has better odds of materializing than what the broader market is currently pricing in, though the basis of this assumption is that consumer spending continues to advance at a decent clip and inventories are built up as business confidence improves.

The continued deterioration in energy prices has sapped some positive momentum from market participants, with the pause in the advance of global equities and softer commodity prices parlaying into a lower CAD against most of the majors, the one notable exception being the American buck. Since the middle of July the loonie has lost roughly 3% against both the pound and the euro while capitulating just under 7% against the yen. Recently, the downward pressure on the American buck has trumped the weakness in the hydrocarbon market, even as the front-month WTI contract finished yesterday below the $40 mark for the first time since April. From a technical perspective, it appears as if there is more downside to come for crude in the coming days, though a lot will depend on oil inventory data that is due out later this morning. Last week’s build in crude inventories along with increasing rig counts in the US have been the major catalysts for the recent softness in the energy complex, so if today’s release falls short of expectations that there will be a draw of just over 1mln barrels, the bears are likely to welcome this development with open arms and the capitulation of weaker long positions will likely continue. For those corporates with exposure to USDCAD, we would highlight there is likely going to be continued two-way volatility in the pair, and topside risk should the American buck plugs some of its leaks with a decent employment report, while the loonie struggles amid shifting sentiment towards energy markets.

Good luck out there!

Scott Smith, CFA

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