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A Market Hedged on Hope and Waiting for the Bank of Japan

A Market Hedged on Hope and Waiting for the Bank of Japan

James Stanley, Contributor

Talking Points:

- Last week ended with a continuation of the brisk reversal in Risk-aversion that came into markets post-ECB on Thursday. With the Bank of Japan on Friday (Thursday night in US), it appears as though some investors are beginning to price-in hopes of an extension or increase in QE from the BoJ.

- Be careful if betting on more QE from the BoJ. The bank is already stretched after 3 years of QE has been unable to bring inflation into the Japanese economy, and with China being in an already-precarious state, it would make sense for the Bank to reserve whatever firepower they have left.

- The primary driver of strength across markets continues to be Central Bank Support; but the question persists as to whether the Fed will back down from their expectation for four full rate hikes in 2016, and until this changes, we’re likely going to see caution across global markets.

- To follow risk-trends and real-time sentiment, check out our SSI feature.

Last week ended with a blistering rally in risk assets with most stock markets getting a 2%+ pop in very short order, and this week opened as if that theme of strength might continue. But that was a short-lived prospect as risk aversion took center stage once again during the overnight session. This was coupled with a drop in Oil, so many news outlets right are connecting those dots and alluding to stocks being lower because Oil has sold off again after last week’s 12% rip off of the lows. If you want to get in-depth behind what’s going on with Oil prices, myself and Christopher Vecchio produced a special report on this topic that was released this weekend.

Old Support, New Resistance on USOil

Created with Marketscope/Trading Station II; prepared by James Stanley

Be careful with that type of narrative right now; because tensions are still high and the potential for huge volatility (in both directions) still exists. This is what often happens at major market turns as new bears and old bulls slug it out to see who is going to control price action moving forward. Likely, there is some impact to stocks with Oil selling off further. We’ve been discussing how Oil has a leading component for stocks, especially US stocks, for the better part of three months now. For years this relationship was reversed, where lower oil prices were actually thought to be a stimulus for the US economy, given the fact that much of the oil being used was imported into the economy. But the Shale revolution in the United States coupled with six years of ZIRP driving investment flows into new technology has changed all of that, as the US has actually become an exporter of Oil. As we mentioned back in October, the fact that the United States is a net producer in Oil now versus a new consumer, lower Oil prices would likely hit US stocks.

But this type of transmission takes time, as it’s the quarterly reporting of companies with energy exposure that will likely be the bearish factor to drive stock prices lower on this theme. And we’ve seen some of this already, but the big movements in Oil have been since June 24th of last year with a hastening in the trend over the past three months as Oil has fallen from the $50-neighborhood all the way to sub-$30. So the coming quarters will likely be unkind to American corporate earnings as the impact of these dramatically lower Oil prices make their way into energy producers’ numbers, and it would be logical to expect investors to begin pricing this in ahead of time under the same expectation that we just shared with you; but it’s unlikely that this fear has been fully priced-in just yet, because there is another factor keeping hopes (and stock prices) from falling further.

Created with Marketscope/Trading Station II; prepared by James Stanley

The Turn-Around Factor Last Week appeared to be the ECB, as hopes for more Central Bank Support stemmed the declines, at least temporarily.

We discussed this in the article, Stocks Still Falling, Fed Still Talking, in which we alluded to the fact that the big push factor for markets right now seems to be the Federal Reserve’s hawkishness towards 2016 rate hikes. To tie this correlation together, the real pain in global equities started right around the time of that first rate hike in over nine years. We talked about this the day after that rate hike in the article, Rates are Up, but the Road is Long. But it probably wasn’t that 25 basis point hike that’s caused fear and pandemonium, and more likely the Fed’s insistence around their expectation for four full hikes in 2016, while a litany of other factors hit pressure points in global markets.

Forward guidance was once a stimulus measure, telegraphing to markets that rates would stay ‘really low for really long.’ But in a rising rate environment, forward guidance is a major drag with a leading impact, as the Fed telling markets that they want to put in a full 100 basis points of hikes throughout the year creates a need for risk aversion. And after six years of easy money policies have ran asset prices to record-high levels, investors are rightfully cautious.

Two weeks ago, we saw the most hawkish member of the Fed, Mr. James Bullard, take a decidedly dovish stance in stating that falling Oil prices could affect the Fed’s rate hike forecasts for this year. This seemed like he was effectively saying ‘ya, that four hike thing is just an idea.’ And last year, this likely would’ve brought strength back to stocks as Mr. Bullard was one of the hardest and most aggressive proponents of higher rates. And he seemingly raised the white flag on that topic two weeks ago, and we discussed that in the article, The Bears are Out of Hibernation: What Might Send Them Away?

That commentary gave a brief amount of support for a short period of time, but sellers just came right back and used that blip higher as an opportunity to sell at a better price.

But what really seemed to turn around stock prices was the ECB meeting last Thursday, in which Mr. Mario Draghi alluded to the fact that the ECB may look to increase their QE-policy at the March meeting. This was something that markets were really able to run-on, as the prospect of additional easing coming out of Europe was enough to send risk assets shooting higher off of their lows.

This seemed to have a synergistic effect with the movements that we saw on Thursday and Friday, as these rising prices squeezed a heavily short market, creating more top-side pressure and squeezing shorts even further.

This led into commentary on Friday alluding to the upcoming Bank of Japan meeting, where some folks, at least judging by price action, have begun to put on bets that the BoJ may increase stimulus later on this week. This is similar to the most recent BoJ meeting in the third week of December, in which the Yen weakened and the Nikkei rose ahead of that Bank of Japan monetary policy statement. But no new stimulus was announced and those trends just moved right back in the direction that they were previously going; Yen strength and Nikkei weakness.

The big question here is whether the Bank of Japan has the ability to do another round of stimulus. With China looking to be in a very precarious spot and with many expecting Yuan-weakness in the not-too-distant future, would the Bank of Japan really want to unleash one of their final arrows this early in the year when they may have a larger need for ‘emergency-like’ policy later in the year?

We’re already seeing strains from 3+ years of QE in Japan, as the Bank of Japan owns over 30% of the Japanese Government Debt market, and there are legitimate questions as to whether or not there are even enough bonds left for the Bank to do another round. My colleague Christopher Vecchio discussed this in his trade of the year on GBP/JPY, which has already limited out in the first three weeks of the year.

This is one of the reasons that BoJ QE was directed to purchasing stocks at their Halloween decision in 2014, and that hasn’t worked out very well, as the volatility in global markets in August and September of last year equated to a $64 Billion loss for the Japanese Government Pension and Investment Fund. And this is a pension that’s going to be a huge necessity for the aging population of Japan, where there are two people over the age of 75 for every one under the age of 15.

So, Japan has some very real problems to contend with and it’s unlikely that doing the same thing (that hasn’t shown signs of ‘working’) would be the most strategic way to go. So, we’ll probably hear the Bank of Japan stand pat on Friday (Thursday night in the United States), and this could lead to an extension in Yen strength as safe-haven bets continue to build in risk-averse asset classes.

Created with Marketscope/Trading Station II; prepared by James Stanley

There are a lot of reports out there that are tying last week’s turn-around in stock prices to the Bank of Canada’s lack of a rate cut, positing that the Bank of Canada not cutting rates meant that they thought the Oil declines were over (or nearing over). Be very careful with that. Mr. Poloz of the Bank of Canada has been rather clear over the past few months when discussing this topic and alluding to the fact that he’s going to let newly the newly installed Prime Minister, Justin Trudeau, embark on the fiscal stimulus policies that have recently gotten him elected to office. It makes sense for Mr. Poloz to keep policy in-check right now, as QE around-the-world hasn’t really shown any promise of eliciting growth in ‘real’ economies.

And even bigger picture, this brings up the prospect of monetary policy management versus fiscal policy. Monetary policy is not a panacea; it’s designed to have a short half-life. Its fiscal policy that really changes an economy and fiscal policy is controlled entirely by politicians. When TARP and QE1 were triggered in the United States, it was designed to stem the bleeding long enough for politicians to ‘fix’ matters. But with QE bringing asset prices back to more palatable levels, most politicians passed financial regulations and just moved on with little focus on Fiscal policies designed to grow the ‘real’ economy. Each misstep or hiccup was offset by more QE, and this only elevated asset prices even further while inflation continued to lag and the employment picture remained lackluster.

So, Canada is trying something new, and the voters of Canada have said that’s what they want. Does this mean that CAD weakness is over? No. But it does mean that strong correlation that we’ve seen over the past three months in which lower Oil prices were a direct hit to Canadian Dollars may be coming to an end.

--- Written by James Stanley, Analyst for

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