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Risk Markets on Edge Ahead of FOMC, BoJ

Risk Markets on Edge Ahead of FOMC, BoJ

2016-09-16 13:10:00
James Stanley, Strategist

Talking Points:

- Global equity markets are continuing to hold-on to recent losses as we near to critical Central Bank meetings next week out of Japan and the United States.

- The source of concern is whether the punch bowl will be pulled from global risk markets as Central Banks may get more risk averse towards future looseness of policy. If history is any guide, this probably won’t happen; and more likely we’ll see a ‘hawkish hold’ from the Federal Reserve along with dovish commentary or perhaps even a dovish action (depending on the results of the ‘comprehensive review’) from the Bank of Japan.

- If you’re looking for trading ideas, check out our Trading Guides. And if you want something more short-term in nature, check out our SSI indicator. If you’re looking for an even shorter-term indicator, check out our recently-unveiled GSI indicator.

Next week brings markets the widely-awaited meetings from the Bank of Japan and the Federal Reserve, and if equity markets around the world are any indication, investors are not taking the risk of what may happen around these meetings lightly. For the first time in months stocks have seen some form of a sell-off or retracement in their up-trends. After the Brexit referendum, global equities shot-higher under the premise that global Central Banks would look to offset that Brexit risk with even more fast-and-loose monetary policy. And while the Bank of England came-up with a massive bond-buying program, they’ve been the only major Central Bank with any form of a stimulus response. And perhaps more worrying to equity investors, the Federal Reserve has continued to take on a persistently hawkish stance even despite middling data that is making that ‘risk on’ trade no longer as comfortable.

What really appeared to kick off the concern were comments last Friday from Fed member Dennis Lockhart. Mr. Lockhart, a noted centrist who has remained in the relative middle of the whole ‘hawk v/s dove’ debate of the past six years, had taken a markedly more hawkish tone during an interview. Mr. Lockhart said that serious discussion of a rate hike needed to take place, and this very much caught investors by surprise. This hawkish nod sent stock prices lower (shown with the red box below), breaking the range in the S&P 500 that had built over the prior two months (shown in purple).

SPX500, S&P 500

Chart prepared by James Stanley

To be sure, few are actually expecting a rate hike on Wednesday. The median expectation for next week’s FOMC meeting would appear to be looking for a recursion of last year’s September FOMC meeting, in which the bank made no adjustments to rates but warned that hikes were probably coming later in the year. And after initially rallying on the news of no rate hike, as the reality set-in that the Fed was still hawkish and looking to hike at a near-dated meeting, an aggressive reversal took place and stocks continued to reel lower for much of the rest of September.

SPX500 S&P 500

Chart prepared by James Stanley

But what brought life back to stocks at the end of September of last year was the same driver that’s been strengthening stock prices for the past six years; and that’s dovish Central Banks willing to stay on ‘emergency-like’ monetary policy in the effort of massaging the global economy through slowing data.

What Makes this Time Any Different?

One source of concern appears to be Central Banks’ ability to do more QE. While QE had become the standard policy mechanism to offset risk aversion, more recently questions have abound about ability of major Central Banks to keep doing more, and many are beginning to run out of assets to buy. For example, the Bank of Japan now owns more than 38% of their own government bond market. For almost two years the Bank of Japan has been buying stocks with QE, and this is a really dangerous type of thing because now when stock markets swing, Japanese pensions go along with it. But this isn’t the only risk: In Europe, their bond buying program has created considerable distortion with yields moving negative across much of the debt landscape. We’ve even seen some junk-rated bonds trade at negative yields. Or, to put it otherwise, people are actually paying (and not earning interest) to invest their money with a company that carries a debt rating of non-Investment grade junk.

And while this may not sound like a concern now, imagine what happens when rates actually move up? As interest rates move higher, bond prices move lower. For those buying yield whilst at negative rates, they’re buying when prices are at or near all-time highs. As rates move up, as the Central Bank looks to ‘normalize’ policy, investors have a very strong incentive to want to get out of that bond (as future losses in a rising rate environment are a strong certainty). And as in any other market, investors selling can create lower prices (yield spikes), and this can elicit even more selling as investors all rush for the door at the same time. This is like the taper tantrum and very similar to what the United States is going through right now in attempting to ‘normalize’ policy after 7+ years of easing. We discussed this theme applied to the German Bund in Tuesday’s article, It’s Not Panic if You’re the First One Out the Door, and on the chart below, we’re looking at recent price action in the German DAX after the most recent ECB meeting.


Chart prepared by James Stanley

The Big Question for Next Week

The big question for next week is how much artillery for future stimulus the Bank of Japan might have, along with how aggressively the Fed might look to ‘normalize’ policy in the coming months. There’s a chance to see a change-of-pace from each of these banks, as the BoJ is preparing a ‘comprehensive review’ of their current policies while there have been rumblings of the Fed beginning to change their targets for ‘data dependency’ behind future interest rate hikes; as in targeting nominal GDP or potentially raising the inflation target to give the Fed more ‘room to work’ as they look to re-fire growth through continued low rates.

One market that will likely be on the move next week is USD/JPY. Should the BoJ get more aggressive with their QE-strategy, the Yen could weaken mightily. On the chart below, we look at the current congestion in USD/JPY as we approach next week’s Central Bank meetings from the United States and Japan:

USD/JPY, U.S. Dollar - Japanese Yen

Chart prepared by James Stanley

--- Written by James Stanley, Analyst for DailyFX.com

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