June 24, 2013

Market hangover lingers after tide-changing Fed statement

Financial markets have started the week in a subdued mood as investors struggle to imagine a 'QE-less' world.

Last week's stunning declines in equities, commodities, commodity currencies and bond markets across the globe has unnerved investors worldwide. The Fed did not signal and end to QE, but simply a intention to do so at some time in the future depending on employment, inflation and growth. The intended policy shift was enough to induce expectations of QE removal and thus encourage deleveraging and risk-aversion. Removal of QE would undoubtedly create a liquidity shortage and create a higher demand for the USD - the fact that we're seeing such strong USD bids and risk-aversion is more of an indication of how speculative and short-minded financial markets have become in a post-GFC world, rather than an early pricing in of QE removal.

The likelihood of the Fed actually reducing their $85bn per month purchases in the near future remains low (given a slowly recovering labour market, low inflation and anaemic GDP) which means QE will continue unabated for at least another 12 months if not longer. If this proves to be the case then expect the volatile declines seen over the past 7 days to unwind significantly. It could also mean that we see fresh highs in equities, commodities and risk-FX alongside fresh lows in US bond yields in the short-medium term. As we suggested in our recent article 'Shocked and awed markets still reeling after FOMC meeting', today's financial markets are to a large extent 'broken' and do not reflect the actual economic realities they're supposed to reflect. What we could potentially see over the coming months is a renewed expectation that the Fed will forge ahead with asset purchases and thus create more speculative asset price rises (similar to QE1, QE2, QE3, Twist and QE4). The fact that unemployment could at this point be increasing would not matter to 'high-seeking' speculators - the financial markets are clearly more responsive to QE addition/subtraction then they are to economic fundamentals.

Just as a hypothetical example - imagine that the next Employment Report from the US Bureau of Labour Statistics (due for release on July 5th and expected to show 175,000 jobs created) shows a below-par level of hiring. Instead of the 175,000 jobs expected, we see a rate of 50,000 created as an example. Instead of being seen as a negative sign for the US economy leading to a weaker USD, weaker equities, higher bond yields etc. we are likely to witness a spike in US equities, lower bond yields and higher commodity prices because speculators would expect a delay to QE tapering, and asset purchases to continue for longer (and maybe even increase). Such a counter-intuitive and paradoxical state of affairs underlines our point of view that the financial markets are dysfunctional due to central bank policy and political intervention.
In these types of market conditions - short-term trades with limited risk or hedged trades between strongly correlated assets are the most efficient trading strategies.

Treasury issuance vs. Fed tapering

When considering the real effect of Fed tapering on financial markets its important to consider the supply of Treasuries (issuance) in addition to Fed purchases. Total issuance of long-term debt by the US Treasury has been falling since 2009 and is likely to fall further going into 2014. In 2009 net issuance was circa $1.8 trillion USD, falling to $1.5 trillion in 2010. Issuance then declined to circa $1.1 trillion by 2011 and 2012. This trend is likely to continue given the improving US budget deficit.

The Fed purchases $45bn per month in US Treasuries making the annual total approximately $540bn. When comparing issuance to Fed buying, eventually there is no need for aggressive buying of Treasuries given the slowing rate of growth of the total debt stock. The decline in issuance is likely to give the Fed some breathing room and help it to meet its 2014 target for tapering asset purchases.

This coming week, the Fed has scheduled an extensive list of speaking engagements for its members in order to talk the market up it seems. And also to clarify their stance. Fed speakers could reverse the severely hawkish tone set by Bernanke last week and help markets return to their risk-loving, central bank supported selves. The shocking rate of declines in some markets has led to worries of market destablisation and short-term funding stress in some medias over the weekend. If we do see a continuation in the rate of declines this week, expect to see regulators step in with short-selling bans on stocks, pre-emptive market closes, artificial currency intervention, bracketed by extreme market volatility.

What to expect this week

We are likely to see intense volatility over the coming weeks as both economic and political policymakers try to repair the damage done by the FOMC. The clarification process should gradually help markets to settle into new ranges under some sort of stability.

Given the lack of significant macro data this week, we expect corrections to last week's brutal market moves. Additionally, we expect QE policy/expectations to be resurrected over the coming months as investors witness the inevitable undershoot of actual macroeconomic results versus overly-optimistic expectations set out by the Fed. US macro data will have an even stronger market impact now that the whole of the trading community is aware of its tie to future QE policy. Although market participants may be expecting a liquidity shortage because of the Fed's intention to wind down asset purchases, the reality remains unchanged - world markets are dependent on central bank liquidity and unless strong GDP and wage growth materialise out of thin air, we are probably going to see asset purchases continue at their present levels ($85bn per month). The Fed just doesn't know it yet or is unwilling to admit so.

Europe - remember me?

European markets will likely be focused on the fallout and spill over of last week's events. In Europe, the main barometer is sovereign bond yields. The Fed's tapering plans have helped bond yields to rise across the G20 board, not just in the US. For countries such as Italy, Portugal, Spain, Greece and Ireland even a paltry rise in funding costs could spur speculative selling and create a funding problem amidst increasing political turmoil. This may well be a topic of discussion for the EU Leaders Summit at the end of the week in Brussels. Event risk will emanate primarily from Germany - where business sentiment, unemployment, retail sales and inflation data are all scheduled.

Commissioned by Think Forex