The Flames Have Been Fanned

Most people just don’t understand
The reasons the flames have been fanned
For markets to fall
While growth doesn’t stall
And so, now relief, they demand

However, the Fed’s displayed phlegm
Amid the increasing mayhem
The moves must be bigger
If they are to trigger
Some comments, the fall to condemn

As we have seen all week, the equity markets remain the dominant discussion topic and continue to be the market driver. Arguably, the proximate cause of yesterday’s sharp decline was the lackluster 30-year treasury auction, which helped to extend the recent narrative of higher US rates undermining equity valuations and cause a repricing of risk. But at this point, with stocks closing yesterday down 10% from their recent peak, we are beginning to see an increasing amount of downward momentum in the stock market. That means that we may not need much in the way of continued bad market news to see this process continue. And it is important to remember that economic news is not necessarily market news. The stock market can continue to decline and we can see a significant uptick in volatility across all markets, while the economy performs well. In fact, I would contend that is a reasonably high probability outcome.

Consider the fact that one of the key drivers of all asset prices since the financial crisis has been the extraordinary monetary policies implemented by the major central banks around the world. The $15 trillion of liquidity that they created to purchase assets never found its way into the price of goods or services because it was too busy flowing into the price of assets. The result was the greatest simultaneous bull market in stocks and bonds ever seen. But now, as the central banks embark on the process of removing all that liquidity, it should be no surprise that asset prices are falling. In fact, it would be shocking if they didn’t. So perhaps, maybe it wasn’t only yesterday’s Treasury auction that caused problems, but also the comments from the BOE. If you recall, Governor Carney hinted at further rate hikes and the removal of accommodation from markets due to improving growth prospects and increasing price pressures. While the pound was the immediate beneficiary yesterday, it has since given back much of those gains as the bigger picture of asset price retreats overwhelms everything else. Markets remain very interconnected but more importantly, virtually all asset prices have been the beneficiaries of monetary policy for the past nine years. As that policy changes, all assets are going to be negatively impacted. And the one thing that will get those policies to change is strong GDP growth! So for the time being, we are likely to see good economic news lead to declining stock and bond markets around the world.

One other thing to remember is that I assure you the central banks will be looking at percentage movements, so the fact that the Dow has fallen more than 1000 points in two of the past four sessions is far less impressive given the level of the Dow. 4% declines are not life threatening. One-day declines of 8% or 10% are going to be required to increase central bank angst.

But on to FX. Actually, the biggest mover overnight has been the Norwegian Krone, falling more than 1.25% after data releases showed inflation pressures remain subdued despite ongoing growth. The market saw this and discounted the idea that the Norges bank would be tightening their policy any time soon, hence the NOK’s decline. The next biggest loser in the G10 space has been the pound, which despite yesterday’s BOE comments, has responded to a series of poor data. IP fell a more than expected -1.3% and the Trade Deficit grew dramatically to £4.9B (exp £2.4B). This has removed all of yesterday’s gains and then some. In fact, from the peak, it is lower by 1.7%, although from the close just 0.7%. At the end of the day, it remains difficult for me to foresee how Brexit is going to be a near-term positive for the currency, and I continue to believe that the BOE remains far more quiescent than the market expects. This idea has been bolstered by reports that PM May is encouraging her Brexit negotiators to remain firm on British commitments to free trade without sacrificing sovereignty. I don’t know how well that will end.

Pivoting to the emerging markets, ZAR has once again benefitted from the stories that President Zuma is going to be resigning soon, having rallied a further 0.5% this morning. The rest of EEMEA, though, has been far less interesting, with de minimis changes similar to the euro’s virtually unchanged stance. Interestingly, despite the ongoing rout in Chinese equity prices, CNY has actually strengthened overnight, gaining 0.4% and unwinding some of yesterday’s losses. This could be funds coming home to cover equity losses, or potentially funds coming home ahead of the Chinese New Year. Keep in mind that markets there will be closed for most of the next two weeks. I continue to believe the CNY will fall throughout this year, but thus far, I am on the wrong side of that trade.

There is no US data today nor any scheduled Fed speakers. The one consistent thing we have heard from the Fed has been that the recent equity market movement has been “healthy” and the magnitude, given how far we’ve come, has been “small potatoes”. One thing Dudley did say was that if the market fell far enough, it would impact his personal view on the timing of policy changes, which means that the Fed put still exists. But I continue to believe it is still far out of the money. Equity futures are pointing slightly higher this morning, but I see no reason for the downward momentum there to wane. I like the dollar to continue to hold its own overall amid another down day in the stock market.

Good luck and good weekend