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The landscape of global monetary policy is changing. In late 2015 we had
the Fed hiking, signalling more to come, the ECB holding back on fresh QE and
even the BOJ, which has engaged in more easing than any other central bank in
history, was sitting on its hands.
That tune has changed.
The BoJ moved to negative rates this week. The Fed didn’t hike and
signalled that they aren’t going to hike in the short term. The ECB is making
noises about expanding its QE programs. In this article we explore direction
of monetary policy going forward and its implications for financial markets.
The Fed Was Dovish This Week
This week the FOMC statement was very clear about highlighting the risks
stemming from the recent instability in global markets and widening of credit
spreads, saying they are “closely monitoring” the future impact this will
have on the economy. The Fed had stated previously that the risks to the
economic outlook were “balanced” but they are now “assessing the
implications” of recent developments “for the balance of risks to the
outlook”. This is a step towards the Fed saying that the balance of risks are
to the downside, even though they are not quite there yet. If the
Fed sees the balance of risks to the downside then they will not increase
interest rates.
Weakening economic data was acknowledged, a move away from previous
statements that said that the economy was expanding “at a moderate pace”, and
this weakening was confirmed by Friday’s softer GDP number. Yellen also noted
spending and investment were increasing at “moderate” rather than “solid”
rates, but did note that, “labor market conditions improved further”
referring to the stronger NFP print in January. Strong employment data has
been a theme of last two years. The Fed’s target there has been met, and therefore
strong employment does not add pressure on the Fed to hike; it’s now all
about inflation and financial conditions.The Fed pointed to
disinflationary pressure directly, saying they expect it “to remain low in
the near term, in part because of the further declines in energy prices”.
Fed Cannot “Surprise Hike”
Time and time again the Fed has stressed the cautious nature of this
tightening cycle. They have made it clear that market stability is critical
to being able to lift rates from zero without negatively impacting the
economy. Therefore the Fed will not hike without the financial markets
expecting such a hike, or the hike would cause unnecessary volatility in
asset prices, particularly in bond and interest rate markets. Currently
pricing implies a 16% chance of a hike in March, 22% by April and 33% by
June. Even September less than 50% priced for a hike (data taken from the CME
FedWatch tool and Fed Funds Futures Pricing).
Without the market pricing more like 75% for a hike the Fed
simply will not go.
In our view the Fed closed the door to a March hike with their statement
this week. The probability of a hike in April would need to more than triple
for us to be persuaded that the Fed may indeed hike then. That leaves us
looking at June, which, whilst low at 33%, could still see a Fed hike if
conditions improve. However in the short term we can say with a high degree
of certainty that the Fed will not be increasing interest rates again.
Gold Prices Supported By Fed
When the Fed hiked in December and market pricing at for tighter monetary
policy peaked, gold could not break below $1050. Having been gold bears
through 2013, 2014 and 2015, we exited the bear camp not long after the
December FOMC, saying “This decline [in gold] continued until the rate
hike was announced. Following this gold initially moved lower, but then began
to recover and regained ground on Friday, and has the potential to continue
this recovery with no bearish catalyst to keep the price falling.”
Technically $1050 is now a massive support level, and is not going to
break with the Fed on hold. Short term we believe gold prices will continue
to move higher targeting $1150. At that level the risks are more symmetric,
since it will take a major event for gold to break its major downtrend
resistance around $1180.
BoJ Takes Easing To 3D
Late this week the BoJ today surprised the market by announcing that it
would adopt a negative discount rate, in order to counter downside risks to
growth and inflation. The BoJ is prepared to take rates even further negative
if need be. The bank noted that this a third dimension to its already
aggressive easing stance. The first dimension is the quantity of money, with
the base already increasing at JPY 8Otrn a year. The second is asset
purchases, mainly JGBs, but also JREIT and ETFs. Now they have a third
dimension, negative rates, which they can utilize in addition to be the first
two.
Given how linked the major global economies are, it is rare for the
monetary policy of the major central banks to move in different directions.
Euro, USD, and Sterling all strengthened versus the Yen following this
action. The currency strengthening shifts the outlook for monetary policy for
those currencies, as currency strength needs to be combated with a more
accommodative stance to prevent the stronger currency impacting exports, and
therefore growth. Thus in an environment where one central bank is easing
monetary policy, the others are (at the margin) more inclined to ease also.
Potential ECB Easing
Flying slight more under the radar than the actions of the Fed and BoJ
this week, let us not forget that Mario Draghi signalled last week that the
European Central Bank is prepared to embark on a fresh round of monetary
stimulus as soon as March. Draghi said the ECB would “review and possibly
reconsider” its stance at its next meeting. The Euro fell 1 cent that day to
1.08 and European equities gained 2%.
The recent rhetoric of the Fed and actions by the BoJ add weight on the
ECB to act. Whilst equities may have stabilized the underlying condition of
the European economy is still far from ideal and deflationary risks are still
present. We expect the ECB to act and moderately increase their QE program,
accompanied by strong language suggesting they will do more if required.
Risk On
The shift in global monetary policy to a more accommodative stance implies
“risk on” for financial markets. Risk assets should perform now after a
brutal month, implying equities to move higher, volatility to decrease and
some relief in hard hit sectors such as high yield. We went long S&P call
options this week and expect the rally in stocks to continue for another
3%-5%, targeting 2000 in S&P.
China Devaluation Risk After New Year
Chinese New Year is unlikely to see the Yuan devalued with most Asian
markets half closed and therefore liquidity being drastically reduced. The
removes one of the year's drivers of risk off, at least for now, so we are
comfortable being long equities here. However after Chinese New Year we will
reassess, since further devaluation is likely in our view and this could send
wobbles through financial markets again, abruptly ending the “risk on” tone.
Some have argued that the market action this week means Yuan devaluation
is less likely. We disagree. Whilst equities in freefall is somewhat of a red
light for further Yuan devaluation, (since China doesn’t wish to de-stabilize
their own market, or the global scene, more than is necessary) a recovery in
stocks turns the light back to orange. The BoJ action arguably puts the light
right back on to green, with another major Asian economy actively
trying to devalue their currency, why wouldn’t China follow suit?
Therefore before Chinese markets come back after their New Year we will
likely exit our longs as the risk of further devaluation increases. For now
we are content to stay long a ride the bounce, we are simply noting we view
this move as a bounce not a major turnaround.
Trading Themes
The Fed on hold, BoJ going to negative rates, potential ECB easing and a
temporary respite from Yuan devaluation are supportive of risk assets.
Equities should bounce here and 1850 in the S&P will hold. Therefore we
favour selling medium term put spreads with strikes equivalent to 1800-1850
and buying short dated, high gamma calls. Volatility wise we favour a lower
VIX and steeper VIX curve.
Gold has big support at $1050 and whilst we are bullish short term we are
not expecting an aggressive, extended rally. Therefore we favour selling near
term OTM put spreads. If you wish to find out what these trades are and gain
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