Relief Rally Mode Activated

Relief Rally Mode Activated

  • Markets hung heavily on the words of Fed NY President Dudley
  • But some observers may have exaggerated what Dudley meant in his comments
  • While talk of QE4 seems wide of the mark for the Fed, the ECB meets next week and it may signal that the magnitude and duration of its asset purchases could be expanded
  • The dollar’s strength against the yen have come despite comments from BOJ Governor Kuroda denying plans to increase asset purchases

Price action: Markets across the board are rebounding. The euro fell back below the $1.113 level. While there are some intermittent chart points near $1.1265 and $1.1220, the next significant target is near $1.1120. Sterling is trading below the $1.1550 level. The Australian and New Zealand dollars are outperforming at $0.7160 and $0.6480, respectively. The yen is underperforming, with the dollar rising to ¥120.40. EM currencies are also rallying, notably the RUB, TWD, MXN and TRY. In the equity space, Asian indices were up across the board with the Nikkei 1.1%. The Shanghai Comp was up 5.3%, with the gains coming almost entirely in the last hour of trading, with some participants citing official intervention to support the equity markets. EuroStoxx is up nearly 3.0% with gains evenly distributed across sectors. Oil prices are rebounding with WTI and brent futures contracts up nearly 4%.

  • Markets hung heavily on the words of Fed NY President Dudley. In particular, the line that “the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago.” Dudley is perceived as a dove, therefore it’s expected that he would push the line for a later hike. So perhaps the most notable part of this sound bite was the last part: “than a few weeks ago.” Many surely read this as a tacit acknowledgment that the fall in stock markets and commodity markets, and/or China’s policy changes had an impact on his thinking. This is especially the case since US data has come in strong over the period. Some observers may have exaggerated what Dudley meant, or have been selective in what they emphasised. We note that Dudley also said it was “important not to overreact to short-term market developments,” and that a rate hike in September could become more compelling again after upcoming data.
  • On one hand, the reverberations from the international developments will not be reflected in the next batch of data; on the other hand, the data will likely show that the US economy was in a position that the short-term shock could be absorbed.   Not only did yesterday’s durable goods orders suggest that business investment is off to a good start in Q3, but was also consistent with the upward revision expected to be reported today for Q2 GDP.  Rather than expand by 2.3% as initially estimated, the US economy is expected to have grown by 3.2%.  Although inventories appear to have contributed more than the consensus had anticipated, personal consumption is also likely to be lifted above 3.0%. Watch initial jobless claims, too.  It is the closest to a real time read of the US labor market.  Small decline from the previous week is expected, though the four-week moving average may creep up a little.  Weekly jobless claims averaged 273.6k in the five week reporting period in July.  The rolling four-week average will likely be near there now.
  • The Federal Reserve does not meet for nearly three weeks.  That is plenty of time to get a new reading on the labor market, and for markets to stabilize.  This is exactly what Dudley said.   Often when people talk about the independence of central banks they mean independent of meddling by the elected representatives of the people.   However, in the current context, the Fed needs to show that monetary policy is not tied so tightly to the performance or volatility of the stock market. It needs to show that monetary policy is independent of how fast China operationalizes it’s longstanding promise to grant market forces great influence on its currency.  It needs to show it is independent of how much surplus oil US shale producers and Saudi Arabia (or non-OPEC and OPEC) generate.
  • This week, Constancio, Vice President of the ECB, played down the market volatility and noted the resilience of the German IFO report to suggest that fundamentals remain intact.  A week ago the ECB’s Coeure commented how the central bank does not take its only policy cues from the equity market.   While the institutional arrangements and frameworks vary from central bank to central bank, on this there is likely a meeting of the minds.
  • In this context, talk of QE4 in the US is not particularly helpful or insightful.  Just like the Fed’s asset purchases sent reverberations through the global capital markets, and talk of tapering did the same, a new round of QE now would be exceptionally disruptive. The change of heart would risk the Fed’s credibility after it has repeatedly warned that lift-off was likely this year.  It would smell of panic in the face of the drop in equity prices, a market in which Yellen had identified as having elevated valuations.  Some have long advocated more fiscal stimulus in the US, such a public works program on a larger scale.    It is not clear that at this juncture, in lieu of a political agreement to expand public investment, would be a fair substitute.   Note that Japan’s herculean efforts to expand its balance sheet at an unprecedented pace have not produced the desired results. The impact on inflation from the ECB’s asset purchases is not a resounding success either.
  • While talk of QE4 seems wide of the mark for the Fed, the ECB meets next week and it may signal that the magnitude and duration of its asset purchases could be expanded. Although M3 money supply was a bit stronger than expected (5.3% vs 4.9%) and private sector lending improved, the continued decline in energy prices and the rise in the euro make it more difficult to fight deflationary forces.  Tomorrow, Spain and German release preliminary August inflation reports.  Price pressures in both countries may have eased, and Spain may have slipped back into outright deflation.
  • The dollar’s strength against the yen have come despite comments from BOJ Governor Kuroda denying plans to increase asset purchases.  He maintained that the inflation target can be reached, while weakness in production and exports are temporary.  Many economists expect QQE to be expanded as early as October. This is rooted in recent labor market developments that have not been as favourable, and consumption still tamed. Also, real wages are steady and oil price have dropped further. We are less sanguine about imminent easing in Japan, and think that the bar is higher than the consensus appreciates.  The BOJ appears to be informally adopting a core-core measure of inflation that excludes food and energy, and appreciates the disruption that the current operations are having on the liquidity in the bond market. One option could be for Kuroda to extend the deadline of the target, for example, to the end of 2016FY.
  • Other data released overnight included UK Nationwide housing prices, which came in close to expectations at 3.2% growth y/y. This is the lowest pace of growth on a y/y basis since June 2013.  In Australia, private capital expenditures fell by more than expected to -4.0% in Q2, though still better than the -4.4% in Q1. The disappointment did little to deter the Australian dollar which continued to be the best performing major currency for the session.