The Fed's message: 'Trust us, all is well’

There are several conflicting cross-currents in financial markets, but the wash up is the Fed’s message that the world is better than you think and the market seems to be warming to this.

Federal Reserve
Source: Bloomberg

The debate on whether the Fed hikes in the June to September window rages on and it’s no surprise that the US five-year treasury saw aggressive selling last week, to close up 16 basis points. Naturally the USD has rallied in sympathy, with the broad-weighted putting on 0.8% last week and the greenback remains a key focus this week, especially with a raft of Fed members due to speak. If we look at last week’s fund flow data we can see nearly $4 billion pulled out of US equity funds, while in the ETF (Exchange Traded Fund) space we saw moving flow out of the ETFs that track the S&P 500, Russell and Emerging markets.

If we should be following the money flow it certainly doesn’t seem to be affecting credit markets with spreads narrowing modestly on Friday. Implied volatility is subdued and the S&P 500 refuses to close below the key 2039 level. Ultimately, while the USD looks supported, overall financial conditions haven’t rolled over. Could it be the market is actually seeing the Fed’s fairly optimistic stance as bullish? This could be the case, but it’s worth highlighting that whenever the Fed removes its concerns about instability in the global economy over the last few years (specifically emerging markets), it has generally marked the top in the S&P 500. The fact that implied probability of a hike through to the September has increased to 80% seems fair, and the Fed will be pleased with the lack of negative reaction in the markets.

The US payrolls on 3 June (consensus is calling for 163,000 jobs) and Janet Yellen’s 6 June speech are now key. As things stand, the market seems comfortable with higher rates and there seems no reason to be overtly bearish until the S&P 500 closes below 2039 and the VIX trades into the 20% region. A break of the April downtrend at 2069 would even suggest looking more intently at long positions.

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While sentiment is certainly bearish, if price reacts on a more positive note, traders should never be loyal to a view. The ability to react is what helps shape an edge.

The ASX 200 will find some solace from the buying in US markets on Friday, although our call is for a flat open. Iron ore futures fell 4.4% on Friday and thus BHP should open 1.4% weaker. Once again, banks look supported on lower volatility and the financial sector looks set for the best May since 2001. The key question traders will be asking is whether the local market can make it seven weeks of consecutive gains, and a break of the 5300-5400 range would clearly help here.

The AUD/USD is clearly supported at $0.7210 and consolidation is seen here. This is the line in the sand for traders and a daily close below here suggests adding to short positions.

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