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A sense of calm has descended on the capital markets once again. It seems the volatility we saw a couple of weeks ago is behind us for now, with the VIX falling back in line with the year’s average at 14%. Fed president James Bullard’s recent comments were a key catalyst, although we have seen the BoJ, BoE, ECB, PBoC and now the Riksbank in Sweden all coming out with dovish or equity-supportive actions. This has given investors the confidence to put money to work in the equity market.
Solid earnings beats from US corporations have given the market rally credibility, helped to a degree by the fact the yield on offer in the equity market is above that of the US 10-year bond. Pullbacks in the equity market will be jumped on ,with everyone seemingly a trend trader again. The Dow Jones, S&P 500 and NASDAQ are not technically overbought yet.
Further gains in the US market will put backbone into other developed markets. However, it seems global liquidity and fund flow is still headed for US shores, presumably because profit margins are still so much better than in most other regions. The German DAX, for example, is still 10% away from the highs made in June and yet still hasn’t cleared the 50% retracement of the recent sell-off.
ASX 200 looking toppy
In Australia the ASX 200 is flat today with banks under pressure, although there isn’t any clear cut catalyst for today’s move. Perhaps there are a few longs who have taken some exposure off the table ahead of NAB’s pre-market release tomorrow. The market is looking for cash earnings of A$5.1 billion and a 99c final dividend with 2H net income margins of 1.89%, but of course there are areas investors will be keen to explore. A miss would naturally affect the broader market.
Technically, there are signs we could see a slight pullback in the Australian market here, with the stochastic and 14-day RSI starting to roll over, as well as the index finding good sellers at the 61.8% retracement of the August-to-October sell-off (at 5466). I wouldn’t be surprised to see a move back to 5400 in the short term from here, but we have seen a period of underperformance relative to US markets. It’s likely this will continue.
The question now is whether the Fed will rock the boat in today’s meeting? I personally can’t see this happening and, judging by the fact the S&P 500 closed at session highs, it seems the wider trading and investor community don’t either. Implied overnight options volatility in EUR/USD (12.48%), AUD/USD (16.1%) and USD/JPY (13.96%) are certainly elevated, but that is happening because the market is still somewhat on edge after the recent moves. Plus, of course, we do have the Federal Reserve demanding the capital markets’ attention.
All about the Fed
There has been a lot of water under the bridge since the last FOMC meeting. But if we forget about all the news flow and repricing of interest rate markets since the 18 September meeting, in theory there is reason for the Fed to be quite positive, at least from a capital market perceptive. Since the last meeting, the US ten-year treasury has fallen 33 basis points. Retail gasoline prices have fallen 10% (currently at the lowest levels since December 2010) and the S&P 500 is only 1.1% lower, while the USD (on a trade-weighted basis) is up 1.5%.
These moves do lower the prospect that the Fed will talk specifically about the capital markets, but it certainly doesn’t give them scope to be hawkish. With inflation expectations falling, it will be interesting to see if the statement explores inflation expectations in more depth, especially as Mr Bullard planted that seed on 16 October.
We should see the Fed end its QE program, pushing the US into a new era of monetary policy, although the cynics still feel that QE4 is just around the corner. The statement should continue to voice a ‘significant under-utilization’ of the labour market and a ‘considerable’ period of time between the end of QE and the first rate hike.
Recall the Fed’s last set of projections portrayed the funds rate would be at 1.37% by December 2015. The market is pricing the funds rate at 45 basis points by this period, so someone is clearly wrong. If trading is taking advantage of price misalignments, then this is perhaps one of the biggest divergences in many years. While we won’t get any new projections, rhetoric suggesting their view hasn’t materially changed could cause a USD rally. The fact we have already started to see a bear flattening of the US yield curve today (with the two-year treasury up three basis points today) is interesting.
The USD is consolidating, and is in a triangle pattern on the daily chart. My best guess is we will get a break to the upside, with the USD index needing to break above 85.71 (spot now at 85.41) for this pattern to play out. Traders will be looking to buy the break here, which should coincide with EUR/USD trading towards $1.2600, USD/JPY towards ¥108.93 and AUD/USD to $0.8800. Watch price action in the NZD too, with the RBNZ due out shortly after the FOMC meet. With soft inflation, it’s realistic to believe the statement will be fairly neutral.