Of course, market participants are not overdoing the rallies in regional markets. Most Asian indices closed higher. The Shanghai Composite Index built on the late surge seen yesterday, but was unable to clear the 3200 level. The Nikkei 225 and ASX 200 made good gains of 1.4% and 0.9% respectively.
However, the currencies were not doing much. Majority of Asian units were kept in a range, except for the Korean won, which advanced 0.9% against the dollar. This rebound should be viewed as a correction after the KRW weakened to a five-year low of 1208 per USD in August. The major currencies were similarly subdued. EUR/USD was trading flat during the Asian session, alongside the GBP and CAD. The Japanese Yen weakened modestly against the greenback.
Certainly, the implied probability of a hike is at a low 32% according to the futures market. There is a lot of focus on the theory that the Fed would only raise interest rates when the market has priced in 70% or more likelihood, based on the previous rate hikes in 1999 and 2004.
While my base case is still for a December rate move, a stand-pat decision in the September FOMC meeting may be more confusing for the market. Essentially, further delay in the rate normalisation will suggest that the Fed is still not comfortable with the current economic conditions, but more importantly, the outlook for US growth and inflation.
The market might think that if the Fed is worried, then it should also be concerned. A greater significance is that it will not help reduce uncertainty.
The last few sessions of risk rally may dissipate rather quickly, since continued uncertainty clouds investment decision. The risk-on, risk-off cycle will persist. If there is a hike tonight (or 2am Singapore time), the decision is expected to be accompanied by an emphasis that the normalisation pace will be gradual and calibrated to both economic and financial conditions.
While there will likely be a dip if the Fed proceed with a rate hike, the removal of the uncertainty surrounding the rate move timing will provide an improved backdrop for investors to get back on the risk wagon (for the longer haul) after the initial market reaction.
Admittedly, inflation is still a sticking point. However, the labour market continues to improve. Furthermore, financial conditions in the US is back to expansionary stage, according to the Bloomberg US financial condition index, which improved to 0.05 bp on Thursday. This index tracks the overall level of financial stress in the US money, bond and equity markets to assess how accommodative or tight financial conditions are in the country.
Meanwhile, the Bank of England (BoE) will be looking at what the Fed does this week. If there is indeed a rate hike, it may support the BoE’s bias to tighten policy early next year. Given solid UK labour data and hawkish statements from the BoE, a Fed rate increase can be a tipping point for the British monetary authority. This suggests that the sterling could see more strength in the coming months.
Instead of long GBP/USD, I prefer to express a GBP bullishness via a short EUR/GBP. The policy divergence between the ECB and the BoE makes this a more compelling case, since the Fed and BoE are on the same (hawkish) side. The risk to this trade however is that risk aversion continues to persist which might boost the euro as investors further unwinds carry positions. Clearly, a no-move from the Fed may push back the view of when the BoE will tighten policy.
The Chinese markets continues to confound investors. The Shanghai Composite Index was on a northerly path for most of today, before pulling back sharply in the final half an hour of the session. The Index was up over 1% prior to 2.30pm local time before diving 3.7% into close. SHCOMP closed down 2.1%.
While renewed risk of another major selloff have led the government to restart its state buying support, the seemingly arbitrary timing of it is causing confusion to the market. Investors are not clear about the strategy of the ‘national team’ as there is a lack of information on state buying. This is creating more volatility in the domestic stock markets.
The 10-day historical volatility has picked up since the start of the week. Nonetheless, Chinese equities are settling into consolidation after Black Monday (24 August), despite the recent fluctuations. The CSI 300 is mostly stuck within the 3000-3500 region.
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