It seems that we loosely got our wish as the Fed provided a more explicit view on tapering than what many had been positioned for. The Fed president, Ben Bernanke, also spent a reasonable amount of time trying to explain the difference between an end to QE and a rise in the funds rate, however it seems no one really paid attention to that; the market had heard enough – the Fed will ease off from asset purchases in September, perhaps October, as long as economic data continues to trend to plan.
The bond market is the centre of the world right now and the financial markets wanted to hear how much of a concern the recent back-up in yields on the long-end of the curve had been. The result was a Fed who didn’t express any concern on the huge moves throughout May and into June, and that the ‘don’t fight the Fed trade’ is over. Fixed income traders have essentially been given the green light to short US treasuries and any notion that Mr Bernanke would look to appease the equity market and keep borrowing costs low have been sadly mistaken. The Fed president didn’t even show too much concern on inflation, which in their minds should gravitate back to target.
What we will say though is we think the equity market reaction is unjust and an over-reaction. Taking a step back we are left with a clearer idea as to when the Fed tapering will occur. We are left with a date for when QE should finish (mid-2014) and we even have a complete threshold (7% unemployment) for which this will be achieved. The ‘Bernanke put’ is still there if the economy heads south again, although if everything goes to plan organic growth will be seen; potentially heading to 3.25% in 2014. As said in previous reports, the rotation from stimulus lead growth to organic growth is never going to be smooth, but when the market works out that the Feds plan is actually a good thing then hopefully clearer heads will prevail.
The key is the bond market; with the US yield curve now at 203 basis points (the highest since October 2011) the unwind of the carry trade has been vicious with huge moves in AUD/USD, USD/MXN, USDZAR and USD/BRL. Upside now in US yields will have traders liquidating these positions in droves and heading into the USD and anyone wanting to know where the AUD/USD is headed needs to firmly have a view on the US fixed income market, because if the US ten-year is headed for 3% over time then the pair will head firmly below 0.9000, despite every hedge fund and leveraged player being max short already.
Asian equities have been absolutely savaged today, helped largely by a contraction in the HSBC China PMI print, which hit a nine month low. The ASX 200 is down 2.4% and there seems to be a whole world of pain for the bulls today. Moves like 4.1% and 3.6% in RIO and WBC respectively can be seen, and this is a market now that will be happy to pull longs, revert to the side lines and watch until clarity is restored. However, the concern is not just that we are seeing the start of a normalising of Fed policy, but for us this has everything to do with China.
As detailed the HSBC PMI print was weaker than forecast, with the forward looking new orders sub component at 47.3 (a ten month low). However, it’s the moves in the interbank market that have caught the market’s attention. Again the seven-day repo (a gauge of confidence to lend in the interbank market – see below) has blown out, trading in massive 25% to 8% range; while three month SHIBOR and other short-term funding markets have also sky rocketed. The inversion in the local yield curve is there for all to see and this is the PBOC’s way of saying to the banks ‘you’ve got yourself in this position, we are not going to help you out of it’. This is a story about leverage and credit, with Fitch recently estimating that total credit (including off-balance sheet loans) has increased to 198% of GDP last year. Money supply is rising at just under 16%, relative to the official target of 13% and now something has to give, the clean-up of the banking industry is underway and the PBOC are happy to forgo short-term growth and concentrate on financial stability. Growth therefore is on the back burner and commodity currencies, commodities and growth focused equities are going to suffer as a consequence. Forecasts of 8%-8.5% growth are looking wildly optimistic and we’d sit in the camp that growth of 7.4% this year is much more realistic.
European markets not only need to price in the Fed meeting and the fall in the S&P 500, but also weakness in Asia; notably the Chinese equity markets which are down over 2%. US futures have fallen a further 0.3% from the cash close and thus Europe is shaping up for a shocker, with heavy losses across the board. Data seems largely irrelevant as markets will largely be driven by sentiment around China and the Fed. However it’s still worth keeping an eye on the data with the Philly Fed and existing home sales in focus in the US, while in Europe we get manufacturing PMI (advanced) and consumer confidence. On the currency side GBP/USD looks interesting - it has found sellers as it approaches the previous uptrend drawn from the 2009 low. This key day reversal has caught our interest and we feel shorts from here are the way to go. UK retail sales out today could help this idea.