Capital Market Drivers

It may have many faces, but there is one dominant theme in the capital markets:  unwinding strategic positions that have been established in the post-Lehman environment.

Prospects for the end of the third round of asset purchases in the US has provided a major spur.  In addition, the dramatic reversal of Abe-inspired equity market advance and yen slide was another source of disruption.  The liquidity squeeze in China, begun,  perhaps by the crackdown on capital flows disguised as trade flows, and exacerbated by the PBOC's reluctance to continue monetizing what it judges to be an excessive expansion of credit may be another, even if under-appreciated, impetus for the portfolio adjustments.
 

Emerging markets are at the nexus.  EPFR reports three consecutive weeks of outflows from emerging market bond ETFs and mutual funds.  The pace of selling appears to be near record levels.  The JP Morgan EMBI yield has risen above 6% and stands at its highest level since in 18 months. 

Emerging market equity funds have also seen large scale liquidation. Since May 22, before Bernanke testified before the Joint Economic Committee of Congress and discussed the possibility of a reduction of long-term asset purchases, the MSCI Emerging Markets Index has fallen more than 16%, including today's 1.5% decline.   

Mutual funds and ETFs tend to be dominated by retail investors.  These flows do not capture the activity of the large institutional investors who invest directly in the emerging markets.  Some data suggest foreign investors, excluding banks, bought $1.1 trillion of emerging market debt in the 2010-2012 period and about $220 bln of emerging market equities.  The extent of the unwinding is difficult to measure.  In terms of time, our sense is that some of those positions have been built up over a couple of years and we are likely to be still in the early stages of the adjustment.

We suggest that market positioning is driving prices more than a fair value model would imply.  Even if, and we think that is a bigger and more important if than many observers seem to recognize, the US economy continues to recover and the risk of deflation does not grow, the Federal Reserve is not considering tightening of monetary policy.  It is not thinking about hiking rates.  A rate hike does not seem likely until 2015, and that assumes QE3 ends around the middle of next year.  

In addition, Bernanke indicated that the Fed's balance sheet will remain larger for longer than many participants had thought.  Bernanke signaled that a consensus has emerged toward not selling off the mortgage-backed securities it has purchases.  There had never been talk about selling off Treasuries it had purchased.  This is important because the Fed has consistently argued that the impact of its QE was not so much in the purchases, for which banks are credited with excess reserves, which lie mostly idle, but in the hold of the risk-free securities off the market.

In fact, not only is the Fed not tightening, the Fed's holding of MBS securities is one of the reasons why this may not be a repeat of its change of policy in 1994 and 2003.  Convexity hedging from the mortgage security holders was a factor that helped fuel the upward spiral of interest rates then.  The Fed's holdings now ensure that this pressure is reduced, though of course, not negated in full.  

Moreover, in both 1994 and 2003, US inflation had begun rising and the Fed reacted.  Now inflation is not rising, but to the contrary, the core-PCE measure, which we will be reminded on Thursday is near record lows.

Given the data dependence of the Federal Reserve, the market can be expected to be more sensitive to US data, especially forward looking indicators, like Tuesday durable goods orders report.  Case/Shiller house prices the same day will illustrate the Fed's observation that downside risks have been reduced.    Last September, when the Fed announced its was launched QE3, house prices had risen about 3% year-over-year.  In May, the pace is expected to be above 10.5%.   According to CoreLogic, 1.7 mln few households have negative equity in the past year alone.  

The negative linkages between Japanese government bonds and US Treasuries appear to have been broken. Over the past month, US 10-year yields have risen about 50 bp while the 10-year JGB yield is essentially flat.  The wider interest rate differential--now above 165 bp at a 2-year high--has also helped the dollar recoup almost 50% of the decline it is saw against the yen from late May through mid-June.  Indeed, the dollar was turned lower at that retracement objective in Asia just above JPY98.70.

Recall, that the weekly MOF data shows that Japanese investors have sold the equivalent of $84.5 bln in foreign bonds and almost $46 bln of foreign equities on a net basis thus far this year.  And this seems independent of any Fed tapering talking.  Separately, the head of Sumitomo Life was quoted in the local press indicating that he has not desire to take on foreign exchange risk with the dollar near JPY100. Nor were Treasury yields attractive a little above 2% while the 20-year JGB at 1.6%-1.7% (actually 1.78% today) id not encourage foreign investment outflows.  

Whereas Fed is contemplating reducing the pace of its accommodation, the Bank of Japan may still have to do more if its 2% inflation objective is going to be taken more seriously by Japanese institutional investors, like the Government Pension Investment Fund, the largest pension fund in the world.  ECB President Draghi may not emphasize it in tomorrow's speech in Berlin, but he continues to hold out the possibility of more action.   

That said, the recent data suggests a cyclical recovery is underway in the euro area, though this week's data is unlikely to shed much fresh light.  Money supply growth and lending to the private sector is likely to have remained weak.  The defection from the Greek coalition government and the ability to satisfy the IMF in terms of next year's funding (which may be the key to its authorization of the next tranche payment) may be more important than the region's economic data.

European leaders failed to reach an agreement over the weekend on dealing with bank failures.  Germany and France were on opposite sides of the issue.  Another attempt will be made later this week.  Separately, the German June IFO was reportedly largely in line with the market consensus.  The current assessment was a bit softer (109.4 form 110.0 in May) while the expectations component improved (102.5 from 101.6).  The negativity of the long winter and severe flooding appears to be lifting. 

The larger investment climate may be more important for sterling that the CBI distributive trade survey on Wednesday and the final estimate of Q1 GDP on Thursday.   The yield on 10-year gilts has risen 50 bp over the past month (the same as US 10-yr Treasury yield) and this may create a window of opportunity for the incoming Governor to test the effectiveness of his forward guidance tools.  News that the UK's Vodafone struck a preliminary deal to acquire Kabel Deutschland after increasing its bid to 7.7 bln euros appears to have provided an extra weight on sterling. 

Separately, the UK became the first G7 country to enter into a swap agreement with China.  A 3-year, CNY200 bln (~$32.5 bln) swap agreement was announced over the weekend and is seen as a necessary step toward the London being an important offshore center for yuan and yuan-denominated instruments.  A little more than a dozen other countries have swap lines with China.

The PBOC made its first formal response to the liquidity crunch and in a statement dated June 17 (though posted on its web site earlier today) said there was "a reasonable amount of liquidity".  The 7-day repo rate, a measure of interbank liquidity, fell a little more than 100 bp after sliding 227 bp before the weekend, to stand at a still lofty 7.32%. Chinese shares tumbled 5.4%, their biggest decline in more than three years and brings the two-week decline to 12%.  The yuan fell the most in six week today, with the PBOC reducing its fix for the fifth consecutive session, the longest such streak this year.