Market Responds Dramatically to Bernanke

The global capital markets have been thrown into a tizzy by comments from Federal Reserve Chairman Bernanke.  US bonds and equities sold off yesterday on ideas that Bernanke was signaling a tapering off of QE.    The knock on effect was seen in Asia, even before the disappointing the flash China PMI from HSBC that showed the first sub-50 reading in seven months (49.6 vs 50.4 in April, with a fall in new orders and new export orders).  

Japanese government yields, which have been rising in recent days, initially jumped to 1.0% on the 10-year yield, almost triple the rate seen on the day before the BOJ announced its massive easing operation in early April.  The bond market recovered as the stock market tanked  The Nikkei lost 7.3%, essentially cutting in half gains over the past month. 

The rise in Japanese yields hurts financial sector as they are large holders of government bonds.  The financial index within the Nikkei shed 10.4% today, leading the market lower.  Regional markets also tumbled with the MSCI Asia-Pacific Index off about 3.3%. 

The behavior of Japanese investors is interesting.  The weekly MOF data shows that after three weeks of buying Japanese investors returned to selling foreign bonds.   In fact, the JPY804.4 bln of foreign bonds sold in the most recent week offsets in full the almost JPY700 bln bought over the past three weeks.  Japanese investors sold foreign equities snapping the two week mini-buying spree.  The JPY136.9 bln sold is more than purchases made during the four weeks this year that Japanese investors did buy foreign stocks.  

The foreign appetite for Japanese shares was unabated, with another JPY716 bln poured in.  Foreign investors have bought roughly $79.5 bln of Japanese shares so far this year.  Many have bought Japanese stocks on a currency-hedged basis.  Given the fall in the prices, they have had to adjust some of the hedges (by buying dollars), but the dollar demand has been swamped by the powerful short squeeze in the yen.  The The dollar had set a new high for the move yesterday near JPY103.75 and in early Europe had dipped below JPY101.  The next level of technical support for the dollar is seen near JPY100.40-60 area, which corresponds to a retracement objective and the 20-day moving average, which caught the last dip below JPY9900 earlier this month.    

The euro hit was hard yesterday after moving to $1.32 on the initial reaction to Bernanke.  However, despite the large sell-off in European equities (Dow Jones Stoxx 600 off 2.25% near midday in London), the unwinding of yen crosses, and flash PMI data suggesting the regional; economy is still in a bad way, the euro itself is trading firmer.  The Swiss franc, though, like the yen has surged.  The dollar was at a 10-month high against the franc yesterday near CHF0.9840 and was trading two centime lower in Europe. 

The flash PMI composite rose to 47.7 in May from 46.9 in April. It is the fourth month below 48.0, let alone the 50-boom/bust level.  Both manufacturing and service PMI readings edged up from German and France, but there is nothing suggesting a recovery in Q2.   

Separately Spain's bond auction went off without a hitch, though slightly higher interest rates and it was able to raise a little more than it anticipated.  Peripheral bond yields are generally facing some selling pressures.   Italy, Spanish, and Portuguese 10-year bond yields are 7-8 bp higher.    Bunds and gilt yields are a couple basis points lower.  US Treasuries are also a bit firmer and the US S&P is called to open sharply lower (~-1.25%). 

Bernanke did not seem to us to break new ground and we suspect that many have read too much into his responses to questions by the Joint Economic Committee of Congress.  We know from past comments by Bernanke that the Fed can and will adjust the pace of its purchases depending on the flow of economic data.  The FOMC included this in the last statement.  Bernanke and Dudley and others have also reiterated this.  

In essence, in response to some regional presidents' comments,  like Plosser, who suggested maybe tapering off purchases as early June, the Fed's leadership, Bernanke, Yellen and Dudley (BYD), have said, they need a few more months of data before being able to assess the situation.  This underscore the data dependency of the decision.  But this is simply an agnostic stand.  BYD have also noted the fiscal drag that is still unfolding and past episodes where the better economic data was not sustained.  

In fact, there is some merit to the argument that Q1 and Q2 were ended prematurely as the economy did not enter a self-sustaining course.  Bernanke's prepared remarks showed a clear, to us, desire not to three-peat the mistake.  The economy has lost momentum in recent months.  Non-farm payroll growth slowed in March and April well below the 200k+ needed to make some, like Evans, more comfortable that the economy is truly catching now.  

The performance of the economy over the next 3-4 months is important, and until then the Fed is buying $85 bln a month of long-term assets and, even if its slows its purchases in September, it will be continuing to ease policy, at a slower pace.