Market Bracing for a Big Week

This will be an eventful week.  There are three major central bank meetings:  BOJ, BOC and ECB.  The ECB is widely expected to announce a wider bond buying program that will include sovereign bonds.  January 25 Greece holds national elections in which Syriza is maintaining a small lead.  

The main development today has been the market's reaction to news that Chinese officials are toughening its enforcement of margin rules in the equity market.  This sparked a 7.7% drop in Shanghai Composite, which is its biggest decline in five years.  Financials and the energy sector lost nearly 10%.  Recall that the market had rallied nearly 40% since the unexpected rate cut in late November.  

After gapping lower, the Shanghai Composite closed below its 20-day moving average for the first time sine late-October.  It finished near its lows and, as one can imagine, the technical tone is poor.  The 38.2% Fibonacci retracement is found about 2% below today's lows, and the 50% retracement is about 3.5% lower than that.    Chinese officials are likely surprised by the magnitude of the losses, but may find it difficult to admit or back track.  

Other Asian markets, except for Hong Kong rose on the heels of the US equity market gains before the weekend.  European bourses are also higher.  The Dow Jones Stoxx 600 is up nearly 0.75% around half way through the London session.  Energy and utility sectors are trading heavily. Of note, Swiss stocks are staging a bit of a recovery after last week's slide, and are up about 3.5% today.  Oil prices, which were squeezed higher before the weekend, are shedding 50-60 cents now. 

Bond markets are mostly firm, with many European sovereigns slipping marginally to new lows.  The 10-year Swiss bond is yielding -12 bp.    There is some speculation that the Swiss National Bank has intervened.  The euro finished last week near CHF0.9940.  It is now trading around CHF1.0080.  It has not traded above CHF1.06 since the low was recorded.  

The US dollar is trading within the pre-weekend range against the major currencies.  The Canadian dollar is the lone exception, and there the greenback briefly slipped marginally lower.  With the US markets on partial holiday, and the week's big events still ahead, continued range trading is likely. The euro did recover toward $1.1620 in the European morning, but those upticks were sold. The euro has fallen 10 cents since mid-December as the risk of more resolute efforts to expand the balance sheet grew.   The relationship between the currency movement and the central bank's balance sheet is not as simply as one is often led to believe.  

Since the dollar peaked against the yen on December 8, the BOJ has expanded its balance sheet by almost 2%.  It is about 60% of Japan's GDP.  The SNB's balance sheet is roughly a little more than 85% of GDP.  The Federal Reserve's balance sheet is about 25% of US GDP.    

The dollar appeared to sell-off as the Fed prepared the market for an asset purchase program, but often traded higher on the fact.  Given the anticipation and market positioning, we suspect a similar scenario may unfold with the ECB on Thursday.   The ECB needs to overwhelm market expectations, which, given the leaks and debates in the press, will be difficult to do.  Moreover, the compromise between the pooling of risk and size of the program may not be sufficient to shock investors.  On top of that, many share our concerns that what ails the eurozone might not be amenable to monetary policy.  Initial conditions of the asset purchases matter, and roughly a quarter of the sovereign bonds in the euro zone have negative yields.  

The SNB's have embarked on their third strategy to arrest deflation.  First was the purchases of foreign bonds.  Second was the franc cap.  The third strategy, which is underway now, is the use of negative interest rates.  The BOJ is aggressively expanding its balance sheet in a unprecedented speed, and yet price pressures are easing not increasing.  In fact, this week the BOJ is likely to cut its forecast for inflation.  Leaving aside economic theory, the developments on the ground make one question the probability of success by the ECB.