Twas the Week Before Christmas, Amidst Powerful Trends

The capital markets have been buffeted by political developments and central bank policies.  The direct influence of high frequency data seems to have diminished in recent weeks.  With less participation in the year-end markets, this is likely to continue to be the case over the next two weeks.  

There are several powerful trends in the global capital markets.  The trends appear to have begun at the start of the fourth quarter.  Three trends have been particularly robust.  The dollar's climb against the yen, the rise in US 10-year yields, and the rise in Japanese stocks.  The three have risen in nine of the past 11 weeks and six in a row.  

The Dollar Index has risen, as have two-year US Treasury yields, and gold has fallen in eight of the past 11 weeks.  The euro has risen, alongside the Dow Jones Stoxx 600 in seven of the past 11 weeks.  What may surprise many is that the FTSE All-Shares Italian Banks Index has also risen eight of the past 11 weeks,  including the past three weeks.  MSCI's Emerging Market equity index and its Asian Pacific Index has fallen in seven of the past 11 weeks.  The light sweet crude oil futures price has risen in seven of 11 weeks, but Brent only rose in six weeks.  

Due to the China's national holiday, its markets were opened a week less this quarter.  However, powerful trends are also in place.  China's 10-year yield has risen in seven of the past 10 weeks. Although the Shanghai Composite has risen in six of ten weeks, it has fallen three in a row now and four of the past five weeks.  The dollar has risen against the yuan in eight of the past ten weeks and 24 of the past 32 weeks.  

A key issue now is whether the trends are extended or a profit-taking phase is seen into the year-end. It is a question of psychology, and perhaps a subject for game theory.  Arguments that things have gone too far too fast are several weeks old, though it is true, of course, that technical readings are even more stretched.  And if the market was exaggerating the likelihood of the kind and magnitude fiscal stimulus that is likely to pass a more conservative Congress, then it similarly overreacted to what appears to be relatively modest changes in the average (rather than the median) Fed's forecast.  The average for next year, for example, increased by nine basis points, though the median is increased by 25 bp.  

The direction of market overreaction is itself an important tell or indicator of the underlying pressure. At the same time, the structure of ownership of government bonds has changed.  Central banks own a lot more than in the last cyclical increase in yields.  Many private sector investors hedge. Officials typically don't.  The same is true of the US mortgage-backed securities.   The MBS on the Fed's balance sheet is not being hedged.  If they were in the private sector hands, Treasuries or some derivative thereof would have been used, leading to even greater pressure on US rates.  

The dollar's appreciation against emerging market currencies would be expected to spur intervention to slow the depreciation, especially by those countries with large or quick pass-through to domestic inflation or, are already experiencing rising price pressures.  It is unexpected then that the Federal Reserve's custody holdings (of Treasuries and Agency bonds) have risen for the past five weeks.  The counter-intuitive increase of $42 bln compares with a draw drown of about $213 bln in the year up until then.  

Countries, companies, and investors have different exposures, risk tolerances, and objectives.   Their ability to cope and the changing investment environment will vary.  China is having a particularly rough time even though growth appears to have stabilized.  Indeed, the stabilization of the economy allows officials to try to curb some excess, and this is pushing in the same way as a rise in US rates--forcing a deleveraging.  The benchmark 10-year Chinese government bond yield rose 18 bp last week to bring the increase since the end of October to 66 bp.  The US 10-year yield has risen 76 bp in the same period.  

Economic conditions and market participants may be somewhat less prepared cope with the surging interest rates.  Pressure came to a head before the weekend.  Estimates suggest that the PBOC provided as much as CNY600 bln ($$86.5 bln) in loans to financial firms over the past two sessions and encouraged the large banks to extend credit to non-bank financial institutions (shadow banking?).  

The pressure is being exacerbated by year-end considerations, and many institutions are preparing for the New Year when individual quotas on taking money offshore are renewed.  The idea is that banks are amassing liquidity in preparation for this anticipated demand at the start of 2017.  At the same time, China is also tightening and expanding formal and informal capital controls. 

The Bank of Japan and Sweden's Riksbank hold policy meetings.  There is potential for both central banks to surprise the consensus which is looking for unchanged policies.  The surprise could come from the BOJ in the form of tweaking its goals.  Its new declaratory goal is to keep the 10-year yield near zero.  It has crept up to 10 basis points at the end of last week.  It had intervened in the longer-end of the curve, according to reports, and this seems to yield favorable results.  The 20-year bond yield reached 68 bp on December 13 and following BOJ efforts; the yield finished the week 10 bp lower.  

Most expect the Riksbank to leave its deposit rate at minus 0.50%.  The central bank put investors on notice in October that the probability of a rate cut had increased.  However,  of the 16 "qualified economists" in the Bloomberg survey, only one expected a cut now.    The idea is that the Riksbank may not be in a hurry to deliver a rate cut.  Deflation forces have not only been beaten back, but price pressures are accelerating.  The 1.4% year-over-year pace in November contrasts with the 0.5% pace at the end of last year.  The CPI measures that adjust for fixed rate mortgages rose to 1.6% in November from 0.9% at the end of 2015. 

Of note, Canada unveils its new measures of core inflation with the CPI.  These are a trimmed, median, and common measures.  Its previous core measure was 1.2%.  October retail sales are likely to bounce back strongly from the flat reading in September.  However, it might not be sufficient to prevent the October monthly GDP contracting.   

Less attention than usual may be paid to the minutes from the recent Reserve Bank of Australia meeting.  The day after the meeting, the government reported the economy contract more than expected (0.5%) in Q3.  

Some observers are playing up the importance of Yellen's speech on Monday in the US afternoon.  It is the first appearance since the FOMC meeting.  We make two points. First, she rarely goes beyond what is FOMC statement and her press conference.  Second, she is delivering a commencement speech at the University of Baltimore.  It is hardly the forum to get into the nuances of monetary policy, the Fed's balance sheet, or the implications of a fiscal policy that does yet exist. 

Disclaimer