This week Bernanke surprised the markets outlining the chance of early tapering of QE (December meeting). For us this is quite surprising, as we still believe the US economy is not performing as well as it was believed this spring. Three main reasons have worsened our outlook on the US economy.
1) Declining inflation. The level is way below the target and the last read was at 1.0% compared to 2.0% in July.
2) Labour market trends: the labour market has lost his previous strength, the No-farm pay roll 4-weeks moving average is declining and the last isolated spike (204k vs 125k expected) is not enough to affirm that the previous momentum has come back. Moreover, we have the participation rate puzzle: The participation rate is declining quickly and it has reached the lowest level since the 1970s. This is clearly a weak sign for the labour market.
3) Economic sentiment: The main economic sentiment indicators are declining considerably, in particular the Michigan consumer confidence index is declining from 78 in the summer to 72 now.
Clearly Bernanke knows that. So why did he talk about the chance of a December tapering? Because of expectations! You will find a more detailed explanation in our economic article “What game is the FED playing” but essentially, we think the FED is trying to lead market expectations so that assets prices will follow the path they want. We believe the FED now fears a bubble and so they want to calm down the markets to avoid a crash that cannot be sustained at this stage of the economic recovery. Another reason for a December tapering is that Bernanke will end his mandate in January and if the tapering is not well implemented we doubt that FED officials would want to destroy the credibility of Yellen at the beginning of her mandate. If Bernanke does it and it looks too bad, Yellen can come and save the day.
As a result, we believe that at the December meeting the FED will do two things:
1) Start tapering
2) Lower unemployment threshold to reinsure the market that the rates will be low for a very long period of time and so rates hike will be postponed (given the three points outlined at the beginning).
Given the picture above, clearly SHORTING the S&P 500 is a good trade.
Clearly tapering talks are negative for US stocks and the may prove to be much more significant than they were last spring as there are no good signs coming from the real economy. However, because we expect also a dovish measure at the December meeting the shock should not be so strong. We think after the decline, that we forecast to be around 8% by year-end, the January earning season will be the key catalysts for the performance of the index as multiples are already very high.
This is the most interesting part. Our ideas are:
Sell 6m T-Bill, Buy 4Y UST Sell 10Y UST
Receive 5Y, sell 5Y UST.
The first trade reflects our view on how the UST curve will move if early tapering and a lower unemployment threshold will be implemented. In the short term, the unexpected liquidity shortfall will cause short term rates to raise. On the other hand, the 4Y maturity is the most likely to be affected by the lower unemployment threshold as rates will be expected to raise later. The 10Y rate should also move but less and 10Y UST are one of the maturity most sought after by the FED.
The second bet essentially reflects the same logic. Receiving forward rate means receiving fixed in a 3y1y forward starting Interest rate swap. Receiving fixed means that the 3y1y rate will go down.
The third one is a really interesting one and is more based on supply and demand. Right now FED is buying more 5y and 10y. As a result if the FED stops buying, the 5Y UST price will go down and the yield up. However, the 5Y Interest rate swap fixed rate (that is commonly known as the 5Y rate) will go down because of the expectation on rates dynamics. Clearly, the rate expectations can also push the 5Y UST yield down overcoming the FED effect on it but clearly, it should go down less than the IRS rate.
This week has been quiet in Europe, interesting divergence in the economic performance. Germany beats expectation while the periphery lagged back with France dramatically underperforming as the PMI composite was well below the expectation (48.8 vs 51.0). Also the aggregate level of the PMI was below expectation (51.5 vs 52.0). This is pretty worrisome as it is the second week that PMI comes short of expectations and the French level is really low. These are not good news, as it seems that the recovery path has stopped and it might revert.
On the other side Germany keeps surprising on the upside and this is clearly good for our position in German break-even inflation.
After the rate cut European equities look like the rising star, accommodative policy and small signs of recovery. The main problem are the data and this week we have not had a significant amount of data to make the picture more clear. However, a good trade is LONG EURPEAN FINANCIALS. Why? This trade has an asymmetric profit opportunity, as it will be profitable in two out of the three scenarios possible.
First, if the economy improves (both core and in particular the periphery) then inflation fears will calm down and then improved economic performance will clearly be bullish for the sector (which is one of the most cyclical).
Second, if the economy does not perform well other measures would be required in order to boost the economy. Then, we think the most likely outcome would be a new round of LTRO. Indeed, negative depo rate will be harmful for those banks that have to keep excess liquidity for regulatory reasons and thus this measure may have undesired effects.
The third scenario is a new European crisis or at least serious doubt about the economic recovery, probably led by France. Clearly this would be very negative for the sector.
The United Kingdom is currently on the road to full recovery. Some believe this is an overstatement, but all the signs show strong fundamentals that give us signs to believe we are going in the right direction.
Let us look at last week’s data:
On Monday, the Right move residential property price index soared by 4% (YoY). There is a strong rise in UK property now and this is hardly a bubble as it is indeed driven by low interest rates, but most of all higher consumer confidence and public perception that recovery is underway. London has become the billionaire’s city where to be: it provides excellent education, low taxes and almost no bureaucracy at all.
This Thursday’s BoE Minutes provided further market reassurance that the pace at which Q.E. is going will not slow down for now but will remain stable, and chance of interest rate hikes is quite slim indeed. Mark Carney’s speech this week informed us that the 7 % mark might well not be a trigger for interest rate hikes. What we can take from his words is that “unbalanced growth is better than no growth”, for now, but he foresees full growth ahead. FTSE 100 closed on Thursday’s session virtually unchanged but 0.61% higher than Wednesday morning before BoE’s statements. On Friday, it slipped 0.11 %.
Wednesday the 27th: UK Nov GDP release. The latest being 0.7 % (QoQ), we believe there are strong fundamentals within the UK economy as to expect a further unpredicted growth.
Given the situation, a good trade is LONG GBP-JPY.
Enter around the 163.7 mark. Timeframe: 3 weeks. There may be some consolidation in the very short period around the 163 mark, but next week’s events should push the sterling up even further.
One week analysis on a 30 minutes basis shows the pair has been moving quite on the upside of the Exponential Moving Averages, and RSI shows results around the 50 mark, so the currency does not look too much over bought.
Let’s take a look at what is happening in Japan:
Even Japan is showing moderate signs of recovery, says BOJ’s Kuroda. Stimulus will be held steady for now, but BOJ is ready to ease policy again if risks to the economy materialize. Japan’s economy in July-September slowed down due to house-holding spending and exports, but analysts expect growth to accelerate in the coming months. This though is in contrast with Japan’s uninterrupted trade deficit which on Wednesday widened to ¥ 1,072.5B as a result of imports’ growth outpacing exports. These have been rising steadily especially in the vehicle industry, but the offshoring of much of Japan’s manufacturing is increasing the costs for industrial components such as semiconductors and optical lenses, in this way wearing down net exports by relevant amounts. According to many, Japan’s manufacturing industry can’t be saved because of competition from newly industrialized countries. Consequent to this trade balance result, next week provides two important events for our trade.
Monday the 25th: BOJ minutes. BoJ will likely speak about the current situation and give any hint for further Q.E, especially after yesterday’s trade deficit release.