Drivers & Outlook For Recent Upside-Down Markets

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There is nothing really new on the global growth front right now. Economic momentum is expected to gradually accelerate in the US. In the Eurozone, the idea that the recession could terminate sometime in Q3 seems to be confirmed by most recent indicators. If the Japanese economy is still fighting deflation, the willingness of policy makers to reflate very much remains intact. There is no main reason to express any serious concerns about slightly slower growth than forecast in China as long as the government, if needed, has both the will and means to provide further stimulation if needed.

In such an environment, how can we explain that most markets are upside down with a lack of consistency according to relative developments? Let’s discuss this latter point: isn’t it peculiar to record a significant decline in the USD index (-4.3% since 23 May) while either US yields or risk aversion are climbing? Coming back to the former, the more likely fundamental explanation for the markets ‘change of foot’ is a halt in the process of tail-risk reductions, launched a couple of quarters ago with two majors decisions: (1) the ECB doing “whatever it takes” to ensure the long-term survival of the Eurozone; and (2) the Fed embarking on QE3.

Taking the perspective that the Fed should begin to taper off QE3 sometime in autumn the market enters another era. The impression that low long-term yields, for a while now, are a kind of hunting license for risky assets is thus brought into question. Markets are looking for new guidelines from policy makers. Alas, for the moment their communication suffers from a lack of clarity.

In that sense, the FOMC meeting will be next week’s ‘grand affaire’. If the Fed is prepared to increase or reduce bond purchases, depending on economic data flow, markets would give more weight to the latter. The challenge for the central bank, and more especially for Chairman Bernanke during the press conference, will be to convince market participants that purchasing less assets (if labour date are supportive) is not tightening policy. Will they succeed? We suspect the response should lean more towards the negative side. This suggests that risky asset prices will be shaped by the balance between still upward pressures on rates and the data driven perception of growth strengthening. In the end, our scenario pleads for a parallel rise in long term rates and equity prices. How much time will it take for markets to forge their conviction? This is currently both the more important and more difficult question. We would be surprised if the dust settles in most global markets over the next few weeks.

While the ongoing policy experience in Japan is important for markets (which set of initiatives to use to fight against deflation?), the recent mistaken communication by BoJ governor Kuroda is an issue. In the press conference following the last monetary policy committee meeting, he was simply not able to convince markets as to how the central bank will approach the lessening of JGB market volatility. The BoJ’s main goal is to boost inflation expectations. This implies being able to maintain a high level of market confidence in its initiatives, permanently. With an ineffective monetary policy, the government will encounter serious difficulties when implementing structural reforms over time.

The ECB is also in the spotlight. What does it have the right to do, and is it communicating and explaining well enough? This is more or less the question being discussed by the German Constitutional Court. More precisely, the court must consider whether the ECB, with its OMT programme, has overstepped its mandate and so imposed excessive risk on German taxpayers. Everybody should be convinced that the main goal is to repair broken monetary policy transmission mechanisms and be aware that the related strict conditionality minimises sovereign risks. It is likely that there are no alternatives.

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