Financial markets are beginning to show signs of change. Volatility in FX markets in particular has increased (see first chart below) which is often the canary in the coal mine for other assets. Having witnessed a few false dawns already this year, we believe that the signals being generated this week are the real deal. The FOMC meets this week and is likely to discuss the timing and trajectory of rate rises which could appear more hawkish than many investors expect.
Volatility in FX markets, along with other assets, was in a very steady decline all year and reached historically low levels in the Summer. The chart below shows 3 month 'At the Money' volatility for G7 currencies. Having touched 5% in the Summer, there has been a large increase in the last two weeks up towards 8%. The current level is still low by historical standards and we expect volatility to move higher in the months ahead driven by diverging central bank actions, reduced US Dollar liquidity and the seemingly inexorable drive towards currency wars as politicians resort to the simplest, yet inevitably most harmful, action instead of implementing tougher structural reforms.
The USD bullish case really began to develop in May when the Euro started to weaken on Draghi's commitment to significantly ease policy. The recent weakness in Sterling (obviously driven partly by concerns over the Scottish independence vote) helped strengthen the case. However, it was still unclear as to whether this was USD strength or Euro and Sterling weakness. The broad based performance in the US Dollar this week significantly strengthens the general USD bullish thesis. In particular, strength against commodity and EM currencies makes us believe that a significant rise in the Dollar is only just starting.
The chart below shows the weekly Aussie Dollar versus US Dollar. Last week, the Aussie Dollar fell by 3.6% from an historically significant pivot point and was the worst performing major currency by a long way. Having been a popular carry trade or high yielding currency to own, this breakdown is a sign that investors are shifting away from 'risk on' trades. It is also significant that the decline happened in a week when the employment data showed that Australia created the most jobs in August in over 20 years. When popular carry trades blow up like this when volatility is rising from historically low levels, it could mark a sign of broad 'risk off' not just in FX but probably also in equity and credit markets.
Looking ahead to the Fed next week, the hawks (including us) are looking for a change in language indicating that the rate rising cycle will start sooner and be more aggressive than current market expectations. This would be very supportive for the US Dollar and should weigh on bond and equity prices. We believe that a number of the regional Governors are on the hawkish side of the camp (see below) and the question remains on whether Janet Yellen holds the upper hand, remains dovish and talks about rates remaining low for an extended period of time after QE ends next month.
There were two interesting papers this week that support the more hawkish scenario. First, the San Francisco Fed published a paper on Monday concluding that investors are expecting a more accommodative policy than FOMC participants. This is quite a statement to make, although we simply don't know whether these are the personal views of the authors and simply stating facts about the rates market versus the Fed "dots". Alternatively, is this the Fed subtly trying to communicate with the market that they are serious about rate rises starting Q2 next year and that the market is wrong in being so dovish?
Secondly, economists at the Federal Reserve and the Cleveland Fed presented a paper on Friday discussing the drop in the US labour participation. The authors blame the lower participation rate on "ongoing structural influences that are pushing down the participation rate rather than a pronounced cyclical weakness related to potential jobseekers' discouragement about the weak state of the labor market... We see further declines in the aggregate labor force participation rate as the most likely outcome." This is not a view shared by Janet Yellen who believes that the decline is due to discouraged workers dropping out of the workforce who could subsequently return when the jobs market improves. This is basically the structural versus cyclical argument and if the balance tilts towards structural, implying there is little that the Fed can do to improve the situation, then Fed policy likely shifts hawkishly.
Assuming a more hawkish Fed next week, we look for US Dollar gains to be extended immediately. A less hawkish Fed probably just delays rather than derails the higher rates environment and so will only delay the next move higher in the US Dollar. Regardless of the ebb and flow in the Dollar, we should expect the Euro to be independently weak in the months ahead.
Moving onto other asset classes, what happens to equities and bonds if the Fed does move more hawkishly?
At the moment, the interest rate market is too dovish compared to the Fed dots, and so a confirmation of the dots or something more hawkish could have quite a marked impact on the short end of the curve. We continue to be of the view that developed economies will struggle in the face of "secular stagnation" headwinds, and we see the long end of the curve anchored at low yields with any rate rise cycle increasing the potential for a recession in 2015. So we are looking for a flatter interest rate curve in the US.
In equities, the August rally has so far stalled in September despite the recent policy initiative from the ECB. We continue to believe that the upside for equities is modest with Fed QE nearly at an end and rate rises being discussed, and in fact, equities look vulnerable to a decent correction. That said, our fundamental analysis has not helped us in recent months, and with the short term trend still upwards, we need to see downside momentum to develop. Perhaps this will coincide with a more hawkish Fed.
We continue to see divergences build. For example, the S&P versus junk bond spreads, shown in the chart below. Volume remains tepid and the divergences between price and advance/decline and price versus new 52 week highs/lows is now quite striking. Perhaps the chart to really keep in mind is the S&P 500 versus Junk bond spreads. We believe that both assets are in bubble territory, but history shows that equities are more vulnerable after junk bond spreads have widened out – exactly what is happening now. It is no accident that this is occurring as QE is coming to an end. If the under-performance of Junk bonds continues and equity market volatility increases, then equity markets will become increasingly vulnerable to a 10% + correction which could easily morph into something more serious.
To wrap up, financial markets are changing character. This change is starting before a very important Fed meeting this week (not to mention the Scotland vote and ECB liquidity announcements) and although this uncertainty may well be yet another false signal for the bears, can the bulls continue to ignore ALL the bearish signals? At the end of the day, it will be lower prices coupled with a more hawkish Fed that will cause investors to become increasingly bearish. Although we can only speculate when that time will be, we would caution that with poor liquidity in markets and a large number of investors potentially looking to exit at the first sign of a change in long term momentum, it may not be easy to sell at the price you want.