Overnight the S&P500 fell for the second day in a row, for the largest two-day drop in 7 weeks. Sounds dramatic, but bringing this move into some perspective, the index is now down a mere -0.7% over the last two days! Weakness mainly attributed to Fed speak from a couple of Fed officials: Atlanta Fed President Lockhart talked about removal of the extraordinary policy program while Chicago President Evans said "We are quite likely to reduce the flow of purchases rate starting later this year…”
Despite the taper talk the USD finished the session weaker, with relative strength seen in EUR and particularly JPY.
I have previously mentioned that I currently view USDJPY as a key indicator of the market’s preference for risk. Following USDJPY’s break of near-term congestion to the downside I fully expected the pair to test 97-ish (i.e. the long-term uptrend line). USDJPY is now trading below this trend line (see chart below). A convincing break to the downside from here will usher in a period of risk-off.
Keep an eye on this. A sharp change in risk sentiment could result in a sharp pullback for equities with NYSE margin debt levels at/near all-time highs:
There will be a lot of chatter on CNBC etc. about the “unwinding of the Yen carry trade” if USDJPY does break down. This type of chatter comes from people who do not understand what a carry trade is. A carry trade (in FX) is where one borrows in a low yielding currency (e.g. Yen) and buys a high yielding currency (e.g. AUD) in order to generate returns from the resulting positive cashflow (termed positive carry). Interest rates in both USD and JPY are effectively zero – there is no interest rate differential that makes a “carry trade” worthwhile, particularly when you consider USDJPY volatility is currently around 12%. Heck, even if you borrow JPY at (say) 0.20% and invest in AUD at (say) 2.20%, your positive carry is only 2.0% p.a. When the volatility of AUDJPY is 12.6% you are ipso facto expecting the majority of your returns to come from currency movements not positive carry (whether you realize it or not!): Therefore not a carry trade.
I still wonder quietly to myself whether the Fed is being overly transparent with respect to communications on their plans for QE. I just feel that if one day in the future we were to read the Fed minutes and learn after the fact that the Fed only bought $65 billion worth of securities instead of $85 billion the previous month – particularly if unemployment had already reached the 6.5% mark - the world and financial markets would carry on without much anxiety.
But that is just wishful thinking and we are in a world, currently, where the market is Fed obsessed. Following the move in 10 year bond yields following the initial tapering discussion, much of the world is convinced we are at or very near the point where bond yields break higher for good. Certainly the upward move in 10yr bond yields has been quite dramatic (see chart below):
A longer term chart (below) always helps lend a sense of perspective:
Clearly the 30-odd year bull market in bonds is getting long in the tooth and I am not arguing for further strong gains in bonds here. However I do think the Fed’s expectations for the US economy are rather optimistic. The consumption trends of the American consumer and indeed the ongoing durability of the investor-driven buy-to-let housing recovery we are seeing are likely to be constrained by the continuing lack of income growth experienced by the average US consumer. Further, the 9th July announcement that US banking regulators are to impose a 6% leverage ratio on the 8 largest banks will likely pose a headwind to re-leveraging (assuming there is even robust end demand for credit).
Accordingly I expect cash rates to be stuck at zero for a long time and I wouldn’t be surprised if bond yields are range bound for much longer than most currently expect. Betting on higher rates seems like the right move on a 5 year view. On a 1 or 2 year view I’m not so certain.
Before I finish, a quick word on Apple. The technical set-up on this name looks appealing. The stock is attempting to break through resistance at around $466. If successful, the double-bottom would target ~$544 which coincidentally (?) is in line with a 50% retracement from the recent high to the low. Also…The high occurred on 21st September 2012 and the low occurred on 19th April 2013. That’s 143 trading days…VERY close to the Fibonacci number 144…but I’m sure that’s just coincidence too ;)