What We Learned Last Week

May 27th, 2013
in contributors, syndication

The Coming Week: New Lessons On The Rally’s Health

by Cliff Wachtel, Global Markets

Part 1: Daily Breakdown

Top Market Movers From Prior Week:

  • Rising Perceived Risk of QE Cutback
  • New Evidence of Struggling China Recovery

The prior week was the first down week since mid-April for the US and Europe, and the first real weekly decline in Japan since November 2012.

Follow up:

Monday: Asia, Europe Up On US Performance Friday, Weak JPY, US Down On Further Hawkish Comments

Asian indexes mixed mostly higher. The Nikkei again hits new highs due to continued declines in the JPY and increased optimism after the government upped its assessment of the economy for the first time in two months. Adding to the good mood:

  • Signs of an improving U.S. economy and Wall Street’s record closing high on Friday.
  • A Nikkei report that Japan and India are expected to agree to resume talks toward a civilian nuclear cooperation deal at their summit meeting this month. Manufacturers of nuclear reactors benefited on the report.

Otherwise there was no news out of Asia or elsewhere on Monday and much of Europe had a bank holiday.

European shares also hit new five year highs on follow through effect from the strong US and Japan closes. Meanwhile EU crisis complacency is alive and well, as yields for Italy and Slovenia fell to lows for the year. Key for Slovenia is to maintain its A- S&P credit rating, which allows its banks to pledge their government bonds as collateral.

US indexes were overall flat to slightly lower on hawkish comments from the usually dovish FOMC member Charles Evans renewed fears of coming reductions in bond purchases that have fueled the long stock market rally despite the absence of supporting fundamentals to justify all-time highs.

Tuesday: Caution And Speculation On Fed QE Tapering Dominates Trade

Asian and European indexes were mixed on caution ahead of Fed Chairman Bernanke’s testimony to Congress. His appearance was expected to clarify whether hints about the mere possibility of cutting back on QE are true. Thus it was expected to be the event

US indexes were higher due to (what else?) dovish comments from Fed regional presidents Dudley and Bullard. While they didn’t specifically deny the possibility of some kind of curtailment, they made clear that QE is far from done.

In sum, indexes moving on sentiment about whether the Fed will or won’t materially reduce QE in the coming months.

Wednesday: European And US Indexes Diverge On Timing Difference

Asia was mostly higher, with upbeat BoJ comments fueling Japan shares and those related to them. The central bank kept rates steady, but upgraded its outlook for Japan.

Europe and the US had completely different closes. Europe ended firmly higher, the US firmly lower, all due to a matter timing.

Here’s how it went -

  • 10:00 AM EST (3pm GMT), Ben Bernanke testified before the Joint Economic Committee of Congress. He emphasized that premature tightening or tapering risked slowing or killing the economic recovery. That was all that Europe heard while its stock markets were still open. European traders took this to mean that there were no imminent plans to cut back on QE. That equities – supportive consensus caused European indexes to close higher.
  • However during the Q&A session that followed, while European traders were heading home, Bernanke reversed himself, saying that the Fed in fact could taper bond purchases in the next few meetings if the economy improved enough. While that might seem obvious, markets interpreted it as a very intentional hint that his earlier remarks were quite subject to change. That had traders slamming the sell button, and markets headed lower for the rest of the day.
  • At 2:00 PM EST (7 PM GMT), the Fed released the minutes from its latest Federal Open Market Committee (FOMC) meeting. Tweeted Deutsche Bank’s Joe LaVorgna,

FOMC minutes show a willingness to taper asset purchases this year; … We expect the taper will begin in either late Q3 or early Q4.

So in fact a reduction in QE is on the menu later this year, as long as there is no surprise contraction in the US economy, and that brought a predictable response from US markets.

All US indexes ended firmly lower, with the S&P 500 1% down. The USD soared. Even if the Fed does little, Bernanke confirmed that the Fed is heading towards tightening, while the other central banks are steady or heading to easing. Like stocks, currency trends are profoundly influenced by expectations in rate changes, but in opposite ways. Stocks drop on rate hike expectations, whereas currencies rise when their central bank goes into tightening mode.

Thursday: All Regions Lower On Bernanke Remarks

Not surprisingly, Asian and European indexes plunged, catching up to the newly reinforced perception that QE 3 isn’t infinite, and may well be cut back in the coming months if the US recovery stays on course. That’s a big “if” but the mere chance of a cutback in stimulus is a game changer. Until the past few weeks, there was no end in sight to QE and Bernanke had indicated the Fed could ease further if needed.

Asia and Europe were down overall 1-2%, with the Nikkei power-diving over 7%.

Of course the EURUSD fell hard on this news as it reinforced the notion that the Fed is tightening relative to the ECB. As we cover in depth in our award winning book, changing expectations on interest rates are a prime driver of currency prices.

Also weighing on markets:

Weaker than expected Chinese manufacturing data exacerbated these moves, but was secondary in influence to Bernanke’s remarks. Of course the mechanics are a bit more complex. Bernanke’s remarks caused a 10bp jump in US Treasury Note yields, which in turn caused a JGB yields to gap higher, and that caused a selloff in the Nikkei. The rising fear upped demand for the JPY, which continues to respond as the ultimate safe haven in times of fear. That’s a delicious bit of irony given the JPY’s likely long term fate, but that’s how currency markets behave these days.

Euro-zone PMIs, while slightly better than expected, continued to show contraction in the region, albeit at a decelerating pace.

US indexes closed only modestly lower, as they’d already absorbed the news of possible QE cuts a day earlier. In fact, they recovered most of their early losses 1% – plus losses as the usual buy the dip mentality kicked in.

Friday: Overall Mixed To Lower On Continued Negativity From Fed, China

After Thursday’s -7% bloodbath, the Nikkei bounced back almost 1% and other Asian indexes were mixed. The main cause for the pullback was the news that the Fed may indeed pare back QE. That caused US 10 year bonds yields to spike, which their Japanese counterparts to do the same, and scared Japanese stock investors. The big ramification was that it raised questions about the sustainability of the Japan rally and the credibility of Japan’s radical stimulus policies (aka Abenomics). [See Part 2 for details on these questions and possible outcomes.]

European indexes closed mixed but overall lower, again mostly due to concerns about Fed QE cutbacks that could leave stocks prices to be more dependent on traditional economic growth and earnings metrics. It’s no surprise that brought continued selloff as these have not been inspiring in recent years. It’s widely understood that stimulus has kept asset prices up, so if stimulus is due to be reduced, stocks should follow it lower.

US indexes were essentially flat on Friday on light pre-holiday weekend volume.

Part 2: Lessons, Conclusions

[Having reviewed the prior week in Part 1, here are the key lessons and conclusions.]

Rally On? Three Things To Watch

As we mentioned last week and in our 2013 forecast, the fate of global markets likely rests on the twin fundamental pillars of:

  • QE continues and continues to work at propping up asset prices, repress interest rates low enough to force the added liquidity into risk assets like stocks.
  • Continued complacency about EU crisis risk (and no other surprise crises, of course)

We watch for any material news on these.

Then there’s a third thing we watch carefully.

  • Price Action – What The Markets Think: Regardless of what we think is happening with the fundamentals, we base decisions to enter or exit positions based on actual price action on the charts of our chosen risk barometers, whether they’re the S&P 500 or something else.

First, let’s look at those two fundamental pillars.

QE Continuation In Doubt: Fed Feeds Tapering Speculation

Fed Chairman Bernanke’s comments in the Q&A session following his prepared statement to Congress, and the FOMC minutes last Wednesday were together the undisputed chief market mover this week, because they clearly raised expectations about the pace and extent of the Fed’s tapering of QE.

Why the big deal? There are good reasons to shrug these off:

  • First, taken together they were ambiguous. The message was that any Fed tightening would depend on continued improvement in the US economy.
  • Second, as Josh Brown pointed out here, Bernanke believes a key cause of the Great Depression was that the government tightened too quickly, so any coming moves to reduce QE are likely to be very gradual. The Fed would rather err on the side of caution.

The reason markets reacted so strongly is simply that, as we stated in our 2013 forecast, markets believe that QE, with its continued flow of cash seeking a home and low yields, is the only thing holding up risk asset prices in the face of headwinds that would normally prevent a long term rally:

  • weak global economic and earnings growth
  • ongoing risk of contagion from the EU

The pullback in the days that followed confirmed our belief that the rally still lives or dies on continued QE.

The Fed knows that too. As long as inflation isn’t a threat that means any meaningful tightening isn’t coming until unemployment gets near its 6.5% target and other growth metrics like consumer spending reflect that improvement.

Ramifications Of Fed Moves

Pullback More Likely Than Reversal

Until we see more evidence that there is going to be a sustained curtailment of QE, or that markets are starting to pay attention to the weak global and earnings growth or EU contagion risk which has persisted in past years (no evidence of that thus far) then we’re not likely to see more than the long anticipated normal bull market correction.

Japan Rally Gets First Big Test

The Fed news sent USD and Japanese 10 year note yields higher, and that sparked the first big selloff and down week for the Nikkei since November 2012.

USD Continues To Evolve, Show Risk Currency Characteristics

Any hint of fed tightening should send the USD soaring, yet it was down against a number of currencies, even the EUR. There are no fundamental explanations. Europe continues to look awful, especially compared to US data. This was a technical move, likely driven by the Japan stock selloff. Those long Japanese stocks were hedging their risk of continued declines in the JPY by being long the USDJPY pair. When Japanese stocks sold off, so did those USDJPY hedges.

Complacency On EU Crisis

Calm about the EU was the other requirement for the rally, and that remains firmly in place. Never mind that the EU economy continues to deteriorate, as shown by the past week’s PMI showing further contraction, or that Spain remains a genuine contagion risk. GIIPS nations’ bond yields have been overall steady or falling, as was the case for Italy and Slovenia this past week. EU is likely to stay quiet at least until after German elections this fall. A further sign of easing concern about the EU came from Citi Bank economist Willem Buiter, who pushed off his 2012 prediction that Greece would  leave the EZ in by no later than mid-2014. He still believes there is a high risk of a Greek exit at some point in the coming years.

Nothing in the EU has improved, but calm remains. We don’t believe it, but we’re unlikely to know of the next crisis until it’s already hit.

Bigger Black Swan Risk In ME?

Actually at the moment you could argue that the bigger source of market scaring black swan risk is the Mideast. No less than three of Israel’s neighbors’ central governments have limited meaningful control over their common border with Israel (and their countries in general). Israel is coping with its own budget problems, and boy do wars mess up a budget, but the threat of WMDs leaking into Hizbollah’s hands on Israel’s Northern border could force Israel’s hand. Four more years of Obama only makes Israel feel more like it must act on its own, given Obama’s ambivalent attitude to a viable Israel or to the need to recognize the global Jihad threat as a global threat rather than the acts of an isolated few.

The Other Big Market Mover To Watch: China Recovery Deferred

A disappointing Chinese Flash PMI report of 49.6 in May vs. 50.4 showed the first sub-50 reading (contraction) in seven months, confirming fears that the second largest economy is decelerating, and that dampened hopes of a Q2 China recovery.

This report suggests that the official manufacturing report due out next week on June 1 will also print below the 50 contraction line. As long as China’s central bank remains cautious about easing, the most likely source of hope comes from reform progress. The next big event on that front comes in the weeks ahead, when new leaders will hold a high-level meeting on China’s urbanization strategy.

Given China’s role as the prime commodity consumer, the news had more impact for commodity economies like Canada and Australia, and their currencies, the CAD and AUD, than for global markets. Both their stocks and currencies felt the pressure.

Technical Picture: Risk Trends Healthy, A Scary Signal

The weekly S&P 500 shows a typical picture of other major global stock indexes.

Source: MetaQuotes Software Corp, thesensibleguidetoforex.com

Click to enlarge

As we noted last week, all time resistance around 1556 has been decisively broken, and long term momentum remains very strong. For example:

All weekly moving averages continue to trend higher from the 10 week EMA (blue) to the 200 week EMA (violet).

The index remains firmly in its double Bollinger band buy zone, the area bounded by the upper orange and dark green lines. That suggests the trend still has strong upward momentum. See here for a quick look at how to interpret these.

If we zoom in on the daily chart below, however, there is reason to believe that some kind of pullback is coming.

Source: MetaQuotes Software Corp, thesensibleguidetoforex.com

Click to enlarge

As Josh Brown noted here Thursday:

The very frightening statistic that’s been making the rounds overnight is that the last two times the S&P 500 touched a record intraday high and then closed down more than 1% from that high were October 11, 2007 and March 24, 2000, the last two major tops for the market, both of which occurred before historic crashes.

Meanwhile, the uptrend is still intact. However the index has left its upper double Bollinger band buy zone, suggesting that short term momentum is neutral.

Currency Wars: Smaller Central Banks Strike Back

The China data, especially in combination with the past week’s contracting PMIs from Europe, reinforces the weak global growth picture. That fact in turn will reinforce the spreading trend of central bank easing. Last month, 14 central banks cut their rates, either in response to the overall slowdown or to specifically protect their exports. See here for details. As the author of the only book I know of that shows investors safer, simpler ways to cope with a world of debased fiat currencies, my thanks goes out to them all.


wachtel-book-sensible-forex-150x200As always, we warn readers that just as any prudent investor diversifies into different asset and sector classes, so too they need to diversify their currency exposure. You don’t need to open brokerage accounts all over the world, or engage in high risk, complex forex trading. You do need to understand the range of safer, simpler, smarter ways to get that diversification. To help you with that, I’ve written the only collection of forex solutions for mainstream risk averse investors and traders, The Sensible Guide To Forex, Safer, Smarter Ways To Survive And Prosper From The Start.

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