Thursday, April 28, 2016

Markets: The Yen and The Yang

A shaky market trying to forget the early Q1 blues just need another focus shift to scare itself in to another round of sell-offs. And the BoJ action today may as well be the catalyst.

BoJ has very few solid reasons not to act today: The inflation prints have been horrible, in the negative territories. Even the core inflation (ex fresh food, the measure BoJ prefers) registered negative. If I am not mistaken that will be lowest since BoJ expanded the QE in line with Abenomics in 2013. The market actions, either from the  breakeven inflation markets, or the recent rally in yen, does not support any case of enthusiasm there either. Negative rates so far is quite untested for jacking up inflation expectation. They have been successful for exchange rates policies in smaller European nations, but for Japan the market has given a clear thumbs down with yen rallying instead. And the Japanese banks have not been much amused with it either. That, and many other things (jump to first of Q&A), will possibly floor the use of negative rates in future.

There are three possible interpretation here. The first one is that BoJ gave it a pass to focus in June, by which time a Fed course of action will be clearer and probably priced in - this implies a question of time. Second, BoJ is really more optimistic than markets, which implies a question of further data. And lastly, BoJ is running out of options. This is the worst of course. In principle it is hard for a central bank to run out of options. But honestly, looking ahead for Japan, one can be hardly optimistic about the effectiveness of a monetary lever.

Whichever the case, if markets interprets things more in the line of the third, it is not going to be nice.

Monday, April 25, 2016

Macro: FOMC - Commodities De-correlation Will Bring Back Domestic Focus

Back in 2014, I made a calculated guess on the possibility of the oil prices taking on a larger influence on returns across different asset markets through increased correlation.

Over the course of next almost one and a half year, that is pretty much what we witnessed. Around late 2014, the correlation of oil and commodities to risk assets started to pick up, reaching the highest level since the 2012 very recently this year. Not only risk assets, oil (and in general other commodities) saw a general increase in correlation across other asset classes around the same time. This includes the inflation market (both TIPS and breakeven swaps), rates (both yields and slopes), FX (G10 returns for example) and even volatility (VIX) in absolute terms.

Of course this is no way unique. In general the post-crisis era has seen a much more significant correlation of commodities or oil prices to other asset classes. This is partly due to the typical high-correlation market condition (RORO: risk-on/ risk-off) that prevailed most of the time since then. But this is also because in a low rate, low inflation environment, oil and commodity prices can significantly influence inflation expectation and hence returns in most asset classes through various channels (including expected central bank reactions). However, it appears very recently we are close to the peak, if not past it already.

The chart above shows how the broad cross asset correlation has played out since 2010. The horizontal axis plots asset factor correlation to inflation expectation (5y TIPS breakeven). Vertical axis plots the same for correlation to Brent crude prices. The size of the bubble shows the prevailing level of VIX.

The difference in the latest round of rise in cross asset correlation driven by oil and inflation since late 2014 (compared to earlier RORO period of US Debt Ceiling Crisis or European Sovereign Debt Crisis,) is a decoupling of the correlation drivers. While crude and inflation expectation are still highly correlated to most other asset classes, very recently, the crude has come off, while inflation still remains a major driver.

This possibly brings us back to focus on the influence of inflation expectation vs. commodity prices on risk assets. One potential mechanics can be as explained in this piece by former Fed chair B. Bernanke. The component of oil price moves that captures future expected demand is probably stabilizing. And the correlation of risk assets to the residual components may be declining. This will most certainly materialize if oil and general commodity prices stabilize around current level. We have already seen some early signs of this, like the muted response from the market on the latest Doha talks.

This means, even as inflation expectation continues to drive cross asset returns, we will now focus more and more on domestic inflation. And historically realized inflation measures, especially core inflation measures (as opposed to inflation expectation) have been quite uncorrelated across geographies. The chart below shows nominal GDP for developed economies in expenditure components as well as in region-wise split. Notwithstanding the bad streams of economic data, many regions are doing quite well. US consumers still doing okay, dollar block in general has been quite resilient and even Euro area has recently got a boost from investment spending. And this is  in spite of the significant contraction of the government budget.

The implication of the above is, going forward, FOMC will possibly be much less tied to global commodity cycles corrections, and that will be a huge breather. This will be especially true as the base effects kicks in if commodities stabilize during the remaining period of this year. That might just make the current FOMC dot plot (median year end rate at 87.5bps) quite plausible. However, the market is still pricing around 65% chance of further hike by year end, of which around 40% for just one more 25bps hike. The realized hikes will probably match or exceed this if this de-correlation continues. In this line of argument, this week FOMC is expected to come out much more hawkish than the last.

In the medium term this will not be much damaging, even if we do realize these two hikes. I think unlike during taper tantrum, the markets now understand and appreciate the Fedspeak of slow pace of hike. But that does not exclude for short term gyration, especially for risk assets.

Data in the charts are from Fred database, Bloomberg and Yahoo Finance.