We have in recent weeks (see here and here) identified four primary drivers shaping the investment climate: speculation about Fed tapering, stabilization of the Chinese economy, the reflation story in Europe and renewed capital outflows from Japan.
While near-term risks to this scenario are minimal, we are concerned that next month is a different story. Specifically, we think there are substantial risks that the market will be disappointed by the FOMC.
We have highlighted three dimensions to the issue: when, how much and what asset (Treasury or MBS) should experience reduced buying? We have been skeptical about the tapering in September, but even if it does materialize, the reduction of purchases may be smaller than the $20 bln initially expected and the $15 bln that it appears is now the consensus.
Outside of the weekly initial jobless claims, much of the recent string of real sector data has been decidedly mixed. And there is really no compelling evidence that core inflation is moving back toward the Fed's target. A strong case can be made that more data is needed
We emphasize the fact that by their own reckoning the Federal Reserve exited previous quantitative easing programs prematurely in the sense that they agreed to initiate a new program.
Some have argued the tapering decision is a function of technical considerations, like the fact that the deficit has fallen more than anticipated and this has reduced the new supply of Treasuries. If the Fed were to reduce its purchases of MBS, this would cast doubts on that explanation for the Fed's tapering.
The other part of the general narrative that is at risk after this month is the European reflation story. It is not so much that the European recovery will reverse, but rather that other issues will become more salient, especially after the German elections. These include progress on the banking union, which requires a more rigorous examination by the ECB, Greece's apparent funding gap, the fragility of the Italian government as it turns to the 2014 budget.
The stabilization of the Chinese economy theme is intact. Last week's news that China's power output last month was at a one-year high (8.1%) helped reinforce that view and the flash HSBC manufacturing PMI is also expected to show improvement. The Chinese government appears to have taken some modest and targeted fiscal measures to help support the economy. In addition, expanding "free trade zones" to other cities, including Shanghai, is also expected to help buoy the economy.
The most recent Ministry of Finance data showed Japanese investors have continued to buy foreign bonds. During the six week buying streak, about $53 bln of foreign bonds have been bought. Japanese investors have continued to sell foreign shares, but at less than $5 bln over the past six weeks, it is not much of a rotation taking place.
For their part, foreign investors have sold Japanese shares for three weeks through August 9. During this run, they have sold a little less than $3 bln of Japanese shares, which is less than the amount bought in any of the prior four weeks. Foreign investors have also bought around $5.5 bln of Japanese bonds over the past couple of weeks.
Since Japanese investors have become net buyers of foreign bonds, core bond markets have sold off amid the tapering talk and relation news and the yen has strengthen against the US dollar. This may begin tempering the demand for foreign bonds, even though the US premium over Japan has risen above 200 bp to reach its highest level in more than two years. Recall that as recently as late May, the premium was near 100 bp.
The widening spread partly reflects the success of the Japanese government. After a tumultuous start to the quantitative and qualitative easing announced in April, the JGB market has stabilized. Even in the wake of the a 33 bp rise in US and German 10-year benchmark yields over the past month, the yield on the 10-year JGB has fallen by around six basis points.
In addition to the stabilization of the JGB market, there are four other developments in the fixed income market to note.
First, the Australian dollar's recovery in the spot market has coincided with the OIS market nearly taking back the expectations of another rate cut. To the contrary, we expect another 25 bp rate cut in Q4, perhaps in the second half.
Second, UK gilts are underperforming and sterling moved higher for two weeks. The UK has offered a premium over the US on 2-year funds. It now offers a premium on 5-year government borrowings. The 12 bp premium the US offers over the UK is likely to narrow further. The UK economy appears to be accelerating even though the extended stagnation period did not wring inflation out. This is incidentally part of the opt-out clauses for the forward guidance.
Third, unlike earlier increase in US yields, the peripheral bond markets in Europe have rallied. Yields have fallen in absolute terms and relative to Germany. It is not just Spain and Italy's bond markets that have outperformed, but so have their stock markets. This is consistent with reports of new foreign interest and flow of funds.
This may help explain another phenomenon. The US-German interest rate spread collapsed from almost 30 bp about a month ago to less than 10 bp last week (before stabilizing around 12 bp). The movement in the spread owes more to the increase in German yields than US yields by a function of almost 3 to 1.
Perhaps the global reflation story and the perceived less need for the security of Germany and the US amid signs that the Japanese recovery story is waning is driving the reallocation of capital, with the periphery of Europe clearly favored. If this is the case, it is notable that the emerging markets do not appear to be being helped by the global reflation theme.