Market Sentiment Flux

Tectonic shifts in central bank policy and market psychology in global markets over the past month has left traders exhausted and confused - opportunities remain plentiful but risks are elevated.

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Since June, the Fed and broader central bank policy around the globe have been the key theme. When you have the world's largest economy hinting to tighten monetary policy whilst other G20 economies are proactively loosening policy - you will see sharper, short-term focused trade flow with higher volatility and numerous reversals as market participants rush in one direction, only to reverse as expectations and sentiment change course. Uncertainty is often the biggest driver of markets because a) today's markets are predominantly speculative b) uncertainty plays up to, probably our most visceral emotion - fear c) we always worry about things we don't know or can't control. Fear of loss and or fear of not matching particular targets/expectations encourage traders to act irrationally and contribute to making markets even more speculative and emotional. It’s a self-affirming phenomenon and we've been seeing more of it since the GFC in 2007/8.

When we look at the Fed's recent shift towards hawkish policy (followed be a hasty retreat a couple of weeks later) it’s clear that yield differentials and future yield differential expectations are the root of the causality tree in FX. No other factor matters more in a market that is obsessed with yield, return and safety of capital. The US dollar spiked higher after the FOMC meeting on June 19th but has gradually waned following gradual investor realisation that the Fed was probably too optimistic or the central bank was simply misunderstood. Either way, USD fell across the board this week due to Fed comments pleading with the market to stop its assault on US short-term bond yields. As an analogy, the market was like a spoilt child throwing a tantrum because the vending machine serving all the sweetest candy would be discontinued soon. Realising that the child would make a lot of noise and annoyance, the parents didn't hesitate to cancel removal of the vending machine. If anything, they’re thinking about how to re-stock it without giving everyone in the vicinity bad teeth. The Fed & the US Treasury have been like dysfunctional parents to a market that is short-tempered, naïve and temperamental.

The market moves seen since the Fed announced a possible ‘tapering’ scenario have been extensive and have consolidated. The USD is higher in all FX pairs, Gold/Silver are sharply lower, so too are commodities (with Oil bucking the trend due to supply concerns in the Middle-East). The bond market has seen the strongest effects however, with short-term yields in the U.S. and elsewhere rising.

Going into the end of this week, investors/traders are suffering from an element of market exhaustion. We’ve seen some pretty wild moves - AUD & JPY pairs, Metals and Equity Indices have been the volatility leaders and have thus forged the best short-term trading opportunities. As we’ve discussed in previous articles and via our webinars, the Fed’s current policy and expectations of future Fed policy are the only things that truly matter in both the short and long terms.

Market moving data remaining this week

European Industrial Production (-0.2% exp; 0.4% prev.)
Producer Prices Index(PPI)(0.5% exp; 0.5% prev.)
Core Producer Prices Index (PPI) (0.2% exp; 0.1% prev.)
University of Michigan Consumer Sentiment (85.3 exp; 84.1 prev.)
New Loans in China (800bn exp; 667bn prev.)

Note: Considering market focus on factors that relate to U.S employment, inflation and GDP in view of the Fed’s ‘forward guidance’, we advise traders to concentrate focus on macro data that most closely impacts those factors

Market sensitive data next week: Click here for a detailed list of all upcoming macro data events

Highlights include:

Chinese GDP
US retail sales
RBA minutes
UK CPI
European CPI
US CPI
Bank of Canada(BoC) interest rate decision
Fed’s Beige Book
UK retail sales
UK Public Sector Net Borrowing

Looking forward, the key question is: What degree of QE tapering will the Fed commit to? It seems that from a market sentiment perspective, the markets do not want QE to end and will continue to throw tantrums every time the QE nectar removal is mentioned. Most of the equity gains, bond yield stability and credit market liquidity has been courtesy of Fed policy so it will be interesting what actually happens to financial markets when QE actually stops. Can the markets survive without the Fed’s protective wing and shelter?

The reality is that they probably couldn’t given the huge (and expanding) level of personal, corporate and government debt in the developed world. Market participants may price in hawkish expectations for days or weeks at a time, but a sustainable path away from QE seems unlikely because of the high dependence on cheap capital. A sustainable path towards economic recovery without the aid of QE is simply unfathomable. The world is ridiculously reliant on debt while debt has admittedly been the problem all along. The fact that a stable resolution to the debt spiral has not been found for over 5 years, despite dozens of G8/G20/EU/Troika meetings probably means the only true solution is a default on obligations. Such a move would help the majority of people caught up in the toxic debt mess i.e. homeowners, consumers, SME’s, public workers and savers. The problem is that these are not the entities in charge of national economic policy, laws, and regulations and so on. The people making all the decisions are carrying none of the risk –this aspect has to change if QE or any other future policy has a chance of working.

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Commissioned by Think Forex

Written by George Tchetvertakov

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