The big news this week was the Fed’s decision to have a more
relaxed approach on inflation in order to stimulate economic growth, and the market’s reaction suggest investors are now expecting interest rates to remain low for even longer now. Traders did not look too far ahead and decided that selling the dollar now made more sense in order to take advantage of the downward momentum. However, one longer-term concern, which could come back to haunt the dollar shorts, is this: If the Fed allows inflation to overcook by not reacting fast enough, then it may have to tighten its belt more aggressively when it finally does start its hiking cycle in an effort to bring prices back under control. Such a policy response will stifle economic growth and will most likely send the dollar soaring higher. However, that is something to worry about at some later point in time. Early next week may be too son, though, as investors are convinced rates will not be going up any time soon. So, heading into the long weekend break, the trend of “
short: dollar and long:
stocks,
gold and
bonds” remained intact.
Will Abenomics end with Abe?
Although Monday will be a bank holiday in the UK, there’s potential for a sharp move in non-UK assets. In particular, it is worth keeping an eye on the Japanese yen and Nikkei index. The yen rallied sharply on Friday while the Nikkei sold off, following news that Japanese Prime Minister Shinzo Abe has decided to resign so that he could undergo treatment for a chronic illness. The markets responded by dumbing the USD/JPY and other yen crosses. While some economists don't expect Abe's departure to trigger changes in Bank of Japan's monetary policy, the market's reaction suggest otherwise. So, it is something definitely worth keeping an eye on in early next week:
Abe will stay on until a successor is chosen from the ruling Liberal Democratic Party (LDP) which is on the conservative side of the Japanese political spectrum. Abe is the longest serving prime minister in Japanese history. When he came back to power in 2012, Abe came with his proclaimed Abenomics, a series of initiatives designed to boost the economy, an economy which has stagnated for the previous two decades. This was done by changes in (1) monetary policy to make borrowing easier to allow consumers and businesses to borrow more cheaply, and (2) fiscal stimulus in the form of infrastructure spending and tax breaks for companies. He also introduced structural reforms which came in the form of labour liberalisation and adding of more women and migrants into the workforce, to make up for an increasing older population.
However, despite Abe’s efforts, Japan has seen mediocre economic growth in the las 5 years with the economy growing less than 1% in the 3 of the last 4 years. The unemployment rate however has been falling for the last decade with the unemployment rate hitting 2.29% for 2019. Japan has also seen far less damage from the pandemic compared to G7 nations with deaths of just 1,241. The Japanese economy saw a GDP fall of 7.8%, which was still a lot better than other G7 nations.
The key question is who will replace Abe and how that might impact the nation’s macroeconomics. Friday’s reaction in Japanese stock market certainty doesn’t paint a bullish picture, but this could be good news for the yen due to its perceived haven status.
Raised options activity point to potential weakness for stocks
Aside from the Japanese yen, I am also watching the US equity indices closely as the rally has almost turned vertical – especially for technology names. Like many other analysts, I reckon there is irrational exuberance given the current economic situation. While I am not necessarily suggesting you should be fighting the bull trend, there is a growing feeling among analysts that a big correction is forthcoming. Bullish investors may wish to proceed with a higher degree of caution. There are plenty of reasons why a sell-off could be on the cards. Among them is the apparent hedging activity we have observed over the past few days, suggesting stock investors are preparing for potentially another big fall in stocks. As a result of heightened options transaction, the Volatility Index (VIX) has started to creep up again. This is a potentially bearish sign for stock markets and needs to be monitored closely in the upcoming week(s).
Look Ahead
Later in the week, the focus will turn to US economy as we will have the key monthly employment report on Friday along with several other data releases. There will be plenty of other macro data which should provide some tradable opportunities in FX, not to mention the Reserve Bank of Australia’s rate decision. But the immediate focus will be activity at the Chinese manufacturing sector. Here are the data highlights for the week ahead:
Monday August 31st