Today’s post-European open ramp in the USDJPY may have boosted risk sentiment after yesterday’s sharp selloff, and lifted global equities off session lows, but for many this is “too little, too late”, with Bloomberg’s commentator Marc Breslow noting earlier that at this point “it’s a matter of when not if markets break down”, a sentiment which was shared overnight by SocGen’s FX strategist Kit Juckes, who in a note writes that “The wider Fed debate is about the impact on risk assets of shrinking the balance sheet. If near-zero rates and central bank buying of bonds have been the fundamental driver of global capital towards higher-yielding assets, then reversing both parts of this can’t be helpful. Which is how markets have reacted overnight. ”
Below are key excerpts from his overnight note:
The focus of FOMC Minutes was on when/how to start the process of reducing the Fed’s balance sheet. There was nothing to change the view that 2017 will see three rate hikes, but if rate hikes happen concurrently with a shrinking Fed balance sheet, that may have an impact on the terminal Funds rate. 1yr rates in 5 years’ time are now priced at 2.55%, 30bp below their highs for the year and the sense is that the Fed isn’t that bothered about a market which prices a lower terminal rate than the ‘dot-plot’ suggests. This matters for two reasons. Firstly, what matters for the dollar now that the rate-hiking cycle is underway is not how many hikes we get this year (or next) but where the Fed’s going in the longer run. And secondly, it’s important for the path of longer-dated Treasury yields. The dollar gets not help from the Fed if we’re collectively tempted to revise terminal Funds down rather than up. And with 10s still flirting furiously with the bottom of their 4-month range, the danger of a break lower’s clear.
The most immediate direct impact of this is on USD/JPY. If I’m a long-standing long-term USD/JPY bull, then I’m a short-term rabbit. 110 won’t hold if 2.30 breaks in 10s and nor will 109, and so on…
The wider Fed debate is about the impact on risk assets of shrinking the balance sheet. If near-zero rates and central bank buying of bonds have been the fundamental driver of global capital towards higher-yielding assets, then reversing both parts of this can’t be helpful. Which is how markets have reacted overnight. The caveat though, is that the FOMC Minutes got to great pains to stress that any move will be gradual and predictable, and accomplished mainly by phasing out reinvestment of maturing bonds. If I weigh a low terminal Funds rate against a super-cautious and very drawn-out normalisation of the Fed’s balance sheet, I can’t really see reason to worry about crowding-out of capital from emerging markets. I still worry much more about over-accommodative policy and ever-rising debt. So, a risk wobble today but no change in trend.