Last week, we set out the case for being constructive on the US Dollar. Although the resilience of the Dollar in the face of weak data is impressive, in reality the Dollar, along with bonds and equities, remains within well-established ranges. Hopefully September will see price break out of these ranges which will likely throw up better opportunities for making money. Important central bank meetings may be obvious events but price may break at any time.
Perhaps the most intriguing chart remains 10 year Japanese bond yields. Despite the Bank of Japan basically cornering the bond market through their QQE and NIRP policies, yields have been edging higher in recent weeks; this was not supposed to happen (see chart 1 below). Is the BoJ allowing this to happen as they rethink policy and realise that negative rates is a failed policy? Perhaps the market simply sending a message that they are not willing to tolerate negative yields any longer and that they are losing faith in central bank policies. Either way, a move back into positive yields will have a potentially big psychological impact.
Chart 1 – Japanese 10 year bond yield with 50 and 100 day moving averages
We should not underestimate the importance of the September BoJ meeting. If they were to come out and begin to remove their negative interest policy, this would be a huge blow, not just to their credibility, but also that of the ECB where the deposit rate at minus 40 basis points is causing a lot of problems in the financial system. The picture for German bond yields in similar to Japan, and again we think a move back into positive yields could be very important.
Chart 2 – German bond yields
If yields do move back into positive territory, we cannot know whether it would be a benign event or a trigger for market losses across the board as the search for yield unwinds and central bank credibility is questioned. The stakes could hardly be higher with leverage having picked up over the summer months as volatility collapsed, any bond and equity sell off accompanied by rising volatility could be very dangerous indeed.
European equities remain capped at well-defined resistance as can be seen in chart 3. It would appear that we are at an important juncture and European stocks either make a bullish break out, or reverse some recent gains. The risk here is that if bond yields move higher, the value of yield available from equities diminishes on a relative basis.
Chart 3 – European equities
In the US, it has been well publicised that major equity indices have traded in their tightest range for over to 50 years (depending on how you measure it). It hardly matters where we look, there are a large number of markets that are stuck in a tight trading range. At some point, these ranges will also break. In fact, the message seems to be reasonably clear here. All markets are inter-connected and both bonds and equities are trading purely on yield and liquidity which is being massively distorted by central bank policies. Bonds may well be on the cusp of breaking out (i.e. yields higher and prices lower), and it would seem sensible to expect equities to trade alongside bonds.
We have pretty much exhausted the analysis of central bank policies. These have worked far too well in inflating asset prices, but at the long term cost of financial stability. Furthermore, any economic gain has been to the benefit of the few which is also unsustainable in the long term. At some point, tight trading ranges always end, and although our fundamental work suggests that prices should break down and trade at much lower levels, we will have to take the evidence as we see it. If prices succeed in a bullish break out across the board, then we will have to assume higher prices ahead until the evidence changes.
Overall, we think that markets are at a very important juncture. The next move could happen because of central bank policy changes or simple market forces, and frustratingly could be either up or down. Our best bet is that prices break down, and central banks are losing credibility, however, we have to remain alert to the alternative.
The RMG FX Strategy UCITS fund enjoyed a decent performance in August, please let me know if you would like some information on this mandate. Some basic data can be seen HERE.
Stewart Richardson
Chief Investment Officer
