“In any event, watch the BoJ tonight. USD/JPY sunk to 20-month low at 105.44 before bouncing following the Fed decision. If Japan doesn’t play this exactly right, you could see further yen strength - and we’ve seen what that does to US stocks.”
That’s what we said on Thursday afternoon after the Fed struck an even more dovish tone than the market anticipated. In “better” times, that would have ignited a risk-on rally. Instead, the market faded the news and by the end of the session, stocks had logged their fifth straight day in the red. Here’s BofAML’s admittedly dry take on the FOMC:
“Wednesday’s communications were interpreted as dovish by the rates market, which caused the curve to modestly bull steepen and result in 2- and 10-year yields declining on the day by 4 and 2 basis points, respectively. Although the FOMC statement was little changed, the Summary of Economic Projections (SEP) were seen as reflecting a degree of caution as the near-term GDP and 2017 to 2018 median dots were revised lower. These downward revisions were interpreted as reflecting a more accommodative stance of policy and the front-end of the rates market adjusted accordingly. The market is now pricing around 45 percent odds of one hike by the end of the year and the market is not pricing another full rate hike until the end of 2017.”
None of that was good news for the BoJ. Had the Fed hiked (as planned before the May payrolls report threw everything out of whack) the yen would have had more breathing room. Tighter policy in the US would have pressured the dollar higher and the yen lower. Think of it as passive easing for the BoJ.
But the Fed didn’t hike and so, it was either Japan eased or else watch the yen climb. Japan stood pat and here’s what happened next:
That of course caused the Nikkei to fall 3%. The weakness spilled over into European equities and stocks sank at the opening bell on Wall Street.
It’s the same ebb and flow we’ve been witnessing all week. The yield on the 10Y German bund once again fell below zero and Treasurys rallied with the yield on the 10 now all the way down at 1.52%. Oil fell, gold rallied. A classic risk-off move that was visible a mile away.
(Chart: BofAML, Bloomberg)
Meanwhile, Brexit angst is running at a fever pitch. “Those campaigning to leave the European Union held a steady lead in opinion polls with a week to go until the referendum,” Bloomberg wrote, early this morning.
What’s interesting to note is that geopolitics is squarely in the driver’s seat here. Indeed, it’s the fear of Brexit that set the tone this week and really sparked risk-off sentiment. It just so happens that this was a week in which the Fed and the BoJ faced two of their toughest decisions yet.
With the market already on edge, central banks were likely just as scared of easing as they were of tightening or, in the BoJ’s case, remaining on hold. Results have been mixed lately when it comes to more easing, as was made abundantly clear in the aftermath of Japan’s move into negative rates which was promptly greeted with a yen rally and a Nikkei selloff.
With that in mind, let’s look at the extent to which the UK referendum is driving sentiment. Consider that the ECB just activated its new corporate bond buying program. One would think that would have a dramatic impact on EU corporate bond yields. When the central bank has promised to buy billions upon billions every month of one particular asset class, one would naturally expect sentiment around that asset class to be quite rosy. After all, there’s going to be an overt and perpetual central bank bid under it.
Not this time. Or at least not at the outset. CDS spreads (i.e. the cost of insuring debt) on euro credit have blown out in tandem with the odds of Brexit as the following graphic from BofAML makes clear:
(Chart: BofAML)
Here’s a bit of color from BofAML:
“Sorry FOMC but the focus is all on Brexit. No doubt that in a few years somebody will back test the impact of central banks buying corporate bonds and find that during the first five business days of the ECB’s CSPP European IG CDS credit spreads widened about 15bps (iTraxx main). We hope they discover the true underlying driver of credit spread widening, namely the concurrent spiking probability of Brexit to about 43% from roughly 30%.”
This is yet another reminder of why you have to take a holistic approach to this. Sure, the Fed and the BoJ mattered and it can certainly seem like what goes on in Europe or the Mid-East is a world away. In fact, those events are a world away, but they often set the tone for markets. The yen would probably be rising anyway (i.e. even if the UK referendum were not in play), but Brexit risk set a broad risk-off tone headed into the week. That ultimately determined how the market reacted to central banks.
This will also be the case next week in the days leading up to the vote. And if you want to get an idea of just how contentious this situation truly is, consider the following from Reuters:
“A British member of parliament was in critical condition after being shot and stabbed in her constituency in northern England on Thursday, British police and media reports said.”
“Jo Cox, 41, who is a lawmaker for the opposition Labour Party, was attacked as she prepared to hold a meeting with constituents in Birstall near Leeds.”
Meanwhile:
(Chart: Bloomberg)