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Thoughts From the Trading Trenches - January 2014

13 Years ago | December 31, 2013 12/2/23, 12:00 AM

In the January Issue

More of the Same? A Look Ahead to 2014

By Jay Meisler

The coming year is likely to be another one characterized by a data dependent market given the focus on monetary policies. Most glaring is the divergence between the monetary policy currently being conducted by Japan vs. countries like the U.S. and U.K. Japan is expected to add a fresh round of stimulus to offset the drag caused by a hike in the sales tax while the Fed has started to taper its bond purchases and expectations are that the Bank of England could raise short-term interest rates sooner than generally expected due to an improving economy.

It is no wonder the JPY has weakened both vs. the dollar and on its crosses. The EURUSD is the enigma as it confounded forex trading forecasts of a weaker currency this past year with several explanations being given for its outperformance. Some attribute it to tighter liquidity caused by a combination of bank repayments for the ECB LTRO and European banks repatriating cash to shore up balance sheets ahead of bank reviews. In addition, the ECB appears to be in no rush to ease further despite the talk of negative interest rates. A test for EUR strength, meanwhile, could come once these liquidity pressures ease.

There is another explanation for the firmer EUR, which has to do with credit swap trade lines that bypass the dollar but for now it appears that funding pressures and tight liquidity as well as demand coming from various crosses (e.g. EURJPY, EURAUD) have been boosting the EURUSD.

Whatever the case, global markets will likely remain hyper focused on economic data as the end of the open monetary spigot in countries like the U.S. and U.K. comes closer on the horizon. While these central banks have used forward guidance that short-term rates will stay low for an extended period as a way of guiding expectations, market sentiment can easily change should economic conditions warrant. It is a little like verbal forex intervention, which can be an effective tool until markets put it to the test.

What Would Force the Market to Test the Central Banks?

In one word, INFLATION. Until now, central banks have had the cover of low inflation to pursue extraordinary monetary policies (i.e. quantitative easing) that in other times would have been deemed radical or even heresy by mainstream economists. These economists are probably rolling over in their graves at the sight of central banks printing money by buying government bonds that fund budget deficits.

I am not saying the inflation genie is waiting around the corner or is even close to popping out of the bottle but if you are looking for something that would cause central banks and markets to turn cautious, it would be a shift in trends towards higher prices. At the current time this does not seem to be a risk as there is no inflation threat now because the major economies have very large excess capacity, especially labor, that will be very, very slow to change. This is one reason why central banks, such as the Fed and Bank of England, have been focusing on the unemployment rate as a key indicator although both have indicated that this is more of a moving than stationary target.

Inflation is thus the wild card as the lack of pricing pressures has allowed central banks to pursue dovish monetary policies. This includes the use of forward guidance to indicate there is no risk of a near-term rise in short-term rates, which has helped fuel a rise in stock prices, even as the Fed starts to taper its bond purchases. Forward guidance is like verbal intervention, markets will follow the central bank lead until conditions suggest it is no longer wise to do so. At this stage, it would take a rise in inflation to lead the sheep away from slaughter.


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