There are only 2 things that drive asset prices over the intermediate to long term: economic conditions and how central bankers respond to the those conditions.
Everything else is a derivative of those two factor. It’s a central bankers world, the rest of us are just living (and trading) in it.
Most of the world’s major central banks are initiating looser monetary policies.
That said, November marks the beginning of a new phase in global monetary policy. The Federal Reserve ended its QE3+ purchases and the ECB continued to articulate its plans to expand its balance sheet in order to fight deflation. Both of these scenarios were “known knowns” by the markets.
However, this past month also saw a couple of surprises on the monetary policy front.
The Bank of Japan unexpectedly and dramatically stepped up its asset purchases, saying that it would triple its purchases of exchange-traded funds (ETFs) and real-estate investment trusts (REITS).
The policy move comes, like the ECB, from fear of a deflationary death spiral and the hopes that a pick up in asset purchases can keep the deflationary wolf at bay. In addition, the Japanese government's largest pension fund announced aggressive portfolio diversification plan, which includes doubling its allocation of both foreign and domestic stock allocations.
This past Friday, China decided to join the easing party by providing an early Christmas present and unexpectedly cutting rates for the first time since 2012.
Chinese Secret Santa
The PBOC has been providing extra liquidity to the system via short-term loans to certain commercial banks. All the while, the PBOC has stated publicly that it had no intention of direct easing via rate cuts because it was committed to the reform plan that it began executing at the beginning of the year.
I guess we’ve learned that central bankers tell the story that best suits them for that particular day and that the story can change quickly and without warning.
On Friday, the PBOC cut its one-year deposit rate by 25 bps and cut the lending rate by 40 bps. Clearly the rate cut reflects greater concern about the trajectory of the Chinese economy and the continued falling inflation amid the slowest full year growth for China since 1990.
In addition, to the disappointing report last week from the “Big 3,” which are fixed assets investments, retail sales and industrial production which were reported in the prior week, last week saw a continuation of bad data.
First, housing data showed that home prices slipped 69 out of the 70 Chinese cities that are tracked. And second, HSBC’s flash PMI for November showed a month over month slowing from October and hitting a fresh 6-month low.
The rate cut also could be in response to that fact that although nominal interest rates have been relatively stable this year, real rates have been on the rise in recent months as inflation sinks lower, which is effectively monetary tightening.
That said, the rate cut isn’t likely to have a significant direct impact on the economy but the indirect impact could be very meaningful. Friday’s policy move signals to the markets that the PBOC is still willing to side step reform if they don’t like the fundamental data they are receiving.
The fact that the PBOC has signaled clearly that it's still willing to play ball, is a significant shift from what their stated policy intentions have been since initiating their financial reform plan.
Obviously the rate reduction aligns China with both the ECB and the Bank of Japan in initiating new stimulus just as the Federal Reserve has stopped its quantitative easing program.
Central Banks Speak
The PBOC wasn’t the only bank to speak publicly last week.
The FOMC released its latest minutes on Wednesday and indicated that it was not in any hurry to raise interest rates before the middle of next year.
The FOMC statement didn't drop the "considerable period" phrase to describe the time between the end of QE and the first rate hike. However, the minutes show it was a point of discussion and a compromise was achieved to emphasis the data dependency of the Fed's actions.
The minutes also revealed that some officials were more concerned about a further breakdown in long-term inflation than they were about growth faltering. The Fed officials also debated whether to mention the recent market turmoil, and after some debate, opted not to include that in the statement.
All-in-all, there were no suprises in the FOMC minutes and the markets reacted in kind.
Then it was Draghi’s turn. Draghi said inflation has to be lifted as fast as possible and that the ECB would widen its asset purchase plan to achieve this, if necessary.
His comments held out the possibility that the ECB will announce an increase in the range of assets it will purchase at its meeting this week and that it is highly likely that we are in for another round of cuts in the Eurozone forecasts.
Ways to Play
It’s self defeating for me to spend too much time discussing markets outside of the 8 Focus Markets. But the shift in the PBOC’s policy last week provides with an opportunity to point out the right and wrong ways to trade such a shift.
The wrong was is to go all-in LONG in China based on the policy change. From a price action perspective, there are a number of Chinese markets that may begin to look very bullish, FXI included.
The problem is that the underlying fundamentals of those markets are rotten. The right way is to look at derivative trades that will be helped by the tailwind of the PBOC’s policy.
For instance, Taiwan is one particular market that has strong fundamentals and an equity market that looks very bullish from a quantitative perspective. Taiwan’s GDP has been accelerating at the margin for 5 straight quarters and the Taiwanese equity market (EWT) has been very bullish despite the pullback that occurred during October.
Generally speaking, monetary policy amongst the G10 is highly correlated. And the markets are in unprecedented territory.
Never before has an economy stayed in a zero interest rate environment for as long as the US has since The Crisis. And never before have the financial markets had to price assets based on a major central bank entering a tightening phase while the rest of the world’s major central banks ratchet up a fresh round of quantitative easing.
Since “never” is a long time, it’s impossible to know how financial markets will trade going forward or what the next 2-3 years have in store. But what I can say definitively is that there will be immense opportunity for those that are capable of seeing the forest for the trees and November 2014 will have marked the beginning of the phase of financial market evolution. You know what they say about things that come easy, “Easy come, easy go.”