The most important variables in financial markets are the economic conditions and how central banks respond, with the emphasis on “how central banks respond.”
From a macro perspective, there is only 1 true trade at any given time and that’s the price of money. Every other trade is simply a derivative of a trade on the price of money.
Central banks control the price of money and drive everything with interest rates. Bankers use monetary policy to get supply and demand moving in the economy and by encouraging people to move along the risk curve with their investable assets.
So the secret sauce is to understand how the policy of various central banks will impact asset prices and then trade accordingly. Everything else other than monetary policy is a distant second as it pertains to being a driver of asset prices.
I’ve been discussing the US Divergence Trade since last September. This is trade is entirely driven by the tightening monetary policy of the Fed here in the US as compared to the aggressive easing monetary policy of other central banks around the world, most notably the ECB and the Bank of Japan.
It's difficult, at times, to stay focused on the big picture. This key element of the present big picture is the divergence between the US and the rest of the global economy.
This trade and this trade alone is dominating the landscape right now.
Assets are being price based, in large part, on this trade. Last week, both sides of the US Divergence trade equation were driven home. The US side of the equation is intact as the Fed stands ready to raise rates by mid-year. I don’t expect much change to the language of the Fed statement this week but I do believe that the March meeting will be critical if in fact the Fed remains on course for a mid-year rate hike at that time.
The Eurozone part of the equation was bolstered when the ECB released further details of its next round of easing last week. The main measure is an expandable asset purchase program totaling $60B Euros a month and that includes Eurozone agencies and sovereigns. This expanded program will complement the current covered bond and ABS (asset backed securities) purchase programs.
This new round of asset purchases will start in March 2015 and run until the end of September2016 or until the inflation outlook converges to 2.0%. This inflation target means that this program could turn out to run longer and require more capital.
If the $60B a month doesn’t move the inflation needle higher, the ECB would be required to either ease some of the conditions of its bond purchases or to contemplate other asset classes such as equities, exchange-traded funds and real estate investment trusts.
The Bank of Japan part of the equation was also confirmed.
In it’s latest meeting, the BOJ cut its consumer inflation forecast for 2015 and extended the two lending facilities that have been in place for months now. It was clear that the BOJ is not in a rush to offset the deflationary impact of the falling energy prices.
That said, the BOJ did raise its growth forecast for both 2015 and 2016. However, this optimistic outlook for Japan’s economic growth is based on a healthy assumption that oil will be trading back at $70 a barrel by the end of next year.
Crude was trading at $94 a barrel two years ago. Could you have accurately predicted it would be trading at $45 today? Me either.
Any forecast that is based on the assumption that you know where any asset is trading in 2 years is utterly absurd. The key takeaway is that monetary policy remained status quo in Japan and aggressive easing is still in place.
In addition to the major players, there were a number of other central banks who are also confirming our US Divergence equation. Denmark cut rates by 20 basis points last week. The Bank of India actually came out in between its planned meetings to announce a rate cut.
This was the latest in a long line surprises by other emerging market central banks that have all been in the direction of further easing. The largest surprise last week was the rate cut by the Bank of Canada.
The decline in oil prices forced the BOC to cut rates for the first time since it began tightening in 2010. The market reacted by pushing the Loonie (great name for a currency) to its lowest level in 6 years. If oil prices stay under pressure for a prolonged period of time, there could be further cuts but the BOC will be hesitant to engage in further cuts because of the immense pressure that will put on the Loonie.
In addition, to these events, most market participants are expecting the Reserve Bank of Australia to resume its owning easing cycle when it meets in February. There are no fewer than 8 central bank meetings in the emerging markets in the week ahead: Thailand, Israel, Russia, Hungary, South Africa, Mexico, Colombia, and Malaysia.
I suspect that it's only a question of time before each of these central banks chooses to cut rates too. This economic and policy divergence between the US and the rest of the world will likely last not just months but likely quarters and maybe even a couple of years. Make sure you are monitoring this divergence and that your trading is aligned with it.
It also might be worth while as we move through 2015 to look back at last week’s TWR, “Great Expectations” to remind yourself of what developments in global markets would indicate that the US Divergence trade may be coming to an end or shifting.
If you focus on the secret sauce of the global economy and how central banks are responding, you will have an edge over most market participants.
As President James Garfield famously said just 2 weeks before his death, “Whoever controls the volume of money in our country is absolute master of all industry and commerce…and when you realize that the entire system is very easily controlled, one way or another, by few powerful men at the top, you will not have to be told how periods of inflation and depression originate.”