Three things

As you wonder how high equities can climb, here's a quick catch-up on some things occupying the mind of the market this week.

27 Oct 2017

As you wonder how high equities can climb, here's a quick catch-up on some things occupying the mind of the market this week.

Tinker Taylor Yellen Powell

Who will be the next Chair of the US Federal Reserve? The US bond market has been selling-off this week (yields up) partly in anticipation that the next Chair may be a "hawk" – one who will take a tougher stance on monetary policy. Current reading suggests Yellen is out and it is between Taylor and Powell. Both are considered more likely to raise interest rates than Yellen; Taylor more so than Powel. Regardless of who is more "hawkish”, history has shown the nomination of a new Fed Chair has sparked a sell-off in bonds. This has applied even for perceived "dovish" Chairs. When Janet Yellen took over from Ben Bernanke in 2014 US 10-year bond yields rose 40bpts. The announcement is due before Trump's visit to Asia on 3 November. Yellen's term expires in February 2018.

Patience is a virtue

First it was Janet Yellen opening wondering why inflation hasn’t emerged yet. Then it was the Bank of Canada becoming a little more circumspect on further rate rises. This week it is the ECB and RBA. Central banks have turned slightly more dovish, more patient, on the prospect of inflation driving them toward higher interest rates. The ECB's announcement to taper bond buying from €60 billion per month to €30 billion starting in January next year and continuing for at least nine months was as expected. The ECB also said it would keep rates “at their present levels for an extended period of time, and well past the horizon of the net asset purchases”. The market interpreted this as a dovish signal and bond yields and the euro fell as a result while equities rallied. If the US Federal Reserve experience is anything to go by the market should not have been so surprised. It took the FOMC ten months to complete its taper program and another 15 months after that to begin raising rates. So we are at least two years away from any hike in rates from the ECB. Bond markets came around to that realisation despite getting what was expected from the ECB. A speech from the RBA this week noted that “there still remains a sizable degree of spare capacity in the labour market”. This is despite the unemployment rate falling from a post-crisis high of 6.4% to 5.5% currently. Importantly, the Bank still assesses the NAIRU (the rate of unemployment where inflation is neither accelerating nor decelerating) at 5%. So focus will remain on the employment data for clues as to the next move from the RBA. All central bankers agree, however the business cycle has not been un-invented, just elongated. This means patience will need to be the markets' greatest virtue.

US tax "reform"

The downward pressure on the euro was re-enforced by growing confidence in the prospect of tax "reform" (read tax cut) in the US with the passing of the budget through the House on Thursday night. This now unlocks the process of "reconciliation" whereby the Republicans now only need a simple 51-seat majority in the Senate to pass tax legislation. Absent any tantrums or disagreements amongst themselves the Republicans have a 54 seat majority in the Senate. This means we are now closer to potentially seeing a lower corporate tax rate in the US. This has seen bond yields in the US rise along with the US dollar. Positive earnings outcomes have added to the momentum. Against the greenback the Aussie dollar lost over a cent after the vote. It is now down almost two US cents on the week after being hit by the weaker-than-expected CPI data in Australia on Wednesday. A tax plan is set to be unveiled to the House next week with drafting for the bill scheduled the week of 6 November. We have removed our underweight Aussie dollar relative to NZ dollar position and in some of our multi-asset funds have opened a short Aussie dollar relative to the US dollar position. We are watching EM debt closely. Local currency-denominated EMD has benefited significantly from EM currency strength against the dollar. In a stronger dollar environment, we would expect hard currency EMD to fare better than local currency EMD.

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