Risk is back on, but can it last?

Last week was pivotal for financial markets, and some may argue that it heralds the start of the famed ‘Santa rally’ that can happen as we move into year end. US stocks recorded their best daily performance in 6 months on Thursday, and US 10-year Treasury yields had their largest 2-day decline since March. The driver was the Federal Reserve meeting, where Fed chair Jerome Powell gave signs that rates are tight enough and there will not be any imminent rate hikes. To counter that argument, he also didn’t mention that there will be any cuts anytime soon, however, the scale of the reaction to last week’s Fed meeting was a sign of how anxious investors have become about what the Fed will do next. Stocks rallied on a broad basis, and volatility declined. As Treasuries rallied and yields fell across the US yield curve, the dollar also tanked, with the Dollar Index down more than 1% on Friday, its biggest drop since July. A weaker than expected payrolls number on Friday and a higher unemployment rate also reinforced the theme that the Fed are done tightening.

Why risk sentiment is buoyant

As we have mentioned in prior notes, the market was crying out for the Fed and other global central banks to provide a framework for their future policy decisions. After months of saying that they were data dependent and fully reliant on inflation and employment numbers, which are subject to errors and revisions, the main central banks including the Fed, the ECB and the BOE, seem now to be firmly on pause. While the economic data still matters, it is taking a backseat, because the Fed et al have hiked rates to such a large extent already, they are happy to take a prolonged pause before their next move. This framework that central banks have finally provided have helped to calm financial markets and spur risk sentiment. In hindsight, the bond market rout that took place in the summer and gathered speed after the September Fed meeting, seems strange, for example, we now know that the Fed was most likely done hiking in July, yet why did that spur the market to dump bonds on a massive scale? We may never know all of the motivations for the summer’s market moves, which also triggered a selloff in risky assets, however, it could present the opportunity for a prolonged rally in risky assets and a recovery in US bonds since the prior sell off in bonds was so sharp.

Fed rate hike expectations fall sharply

As we mention above, the market may have been too aggressive pricing in further Fed rate hikes in recent months, however, that is now being reversed and there has been a decent loosening in financial conditions. There is now less than a 5% chance of a further rate hike to 5.5-5.75% from the Federal Reserve at their December meeting. Likewise, the market is also pricing in a faster pace of US rate cuts, according to the CME Fed watch tool. There is currently a 37.3% chance that US rates will fall to 4.75- 5%, two rate cuts, by June 2024, up from 20% a week ago. This is a big move for the Fed Funds Futures market, and it may signal a persistent shift in financial markets that could be bullish for stocks and bond prices. The turn in the bond market is also having a major impact on the dollar, which fell sharply on Friday, $/ Asia crosses had a meaningful reversal on Friday, and for now the leakage in the euro and the pound is on hold, as the market figures out how far the dollar needs to fall. We believe that will be decided by the bond market, so if we get further declines in Treasury yields, then we should see further dollar weakness.

FX and oil outlook

From an FX perspective, our focus is USD/JPY. It fell 0.7% on Friday and is back below the critical 150.00 level. This pair is still up some 13% YTD, thus there could be further room for the yen to claw back some recent losses. 148.70, is a key support level in the short term, ahead of 146.50 from mid Sept. If the yen rallies substantially, this could be good news for Japanese stocks. Oil is also in focus this week, usually when the dollar declines the oil price rises, since you will need more dollars to purchase a barrel of oil, however, that did not happen last week, and oil was down more than 2%. Brent crude has now fallen more than $7 per barrel since 20th October. There could be some mild upward pressure on the price of Brent on Monday after Saudi Arabia confirmed that it would be extending its 1 million b/d production cut into December. It also said that it would review its decision next month, which opens the way for Saudi’s production cuts to extend into 2024, something that the oil market could absorb for now, but not If the Israel/ Hamas war escalates in the coming weeks. In the short term, the biggest risk for oil traders is a short squeeze caused by geopolitical risks, and the fact that the oil market is net short once again, thus positioning could make a long oil trade interesting from here.

However, bar any escalation in geopolitical risk, any upside for the oil price could be limited in our view, since news at the end of last week also confirmed that Germany’s energy demand is at a 50-year low. This is not good news for an industrial economy, and it also suggests that German industrials could be in for a tough time through to the end of the year. However, whenever we see that demand is at a multi-decade low, usually that means that recovery could be around the corner. With the interest rate tightening cycle likely at its peak, this could be the nadir for the German economy, which has experienced a tough couple of years.

UK recession watch

While Germany has suffered, the UK economy has managed to avoid recession and prove the naysayers wrong. Can it continue to do so? We will find out on Friday when preliminary Q3 GDP is released in the UK. The PMI data is considered a lead indicator and it has been weakening in recent months, which is not supportive of a strong reading. The market is expecting a -0.1% reading, however, last Thursday the BOE said that they excepted growth to be flat in Q3. While that is nothing to write home about, it is better than negative growth. GBP/USD had a strong end to last week, and is back above $1.2370 at the time of writing. If we see further dollar declines this week, then $1.25 is a resistance level to watch.

Is the market too positive?

To finish, financial markets are in a better place fundamentally, not because the skies ahead are brighter, but instead because global central banks have been firmer in their policy framework, which currently means they are on pause and are unlikely to hike rates from here. We think that this was the main driver of risk sentiment at the end of last week. Financial markets and traders had been craving this certainty from the Fed, and they reacted strongly to it. For example, the S&P 500 and the Nasdaq both rallied 5.29% and 5.7% respectively last week. While for most of this year, the stock market has been led higher by a few big names, last week saw a broad-based rally, which suggests that it could have legs. For example, some of the recent IPO disappointments also rallied strongly on Friday. Chip maker Arm Holdings rose 1.27%, although it is down 4.65% since its IPO, and Klayvio rallied nearly 4%, although its stock price is down 14% since it listed. There is one caveat to the optimism, some are arguing that stocks are rallying because of growing recession risk: a less hawkish Fed, weak manufacturing and service sector ISMs for October and a weak payrolls number for October and higher unemployment rate. That is a weird reason for a market to rally, and if it is the only reason, then the rally could be short lived. However, based on our arguments above, we think that the outlook is more positive that that, for now.