Powerful Trends in the Global Capital Markets

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The capital markets have been buffeted by political developments and central bank policies. The direct influence of high frequency data seems to have diminished in recent weeks. With less participation in the year-end markets, this is likely to continue to be the case over the next two weeks.

There are several powerful trends in the global capital markets. The trends appear to have begun at the start of the fourth quarter. Three trends have been particularly robust. The dollar's climb against the yen, the rise in US 10-year yields, and the rise in Japanese stocks. The three have risen in nine of the past 11 weeks and six in a row.

The Dollar Index has risen, as have two-year US Treasury yields, and gold has fallen in eight of the past 11 weeks. The euro has risen, alongside the Dow Jones Stoxx 600 in seven of the past 11 weeks. What may surprise many is that the FTSE All-Shares Italian Banks Index has also risen eight of the past 11 weeks, including the past three weeks. MSCI's Emerging Market equity index and its Asian Pacific Index has fallen in seven of the past 11 weeks. The light sweet crude oil futures price has risen in seven of 11 weeks, but Brent only rose in six weeks.

Due to the China's national holiday, its markets were opened a week less this quarter. However, powerful trends are also in place. China's 10-year yield has risen in seven of the past 10 weeks. Although the Shanghai Composite has risen in six of ten weeks, it has fallen three in a row now and four of the past five weeks. The dollar has risen against the yuan in eight of the past ten weeks and 24 of the past 32 weeks.

A key issue now is whether the trends are extended or a profit-taking phase is seen into the year-end. It is a question of psychology, and perhaps a subject for game theory. Arguments that things have gone too far too fast are several weeks old, though it is true, of course, that technical readings are even more stretched. And if the market was exaggerating the likelihood of the kind and magnitude fiscal stimulus that is likely to pass a more conservative Congress, then it similarly overreacted to what appears to be relatively modest changes in the average (rather than the median) Fed's forecast. The average for next year, for example, increased by nine basis points, though the median is increased by 25 bp.

The direction of market overreaction is itself an important tell or indicator of the underlying pressure. At the same time, the structure of ownership of government bonds has changed. Central banks own a lot more than in the last cyclical increase in yields. Many private sector investors hedge. Officials typically don't. The same is true of the US mortgage-backed securities.  The MBS on the Fed's balance sheet is not being hedged. If they were in the private sector hands, Treasuries or some derivative thereof would have been used, leading to even greater pressure on US rates.

The dollar's appreciation against emerging market currencies would be expected to spur intervention to slow the depreciation, especially by those countries with large or quick pass-through to domestic inflation or, are already experiencing rising price pressures. It is unexpected then that the Federal Reserve's custody holdings (of Treasuries and Agency bonds) have risen for the past five weeks. The counter-intuitive increase of $42 bln compares with a draw drown of about $213 bln in the year up until then.

Countries, companies, and investors have different exposures, risk tolerances, and objectives. Their ability to cope and the changing investment environment will vary. China is having a particularly rough time even though growth appears to have stabilized. Indeed, the stabilization of the economy allows officials to try to curb some excess, and this is pushing in the same way as a rise in US rates--forcing a deleveraging. The benchmark 10-year Chinese government bond yield rose 18 bp last week to bring the increase since the end of October to 66 bp. The US 10-year yield has risen 76 bp in the same period.