Flows exit stocks, as markets discount NFPs

Flow exits equities

Global stocks fell on Monday. The losses were very broad based, as equity traders caught up on the information that had already, effectively, been baked into rates markets. The ASX 200 was one of the worst performing major share indices: it shed 1.17%, with market breadth a lowly 17.5%. Wall Street has performed stronger overnight, with the S&P 500 giving up half-a-per cent. That’s lead SPI Futures to climb roughly 10 points, suggesting a bounce for the ASX today. The AUD, as a pro-risk currency, is down at the expense of a stronger USD. The stronger greenback has also hastened gold’s pullback.

Markets banking the easy returns

The trading week began defined by an overall sense of cautiousness, if not concern. Trading activity was low, so the moves out of risk assets last night were hardly vigorous. But there was certainly a slow receding of (some) optimism, as traders of rate-cut expectations by the world’s largest central banks. To be clear: this is a marginal move, characterized by revising of the global rate outlook, rather than a total reversal of it. Nevertheless, the new expectations had to be discounted, and that culminated in a modest dulling of the bullish sentiment that’s driven stock markets to their recent highs.

Markets adjust to new Fed expectations

There’s been a reflexive element to that dynamic too, well encompassed by the flattening US yield curve. Diminished expectations of an aggressive 50-basis-point cut from the US Fed this month has led to a greater lift in short-term interest rates than that of long-term rates. This price action has been fuelled by the belief that less accommodative monetary policy conditions will impact the longer-term US, and therefore global, economic outlook. Furthermore, the narrowing of this spread between short-term and long-term rates has raised the prospect of relatively tighter financial conditions, with the marginal drop in liquidity reducing the appeal of risk-assets.

A negative feedback loop

In these situations, markets slip out of the goldilocks zone – the place in which, up until recently, global markets had been occupying, and relishing. Like any social phenomenon, the effects are self-perpetuating: fundamentals look okay-enough, so markets bet on less stimulatory policy conditions, which leads to tighter financial conditions, which diminishes the outlook for markets, which eventually weighs down on the “real economy”, which finally leads markets to increase bets again of stimulatory policy. If these bets are in turn supported by policymakers rhetoric, then markets can return to that “goldilocks zone” – to begin the cycle over again.

A revision of timing, rather than reversal of fortunes

Right now, markets are in the part of this little cycle whereby expectations about the aggressiveness and immediacy of interest rate cuts are being pared, and likely deferred. This is probably not a trend-change – at least, the information doesn’t currently exist to suggest that this is what’s unfolding. Instead, markets are experiencing a moderation, and that’s prompted a little drawdown as market dynamics are revised. Fortunately, this is a situation that won’t linger by itself for long: tonight, markets get to update the narrative to some extent. Tonight, Fed Chair Jerome Powell speaks, kicking-off several days of communications from Fed speakers to the market.

Fed speakers to fill in the blanks and gaps

Aside from US CPI numbers, and barring any nasty surprises in the US-China trade-war, or maybe in the US-Iran stand-off, the litany of Fed-speakers, as well as FOMC Minutes, will pose the biggest risks this week. And given what markets are baking in about Fed-policy, risk could be asymmetrically skewed further to the downside. Financial markets have full priced-in a rate cut from the Fed at the end of the month; and recent Fed-talk has implied a “double-cut” at the Bank’s July 31^st is probably unnecessary. Hence, the greatest risk is if the Fed suggests that perhaps a cut this month may not be necessary at all.

Stocks balancing act ahead of US reporting season

Considering the trajectory of the global economic cycle, interest rate cuts from the likes of the Fed, the ECB and BOJ remains a matter of when and not if. That being the case, markets ought to, in time, return to the trends and themes dominating trade prior to Friday’s NFPs release. The core question will become, though, whether stocks (in the US in particular) can regain the same momentum they’d recently built-up. Afterall, US reporting season is next week, and if US corporates start showing the effects of the global economic slow-down, it may well truncate the life of this record bull market.