Morning Brief – Tightrope

Tightrope

 

The three phase pandemic from an FX and rates perspective goes as follows: Tantrum, Blinkers and Tapering. The blinkers are still on the international market and still subduing volatility in the foreign exchange market, but yesterday we got a real taste of what tapering looks like and therefore what is in store for the market in the coming months. Following rising (yet ultimately denied) tapering expectations in the United States and the havoc that has brought to USD crosses, the taper tightrope is strung taught in front of every central bank on the planet. For major central banks, I’d want to see a seriously long balancing pole to steady them as they take the first steps on the rope.

 

First off, when the market begins to wobble and see a rising threat beyond its capabilities the tantrum phase begins. Asset valuations start fluctuating wildly, every asset with even a whisker crossing the line of risk vs. safehaven status is sold off and asset prices, the barometer of a confident and healthy market oscillate continuously. Anything carrying the title of junk, offering a dividend, within the emerging market basket or just out of favour with the wider market is thrown to the wayside. In particularly severe cases as we saw in March last year at the beginning of the pandemic, even safe haven assets can shed value as forced liquidations in favour of cash to cover margin calls in other markets can disturb safehaven price dynamics. However, the tantrum phase that saw USD gain a handful of cents on the Pound, Euro and most of its counterparts on a daily basis has all but passed and unless the pandemic morphs into something almost unrecognisably worse than we understand it to be today, should not show its head again in the name of Covid-19.

 

The blinkers phase occurs when the market is blinded by the inundation of cash provided by the seemingly endless printing of money at global central banks. Is it this activity that both staves off the risk of asset price turmoil created during the tantrum phase but also builds note by note, asset purchase by asset purchase and rate cut by rate cut the propensity for tapering risk: the third phase. The blinkers placed upon global markets create that risk that once the blinkers are off, if the world isn’t as appealing as the green-tinted hue of ample liquidity, markets will shed value from assets once more. In a way, the blinkers phase allows for stability in markets despite turmoil still being abundant in the real economy pushing the short term and often over priced risk out into the future to be dealt with in a more orderly fashion during the tapering phase. We are coming towards the end of this phase as a global economy as vaccination efforts promise to diminish the threat that Covid-19 presents to our populations and global trade resumes following more than a year of rolling lockdowns.

 

The ending of the furlough program, rising inflation, economic growth, interest rates and swelling equity markets are all emblematic of a global economy starting to become ready for the blinkers to be taken off. Following an interest rate decision yesterday, it appears the Bank of Canada are ready to remove the bank notes from the eyes of the economy and begin to normalise policy. That spelled good news (from a pure CAD valuation perspective) for the domestic currency, but could hamper the performance of the Canadian economy as it emerges from the pandemic-induced super recession. Following a decision yesterday by the Bank/Banque the Loonie gained 1 cent versus the US Dollar in two minutes, and a further cent versus its major peer the USD in the hour that followed. So what did the bank do and what lessons does it provide to the wider market?

 

Despite holding interest rates stable and continuing to pursue it’s asset purchase program, the BoC reeled in its expectations on when the output gap and economic scaring created by the pandemic would be eliminated from Q1 2023 to H2 2022. Forecasting near full output and revising up the immediate and retrospective outlook for the economy gave hawkish overtones to the monetary policy decision and led markets to price in the expectation that Canada will be one of the first banks to normalise policy following the pandemic. Upon closer inspection the central bank merely highlighted the immense role that it has played in providing abnormal levels of liquidity to stabilise the market and therefore was required to withdraw some of this. The lesson to be learned therefore is that stray even a millimetre from the easing path and markets will take a mile in their hunt for yield, and facilitate wild swings in the prices of domestic assets.

 

 

 

Discussion and Analysis by Charles Porter

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