Markets have hit a reflection point on central banks' reflation trade. Perhaps reflation is not the correct term since policy makers are not waiting for inflation to reach satisfactory levels but rather are using the solid economic outlook to unwind extreme policy measures.
Market movements for most of the summer have been lacking historical recognisable patterns. However this week, particularly, behaviour is starting to exhibit identifiable trends. Bond yields are rising globally, driving FX and equity markets (slow motion taper tantrum). Traders are slowly liquidating low yielding G10 and high beta EM currencies. So far the move has been orderly, however, it’s easy to see how the rotation could change to disorderly.
The BoJ were forced to intervene as 10yr JGBs hit the upper threshold of curve control strategy at 10bp. The Japanese central banks offered unlimited quantity of 10yr JGB at 11bps. The decisive move highlights the BoJ’s commitment to achieve its 2% inflation target and pinning the rate curve long-end.
Investors are now convinced that for a majority of G10 central banks, the next move will be tightening. It may be represented by subtle shifts in language that removed the probability of lower interest rates or additional asset purchased but comments can have tightening effects.
Speculations of the ECB exit has weighed on German equity markets despite Draghi’s efforts to backtrack from original statements. Despite the summer heat, traders should be wary that a shift in monetary policy regime generally have extreme consequences in financial markets. As yield differentials widen, watch for carry heavy positions to unwind while in-stock interest rate sensitive sectors such as real estate and construction will come under selling pressure.
By Peter Rosenstreich