The US reports the monthly employment data today, but there are greater forces at work and it is not clear that the employment data arrest those forces that have injected volatility into the global capital markets. Participants are disappointed with what Japanese Prime Minister Abe promoted as the third arrow of his stimulus program. The ECB's Draghi disappointed expectations of those looking for greater action. A negative discount rate, like the OMT, had the desirable impact from the brandishing, not the deployment.
We have argued that the recent tapering talk helped let the air out of the asset markets that some of its critics were arguing were bubbles (which seems to be another word that has taken on a life of its own, without any agreed upon definition). Fed officials, like Bernanke, Yellen and Dudley talked about requiring more data before being able to decide whether to change the pace of long-term asset purchases. We did not see as simply an agnostic data-dependent position. The top officials at the Fed have warned about the fiscal drag that has still not been fully felt. The economic activity has clearly slowed over recent months.
Measures of core inflation remain low, with the core PCE deflator near record lows. The monthly jobs report is among the most difficult of the US high frequency data to forecast. It is volatile, with numerous components, and few reliable inputs. That said, the consensus forecast of 165k is probably on the high side of expectations following the weaker than expected ADP survey, and soft employment readings from both ISM surveys and the newer PMI. Weekly initial jobless performance would also point to less net job growth.
Yet for medium term investors, it might not make much of a difference, barring a significant surprise. Whether the Fed tapers off in Q3 like many have suggested, or waits until late Q4, or even early Q1 14, like we have suggested, a reduction of QE is likely. More investors are coming around to the view that the interest rate cycle is over.
The importance of US rates in the global capital market should not be under-estimated. Higher US rates drives up global rates, in general. Given the lack of a synchronized business/economic cycle, many countries, including the periphery of Europe (but also core countries such as France, Netherlands and Belgium) are ill-prepared to cope with higher interest rates. Ironically, the interest rate differentials have moved against the US this week, as US rates have slipped while Europe, Japan and emerging market yields are higher.
Nevertheless, the first instinct for leveraged participants is to unwind those strategies that worked well in a low and falling interest rate environment. This coupled with the thinner liquidity outside of the core markets helps explain the price action and volatility.
We do recognize that in addition to the tapering story in the US, many also appreciate the contradiction in Abenomics, which seems to have been endorsed numerous countries and economists, including France's Hollande earlier today.. If Japan is successful in lifting inflation and inflation expectations, JGBs yields have to rise. This too has injected volatility into the capital markets.
