Santa rally expected to resume as BOJ in focus

<p>The markets are desperately seeking direction this Christmas week, as early holidays, timed with the Fed meting last week, leave markets thin with liquidity. We […]</p>

The markets are desperately seeking direction this Christmas week, as early holidays, timed with the Fed meting last week, leave markets thin with liquidity. We expect the current risk-on trade to resume on Tuesday, as US Treasury yields climb once again in early trading. This comes after an exceptionally directionless Monday.

Geopolitics makes for nervous trading conditions

The geopolitical backdrop to trading on Tuesday has darkened in the last 24 hours with a potential terror attack in Berlin and the shooting to death of the Russian Ambassador to Turkey. This may be enough to boost safe havens on Tuesday, after a rally in US Treasuries (yields fall), gold and the yen as the news broke on Monday. The Russia/ Turkey issue could make an already tense situation in Syria worse, so we will look out for further information on this shooting on Tuesday. While we doubt that the risk on trend has come to an end, recent events are enough to remind people that Holidays are coming, and it could be time to book some profit.

Why you need to watch US Treasury yields

To gauge whether or not risk sentiment can be maintained until year-end, take a look at US Treasury yields. If the 10-year yield falls below 2.5%, it is currently at 2.53%, this could signal a deeper retraction for risky assets and a revival for safe havens, as it is a critical level of support for US government bond yields.

At this stage, we expect that there is more upside to come from US Treasury yields, and this is a mere pause. We believe this because the US yield spread (the 10-year Treasury yield – the 2-year Treasury yield) continues to steepen, even if it has fallen back from recent highs, as you can see in figure 1 (see document attached). The steepening trend looks in tact, which supports a further increase in US yields and, for now, a gain in US stocks.

There is still time for Santa to get his rally on

To get an idea of the type of environment we are in, stocks stalled on Monday as US Treasury yields retreated. This suggests that rising yields is a sign of confidence in Trumpenomics, which is good news for stocks right now. When yields fall, so too does the stock market. While rising yields and rising stock markets are not compatible forever, they may continue to move in synch into the New Year.  It is worth remembering too, that traditionally this is a good time of year for stock markets, the so-called Santa rally can see global stock markets perform well into year-end. Thus, any pullback in the major stock indices early this week could be used as a buying opportunity in the coming days, so bears should beware.

BOJ press conference could boost USDJPY

Elsewhere, the BOJ left rates on hold today, as expected, but had a brighter outlook for the Japanese economy. This makes it less likely that there will be more stimulus from the BOJ next year, and the Bank will remain on hold for the long-term. The market reaction to this move has generally been a stronger USD/JPY. Although the BOJ economic outlook is more upbeat, it isn’t enough to compete with the Fed and its rate-hiking cycle for 2017, which will continue to give the US dollar the yield advantage.  Japanese stocks like it though, and the Nikkei is up 0.5% already, as a weaker currency, a brighter economic outlook and a low interest rate environment boost the Japanese corporate outlook. We need to wait for governor Kuroda’s press conference later this morning, but we expect USD/JPY could be in consolidation mode this week, as the yen has already declined sharply in recent days. Thus, this BOJ meeting may not be enough to push USD/JPY above 120.00 in the short term.

Can the Fed’s Janet Yellen revive the US dollar rally?

Interestingly, the US dollar jumped on the back of a speech by the Fed’s Yellen on Monday evening that the strong US economy should boost US living standards. This could trigger a further recovery in the dollar on Tuesday, which would leave the euro, pound and yen vulnerable, in our view. Data wise, it is likely to be a quiet one. Retail sentiment out of the UK, along with current account data from the Eurozone are the highlights.

Figure 1: US Yield curve: 10-year -2-year treasury yield spread 

20_12_chart1

Source: City Index and Bloomberg

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