In her last press conference after the minutes of the US Federal Open Market Committee (FOMC) were released, the Federal Reserve chairperson Janet Yellen said interest rates would start rising six months after the quantitative easing (QE) program completely winds down. Bond market traders have had to adjust their positions accordingly as the rate hike is now being priced much earlier than it was previously expected. Market expectations are for the first rate hike to occur somewhere around May-June 2015.
In the last week, the US yield curve has drastically flattened with the short-term rates rising and long term rates falling. The spread between the 5-year notes and the 30-year bonds is at its lowest level since 2009. The gap between the 2-year and 10-year yields has also narrowed but not quite as sharply.
As of now, we should expect this trend to continue unless the non-farm payrolls data and housing data disappoint in the coming weeks. If that is the case, the “doves” led by Yellen would want to put a brake on tapering while the hawks would not.
These differences between FOMC voting members might cause volatile moves in the dollar and bond yields. For the time being, it is important to note that the market is still expecting slow growth and low inflation over the long run which is implied by rates falling on the back end of the yield curve.
On the currency front, the US dollar normally rises against the Japanese yen when US 10-year yields rise. A stronger correlation is displayed between the 2-year and 10-year yield spreads and the Japanese Yen. As long as the spread keeps narrowing, we should expect a weaker dollar against the yen. This will likely change after the first consumption tax hike takes place in Japan after a gap of 17 years in April.
On the stock market front, the S&P 500 has held up pretty well with the news of the Fed taper. However, there is one note of caution. US stock market margin debt is at record high levels. Any sell trigger catalyst can lead to a capitulation phase as leveraged long positions will be forced to liquidate their positions, if a sell off does indeed take place.
According to Credit Lyonnais Securities Asia (CLSA), an independent brokerage and investment group, the margin debt balance of New York Stock Exchange rose 24 percent year-on-year to a record high of $451 billion in January. This is equivalent to 2.8 percent of the S&P 500 market capitalization as compared to the 2.9 percent, which was the peak seen in 2008.
There is an all important European Central Bank (ECB) monetary policy meeting this week. As discussed before, the sentiment remains mildly bearish. The euro-to-US dollar rebounded off the key 1.37 support level. However, we can see a strong surge in the euro if ECB President Mario Draghi does not talk the euro down and expresses no discomfort with a stronger currency.
Looking at the daily charts of the S&P 500 futures, next support levels are seen at 1,835 and 1,827. The Ichimoku cloud chart overlay does not suggest any breakdown in the upward momentum and the relative strength index (RSI) is currently 50, which by no means suggests an overbought territory.
In the coming weeks, the market would be watching the pace of the yield curve flattening. Yellen would not like things getting heated up too fast to spook the markets.
(Vatsal Srivastava is a senior market analyst. The views expressed are personal. He can be contacted at vatsal.sriv@gmail.com)