The Fed and The Yen

A lot of traders are having trouble making sense of this market. Here are some comments and links that should help us get clearer about what's going on:

1. Here is the Fed tapering argument that everyone is worried about. The Fed will reduce large scale asset purchases (LSAP) if and only if the employment picture shows, in Bernanke's words on May 22, "sustainable improvement". If LSAP is reduced, there will be less demand for risky assets as the supply of higher quality fixed income assets increases. That is, stocks will tumble. The problem with the first step in the argument is that the employment picture has not improved all that much, so expectations of reduced LSAP seem premature.

The Fed didn't adopt the Evans rule just so they could turn around and break it. The problem with the second step of the argument is that, if the economy is strong enough to justify a normalization of Fed policy, then it doesn't necessarily follow that risky assets would suffer. A rebound in wages and continued supply pressure in the housing market could keep the bid under stocks.

2. What about the sharp move higher in real interest rates? Karl Smith mentions that it could be because of a higher risk premium on U.S. bonds. But the dollar is surging, and the attached chart from me shows that implied volatility term structure on bonds hasn't even flattened to new YTD highs. Instead, Karl thinks that the decline in commodity prices could be spurring an increase in domestic U.S. consumption - especially as weaker demand in China puts more supply-side pressure on commodities. ( Modeled Behavior) The retail sales data for May released this morning showed an increase of 0.6%, beating expectations.

3. The selloff in Japan has been widely blamed on weak-hand foreign investors taking profits after a disappointing news cycle; but weekly data from the Ministry of Finance shows that foreign investors were actually net buyers in the week ending June 7. Foreign investors were massive buyers in May, too. ( Marc to Market) Given the continued weakness in Japan, it won't be surprising if the data for this week turns a bit.

4. In the short term, market stresses justify sitting on your hands for the moment. The bid in equity implied volatility -- look at a moving average of the CBOE Volatility Index (VIX), for instance -- is a very noisy indicator over the short term, but historically it has paid to stand aside when demand for protection is this strong.

Skip makes a great point in his note this morning. The central bankers of the world are smart and market-savvy, and you had better be a world-historical genius if you're going to invest based on the thesis that they'll tank the markets in such a clumsy way.

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