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The Fed could hurt the markets

Stock markets are lower in Europe as the market digests the FOMC minutes, which, as we predicted, were worth staying late in the office for. The Fed engaged in a detailed discussion about how to shrink its $4.4trillion balance sheet at its meeting last month, and also pointed out the high valuations of US stock markets. This has led to a risk-off tone as we approach 48 hours full of key event risks.

Risky assets look vulnerable
Although the S&P 500 only dropped 0.3% on Wednesday night, there was a clear preference for defensive stocks, with utilities closing higher, while riskier sectors were under the most pressure including financials, IT and energy. The key question now is will markets wilt as we lead up to the US/ China summit in Florida today and tomorrow, and the NFP report on Friday. Or will the retreat in US Treasury yields on Wednesday provide a cushion if stocks fall further?

Although the Fed minutes said that shrinking its balance sheet would be a slow and gradual process that will be well signalled to the markets in advance, the market will need to get used to a new reality. During the process of expanding its balance sheet, US Treasury yields gradually fell to record lows. Although Treasury yields declined on the back of the minutes on Wednesday night, we believe that we could see yields gradually rise over the next few years as the Fed embarks on its normalisation process. So, while the day-to day movement in Treasury yields may still be low, investors will have to factor in the prospect of higher yields in the medium to long-term, and that could impact risk sentiment in the short term.

The ECB vs. the Fed

The euro has tanked on Thursday after the President of the ECB said that he sees no cause to deviate from the current forward policy guidance. At the time of writing, EURUSD has made a bottom around 1.0630, but we think that the FX market may have over reacted and instead we look to German 2-year bond yields, which are at the highs of the day and could help boost the euro later on Thursday. Essentially, Draghi’s comments are not new news, so we expect their impact on the market to be short-lived.  We think that the euro will struggle in the long-term, especially now that the Fed is openly discussing shrinking its balance sheet, while the ECB’s balance sheet is set to overtake the size of the Fed’s in a couple of months’ time.  In the medium-term it’s the Fed that is the real market driver, not the ECB.

Can Trump hold his tongue?

Ahead today, markets will be looking for any tension between President Trump and China’s President Xi, any sign of discord could be enough to trigger significant declines in global risk assets. For now the S&P 500 is holding ahead of key support at 2,344 – the 50-day sma. If this level is broken then it could signal a deeper pullback is on the cards and volatility may rise.

The great NFP conundrum
Throwing a spanner in the works is the NFP report due on Friday, City Index’s proprietary model is expecting a larger than expected number. We will send out our report later today when we get our final NFP prediction. But if we are correct in expecting a larger number than the 180k currently expected, then we could see volatility spike as the market reaction could go one of two ways: will a stronger payrolls report support an earlier normalisation of the Fed’s balance sheet, which could be bad for risky assets, or will the market see it as a sign of economic strength helping risk to rally?

Overall, closing prices are going to be critical for the markets this week. If there is any further weakness in stocks and other risky assets then we might see an early start to “sell in May and go away”.

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