Stocks rebound following three day weekend. The S&P500 gained 2.5% to 1,969 and the Dow Jones added 2.4% to 16,492. The VIX continues to drift downwards, falling more than 10% today to 24.9 down towards historical average levels. Economic data in China today was weak, showing that the value of imports fell 14.3% from the previous year. This is not a healthy sign for many of the emerging markets and commodity-reliant countries who are suppliers to China. In spite of this figure, stocks in China rose which prompts many analysts to suggest that the PBoC once again intervened. Anthony Karydakis, chief economic strategist at Miller Tabak, suggests that the steps that Chinese authorities are taking to shift the economy from export-reliant to domestic consumer driven will start to materialize later this year. Data in the eurozone was strong where Germany’s trade balance in July reached a record high. Similarly 1Q and 2Q GDP for the region was revised upwards. The region is on track for a 1.5% annual GDP. Coupling with the stock rally in the US, markets represented a risk on attitude as Treasury yields rose. The 10 year added 7 basis points to 2.20% and the two year added 4 basis points to 0.74%. The euro was stronger against the dollar possibly due to economic data, rising 0.4% to $1.1207 (dollars per euro).
The FOMC is faced with an unclear decision regarding interest rates later this month. By some indicators the US economy is on the road to recovery as several years of monetary easing have allowed businesses and households to recover from the recession. However in spite of this recovery there are several headwinds to inflationary hopes which the Fed are unable to control. Members of the Fed such as James Bullard appear ready to raise interest rates as soon as this month. Janet Yellen too has cited that rates are at the lowest level relative to income since the 1980s. This appears to support the idea that rates held at zero are not warranted given the current state of the economy. Complicating the Fed’s decision is areas of risk on both ends of the spectrum. If rates are kept at low, asset bubbles could emerge in the US. Already several areas such as car sales and commercial real estate prices are at their highest levels dating back to pre-crisis levels. Inflation remains tame however, however some argue that this may be due to technological progress and that asset bubbles may be a bigger concern. Stanley Fischer, another FOMC member, believes that wage gains and inflation are on the verge of taking off, and that the Fed should raise rates before then due to the lagging effect of monetary policy. If the Fed raises rates too early, it risks magnifying the deflationary pressures of low commodity prices, the strength of the dollar, and the global economic slowdown. If deflation sets in, it can be a dangerous cycle that takes years to escape.
The size of emerging market foreign reserves remains healthy by historical standards in spite of recent outflows. Foreign reserves around the world remain relatively high and have grown over the past decade. Emerging markets have been accumulating reserves to prevent another currency crisis (late 1990s), and to maintain pegs. To keep a low exchange rate peg to allow goods to become more competitive a country would sell it’s own currency and buy foreign currencies on the open market (opposite dynamic for strengthening own currency). Over the last decade foreign reserves have been accumulated through rising oil prices (up until one year ago), current account surpluses (signifies a country has more foreign assets than liabilities), and capital inflows. In spite of this trend over the past decade recent months have started to show a reversal as the Fed prepares to tighten and outflows begin from emerging countries. The pace of outflows has not frightened analysts, however it will be something to watch depending on the Fed’s tightening trajectory, foreign monetary easing, and the scale of the global economic slowdown.