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Risk on, Risk off

August 2016

It’s a rare unusual market where global stock indices and bonds are rallying together. Is a quick sell-off on the horizon?

Equities on Fire
U.S. stocks have touched record highs in recent days, and emerging market equities are up over 25% from January lows. The combination of upbeat U.S. data and more stimulus hopes contributed to the risk-on trade environment, sending Asian equities higher on July 12 after the S&P 500 set a new record high on July 12. The U.S. equities finally managed to break above last year’s record highs, supported by solid economic data and prospects of new round of monetary easing by major central banks. According to FXTM Chief Market Strategist Hussein Sayed, the incredible reversal in appetite to risk sent MSCI international world index within a whisker of 2016 highs, as global equity markets recovered almost all losses post the U.K.’s vote to leave the European Union. Emerging Markets have been major beneficiaries of the current risk-on environment, with non-resident portfolio inflows into the seven EMs reaching over $12 billion since Brexit. $8.2 billion has flown into equities alone, IIF data show.

Bond Yields Dip
Along with stock market rally, the U.S. yield curve too continued to flatten with long dated bond yields declining to record lows. In a regular trading environment stocks and bonds should be moving in opposite directions.

On July 6, 10-year treasury yields dropped to a record-low 1.32%, as nervy investors post-Brexit continued to run for safe haven assets. On July 27, the US Fed voted to keep interest rates on hold. The accompanying policy statement could be characterized as more optimistic relative to what was seen in the June statement, with the FOMC noting in increase in labor utilization, describing household spending as growing ‘strongly’, and stating that economic activity was expanding at a ‘moderate’ rate. In addition, the Fed added a sentence acknowledging that ‘near-term risks to the economic outlook have diminished’, which perhaps highlights their view that spill-overs from the Brexit referendum on the U.S. economy will likely be minimal. A report by Emirates NBD Global Markets & Treasury notes in a report that this latest statement reinforces its view that a September rate hike remains a possibility, so long as the data flow continues to point in the right direction. In response to the Fed statement UST yields fell about 6bps to settle below 1.4%. This morning yields have edged up slightly. Fixed income generally moved higher in response to the Fed with the only significant standout being high-yield corporate debt, no doubt let down by a tanking oil price.

Other safe havens such precious metals too rallied with gold and silver soaring to a 2-year high in the early week of July. Analysts expect current geopolitical and economic risks will likely lead more investors to increase their allocation in gold with $1,400 a potential target in the short run.

The Pound Recovers
The pound recovered more than 4% from its 31-year trough in July’s second week, mainly driven by short covering positions and triggering of stop losses above 1.3 levels, as markets celebrated the news that Theresa May is set to become the next UK prime minister. However, Sayed believes volatility in the currency is far from over.

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