Ok I have meant to produce the following analysis for a long time and now that the market is focussing on the next Fed meeting I feel that it might be the right time to release a first version of this. In summary, the following report shows what were the cumulative returns of the S&P500 index 10-day prior and following the FOMC meetings. It also shows how the delivered volatility of the S&P500 changed on average prior and after the Fed annoucements. I have split my analysis to show the market reaction as for when when there was not change in the Fed Funds target rate, when a cut in the rate occured and when there was hike. I will provide an analysis showing what was the impact on the US trade weighted index and the VIX in further posts…
From 1982-10-05 to 2015-10-28there was 352 Fed meetings.Out of those 33 meetings translated in an increase in the target rate and 33 in a cut. The below charts shows when those took place and also the distribution fo the changes in rate.
The charts below show the S&P500 response for all of the Fed’s meetings and the delivered volatility 10 days prior and after the meetings.
The charts below show the S&P500 response and delivered volatility for all of meetings where a cut occured
The charts below show the S&P500 response and delivered volatility for all of meetings where a hike occured
The charts below show the S&P500 response an delivered volatility for all of meetings where there was no change in the Target rate.
As a general remark it would seem that the volatility of the S&P is higher prior the meeting and tapper down after the Fed annoucement (this is not as visible for the cuts and hikes. This is probably the result of the low level of observations in the respective samples…). There is no real clear pattern in which way the S&P500 response to the annoucnements be them hikes, cuts or no change….
As it has been a while since I have posted something and my broken arm is no longer a valid excuse , I thought I would provide an update on trends in US mutual funds flows. To my surprise, bearing in mind the current geopolitical risks, there has not been much change over the last few weeks. US investors have held onto their preference for international equities whilst staying shy from the US stock markets. Also the trend of inflow into bonds remained despite growing expectation of the Fed becoming more hawkish down the line. The map below shows the T-stats of the inflow/outflows across different time periods.
Clearly the dovish tone adopted by the Fed has helped both the trend in equities and also bonds. The question is how long can this last ? Clearly the strengthening observed in the US job market demonstrates that significant growth has rooted. Down the line this will create an issue for the fed, as managing rate expectations whilst turning away from a dovish stance may prove challenging. To me the most interesting point of all is how US investors voted with their money. As can bee seen from the below charts they have stayed well away from US equities whilst investing in Foreign equities. In fact out of the US$ 133 bn invested in US mutual funds 44 % (US$ 59 bn) went into foreign equities so far this year, whilst US$ 5bn came out from US Stocks funds.
As said in my previous posts I believe that what we are seeing could be a good explanatory variable as of why the dollar has been so weak and particularly against the EURO despite the monetary expectation in Europe and the US. Bearing in mind the current market positioning and central bank flows it may well be that the EURUSD is currently undervalued….
As market risk has been trading on the low over the last few months I thought that I would post a few charts of mine. First looking at the VIX as a measure of financial market risk we are indeed trading at relatively low level, though we are still a few points away from the 9.31 the lowest ever close that printed on the 22nd of December 1993 . The two states Markov regime switching remains clearly on risk seeking mode.
Contributing to this low volatility has been the massive inflows that we have seen on equity markets. However I would not call this level abnormal, the chart above start from January 1990 and show that we have indeed experience long period of low volatility in the past. The chart below shows the significance of inflows/outflows in US mutual funds tracked by the ICI . The chart on the left shows the T-stat of the inflows for the main asset classes over various time horizons. It is clear that the preference has been for equities, and this with good reasons as discussed in my previous posts. So far in the US alone we have seen close to USD 120 billions of new inflows in US mutual funds.
Out of this, as shown by the right hand chart, close to 40% went into Foreign equities , only 5% into US equities and 21% in hybrids. if we assume a 60/40 benchmark this means an extra 8% into equities. Therefore potentially 53% of the 120bn invested went into equities. This is somehow in decline in respect of what we have seen in the first half of 2013 where 162bn went into US mutual funds, with an estimated 62%allocated to equities. However this is without any doubt a contributing factor to the low level observed in the VIX. Clearly central banks monetary policy and also the implication for the bond market of an exit scenario on the back of better economic fundamentals has somehow been behind the great rotation that started now a couple of years ago. The last chart showing the cumulative inflows in the main asset classes indicates that there is still some way to go….I ll stick to equities as usual….
Ok it has been a couple of eventful weeks if you were invested in equities be them from developed markets or emerging markets. Clearly the scaremongering of analysts and journalists paid by the line rather than the true profit they generate has somehow fed into the volatility and sudden lack of rationale of markets. We have seen a spike in the VIX and as indicated by a 2-state Markov regime switching model a risk off scenario. As mentioned in my previous post, it is worth bearing in mind that those periods of risk aversion tend to be short and somehow provide good ground for opportunities.
True the sell off somehow pushed most equity markets in the red. But if one take time to look at the moves that unfolded they have not been really out of tune from what could be expected from the median risk of equity markets. By that I mean that if you assume that equity markets have typically an annualised volatility of 20% this means that the monthly move expected under a normal distribution assumption should be tantamount to 20% * 1.6450 /sqrt(12) = +/- 9% . So true enough some of the markets such as Japan and Chile have gone somehow out of this range as shown in the below chart. But I would argue that we are not miles away and that there is no reason to panic because a herd of unknown analysts have come out from the woodworks forecasting the end of the world as we know it…..a loss of nerves is is to be expected every time we have a down move of more than 5%.
In respect of the S&P500 the move we have seen over the last 21 days is indeed pretty much middle of the road as a close neighbour analysis using daily data back to 1980 demonstrates. From there the scenarios are quite varied…
So let’s go back to the catalyst of those financial ripples, the Fed policy an its impact on global liquidity. Well , there is nothing new about the Fed reducing its liquidity supply. We have been told last year what was the plan and you are better getting use to it ! Bottom line is that things are going very well in the US, the data is clearly indicating a strong recovery which is logically feeding into both the housing markets and the equity markets. So it may well be that the liquidity which is smoothly withdrawn by the fed will in fact be replaced by investment flows and a growing trading activity between the developed world and emerging market countries as those economies recover and re-leverage. Perversely this could have a negative effect on the dollar as it will mean more cross border flow toward new international opportunities by US investors and corporates. Also as growth come back and US withdraw some of its liquidity it is likely that some of the EM countries will draw on there reserves which is predominantly made of US$ to stimulate their own economies. Anyhow it is worth looking at the latest batch of data on inflow in US Mutual funds as it now cover the recent period of volatility.
And guess what…. investors are still buying international and domestic equities significantly. Bonds flows have somehow recovered ever so slightly….though my view is that they will probably shift back to negative for the reasons presented in my previous posts…..So I think I ll keep re-investing those dividends in financial equities for a while..
Ok everything was going well and then suddenly the market decided to remind itself that the Fed was in tapering mode and that this should feed into EM liquidity. Bearing in mind what the Fed told us about the tapering early December and that overall US data has been on the good side, I am not so sure this FOMC release should have been a surprise to anyone. Anyway it has been a bit of a bloodbath over the last week in preparation of the release as can be seen from the below charts. The first one shows the T-Stats (i.e mean return/standard deviation * sqrt(sample size -1)) over various time horizons for major equity markets whereas the second one shows the components of the FTSE 100, my current playground. The greener the best and the redder the closer to hell for the bulls…
So what is the driving reason to sell equities and “risky assets” aside generating fees and commissions for some ? Clearly the market does not seem to be at its most rational state. The Fed tapering as mentioned in my other posts should be good news since it is driven by the bettering of the US economy. Even things seems to get better in some part of Europe. Ok China is slowing down as per its latest data points but this is engineered and certainly not an abrupt surprise. Anyhow the Chinese government has ample reserves to steer their economy up if they wanted and Japan is really picking up at long last. Looking at my favourite data which track US mutual funds inflow/outflows it looks like recent events have not slow down the appetite of US investors for international equities. In fact we carry on pretty much on the same established trends of last year. Buy equities and stay away from bonds….and the bond inventory is humongous which does not bode to well in a cycle were rate3s are likely to go up at one stage…R.I.P PIMCO and alike….
So what to do when its getting tough ? Clearly the world is not any different than what it was in the last quarter of 2013…The global economy is slowly but surely re-leveraging and the central bank will remain accommodative potentially leading us to an inflation surprise down the road. Though we admittedly have some time before we get there as we clearly need the consumers to reach his wallet in a more significant fashion. The risk environment is in safety mode as shown by a Markov 2-state regime switching model. And yes the VIX the so called index of fear as spiked….
However as a quick observation , historically those period of loss of nerves by market participants are not very long lasting and tend to open new opportunities. Now the Fed has released its statement it is time to buy back those stocks….hopefully at a lower cost after fees….Else just hang on to your longs….
Quite clearly the last Fed meeting of the year was important. We got the long awaited announcement that the purchase of Treasuries and MBS would be reduced. The rate of 10 billions a month at which it decided to decrease its security purchase was mild enough to demonstrate that the Fed meant to remain accommodative and that its main concerns were the relatively high unemployment rate and the stubbornly low inflation rate, as shown in the word cloud of the Fed Statement.
To put in context how mild this reduction of security purchase by the Fed is, it is worth bearing in mind that US mutual fund holders have been redeeming from bond funds at an average rate of 23 billions a month over the last seven months. This probably supports my contention that the Fed will accept to lag the market shift in asset allocation so as not to send those long term rate flying… but ultimately the 10 year US rate is more likely to trade close to 4% than 2% within the next year or so as private sector redemptions and government withdrawal of liquidity will ineluctably bear on bond valuations. So we will see further steepening in yield curves. The reason behind the price dynamic is clearly driven by growth expectations which are rationalised by the continuous decrease we have observed in US unemployment and general pick up in economic activity. Anyhow it seems that the market took the news very well since we have seen a small upside in equity markets and the VIX has been holding at what once would have been deemed insanely low levels as shown in the below chart.
As of why the VIX remain so low, my theory is that the dynamic is supported by the significant inflows we are seeing in the equity markets. selling short the VIX should indeed correlate with a long position in equity markets. Anyhow the last batch of data has just been released by the ICI and guess what ? It is redemption time again for those fixed income funds. Somehow the Fed meeting which acted as a beacon for the Roubinni’s of this world and black swan watchers proved to be a damp squib because of the modest decrease in security purchase announced. Not surprisingly there were a few outflows for domestic equity funds ahead of the Fed release and the outflows in bonds was as usual negative (as would be consistent with a decrease purchase by the Fed). It is worthwhile noting however that the flows toward global equity funds remained significantly positive. This ultimately lead me to thing that this will put pressure on the US$ particularly against the EURO because of the country weighting in MSCI and other equity benchmarks. Below are the usual map charts and cumulative charts.
As mentioned in the above the inflows into equities and outflows from bond products are taking place in a relatively low risk environment (as expressed by the VIX). I find this interesting as it is consistent with an orderly shift in asset allocation. We are not talking about the kind of asset shift we have seen in 2007/2008. It was then clearly driven by a strong risk adversity and therefore not a long lasting proposition. The chart below illustrates well the new flow dynamic we are experiencing.
This kind of configuration tends to occur when an equity bull markets is taking hold. So my view remain stubbornly unchanged and you are better to get used to the above charts….the bloodbath for bonds has just started it will be slow and agonising…I will stay long equity Beta.
Well yes it is FOMC time again and its seems to me that it is all dovish again and that definitively the Fed will stay behind the curve as long as is needed to have 100% certainty that when they hit the brakes they will not send the economy back into a tailspin ..However this still plays well into my scenario of a forthcoming bond crash as in doing so they will leave ample time for investors to front run them when time comes to take this liquidity away (My next post looks at the ICI latest data release on US Mutual funds flows, so watch out…)…all this seems very bullish equity and bearish dollar if you ask me….but you may have already read my previous posts …anyhow I though I would try to go quantitative on the Fed semantics and try to see if we have any notable changes in their wording by creating a word cloud for their July release versus this September. Basically the script looks at the frequency of each words in the release and scale those words accordingly to the observed frequency. So the more repeated the word the bigger it is represented in the cloud. As you can see from the below it does not seem to be any material change…..same all same all….this monetary policy is not about to change…..
July release September release