The End Of The Risk Rally? Probably Not

The sell-off has continued in European trading with European stocks trading sharply lower; the yen and Swiss franc are stronger and emerging markets are generally under selling pressure.

Five overall reasons for the sell-off in risky assets:
The first one is the obvious one: that we were simply in for a market correction – profit taking after more than six months of a rally in risky assets. Several stock markets (U.S., Japan, Germany) are technically in very overbought territory. This normally triggers a correction sooner or later.

Second and a lot more important – Federal Reserve chairman Ben Bernanke’s testimony to the Joint Economic Committee of Congress has led some market participants to think that the Fed will scale back monetary easing more rapidly as the U.S. economy continues to improve.

Third, fears of the Fed ‘scaling back’ are also likely to be leading to – prematurely, in our view – speculation that the Bank of Japan might be close to starting to scale back its unprecedented monetary easing. The fears might have gained ‘support’ from some unfortunate comments from Japanese government officials in particular about the development in the Japanese FX and fixed income markets. If the markets start to fear that the BoJ has shaky hands, it is certainly a very good reason for taking profit on ‘the Japan trade’.

Fourth and probably the initial ‘trigger’ of the day’s sell-off is increased concern about a continued and fairly sharp slowdown in Chinese growth.

Last, economic data has surprised on the downside for some time now without the market reacting. Given the technically overbought markets and initial talk of a Fed exit, the markets may be catching up a bit with recent months’ weak data.

Of these five factors, we believe that the Chinese growth concern is fundamentally the most important as we don’t think that the BoJ is anywhere near to scaling back on monetary easing. The Nikkei sell-off might even push the BoJ in the direction of more monetary easing and even though the Fed is moving closer towards scaling back, we also think that it would be extremely cautious not to exit the present policies in an abrupt way.

What we would like to see to keep the risk rally going
Fundamentally, we think that the BoJ is far from scaling back monetary easing and we are not in for a sharp change in US monetary conditions. However, the markets are nervous about these issues. Therefore, to keep the risk rally on track we would probably need comforting comments from both central banks on the future of monetary easing.

To Read the Entire Report Please Click on the pdf File Below.