What is happening in the markets this month? Having been highly-correlated for months, they are suddenly doing all kinds of things, like a bag of marbles that has suddenly split. This is an attempt to make a coherent story about what is going on.

  • The markets that are following the script are the USD and equities, the drop on Friday notwithstanding. After a brief rally at the start of the year, the USD has been falling. At the same time, the S&P 500 has been rising. This is consistent with my central thesis, which is slow recovery + QE = rising financial asset prices. The JPY and CHF, which both tend to rise with risk-aversion, have dropped back as equities have risen.
  • Equities have been weaker in emerging markets partly as a result of concerns about, in China, monetary policy, and, in other emerging markets, the risk of currency intervention and capital controls in order to prevent QE-driven currency appreciation and an actual pause in the growth trajectory of some EM (e.g. Brazil).
  • The EUR and GBP have both been rising as higher inflation raises the possibility of rate hikes in both Europe and the UK. The GBP suffered a setback last week after a surprising weak Q4 GDP number, but is now rising again. Inflation = rate hikes = currency appreciation is the story that is driving the markets for the time being.
  • China-sensitive markets have taken a pause in January as concerns about monetary policy, rising interbank rates and the run-up to the Spring Festival holiday have reduced Chinese buying. Copper, platinum and palladium have flatlined, the NZD and AUD have dropped back (also partly on an apparent pause in domestic growth and, in Australia, the recent floods). Soybeans, wheat, corn, sugar and coffee have been unspectacular as well, but have edged upwards, largely on account of crop damage caused by the La Nina weather phenomenon. These markets should all resume their upward course after the Chinese holiday, and it will be a bearish sign if they do not.
  • Why has gold fallen back? There are two possible stories here. It might be that deteriorating sentiment in China and India, important buyers, has led to price falls that have in turn cause ETF outflows in the US. Or it might be that higher treasury yields are slowly eroding the attractiveness of gold as the opportunity cost of holding it becomes clear.
  • Oil continues to rise on strong global demand — demand estimates seem to be constantly moving upwards. Most of the rise came at the start of the month, however, and since then oil has flatlined with everything else. At least, that is what it was doing until the unrest in Egypt led to a bounce on Friday. The underlying picture, then, is the same as the other China-related commodities. When I say “oil”, I of course mean Brent, as West Texas Intermediate has been doing its own thing, most likely caused by market overreaction to high inventories at the delivery point at Cushing, Oklahoma.
  • Finally, Treasury yields have drifted downwards as the expectation of future rate hikes on account of the new QE and fiscal stimulus programmes in the US has moderated a little (likely due to the continued poor performance of labour-market indicators — the market reacted to a turn in the second derivative but the direction of the first still matters). Bunds have dropped on rising rate-hike expectations and perhaps fears over Germany’s likely need to bail out the PIIGS.

What are the trading implications of this picture? The main question is whether Chinese buying will come back after the week-long holiday that starts on Wednesday, or will continue to drop away. I do not believe that monetary policy will be tightened to the extent that it puts an end to these trends, but I worry that I am being too contrarian. When a question is hard to decide, however, I let the market tell me what the right answer is, and for now the markets say the trend goes on. The other question that leaps out is — what should I do about equities. I have missed the whole of the recent equity rally because I took profits early (in October) and did not get another trading signal (in the case of equities, a re-test of a breakout). I need to find a better signal.

For months, Chinese growth has exerted a continuous upward pressure on asset prices, and prices were only able to fall when there was some tangible worry — like double-dip recession in the US, the worry that led to the biggest sell-off last year. With QE2, fiscal stimulus and an improving economic picture in the US, there should be nothing to push markets down (the PIIGS being a sideshow). But the constant pressure of China now seems in doubt, and that fact is starting to have market effects.