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BOJ Rate Decision: Bank of Japan Keeps Policy on Hold After September Meeting

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The Bank of Japan (BOJ) has voted to keep its trend-setting interest rate at record lows, as policymakers continue to rely on record stimulus to keep the economy humming.

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BOJ Policy Decision

In an 8-1 vote, the BOJ kept its benchmark interest rate at -0.1%, where it has stood since January 2016. The decision was widely expected by economists, who say the BOJ is unlikely to budge on monetary policy anytime soon.

The BOJ also maintained its purchase of Japanese government bonds (JGBs) so that the 10-year JGB yield remains at zero percent. Meanwhile, annual bond purchases continue to be held at ¥80 trillion.

The BOJ shifted course on monetary policy last September when it made yield-curve targeting its central concern. Since then, it has been status quo.

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Economic Picture Brightens

Central bankers have been largely hands-off to let monetary policy do its job. Recent data suggest ultra-loose policies are finally having their desired effect. Japan is currently in the midst of its longest period of uninterrupted growth in more than a decade. Quarterly gross domestic product (GDP) expanded 0.6% between March and June, the fastest in more than two years.

In annualized terms, the economy expanded 4% in the second quarter, official data showed. That was much bigger than the 2.5% annualized gain forecast by economists.

Japan has now been on the right side of growth for six consecutive quarters and nine of the past 11.

Strong domestic demand and a synchronized global recovery lifting Japanese exports have been the main factors behind the growth.

Despite solid growth, inflation continues to lag the central bank target of 2%. Core inflation rose in July for the seventh straight month, but came in at just 0.5%. National CPI also expanded 0.5% annually in July for its seventh straight gain.

Inflation has been so disappointing that the BOJ recently postponed its inflation deadline for the sixth straight time. The move highlights the growing frustration with low inflation under the Abe regime.

Yen Losing Ground

Japan’s currency declined again on Thursday to trade at fresh two-month lows. The dollar-yen (USD/JPY) exchange rate reached a session high of 112.65 before paring gains. At the time of writing, the pair is up 0.2% at 112.51.

The yen has been in free-fall for the past two weeks as risk sentiment returned to the financial markets. The yen is a highly liquid reserve currency that usually receives strong bids during periods of instability. With investors pouring money into stocks, the yen has fallen by the wayside in recent weeks.

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Economy

U.S. Nonfarm Payrolls Unexpectedly Decline in September

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The U.S. job machine slowed significantly in September, as Hurricanes Harvey and Irma ripped through the southern states, disrupting local economies in their wake.

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Overall nonfarm employment fell by 33,000 last month, following a revised gain of 169,000 in August, the Department of Labor reported from Washington. Analysts in a Bloomberg survey forecast an increase of 100,000.

The jobless rate declined to 4.2% even as workforce participation rose. That’s a level not seen since 2001.

Signs of wage inflation were present last month. Average hourly earnings rose at a faster 0.5% on month and 2.9% annually, official data showed.

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Earlier this week, payrolls processor ADP Inc. said U.S. private sector employers added 135,000 positions last month. Economists had projected 98,000.

Hurricane Harvey made landfall in Texas at the end of August, triggering the biggest weekly spike in jobless claims since 2012. A total of 298,000 Americans filed for state unemployment benefits in the week ended Sept. 2, a gain of 62,000 from the week before.

September was the first negative reading on payrolls in seven years. Hiring is expected to rebound in the fall as the states of Texas and Florida resume cleanup efforts in the wake of hurricane season.

Solid employment growth has been one of the few mainstays of the U.S. economic recovery, prompting the Federal Reserve to gradually normalize monetary policy. The Fed is widely expected to raise interest rates again before year’s end. The Fed’s “great unwind” of its balance sheet will begin this month at a rate of $10 billion.

The report had no immediate impact on the currency markets, with the U.S. dollar index (DXY) rising gradually shortly after the data were announced.

«Featured image from Shutterstock.»

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Analysis

Breaking News: Dollar Soars as Fed Reveals Tapering Plan

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Highlights of the Fed Meeting

  • The Fed will start reducing its balance sheet next month
  • No interest rate change this time around, benchmark rate remains at 1.25%
  • December hike much more likely than previously
  • No change in outlook language

Overall our expectations of a slightly hawkish Fed were fulfilled, as the immediate start of the tapering is quicker than expected, and 11 was the number of Fed officials that see another rate hike in 2017, with only for expecting the rate to remain 1.25%. The market is pricing in a 50% chance for a hike and the ratio suggests that the majority of the Fed officials are leaning towards another tightening step. We expect the Fed to closely monitor the reaction of the market and intervene verbally should risk assets react in an “unwanted” way.

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EUR/USD, Hourly Chart

What’s Next for the Markets?

The Dollar is rallying heavily after the hawkish announcement and the with the significant devaluation of the currency in recent months, there is ample room for a bounce to form. The currency pair has a strong support zone near 1.17 that could serve as a primary target for the move.

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Stock markets are tumbling int he wake of the decision but given the recent strength in equities, in the face of the rising interest rate expectations, we don’t expect a serious move lower after the decision, despite the valuation concerns. Financial stocks should outperform, on the rising rate expectations, while tech issues and growth stocks should lag the broader indices. The major indices are around 0.5% lower since the decision, but even the short-term uptrends aren’t in danger for now.

S&P 500, Hourly Chart

Bitcoin got slightly lower following the announcement, but the decline is minuscule compared to the recent moves in the coin and it seems unlikely that it will have a meaningful effect on the cryptocurrency segment, despite the theoretically bearish implication. Gold will likely be pushed lower in its correction, but the long-term uptrend should remain intact.

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Commodities

How have various asset classes performed during previous wars

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North Korea, the dictator ruled nation has been threatening the US and its allies with a possible missile attack, which may also have a nuclear warhead on it. The experts are divided on the actual capability of North Korea to undertake the attacks, however, its leader, Kim Jong-un leaves no opportunity to provoke the US and its allies.

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Key points

  1. Stocks perform better than average when the conflict starts
  2. Gold rallies before the start of the conflict
  3. Bonds have underperformed stocks during previous wars
  4. The US dollar has fallen on few occasions during a conflict
  5. The current war, if it starts, can severely impact electronic goods
  6. The US national debt is likely to balloon if US involves itself in South Korea’s reconstruction after the war ends

Though North Korea’s military prowess is nothing great to write home about, it can still cause extensive damage to millions of civilian lives and the economy of its neighbor South Korea, to some extent Japan and the US territory of Guam. However, in this article, we shall restrict ourselves to the impact of the war on various asset classes and the world economy. We shall use the historical evidence to arrive at our conclusion.

How does the US stock market perform during wars?

The US has fought several wars since 1960 as shown above. While a few ended quickly, others have been a long-drawn affair. Notwithstanding, Barron’s has outlined the effect of the following seven major hostilities on the Dow Jones Industrial Average since early 1980s.

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Serial No War Year
01 The US invasion of Grenada 1983
02 The US invasion of Panama 1989
03 The first Gulf War 1991
04 The US bombing of Kosovo 1999
05 The US War of Afghanistan 2001
06 The second Gulf War 2003
07 The US bombing of Libya 2011

Source: Barron’s

The markets hate uncertainty; a proof of this is the average 0.6% drop in the Dow a month prior to the start of the conflict.

However, once the conflict commenced, the Dow quickly turned direction, rising 4% in the first month. The rally did not stop there. Over the next three months, the Dow rose an average 6.7%, and the gains swelled to 7.2% after six months of the start of the conflict.

Therefore, if history repeats itself, a war between the US and North Korea – if it were to happen – will not start the next bear market.

How does gold perform during wars?

Gold is considered as a safe haven during times of uncertainty. Therefore, the yellow metal has rallied from about $1260/toz to about $1360/toz levels, as tensions escalated between North Korea and the US.

But, will gold continue its rally if the war starts?

Economists at Capital Economics have analyzed gold’s performance since 1985, during military conflicts, acts of terror and political tension.

They established that “over the past forty odd years, the price of gold has on average risen by 4.1% in the six months prior to a conflict turning into a full-blown war. However, it barely moved in the months following the event. This makes sense as gold thrives in periods of elevated uncertainty and the start of an armed conflict partly erases that.”

Performance of long-term bonds during wars

Though bonds are also considered as a safe haven investment, their performance has lagged their historical average during wars, according to a study by the CFA Institute. The possible reasons are an increase in inflation during war times and the second is the higher borrowing by the government to fund the war. Due to these two, bond prices fall. Therefore, selling out of stocks and buying bonds fearing a conflict might not prove to be a good strategy. The only aberration was during the gulf war when bonds beat stocks, albeit marginally.

How does the war affect the US dollar?

The evidence of the past three decades shows that the US dollar weakens during war, according to Kathy Lien, Managing Director of FX Strategy for BK Asset Management. The US dollar fell 5% when the Libyan war started and fell 9% during the first three months of the second gulf war. The dollar was weak even during the first gulf war.

However, this time, the situation is more complex and a lot of currency movements will depend on whether China actively involves itself in the war or remains neutral. The Australian dollar, the New Zealand dollar, and the Japanese Yen will see large moves if China supports North Korea directly during the war, else the movement in the currencies is likely to be comparatively subdued.

“As the tensions grow the dollar will suffer and the actual announcement of war could take USD/JPY to 105 but if it’s a swift victory the pair would also recover quickly,” said Kathy.

Though historical evidence gives us some idea about the possibilities, every new war is different because it involves different nations and affects different asset classes.

What sectors will be affected if a war with North Korea takes place?

Commodities

North Korea, in itself, can’t impact commodity prices. However, it is surrounded by nations that are major consumers of commodities. China is one of the major consumers of commodities, however, it is unlikely that the war will impact China’s consumption materially.

South Korea is a major importer of coal and exporter of steel. Both these commodities will be majorly impacted because South Korea will be severely affected if a war breaks out. Similarly, liquified natural gas prices will be affected, as Japan is its largest importer in the world.

The seaborne trade will also be severely affected because China, South Korea, and Japan receive about one-third of the global seaborne crude supplies. Similarly, 84% of the world’s iron ore and 47% of the metallurgical coal reaches the shores of these three nations through the seaborne route.

The agricultural commodities will also be affected because China is a major importer of rice and soybeans while Japan is of corn.

Economic costs of the war

War has both a direct and an indirect impact on the economy. South Korea is a hub for manufacturing liquid crystal displays, semiconductors, and cars. A war will impact these activities, leading to a shortage across the globe. The alternative suppliers can’t bridge the gap in such a short span of time.  Therefore, prices of various electronic products are likely to rise significantly, which will impact the developed economies, including the US.

“U.S. spending on electronic items, including smart phones, cameras, tablets and computers accounts for roughly 1 percent of the consumer price inflation basket. If a war in Korea caused prices of these items to double, it would add 1 percentage point to U.S. inflation,” a report by the research consultancy Capital Economics warned, reports CNBC.

If inflation rises sharply, the Central Banks will be forced to raise interest rates, jeopardizing the fledgling global economic recovery.

Additionally, if South Korea’s gross domestic product (GDP) falls by about 50% due to war, it will reduce the global GDP by 1 percentage point, according to the report.

Once the war ends, South Korea will need huge capital to rebuild its infrastructure. If the US involves itself and ends up spending the same amount as it did in Iraq and Afghanistan, then the federal debt will reach 105% of GDP, the economists at Capital Economics warned.

Conclusion

Though historical evidence suggests that the equity market returns are better than average during a war, the situation might be different this time because of the nations involved. Any jolt to the weak economic recovery across the globe will dent the confidence of the investors. Therefore, we don’t expect the stock markets to rise substantially during the war.

Gold’s performance is somewhat neutral and it can be used to protect the value of the portfolio. Therefore, selling some overvalued stocks and buying gold might be a good strategy if a war seems imminent.

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