Appetite to risk evaporated as Fed signalled double tightening whammy

Equities across Asia fell on Thursday following Wall Street’s biggest one-day reversal in 14 months after the Fed minutes indicated that officials are ready to target the over bloated balance sheet. 

The Japanese Yen led the gains in currency markets, touching its highest levels in more than four months against the dollar. Government bond yields dropped across the globe, and futures markets are indicating further declines in U.S. equities.

Yesterday’s Fed minutes sent a couple of warning signs which have led to this reversal. The expected gradual increase in interest rates was not one of them given that this factor has already been priced in the markets. However, the discussions of reducing the balance sheet, currently at $4.5 trillion, wasn’t received with open arms as it suggests a double tightening policy, “combination of higher rates and reduction in QE.” This is likely to be the next hot topic in monetary policy actions, and the key question is going to be; will the Fed successfully remove unconventional policies without disrupting the markets?

The more compelling message was related to equity valuations. Some Fed participants viewed equity prices as quite high relative to standard valuation measures. Well, there’s nothing new here. Whoever is buying into this market already knows that valuations are overstretched, but this isn’t the kind of message an investor wants to hear from the system which supported the 8-year bull market. We rarely receive such comments from monetary policy makers, and while it doesn’t necessarily mean a correction is due immediately, investors should become more cautious.

The biggest one-day reversal in 14 years was significant enough to make headlines, but overall, markets still believe that Trump has their back, and whatever we’re experiencing now is just some noise. However, in my opinion, valuations are not just high relative to standard measures, they are unrealistic. Earnings remain the key missing component of the most recent rally, and if we don’t see a significant improvement in the next two-quarters, there’s very little chances to keep going north.

Today’s Xi-Trump meeting will attract all of the market’s attention. Trump already assumes it will be a “very difficult” meeting, criticizing the trade deficit with China and job losses. The discussions will focus on global, regional, and bilateral issues of mutual concern according to the White House, but traders’ spotlight will be on the trade part. The best-case scenario is the meeting ends peacefully, with both presidents shaking hands and probably playing some golf. But given that the two men are at opposite sides on several issues, it is unlikely the meeting will end in such a way. If they don’t get along and the US-China relationship becomes gloomy, expect another wave of risk aversion to hit the markets.