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MARKETS

U.S. stocks are trading decidedly higher Thursday as relief from a move lower in rates is supplemented by a dovish data hat trick.

Is Goldilocks in the house, or are we experiencing a big old short squeeze, or will the Fed be able to avoid the consequences of its own success?

If Goldilocks isn't in the house, she certainly appears to be knocking at the door after Wednesday's FOMC meeting's dovish outcome continues to be embellished by numerous venues, spurred on by a dovish hat trick of ostensibly "soft- ladning" data inputs. 

A reported sharp drop in unit labour costs, in-line jobless claims and higher non-farm productivity -- all indicate that the labour market is healing well and illustrating how a key driver of inflation (wages) is likely well on a path toward normalization. 

Higher non-farm productivity is one of those data points investors can't help but feast on significantly. It's a "major league" buy signal because higher productivity is a crucial way to sustain solid economic growth without experiencing unacceptably high inflation levels. Put another way, unit labour costs should be lower if productivity rises and wage growth is cooler. In Q3, they were.

Dovish comments from the Federal Reserve and benign inflation data combine to take out some higher rate expectations, and yields on 10-year US Treasury are down another 9bps today to 4.68% -- now a whopping 25bps lower than pre-FOMC levels.

Naturally, equity investors are welcoming with open arms the drop in both rates and inflation driving the risk on vibe -- all against a backdrop of remarkable growth momentum that the US economy saw in 3Q.

The combination of robust growth and lower rates is creating a "goldilocks" scenario, leading to gains in sectors like energy, materials, and financials, as well as long-duration sectors like technology.

In addition, Market dynamics are incredibly favourable for the Santa Melt-up playbooks to come off the shelf as CTA's are big short, suggesting if this rally rolls, there will be significant buy orders lining any up tape over the next month as short cover buy reverse programs kick in.

And with the potential waves of synthetic short gamma as funds, both fundamental and systematic, become the forced 'buyers higher' and have no option but to add back exposure the more we rally.

One problem, however, hiding in plain sight is that the Fed could fall victim to its own success. Fed officials had been using various forums and public appearances to communicate a nuanced message to the market: the sharp increase in long-term US Treasury yields that began in August could effectively replace the final rate hike indicated by the September dot plot. The idea was that the rise in long-term yields could tighten financial conditions, doing some of the work the Fed intended to accomplish with rate hikes.

However, openly conveying this message risked sparking a bond rally, leading to a reversal of the very dynamic that the Fed was trying to achieve. If long-term yields fell and stock prices rose, it would ease financial conditions, potentially negating the justification for skipping the final rate hike. 

OIL MARKETS

Oil prices have been on a macro rally due to a notable decline in the US Dollar Index. This decline is driven by investor expectations that the Federal Reserve has finished its aggressive tightening cycle, especially after the central bank opted to keep interest rates unchanged for the second consecutive meeting on Wednesday.

And significantly on the supply side of the equation, amid artificially tight market conditions and after six months of eased sanctions on Venezuelan oil by Washington, the country's oil exports experienced a decline in October. 

Now, there are indications of political interference that could potentially lead to reversing the sanctions deal. This situation highlights the complex and volatile nature of Venezuela's oil industry and the impact of political factors on its oil exports.

Finally, the weekend is upon us, and some traders have little issues booking profit from shorts and rolling it into the top side cover, given the Middle East weekend headline risk. The call skew is down, making the cheaper but also suggesting the market now thinks the odds of a broader dust-up are lessening. However, even if there is only a minuscule chance of the whole Middle East powder keg explosion, the minuscule is too big when religion is stoking the narrative.

BANK OF JAPAN

 ( OPINION PIECE) 

The Bank of Japan (BoJ) seems to be gradually moving away from its ultra-accommodative monetary policy, characterized by negative interest rates and a 10-year bond yield anchored at zero. This shift suggests that the BoJ may be transitioning toward a more normal monetary policy stance as it aims to reduce its footprint in the market and address some of the challenges associated with its previous policies. While the BoJ is not explicitly stating this shift, the Yen's DNA is gradually adjusting to the subtle changes in its approach.

Given the changing monetary policy stance in Japan, markets are beginning to consider the possibility that higher-yielding credit opportunities in Japan could start to attract investors who might have previously favoured US credit alternatives. As Japan's monetary policy becomes less accommodative, the yield differentials between Japanese and US credit instruments may become more attractive for investors, potentially leading to a shift in their preferences. This could impact capital flows and asset allocation decisions in the global credit market.

But let's be clear: this is why central banks worldwide do not operate in a vacuum and remain in communication, and possibly why the Fed is steering global yields lower while the BoJ is trying to nudge yields higher. Ultimately, central banks worldwide do not want financial plumbing to get clogged and all hell to break loose when the BoJ officially declares the end of YCC and the eventual monetary policy pivot. However, most officially think the former is done and dusted.

And it is not like inflation is rampant in Japan; it could buy the BoJ some time, which might buy the US Treasury some time to get its refunding house of cards in order.

Ultimately, the depth and breadth of US bond markets, combined with the absence of competing domestic alternatives in Japan, are likely to prevent a substantial decrease in foreign net purchases of US paper.

However, several conditions could increase the selling pressure, such as a significant strengthening of the Japanese yen (JPY), a sharp steepening of the Japanese Government Bond (JGB) yield curve, and a substantial narrowing of the yield differential between JPY and USD-denominated bonds. But these are factors both the BoJ and Fed can guide with caution.

While these conditions could lead to some reduction in foreign purchases of US credit, it would require a high bar to significantly disrupt the current market dynamics, given the prevailing market pricing and conditions.

But at the end of the day, this will be a highly global coordinated effort to scrap the BoJ from this now unwanted policy. But at any level, getting out from under the YCC umbrella and, more significantly, zero interest rate policy could be risky business even with the most coordinated exit strategy.

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