Sentiment is now reliant on the oil price as the FOMC looms large this week

Macro Outlook

In he past week, finally financial markets seem to have woken up to the potentially bearish implications of a collapsing oil price. Traders seem to have previously convinced themselves that it was just a production issue with over supply. However with deteriorating data from China and Japan the fall is also a function of weak demand, which is a bearish indicator. With risk appetite subsequently dropping sharply, the market’s supposed “fear” gauge has spiked higher, investors have flooded into safe haven assets such as US Treasuries. Subsequently, equity markets have corrected sharply from key highs and the US dollar has been hit by profit-taking. It is my feeling that whilst the oil prices continue to fall, investors will remain fearful and this will drive demand for portfolio protection (as depicted by the rising VIX Index) and safe havens will benefit. As we move into the last serious week of trading (i.e. with a full complement of traders) there is a raft of key data to drive markets. However if the flash manufacturing PMIs out of China and Japan continue to disappoint, the oil price could be driven even lower. The Federal Reserve meeting could then take on added significance, especially if they hold off on an expected altering of the wording on the statement, due to global financial concerns.

Must watch for: FOMC meeting and press conference

Impact: How will the Fed react to the huge Non-farm Payrolls number (in addition to the improvement in average weekly earnings)? The Fed has brought to a close its programme of QE and now could be time to remove the “considerable time” words from its statement with regards to how long it intends to keep rates at record lows. If not this month then when? From the beginning to 2015 the FOMC loses three of its most hawkish voting members and this could just hold off further tightening signals. Now is therefore the time to change the wording.

Foreign Exchange

I remain a long term dollar bull but the near term outlook is cloudy. The Dollar Index has been under pressure over the past week with a pullback within the big uptrend on DXY that has been in place since August. Sentiment plays a big role in the markets and near term the dollar is out of favour. The drive into safe haven US Treasuries is pushing yields lower which is harming the near term prospects of the dollar. It could be that whilst Treasuries are the flavour of the moment, the dollar will struggle. However, could things take a turn for the better on Wednesday evening with the Federal Reserve set to announce monetary policy? A change of the wording to remove “considerable time” from the statement would be a hawkish shift and would support the dollar. Until then though the greenback is under pressure. For the first time in months, the near to medium term outlook for EUR/USD is not bearish and for USD/JPY is not bullish. Corrections are threatening but if the Fed signals a further step down the road towards tightening the dollar could strengthen again.

WATCH FOR: With such a heavy week of economic announcements there is unlikely to be much winding down for Christmas quite yet. The flash manufacturing PMIs will be key, whilst the German ZEW and Ifo will also be key for the euro. Dollar traders will be obviously watching the FOMC to provide the greenback with support. The yen traders will be watching for the BoJ on Friday.

Indices

As investors become increasingly concerned by the plummeting price of oil (driven not only by supply issues but also a lack of demand), and what is now becoming a succession of weak data out of China and Japan, equity markets have come under pressure. The European markets are especially under fire and are underperforming Wall Street. With the FTSE 100 being heavily weighted in oil and mining stocks (around 30%), both of which are impacted by the oil price and especially China, the sell off has been significant. The spike higher in the VIX Index shows that investors are increasingly fearful and are rushing to purchase portfolio insurance (i.e. buying S&P 500 puts) to guard against a continued decline. However, the S&P 500 is far more exposed to the US economy which is a relative outperformer. I would not expect volatility to subside too much this week with big focus on the flash manufacturing PMIs. With the Asian data having been so weak recently (Chinese industrial production was the latest disappointment on Friday) any further disappointment will hit risk sentiment again. The Eurozone PMIs have also rolled over recently and a look at how Germany, France and Italy are performing will also be of key importance.

WATCH FOR: The flash manufacturing PMIs from China, Japan and the Eurozone will set the tone for investor sentiment on Tuesday, whilst the outlook of the FOMC will drive sentiment on Wednesday and into Thursday.

Other Assets: Commodities & Bonds

The oil price continues to dominate headlines in financial markets, with far reaching consequences across all asset classes. The global supply glut has been well documented and the price has been under almost incessant pressure since the decision by OPEC to maintain production levels. However, a lack of demand is also an issue. On Friday the International Energy Agency cut its demand growth forecasts for 2015, as it noted that the decline in the price of oil has yet to have an impact on demand. While this is the case there is little reason why oil should find any support.

The sharp decline in the price of oil has investors concerned and they have turned to the safe haven of Treasuries which is pulling the yield lower again. Yield curves are flattening across the board as longer dated debt outperforms the short end. This is certainly a bearish reflection of the investor sentiment and in the case of the Eurozone 10 year yields, the continual plummet to new lows just shows the concern of the threat of deflation and continued stagnant growth. The bond markets continue to price in the announcement of QE by the ECB.

WATCH FOR: Continued pressure on the oil price to impact on general risk appetite. A hawkish shift in wording of the FOMC statement could provide US Treasury yields with some support.