Not to be left out, the Bank of Japan (BoJ) this week announced its own new version of monetary stimulus, although the move is relatively mild compared to the U.S. Federal Reserve’s QE3. The BoJ is increasing current asset purchases from 45 trillion yen to just 55 trillion yen (an increase equal to about $127 billion dollars).
Japan’s central bank is attempting to decrease the value of the yen, which has been rising since March. Unfortunately for Japanese exporters, the effect so far has been fleeting. In the first chart, you can see the overnight reaction to the easing announcement.
Click to EnlargeFor those of you who may be unfamiliar with the currency market, this chart is telling traders that for an hour or two, the Japanese yen did weaken against the dollar. If that could be sustained, it would be good for Japanese exporters. However, we don’t think a lot of commentary is needed to describe what happened to that initiative by the time North American markets opened.
The Japanese yen matters to U.S. investors because Asian financial health drives growth in Western markets as well. Japan, China, Singapore, South Korea and even India are struggling, and so far the stimulus from the Fed, European Central Bank (ECB) and now the BoJ hasn’t done a lot to help.
The Japanese yen acts as an alternative investment in the Asian region when economic growth is weak. Strength in the yen isn’t good because it indicates that investors are nervous and unwilling to invest in favor of growth.
Normally, we would expect all this central bank activity to show up in commodity prices as well as exchange rates. Quantitative easing is inherently inflationary, so as long as growth expectations remain constant, then commodity prices should rise. If expectations for growth drop, then it could offset any QE gains in commodity prices, which matters a lot to stock investors looking for new long entry opportunities.
Click to EnlargeThe next chart is an average of commodity prices during the last seven months. Following the Fed’s announcement last week, commodities have been selling off. It’s true that much of this selling has been concentrated in oil, but other key commodity groups like metals and agricultural contracts haven’t gained anything either.
We think this means much of the potential growth that the Fed could have created was already priced into the market during the third-quarter rally.
Some important commodity prices were run up so high before this round of stimulus that they’re bumping against some very firm long-term resistance levels. For example, despite strong momentum recently, copper futures are hitting the same level that turned prices lower in 2006, 2007, 2008, 2010 and early 2012. Copper prices are very sensitive to expectations for manufacturing growth in the U.S. and Asia, and are a bellwether for economic growth.
Click to EnlargeCopper moved a little higher than the current resistance level in 2011 after QE2 was unleashed, but the subsequent double-top led to a predictable decline later in the year. Copper isn’t dropping yet, but it isn’t rising either, which is strange considering the amount of easing that has been announced over the last two weeks. We would have expected prices to climb on higher growth and inflation expectations — and yet neither is showing up in the price.
Unfortunately, the message we seem to be getting from the commodity market is that traders aren’t quite ready to reset growth expectations in the near term.
It’s possible that too much has already been priced into the market. It’s also possible that reports from economies that are expected to drive growth this year in Asia, Brazil, India and the U.S. just aren’t good enough to bet on a longer rally like those in 2009 and 2010 after the previous two versions of QE.
If commodity prices form a broader decline, we would expect stocks to follow. That exact scenario played out in 2009, 2011 and early 2012. You could consider this analysis as a version of the transport/industrial stock relationship in classic Dow theory. If demand for commodities is so soft that even easing-based inflation can’t push prices higher, then what are public companies making and buying?
Prices are riding a razor’s edge of investor sentiment, and if a broader decline starts, bulls could start taking profits quickly.
For option traders, this isn’t necessarily bad news. Weak commodity prices aren’t the end of the world, and a decline in stocks will present profit opportunities to the downside. The last market decline in April and May this year was a very profitable period for us at SlingShot Trader because overbought stocks tend to drop far and fast.
The asset price divergence we’re watching now is very similar to the early stages of the March-April divergence that proceeded that profitable period.
John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.