BY Christopher Dembik
Traditionally, July is a relatively stable month for investors.
However, in recent years, they have learned the hard way that there is no longer a quiet summer in financial markets. Investors will have to watch out for three main events next month that can influence financial assets.
Fed on Standby
The first event is the Federal Open Market Committee (FOMC) meeting that will be held on July 26 and 27. At its June meeting, the Fed held rates steady and signaled a shallower pace of rate rises next year and in 2018.The Fed still wants to hike rates twice this year but this scenario seems increasingly unlikely.
Because of the slowdown in the labor market, low productivity growth and a difficult international environment, the Fed will certainly maintain the status quo on interest rates in July again.
Currently, the market anticipates no hike in 2016.
The probability of a rate hike this month is at 4 percent and in September at 15.5 percent, according to Bloomberg.
From our point of view, the only credible option for the Fed is to raise rates in September because it cannot do so too close to the U.S. Presidential elections that will take place in November.
Therefore, there is a very limited window of opportunity for the Fed to continue the interest rate normalization this year.
The U.S. monetary policy seems paralyzed, as it was during the same period last year.
That has important consequences for financial markets.
Since the prospect of higher returns on U.S. dollar-denominated assets is highly unlikely, investors are forced to rethink their capital allocation. This partly explains why the rise of the Dollar Index has stopped in recent weeks.
China is Back
Focus will also be on China this month. Due to significant economic downward pressure, an significant devaluation of the yuan could occur this summer.
This is a risk that has not been yet well priced in by the market as investors were obsessed by the U.K. referendum.
For now, the adjustment of the exchange rate against the dollar, which has led the Chinese currency to its lowest value since 2011, went smoothly.
It did not cause investor panic as was the case in January 2016.
However, China may be forced to accelerate the pace of depreciation of the yuan, which could put investors into a cold sweat.
Everyone remembers the market turmoil that happened in August 2015 when China conducted three successive devaluations of its currency while most of the investors were on holiday.
The evolution of China’s foreign exchange reserves can provide clues about a forthcoming devaluation. In May 2016, the reserves reached $3.1 trillion, which represents a drop of 16 percent compared to January 2016.
The International Monetary Fund (IMF) has already established that the country cannot afford to let its reserves fall under the minimum threshold of $2.8 trillion.
Otherwise, the People’s Bank of China (PBC) would not have enough reserves to react to external shock and it would be forced to let the market decide the exchange rate of the yuan.
Therefore, the next publication of China’s foreign reserves, on July 8, will be a key event for markets.
Failure of Abenomics
Finally, the main political event will be the upcoming Upper House election in Japan on July 10.
It may have a long term impact on the evolution of expansionary monetary policies and, therefore, on financial markets.
It can be considered as a referendum (another one) on Abenomics, a term referring to the economic policies advocated by Japan’s Premier Shinzo Abe since December 2012.
However, it is a low-risk election for the ruling Liberal Democratic Party and its junior coalition partner, Komeito, that are assured of keeping a majority.
There is uncertainty remaining about the economic policy that the government will implement in the coming months.
It postponed raising the consumption tax until the fall of 2019 and seems to have no concrete strategy in order to strengthen growth and inflation.
Economic stagnation is set to continue with gross domestic product (GDP) expanding 0.5 percent in 2016 according to the World Bank. Risks are rising, given their link to a higher yen and elusive consumption growth which may push GDP lower than expected.
The current negative trend in the industrial production confirms the downturn and the failure of Abenomics.
The quantitative and qualitative monetary easing (QQE) caused a temporary burst of industrial production in the fourth quarter of 2013 and the first quarter of 2014, but it vanished swiftly.
And it seems that another “lost decade” looms for Japan.
What policymakers need to understand is that the country is sending a message to everyone: focus on productivity and fiscal policy, not on markets and monetary policy.
Christopher Dembik is the head of Macro Analysis at Saxo Bank