There is a sense that the markets are at crossroads.  Many suspect there has been a trend change. The reason for many to buy the dollar was the Fed was going to raise interest rates.  Lift-off may not be simply postponed until December, as was the decision to begin tapering, but a growing number of participants do not see it until March. 

Meanwhile, the OPEC and some non-OPEC countries will meet just as the US Department of Energy warns that US oil output is likely to trend lower through the middle of next year. This sent oil prices back above $50 for the first time in two and a half months.  Since late-August the CRB Index is up 10%. 

Some argue the emerging markets have discounted too much bad information. With the ECB and BOJ still engaged in unorthodox easing of monetary policy, and likely to do more rather than less, China is gradually easing and providing more fiscal support, the global economy remains awash with liquidity.  Over the past three years, the MSCI World Index (DM) is up almost 28% while the MSCI Emerging market equity index is down nearly 14%. However, since September 29, this has changed.  Emerging market equities are up 12.5% while the World Index is up 8.5%. 

The euro bottomed in March near $1.0450. It spiked to almost $1.1715 on August 24 and has been carving out a new range. The $1.1100 area looks to be the bottom of the range. It is the top side that is being fished for presently.  As it is, three-month implied volatility has fallen seven-month lows (9.4%). There is scope for additional declines in the implied volatility, but such a decline often precedes strong moves.   

The same broad narrative applies to the yen as well.  The dollar recorded its highs against the yen four months ago near JPY125.40. On the August 24 it crashed to around JPY116.20 and has been in a new range since between JPY118.60 and JPY121.60.  The implied volatility (three-month) fell below 9.2% before the weekend, the lowest level in two months. This is also reflected in the narrowness of the Bollinger Bands (analysis here).  While we suspect the coil may continue in the near-term, it is setting the stage for a potentially powerful move.  

II

Nevertheless, our analysis leads up to conclude that this is a market correction not a reversal of the underlying trends.  How investors should respond is a question of time-frames and risk appetites, which cannot be deduced from first principles.   

While central banks quantitative easing may have contributed to the low interest rates, the low inflation and subdued real growth offers a more robust explanation.  It also can explain why the QE route was chosen in the context of not only the zero-bound (which the ECB, SNB, and Denmark and Sweden’s central banks demonstrate, there is no such a bound in the first place) but also given the lack of much appetite for sustained and substantial fiscal stimulus.  

The main conditions in the high income economies that are producing the weak growth are poor productivity gains and slow workforce expansion.  There is nothing to suggest that these conditions have changed in the past few months.  In the US, for example, the labor participation rate is sitting in its trough six years into recovery/expansion and with unemployment at 5.1% (the unemployment rate for college graduates is half of that) .  Productivity gains are dismal.  The 0.7% rise over the past year is a third of the long-term average.