The fire is out, but uncertainty remains

The atmosphere of panic that prevailed last Monday has given way to a calmer environment. This respite, like the outbreak that preceded it, is the result of a number of factors. At the epicentre of this episode of instability, the Japanese market has recovered almost half of its losses since the beginning of the month. This rebound, which coincided with a welcome fall in the yen, was supported by comments from Bank of Japan Deputy Governor Shinichi Uchida. He devoted a large part of his speech to fundamental developments, which he viewed as favourable, but noted that the extreme volatility in the financial markets warranted close attention and signalled the Bank of Japan’s intention not to raise interest rates further in such an unstable environment.

The restoration of investor confidence can also be attributed to a number of reassuring indicators published in the US. The rebound in the ISM services PMI helped to limit the damage. In contrast to the manufacturing gauge, the index rose above 50, a level synonymous with expansion. The sharp fall in jobless claims, from 250,000 to 233,000 in the latest weekly figures, calls into question the accuracy of the employment report that triggered the fall in the dollar and Western indices on 2nd August.

Dovish comments from a number of Fed governors also played a supportive role, although central bankers did not confirm the expectations for rapid and substantial rate cuts that emerged last Monday. The rally on Wall Street, the narrowing of credit spreads and the fall in implied volatility in the options market have removed calls for immediate rate cuts, but many investors are still hoping for a bolder easing cycle than the gradual adjustment that seemed on the horizon.

The scenario of a slow normalisation of monetary conditions is not completely discarded, however, and could regain favour if the inflation figures expected on Wednesday highlight persistent tensions, or if the employment report due to be published at the beginning of September reverses the worrying diagnosis made on August 2. The rally in risky assets has already been accompanied by a rebound of almost 20 basis points in the dollar yield curve. At around 3.95%, the yield on the US 10-year T-Note looks reasonably attractive given the resurgence of recession risks and a correlation regime that reinforces the benefits of multi-asset diversification.

In Europe, euro-denominated government bond yields have also climbed back, as investor appetite for risky assets has returned. Despite the persistent stress on services prices highlighted by preliminary inflation figures, the ECB is expected to cut its key interest rates by 0.25 percentage points at its meeting on 12 September. The strengthening euro and the sluggish economy provide ample justification for a gradual easing of monetary conditions, which are currently clearly restrictive. The Swiss franc capital market has not been spared the turbulence that has highlighted the franc’s safe haven status. The dramatic strengthening of the Swiss currency is likely to prompt the SNB to cut its interest rate for the third time in a row, in order to counter the effects of the cuts expected in Washington and Frankfurt.