We may have entered a New Year but from where we stand the themes that dominated the second half of 2015 are likely to be the principal drivers of investment and trading decisions in 2016 .Though there will be some additional factors to consider such as the US Presidential election, which will hot up from the end of Q1, with the primaries and nomination contests. We will return to the race for the Whitehouse before the end of this article but for now let's consider the themes which continue from the old year into the new.
US Interest Rates
The US Federal Reserve Open Markets Committee or FOMC decided to raise US interest rates at its December 2015 meeting ending nearly a decade of declining borrowing costs. We took the view for most of 2015 that the Fed would not raise interest rates because the economic data that we were seeing did not support the need for such a rise.
However two very strong unemployment reports, at the end of the year, provided the FOMC members with an excuse to pull trigger, which they happily did. No doubt they were mindful of the fact that if they did not act in December 2015 then they may have let the opportunity to act pass them by completely. As aside from the employment situation, much of the data coming out of the USA is suggestive of an economy that is slowing down, rather than one which is heating up.
Against this background we don't expect any further near term tightening. The Fed Funds Futures, which are a barometer of US money markets views on Fed Policy, show that traders believe the back of 2016 is the most likely point at which the Fed will raise rates once more.
The probability of rate rise in January 2016 stands at just 12%, based on this metric. The market places an 81% chance of June 2016 rate rise. Whilst that for September 2016 is at 90%, climbing to 92% by the time we get around to November.
Probability of a US rate rise by Nov 2016 as implied by Fed Funds Futures
If US economic data starts to surprise to the upside once more, then these projections could of course shift. Though expectations for US Q4 GDP are not encouraging, with the Atlanta Fed GDPNow model currently suggesting a growth rate of just + 1.3% ,down from its prior forecast of +1.9%.
The ECB underwhelmed the markets with December's modest enlargement to its program of Quantitative Easing .Investors wanted to a see a lot more in the way of affirmative action from Mario Draghi and his colleagues on the ECB council. A weak Euro has undoubtedly helped the export lead portions of the Eurozone economy. But we have yet to see conclusive proof that the ECB actions to date are having a lasting & beneficial effect on the domestic economy, which is a likely to be a key component in any sustained recovery for the Eurozone as whole.
France remains an area of concern as does the very high level of unemployment in Spain. Which though declining still remains well above 20%. Against this uncertain backdrop traders remain short of the Euro versus the USD. With Admiral Markets sentiment indicators suggesting a 71% to 29% bias to the short side (as of 04-01-2016). However this ongoing bias has effectively created a short squeeze in the wake of Decembers ECB meeting.
Sentiment in EUR USD clearly favours the short side
The paradox here is that though the majority believe that the Euro should weaken, whilst they back that view with short positions it is unlikely to do so. As looser shorts scramble to cover on any near term weakness. As we have noted before the exit from crowded trades can be an ugly affair and that may well be the case here.
The Future path of US interest rates could have significant baring on the strength of the USD over the course of 2016.But as we have already noted the markets view that future rate rises are more likely to happen in the second half of 2016 if not the final quarter of the year .
That expectation may help keep a lid on US dollar strength at least in the opening phases of 2016. After all Dollar Index (the dollar measured against a trade weighted basket of its peers) sold off in late November from 100.24 a similar level to that which it rejected back in March 2015. From which it corrected all the way back to 93.14 by the middle of May.
Dollar strength is of extreme concern to many Emerging Markets for two very important reasons. The first is the negative correlation between a strong dollar and the price of global commodities. That is a strong dollar drives down commodity prices which make up a large portion of Emerging Markets exports. The second reason is that Emerging Markets have borrowed heavily in US dollars which have flowed freely since 2009. Thanks to near zero interest rates and three rounds of US QE.
Should the dollar rally strongly once more we could see the Emerging Markets caught between the proverbial "rock and the hard place". In a vicious circle of falling commodity prices, reduced incomes, weaker local currencies and dearer to service US dollar denominated debt.
The Emerging Markets may get some respite from the dollar in the first half of 2016, but should the market start to believe that Fed will move to tighten more aggressively, that period of grace could quickly evaporate. A tentative base has begun to form in some commodity prices but the CRB Commodity Index (which tracks the prices of many globally traded commodities) finished 2015 down by some 22.9%.
We shouldn't overlook the influence of China in this process and in 2016 as a whole .Weak Chinese Manufacturing PMI data, out early on Monday, saw the Yuan ease and Asian and then European equities sell off sharply once more.
The US Presidential Election
Over the last quarter of 2015 the media upped its coverage of the race for the US presidency. Much of that coverage has been reserved for the outspoken Republican candidate Donald Trump. Whose sensationalist no holds barred rhetoric has kept him front and centre. What seemed initially to be the fancy of very rich individual is now looking more and more like a serious campaign and one which has a chance of securing the Republican nomination. Particularly as Mr Trumps outbursts have effectively kept his many Republican rivals off of the airwaves or at the very least pushed them much lower down the schedule.
There are around dozen Republican candidates still in the mix. Though we would expect that number to be whittled down ahead of the start of the primaries in late February. Its will be at this stage that we will get a feel for just how much mainstream support Donald Trump has, compared to his rivals. Of course there is always the possibility that he could forgo the nomination and stand as an independent candidate .Whilst he may not be able to win without party support he could splinter the Republican vote. It's hard to conceive of Mr Trump as President but his campaigning to date has been savvy and it's unlikely that his contentious comments and suggestions are randomly shot from the hip. But rather form part of a predetermined strategy. So for now watch this space and keep an eye on the polls but the nearer he gets to the Whitehouse the more concerned I would think the market will become.
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