A Nightmare Ahead For The BoJ

Prior to the European open today, and headlines being directed towards bank shares falling sharply downhill, market observers were very closely monitoring the developments in Asia and in particularly the Bank of Japan (BoJ) and the People’s Bank of China (PBoC). One of the reasons for the sudden increase in investor attention towards the BoJ is because the EU referendum result has presented nothing else but a nightmare scenario for a central bank that was already horrified by an unwarranted and dramatic rebound for the Japanese Yen throughout 2016. Make no mistake, the BoJ must be in a complete frenzy internally right now because they are fully aware that the unexpected shock from the EU referendum has left a severe threat of a prolonged period of risk aversion in the markets, with this ultimately meaning there is quite simply nothing that the BoJ can do to prevent further strength in the Yen.

We have seen it time and time again and it has now been fully installed into the minds of investors across the globe, in times of uncertainty the safe-haven appeal of the Japanese Yen becomes the best friend to any investor. There had already been an astonishing and dramatic rebound in strength in the JPY over the previous six months and the exceptional period of uncertainty that the markets are at risk of facing for a significant period of time means that this trend is going to continue. Can the BoJ intervene to prevent this strength? Sure, but there is absolutely no point in intervening until this period of uncertainty is over and it might very well not be the case for months. Equally, once the BoJ intervenes the game of cat and mouse with investors emerges and quite frankly in this uncertain environment it would be a waste of FX reserves to try strengthening the Yen.

So what is the BoJ going to do? It will no doubt continue to monitor the further rebound in Yen demand and speculation will remain as to when the BoJ is going to push the buzzer when it comes to intervening in the markets. However, the central bank would be best advised to wait until any upcoming G7/G20 meeting for exceptional intervention where they can fully express their distress at the unwarranted demand for the Japanese Yen. The train of thought within the BoJ will be that by the time the upcoming G7/G20 meeting occurs, there should hopefully be some contingency plan to this unexpected mess that would also calm this sudden period of investor uncertainty.

It isn’t just the BoJ that are going to be horrified at the thought of a prolonged period of risk aversion being upon us, this is also the worst news that the emerging markets could receive. It hasn’t been touched on too much, but the outcome of the EU referendum and the threat of risk appetite being diminished is not just going to impact global stocks, it is also going to outright signal to investors to stay away from the emerging markets. Emerging markets are always impacted heavily by any period of risk aversion in the markets and this was always the threat of the EU referendum;, being that the indirect impact that a shocking outcome would lead to investors escaping away from risky assets like stocks and there is arguably no riskier asset to invest in than the EM’s. There should also be no surprise at the weakness in the Chinese currency from the PBoC early this morning, risk aversion also impacts China and the PBoC are now going to need to continuously monitor intervening in the Yuan to prevent further weakness in the currency. The major issue for the weakness in the Chinese Yuan is that it leads to the return of the threat between both capital outflows and the PBoC needing to resume the expenditure of FX reserves.

The question is going to be asked by some whether the overall reaction to the events of the referendum has been an overreaction. The bitter truth is that the financial markets severely under-priced any possibility of a UK exit outcome, and it was the naivety of investors to even discount a small possibility of a UK exit outcome that has encouraged such an extreme panic across investors. Traders were at first reacting to the news, and now they are pricing in the uncertain consequences across the global economy. Why investors didn’t even think of the consequences to at least UK banking stocks is completely beyond me. The reaction to the British Sterling is justified because the markets were ignorant to price in a rebound for the currency in the final stages before the referendum, to then be left in complete and utter shock.

The GBP/USD has just minutes ago fell to a fresh-30-year low below 1.32 and I personally think that those who expected the GBP/USD to drop into at least the very low 1.20’s during 2016 are going to be proven justified. There is just so much uncertainty ahead for the UK economy that you would be an extreme risk taker to price in a further mid-longer term rebound in the Pound at this point. This is no longer just as simple as a major economy porcing the European Union, this is now a United Kingdom that clearly has no plan and is going to be without a Prime Minister in a couple of months. On top of this it is appearing inevitable that Scotland is going to call for another referendum. Even if there was an exceptional turnaround where the outcome got reversed, you just have to admit that the reputational damage to the UK economy has already been done. The whole world is now watching the events unfold around the United Kingdom, and unfortunately all events are currently being expressed in a negative light.

It hasn’t been said too much but Bank of England (BoE) Governor Mark Carney probably has one of the most difficult jobs across the financial world ahead of him. Although it is clear that the BoE carried out many risk assessments before the shocking outcome, these are always just assessments and you can never be sure of the consequences of such an historic event until it occurs.

There is one major element to the unexpected events that still has not been priced into the financial markets, with this being what does this mean to the US Federal Reserve? There is absolutely no way that the Federal Reserve can carry through with their intentions to raise US interest rates, and there was speculation over the weekend that the Federal Reserve might even need to drastically chance course and cut interest rates instead. Basically, if the old saying nothing is for sure was ever correct it most certainly is now following such uncertainty across the global financial markets.

It just has to be said that the surely pushed back US interest rate expectations have still not been priced into the Dollar, which means there is a risk of a sudden twist towards extreme USD weakness ahead.

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