Abeconomics, the Fed and the Nikkei

by George Hatjoullis

Nikkei

The Nikkei has not traded in the 14000 to 15300 range suggested in my previous Abeconomics blog but has rapidly moved down to test the trend line that delineates the Nikkei rally. Today the Nikkei bounced from the trend line and defined the line as important support (see above chart courtesy of IG Index). Do we rally from here  and if so when?

Unfortunately, the answer depends less on fundamental factors than technical. The correction has probably left some investors underwater. On the other hand, domestic investors have yet to properly participate in this rally and the sell off may be deemed an opportunity. Prime minister Abe is exhorting Japan pension plans to invest more in local equities (http://bit.ly/18KJmI4). Exhortation is a curiously effective policy tool in Japan. The aggressive monetary policy is proceeding as planned and the JGB market appears not yet to have dislocated. There is good reason to believe that the Nikkei will embark on  the next leg of the rally soon. The first objective is to take out the recent high which would put the index above a falling downtrend line (not shown above) and already seen to be important resistance.

The previous blog noted that the Nikkei index was heavily overbought at the initiation of the correction but then it had been overbought for some time. It is now equally oversold. The conditions for a resumption of the rally are good. However, it is now summer and the silly season. Thin markets and senior traders on the beach can be a recipe for volatility. Ultimately what one does with the volatility depends on ones outlook.

The thrust of Abeconomics is the domestic economy. The Nikkei is sensitive to global trade because of the heavy exporter presence. The link is the yen and in particular dollar yen. The thrust of monetary policy can only weaken the yen. Moreover, the pending exit of the Federal Reserve of the USA from QE should, logically, create a dynamic that favours dollar yen rallying. The dollar had become overbought and so a correction was inevitable (timing always tricky) and has at least in part occurred.

The likely exit of the Fed from QE has rattled all equity markets but this only makes sense on a simplistic narrative. This has been covered in previous blogs. This simplistic narrative can see equity markets fret over the summer months. However, ultimately the Fed exit from QE is tantamount to taking the US economy off life support. Logically this is a positive for equity markets and not negative as it implies the Fed think the patient can now make it alone.

During the summer, and as long as the simplistic scenario prevails, we may see equities rally on bad economic news (Fed delays QE exit) and fall back on good news ( Fed accelerates QE exit). This simplistic narrative will not last unless the new narrative is that the Fed is not competent and is removing the US economy off life support before it is ready. In fact the Fed is more likely to keep it on life support longer than is necessary which underlies my bullishness too some extent.

So back to the Nikkei. The US economy is in good shape and as this view gains popularity the Nikkei will benefit more than proportionately. Moreover, renewed strength in dollar yen will give the Nikkei a further boost. Finally, the growing liquidity within Japan must go somewhere. It must now start leaking into domestic equities and property.

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