FINANCIAL REVIEW

King Dollar and the Eurozone

Sinclair Noe — October 10, 2014

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Financial Review

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DOW – 115 = 16,544
SPX – 22 = 1906
NAS – 102 = 4276
10 YR YLD – .02 = 2.30%
OIL – .25 = 85.52
GOLD – .60 = 1224.00
SILV + .05 = 17.50

The 10 year German bund has a yield that is 141 basis points lower than the US 10 year Treasury note. The yield on German debt will get you 0.89%. Standard & Poor’s lowered France’s credit outlook today, and you can still get a 10 year French note with a yield of 1.25%. A 10 year note from Spain will only get you 2.06%. Is this because the US debt is riskier than the Spanish debt? No, just the opposite.

The problem in the Eurozone is deflation, and it threatens to bring the economy to a grinding halt, and send the EU into a triple dip recession. The president of the European Central Bank, Mario Draghi, gave no indication of any further monetary stimulus beyond what was announced this summer, suggesting in a speech in Washington that governments needed to do more on the fiscal side. Draghi said in effect that Eurozone countries that have enough money should spend it, a clear reference to Germany. His comments echoed remarks this week from Christine Lagarde, the head of the International Monetary Fund.

Today, German Chancellor Angela Merkel said her government was examining how to encourage investment, particularly in the “digital sphere” and the energy sector. Merkel did not elaborate, but the hint was that Germany might use government spending to stimulate growth, a possible shift in position that could ripple across the entire Eurozone. Merkel’s remarks may have been less a declaration of policy change than a signal that her thinking on stimulus was evolving.

On Wednesday, the Federal Reserve released minutes from the September FOMC meeting, and they expressed concern about the global economy and the dollar. In the past 4 months the dollar has jumped about 8% versus the euro; that kind of swing can prove a threat to trade and to financial markets. The Fed normally focuses on the US economy, unless there are global developments that are important enough that they could intrude. Fed officials pointed with concern to the slowdown in China, Europe and Japan. They also worried that the concurrent strengthening of the dollar would add to the risk of price deflation.

We know that a strong dollar could weaken US export performance and hold back growth, but the recent global slowdown represents a more ominous problem. Global economic weakness would undermine the ability of the Fed to maintain financial asset prices well above the levels strictly warranted by the fundamentals. Of course this has been how the Fed has addressed the crisis and the recovery for the past 6 years, they pumped up Wall Street with easy money. A global slowdown threatens that tactic.

The events of the past week indicate the Eurozone and especially Germany might be closer to a move away from the single minded focus on budget austerity that has, to date been an absolute failure. The bigger question is whether the Eurozone countries and the ECB will take action, and if they can actually do anything before the continent slips into full-fledged deflation; and further, what role that might mean for the Federal Reserve.

Finance ministers and central bankers gathered in Washington for the annual meetings of the World Bank and International Monetary Fund and today, Treasury Secretary Jack Lew urged the Group of 20 major economies to refrain from competitive currency devaluations. Federal Reserve officials are hunting for new tactics to raise price increases to their target as slowing global growth, cheaper commodities and flat wages sound warnings that inflation is descending toward the danger zone.

With inflation at 1.5% according to the Fed’s preferred index, low-flation is getting to be a real issue again. We know a stronger dollar makes US exports overseas less affordable, but a strong dollar makes it cheaper for Americans to pay for imported goods. A 10% increase in the dollar versus currencies of major trading partners could trim inflation by a quarter percentage point, and the Fed has not yet communicated a plan for how they will lift inflation to their desired target of 2%.

An inflation rate approaching zero is bad for the economy because of its impact on behavior by businesses and consumers. Companies’ inability to raise prices hurts profits, and they rarely compensate by cutting wages, so they fire workers instead. Consumers anticipating falling prices may postpone discretionary purchases. This can combine to create a vicious circle of less spending and further downward pressure on prices. Think about your own situation; in the past couple of weeks you’ve seen prices at the pump drop. Were you tempted to drive another day or two before you fill up the tank in the hope that you might save a few pennies per gallon?

And what we are seeing in the Eurozone is that once low-flation becomes deflation, the central bankers don’t really have the tools to deal with the problem. It is known as pushing on a string. They can flood the markets with easy money, but they can’t create demand, because, you know, prices will be lower next week. As we are seeing in the Eurozone, and as we saw in Japan, if you let it go on for too long it becomes a lock-in, it reinforces a bad outcome.

Substantial rallies in the dollar have the power to slam the brakes on GDP growth in a way that Fed tightening even doesn’t. GDP growth could decline by a percentage point if the rapid move in the dollar continues through early 2015. That fall in GDP is even larger than what would occur as a result of a 50-basis-point rise in long-term interest rates, and it works with a lag, too. Even when the dollar rally tapers off, it would be expected to constrain GDP through early 2016.

And for now at least, you might reasonably expect the dollar rally to continue; there is a trend in place. The long dollar bets mean money is being parked in the US, and that means continued downward pressure on long-term interest rates, at least for now. And another thing, when there are very rapid and pronounced changes in the exchange rate there is a tendency for investors to lock in gains from previously accumulated US assets. In other words, there is a tendency to sell stocks, and companies with overseas exposure are more likely to experience a greater decline. And the selloff in stocks is yet another hit to US GDP. It’s a nasty cycle.

On Wall Street, stocks closed out a volatile week with another triple digit loss for the Dow, giving the market the worst week since May 2012. The Dow industrials have now turned negative year to date. Yes, that was fast. The Dow lost 2.7% for the week. The S&P 500 dropped 3.1% on the week. The VIX, the volatility index jumped 45% for the week. The Stoxx Europe 600, Europe’s benchmark stock index posted its biggest slide in 2 years, down 4.1% for the week. The S&P 500 is sitting right at its 200 day moving average. The Dow Industrial dropped below the 200 day moving average, about 40 points lower.

A moving average is simply an average of a certain number of data points. The 200-day moving average is calculated by summing the past 200 days and dividing the result by 200. The 200-day moving average represents the average price over the past 40 weeks. This helps to smooth out day to day volatility and give a longer-term look at the overall trend. The 200 day moving average is considered a very important level of resistance or support; in this case, support. When a stock or an index breaks down below this key level of support you sometimes see a bounce, because there will be some investors who think they are now able to buy stocks cheap. But the bounce can sometimes be misleading; that’s known as a dead cat bounce. If dropped from high enough, even a dead cat will bounce. So the next few days will be critical to see if the markets can bounce, and if they can bounce, will they rally, or will prices just keep falling from here. If we don’t see a turnaround, it would confirm a downward trend.

This week the Nobel Committee handed out prizes for a better lightbulb, the LED; a better microscope, that sees nanoparticles; and a French author that I had never heard of. Today, Malala Yousafzai and Kailash Satyarthi have won the Nobel Peace prize. If you have not heard the story of Malala or heard her speak, you should; she will inspire you. She is the daughter of a teacher, and she grew up in and around schools, at least until 2008, when the Taliban took control of the Swat region of Pakistan, where she lived. The Taliban tried to close down schools for girls. That year, her father took her to Peshawar where she made a speech in front of national press titled “How Dare the Taliban Take Away My Basic Right to Education?” She was only 11 years old. In early 2009, Malala started blogging anonymously for the BBC about what it was like to live under the Taliban.

Two years ago, armed men boarded the converted truck that Malala and her classmates used as a makeshift school bus and they shot Malala in the head. She survived. Nine months after she was shot, Malala gave a now famous speech at the UN, where she said: “They thought that bullets would silence us. But they failed.” She’s continued her high-profile campaign for girls’ education with The Malala Fund, which raises money to promote girls’ education.

At 17, Malala is the youngest winner of the Nobel Peace prize, which she will share with 60 year old Kailash Sayarthi. In 1980 Satyarthi founded the Save the Childhood Movement, and he has helped rescue more than 80,000 children from bondage, trafficking and exploitative labor in the past three decades; he also spearheaded a movement to make free and compulsory education a constitutional right for children in India in 2009.

The Nobel committee said it “regards it as an important point for a Hindu and a Muslim, an Indian and a Pakistani, to join in a common struggle for education and against extremism”.

Wednesday, April 09, 2014 - Feeding Time at the ZIRP Trough

Financial Review with Sinclair Noe

DOW + 181 = 16,437
SPX + 20 = 1872
NAS + 70 = 4183
10 YR YLD un = 2.68%
OIL + 1.04 = 103.60
GOLD + 4.30 = 1313.30
SILV  - .22 = 19.95

In an otherwise light week for economic news, the big report is today’s release of the FOMC minutes from last month’s meeting. No surprises. You may recall that after the last meeting, Chairwoman Janet Yellen talked about the possibility of raising the fed funds target rate after a “considerable time”; when pressed she indicated a “considerable time” was about six months after the Fed ends it asset purchases under Quantitative Easing. That would mean late spring or summer of 2015.

Fed policymakers were unanimous in wanting to ditch the thresholds they had been using to telegraph a policy tightening; no hard and fast target of 6.5% unemployment or 2% inflation. The minutes indicate the Fed would like to see more improvement in the economy; the emphasis on quality rather than quantity. In other words, the Fed remains dovish, and they will taper but they will also keep rates low for a long time. And also, those “dots” are over-rated.

The dots are actually charts suggesting the fed funds rate would top 2% by the end of 2016. In the minutes published today, several policy-makers claim the charts overstated the shift in projections, which would suggest the Fed is not ready to tighten policy. A couple of the voting members wanted to commit to keeping rates low if inflation remains persistently below the Fed's 2-percent goal.

Wall Street loves feeding at the Zero Interest Rate Policy trough. Stocks were up. Despite the three-day selloff, the S&P 500 index managed to hold above its 50-day moving average around 1,840, a key support level. The Nasdaq Composite is in positive territory year to date.

In other economic news, Commerce Department data showed that wholesale inventories rose at a slower pace of 0.5% in February, in line with expectations, after a revised gain of 0.8% in January, which could support views that restocking did not help the economy in the first quarter. You recall that companies were overstocked on inventory in the fourth quarter; we haven’t worked our way through those full shelves, and that likely means that the economy is slogging along in the first quarter.

The IMF, the International Monetary Fund says the global economy is strengthening but emerging markets still face challenges from outflows of capital and the big threat for the global economy is super-low inflation, or low-flation.

The IMF expects the global economy to grow 3.6% this year and 3.9% in 2015, up from 3% last year. Those figures are just one-tenth of a percentage point below the IMF's previous forecasts in January. And the forecasts will likely be revised lower as more months pass; that seems to be the tendency. The IMF made no changes to its forecasts for US growth, which it estimates at 2.8% this year and 3% in 2015. Overall, the recovery seems to be broad, fairly strong and more stable.

The IMF and the World Bank will hold their spring meetings in Washington this weekend. Finance ministers and central bankers from the Group of 20 leading economies will meet Thursday. The IMF is expected to reiterate the message that central banks should be more aggressive.

Inflation in the 18 countries that use the euro currency fell to an annual rate of 0.5% last month. Though consumers can enjoy flat prices, ultra-low inflation can stifle growth. People and companies postpone purchases knowing that prices will be little changed months later. Debts become harder to pay off. That's a particularly severe problem in Europe, where many governments remain squeezed by debts. Super-low inflation also raises the risk of deflation; a decline in wages and prices that slams the brakes on economic growth.

Another topic at the meetings is expected to be inequality. The IMF’s new interest in income distribution coincides with other, seemingly unorthodox positions coming from the fund and some of its experts since the financial crisis of 2008. It has come to support some controls on cross-border capital flows. Its research has argued in favor of fiscal stimulus, pointing out its positive impacts on economic growth.

In the latest edition of the World Economic Outlook, the fund makes the case that inflation in the United States and other developed nations should be higher to help pull the world economy out of its morass. IMF Director Christine Lagarde now argues economic policy cannot be only about promoting low inflation and robust growth. Healthy, stable economies also depend on a reasonably equitable distribution of the rewards. The study concludes a flatter distribution of income contributes more to sustainable economic growth than the quality of a country’s political institutions, its foreign debt and openness to trade, its foreign investment and whether its exchange rate is competitive.

Deep inequality breeds resentment and political instability, discouraging investment. It can lead to political polarization and gridlock, as it cleaves the political system between the interests of the haves and the have-nots. And it can make it more difficult for governments to deal with brewing crises and economic imbalances. An analysis published last year by economists in the IMF’s fiscal affairs department concluded that efforts to curb budget deficits increase inequality, especially if they take the form of spending cuts. It suggested that targeted government spending and progressive taxes could offset some of these effects.

Fears that High Frequency Traders have been rigging the stock market went mainstream last week when 60 minutes ran a story on Michael Lewis’s new book “Flash Boys”. Then the FBI announced it would investigate; my guess is that this will slowly fade away in the light of the Holder Doctrine, which basically says that the Department of Justice and other supposed law enforcement types only arrest petty criminals, and if you have enough money and provide jobs, you are entitled to a “get out of jail” card.

Anyway, the High Frequency Traders are nothing new, they've been around for a long time. The major exchanges lease high speed access. Perhaps less well known are the dark pools. So much trading is now happening away from exchanges that publicly quoted prices for stocks on exchanges may no longer properly reflect where the market is. And this problem could cost investors far more money than any shenanigans related to high frequency trading.

When the average investor, or even a big portfolio manager, tries to buy or sell shares now, the trade is often matched up with another order by a dealer in a so-called "dark pool," or another alternative to exchanges. Those whose trade never makes it to an exchange can benefit as the broker avoids paying an exchange trading fee, taking cost out of the process. Investors with large orders can also more easily disguise what they are doing, reducing the danger that others will hear what they are doing and take advantage of them. 

The rise of "off-exchange trading" is terrible for the broader market because it reduces price transparency. The problem is these venues price their transactions off of the published prices on the exchanges; and if those prices lack integrity then "dark pool" pricing will itself be skewed. Around 40% of all US stock trades, including almost all orders from "mom and pop" investors, now happen "off exchange," up from around 16% six years ago.

A brokerage has several ways to fill customers' orders. It can match buy and sell orders from its own customers, known as "internalizing," or sell its orders to another broker that can do the same. Brokers also send trades to "dark pools," which are similar to exchanges, except the fees are lower and they are anonymous, with orders going unreported until after they have been executed. And finally, they can send trades to exchanges, where they will have to pay higher fees. A major concern with off-exchange trading is that brokers who internalize trades and offer dark pools do not provide any data to the market before the trade is executed.

On a stock exchange, when an order is sent in, the price of the stock is adjusted and everyone with a data feed sees it. Dark pools only report data after a trade has occurred. At that stage, information about the trade has little influence on the price. In other words, dark pool trading is priceless, and you actually need prices to have a marketplace; price discovery is an essential element; cut that out of the equation, and you can see some serious manipulation and distortion.

And finally, in today’s edition of “Banks Behaving Badly”, Bank of America has agreed to pay nearly $800 million in fines and restitution to settle allegations of deceptive marketing and unfair billing involving credit card products. The Consumer Financial Protection Bureau and Office of the Comptroller of the Currency said the bank had misled roughly 1.4 million people about the cost of two credit card payment protection products, which allow consumers to suspend minimum card payments if they lose their job or suffer a severe illness, and the amount of time they would receive benefits from them.

The bank also billed customers for identity protection products before they received them and did not provide some fraud-monitoring services consumers thought they were buying. About 1.9 million people were unfairly billed. The fines work out to about $5 million the rest in restitution. The bank says it has already issued refund payments to most customers who were affected. Bank of America neither admitted nor denied wrongdoing.

Thursday, April 03, 2014 - Tomorrow, Tomorrow, It’s Only a Day Away

Financial Review with Sinclair Noe

DOW – 0.45 = 16,572
SPX – 2 = 1888
NAS – 38 = 4237
10 YR YLD - .01 = 2.79%
OIL + .73 = 100.35
GOLD – 3.10 = 1287.80
SILV - .16 = 19.92

Forget about today; at least in terms of Wall Street trading. Tomorrow is more important. The first Friday of each month is always a big day because of the monthly jobs report; tomorrow, maybe more than most. The consensus estimates called for 200,000 net new jobs in March and the unemployment rate is expected to drop to 6.6% from 6.7%. Then there is the whisper number. Many people believe the harsh winter weather has held back hiring, like a balloon trapped under water by a thin sheet of ice, and when the ice melts, as it did in March, the balloon will jump out of the water like a salmon swimming upstream. Weather sensitive industries such as retail, construction and manufacturing might be especially strong performers.

A March jobs report that shows a broad increase in hiring across most or all industries would show the economy is recovering and everything, including the Fed, is on track. A disappointing number, though, would bolster the case of the increasingly famished Wall Street bears that bad weather alone is not the source of weak economic growth so far in 2014.

And if the number comes in right at expectations, we’ll have to go to the tiebreakers. We will look at the number of hours worked, In February, inclement weather kept people from getting to work, at least for a few days. The result: The average workweek slipped by 0.1 hour to 34.2 hours in February, the lowest level since January 2011. Fewer hours mean less take-home pay for many, translating into weaker consumer demand and slower economic growth. The wintry mix continued to hit parts of the country in March but the effect shouldn’t be as bad as earlier in the winter. Even a partial reversal of the weather distortion should generate a rebound in average weekly hours worked, which have slumped from 34.5 last November.

We’ll also look at the U-6 underutilization rate. Federal Reserve Chairwoman Janet Yellen this week highlighted the 7.2 million people who would like a full-time job but instead are working only part time. It’s a sign of slack in the labor market and one reason the Fed is likely to keep rates low for a long time. “This number is much larger than we would expect at 6.7% unemployment, based on past experience, and the existence of such a large pool of ‘partly unemployed’ workers is a sign that labor conditions are worse than indicated by the unemployment rate.”

And we’ll look at the participation rate, the share of working-age adults who have a job or are looking for work, held steady at 63% in February, near a 35-year low. That’s partly because baby boomers are retiring in greater numbers but may also indicate some people are frustrated with their job prospects and have dropped out of the labor force. Greater labor-force participation would be welcome, even if that keeps the unemployment rate from falling further.

Of course, that 200k jobs figure is just a guess, an arbitrary number pulled out of a hat. Total private employment reached 115,848,000 in February, close to the seasonally adjusted record of 115,977,000 from January 2008. If the private sector added more than 129,000 payroll jobs in March, the US will be back to its peak level of private-sector employment. Of course, a lot has changed since the prior peak. State local and federal governments have shed more than half a million jobs, leaving total employment still shy of its all-time high. The population is bigger: The civilian labor force has expanded by 1.6 million since then. And the mix of private-sector jobs has changed. For example, more people work in temp and health care jobs, while fewer are in construction and manufacturing.

With the Federal Reserve in the process of tapering down its bond purchases, big surprises on either side of the forecasts could upend expectations about the pace of the Fed’s stimulus withdrawal and the timing of eventual rate hikes. As important as the jobs figure is, it is also important to remember that, as Fed Chairwoman Janet Yellen has noted, unemployment isn’t the only number policy makers will consider.

It would take a really big number to move the bond market, but something north of 250,000 jobs could push the yield on the 10 year Treasury note above 2.8%. Market expectations appear to be biased toward higher yields.

A strong jobs report would also be bullish for the dollar. Today the dollar moved higher against the Euro as European Central Bank President Mario Draghi said policy makers were discussing the possibility of using quantitative easing and other unconventional stimulus measures to counteract extremely low inflation.

The ECB's governing council held its key interest rates unchanged for the fifth month in a row, despite an unexpected slowdown in area-wide inflation and worries about deflation.  Of course, Draghi has been trying to jawbone the Eurozone into economic growth for a couple of years, vowing to do whatever it takes but never actually doing whatever it takes, even as the destructive spiral of falling prices pushes consumers to put off purchases, thus destroying salaries, jobs and investment.

Meanwhile, International Monetary Fund Director Christine Lagarde was railing against the deflation ogre again, and warning the ECB about the dangers of “low-flation”, which is apparently a freshly minted economic term, and calling for more monetary easing by the ECB and the Bank of Japan. Draghi said the IMF has been “extremely generous” in suggesting what the ECB should or shouldn’t do. In fact, he urged the IMF to share the generosity “with other monetary policy jurisdictions, like for example issuing statements just the day before a (Fed) meeting.”

Which also means the ECB will not do whatever it takes to stoke the economic engine. And Lagarde was wrong; they don’t face “low-flation”; prices are falling.  The European Central Bank has let it happen. Deflation has been running at an annual rate of -1.5% in the Eurozone over the past five months, when adjusted for austerity taxes. Prices have dropped more than 6% in Greece, more than 5% in Italy, more than 4% in Spain and Portugal, 3% in Slovenia, and 2% in Holland. A little bit of stimulus would push the currency lower and goose exports and economic activity, but Draghi does nothing but jawbone; his constant promises to do whatever ring hollow.

Deflation can create some serious conundrums for debt. When a country’s debt burden rises faster than nominal GDP, it could engulf the private sector as well; tightening the vice on households and companies with fixed-rate debts; it would erode bank assets; risk fresh bank failures and hit life insurers through a mismatch in maturities.

An International Monetary Fund study detailed this week, that there's still a running assumption that governments would again rescue the biggest banks in the event of another panic. The IMF found that at least through 2012 the euro zone's biggest banks still benefited from an implicit taxpayer subsidy of $90 billion to $300 billion. Subsidies for UK and Japanese banks may have been as high as $110 billion and they ranged from $20 billion to $70 billion in the United States. So the risk, you might assume, is still loaded on the government's tab. Yet government borrowing costs across the western world and beyond have rarely, if ever, been lower.

Eurozone loans to businesses are contracting at a rate of 3%. The ECB is missing its 2% inflation target by 150 basis points, and will continue to miss it badly in 2015 and 2016 based on its own forecasts. Despite Draghi’s incessant and unbelievable jawboning, the ECB has consistently refused to offset the contractionary effects of austerity with enough monetary stimulus to keep GDP growing faster than the debt of the southern nations; and the more austerity the more the debt burden to GDP ratio has climbed. In Italy the debt climbed from 119% to 133% since 2010 despite harsh fiscal policy.

Say what you will about the Fed, and I have said plenty; their QE policy has been misdirected and has led to greater inequality, but at least the US maintains its global position as the cleanest shirt in the dirty clothes hamper because we weren’t hit with the double whammy of tight monetary policy and draconian fiscal austerity. (just the fiscal part)

The ECB insists that the latest dip in Euro inflation is due to falling energy costs, and therefore transient. That could all change if Russia decides to ramp up the use of natural gas as an economic weapon, and a precedent was set earlier this week. Rising energy prices in combination with falling prices for almost everything else would make for a really ugly mess in Euroland, and might force Draghi to stop sitting on his hands.

While offering her advice on “low-flation” to the ECB today, IMF chief Lagarde also spoke about other threats to global growth. Another threat is high corporate leverage in emerging economies, which if not adequately addressed will be worsened by the turmoil from eventual monetary tightening in advanced economies, especially the US. Yet another obstacle is the rise of geopolitical tensions, which could cloud the global economic outlook. "The situation in Ukraine is one which, if not well managed, could have broader spillover implications."