FINANCIAL REVIEW

Fed Patiently Makes Hawkish Sounds

Sinclair Noe — January 28, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 195 = 17,191
SPX – 27 = 2002
NAS – 43 = 4637
10 YR YLD – .10 = 1.72%
OIL – 1.19 = 44.26
GOLD – 8.80 = 1284.30
SILV – .07 = 18.06

Microsoft’s stock logged its biggest one-day dollar decline in nearly 15 years on Tuesday, after the company posted disappointing earnings Monday afternoon. Shares of Microsoft closed down 9.2%, or $4.35, to $42.66 on Tuesday, wiping out $34.7 billion in stock-market value. The Dow Industrials dropped 291 points Tuesday.

Then after the close of trade yesterday, Apple posted the largest quarterly net income of any public company in history; $18 billion. That provided an early boost to the markets today; at least until the FOMC statement.

The Dow Industrials are down from record highs, but not too bad. Since hitting an intraday high of 18,103 on December 28th, the Dow has been choppy through January; on three occasions dropping down to the 17,200 range but not dropping under (17,262 on January 6th, 17,243 on January 16th, and 17,288 yesterday). These three lows formed a floor, or a level of support for the Dow. Today, the Dow closed at 17,191; we broke support. And the next level of support is 17,067 from mid-December and the big round number of 17,000. If we break the 17,000 support, the next level is 15,855 from mid-October.

The Federal Reserve continues to try to make the case for patience; which is to say, a low interest rate environment, at least for now. The FOMC wrapped up their two day policy meeting today and repeated it would be “patient” in deciding when to raise benchmark borrowing costs from zero. They were a little more upbeat about the economic outlook, saying “Economic activity has been expanding at a solid pace,” a slight shift in words from their earlier assessment of a “moderate pace” of growth.

The FOMC issued a statement but there was no news conference today. The statement said: “Labor market conditions have improved further, with strong job gains and a lower unemployment rate,” and “Recent declines in energy prices have boosted household purchasing power.” The Fed believes the economy will move to 2% inflation “as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.”

Low oil prices are a key part of the equation. If prices rebound quickly, and climb back to $100 a barrel, then the Fed will probably respond with higher rates. But the drop in oil has been so strong it might not be a “V” recovery. There are benefits to the economy from lower oil prices; it stirs the animal spirits. Also, it tightens the screws on oil producers such as Russia and Iran and Venezuela, making them more receptive to negotiations.

It was one of the shortest statements in a couple of years, likely designed to give the impression that everything is normal, everything is on pace for the long promised rate increase. No reason for delay but no rush either. The overall tone of the statement was bit more hawkish and that sent stocks and oil lower, but pushed bond prices and the dollar higher.

There are some people who believe the dollar will crash, the economy will implode, and zombies will roam through the streets; even though they have no facts to support their theories. The problem is that the Fed is still saying they will eventually try to raise interest rates – despite speculation of QE4.

Those looking for the Fed to save the day with QE4 are probably looking in the wrong place. The US economy is the cleanest shirt in the dirty clothes hamper, and it just doesn’t make sense for the Fed to jump back into QE, not now; they are well aware that such a move would smack of desperation, have political implications, and likely produce less than satisfying results.

Plus, you may have noticed the economic data doesn’t support such a move. The unemployment rate is down, and even though wages have been stagnant for the long-term, they aren’t collapsing. (Note: I’m not saying wages will jump; just that there doesn’t seem to be a big chance of a large decline). Most of the economic data is pretty decent: third quarter GDP was very solid, and first quarter GDP should be decent (we’ll find out later this week). Consumer confidence is high, even if that isn’t translating to durable goods orders.

Perhaps the biggest long-term market risk is the amount of debt companies have piled up in the low interest rate environment that the Fed has created. Companies have used low interest debt to engineer buybacks and acquisitions, and sometimes just to keep dollars offshore and away from the IRS. And it isn’t just companies but the government as well; debt service on $18 trillion in debt would get expensive fast. If the Fed raises rates, they run the risk of having to reverse course and undo rate hikes if it goes bad and the economy comes to a screeching halt. There is no fundamental reason right now to raise rates and there is really no reason for the Fed to try to get in front of the recovery; it smells a little too much like 1937. So, for now the Fed can jawbone; that is, to issue hawkish statements without actually doing anything hawkish; and then sit back and wait, patiently.

No matter how it plays out, the Fed would have to communicate, they would have to lay out a full-fledged campaign or a full-fledged crisis to get to justification for QE4.

This is not about American fears, it is more about global weakness. It is about how the world transitions away from Fed-driven liquidity and passes the baton to the rest of the world. If you haven’t noticed, the hand-off has been taking place. The ECB introduced QE last week, which is probably too little, too late; the most likely result being the Eurozone will need another round of QE. Japan has been in QE mode for quite some time; actually QQE – the Bank of Japan’s promise to double the monetary base, which will likely be extended in April. China’s economy only grew at 7.4% in 2014, the slowest rate of growth in 24 years, and they are now targeting 7% growth for 2015, and to achieve that they will inject liquidity.

This is all about what is happening around the world, not America. The concern is not just that weak global growth will dampen US exports, or that a strong dollar with further hurt the export sector of the economy and cut into multinational profits. The strengthening of the dollar can lead to imported deflation, touching off another down leg in the US with the rest of the world sneezing, the US catches cold.

While it is possible that Yellen could turn more dovish, any such move would probably not entail QE4 (unless there is a crisis). If domestic growth is threatened by global factors, look for the Fed to use unconventional tools. And if you think QE and interest rate policy are the only tools in the toolbox, think again. One easy move would be to stop paying interest on excess reserves held by banks at the Fed. Stopping those payments could force the banks to pull their excess reserves and find more profitable uses for the funds, like making more loans; at least in theory. In practice this has been an ineffective tool, but it is the opposite of tightening.

The Fed could also take action to devalue the dollar, slowly and incrementally of course, to revive exports. The Fed could relax credit restrictions. The Fed could buy different debt instruments, tied directly to infrastructure. Or Fed Chairwoman Yellen can use the bully pulpit to push for fiscal stimulus.

For now, the focus will be on how the liquidity baton is passed from the Fed to the other central banks. And the “patience” of the Fed is just an opportunity to assess the progress of more easing from the rest of the world.

It is earnings season and here are a few selected reports:
After the closing bell, Facebook reported net income rose to $701 million in the fourth quarter, compared with $523 million a year ago. Profit excluding some items was 54 cents a share, topping estimates. Revenue grew 49% to $3.8 billion, also topping estimates. Facebook was flat to slightly lower in after-hours trading.

AT&T posted fourth-quarter earnings of $0.55 cents per share excluding items, up from $0.53 cents a share in the year-earlier period. AT&T also reported robust subscriber growth, announcing 1.9M net subscriber adds.

Boeing climbed 3.1 percent after posting profit that beat analysts’ estimates and predicted that it would make good in 2015 in converting a record jetliner-order backlog into cash.

About 77 percent of the S&P 500 companies that have posted earnings this season have beaten analyst estimates, while 55 percent have topped sales projections – this according to data from Bloomberg.

FXCM Inc., the currency brokerage that almost collapsed this month as the Swiss franc surged, will seek repayment from institutional and high-net-worth customers whose accounts went negative amid the volatility. Those investors account for about 60 percent of the brokerage’s losses. However, New York-based FXCM said today in a statement that traders who made smaller bets, about 90 percent of clients with negative balances, will have their losses forgiven.

Royal Dutch Shell has signed an $11 billion deal with Iraq to construct a petrochemicals plant in its southern oil hub of Basra, after signing a memorandum of understanding with its Industry Ministry for the project in 2012. Shell’s facility, which is expected to come on line within five to six years, would make Iraq the largest petrochemical producer in the Middle East.

FINANCIAL REVIEW

Theories on Apples and Applesauce

Sinclair Noe — January 16, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW + 190 = 17,511
SPX + 26 = 2019
NAS + 63 = 4634
10 YR YLD + .04 = 1.81%
OIL + 2.32 = 48.57
GOLD + 17.70 = 1281.30
SILV + .83 = 17.88

Stocks bounced back after five sessions of losses. All 10 of the S&P 500 sectors were higher, though energy led the charge, rising 2.8%. U.S. crude oil futures settled up 5% after the International Energy Agency said there were signs that lower prices had begun to curb production in some areas. On the week, oil rose 0.7%, snapping a seven-week losing streak. The IEA report said that the market’s floor was still anybody’s guess, but “the sell-off is having an impact,” and “A price recovery – barring any major disruption – may not be imminent, but signs are mounting that the tide will turn.

We love lower gas prices. A gauge of consumer sentiment jumped up to an 11 year high this month. The preliminary January reading on the University of Michigan’s consumer-sentiment index increased to 98.2, the highest level since January 2004, from a final December reading of 93.6. Also, more households were reporting increases in household incomes.

Consumer inflation in December saw the biggest monthly drop in six years. Consumer prices, the CPI, fell 0.4% in December. You know the big driver for lower prices; energy prices plunged 4.7% in December, the biggest drop since the end of 2008, as gasoline prices fell 9.4%. Overall consumer prices grew 0.8% in 2014, the second smallest calendar-year increase in the last five decades. Core inflation was 1.6% during 2014. Also, the government reported that inflation-adjusted average hourly earnings rose 0.1% in December. For the year, real average hourly earnings rose 1%.

Good news, everything is on sale. Well, not everything; beef, tomatoes, and eggs went up in price; and rents jumped last year. Most things are cheaper but it may not be cause for celebration. We’ve just seen the weakest stretch for prices since 2009, which was not a good year for the economy. The euro zone is in outright “deflation,” which is the opposite of inflation, prices fall instead of rise. Japan, went through a couple of lost decades when prices just went flat or even dropped. Japan has already started on a quantitative easing program. The Eurozone is expected to announce next week that they will start buying sovereign bonds to stimulate their economy.

Of course the problem is that when prices are falling we tend to put off buying stuff because we expect we can get a better deal tomorrow or next week. When everybody is waiting for a better price, nobody is actually buying; when people stop buying things, it is bad for the economy; really bad. The Federal Reserve tends to think this won’t be a problem; they are planning on raising rates at some point in the not so distant future. Unless something upsets the apple cart.

By the third quarter of this year, the Federal Reserve’s 0.25 percent interest rate is expected to at least double, according to economists surveyed by Bloomberg News. The Fed already has an idea of what the market impact will be: The so-called taper tantrum in May 2013, when then Fed Chairman Ben Bernanke first suggested the U.S. bond-purchase program would be scaled back, saw the yield on the 10-year Treasury jump half a percentage point in four weeks to end the month at 2.13%.

There’s a risk, though, that this time, having flagged the prospect of a change so far in advance, policy makers will be complacent about the probable market reaction. That’s what happened in 2008 when Lehman Brothers went bust. Treasury officials convinced themselves that the financial crisis had been rumbling on long enough for participants to have shielded themselves against the collapse of a big firm; turned out, not so much.

Right now there is a sort of similar situation with regard to Greece, where the problems have been going on so long, that people forget that Greece is on the edge of collapse. Today, two Greek banks applied for emergency funding from the national central bank. This could be a signal that depositors are pulling their money out at an alarming rate. Or it might just be another scheme to scare Greek voters ahead of next week’s election. After the election, the Greeks might repudiate their sovereign debt; the Euro Union might kick them out. Maybe it won’t be a problem.

The big problem seems to be when something happens without warning; like the Swiss abandoning a cap on their currency. Boom, markets move fast, somebody loses a boatload of money. Soon after the Swiss National Bank unexpectedly ended its three-year policy of keeping the franc weaker than 1.20 per euro, bearish bets on Europe’s common currency soared. While setting a record low versus the franc yesterday, the euro also plunged 3.5 percent against a basket of 10 developed-nation peers, the most since its 1999 debut, and reached an 11-year low against the dollar today. When the news was first announced, the franc exploded, up 41% versus the euro before things calmed down.

Generally, currency trades don’t have big moves. And so brokerages and exchanges allow leverage to entice traders. The U.S. Commodity Futures Trading Commission allows investors to put down as little as 2 percent of the value of their foreign-exchange bets. Brokers may get stuck with the balance of losses suffered by clients who used leverage, borrowed on credit cards, or did both to bet against the franc. FXCM handled $1.4 trillion in currency trades last quarter; today they say clients owe $225 million on their accounts. This afternoon, Leucadia National announced it would provide $300 million in financing to FXCM, which would allow FXCM to maintain its regulatory capital requirements. FXCM isn’t the only casualty from the franc’s sudden move. Global Brokers Ltd., based in New Zealand, said losses from the surge are forcing it to shut down.

Meanwhile the Chicago Mercantile Exchange announced that it will double, then triple, margin on Swiss franc futures contracts. That means they will extend a bit more credit and hope their customers just wait it out and everything will return to something like normal. That will reduce the margin calls but it won’t eliminate them, and I suspect we’ll see some more tales of woe in coming days. And that includes some of the big banks; both Deutsche Bank and Citigroup each reported lost $150 million on Swiss franc trades. The losses are mounting, but so far nothing the markets can’t absorb.

Now let’s look at another market that has seen some fast moves – oil. We’ve been tracking the decline since last summer, but still, that is considered a fast move. The day traders have certainly had their chance to get in or out of a trade, but there are many other investors who can’t jump in and out of positions quite so fast. For example, there is quite a bit of debt associated with oil exploration and drilling and refining. And that energy debt is then bundled together in pools, known as CLOs or collateralized loan obligations, and then those CLOs are traded. But the market for CLOs is not as liquid as you might think, and it becomes less liquid when it looks like some off the loans that were bundled might not perform.

Under provisions of the Dodd-Frank Act, banks are required to sell their stakes in certain complex securities, such as CDOs and CLOs. But there has been a push to repeal parts of the Act. The Volcker reprieve would have given banks until 2019 to sell their stakes in CLOs. Much of the recent energy boom has been financed with junk debt and a good portion of that junk debt ended up in collateralized loan obligations. CLOs are also big users of credit default swaps, which are an important target of the Dodd Frank push-out. In addition, over the past 6 months banks were unable to unload a substantial portion of the junk debt originated and so it remained on bank balance sheets. That debt is now substantially underwater and, potentially, facing default. To hedge or hide the losses, banks are using credit default swaps. Hedge funds are actively shorting these junk debt financed energy companies using credit default swaps.

The Dodd-Frank Act was supposed to get the banks out of that derivatives business in 2015, but if the banks had to mark to market on those CLOs today, it would likely lead to big losses. And so they are asking the politicians to delay implementation of the Volker Rule, so they have more time to sell off their bad CLOs, or maybe for the market to rebound. The reason to expect such heavy concentration of energy debt in CLOs is that energy debt has made a big increase in its total share of the junk bond market, up from 4% ten years ago to 16% now. 16% might not seem like a big deal until you realize that the real increase in energy credit issuance happened in the last few years, so the proportion of energy borrowing to total risky borrowing was vastly higher of late so as to move the averages so much in a short time.

We don’t know exactly how much bad energy debt is bundled into CLOs. Some estimates peg it around $200 billion, but that doesn’t mean everything will go into default. But here is where CLOs are dangerous; they take good energy debt and bad energy debt and other types of debt and they smash it all together. It’s kind of like taking a bunch of apples, and making apple sauce. And once you smash the good apples with the bad apples, you can’t unmake the apple sauce.

The opacity of the banks’ situation is creating a mindset on Wall Street to sell first and ask questions later. On days when oil is plunging in price, big bank stocks are getting hit across the board. Institutional investors with large bank positions who can’t readily dump shares are trying to hedge their exposure by buying puts on Exchange Traded Funds (ETFs) which track the financial services sector. Wholesale dumping of shares could come later if more negative news emerges.