Financial Review

Stormy Weather

Sinclair Noe — October 23, 2015

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

Subscribe: iTunes | Android | RSS

DOW + 157 = 17,646
SPX + 22 = 2075
NAS + 111 = 5031
10 YR YLD + .05 = 2.08%
OIL – .65 = 44.73
GOLD – 1.90 = 1165.00
SILV – .03 = 15.91

After Thursday’s closing bell Microsoft, Amazon, and Alphabet all reported very strong third quarter earnings, and these companies are big enough to lift the entire market; today they added $80 billion in market cap. Amazon and Alphabet hit all-time highs, and Microsoft moved to its highest levels since 2000. Toss in a little central bank easy money and you’ve got one of the best two day rallies in a long time.

The S&P 500 gained 2.1% for the week; its fourth straight weekly gain; moving into positive territory year to date. For the week, the Dow rose 2.5 percent and the Nasdaq gained 3 percent. Oil capped its biggest weekly decline since August as expanding U.S. crude stockpiles exacerbated a global glut, and the dollar moved higher, especially against the euro.

China’s central bank cut interest rates today for the sixth time in less than a year (down 25 basis points to 4.35 percent) , and it again lowered the amount of cash that banks must hold as reserves. Monetary policy easing in the world’s second-largest economy is at its most aggressive since the 2008/09 financial crisis. The People’s Bank of China said it was freeing the interest rate market by scrapping a ceiling on deposit rates; which will, in theory, allow banks to price loans according to their risk, and remove a distortion to the price of credit that analysts say fuels wasteful investment in China.

At a rate review next week, the Bank of Japan will cut its growth and inflation outlook for this fiscal year but only slightly tweak its projections for 2016. The BOJ can still maintain it’s on course to meet its inflation goal of 2% next year without needing to step up its massive asset purchase scheme.

While the Eurozone’s composite PMI unexpectedly increased to 54 in October from 53.6 in September, signaling a pickup in activity, forward-looking indicators point to a risk of a slowdown, according to Markit Economics. Service-sector expectations for the year ahead fell to a 10-month low.

Stocks across the globe extended a rally from the previous session, as central banks exert their dominance on markets. Yesterday, ECB President Mario Draghi signaled his willingness to add more stimulus to the Eurozone’s flagging economies, possibly at the next ECB meeting in December. The euro dropped for a second day versus the dollar, down 2.8% for the week. The euro is down more than 8 percent against the dollar year-to-date, and has fallen by 12 percent over the past year. Call it an accidental devaluation of the euro. The ECB claims it is not their intention to devalue the euro, but there simply doesn’t seem to be much evidence that QE and zero rates have done much to drive inflation higher. Still, the market salivates and sells euros when Draghi says QE.

Against a backdrop of ongoing stimulus in Japan, a big burst of new stimulus in China, and anticipated extension of stimulus in Europe, it becomes increasingly difficult to imagine the Fed will be able to go against the grain and hike interest rates any time soon. Fed funds futures rates show almost no chance next week when the FOMC meets, and less than a 50% chance when they meet in March.

This has implications across the board. The Federal Reserve’s decisions about interest rates will affect every single person and company in the United States. Walmart will like having cheap imports. Boeing won’t like that its planes cost more to foreign buyers. Family farmers won’t like it; big agribusinesses, like Cargill, will. For banks, a Fed rate increase can be good and bad news: In a recent report on the subject, Goldman Sachs argued that some banks, like M&T and Wells Fargo, are going to be in a bit of trouble, while others will make more money from interest rates on loans. On an individual level, Fed rate increases are better for older people who live on savings and worse for younger people who tend to borrow more.

If the Fed added up all the ways a rate increase helped people in the short term and subtracted all the ways it hurt them, they would never raise rates. While there are winners and losers, on balance a Fed rate increase means the economy will slow down, which on average is worse for everybody. Of course Wall Street loves easy money from the Fed. Global markets are as well trained as Pavlov’s dogs.

This week the People’s Bank of China announced easy money, although most of that stays in China, and the European Central Bank announced it would continue with its QE asset purchases; currently the ECB is buying a little over $90 billion in government bonds each month, and Draghi hinted there might be more coming in December. And the funny part is that all this extra money being pumped into the system should result in inflation, but the opposite is happening. Rates in the Eurozone are near zero, and this week the Italian 2 year government note went negative, as did the US Treasury 30-day bill. So where is all that money going?

Well, it’s going into government bonds. And where are the government bonds going? Well, they are being used as collateral for the $700 trillion dollar derivatives market where they are tucked away as collateral. And the lower the central banks pegs interest rates, the more the banks are forced into taking risks to generate returns, and that means risk, and risk is mitigated (at least in theory) with derivatives, backed (again theoretically) by the collateral of government debt.

And so, some off the biggest news of the week that nobody noticed was a new ruling from a couple of regulators, which will greatly reduce the collateral requirements the big banks must set aside in derivatives deals. The rules are still in draft form, but they would cut in half what the companies must post in transactions between their own divisions. The proposed rules are coming from the FDIC and the Commodities Futures Trading Commission, backed by the financial industry and the rules are apparently being drafted by the financial institutions as well.

It’s difficult to estimate how much is at stake for banks, but the derivatives market is estimated at $700 trillion nominal value; the collateral involved is likely in the hundreds of billions in non-cleared swap trades. The banks think this might free up collateral for other purposes. I’m guessing riskier purposes, but time will tell. What this also might address is the remarkable lack of supply of government debt – how else to explain Italian notes going negative?

Best guess is that we will see continued growth in structured financial assets that made synthetic swaps where the casino banks sold protection based upon bonds, rather than actually investing in bonds, and then called it collateral that could be sold as insurance to guarantee payment on insurance contracts. Sure – what could go wrong?

Analyst sentiment on overall third-quarter earnings has improved following the string of strong results from blue chips. S&P 500 earnings for the period are now expected to have declined a more modest 2.8 percent, compared with a decline of 5.5 percent forecast at the start of the reporting season.

American Airlines reported earnings of $1.9 billion, or $2.77 a share; beating estimates. American realized big savings from lower fuel costs. American’s board authorized a new $2 billion share repurchase program to be completed by year-end 2016. They still face an air fare war. American said it will discount tickets in a bid to win market share.

The Environmental Protection Agency regulatory package known as the Clean Power Plan officially became law today. It was immediately challenged by 24 states, led by West Virginia, in a U.S. appeals court filing in Washington. The states are asking for a court order blocking the measure until the lawsuit is resolved. It’s at least the third time the initiative has come under legal fire. Earlier challenges were rejected by federal judges as premature because the measure hadn’t been published.

The U.S. government no longer has that defense, leaving the regulations open to attack. The Clean Power Plan aims by 2030 to reduce power plant carbon emissions 32 percent below where they were in 2005. The rules require states and utilities to use less coal and more solar power, wind power and natural gas. States are required to submit their initial plans for meeting those objectives by Sept. 6 of next year. Final plans must be submitted two years later. EPA Administrator Gina McCarthy, issued a statement saying the Clean Power Plan is based upon “strong scientific and legal foundations” and is within the authority granted to the agency under the Clean Air Act.

Hurricane Patricia is moving onshore right now around Manzanillo on the Pacific Coast Mexico. It is being called the most powerful storm in recorded history, with winds clocked at 200 miles per hour, which makes it a Category 5. The only good news is that this area of Mexico is not heavily populated. Evacuations have been ordered along the coast. The US National Hurricane Center said Patricia was on track to make a “potentially catastrophic landfall.” Storm surge could top 30 feet. The storm is also expected to bring about 20 inches of rain.

So the storm surge will hit the coast, and then a couple of hours later, the rains will wash down from the mountains. The hurricane is expected to head northeast over Guadalajara, then dissipate as it hits the Sierra Madres, and over the next 2 or 3 days, it should make its way to Texas with heavy rains, and that’s on top of flooding in Texas happening now as the result of another storm system.

Financial Review

Hot Fun in the Summertime

Sinclair Noe — May 11, 2015

 

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

Subscribe: iTunes | RSS

DOW – 85 = 18,105
SPX – 10 = 2105
NAS – 9 = 4993
10 YR YLD + .12 = 2.27
OIL – .10 = 59.29
GOLD – 4.00 = 1184.50
SILV – .13 = 16.38

The S&P 500 Index went up to 2117.69, it sat there for a couple of seconds then fell; the reason this is important, or not, is because 2117.69 is the record high from April 24; also, last Friday, the S&P hit 2117.66 for an intraday high. It has been at or near this level several times in the past 3 months, but it can’t break through. Meanwhile, about $100 million in options on the VIX changed hands at 12:16:04 this afternoon; that’s a little more than a half day’s normal volume in a split second. The VIX is the Volatility Index. Just over 1 million contracts were traded. The trades were spread among four contracts that pay off at different dates and prices, say if the VIX rises to 17 by June or 23 by July. We don’t know who made the trade, but somebody is betting things will get hot this summer.

On Friday, the Jobs Report showed the economy added 223,000 jobs and the unemployment rate dropped to 5.4%. We’ll get more information on the labor market tomorrow with the JOLT survey, which takes a look at job openings and labor turnover; that should tell us whether workers are confident enough about their job prospects to quit their current job. On Wednesday, we’ll get reports on retail sales and inflation at the wholesale level.

The bond market tantrum that lasted for most of the past three weeks seems to be cooling off as signs of mixed global economic growth revive demand for the fixed-income assets. In that time frame, the amount of bonds trading with negative yields has dropped from $3 trillion to $1.7 trillion in a sign that borrowing costs may have hit their floor. Benchmark 10-year Treasury yields at today’s level of 2.27% have risen beyond the level many economists projected for mid-year, while German bunds remain little changed at 0.61%. And it may surprise you that short-term US bonds have been slipping in and out of negative territory.

The problem is there aren’t enough to go around. With supply at multi-decade lows, investors are signaling alarm as regulations intended to shore up banks and prevent a run on money-market funds exacerbate the bill shortfall. Financial institutions expect an extra $900 billion of demand for government securities during the next 18 months, putting pressure on a sizable chunk of the $1.4 trillion bill market. It might even put pressure on the Fed. What if the Fed raised its Fed Funds target rate, and short-term rates went down? The mismatch between supply and demand has been so acute that four-week bill rates fell to minus 0.0304 percent on April 29, the lowest on a closing basis since December 2008. Yields on three-month bills also turned negative. The consequences extend well beyond the fixed-income market as depressed rates in the $2.5 trillion money-market fund industry stand to deprive savers of income long after the Federal Reserve starts raising interest rates.

The Treasury says it will sell more short-term bills, but they haven’t offered details. Meanwhile, the government seems focused on longer-term debt. The average maturity of US debt outstanding has stretched to 69 months. One reason for the increased demand is that banks and other financial institutions have higher capital requirement; that makes deposits more costly for banks to hold, so they are discouraging some depositors from depositing cash; the logical place for cash not deposited is in short-term bills.

Now for the good news/bad news. The good news for the bond market is there isn’t much cash sitting on the sidelines. The bad news for the stock market is there isn’t much cash on the sidelines. Mutual fund managers have the lowest cash levels in history and money market fund levels are lower now than in 2007 and near a record low from 2000 relative to the capitalization of the stock market. This suggests that investors are heavily allocated in stocks. So what is propping up the stock market? Buybacks, mergers and acquisitions, and demand from foreign central banks; all of which falls under the category of financial engineering.

At least 30 countries have loosened monetary policy this year. On Sunday, China’s central bank cut its benchmark one-year lending rates by 25 basis points to 5.1%, its third reduction since November, as economic growth cools to levels not seen since the global financial crisis. The People’s Bank of China also reduced one-year benchmark deposit rates by 25 bps to 2.25%; it also gave banks leeway to offer up to 1.5 times the benchmark deposit rate, up from 1.3 times previously. Now you might be wondering why the PBOC would cut rates, which would encourage more lending activity, while at the same time increasing rates for people to park money in deposits, which takes money out of circulations.

Part of the problem for China is that they still peg the yuan to the dollar, and the dollar has been strong; if the yuan follows the dollar, it leads to effective monetary tightening despite two rate cuts so far.  Since mid-2014, China’s real effective exchange rate has appreciated by more than 15% against its peers. Also, as the PBOC is buying back its own money to protect the level of the yuan, this is again another form of tightening. And in a further counterproductive move, the more China cuts interest rates, the more it encourages capital to exit due to declining yields.  If that new money created is not leaking abroad, it is either going into servicing China’s large existing debt or else is flowing into the stock market rather than going to supporting real economic activity.

And while China has strong capital controls in place, smart investors follow the money. The problem for mainland Chinese authorities is they are not in control of how private holders of wealth move their money.  For example, only last week it was revealed Chinese investors and immigrants together purchased more than $6.3 billion in Australian residential property over the space of 12 months. And if the People’s Bank of China loosens monetary policy at the same time that the Federal Reserve tries to hike rates, this might trigger further capital outflows into the dollar.

China overtook the U.S. as the world’s biggest importer of crude oil in April, with purchases from overseas hitting a new high of 7.4 million barrels a day (equivalent to roughly one in every 13 barrels consumed globally) and topping U.S. imports of 7.2 million barrels per day. While China’s imports are not expected to consistently surpass those of the U.S. until the second half of this year, the move highlights how the U.S. shale revolution has cut the country’s reliance on oil from overseas – and how China’s demand has grown even as its economy slows.

Eurozone finance ministers met today in Brussels to discuss Greek debt. Athens has reportedly scraped together 750 million euro to pay the International Monetary Fund. However, the coffers in Athens are thought to be completely dry and it’s uncertain how Greece will make welfare payments in the coming days. The IMF is now working with national authorities in southeastern Europe on contingency plans for a Greek default.

Citigroup says the Justice Department declined to prosecute the bank after a probe into rigging of the London Interbank Offered Rate, or Libor. In 2013, Citigroup agreed to pay $78 million as one of six banks to settle with the European Union over allegations they rigged interest rates tied to Libor. Citigroup still has legal problems. In a regulatory filing, Citi said it could plead guilty to an antitrust charge to resolve a Justice Department investigation of its dealings in foreign exchange markets. And Citi might not be alone. The parent companies or main banking units of as many as five major banks, rather than their smaller subsidiaries, are expected to plead guilty to US criminal charges over manipulation of foreign exchange rates; deals could be announced this week. It would be unprecedented for parent companies or main banking units, rather than smaller subsidiaries, of so many major banks, to plead guilty to criminal charges in a coordinated action. The banks looking at a forex deal include JPMorgan, Citigroup, Royal Bank of Scotland, Barclays, and UBS. If parent companies of JPMorgan and Citigroup plead guilty, it would be the first time in decades that a major American financial institution has done so.

The Justice Department has been negotiating with the banks for months over how to resolve allegations that traders colluded to rig rates in the largely unregulated $5.3 trillion-a-day currency market. Authorities now may seek to limit the fallout from guilty pleas with assurances from various regulators that banking licenses will not be automatically revoked. Institutions may obtain waivers if the pleas would otherwise prohibit them from business activities such as participating in certain private offerings, or trading in government securities.

Noble Energy agreed to acquire Rosetta Resources for $2.1 billion in stock, giving the natural gas and oil producer a position in two of the largest areas of shale production in Texas. It’s the largest takeover of a U.S. oil and gas producer announced this year. Noble will also assume Rosetta’s net debt of $1.8 billion. The per-share offer is valued at $26.62, a 38 percent premium to the target’s closing price on Friday. The premium for Rosetta is below average for the sector over the past five years, suggesting there are more mergers to come.

DTZ, a commercial real-estate-services firm backed by TPG Capital, has agreed to buy Cushman & Wakefield, the largest closely held commercial-property brokerage, in a deal that values the company at about $2 billion.

The World Health Organization has declared Liberia free of Ebola, marking the end of a national outbreak that infected as many as 400 new victims a week at its peak. Liberia has now gone 42 days – twice Ebola’s maximum incubation period – since the burial of its last confirmed patient without discovering a new case. The disease is still spreading in Sierra Leone and Guinea, though at a slower pace. According to WHO statistics, more than 11,000 people have died from the virus, with about half of them in Liberia.