Financial Review

Fed Day

Sinclair Noe — June 14, 2017

Podcast: Play in new window | Download (Duration: 13:15 — 7.6MB)

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DOW + 46 = 21,374
SPX – 2 = 2437
NAS – 25 = 6194
RUT – 8 = 1417
10 Y – .07 = 2.14%
OIL – 1.78 = 44.68
GOLD – 6.00 = 1261.10
BITCOIN + 1.88% = 2541.31 USD
ETHEREUM – 13.12% = 345.44

Another record high close for the Dow Industrials. Stocks moved lower today after the Federal Reserve announced it was raising interest rates. The move was completely expected, so maybe the markets were reacting to weak retail sales data instead. Stocks recovered from session lows, with the Dow turning positive in the final hour of trade.

The Federal Reserve raised its benchmark lending rate by a quarter percentage point to a target range of 1.00 percent to 1.25 percent. This was the second rate hike in the past 3 months. The hike was widely expected.

In its statement following a two-day meeting, the Fed’s policy-setting committee indicated the economy had been expanding moderately, the labor market continued to strengthen and a recent softening in inflation was transitory. This was in-line with expectations for one more rate hike from the Fed for 2017, possibly in September or December.

The Fed has now raised rates four times as part of a normalization of monetary policy that began in December 2015. The Fed’s decision to raise rates was approved 8-1, with Neel Kashkari, head of the Fed’s Minneapolis regional bank, dissenting in favor of holding rates unchanged. Kashkari sees a very different economy from his colleagues, in terms of both inflation and the labor market.

While Yellen and the members who voted for hikes did so, in part, because they were worried about rising inflation, Kashkari doesn’t share their concern. If Kashkari is right, it means the Fed may be leaving lots of jobs and growth on the table.

The Fed also gave a first clear outline on its plan to reduce its $4.5 trillion portfolio of Treasury bonds and mortgage-backed securities, most of which were purchased in the wake of the 2008 financial crisis and recession. The Fed will allow its bond holdings to mature and fall off the balance sheet without being replaced or rolled over.

The Fed said the initial cap for Treasuries would be set at $6 billion per month initially and increase by $6 billion increments every three months over a 12-month period until it reached $30 billion per month in reductions to its holdings. For agency debt and mortgage-backed securities, the cap will be $4 billion per month initially, increasing by $4 billion at quarterly intervals over a year until it reached $20 billion per month.

Back of napkin math means the Fed will try to shrink the balance sheet in half over about 4 years, once the process starts. No date given. Fed Chair Janet Yellen said the process could begin “relatively soon.”

It won’t take long until you start to feel the rate hike. Look for interest rates on credit cards to jump relatively soon, probably 60 days, or two billing cycles. The average household now pays a total of $1,292 in credit card interest per year, according to NerdWallet’s research. Now that the Federal Reserve increased its rates as analysts expected, the total will rise to $1,309.

On the flip side, savers can look forward to earning higher rates on deposits, but don’t expect much, bank deposits are paying just over 1% which is not enough to keep pace with inflation.

The Fed also issued updated economic forecasts. The Fed’s revised forecasts reduced its estimate for unemployment by year’s end to 4.3 percent from a March projection of 4.5 percent. Unemployment has already reached a 16-year low of 4.3 percent.

The Fed kept forecast for economic growth this year of 2.2 percent, up slightly from its March forecast, with growth of 2.1 percent in 2018 and 1.9 percent in 2019. In a news conference, Fed Chair Janet Yellen said she still expects inflation to hit a 2% target next year, mentioning that recent declines are coming from such areas as telecom.

Earlier in the session we had some disappointing readings on inflation and retail sales.

Higher interest rates are normally good for a currency, but the dollar’s performance suggest traders see little chance for any more increases this year – at least if the turmoil in Washington distracts the Trump administration from implementing its pro-growth fiscal agenda.

Meanwhile, Treasuries rallied, pushing the yield on the 10-year note down 7 basis points and further flattening the yield curve, an indication that debt traders are cutting their expectations for growth. Bond traders are clearly worried the Fed is on a path to harm the nation’s prospects for growth without meaningfully adding to its arsenal of tools to deal with any downturn.

Meanwhile in the oil market, the price of crude is doing its best to keep inflation under wraps. Oil fell below $45 a barrel to its lowest since November as government data showed that weaker demand at the start of the summer driving season led to another increase in gasoline stockpiles.

Gasoline inventories rose 2.1 million barrels last week, according to the Energy Information Administration. Adding to the market pessimism, the International Energy Agency said new production from OPEC’s rivals will be more than enough to meet growth in demand next year, overwhelming the oil group’s efforts to reduce supplies by cutting its own output.

The EIA forecasts output at major American shale fields will reach a record in July.

Consumer prices declined in May, reflecting a big drop in energy prices. The Consumer Price Index, or CPI, edged down 0.1 percent last month following a small 0.2 percent increase in April. Prices had fallen 0.3 percent in March.

In addition to a drop in energy costs last month, the price of clothing, airline fares and medical care also declined. Core inflation, which excludes energy and food, rose a slight 0.1 percent in May. Over the past 12 months, consumer prices are up 1.9 percent while core inflation has risen 1.7 percent.

In May, food costs edged up a tiny 0.2 percent while energy costs fell 2.7 percent, led by a 6.2 percent drop in the price of gasoline. Over the past 12 months, food costs are up just 0.9 percent while energy prices have risen 5.4 percent.

Clothing costs dropped 0.8 percent in May while the cost of new cars and used cars both fell 0.2 percent. Medical services such as the cost of doctor’s visits dipped 0.1 percent in May but have risen 2.5 percent over the past 12 months.

Those low food costs might not last. Wheat has quietly staged a huge rally, as a prolonged dry spell has left the U.S. spring crop in its worst shape in almost three decades. Forty-five percent of the crop, the high-protein variety grown in northern states, was in good or excellent condition as of June 11.That’s down 10 percentage points from the prior week and marks the worst rating for the time of year since 1988.

Futures have surged more than 15 percent in the past month. Spring wheat futures for July delivery reached $6.45 3/4 a bushel, the highest for a most-active contract since December 2014.

The Commerce Department said retail sales dropped 0.3 percent, the first decline since February and the sharpest since a 1 percent decrease in January 2016. Last month, sales fell 2.8 percent at electronics stores, the biggest such drop since March 2016. They fell 2.4 percent at gasoline stations and 1 percent at department stores, which have struggled with competition from online retailers.

Business inventories fell by a seasonally adjusted 0.2 percent in April, following a gain of 0.2 percent in March. It was the first decline since a 0.2 percent drop in October. Sales were flat after contracting 0.1 percent in March. When businesses increase stockpiles, it is generally seen as a sign of their confidence that sales will increase in the coming months. A decrease in inventories can be a sign of pessimism about future sales.

Financial Review

Harbingers

Sinclair Noe — March 22, 2017

Podcast: Play in new window | Download (Duration: 13:15 — 7.6MB)

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DOW – 6 = 20,661
SPX + 4 = 2348
NAS + 27 = 5821
RUT – 0.95 = 1345
10 Y – .04 = 2.39%
OIL – .09 = 48.15
GOLD + 4.00 = 1249.20

London was shaken today by the first major terrorist attack since the 2005 subway bombings. Witnesses told of hearing multiple gunshots after a policeman was attacked outside Parliament. On Westminster Bridge, a car mowed down pedestrians. Two pedestrians and a police officer were killed, and at least 20 people injured, some very seriously.

A vehicle ran over pedestrians before crashing into a fence outside Parliament. A man wielding a knife then ran into the grounds and stabbed a police officer before being shot. Police believe the man, who died from his injuries, was the only attacker and are treating the attack as terrorism.

Global stocks were in retreat mode, but losses were relatively minor. Investors were taking some money out of equities and they’re putting their cash into government bonds.  European markets declined with many indexes down by about 1%. Asian markets ended the day with losses.

Japan’s Nikkei notched the biggest drop of 2.1%. The moves follow a sizable drop for US stocks yesterday. The Dow Industrials fell 1.1%, the S&P 500 dropped 1.2% and the Nasdaq was down 1.8%.

It was the worst day for stocks since October, but it was the first day in which the S&P 500 index traded in a 1 percent range since Dec. 14. In that time, the market did see one other one-day move of 1 percent or greater, when the S&P rose nearly 1.4 percent on March 1 — but since stocks opened sharply higher that day, the S&P did not manage a 1 percent intraday move.

Consequently, the index went 64 days without such a move, which is easily the longest-ever streak according to data that dates back to 1962. The second-place streak, of 34 days in 1995. In the past, after periods of calm, the market tends to continue moving in the direction of the trend – which is up, but calm is not the normal state for the market, so we can expect a period of increased volatility.

So, watch out for some big dips ahead.

That’s the historical tendency, however we also need to watch out for other markets – notably bonds, as we discussed yesterday; where we see a flattening yield curve, and it flattened even more today. A flattening curve means the economic outlook is dampening. When it grows steeper, like it did after the election, the economic outlook is brightening. But a flattening yield curve also influences the stock market negatively.

And if you are waiting for more volatility, you might not have to wait long. Healthcare legislation is schedule for a vote in the House of Representatives tomorrow. This is the first big piece of legislation for the Trump administration, and could serve as a harbinger.

After the health care legislation, Trump’s budget proposal will take front and center and he may face resistance from members of his own party for cuts to environmental programs. That’s due to an Obama administration practice that spread billions of dollars in contracts to Republican as well as Democratic congressional districts. Members of Congress typically resist efforts to cut spending that brings projects and jobs to their district.

A Bloomberg analysis of federal contract data shows that spending related to the environment reached 423 congressional districts in fiscal year 2016 and totaled $5.9 billion. Almost half that spending—47 percent—went to districts represented by Republicans.

Federal contract spending isn’t just spread across congressional districts. It’s also spread across contractors: Last year, 4,462 vendors got contracts categorized as related to the environment, climate, sustainability or similar fields.

Twenty-five publicly traded companies earned more than $10 million each from those contracts. Distributing federal largesse has been standard practice for the Department of Defense for many years, a lesson not lost on the Department of Energy.

President Trump’s second choice to lead the Labor Department is about to get a hearing. Alexander Acosta, a Florida law school dean, testified today. He follows Andrew Puzder, who withdrew his candidacy in February.

The National Association of Realtors says existing home sales declined 3.7% to a seasonally adjusted annual rate of 5.48 million units last month. The NAR says a persistent shortage of houses on the market is pushing up prices and sidelining potential buyers.

Housing inventory has dropped for 21 straight months on a year-on-year basis. With supply remaining tight, the median house price surged 7.7% from a year ago, to $228,400 in February. That marked the 60th consecutive month of year-on-year price gains.

The Mortgage Bankers Association reports mortgage application activity fell from a nearly four-month peak as borrowing costs on 30-year home loans held at their highest level almost three years. Mortgage apps fell 2.7% for the week ended March 18. Average interest rates on 30-year, fixed-rate conforming mortgages, the most widely held type of U.S. home loan, held for a second week at 4.46%, a level last seen in April 2014.

According to a new study from Spectrem Group, the number of millionaire households in America increased by 400,000 in 2016, reaching a new record of 10.8 million. Since the 2008 financial crisis, the number of millionaire households has grown every year, adding a total of 4 million millionaire households.

The number of multimillionaire households has also grown. There are now 1.4 million households worth $5 million or more and 156,000 households worth $25 million or more.

Nike reported earnings that beat estimates but total revenue was up just 5% in the last quarter. The company’s outlook wasn’t that great either. Nike said it expects sales growth to slow a bit this quarter. And future orders, a measure investors look at as a proxy for sales during the next few quarters, were down 4%. Nike is still growing rapidly in emerging markets as well as Asia. Nike was the worst performing stock in the Dow last year, falling nearly 20%.

FedEx said some of its largest retail customers shipped fewer packages during the holiday season than forecast, after the delivery giant had ramped up spending and staffing in anticipation of a crush of deliveries. The outcome hurt FedEx’s bottom line during the fiscal third quarter ended Feb 28. While revenue surged 18%, helped by higher rates and more packages shipped, overall margins fell because of a 30% rise in fuel costs and investments to keep up with e-commerce growth.

Fiat Chrysler is the latest automaker to be named in a growing French investigation into diesel emissions cheating. The Paris prosecutor has opened an investigation into potential aggravated fraud at Fiat Chrysler.

Fiat Chrysler acknowledged it was under investigation for “alleged consumer protection violations” but denied wrongdoing. French prosecutors were already investigating Renault and might open an investigation into PSA Group. This follows the $19 billion settlement between US regulators and Volkswagen.  Last week, German prosecutors raided VW headquarters as part of an ongoing investigation.

ING has confirmed a Dutch criminal investigation, but wouldn’t comment beyond the information presented in the bank’s annual report. The investigation relates to the “on-boarding of clients, money laundering, and corrupt practices,” per the 10-K filing, and can result in “significant” penalties.

Just days after finance chiefs of the world’s top 20 economies dropped their pledge for open trade, the European Central Bank has published a study claiming protectionist trade policies may increase, rather than reduce, a country’s trade deficit.

 Separately, Italy is calling for unambiguous support for an open global economy at a G7 finance ministers summit in May, saying they hope the upcoming G7 meeting yield a strong and clear message… against any temptation of protectionist closure.

T+ 3 is history. The SEC voted unanimously on rules to shorten the amount of time it takes for a securities trade to settle from three to two business days. Wall Street and consumer groups are largely supportive of the effort, as it reduces credit and market risk exposure.

Modern technology lets investors make trades in a matter of milliseconds. But since 1993, the SEC’s rules have required brokers to wait for three business days between the time an investor’s order is executed, to when the cash and ownership of the security are exchanged.

Dutch paints and coatings maker Akzo Nobel rejected a second takeover proposal from US rival PPG Industries, saying an improved $24.1 billion offer was still too low and too risky.

AT&T, Verizon, Enterprise Holdings, GSK and other major US advertisers are pulling hundreds of millions of dollars in business from Google and YouTube, following similar moves by advertisers in the UK. The problem is offensive and extremist content. For example, an ad on YouTube for the new Mercedes E-Class ran next to an ISIL video praising jihad that has been viewed more than 115,000 times.

Google pledged this week to keep offensive and extremist content away from ads, but the cleanup can’t happen fast enough. AT&T said that it is halting all ad spending on Google except for search ads. That means AT&T ads will not run on Google’s video service YouTube and on a couple million websites that take part in Google’s ad network.

AT&T emailed a statement saying: “We are deeply concerned that our ads may have appeared alongside YouTube content promoting terrorism and hate. Until Google can ensure this won’t happen again, we are removing our ads from Google’s non-search platforms.”

Financial Review

No Coffee Today

Sinclair Noe — March 21, 2017

Podcast: Play in new window | Download (Duration: 13:15 — 7.6MB)

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DOW – 237 = 20,668
SPX – 29 = 2344
NAS – 107 = 5793
RUT – 37 = 1346
10 Y – .04 = 2.44%
OIL – .72 = 47.50
GOLD + 10.30 = 1245.20

The Treasury yield curve reached its narrowest level since the end of February, a possible indicator that investors are losing faith in the “reflation trade.” Yields started falling last week after the Federal Reserve raised interest rates for the second time in three months.

Typically, such a move would help push rates higher across the curve to better align with the higher baseline rates. However, the Fed’s reluctance to commit to a faster pace of interest-rate hikes, resulting in a short squeeze, which then lured bond bulls back into the debt market.

Long-term rates continued lower over the past two days as congressional Republicans have struggled to secure the support necessary for President Trump’s proposed health-care overhaul bill to make it out of the House of Representatives. A vote on the bill has been set for Thursday. Trump has said that passage of the bill is a prerequisite for tax reform.

These two events have brought into question the underlying assumptions that helped send Treasury yields rocketing higher in the aftermath of Trump’s Nov. 8 electoral victory. The Federal Reserve said they were sticking to guidance for 3 rate hikes, and not including speculation about potential pro-growth fiscal policies, including tax reform and infrastructure spending, throwing shade on Trump’s yet un-released details about his plans for the fiscal overhaul.

The American Health Care Act is not finding public support; per Five-Thirty-Eight the most recent six polls from firms such as Fox News, Morning Consult, and YouGov/CBS News showed that an average of 30% of Americans support the American Health Care Act, while 47% of people surveyed were against it. And health-care reform is undergoing last minute revisions prior to a vote.

Trump went to Capitol Hill this morning to muster support for the bill, but even if it passes the House, it might not clear the Senate. The bill might pass, or not – time will tell, but for today at least, the markets felt uncertainty. No coffee for the closer.

The stock market sold off sharply with many market leaders of the reflation trade lagging. And this is in context of a market that has priced in tax reform, infrastructure spending, and maybe a bit more.

And it follows on the heels of FBI Director Comey’s testimony before a rare open congressional committee hearing. The market ignored the slam at Trump’s credibility, and while the president himself may be Teflon, the market is not when it comes to his policy initiatives.

Earlier today, Bank of America Merrill Lynch released its monthly fund managers’ survey, with a record number saying the market is extremely overvalued, and just 10 percent expecting to see US tax reform passed by Congress before its August recess, as promised by the administration.

Again, a record number of institutional investors say the US equity market is overvalued. Yet at the same time, a net 48% of these managers say they are overweight stocks in their portfolios, meaning they hold more than their benchmarks would require.

If the health care bill passes the House and Senate, and if we see solid details on tax reform, we might still see a rally, but today was a day of uncertainty.

The Dow and the S&P snapped a months’ long streak without a drop of 1% for either index. As investors sold stocks, they snapped up bonds.

The yield on the 10-year Treasury note fell 4.6 basis points to 2.426% on Tuesday, while the yield on the two-year note shed 3.6 basis points to 1.260%, leaving the spread between the two at 1.166 percentage points, the narrowest level since Feb. 28.

The general direction of the yield curve in a given interest-rate environment is typically measured by comparing the yields on the two- and 10-year issues, although the difference between the federal funds rate and the 10-year note are often used as well.

The underlying concept is straightforward. When the difference between yields on short-term bonds and yields on long-term bonds decreases, the yield curve flattens, that is, it appears less steep. A flat yield curve is typically an indication investors and traders are worried about the macroeconomic outlook.

The big losers today were bank stocks, with the XLF ETF that tracks the sector dropping as much as 2.6%. Individual losers in the banking sector were Goldman Sachs, down almost 3%, Bank of America down over 5.5%, and Morgan Stanley, down 4%.

The US current-account deficit, a measure of the nation’s debt to other countries, fell 3.1% to $112.4 billion in the final quarter of 2016, the government said. The drop in the current-account deficit in the fourth quarter was tied to a large increase in primary income — returns on American-owned assets held abroad. That offset a larger trade deficit in goods.

There are a raft of Federal Reserve officials speaking this week. This morning, Fed Bank of New York President William Dudley gave a talk at a forum on banking standards in London, in which he was critical of Wells Fargo but made no mention of monetary policy. Dudley is calling for better incentives to drive performance on Wall Street, while stating banks have “a long way to go” in reforming internal culture.

Google has issued a public apology to major advertisers after their spots were featured alongside YouTube videos carrying homophobic and anti-Semitic messages. It led to Marks & Spencer, HSBC, the BBC, and McDonald’s pulling ad content from Google sites in the UK.

The tech giant is taking a “tougher stance on hateful content” in response, as well as hiring more staff and tightening safeguards in its YouTube Partner Program.

Wal-Mart will launch its first investment arm to expand its e-commerce business in partnership with retail start-ups, venture capitalists and entrepreneurs. Called Store No. 8, the Silicon Valley-based investment team will work with startups that specialize in areas like robotics, virtual and augmented reality, machine learning and artificial intelligence.

Augmented reality is coming to Apple, and the first fruits could be “Matrix-style” 3D photographs that users can move around – and eventually view through AR smartglasses. Meanwhile, Apple unveiled an updated version of its iPad tablet with a brighter screen and a $329 starting price that is the lowest ever for a full-sized tablet from Apple.

Just don’t take it on a plane. The US issued new rules that will prevent passengers from carrying most electronic devices into the cabin during flights from eight countries in the Middle East and Africa. Passengers will have to check in any devices bigger than a smartphone — including iPads, Kindles and laptops — before clearing security or boarding.

Saudi Arabia may extend production cuts if oil supplies stay above the five-year average. New data shows the US rig count growing for a ninth week. US crude output has climbed to 9.1 million barrels a day, the most since February last year. And a Libya official said two major ports are preparing to restart oil exports.

British inflation last month shot past the Bank of England’s 2% target for the first time since the end of 2013, leaping by 2.3% in annual terms. The British government announced yesterday that Prime Minister Theresa May would trigger Article 50 of the Lisbon Treaty on March 29 and initiate the two-year negotiation process for leaving the European Union.

Goldman Sachs will begin moving hundreds of people out of London before any Brexit deal is struck as part of its contingency plans for Britain leaving the European Union. Leading financial firms warned before last year’s June referendum that they would have to move some jobs if there was a leave vote, and have been working on plans for how they would do so for the past several months.

Many banks now believe they will lose “passporting” rights, that let them sell services across the EU from their London hubs. The bulk of Goldman’s European operations are in Britain, where it has around 6,000 employees.

Britain’s high street banks processed nearly $740 million from a money-laundering operation run by Russian criminals with links to the Kremlin and the FSB, per The Guardian. HSBC, RBS, Lloyds and Barclays are among 17 banks based in the UK that are facing questions over what they knew about the international scheme and why they didn’t turn away suspicious money transfers.

Marriott International plans to add up to 300,000 rooms worldwide by 2019, as part of a three-year growth plan, ahead of the No. 1 hotel chain’s investor day. The owner of Ritz-Carlton and St. Regis luxury hotel brands said it would earn $675 million in stabilized fees from hotel rooms added to its system. Earlier this month, Marriott said it would speed up expansion of its Starwood brand in Europe by 2020.

Target’s first fully redesigned shop in Houston will include two separate entrances: one for time-crunched grocery shoppers, and another for those who want to browse fashion or beauty. The company will use the design, which also includes order pickup parking spots, as a starting point for the 500 stores it plans to make over in 2018 and 2019. It’s part of the $7 billion investment Target disclosed last month.

Sears revealed “substantial doubt” about its ability to stay in business in an annual report filed late Tuesday. The company said in the report, “Our historical operating results indicate substantial doubt exists related to the company’s ability to continue as a going concern.”

Sears said its efforts to generate cash by selling or licensing brands like Kenmore and Diehard, as well as selling valuable real estate, should mitigate that doubt and satisfy its estimated cash needs for the next 12 months. But the company said it can’t make any guarantees.

Financial Review

Two Paths Diverge

Sinclair Noe — December 2, 2015

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

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DOW – 158 = 17,729
SPX – 23 = 2079
NAS – 33 = 5123
10 YR YLD + .03 = 2.18
OIL – 1.67 = 40.1
GOLD – 15.60 = 1054.20

American businesses stepped up hiring last month, led by strong gains in retail, finance and other service industries. Payroll processor ADP says that private companies added 217,000 jobs last month, the most in five months. Service sector firms added 204,000, while manufacturers hired just 6,000. The figures come just two days before the government issues its official jobs report for November. If the Friday jobs report is anywhere close to today’s ADP report, it might lock in a rate hike at the Fed FOMC meeting in two weeks.

The productivity of American businesses was higher in the third quarter than initially reported — but so were labor costs. Newly revised government figures show that productivity rose at a 2.2% annual rate instead of 1.6%. Unit-labor costs were revised higher to show a 1.8% annual increase in the third quarter, and second quarter costs were revised higher. As a result, the year-over-year increase in labor costs climbed to a 3% rate, the highest level in six quarters. Unit-labor costs reflect how much it costs a business to produce one unit of output, such as a refrigerator or a ton of steel.

The Fed published their Beige Book, anecdotes on the economy collected from the 12 Fed districts; the information is published two weeks before FOMC policy meetings. There were no surprises in the report; 9 of the 12 districts report growth, the same as the October report. The economy seems to be growing at a moderate or modest pace. Housing markets improved at a moderate pace. Labor markets are starting to show hints of tightening but we’re not there yet. The conditions in the manufacturing sector were mixed; the strong dollar hurts some areas; low commodity prices hurt some areas, especially the energy sector; but low gas prices were helping consumers. Auto sales were strong. You know this stuff.

Federal Reserve Chair Janet Yellen spoke before the Economic Club in Washington DC; tomorrow she testifies before the Congressional Joint Economic Committee. Today Yellen said the economic data of the past couple of months has been consistent with expectations for an improving labor market and she is confident inflation is headed for the Fed’s target in the medium term. Here’s the key quote from Yellen: “Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.”

If it sounds like Yellen has made up her mind about raising interest rates in 2 weeks, you are correct. The only suspense is her ability to herd the cats in the FOMC to something approaching unanimity. And the markets have priced in a rate hike. The next concern is the pace, duration, and amount of hikes. And the answer is slow and steady, and not over 1% by the end of 2016; again, this is priced into markets. The next concern is how the Fed will go about trimming its massive $4.5 trillion balance sheet and how the Fed can nudge banks to trim their excess reserves without triggering inflation. I posed that question today to Charles Plosser, the former President of the Philly Fed, and the answer was very slowly and cautiously because we are in uncharted territory.

Eurozone inflation held steady at a lower-than-expected 0.1% in November, giving further encouragement to ECB president Mario Draghi to pump up the central bank’s bond buying program tomorrow during a policy-setting meeting. In March, the ECB launched a more than €1trillion-euro stimulus plan running through September 2016 in order to snap a long period of low or negative inflation in the region, but given recent economic figures, that program will likely get a boost.

Greek Prime Minister Alexis Tsipras is hopeful that capital controls imposed at the height of the country’s debt crisis in July can be lifted in the first half of 2016. Addressing a conference of the Hellenic-American Chamber of Commerce, Tsipras said his government had taken the first steps to address non-performing loans and recapitalize banks so they could start lending again to the economy.

In the US we are starting to see hints of inflation, the labor market has shown steady, solid improvement, and economic growth is up. So, while you might argue against a rate hike from the Fed, really the idea is not particularly controversial. Now, juxtapose that against the Eurozone; ECB President Mario Draghi talks about the need for more and more stimulus policy. Tomorrow we’ll see if he can get the idea past the Germans or if the weakness of the southern tier defines the day; if not tomorrow, then he’ll push the idea of rate cuts and more bond buying to a future policy meeting. No matter the timetable, the paths for the Fed and the ECB are laid out, and they diverge. What happens in this scenario?

Well we can look to 1994, when the Fed tightened and Germany was cutting rates; remember, this was before the Euro Union. Back then, the dollar slipped; not really a surprise. History is not on the dollar’s side. In the last couple of decades, the dollar index has fallen every time the Federal Reserve has begun a cycle of interest rate hikes. The dollar just hit a 12 year high, so you might wonder if it is a bit overbought.

Certainly the thinking is that a rate hike would strengthen the dollar against its weaker global counterparts, and it might, for a while but the dollar would be susceptible to pullbacks on any sign of weakness or any sign the Fed is tightening too much or too fast. Even with modest and controlled tightening we might expect to see economic recovery in the Eurozone weighing on the dollar, not in the next month or two but over the course of the next year.

The bet on a strong dollar is one of the most crowded trades in the market today, despite the precedent of 1994. Meanwhile, bets on the euro are the most bearish ever. The US won’t stand by for long if the dollar appreciates significantly and its international competitiveness deteriorates substantially. Companies are already reporting earnings pressures due to the rising dollar, and some are even calling it a currency war, and demanding a more forceful response.

Next, watch the debt markets and especially the yield curve, that’s the spread between the 2-year yield and the 10-year yield. Rising interest rates and short-term debt yields could choke growth, while stable or falling long-term yields suggests investors see lower growth and looser monetary policy further ahead. Some think the yield curve could invert, with the yield on the 2-year dropping below the yield on the 10-year note. An inversion is a pretty sure sign of recession, but we’re still a long way from an inverted curve.

Also keep an eye on the spread between US Treasuries and German Bunds; this interest rate differential between risk free bonds has widened, but it can only be stretched so far. And watch the spread between the dollar and the currencies of emerging market countries. Sharp movements in interest rates and exchange rates can cause volatility in other markets. If it gets severe, it can create shocks.

And keep in mind that even if the ECB and the Fed diverge on interest rate policy, this shouldn’t shock anybody, because it would just be an extension of the existing divergence on quantitative policy. The Fed has already ended its bond buying binge known as Quantitative Easing Part 3, or 4, or whatever; just as the ECB started up its own QE. We already have quantitative divergence. Monetary policy divergence is not that different.

The instinctive reaction of many is that this widening gap between central bank policies must lead to a stronger dollar, but clearly it is not that simple. Different economies, different paths. We have some history to guide us, but it still feels like uncharted territory.

U.S. House and Senate negotiators have reached an agreement on a five-year highway bill that would also reauthorize the Export-Import Bank. The $305 billion bill would be partly financed by use of Fed surplus funds and a cut in the dividends received by commercial banks that own the Fed. House Speaker Paul Ryan predicts the bill will enjoy “good majority support” when it comes up for a full vote.

Crude oil supplies rose by 1.6 million barrels in the week ended November 27, according to the American Petroleum Institute, way above expectations for a decline of 1.2 million barrels. The more closely watched Energy Information Administration report came out later in the afternoon and it showed a buildup of crude supplies and a deepening global glut. Oil prices dipped below $40 a barrel for the first time since August.  The nation’s commercial stockpiles of crude oil, gasoline, diesel and other fuels last week soared above 1.3 billion barrels, a fresh record, according to the Energy Information Administration. Crude-oil stockpiles alone rose for the 10th week in a row, bucking expectations for a decline. OPEC is meeting in Vienna on Friday and there is talk of production cuts to support prices, but for now it looks like the world’s producers are pumping like crazy.

And finally, late news coming in of another mass shooting, this time in San Bernardino. The latest, unofficial tally is 14 dead and 14 injured. A manhunt is underway for three shooters; the suspects were heavily armed and possibly wearing body armor, and a bomb squad was on the scene, trying to defuse what was believed to be an explosive device. It seems like we hear these stories all the time these days. Whatever we are doing, it isn’t working.

Wednesday, May 28, 2014 - Reflecting the Economy

Financial Review with Sinclair Noe

DOW – 42 = 16,633
SPX – 2 = 1909
NAS – 11 = 4225
10 YR YLD - .08 = 2.43%
OIL – 1.03 = 103.08
GOLD = 4.70 = 1259.60
SILV - .01 = 19.13

The major stock market indices were lower, but it wasn’t a big move, and we’ve been 4 up days, so today’s pullback was nothing but a pause. What was interesting today was the move in the bond market. The yield on the 10 year treasury dropped all the way to 2.43%; that’s the lowest rate in almost a year. The 10 year treasury has dropped 22 basis points this month, meaning treasuries are on track for the best month since January. Now, remember that the Federal Reserve is supposed to be tapering, cutting back on large scale purchases of treasury bonds.  

What’s fueling the move? It’s hard to pinpoint one thing. Europe is facing some sort of monetary stimulus package from the ECB next week; meanwhile, a report showed German unemployment rose and that pushed yields on the 10 year bund to 1.28%; that trade then spilled over to the US markets, toss in end of month window dressing and there was likely a short squeeze. There are some big short positions on treasuries right now; more shorts than longs.

At the end of the day, the bond market is supposed to reflect the economy; not an exact image but rather a mirror image. And the US economy is probably not as strong as expected. Tomorrow, we’ll get a revised look at first quarter GDP. The initial estimate on GDP showed just 0.1% growth; a pathetic rate blamed on bad weather; the revision is expected to show the economy contracted by 0.6%, maybe worse. Since the recession ended in June 2009, US GDP growth has dipped into the red only once: the first quarter of 2011, when economic output contracted at a 1.3% rate. It appears likely to happen again. The economy was repeatedly disrupted by cold and snowy weather in the first quarter and much of the activity that did not take place then is occurring now during the warmer spring months. Wall Street expects second-quarter growth to snap back with a 3.8% gain.

But where will the springtime burst of growth come from? Exports? Not to Europe and not to emerging markets. The initial GDP report said net exports subtracted 0.83 percentage point from the GDP growth rate in the first quarter. It may be a bigger drag on growth in Thursday’s update. Construction? A bit, yes, but we continue to see the housing market looking soft. Construction lending is seeing a slow, steady recovery, but it remains 66% below its boom-era peak of $631 billion in outstanding loans in early 2008. Companies restocking their shelves? Not likely. Inventories subtracted 0.57 percentage point from GDP growth, according to the first estimate, and that could grow with this week’s revision; inventories remain high and consumer spending sluggish. Corporate profits? Yes sir that is an area of strength but it’s also a two-edged sword.

The Commerce Department is starting to release a new report on corporate profits. Pretax profits adjusted for depreciation and the value of inventories climbed 1.9% in the fourth quarter to a record $2.13 trillion on a annualized basis. Corporate profits as a percentage of GDP stood at 10.2% in the fourth quarter, just a touch below a record high. Corporate profits are now higher than they’ve ever been before.

Here’s the problem; whenever profit margins reach a high, they tend to peak and then rollover, with the stock market and the economy dragging behind in like manner. It’s tough to keep pumping out record profits, in part because profit margins often depend on cost cutting, not just revenue; there are limits to how much fat a company can trim and there are limits to how much a company can increase sales while simultaneously cutting back on R&D and capital expenditures. Right now, stocks are priced to reflect very high corporate profits. Any disappointment would shake that pricing structure and translate into big stock market losses.

Like any individual indicator, this is not an absolute. Corporate profit margins can remain at elevated levels anywhere from a single quarter to multiple years and don’t typically present an imminent warning threat to the stock market or economy until forming a major peak and sudden decline. Profit margins peak on average before the stock market by more than a year and before recessions by more than two years. It doesn’t work out this way all the time; in the early 70’s profits peaked with the market, and in the early 80’s profits peaked after the stock market, and it is possible that the lag time stretches out so far as to make the indicator more or less worthless.

The point is that there are other factors that must be considered. Think of profits as one measurement of the business cycle. So, despite the Fed taper, there is increasing likelihood that interest rates will remain low and possibly decline a bit; if rates decline, stocks are likely to move up with bonds, as we’ve seen can happen; and if falling long-term yields flatten the yield curve, that would increase the risk of a market crash. In a low-yield, low inflation environment, there is a good opportunity to grow profits and so those crashes tend to be preceded by periods of very strong returns. So the current bull market is likely to remain in place until inflation picks up or low-flation/deflation drags down profits.

Falling yields tend to be somewhat more bullish than bearish, but it’s a poor indicator for how the stock market will react. Falling yields are good especially when we are in a bull market, but they can be dangerous if they should drive down the yield curve spread to an unusually low level and then there is the lag effect I mentioned earlier. When the long end of the yield curve comes down that is good for stocks for a while; it can even result in parabolic increases in the short term, but it also indicates bad news for the broader economy, and eventually the bill comes due.

Yesterday we talked about the proposed new EPA regulations on coal fired power plants. Today we’ll talk about the backlash to those proposals; which, by the way, have not been officially proposed yet. It’s anticipated that the new EPA guidelines will try to reduce the percentage of US electricity generated by coal to 14% by 2030 from about 37% right now. Coal is the single biggest source of electricity generation in the US and has been for more than 60 years. The amount of electricity generated by natural gas would rise to 46% by 2030 from about 30% now under the EPA plan. That would make it the biggest generator of the nation’s electricity.

Meanwhile, opponents of the plan say it will increase the cost of electricity and cost jobs. The US Chamber of Commerce released a study showing it would cost the economy $50 billion a year and destroy a quarter million jobs. Sometimes they just pull numbers out of the air; these reports tend to overlook the externalities associated with a dirty fuel like coal, and also overlook the positive impact of cleaner fuels. Anyway, the mudslinging has started.

And a follow-up on the Detroit bankruptcy story. A task force has issued the most detailed study yet of blight in Detroit and recommended that the city spend at least $850 million to quickly tear down about 40,000 dilapidated buildings, demolish or restore tens of thousands more, and clear thousands of trash-packed lots. It also said that the hulking remains of factories that dot Detroit, crumbling reminders of the city’s manufacturing prowess, must be salvaged or demolished, which could cost as much as $1 billion more.

If carried out, the recommendations by the Detroit Blight Removal Task Force would drastically alter the face of the nation’s largest bankrupt city. They would also cost significantly more than the approximately $450 million that the city already plans to spend on blight, raising questions about the feasibility of the vast cleanup effort, which is part of its larger campaign to emerge from bankruptcy by fall and begin remaking itself.

The blight study, which is perhaps the most elaborate survey of decay conducted in any large America city, found that 30% of buildings, or 78,506 of them, scattered across the city’s 139 square miles, are dilapidated or heading that way. It found that 114,000 parcels — about 30% of the city’s total — are vacant. And it found that more than 90% of publicly held parcels are blighted. The report also made several recommendations for preventing blight in the future, including changes to property tax and foreclosure laws, and heavy fines for scrap metal theft.

The basic plan is to clean up the city, but nobody really knows how to go about the task. Do you clean up by tearing down or do you clean up by building or rebuilding? For years, some have contemplated consolidating some of the city’s neighborhoods to allow the city to provide services to a smaller area, more suited to its shrunken population; Detroit has gone from 1.8 million to about 800,000. And if they don’t get this right this time, it will likely revert to farmland.