The Central Bank Trifecta
From the March 13, 2016 HRA Journal: Issue 248
Another PDAC and Subscriber Summit down and resource stocks –so far—are relatively unscathed. The remaining central bank meetings during the next week will set the tone at least until the next earnings season starts in a month.
Mario Draghi will be a tough act to follow for other central bank heads. He went out of his way not to disappoint this time. The markets are pricing in a dovish duet by Janet Yellen. Probably a correct read but this would be a good time for the Fed to raise rates if they really want to do it. It might be worth waiting to see how that turns out. A hawkish stance would be something of a surprise and an actual rate increase would be a shock to the markets.
The SPX has traded back up to just below the levels of the shallow downtrend that has been in place since last May. Sentiment has turned bullish again very rapidly though bullish traders seemed hard pressed to give a reason for their optimism. Maybe we see new highs on the SPX but I doubt it. There is little reason to expect an abrupt reversal of the trend of falling earnings. If NY is going to press for new highs it should happen before Q1 earnings start to roll out next month. That is asking a lot of a rally that has been largely oil and short covering so far.
Whichever way NY goes it feels like gold is back. Let’s be happy about that, not sweat the small stuff, and look for new trades.
You’ve read my thoughts on how different markets would pan out this year, followed by an editorial mainly focused on the gold market and how the actions of central bankers in particular have been affecting it.
Those ideas will be put to the test through the next week or so. The world’s three major central banks, the European Central Bank, the Bank of Japan and the US Federal Reserve all have policy setting meetings this month. The ECB’s was just completed and the BoJ and Fed are both up this week, with the BoJ on Tuesday and the Fed on Wednesday. Central bank actions and, more importantly, market reactions to those actions, will be a major determinant of the near term direction of currency, debt, equity and commodity markets.
The policy actions just announced by the ECB are an excellent case in point. You can’t fault Mario Draghi for bluffing this time. There were very few central bank policy tools he didn’t draw on. He expanded the QE program and the list of assets it can buy and cut virtually every interest rate the ECB controls at least a little. Several commentators described it, with some truth, as Draghi “hitting the panic button”.
Traders initially played along, selling the Euro for about 45 minutes. It ended when Draghi said in his follow up news conference that he didn’t see rates going much lower. Not a shocking admission from someone who had just cut rates to zero or less and pulled every policy lever. This was meant to be a bracing comment to instill confidence in traders. Not so much. The market didn’t hear “the worst should be over”, it heard “no more ECB puts after today”.
Draghi went much farther than expected installing new stimulus but traders still bid up the Euro. The chart above tells the story. If the latest move in the Euro looks familiar, it should. It’s similar to what happened after the last two ECB meetings. This time at least the Euro dropped before the furious short covering set in and generated yet another 3% lift. There was some pullback after traders thought about the ECB’s moves for a day and decided they were positive after all. The ECBs actions “worked”, at least in the sense most traders care about. Major equity markets extended their rallies. We’ll have to see how things go through the next week as the other two major central banks have their turn at bat and traders contemplate the future, post-meetings.
The Bank of Japan is up next. Expectations are low for the BoJ after it made some of the most dramatic moves in recent months. Kuroda is probably even more intent on getting his currency down than Drahi but has even less chance. In the surreal markets we’re in the forward swap spread on a Dollar-Yen contract allows for a profitable buy Yen-buy Japanese Government Bond (JGB) trade. Even though JGBs have a negative yield foreign buyers are setting up trades where the combination of bond yield and locked in currency gains when the trade is closed out generates a 1% combined yield. There has been massive buying which puts a bid under the Yen the BoJ doesn’t want. Since the BoJ itself represents 70 to 80 percent of the buying in the JGB market (in order to keep yields down) I have no clue how Kuroda gets out of this corner. Neither does he I suspect so I think the B0J will sit tight for a while.
The Big Dog – the US Fed – is the last of the three and the most influential. Markets expect nothing new this meeting. As markets have rallied through the past month bond yields have slowly crept up as well. Although bond traders are still dismissive of the Fed’s guidance they are pricing bonds to reflect increasing odds of another rate hike this year. Current betting is for another 25 basis points in June. Personally, I think the odds of a rate hike at the March meeting are higher than what the market is pricing in. To be clear, I don’t expect an immediate hike. I don’t think the Fed has the guts to do it and the recent ECB moves give them a good excuse to hang back. That said, if the Fed really DID base its decisions on just “data” there was enough strength to justify a move based on good payroll numbers and rising inflation readings.
If the Fed does pull the trigger it should generate the consolidation gold traders are looking for – maybe. A more likely outcome would be a large dive in equity markets, something Fed governors clearly fear. I don’t think hiking rates would be smart. I’m just noting that, based on the metrics the Fed claims to follow, it’s time for another hike.
The fourth central bank most watch these days, China’s, doesn’t have an immediate meeting scheduled. There were comments from its head as this editorial was being completed however, stating the BoC wasn’t targeting more stimulus in the near term. That might disappoint traders who have expected it based on worsening economic readings. On the “bright” side, the new head of China’s securities regulator did assure trades that government backed funds would be buying the market if is weakened too much. Hilarious and refreshingly honest. You can’t make this stuff up.
A look at the US Dollar index gives the counter view of the “Draghi effect”. You can clearly see the three strong down moves following the recent ECB meetings. The most recent one is a bit surprising as the ECB didn’t really disappoint and equity markets responded, albeit on a slightly delayed basis. Some of this is due to movements based on the actual, rather than nominal, yield differentials (as per my comments on JGBs above) and some is “risk on” traders backing out of insurance trades that involve buying the USD. I hope it’s not traders assuming a Fed rate increase is less and less likely. Unless and until we see the equities rollover I still expect the odds of a rate increase are actually higher than they were last month. Note that the moves down in the USD are support for commodities in general, not just gold. Base metals and oil have definitely benefited from that move.
That brings us to the gold market which is what most of you really want to hear about. I placed the gold chart right below the $USD using the same scale for a reason. Looking at the two charts brings home the point that the short term correlation with the USD moved around a lot but, generally, indicated strength in gold regardless of the USDs short term movements. I think that is a good thing as it reinforces the point that gold has been showing relative strength against just about everything. Gold is trading more “on its own” lately, showing little direct impact from recent USD rallies or drops –so far at least. It’s worth noting, and a welcome change, that gold is by far the best performing asset class on a YoY basis right now.
Q2 is not usually a good one for gold. It’s common to see the price drift lower as we head through spring. Gold watchers are worried, and justifiably so, that gold will repeat the pattern of the last two years when it had strong rallies in the first two months of the year just to fade, and fade and… That’s a valid point of concern though this rally IS different than the last two. Gold has now reached new 52 week highs by a wide margin, something it couldn’t accomplish early in 2014 or 2015. The rally has come on significantly higher buying volume than the last two and the price has eclipsed several downtrend lines which it also didn’t do the last two times. I think this is the real deal and a new gold bull market is underway.
Whatever the BoJ and Fed may do this week the list of negative yield government bonds continues to broaden. Negative interest rates remove the main underpinning of the bearish argument for gold. Holding costs aren’t much of an issue any more. As long as that situation prevails there will be an underlying bid for the yellow metal.
All that said, the rise has been very steep and some consolidation, even if it’s only sideways movement that reduces the overbought condition of the market, is in order. It’s comforting to see gold holding up so well when many of factors that worked against it in a bear market are still against it. Clearly, many traders have decided it’s time to have exposure to gold and gold stocks again.
Strong upward moves in base metals and oil are more of a conundrum for me given their pro-cyclical nature. I expected most to bottom this year but didn’t think it would happen this fast. A lot of the oil rally has been covering of massive short positions. Plenty of traders have a bullish longer term view of oil (which I agree with) and seem to fear missing the bottom. There has been some drop off in US production but not enough to make a dent in inventory levels which are still building. Bullish sentiment may simply overwhelm everything else but, if it leads to new money flowing into the US oil sector it could be counter-productive short term.
Several major US producers, including the largest frackers, are assuring shareholders they have their costs down to $40/bbl or less. They are also promising to turn on the taps if the rally carries prices for WTI much above $40 and a few of them have completed large dilutive financings. If producers make good on those promises we’re likely to see oil prices come down again. Maybe not to the recent $27 low but low enough to do some damage to major equity indices.
Base metals seem to generally be following oil. There has been some supply destruction and some traders at least appear to be setting up “reflation” trades. Again, something that will have its day. I’m not sure that day is today but I expect lower lows in NY and several other global equity indices and admit this is colouring my thinking. Copper seems like the best bet, as I noted in the 2016 preview, but I expected improvement coming out of an equities dip, not ahead of it. I’m surprised by the level of buying out of China which I think is partially traders making a Yuan trade. If the Yuan is devalued, copper in inventory would be repriced to reflect the new exchange rate, effectively making copper a way to “short the Yuan”. That’s the only explanation I can think of to for the level of buying in Shanghai which has become the centre of the world’s copper trade. LME copper inventories are near their five year lows but those in Shanghai are now at 350,000 tonnes, almost twice the LME level. I’m not bearish on copper or other base metals per se but don’t be surprised if all of them drift down in the next few months before staging the real recovery.
The Fed meeting will have a big impact on overall market sentiment. Currently, it’s very, very positive, for reasons that elude me. The rally we’ve seen in NY in the past month has market strategists bullish again and overbought and sentiment readings have vastly improved. So far so good, but pretty much what we saw in October-November. Most then were convinced we were about to see new highs on the SPX, and I’m seeing the same comments again.
I’m not going to spend a lot of time on the SPX this issue other than to reiterate earlier comments. We’re still within the longer term down trend and I still think we see a 20% plus drop from last May’s highs before we see new highs on the index.
That view is not based on technicals or sentiment; it’s based on earnings, the measure that ultimately values markets longer term. The first chart below portrays the current and predicted quarterly earnings changes by Wall St analysts. Impressed by the surge in earnings predicted for later this year? Don’t be. Wall St investment bankers decide where they think the SPX will be a year out then reverse engineer earnings estimates to match the projections. The crappier the current earnings are, the bigger the later surge has to be to “match” the estimates for the year end level of the SPX. As you can see from the chart, current earnings are plenty crappy. If you had looked at a similar chart a year ago it would have shown a projected increase in earnings of 20-30% for the current quarter. We know how well that worked out.
The lower chart from Bianco Research is the most important. This very long term chart compares quarterly earnings to recessionary periods. If we avoid a bear market and mild recession after the earnings declines for two (now three) consecutive quarters it will be the first time in sixty four years that has happened.
Bulls will pounce on the fact that there were five instances of two quarters of earnings declines that were not associated with recessions. True, but those earnings drops were all smaller than the current one and ALL were associated with eras of substantial, aggressive monetary easing by the US Fed that helped the economy dodge the bullet. Ball’s in your court, Ms. Yellen.
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