It's approaching that time of year when traders and central bankers alike
depart for long holidays. But this summer is shaping up to be anything but
quiet for markets, with betting on a "Greek Exit" from the Euro roiling markets,
and Red-chip stocks in China nose diving and requiring unprecedented "Plunge
Protection Team" intervention in order to halt the onslaught. After a few weeks
of turmoil, the Greek debt crisis has been kicked down the road for another
few years, with another EU bailout, and after the Shanghai red-chip index,
staged a +10% rebound from its panic bottom lows hit on July 7th, traders now
regard these sideshows as "fixed" and under the control of their central planners.
With these worries can be put on the back burner for now, it's back to business
as usual, - that is to say, back to investing in heavily manipulated markets,
in which extreme emergency policies, such as NIRP, ZIRP, and QE have distorted
the pricing of virtually all assets, and where your local central bank has
your back.
However, with the Federal Reserve poised to hike short-term interest rates
for the first time in nearly a decade, "The actual raising of policy rates
could trigger further bouts of volatility, but my best estimate is that the
normalization of our policy should prove manageable," said the Fed's "Shadow" chief
Stanley on May 26th. Fischer gave no time frame for when the Fed will start
its first tightening cycle since 2004-06, but he made it clear that higher
rates are coming. Still, he warns, communications can be a "tricky business," and
when the Fed does tighten, policymakers are bracing for spillovers to financial
markets both at home and abroad. "Some of the world's more vulnerable economies
may find the road to normalization somewhat bumpier," he added.
The key question hanging over the markets, in general, is whether the Federal
Reserve and its Anglo sidekick, the Bank of England <BoE>, will finally
begin to hike their short-term interest rates in the months ahead. On June
28th, the Bank for International Settlements, <BIS>, based in Basel,
Switzerland, which is an adviser for global central banks, called on the world's
top central banks to start normalizing monetary policy, - either by raising
interest rates, or shutting down the printing presses under the guise of "Quantitative
Easing," <QE>, and the sooner the better.
"By keeping rates anchored at these historic, ultra-low levels threatens to
inflict serious damage on the financial system and exacerbate market volatility,
as well as limiting policymakers' response to the next recession when it comes," the
BIS warned. "Risk-taking in financial markets has gone on for too long. And
the illusion that markets will remain highly liquid has been too pervasive.
The likelihood of turbulence will increase further if current extraordinary
conditions are spun out. The more one stretches an elastic band, the more violently
it snaps back," (like the recent experience in the Chinese stock markets),
warned Claudio Borio, head of the BIS's Monetary and Economic Department.
"Cheap money encourages more debt and creates financial booms and busts that
leave lasting scars on the economy. They underpin both the potentially harmful
high risk-taking in financial markets, while subduing risk-taking in the real
economy, where investment is badly needed. And while increases in interest
rates could cause stock prices to fall, - the likelihood of turmoil is only
increased by waiting," the BIS warned. It advises that monetary policy should
be normalized with a firm and steady hand. "Near-zero interest rates could
become chronic in the world's major economies unless "a firm hand is used to
raise them back to more normal levels." "More weight should now be attached
to the risks of normalizing too late, and too gradually," the BIS warned. "Restoring
more normal conditions will also be essential for facing the next recession,
which will no doubt materialize at some point. Of what use is a gun with no
bullets left?" the BIS report said.
However, the BIS has routinely made such dire warnings over the past few years,
and the major central banks have routinely ignored them. In fact, the Bank
of Japan <BoJ> and the European Central Bank <ECB>, are engaged
in a full blown currency war over the fate of the Euro /yen exchange rate.
Both central banks are printing about $70-billion worth of Euros and yen, and
flooding the markets with ultra-cheap liquidity, that is keeping long-term
bond yields artificially low, and stock markets artificially high. Neither
the BoJ nor the ECB have any plan to roll back the QE-liquidity injections,
anytime soon.
US$ wins the Reverse beauty Contest; Moreover, the monetary policies of the
big-4 central banks will soon be moving further out of sync. The Fed began
to taper its $80-billion per month QE-3 injections back in January 2014, and
finally mothballed it on October 31st, 2014. The Bank of England spent £375
billion on purchasing British Gilts and mothballed its QE-injections in Nov
12. And according to recent leaks to the media, both the BoE and the Fed are
preparing to follow the advice of the BIS, and will be the first of the G-7
central banks to hike their short term interest rates, in the months ahead.
On the other hand, the global markets will be swimming in a sea of liquidity,
as the Bank of Japan <BoJ> and the European Central Bank <ECB> have
both reaffirmed this week, that they will continue injecting a combined $140-billion
worth of Euros and yen into the world's money markets in the year ahead. The
BoJ is continuing its QQE injections at a rate of ¥6.5-trillion per month,
and the ECB is continuing with its first ever QE-1 scheme at a clip of €60-billion
per month until the end of Sept '16, despite opposition from Germany's Bundesbank.
Together with funneling cheap 4-year, loans to banks, the ECB's Q€-1 scheme
will inject more than €1.1-trillion into the money markets. Currency Carry
traders' eyes are fixated on ECB chief Mario Draghi and the BoJ chief Haruhiko
Kuroda who carry around the big bazooka.
A weaker Euro, and a weaker Japanese yen, is precisely what ECB chief Mario
Draghi and BoJ chief Haruhiko Kuroda want. It makes local exports to other
currency areas cheaper, thereby increasing the competitiveness of German, French,
and Japanese Multi-Nationals. At the same time, it increases the price of imports,
thus, reducing the threat of deflation at home. If the Euro and yen hadn't
declined so dramatically in the past year, their cost per liter of diesel would
be -20% less than it is today.
Thus, with full blown QE-schemes underway in the Euro-zone and Japan, and
the BoE and the Fed having kicked the QE-addiction, -- the net result was a
sharp increase in the value of the US$ index, measured against a basket of
six currencies, climbing +20% higher from a year ago, and at one point reaching
the psychological 100-level, its highest in 13-years. Behind the rise, the
US$ rose from around ¥101.50 to as high as ¥125.50, while the Euro
fell from as high as $1.3650 to as low as $1.0400. With the #1 and #2 Fed officials
going on record, and hinting they will comply with the wishes of the BIS, with
a few baby-step rate hikes in the months ahead, the US$ index is comfortably
perched in the zone with support at the 94-level and resistance at the 100-area.
Meanwhile, 1- British pound now buys €1.434 - it's highest exchange rate
in 7-½ years. That is +24% more than the €1.1350 the pound could
fetch this time two years ago. If the ECB ends up maintaining its QE program
thru Sept '16's scheduled end, the upside target for the pound could be €1.50.
Stronger US$ crushes Commodities; While the US$ was displaying extraordinary
strength, and reaching for the 100-level, most of the commodities traded on
international exchanges were taking a beating: precious metals, industrial
metals, grains, softs, you name it, -were hard hit. In large part, this was
a case of a stronger US$ steamrolling the commodity markets. And it was also
a matter of oversupply of crude oil due to record US-shale oil production,
and a significant slowdown in China's economy. After almost a decade of growing
at about +10% / year, the Chinese economy has slowed to +7% per year according
to official statistics, and many private economists estimate China's economic
growth rate has slowed to +5% to +6% annually, the slowest rate recorded since
1990.
China literally props up demand for most of the raw materials that are shipped
across the high seas, but especially iron ore, coking and thermal coal, natural
rubber, steel and copper, which defined the boom years that were known as the "commodity
super-cycle". Across the board, from industrial metals, natural gas, grains,
through to cotton, sugar, and crude oil, prices fell sharply. At its nadir,
in March '15 the Continuous Commodity Index, a basket of 17-equally weighted
commodities, nearly fell to the 400-level, and was trading -27% lower compared
with a year earlier.
At various times during Q'1 of 2015, the price of Gold had fallen to as low
as $1,140 /oz, and was trading -15% lower compared with a year earlier, Silver
was down -27%, Copper was off -27% and Iron ore plunged to a 5-year low at
$47 /ton, and -60% lower than a year earlier. Few were hit as hard as crude
oil prices, with North Sea Brent skidding to as low as $46 /barrel, or -56%
lower than a year earlier. The pain was felt across other commodity sectors.
Coffee fell to as low as $1.28 /pound, or -33% lower, and Sugar got slammed
to $12 /pound, or -36% lower than a year earlier. Corn fell to $3.70 /bushel,
or -24% lower, and Soybeans fell below $10 /bushel, or -30% lower than a year
earlier. But that was only part of the story. Losses were even bigger when
including the total decline most of these classes of commodities suffered from
their peaks, generally reached in the spring of 2011.
In turn, the 4-year Bear slide across the commodity sector, especially the
Crash in Crude Oil, was noticed by traders in the longer-term bond markets.
The yield on the US Treasury's benchmark 10-year T-note fell to below 2%, and
hit low at 1.65% on the last day of January. Britain's 10-year Gilt yield tumbled
to a historic low of 1.50%, and Germany's 10-year Bund yield nearly fell to
zero percent, a few months later. By mid-April, a stunning 53% of all G-7 government
debt was yielding 1% or less.
The sharp drop in energy prices depressed the Euro zone's consumer prices
to levels last seen during the global financial crisis, with only tiny Malta
and Austria escaping deflation. On an annual basis, prices in the 19 countries
using the Euro were -0.6% lower than a year earlier, the EU's statistics office
Eurostat said. Deflation was deepest in Greece in January, followed by Spain,
while almost all Euro-zone countries had negative inflation rates. As such,
the ECB began its Q€-1 scheme, and in anticipation of QE-1, many bond
traders were front running the ECB, - and had driven a stunning €2.2-trillion
of European notes to below zero percent (mostly German and French notes). By
early April '15, all of Germany's debt with a maturity of 7.5-years or less,
was yielding less than zero percent.
Bursting of Global Bond Bubble, Starts in Germany, On April 29th, "mystery" sellers
began dumping the German 10-year Bund futures, and by the end of the day, the
value of entire Euro-zone bond market had lost €55-billion ($76 billion)
in a single day. It was the beginning of a revolt by bond traders against negative
interest rates in Europe. In the eye of the storm, was Bill Gross the bond
guru, - he hit a raw nerve that rattled the QE front runners, by going as far
as to call the 10-year benchmark German Bund "the short of a lifetime" in a
Tweet on April 30th. Double-Line Capital's Jeffrey Gundlach jumped on board,
saying he would lever up "100 times" and make a bearish bet against German
Bunds. Later that day, Germany experienced a failed auction, it only received €3.65-billion
of bids at the five-year note auction, short of its €4-billion sales goal.
Adding to the supply pressure, Italy auctioned €8.25-billion of debt,
while Portugal sold €2.5-billion of 10-year and 30-year bonds via banks.
As fate would have, the bearish remarks by Mr Gross and Gundlach were just
some of the triggers that ignited a mini rout in the German Bund market. A
resilient $20 /barrel rebound in crude oil prices was also a key factor that
enabled the Bund vigilantes to engineer a sudden and sharp sell-off in top-rated,
low-yielding bonds in Frankfurt, and the ripple effects were felt in the bond
markets of England, Australia, Canada, Korea, and the US, among other places.
At the epicenter of the rapid slide in bond prices was the 10-year German Bund
- its yield more than quadrupled to 0.60% in just five days, erasing all the
price gains made this year. Investors in longer dated 30-year German Bunds
suffered bigger losses of -20% from the bubble peak highs, as its yield ratcheted
+100-bps higher to 1.40%, and signaled the passing of the deflation scare.
Specific triggers for the downturn in May are hard to identify, but the sudden
emergence of "reflation" trades in bonds partly reflected the notion that the
ECB's QE-1 scheme was starting to work far more quickly than even optimists
dared hope. Not only have Euro inflation rates stopped contracting, but private
sector bank lending is expanding again for the first time in years, the Euro's
M3 money supply growth has turned positive.
Fed says on Course to hike fed funds rate this year; The markets' attention
now turns squarely on the Fed and the Bank of England, the two central banks
that are expected to follow the BIS's words of advice, by bumping up short
term interest rates in the months ahead. On June 17th, the Fed published its "forward
guidance' report, dubbed the "Dots Plot," which suggests the US's fed-funds
rate, now at 0.125%, will end up at 0.625% by the end of 2015 and at 3.75%
in the "longer run." The Dot Plot graph is essentially a compilation of interest-rate
estimates of the Fed's top 17 officials, with each dot representing one forecaster.
Fifteen of the 17 predict a rate hike before year-end, but none of the Fed
policymakers expect the fed funds rate to hit the 1% mark.
According to a Bloomberg poll of 51-economists, the first Fed rate hike would
take place in September. Already, the yield on the US's 10-year T-Note has
turned upwards by as much as +85-basis points to as high as 2.50%, where it
has temporarily met resistance. "The chances are about 50-50 that the US-economy
will improve enough for the Fed to raise interest rates in September," said
Fed Governor Jerome Powell, on June 23rd, who also expects the Fed to hike
rates again in December. And yet according to the betting on the federal funds
futures markets in Chicago, traders don't expect to see a Fed rate hike in
September, and the earliest date for a rate hike is November or December, and
it would be limited to +12.5-basis points to 0.25%. There is a 50% chance of
a +25-bps Fed rate hike to 0.375% by year's end, according to futures traders,
or a quarter-point less than the "Dots Plot" projection.
Speaking at a meeting of central bankers at England's Oxford University, the
Fed's Shadow chief, Stanley Fischer repeated his warning about the Fed's first
rate hike in nine years. He did not directly address the timing of historic
event, but emphasized that the central bank should stay ahead of the (inflation)
curve, since monetary policy only affects the economy with a time lag. "We
should not wait until we have reached our objectives to begin adjusting policy.
In order to minimize the likelihood of surprises and thus avoid creating unnecessary
market and policy volatility, we are striving to communicate our policy strategy
clearly and transparently," Fischer said.
On July 15th, Fed chief Janet Yellen reiterated for a third time that economic
conditions favor a hike in the federal funds rate later this year, during her
semi-annual policy report to Congress, Yellen said signs of economic sluggishness
in the first quarter were the result of transitory factors, including unusually
severe winter weather and labor disruptions at West Coast ports. However, "if
the economy evolves as we expect, economic conditions likely would make it
appropriate at some point this year to raise the federal funds rate target,
thereby beginning to normalize the stance of monetary policy," she said. As
if to emphasize her warning, Yellen added, "If we wait longer to raise rates,
it certainly could mean that when we begin to raise rates we might have to
do so more rapidly. So there's an advantage to beginning a little bit earlier
so that we might have a more gradual path of rate increases," she explained.
The risk of waiting too long to raise interest rates, in the US-markets, refers
to the risk of seeing unsustainable bubbles inflated in the US-equity markets.
St Louis Fed chief James Bullard warned "a prolonged accommodative stance is
a "recipe for asset- price bubbles and a lot of mischief to happen," he told
Bloomberg Radio. "Asset price bubbles have been a devastating feature for the
US-economy in the last 15-years." Bullard's "base case" is for a rate increase
this year. "We need to get going once we have the opportunity to get going," Bullard
said. "The economy is getting back to normal, but policy is still on an emergency
setting." The problem is however, the dovish Yellen /Bernanke Fed has lost
so much credibility, that nobody believes them, even when they are speaking
the truth.
Bank of England chief Signals hike in Base rate; Perhaps the clearest signal
that the Fed is not bluffing about raising the federal funds rate later this
year, were surprising comments by the Bank of England chief Mark Carney, relayed
to the media on July 14th. Carney, said the time table for the BoE's first
rate hike is moving closer, even though the latest batch of data showed the
UK's inflation rate running at zero percent and the ranks of the jobless had
unexpectedly edged up in the three months to May, the first increase in more
than two years. Like the Fed, the BoE has pegged its base lending rates at
a record low (0.50%) for more than six years, but now, the two central banks
seem to be moving in lockstep, and heeding the call of the BIS, to hike their
interest rates in the months ahead.
Speaking to British lawmakers on July 14th , Carney said households should
start to prepare for higher borrowing costs. "The point at which interest rates
may begin to rise is moving closer with the performance of the economy," he
told parliament's Treasury Committee. Carney's hawkish comments were clearly
unexpected and caught the foreign currency market off-guard. Carney pointed
to the strength of the recovery - the UK was the fastest growing major economy
in the developed world last year - as well as record levels of employment and
rising wages. But he said any increases in interest rates are likely to be
'at a gradual pace and to a limited extent' - with rates remaining below the
5% level typically seen in tightening cycles before the financial crisis. 'I
do think there are a variety of factors that mean that the new normal, certainly
over the next three years, is substantially lower than it was previously,'
said Carney.
Brushing off his reputation as a dove, outgoing BoE rate setter, David Miles
said the case for hiking interest rates was stronger than at any time since
he joined the bank in 2009, raise the possibility that August's meeting could
a close vote among the nine BoE rate setters. Fellow BoE member Martin Weale
has also suggested he will vote to raise rates soon. Miles said "waiting too
long to start a gentle amble to higher interest rates would be a bad mistake," while
emphasizing that sharp rises in borrowing costs should be avoided. "Given that
many of the after-effects of the mess of 2008 do seem to have faded, I think
a first move up in Bank Rate soon is likely to be right. I do not attach great
weight to the idea that starting this process will create great risks of dropping
back into very weak growth, falling into negative inflation and engendering
a splurge in risk-avoiding behavior," he added.
In London, sterling Libor futures traders are taking the hawkish rhetoric
in stride, and are rather complacent, by pricing in the likelihood of a mini
series of baby step rate hikes later this year. The BoE is likely to hike its
base rate +12.5-bps to 0.625% in September and another +12.5-bps increase to
0.75% in December '15. The yield on the 10-year British Gilt has already rebounded
into a range between 1.95% and 2.20%, - up +60-bps from the level where it
traded in early April. And thus, a half- point increase in the BoE's base rate
to 1% has already been fully discounted in the Gilt market.
Nowadays, the BoE is putting more weight on workers' earnings, which are central
to the BoE's thinking about when to raise interest rates. Total average weekly
earnings in the 3-months thru May, including bonuses, rose by +3.2% compared
with the same period a year earlier, up from +2.7% in the three months to April.
It was the biggest increase in total pay over a three-month period since April
2010, the ONS said. Excluding bonuses, pay rose by +2.8%, the biggest increase
in more than six years.
Other reasons that the UK Treasury chief might give the BoE the political "green
light" to begin lifting its base lending rate, includes a healthy housing market
that is spreading to all areas of the UK. The Council of Mortgage Lenders,
which represents major banks and building societies, said gross mortgage lending
soared +29% in June compared to May to an estimated £20.5billion - the
highest level since July 2008. It was also +15% higher compared to the same
time last year. Also, the average UK property value now sits at £274,000,
according to the Office for National Statistics, which is £57,000 higher
than the peak seen in May 2008 just before the downturn that began during the
financial crisis. Nationally, UK homes prices were +5.7% higher in May than
a year earlier . Housing prices in Northern Ireland were growing at twice the
pace of London over the last year.
Speaking in London, Mr David Miles reiterated; The cost of raising interest
rate sharply is particularly high in the UK, where a large proportion of household
debt is in the form of variable interest rate mortgages and where many people
would struggle to adjust to sudden and significant rises in monthly payments.
Given that, I think a first move up in the Bank Rate soon is right," he concluded.
In turn, the British pound soared to a 7-½ year high against the Euro
this week, following hawkish comments by Mr Carney and Miles. Having opened
the week at €1.395, the pound jumped to €1.43 on July 16th, as the
yield on the UK's 1-year T-bill rate rose to +80-bps above Germany's 1-year
schatz yield. That's up from a +22-bps spread seen in March '14, and small
shifts in interest rate differentials can have bigger impacts on exchange rates.
But with inflation well below the BoE's +2% target - official figures published
yesterday showed it fell from +0.1% in May to zero in June - sceptics still
doubt the BoE will hike short-term interest rates any time soon.
Fed deputy sees 3.25% to 4% fed funds rate; Should long term Bond investors
fear the prospect of a tighter Fed policy in the months or years ahead? "We're
going up with the interest rate, then along, then another little jump," warned
Fed Vice Chair Stanley Fischer on June 1st. Fischer added that it is "misleading
for investors and economists put too much emphasis on when the initial interest
rate raise will be; much more prudent would be to consider where the short-term
rate will be over the next few years." Fischer predicted the federal funds
rate will reach 3.25% - to 4% over the next 3-to-4-years.
Looking back at history, to the March 2004 thru June 2006 period, - the last
time the Fed shifted to a liquidity tightening campaign, and hiked the fed
funds rate by a total of +425-bps, - does give some insight into what might
happen with 10-year T-Note yields in the year ahead, if the Yellen Fed goes
forward with a mini rating hiking campaign. Mr Greenspan was at the helm of
the Fed the last time the central bank rolled out a series of rate hikes, starting
in June 2004. Under Greenspan, the Fed hiked the fed funds rate at 14 consecutive
meetings, by +25-bps each time, from a previous 45-year low of 1% to as high
as 4.50%, before the "Maestro" retired in Feb '06. His protégé,
Ben "Bubbles" Bernanke sought to brandish his inflation fighting credentials,
by extending the Fed's rate hiking spree +75-bps to 5.25% in June of 2006,
- the last time the Fed ever hiked the fed funds rate.
However, the story actually begins in May 2003, when Mr Greenspan, nicknamed
the "Maestro" roiled the US T-Note market when he hinted that the Fed might
move to lower the fed funds rate towards zero percentand could start to buy
long-term bonds, to fight off the possibility of the US-economy from falling
into the "Deflation Trap." Thus, Greenspan did threaten to unleash "Quantitative
Easing <QE> during his tenure. The threat of QE did lower the yield on
the US's 10-year T-note from around 4% in April '03 to as low as 3.10% in June
'03. "Should it turn out that - for reasons that we don't expect, but that
we certainly are concerned may happen, - the pressures on the short-term markets
drive the federal-funds rate down close to zero, that does not mean that the
Fed is out of business on the issue of further easing," Greenspan warned on
May 21st, 2003. "Even though short-term rates are at 1.25%, longer-term rates
are significantly above that. We do have the capability - should that be necessary
- of moving out on the yield curve, essentially moving long-term rates down."
The Fed would accomplish that by buying Treasury securities with longer maturities
and setting a cap on their yields (ie; QE). However, two months later, on July
15th, 2003, in testimony to a Congressional panel , Greenspan whipsawed T-bond
traders by doing a 180-degree reversal, saying the Fed wouldn't have to resort
to QE. "The Fed stands prepared to maintain a highly accommodative stance of
policy for as long as needed to promote satisfactory economic performance,
and has substantial room to keep lowering overnight rates. However, Fed members
have concluded it is most unlikely the Fed would need to take unconventional
steps such as buying Treasuries to lower market rates," Greenspan said. Instantly
following his comments, the benchmark 3.375% Treasury note maturing in May
2013 plunged 2-points lower, pushing the yield up +23-basis points <bps> to
3.95%. Bond yields continued to surge higher and by the middle of August 2003,
the 10-year T-Note yield hit a high of 4.65%, and far above the cycle low of
3.10%, hit just two months earlier - on June 5th, 2003.
In May 2004, one month before the Fed actually began its rate hiking campaign,
the yield on the 10-year Treasury note had already surged to as high as 4.95%,
was light years ahead of the central bank. The message coming from the Fed
was the same script that we hear today; "keeping interest rates too low for
so long could cause problems. Some members are concerned that keeping monetary
policy stimulative for so long might be encouraging increased leverage (ie;
borrowing), and excessive risk-taking, (ie; bidding up stock prices). Such
developments could heighten the potential for the emergence of financial and
economic instability (ie; bubbles) when policy tightening is necessary in the
future."
When the Greenspan Fed finally initiated its first baby step rate hike to
1.25% in June of 2004, the 10-year T-Note yield was trading around 4.65%. Yet
what was most confusing and surprising to Fed officials, at the time, the yield
on the 10-year T-note continued to slide -65-bps lower towards 4%, even as
the Fed continued raising the fed funds rate higher to 1.75%, by Sept 2004.
In fact, after 15 straight Fed rate hikes to 4.75%, the 10-year T-note yield
was still hovering around 4.65%, where it was when the Fed started the tightening
campaign. Greenspan called this situation a "conundrum," since the 10-year
yield was little changed at 4.65%, even though the Fed had lifted the fed funds
rate +350-bps higher. The key lesson is; most of the increase in long-term
bond yields, in anticipation of a tightening cycle, has already materialized,
before the Fed even takes its first baby-step rate hike.
