Monetary Policy And Impact On Assets

Submitted by Matthew Corso

Monetary Policy and Impact on Assets

The last note briefly addressed the benefits associated with the reverse repurchase facility (RRF). Indeed liabilities have increasingly moved from bank balance sheets to the Fed, freeing lending capacity. One must recall reserves are not fungible outside of the banking system (but can act as collateral for margin). With flow decreasing, the opportunity for small relative volume bids spread over a large quantity of transactions (most instances per unit time) decreased with market prices in many asset markets. Is more downside coming?
 
A cost of QE is high quality debt remains siloed. As previously described, the RRF allows for assets previously purchased by the Fed to serve the market only in a limited capacity. While they are not able to the reused as collateral, they do replace a portion of the demand for high quality assets in the market, leaving relatively more available for reuse. At present, the 5bps paid by the Fed essentially attempts to put a floor under the short-term price for money. The Fed established an overall cap in September, supposedly because MMFs would view the Fed as a more secure counterparty than banks. I take a different view: They Fed is balancing net income from securities lent with the monetary policy goal of keeping rates up. As Stone & McCarthy recently pointed out, demand exceeded the $300 billion cap, limiting the amount paid-out by the Fed at the 5bps rate, with excess bid via Dutch auction. In the recent auction coinciding with quarter-end the low bid hit a price of –20bps (the counterparty receives less than deposited in order to rent the high quality assets from the Fed). While one may count the result as a limited success in controlling the lower bound of short-term interest rates, the Fed controls the cap for the 5bps rate. Interest on reserves (IOR), at 25bps, holds the entire system afloat, where otherwise extreme supply (especially relative to demand) would dictate a lower price; In economic depression even more so. To improve the optics of control, causality is reversed when speaking of the price of money. The interbank interest rate for reserves is set by market forces, and daily, the central bank adjusts reserves to match. Mechanically the Fed’s “target” is just that, and nothing more. Alternatively, with IOR and the RRF, the prices at the each extremis of the corridor are fiat, and impact the Fed balance sheet.
 
Quantity theory posits price inflation follows from base money creation, meanwhile in developed markets we see the opposite. Investment managers and students of economics need to recognize the quantity theory of money passed away gradually as the link to precious metals was severed. A new paradigm began to unfold with the economic performance leading up to 1968. The market demanded portion of base money, coinage and bank notes, follow from price inflation. Causality between increases in base money and rising prices must does not result from the reserve creation. As Peter Stella pointed out recently:

“The extremely inconvenient fact for the QTM regarding the causal power of the bank reserves component of the monetary base is that—to take the US example—the nominal value of bank reserves held at Federal Reserve Banks between end-1958 and end-2007 fell by 19 percent while the Consumer Price Index rose by 612.5 percent. Therefore, the long-run relationship between US bank reserves and US inflation is actually negative.”

What then accounts for the loss in purchasing power outside of the core price inflation metric? From Peter Stella’s Exit Path Implications for Collateral Chains:

“In 1951, total commercial bank deposits at the Fed were $20 billion larger than they were at the end of 2006.

 

Over the same period, total US credit-market assets rose by over 10,000%”

The result is a consolidated approach must be used to ascertain the quantity of effective money. Austrian true money supply (TMS) best captures one part, and as recently explained by none other than the Treasury Borrowing Advisory Committee, the other part is high quality collateral lent in which further credit is extended against in private institutional markets (including reuse).
 
By using a consolidated view of money the crisis of 2008-2009 can be visualized, where TMS alone is insufficient.
 
Looking forward, the Fed will cease the flow of reserves, and has the capacity for a “ceremonial rate-rise”. A brief overview of the impact on assets follows. With the mechanics now explained, one can see why the end of previous rounds of QE saw long Treasuries and short equity outperform. As previously forecast, we will see this pattern repeat as yield seeking combined with capital preservation desires finds US sovereign debt heads and shoulders above low effective yields in EU or Japanese sovereign debt. Furthermore, the US Treasury is to cut bill issuance trimming ~$60 billion overfunding through end-2015. Less supply, more demand: higher price (and a lower effective yield). The US dollar outperformed as predicted, and the yen may be next on increasing liquidity and capital preservation concerns. Electrical consumption, rail and airline data from China continue to surprise to the downside. Their bubble dwarfs the US housing crisis, and may prove both an even worse misallocation and the catalyst. There will be a rotation as corporate bond excesses unwind along with many REITs and MLPs. Securities representing companies catering to a tapped out consumer, and capital structure safety will prove prudent over longer terms. Generally speaking, US banking system survives a conflagration (due to recapitalization), while some banks in Europe and Canada may not be as prepared. Commodities will bifurcate over time as drought, industrial collapse and war overpower their common dollar denomination. Short the Australian dollar against the US dollar from 1.05 performed well (now .86) and iron ore was previously cited as vulnerable (mid-2013), they remain so. Oil in mid-2014 priced in demand not considerate of recession alongside the return of intermittent supply. Near $110 I recall saying it “can fall anytime now”. Near $85 a barrel now, $75 is likely and results similar to the last crisis are possible. Escalation in war would maintain, or see a return to a more modern price; therefore if drawdown is tolerable over a medium term, oil can be viewed as insurance. In that vein, the precious metals continue to change hands, facilitated as they are apparently viewed only as a Giffen good by western ideology. Lastly, with palladium and platinum demand being mostly absorbed through economic activity, the former is most overpriced of the two.




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Skip Oliva: Will the FCC Let Televised Football Be?

NFLThe Federal Communications
Commission recently repealed a 1975 regulation banning cable and
satellite operators from televising certain professional sporting
events that were not otherwise made available to local broadcast
stations. This regulation formed part of the so-called blackout
rule enforced by the National Football League. Critics have long
decried blackouts as the byproduct of special government privileges
afforded the NFL. But the truth is a bit more complicated than
that, writes Skip Oliva.

View this article.

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The Four Questions Goldman’s “Confused, Understandably Frustrated” Clients Are Asking

One would think that after last week’s market rout, the worst in years, that Goldman clients would have just one question: why just a month after you, chief Goldman strategist David Kostin said to “Buy Stocks Because Hedge Funds Suck; Also Chase Momentum And Beta“, are stocks crashing? No really: this is literally what Kostin said in the first days of September: “investors should buy stocks which should benefit from a combination of beta, momentum, and popularity as funds attempt to remedy their weak YTD performance heading into late 2014.” Turns out frontrunning the world’s most overpaid money losers wasn’t such a great strategy after all. In any event, that is not what Goldman’s clients are asking. Instead as David Kostin informs us in his weekly letter to Jim Hanson’s beloved creations, “every client inquiry focused on the same four topics: global growth, FX, oil, and small-caps.”

So while said clients figure out just what the right question is, here are the wrong ones, aka Goldman’s damage control:

Policymakers focus on anemic growth in Europe and Japan while US economic and company fundamentals remain strong. Investors should focus on “American exceptionalism” and own stocks with high domestic sales. We forecast S&P 500 will rebound by 7% to reach our year-end target of 2050. Buybacks have been the major source of demand for US equities during the past four years with S&P 500 firms repurchasing more than $1.5 trillion of shares. Peak 3Q reporting season is  the next three weeks. Halloween will be the end of the blackout period for most firms. In recent years, 25% of annual buybacks have occurred in November and December.

 

Conversations we are having with clients: Confusion over growth, FX, oil, and small-caps

 

“Whiplash” is how one veteran investor described this week’s market. S&P 500 fell 1.5% on Tuesday as the IMF’s newest World Economic Outlook discussed the weak prospects for global growth. Wednesday registered 2014’s best daily return (+1.8%) supported by the release of Fed minutes that noted US growth “might be slower than they expected if foreign economic growth came in weaker than anticipated”. The clear implication: Interest rates might be held lower for longer than market participants expected. This comfort was short-lived – S&P 500 sank 2% on Thursday and 1% on Friday.

 

Four topics dominated client discussions this week: (1) The uneven global economic outlook with the US expanding above-trend, China slowing, and Europe barely growing; (2) US dollar strength and a euro rapidly moving towards parity by 2017; (3) the bear market in crude oil with Brent plunging by more than 20% since June; and (4) the dismal returns for US small-cap stocks with the Russell 2000 index lagging by 13% YTD for the largest underperformance vs. the S&P 500 since the Tech bubble in 2000. 

 

Investors are understandably frustrated: More than 85% of large-cap mutual funds have lagged their benchmarks YTD and the typical hedge fund has returned just 1% while S&P 500 has returned 5%. Although realized  volatility surged to 15 in the past month, it has averaged just 10 since the start of the year. The dispersion of three-month stock returns stands at the 1st percentile compared with the past 30 years, and P/E multiple dispersion is near the lowest level in 30 years for the S&P 500 and within many sectors.

 

While policymakers voice concerns about the lack of growth in Europe and Japan, US economic and corporate fundamentals remain strong. Unemployment is at 5.9%, the ISM manufacturing and non-manufacturing indices are both solidly in the expansion phase at 56.6 and 58.6, respectively. S&P 500 margins stand at a record high of 9% and capex is growing by 8%.

As usual here are Goldman’s trade recos for the current confused, frustrated environment… of which the Goldman prop desk with take the other side.

(1) Focus on “American economic exceptionalism”. The world lacks growth, but our economists forecast US GDP will accelerate to 3.2% in 2015,  the fastest rate of expansion since 2005.

… re-read that sentence as many times as necessary until you pass out from laughter…

Meanwhile our economists expect Euro area growth of just 0.7% this year and 1% in 2015. US stocks with a high proportion of domestic sales have and should continue to benefit disproportionately relative to firms with a high share of foreign revenues. The performance YTD of US-facing firms (Bloomberg: <GSTHAINT>) versus stocks exposed to Europe (<GSTHWEUR>) totals 1055 bp (+7.5% vs. -3.1%), with 74% of the excess return coming since mid-year (780 bp).

 

(2) Focus on sectors that benefit from lower oil prices. Energy earnings closely follow oil price changes. Brent plunged 20% since June and Energy stocks fell by 11% while S&P 500 slipped only 1%. Without a rebound in crude prices, Energy equities will continue to lag. However, lower oil prices benefit non-energy sectors, particularly Consumer Staples and Discretionary, as input costs decline and personal consumption potentially rises. Other industries such as chemicals and airlines also experience reduced input costs. Investors should overweight Industrials and Consumer Discretionary. 

 

(3) Stick with large-caps despite the siren call of small-cap US equities that have dramatically underperformed. A strengthening US dollar and positive US GDP growth often correspond with Russell 2000 outperformance. However, negative earnings revisions have actually increased small-cap valuations even as share prices have declined. The tight relationship between Russell 2000 relative performance and the slope of the US yield curve highlights the degree to which concerns over growth and Fed policy have biased investors toward the relative safety of large-caps (see Exhibit 4).

 

But, perhaps most important, gone are the days when Goldman could just fall back on the perpetual deus ex of the Fed’s rising balance sheet for one simple reason: it no longer is. Instead, Kostin has found a new idol, the same one we revealed in May: behold the god of stock buybacks, who should make everything better:

Open market share repurchases are typically prohibited during the five weeks ahead of the earnings release date. Roughly 75% of S&P 500 firms will report 3Q results between Monday, October 13th and Friday, October 31st. We are now in a blackout period so companies have been precluded from conducting tactical buyback activity that has supported the equity market during sell-offs in the recent past. Roughly 8% of annual repurchases occurs in October compared with 14% in November and 10% in December. We expect a surge in buybacks starting in November which will serve as a tailwind for the stock market during the last eight weeks of the year.

Or… if companies suddenly find themselves unable to issue debt at preferential terms, and/or if the rating agencies suddenly realize that America’s “Investment Grade” companies no longer are (recall the scariest chart in IBM’s history), and realize that net corporate debt is the highest it has ever been and start serially downgrading IG companies into junk status, watch as Goldman’s latest house of cards supporting idol, falls.




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Is the Dollar Correction Over, or Just the First Leg?

Last week was of two halves.  The dollar correctly lower through midweek and then recovered.  While the dollar’s losses were pared, it still managed to fall against nearly all the major currencies.  However, it finished the week on a firm note, and although it appears poised to move higher in the week ahead, it is not immediately clear that new high is imminent.   

 

If there is one level to watch, perhaps it is the 20-day moving averages.  The euro, the Australian dollar and the Canadian dollar saw intra-day penetration of this average but did not close above it.   The Dollar Index also briefly fell through its 20-day moving average, but quickly recovered.  It has not closed below its 20-day average for three months.  Sterling stalled within ticks of is 20-day average.

 

Many currencies, including the euro, Swiss franc and the Australian dollar finished near their session lows, making a gap lower opening in holiday-thin markets (Japan is closed and the US has a partial holiday) on Monday possible.  Depending on the news stream, we would assume that they would be what technicians call “normal” gaps, which is to say they are filled in the short-term, as opposed to a break away gap, which signal an acceleration, for example.

 

The euro’s price action reinforces that resistance near $1.28.   A break of $1.2600 is needed to signal a new push at $1.25.  A break of $1.25 could spur another 2-3 cent euro decline.   Three-month implied volatility is firm in the middle of the 6.5%-7.5% range that has held since early September.   At the same time, the premium for euro puts has increased vis a vis calls equally distant from the forward strike (three month 25 delta risk reversals).  

 

This suggests that some participants may be rolling short euro spot positions into options, rather than using the options market to hedge the position.      If the underlying position is short euros, a call option could be bought, which would be consistent with higher vol, but not the performance of the risk reversals.  Put options could be sold, but this is not consistent with the increase in volatility or the price action of the risk reversals.  

 

We have often argued that the dollar-yen pair does not typically trend.  When it appears to be trending, it is often moving from one range to another.  The top end of the range is around JPY110.  The dollar held support seen in the JPY107.30-50 area.  The greenback finished last week with three consecutive finishes below the 20-day moving average, which it had not violated once in the past two months.    

 

The five-day average has crossed below the 20-day for the first time since late-July.  However, the dollar’s downside momentum eased, and the Relative Strength index stabilized.    We also note that the US Treasury market also stabilized, albeit at lower yield levels.    Stabilization of the equity market early next week also would help negate some of the bullish yen technical considerations. 

 

Sterling looks particularly vulnerable.  It has given back the lion’s share of the gains seen earlier in the week that had carried it to almost $1.6230 from $1.5945.  The RSI has turned lower, and the MACDs are threatening to cross down.   A break of the $1.5945 low could signal another 1-2 cent decline.  The driving force is the pendulum of sentiment swinging toward a later rate hike.  Soft inflation reports next week, and miserly wage increases, will likely encourage this shift in expectations. 

 

Even significantly stronger than expected employment data failed to lift the Canadian dollar.  This seems to be more a reflection of a firm US dollar environment.  Some observers want to attribute the weakness of the Canadian dollar to the drop in oil prices, but it is a stretch.   The correlation on the basis of percent change is 0.27 and 0.21 over the past 30 and 60 days respectively.    The correlation between the S&P 500 and the Canadian dollar is even stronger at 0.34 and 0.29 for the 30 and 60-day periods respectively.  

 

The greenback is poised to test the CAD1.1280 area, this year’s high and also the upper Bollinger band.    A convincing break would target CAD1.1400.  The US dollar tested support just below CAD1.11.  A break of this is needed to take the pressure off the US dollar’s upside. 

 

The short-covering bounce lifted the Australian dollar from nearly $0.8640 to $0.8900.  However, it reversed lower.  It looks poised to return to the lows and make new ones.    The RSI has turned down, and the MACDs are about to. 

 

The Mexican peso remains heavy, though it gained 0.3% against the US dollar.  The economic news was a bit disappointing.  Industrial output was expected to have risen by 2% year-over-year in August, but rose a more modest 1.4%.  Manufacturing output was half of the 3% the consensus expected.  

 

As we noted with the Canadian dollar, so too with the peso.  Oil prices do a poor job explaining the currency weakness, and the peso, like the Canadian dollar has a somewhat stronger correlation with the US equities than oil.  Over the past 30 and 60 days the peso’s correlation with oil prices is 0.06 and 0.02 respectively.  The peso’s correlation with the S&P 500 is 0.53 and 0.51 for the 30 and 60-day periods respectively. 

 

The US 10-year yield shed 11 bp last week.  The recent peak was on September 19 near 2.65%.  It fell to new multi-month lows just below 2.28%.   The bears continue to be frustrated.  Wasn’t Fed tapering and the end of QE supposed to push yields higher?  Wasn’t the strength of the US economy expected to push up US yields?    The 2.38%-2.40% area may cap yield increases in the near-term, barring a significant upside surprise in US economic data next week.  The key reports include retail sales (Bloomberg consensus is for a 0.1% headline decline ) and industrial production (expected to recover from the -0.4% decline in August). 

 

The CRB Index made a new nine-month low before the weekend, gapping lower at the open.  As seen with the currencies, the 20-day average may be an important level to monitor.  The CRB Index has not closed above this average since the end of August.  It flirted with it early last week, but that marked the high, and it proceeded to drop another 2%.    The plunge in oil prices continued.  The $85 a barrel level has been taken out on an intra-day basis.  The next big objective is $80. 

 

Global equities had a poor week.  Major markets were off 2.6%-4.6%.  The Nikkei fared the best, losing 2.6%, followed by the S&P 500, which lost 3.1%, for its worst week since the middle of 2012.  The key level to watch is the early August low just ahead of 1900, which also corresponds to the 200-day moving average.       A break of that would signal a move toward 1880, and possibly 1845.  The S&P 500 finished on its lows just above that support, increasing the risks of a gap lower opening on Monday. 

 

Observations on the speculative positioning in the futures market:

 

1.  There were three significant gross position adjustments among the major currency futures.  The Australian dollar accounted for two.  The gross longs were slashed by 11.6k contracts to 316k.  The gross shorts grew by almost 13k contracts to 58.1k.  The gross short yen position was cut by 13.4k contracts to 137.4k.  

 

2.  Speculators reduced exposures to the yen, sterling and the Mexican peso as both gross longs, and gross shorts were reduced.  The small adjustment in gross sterling positions was sufficient to turn the net position back to favor shorts.  Gross long euro exposure was cut, though speculators added slightly (about 3k contracts) to the gross shorts.  

 

3.  Speculators added to both long and short gross positions in the Swiss franc and Canadian dollar. 

 

4. Speculators are suspicious of the latest rally in US Treasuries.  The longs took profits, culling the gross position by a little more than 10% to 403.8k contracts.  The bears are were intimidated by the rally, and the short position rose by almost 34k contracts to 496.1k.  This resulted in a swell of the net short position to 92.3k contracts from 12.5k.




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Reason TV: Mike Rowe on the Value of a Strong Work Ethic

Mike Rowe’s new program, “Somebody’s
Gotta Do It
,” premiered on CNN this week. “In each episode,”
according to the CNN website,  “Rowe visits unique individuals
and joins them in their respective undertakings, paying tribute to
innovators, do-gooders, entrepreneurs, collectors, fanatics–people
who simply have to do it. This show is about passion, purpose, and
occasionally, hobbies that get a little out of hand.”

Providing a window into the lives of interesting, hard-working
Americans is nothing new for Rowe, the long-time host of “Dirty
Jobs” (the original title for which was “Somebody’s Gotta Do It”).
Reason TV’s Nick Gillespie talked to Rowe about blue-collar jobs,
the importance of having a strong work ethic, and the high price of
college last December.

The original release date was December 13, 2013. The original
writeup is below.

“If we are lending money that ostensibly we don’t have to kids
who have no hope of making it back in order to train them for jobs
that clearly don’t exist, I might suggest that we’ve gone around
the bend a little bit,” says TV personality Mike Rowe, best known
as the longtime host of Discovery Channel’s Dirty Jobs.

“There is a real disconnect in the way that we educate vis-a-vis
the opportunities that are available. You have – right now – about
3 million jobs that can’t be filled,” he says, talking about
openings in traditional trades ranging from construction to welding
to plumbing. “Jobs that typically parents’ don’t sit down with
their kids and say, ‘Look, if all goes well, this is what you are
going to do.'”

Rowe, who once sang for the Baltimore Opera and worked as an
on-air pitchman for QVC, worries that traditional K-12 education
demonizes blue-collar fields that pay well and are begging for
workers while insisting that everyone get a college degree. He
stresses that he’s “got nothing against college” but believes it’s
a huge mistake to push everyone in the same direction regardless of
interest or ability. Between Mike Rowe Foundation and Profoundly
Disconnected, a venture between Rowe and the heavy equipment
manufacturer Caterpillar, Rowe is hoping both to help people find
new careers and publicize what he calls “the diploma dilemma.”

Rowe recently sat down with Reason’s Nick Gillespie to discuss
his bad experience with a high school guidance counselor (3:20),
why he provides scholarships based on work ethic (6:57), the
problem with taxpayer-supported college loans (8:40), why America
demonizes dirty jobs (11:32), the happiest day of his life (13:14),
why following your passion is terrible advice (17:05), why it’s so
hard to hire good people (21:04), the hidden cost of regulatory
compliance (23:16), the problem with Obama’s promise to create
shovel ready jobs (33:05), efficiency versus effectiveness (34:17),
and life after Dirty Jobs (38:24).

About 41 minutes. Cameras by Meredith Bragg and Joshua Swain.
Edited by Bragg.

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Zenon Evans Discusses Russian Sanctions, North Korea’s Missing Leader on the Tyler Nixon Show at 11:05 a.m.

I’ll be on the
Tyler Nixon show on WGMD in Rehobeth Beach, Del., this afternoon at
around 11:05 a.m. ET to talk about the effects of American
sanctions on Russia, and North Korea’s Kim Jong-un’s prolonged
absence from the public eye. Tune in on your radio, through TuneIn,
or listen to the livestream here.

Related reading: 


Kim Jong-un Misses Key Event; Authorities Maintain He’s in
Control


Where Is Kim Jong-un? Rumors of Coup, Illness Swirl.


U.S. Sanctions on Russia Cause Kalashnikov Rifle Price
Surge


From Moscow With Liberty: Meet the Head of Russia’s Libertarian
Party

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Peter Suderman Reviews The Judge

Could have been worse:

You can tell what kind of movie “The Judge” is just by listening
to the score.

From scene to scene and even moment to moment, it veers wildly
between emotions: It’s all weepy treacle one second, sunny optimism
the next, bouncy and comic for one encounter, then dark and
mournful a beat or two later.

It never quite lands on consistent tone, it’s often overbearing,
and while the moments themselves sometimes work fine, the shifts
are sudden, jarring and forced.

“The Judge” is neither a terrific movie nor a terrible one,
though at various times it flirts with being both. Like its score,
it is often too obvious and prone to sudden shifts of mood and
tone, few of which are earned. But there are a handful of
well-written scenes, and the performances from its all-star cast
make the most of even the mediocre material.

Also could have been better.


Read the whole review
 in The Washington
Times

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Alexis Garcia on Jay Leno and the Politics of Late Night Television

When Leno debuted as the host of
The Tonight Show in 1992, he quickly acted to
differentiate himself from the legendary Johnny Carson and
establish his own brand of late-night talk. One of the ways in
which he accomplished this was to focus on political news and
humor. Leno’s focus on politics and his everyman persona earned him
the top spot in the Nielsen ratings for almost two decades. But
despite his popular success, notes Alexis Garcia, TV critics never
warmed to Leno and criticized him for his milquetoast humor.

View this article.

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Baylen Linnekin on Cracking California’s Egg Law

EggsLast week a federal court in California threw out
a multi-state lawsuit challenging California’s looming egg
production rules. Earlier this year, attorneys general in six
states challenged the California rules, which apply to farmers in
other states, including theirs.

The lawsuit, as Food Safety News puts
it
, “argued that California was not acting to make food safer
nor animals healthier, but to advance its own purely commercial
interests.”

Specifically, the California law, set to take effect next year,
would require egg producers within and without the state to house
egg-laying hens in cages or other enclosures that permit the hens
to stand, lay down, turn around and fully extending their
wings.

View this article.

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