Month: February 2016

Over the past year, and certainly in the aftermath of the BOJ’s both perplexing and stunning announcement (as it revealed the central banks’ level of sheer desperation), we have warned (most recently “Negative Rates In The U.S. Are Next: Here’s Why In One Chart“)  that next in line for negative rates is the Fed itself, whether Janet Yellen wants it or not. Today, courtesy of Wolf Richter, we find that this is precisely what is already in the small print of the Fed’s future stress test scenarios, and specifically the “severely adverse scenario” where we read that:

The severely adverse scenario is characterized by a severe global recession, accompanied by a period of heightened corporate financial stress and negative yields for short-term U.S. Treasury securities.

 

As a result of the severe decline in real activity and subdued inflation, short-term Treasury rates fall to negative ½ percent by mid-2016 and remain at that level through the end of the scenario.

And so the strawman has been laid. The only missing is the admission of the several global recession, although with global GDP plunging over 5% in USD terms, we wonder just what else those who make the official determination are waiting for.

Finally, we disagree with the Fed that QE4 is not on the table: it most certainly will be once stock markets plunge by 50% as the “severely adverse scenario” envisions, and once NIRP fails to boost economic activity, as it has failed previously everywhere else it has been tried, the Fed will promtply proceed with what has worked before, if only to make the true situation that much worse.

Until then, we sit back and wait. 

Here is Wolf Richter with Negative Interest Rates Already in Fed’s Official Scenario

The Germans, with Teutonic precision, call them “Punishment Interest.” Negative interest rates are spreading from the ECB’s negative deposit rate across the bond market and to some savings accounts in the Eurozone. The idea is to enrich existing bond holders and flog savers until their mood improves. Stock prices are allowed to get crushed by reality.

Negative interest rates destroy one of the most essential mechanisms in an economy: the pricing of risk. Investors end up taking huge risks with no reward. Many of them will get cleaned out down the road.

In Switzerland, punishment interest already causes “perverse unpredictable effects,” as mortgage rates have started to soar. It’s wreaking havoc in Denmark and Sweden. Bank of Canada Governor Stephen Poloz let the idea float that he’d unleash punishment interest to destroy the Canadian dollar. The Bank of Japan announced Friday morning – timed for maximum market effect – that it too would inflict negative interest rates on its subjects.

In the US, Ben Bernanke has been out there preaching to the choir about them. Over-indebted corporate America, except for the banks, would love this absurdity; it would allow them to actually make money off their mountain of debt.

“Potentially anything – including negative interest rates – would be on the table,” Fed Chair Janet Yellen told a House of Representatives committee in early November.

Fed Vice Chair Stanley Fischer has been publicly obsessing about them for a while. Monday, during the Q&A after his speech at the Council on Foreign Relations, he said that negative interest rates are “working more than I can say I expected in 2012.”

It seems to be just talk. But negative interest rates are already baked into the official scenario for 2016. It’s in the Board of Governors’ new report on the three scenarios to be used in 2016 for the annual stress test that large banks are required to undergo under the Dodd-Frank Act and the Capital Plan Rule.

The scenarios – baseline, adverse, and severely adverse – start in the first quarter 2016 and also include economic factors in the Eurozone, the UK, Japan, and the weighted aggregate of China, India, South Korea, Hong Kong, and Taiwan.

In the “severely adverse scenario,” things get interesting.

But don’t worry, the Fed emphasizes that “this is a hypothetical scenario” for the purpose of a bank stress test and “does not represent a forecast of the Federal Reserve”:

The severely adverse scenario is characterized by a severe global recession, accompanied by a period of heightened corporate financial stress and negative yields for short-term U.S. Treasury securities.

GDP begins to tank in Q1 2016 and by Q1 2017 is 6.25% below pre-recession peak. The unemployment rate hits 10% by mid-2017. Headline CPI rises from an annual rate of 0.25% in Q1 2016 to 1.25% by the end of the recession. Asset prices “drop sharply,” with stocks down “approximately 50%” through the end of this year, accompanied by a surge in volatility, “which approaches the levels attained in 2008.” Through Q2 2018, home prices plunge 25%, commercial real estate prices 30%.

“Corporate financial conditions are stressed severely, reflecting mounting credit losses, heightened investor risk aversion, and strained market liquidity conditions.” Bond spreads blow out, with the yield spread between investment-grade corporates and Treasuries jumping to 5.75% by the end of 2016.

So things are going to get ugly. And here is what the Fed is going to do next:

As a result of the severe decline in real activity and subdued inflation, short-term Treasury rates fall to negative ½ percent by mid-2016 and remain at that level through the end of the scenario.

Short-term Treasury rates can only fall to a negative 0.5% if the fed funds rate is at that level.

And the whole yield curve comes down, with the 10-year Treasury yield collapsing to 0.25% by the end of this quarter, but then “rising gradually” all the way to a whopping 0.75% by the end of the recession and to 1.75% by Q1 2019 (it’s 1.93% now).

The international component “features severe recessions” in the Eurozone, the UK, and Japan, and a mild recession in developing Asia, along with a “pronounced decline in consumer prices.”

Due to “flight-to-safety capital flows,” the dollar appreciates against the euro, the pound, and the currencies of developing Asia, but will “depreciate modestly” against the yen, “also in line with flight-to-safety capital flows.”

One of the differences between the severely adverse scenarios for 2015 and 2016? The scenario this year “features a path of negative short-term U.S. Treasury rates.”

Who are the winners? Existing holders of long-term Treasuries who will benefit from “larger gains on the existing portfolio of these securities.”

However, the Fed makes no promises about stocks, having seen the debacle playing out in Europe where stocks have plunged despite negative interest rates. And banks will get hit as “negative short-term rates may be expected to reduce banks’ net interest margins and ultimately, to lower PPNR [pre-provision net revenue].

And there you have it. The Fed already has a “path” to negative interest rates.

But note: not a single word about QE.

If the stock market crashes 50% this year, as the “severely adverse” scenario spells out, all the Fed will do is slash the fed funds rate to a negative 0.5%. And if stocks crash only 25% this year, instead of 50%?

That’s the case in the Fed’s middle scenario, the merely “adverse” scenario. Short-term rates will “remain near zero” it says – maybe slightly below where they’re right now. So no negative interest rates. And no QE either. Stocks can go to heck, the Fed is saying. It’s worried about credits, particularly high-grade credits. Junk bonds and stocks are on their own.

And this concept of switching to negative interest rates and away from QE is even in line with the Bank of Japan’s desperate head fake. Read…  QE in Japan Nears End: Daiwa Capital Markets

* * *

Don’t believe it? Here it is, straight from the Fed:

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Hillary Clinton emerged victorious in Iowa on Monday night, but it was a close call.

So close, in fact, that Bernie Sanders wants a recount.

It was “a virtual tie,” Sanders said, describing the proceedings which ended with the Vermont senator being awarded 695.49 state delegate equivalents to Clinton’s 699.57. “After thorough reporting — and analysis — of results, there is no uncertainty and Secretary Clinton has clearly won the most national and state delegates,” Clinton’s Iowa campaign manager Matt Paul said in a statement.

Sanders wants the Democratic party to release the a raw vote count, a rare move, but one he believes is necessary for full transparency.

“I honestly don’t know what happened. I know there are some precincts that have still not reported. I can only hope and expect that the count will be honest,” he said. “I have no idea. Did we win the popular vote? I don’t know, but as much information as possible should be made available.”

“People said we had an inferior ground game, that we didn’t have as good an understanding of the state,” Sanders’ campaign manager Jeff Weaver told reporters. “I think we certainly demonstrated that we had at least as good a ground game and I would argue that we had a better one because we started out [as underdogs].”

Maybe so, but Sanders’ coin flip game was certainly inferior to Clinton’s and it may have cost him a delegate or two. Or three. Or five. 

Here’s what happened in precinct 2-4 in Ames as recounted by David Schweingruber, an associate professor of sociology at Iowa State University who participated in the caucus (from The Des Moines Register):

A total of 484 eligible caucus attendees were initially recorded at the site. But when each candidate’s preference group was counted, Clinton had 240 supporters, Sanders had 179 and Martin O’Malley had five (causing him to be declared non-viable).

 

Those figures add up to just 424 participants, leaving 60 apparently missing. When those numbers were plugged into the formula that determines delegate allocations, Clinton received four delegates and Sanders received three — leaving one delegate unassigned.

 

Unable to account for that numerical discrepancy and the orphan delegate it produced, the Sanders campaign challenged the results and precinct leaders called a Democratic Party hot line set up to advise on such situations.

 

Party officials recommended they settle the dispute with a coin toss.

 

A Clinton supporter correctly called “heads” on a quarter flipped in the air, and Clinton received a fifth delegate.

 

Similar situations were reported elsewhere, including at a precinct in Des Moines, atanother precinct in Des Moines, in Newton, in West Branch  and in Davenport. In all five situations, Clinton won the toss.

When all was said and done, Clinton won six consecutive coin tosses. 

“In another race, those heads-or-tails contests may not have mattered,” The Washington Post wrote this morning. “But, early Tuesday, Clinton was ahead of Sanders in Iowa by just four “state delegate equivalents,” [and] given that slim margin and the unknown intentions of Martin O’Malley’s eight SDEs now that the former Maryland governor has suspended his presidential campaign, those coin flips are looking mighty significant.”

Here’s the absurdity caught on film as incredulous and visibly exasperated caucus goers flip for delegates.

There you have it. Efficient democratic procedures on full display in Iowa.

If that wasn’t exciting enough for you, here’s another flip clip:

No lie: Coin flip broke tie, gave @HillaryClinton a delegate at #IowaCaucus http://pic.twitter.com/PAoKslCJiV via @FernandoPeinado

— David Beard (@dabeard) February 2, 2016

It’s no wonder Sanders wants to see the raw vote. Here’s another account from Davenport courtesy of The Washington Post:

In Davenport, another precinct tied 84-84. It was time for someone to stretch out that thumb.

 

“Bernie’s side has called heads,” the coin tosser said, as documented in Davenport in a video posted by Robert Schule. As if to lend the proceedings an official air, she further explained the procedure: “I’m going to let the coin hit the floor.”

 

Gravity, of course, wins every caucus — the coin fell to Earth as expected. “No one touch it!” someone shouted. Tails again! Cheers erupted from the Clinton camp — and heads proved a loser for Sanders once more.

At the end of the day we suppose there’s a bit of symbolism here. Establishment politician or “protest” candidate, most Americans doubt any real change is coming to Washington in 2016 regardless of who prevails in the national election.

In that sense, it’s all one big coin flip anyway.

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As we wrote yesterday when reviewing the latest note from JPM’s Mislav Matejka, according to the JPM strategist not only had the window to buy stocks into the torrid S&P500 rebound closed, but traders should “start fading it within days” as JPM stuck “to the overriding view that one should use any strength as an opportunity to reduce equity allocation.”

Today, when reading the latest report by BofA’s equity and quant strategy team looking at what the “smart money” – institutions, hedge funds and private clients – are doing, we find that JPM’s advice was heeded, and the rally was indeed sold with reckless abandon.

From BofA:

Last week, during which the S&P 500 rallied another 1.8%, BofAML clients were net sellers of US stocks for the first time in five weeks, in the amount of $1.2bn. Net sales were led by hedge fund clients, who had previously been net buyers for the prior five weeks, while private clients and institutional clients were also net sellers. (Institutional clients have alternated between buying and selling in recent weeks, while private clients have been sellers for the last three weeks.)

 

Perhaps just as notable is that according to BofA, buybacks by corporate clients decelerated last week to their lowest level year-to-date, but on a four-week average basis buybacks are well above last January’s levels.

In other words, just as we suggested yesterday, much of the February buybacks expected by Goldman’s David Kostin to come to the rescue of the market, have been pulled forward into January, leaving far less dry powder available for the month of February.

What was the smart money selling?

Net sales last week were chiefly in large caps, while small caps also saw outflows; clients continued to buy mid-cap. Previously, all three size segments had seen net buying every week of 2016.

Among the details, one sector stands out: recent hedge fund darling, the healthcare sector, is seeing a furious exit by existing holders with sales “the biggest in seven months and the third-largest in our data history” as what worked until now no longer works. Tech was also slammed and sakes were “the largest in fifteen months and the fourth-largest in our data history.”

Net sales last week were led by Tech and Health Care stocks, despite overall 4Q earnings for these sectors coming in better than expected. Health Care—which has been one of the most crowded sectors within the S&P 500—was the worst-performing sector last week, and we’ve noted that revision and surprise trends have been rolling over for this sector. This is the only sector with a multi-week net selling trend, and outflows from Health Care stocks last week were the biggest in seven months and the third-largest in our data history (since ’08), led by hedge funds. Sales of Tech were the largest in fifteen months and the fourth-largest in our data history, led by institutional clients. Energy stocks saw the biggest net buying by our clients last week amid the rally in oil prices; with inflows from all three client groups. This sector has now seen four consecutive weeks of buying by our clients, suggesting increasing conviction that oil has bottomed. Financials stocks also saw net buying for the fifth consecutive week amid the sell-off in this sector, while clients also continued to buy Telecom stocks for the fifth week.

 

But nobody sold more than the very pinnacle of smart money: hedge fund investors, where “net sales last week by hedge funds were the biggest in nearly two years and the fourth-largest in our data history. This follows  near-record levels of net buying by this group in early January.”

One final observation:

“overall for the month of January, clients were net buyers of single stocks, while ETFs saw more muted net buying. This would be the first year in our data history (since ’08) that clients bought single stocks.”

A return to normalcy perhaps?

Finally, while weekly flows tend to be notoriously volatile, the long-term trend across all three investor classes are ver clear.

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“Migrants gone wild” is the new video craze sweeping the internet as cell phone footage of refugee-related shenanigans has replaced clips of Russia vaporizing “the terrorists” on geopolitics junkies’ must watch lists.

So far this year we’ve seen “shocking footage” of a shrieking migrant teen involved in a bitter dispute with an asylum center worker, a clip which depicts dozens of “football hooligans” rampaging through Stockholm’s central train station on the way to accosting non-Swedes, and a number of videos showing police clashing with demonstrators who have taken to the streets across the bloc to protest the influx of refugees.

On Tuesday we get the latest clip out of Europe, this time from Munich where a train going from Sendlinger Tor station to the Munich city center was the scene of what’s being described as an assault on an elderly man perpetrated by “young men of Middle Eastern appearance.”

“The clip shows how several young men of middle eastern appearance attack two elderly Germans, who moments earlier had come to the defense of a young woman harassed by the same group,” RT says. 

Tom Roth, who took the video, says an apparent refugee “touched the back” of a woman prompting the “old men” to scold the migrants and demand that they “behave.”

The situation deteriorated quickly from there as you can see from the video shown below.

Just another day in Angela Merkel’s multicultural utopia.

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Submitted by Ben Hunt via Salient Partners' Epsilon Theory blog,

I'm going full-nerd with the "Lord of the Rings" introduction to today's Epsilon Theory note, but I think this scene — where Denethor, the mad Steward of Gondor, orders his son Faramir to take on a suicide mission against Sauron's overwhelming forces — is the perfect way to describe what the Bank of Japan did last Thursday with their announcement of negative interest rates. The BOJ (and the ECB, and … trust me … the Fed soon enough) is the insane Denethor. The banks are Faramir. The suicide mission is making loans into a corporate sector levered to global trade as the forces of global deflation rage uncontrollably.

Negative rates are an intentional effort to weaken your own country's banks. Negative rates are a punitive command: go out there and make more bad loans where risk is entirely uncompensated, or we will, in effect, fine you. The more bad loans you don't make, the bigger the fine. Negative rates are only a bit worrying in today's sputtering economies of Europe, Japan, and the US because the credit cycle has yet to completely roll over. But it is rolling over (read anything by Jeff Gundlach if you don't believe me), it is rolling over everywhere, and when it really starts rolling over, any country with negative rates will find it to be significantly destabilizing for their banking sector.

There's a reason that the Fed kept paying interest on bank reserves even in the darkest, most deflationary days of the Great Recession. Yes, it's the Fed's job to support full employment. Yes it's the Fed's job to maintain price stability. But the Fed's job #1 — the reason the Federal Reserve was created in the first place — is to maintain the stability of the banking system. Go ask a US moneycenter bank how things would have turned out in 2008 if the positive interest coming in on their reserves had been flipped to negative interest going out on their reserves. Go ask a US regional bank how things would have turned out if they had made even more rewardless risk loans in 2006 and 2007 under the pressure of negative rates. 

Look, I get the "theory". I understand that weakening the yen is an existential domestic political issue for Kuroda and Abe, just as weakening the euro is an existential domestic political issue for Draghi and Merkel, just as weakening the yuan is an existential domestic political issue for Zhou and Xi. And I understand that policy-addicted markets will respond exuberantly to anything that can be described as central bank support for financial asset price inflation. Hey, I'm an addict, too.

But what I'm concerned about is not the theory but the practice. What I'm concerned about is the intentional destabilization of the global financial system for domestic political purposes. What I'm concerned about is the Fed's inevitable adoption of negative rates, something Alan Blinder pushed for in 2008 and Ben Bernanke is pushing for now.

When the ECB instituted negative rates, that was just a point. The BOJ's move last Thursday makes a line. Now we have a pattern. Now we have a market that expects MOAR! Now we have a Fed that will undoubtedly implement negative rates when things get squirrely again, even if there are some in the Fed who I'm sure are shaking their heads at all this.

I've come to expect every elected politician or politician wannabe to rail against "the bankers" and the terrible mess they've made of the world with their "predatory lending" and "easy credit", even though this is exactly what every politician in the world desires. But I didn't expect central bankers to betray their own charges. I didn't expect central bankers to throw their own domestic banks into a battle they can't win.

You know what negative rates are? They are the final stripping away of the illusion that central bankers somehow exist above and separately from domestic politics, that they are wise and able stewards of financial stability. Nope. They're Denethors.

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When it comes to Wall Street permabulls, no one name sticks out more than that of FundStrat’s (formerly JPM’s) Tom Lee. Which is why, when even the traditional CNBC host during market up days, turns modestly bearish as he has in recent weeks and admits the investing community is gripped by a “growth scare” it is a notable event. As he writes, “the S&P 500 has been struggling since the start of the year and markets remain extremely on edge given the multitude of risks facing the market.”

In a curious departure from his traditional happy go lucky style, Tom Lee then proceeds to list all the things that can go even more wrong from here on out:

There are many issues potential becoming so significant that the economy and markets succumb to the risks:

• China: China is navigating an extremely challenging balance of slowing credit growth/expansion while transitioning growth from an investment-oriented to consumption oriented model. The structural changes over the past decade have resulted in China and its EM neighbors increasingly operating as an ecosystem, with the US less affected by “shocks” in China.
• Commodity producers: Commodity producers are seeing increasing financial stress, stemming from falling volumes and prices, currency weakening and diminished confidence by capital markets.
• Deflation: Falling inflation and the pernicious effects of deflation weigh on markets–particularly since, debt burdens become very difficult to manage in a falling pricing environment.
• Credit cycle: Default expectations have risen in 2016, stemming concerns about falling commodity prices and reduced market liquidity. Investors have pulled nearly $80 billion from high-yield mutual funds over the past 18 months.
• Policy divergence: Lastly, investors worry about policy errors from Central Banks. The Fed is tightening while other major countries are easing. Hence, the fear of a continued surge in USD and therefore more headwinds to US corporates.

But Lee’s latest note is especially notable because Lee lays out the following chart which superimposes the confluence of five distinct, and troubling for risk, 1- and 2-standard deviation events which are taking place currently, and highlights that the last time all 5 occurred at the same time was in February 2009.

Here are the 5 outlier events laid out by Lee:

1. HY spreads above 800bp;
2. oil down at least 25% yoy;
3. S&P 500 EPS is negative yoy;
4. Technicals are weak (% of stocks above 200d is below 15%)
5. sentiment is terrible (AAII).

And here is the visual history of the confluence of all these five events over time.

 

What happened in February 2009? Just as the S&P 500 was crashing in clear free fall, it was the Fed which just a few days later, on March 6 2009 bailed out the market for the first time, when it unveiled its expanded QE1 just as the S&P hit its “generational low” of 666.

This time, QE has been dormant for over a year and the Fed just hiked rates.

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