Financial Review

Buckle Up

Financial Review by Sinclair Noe

DOW – 128 = 17,849
SPX – 6 = 2074
NAS + 7 = 4937
10 YR YLD – .04 = 2.06%
OIL – .42 = 43.46
GOLD – 5.70 = 1149.60
SILV – .10 = 15.63


The FOMC will wrap up its two-day meeting on interest rate policy tomorrow. The key question: will the Fed give a hint about raising interest rates? IMF Director Christine Lagarde says even if the Fed is able to manage expectations about an interest rate hike, “the likely volatility in financial markets could give rise to potential stability risks.”


ECB President Mario Draghi says, “Most indicators suggest a sustained (eurozone) recovery is taking hold.”  Draghi is urging governments to use the brighter outlook to advance reforms that would improve the region’s long-term growth prospects. Draghi claims, “Confidence among firms and consumers is rising. Growth forecasts have been revised upwards. And bank lending is improving on both the demand and supply sides.”


Draghi sounds a little overly optimistic. A couple of weeks of bond buying have not changed the overall economies of the Eurozone. Unemployment is still rampant in Spain and Italy and Greece and Portugal and several other countries. No doubt QE is increasing liquidity in the sovereign debt markets; the private banking system are surely pleased with cheap money policy, but it hasn’t changed the jobs picture, it hasn’t resolved the underlying problems of the economy, and it hasn’t resolved the problem of deflation.


Many people thought that QE would result in inflation, or even hyper-inflation. Wrong. Just this year, 23 central banks have cut rates due to sluggish growth. In the process their currencies will weaken. The Bank of Japan maintained its massive 80-trillion-yen stimulus program today, and noted inflation could fall into negative territory because of the continued weakness in energy prices; however, it also said any return to deflation would not last long. A return to moderate inflation might just be wishful thinking.


Meanwhile, the euro is tanking against the dollar as the ECB buys covered bonds from the Euro-banks, while Greece is left to dangle from a short and sharp hook, locked out of the capital markets. Today, Greece began debate on emergency measures to deal with $2.1 billion in debt payments due Friday. Euro quantitative easing has nothing to do with helping Greece attain a stronger economy and everything to do with rewarding speculators and the Euro-banks that sold them bonds. Included in the amount due Friday, payments on a swap originally arranged by Goldman Sachs in 2001. The derivative, now held by the National Bank of Greece, masked the country’s growing debt, helping it meet European Union rules for entering the euro area.


There are only so many entities that can buy so many bonds and filter so much cheap capital into the system for so long. Eventually the ECB will quit QE. Eventually the Federal Reserve will raise interest rates. And then what? Well, the central bankers will look for new ways to finagle the financial sector, but we might reasonably expect more volatility. Maybe the Fed will give us a hint tomorrow.


When we think about volatility in the markets, we tend to default to the stock market, but don’t forget bonds. Consider that the 10 year US Treasury note yields 2.06%. The Japanese 10 year bond yields 0.41%. Germany at 0.28%, and Spain 1.25%. These are historic lows.  So, with the bond market appearing ripe for a dramatic correction, many are wondering whether a crash could drag down markets for other long-term assets, such as housing and equities.
According to Nobel economist Robert Schiller, long-term rates in the US should be even lower than they are now, because both inflation and short-term real interest rates are practically zero or negative. Even taking into account the impact of quantitative easing since 2008, long-term rates are higher than expected. The history of bond markets crashes have been relatively rare and mild. So, there should be no reason for bonds to crash from here… unless, there is a major spike in inflation, or the central banks tighten monetary policy very sharply by hiking short-term interest rates.
For now, the markets are trying to make sense of where everything is headed. The result has been volatility. The Dow Jones Industrial Average was down a bit over 100 points last week, but that hardly does justice to a week with multiple triple digit swings. Three of the last six trading days have seen a move of at least 1%. Today the Dow dropped 128 points, and that was just a move of 0.7%. Still, it can be a bit unnerving. Volatility in and of itself isn’t necessarily a bad thing as markets can continue to climb even as volatility does the same. A rising VIX doesn’t have to correspond with a lower stock market. The VIX (volatility index) trended higher from 1996 right to the end of the dotcom mania. Maybe that is not reassuring, but this is not the internet bubble.


One reason for the volatility is because earnings outlook has turned lower, but even more so because earnings outlook has turned very uncertain; and the reason behind the uncertainty is the volatility of the dollar. Yes, the dollar has been getting stronger; remember that volatility can apply in up or down markets. The strength of the dollar raises questions about whether companies have properly hedged earnings in other countries. Will a higher dollar create a debt crisis outside the US as it has in the past? What will central banks do in response? Which central bank will win the race to the bottom of currency valuations? How will that affect the US economy?


Economic data in the US has been on the weak side lately. A strong dollar doesn’t help. Inventory to sales ratios have now jumped to levels that are comparable to late 2008. Sales were down for the third month in a row led by declining auto sales (-2.5%). Sales were down across a wide swath of industries. The economic expansion since the 2008 crisis may have been disappointing, but it has been remarkably steady. Annual GDP growth has been eerily consistent, between 2 and 2.5% for years. The last time we had such a run of consistent growth was the late 90s; the growth rate was higher, around 4%, but very consistent.


Maybe the strange part of the past few years is just how consistent the recovery has been. Maybe the lack of volatility is a result of the accommodative monetary policy of the Federal Reserve, well balanced against a weak economy, just enough to push forward, but not enough to reach escape velocity. The one thing we know is that markets fluctuate, they don’t move in a straight line. So buckle up, it should be interesting.


Construction on new homes in the United States slumped 17% in February, mostly because of heavy snowfall that sidelined builders in the Northeast and Midwest. Housing starts sank to an annual rate of 897,000 in February from a revised 1.08 million in January. But nationwide permits for future construction rose, suggesting construction will pick up in the spring. The biggest increase in applications for new construction once again involved multi-dwelling projects such as apartment buildings and townhouse rows. Permits for projects of five units or more jumped nearly 20%, reflecting a post-recession trend in which more people are renting instead of owning.


Another factor weighing on housing is negative equity. According to CoreLogic, there are 5.4 million homes, or 10.4% of all homes with a mortgage, underwater in the fourth quarter of 2014. This is down considerably -18.9 percent, from a year ago-but it still keeps these borrowers from putting their homes on the market, because they would lose money. Additionally, of the 49.9 million U.S. homes with a mortgage, approximately 10 million (20 percent) have less than 20 percent equity, and 1.4 million have less than 5 percent. These homeowners also would have a difficult time selling because not only would they lose money in the process, but they also might not qualify for a new mortgage. Arizona is still one of the top 5 states for negative equity, with 18.7% of mortgaged homes underwater.


Exit polls show Israel’s elections are too close to call. Those waiting to find out who will be the next prime minister of Israel need to wait. Binyamin Netanyahu—the serving PM—won the same number of seats as Isaac Herzog’s Zionist Union according to several exit polls. Netanyahu is claiming victory, based on the idea that he can cobble support from other parties, but really, it’s too close to call right now.


American Airlines was added to the S&P 500. The airliner replaces Allergan, which has been taken-over by. The addition will take place after the close of trading on March 20.


Over the past few years we have talked about deferred prosecution agreements or non-prosecution agreements; a common tool used by the Justice Department in investigations ranging from sanctions violations to market manipulations. Such settlements require the banks to admit responsibility and cooperate with ongoing investigations. It is a bank or corporate equivalent of probation. The banks pay a fine and promise not to break the law for a few years, and if they can keep their nose clean, then all is forgiven. The problem is that the banks are repeat offenders.


For example, a few years back several banks were found to be rigging benchmark interest rates, the Libor scandal. Fines were paid and deferred prosecution agreement signed. Barclays, Royal Bank of Scotland, UBS, and HSBC are operating under such agreements. But now, the banks appear to have rigged the forex markets, or the currency exchange market, just within the past 2 or 3 years; which would be a violation of the agreement to stop breaking the law.


Leslie Caldwell, the head of the Justice Department’s criminal division, said in a speech Monday that the US is prepared to tear up settlements and charge banks for conduct covered by the settlements. “Where banks fail to live up to their commitments, we will hold them accountable,” Caldwell said. “The criminal division will not hesitate to tear up a DPA or NPA and file criminal charges.”


Of course prosecutors have talked tough in the past and then followed it up with the vicious pugnacity of a timid meter maid; the results have been predictable; the banksters’ recidivism rate has regularly topped 100%. So, don’t hold your breath.





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