Financial Review

Stormy Weather

Financial Review by Sinclair Noe for 10-23-2015

DOW + 157 = 17,646
SPX + 22 = 2075
NAS + 111 = 5031
10 YR YLD + .05 = 2.08%
OIL – .65 = 44.73
GOLD – 1.90 = 1165.00
SILV – .03 = 15.91

 

After Thursday’s closing bell Microsoft, Amazon, and Alphabet all reported very strong third quarter earnings, and these companies are big enough to lift the entire market; today they added $80 billion in market cap. Amazon and Alphabet hit all-time highs, and Microsoft moved to its highest levels since 2000. Toss in a little central bank easy money and you’ve got one of the best two day rallies in a long time. The S&P 500 gained 2.1% for the week; its fourth straight weekly gain; moving into positive territory year to date. For the week, the Dow rose 2.5 percent and the Nasdaq gained 3 percent. Oil capped its biggest weekly decline since August as expanding U.S. crude stockpiles exacerbated a global glut, and the dollar moved higher, especially against the euro.

 

China’s central bank cut interest rates today for the sixth time in less than a year (down 25 basis points to 4.35 percent) , and it again lowered the amount of cash that banks must hold as reserves. Monetary policy easing in the world’s second-largest economy is at its most aggressive since the 2008/09 financial crisis. The People’s Bank of China said it was freeing the interest rate market by scrapping a ceiling on deposit rates; which will, in theory, allow banks to price loans according to their risk, and remove a distortion to the price of credit that analysts say fuels wasteful investment in China.

 

At a rate review next week, the Bank of Japan will cut its growth and inflation outlook for this fiscal year but only slightly tweak its projections for 2016. The BOJ can still maintain it’s on course to meet its inflation goal of 2% next year without needing to step up its massive asset purchase scheme.

 

While the Eurozone’s composite PMI unexpectedly increased to 54 in October from 53.6 in September, signaling a pickup in activity, forward-looking indicators point to a risk of a slowdown, according to Markit Economics. Service-sector expectations for the year ahead fell to a 10-month low.

 

Stocks across the globe extended a rally from the previous session, as central banks exert their dominance on markets. Yesterday, ECB President Mario Draghi signaled his willingness to add more stimulus to the Eurozone’s flagging economies, possibly at the next ECB meeting in December. The euro dropped for a second day versus the dollar, down 2.8% for the week. The euro is down more than 8 percent against the dollar year-to-date, and has fallen by 12 percent over the past year. Call it an accidental devaluation of the euro. The ECB claims it is not their intention to devalue the euro, but there simply doesn’t seem to be much evidence that QE and zero rates have done much to drive inflation higher. Still, the market salivates and sells euros when Draghi says QE.

 

Against a backdrop of ongoing stimulus in Japan, a big burst of new stimulus in China, and anticipated extension of stimulus in Europe, it becomes increasingly difficult to imagine the Fed will be able to go against the grain and hike interest rates any time soon. Fed funds futures rates show almost no chance next week when the FOMC meets, and less than a 50% chance when they meet in March.

 

This has implications across the board. The Federal Reserve’s decisions about interest rates will affect every single person and company in the United States. Walmart will like having cheap imports. Boeing won’t like that its planes cost more to foreign buyers. Family farmers won’t like it; big agribusinesses, like Cargill, will. For banks, a Fed rate increase can be good and bad news: In a recent report on the subject, Goldman Sachs argued that some banks, like M&T and Wells Fargo, are going to be in a bit of trouble, while others will make more money from interest rates on loans. On an individual level, Fed rate increases are better for older people who live on savings and worse for younger people who tend to borrow more.

 

If the Fed added up all the ways a rate increase helped people in the short term and subtracted all the ways it hurt them, they would never raise rates. While there are winners and losers, on balance a Fed rate increase means the economy will slow down, which on average is worse for everybody. Of course Wall Street loves easy money from the Fed. Global markets are as well trained as Pavlov’s dogs.

 

This week the People’s Bank of China announced easy money, although most of that stays in China, and the European Central Bank announced it would continue with its QE asset purchases; currently the ECB is buying a little over $90 billion in government bonds each month, and Draghi hinted there might be more coming in December. And the funny part is that all this extra money being pumped into the system should result in inflation, but the opposite is happening. Rates in the Eurozone are near zero, and this week the Italian 2 year government note went negative, as did the US Treasury 30-day bill. So where is all that money going?

 

Well, it’s going into government bonds. And where are the government bonds going? Well, they are being used as collateral for the $700 trillion dollar derivatives market where they are tucked away as collateral. And the lower the central banks pegs interest rates, the more the banks are forced into taking risks to generate returns, and that means risk, and risk is mitigated (at least in theory) with derivatives, backed (again theoretically) by the collateral of government debt.

 

And so, some off the biggest news of the week that nobody noticed was a new ruling from a couple of regulators, which will greatly reduce the collateral requirements the big banks must set aside in derivatives deals. The rules are still in draft form, but they would cut in half what the companies must post in transactions between their own divisions. The proposed rules are coming from the FDIC and the Commodities Futures Trading Commission, backed by the financial industry and the rules are apparently being drafted by the financial institutions as well.

 

It’s difficult to estimate how much is at stake for banks, but the derivatives market is estimated at $700 trillion nominal value; the collateral involved is likely in the hundreds of billions in non-cleared swap trades. The banks think this might free up collateral for other purposes. I’m guessing riskier purposes, but time will tell. What this also might address is the remarkable lack of supply of government debt – how else to explain Italian notes going negative?

 

Best guess is that we will see continued growth in structured financial assets that made synthetic swaps where the casino banks sold protection based upon bonds, rather than actually investing in bonds, and then called it collateral that could be sold as insurance to guarantee payment on insurance contracts. Sure – what could go wrong?

 

Analyst sentiment on overall third-quarter earnings has improved following the string of strong results from blue chips. S&P 500 earnings for the period are now expected to have declined a more modest 2.8 percent, compared with a decline of 5.5 percent forecast at the start of the reporting season.

 

American Airlines reported earnings of $1.9 billion, or $2.77 a share; beating estimates. American realized big savings from lower fuel costs. American’s board authorized a new $2 billion share repurchase program to be completed by year-end 2016. They still face an air fare war. American said it will discount tickets in a bid to win market share.

 

The Environmental Protection Agency regulatory package known as the Clean Power Plan officially became law today. It was immediately challenged by 24 states, led by West Virginia, in a U.S. appeals court filing in Washington. The states are asking for a court order blocking the measure until the lawsuit is resolved. It’s at least the third time the initiative has come under legal fire. Earlier challenges were rejected by federal judges as premature because the measure hadn’t been published. The U.S. government no longer has that defense, leaving the regulations open to attack. The Clean Power Plan aims by 2030 to reduce power plant carbon emissions 32 percent below where they were in 2005. The rules require states and utilities to use less coal and more solar power, wind power and natural gas. States are required to submit their initial plans for meeting those objectives by Sept. 6 of next year. Final plans must be submitted two years later. EPA Administrator Gina McCarthy, issued a statement saying the Clean Power Plan is based upon “strong scientific and legal foundations” and is within the authority granted to the agency under the Clean Air Act.

 

Hurricane Patricia is moving onshore right now around Manzanillo on the Pacific Coast Mexico. It is being called the most powerful storm in recorded history, with winds clocked at 200 miles per hour, which makes it a Category 5. The only good news is that this area of Mexico is not heavily populated. Evacuations have been ordered along the coast. The US National Hurricane Center said Patricia was on track to make a “potentially catastrophic landfall.” Storm surge could top 30 feet. The storm is also expected to bring about 20 inches of rain. So the storm surge will hit the coast, and then a couple of hours later, the rains will wash down from the mountains. The hurricane is expected to head northeast over Guadalajara, then dissipate as it hits the Sierra Madres, and over the next 2 or 3 days, it should make its way to Texas with heavy rains, and that’s on top of flooding in Texas happening now as the result of another storm system.

 

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