Tuesday, November 4, 2014

November-December 2014 Outlook: The Relay

TradeTheNews.com November-December 2014 Outlook: The Relay

This past Sunday, New York City hosted its annual marathon amid extremely blustery conditions that brought recent market activity to mind. The extraordinary events of late October reintroduced a concept that was lost on the markets for three years - volatility. With everything but the proverbial kitchen sink thrown at sentiment, US equity markets took a nearly ten percent dip, threatening one of the longest bull runs without a correction in history. An existential crisis in Iraq, sudden visions of an Ebola pandemic, and the uncertainties around the end of the Fed's bond buying program combined to alter the trajectory of markets, if only briefly. But to the delight of risk-on market participants, just two days after the Fed announced the end of QE3, Japan launched a new flight of stimulus-tipped arrows, announcing its giant public pension fund would shift to more aggressive investment while the BOJ expanded its asset purchases. The popular image that immediately took hold in the financial community was that of the Fed handing off the quantitative easing baton to the BOJ (with hopes that the ECB will run the next leg in 2015). Though it is dubious that there was any coordination here, a smooth hand off of that baton will be needed to keep the markets from stumbling.

Fed Finishes the First Leg

At its late October meeting the Fed followed through as promised and tapered the last $15 billion of its monthly quantitative easing program. The QE program was effective in buying time for the economy to heal, and its end should probably be taken as a vote of confidence in US economy. In reality the end of QE3 is just the equivalent of scraping the froth off the top of the stein-full of accommodation the central bank is still providing: A four trillion dollar balance sheet and near zero rates abide.

The withdrawal of the two dissenting votes at the October FOMC meeting indicates that the hawks on the committee are satisfied that the end of QE3 is the first step in the long process of unwinding accommodation that will next move to rate tightening some time in 2015. The hawks are rooting for 'rate lift off' in the early part of next year, while Fed Funds Futures show the markets see it in the latter part of 2015.

Though the Fed is now looking out toward normalization on the horizon, it has been increasingly stressing that policy decisions are strictly data dependent. This principle was important enough that it was written into the October monetary policy statement: "if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated." This leaves wiggle room on both sides of the equation, but the data has been trending better since the spring. Indeed, one development that could accelerate the liftoff schedule would be the materialization of an as yet elusive pick-up in wage inflation.

The next leg of the race for the Fed will start at the December 17 FOMC meeting, when it is expected to address the forward guidance statement that says rates will stay low for a "considerable time following the end of its asset purchase program." New language is in order to further emphasize data dependence and to move away from any calendar-based notions about when rate tightening will begin.

Thus the Fed is giving itself a broad timeframe for when rates might start rising and even when it does begin, the central bank has told us that rates will likely keep rates below normal for "some time" (a clause that has been in the FOMC statement since March). Markets may soon start to dread rate lift off, but it is not likely to lift far off of zero. Though the US economy appears to be ahead of most of the developed world in the recovery cycle, the fact that Europe and Japan have just launched new stimulus packages and are hinting at more could keep the Fed chained to low rates for the foreseeable future, even if a token rate hike comes next year.

In the meantime, the specter of a currency war could arise again as the BOJ and ECB policy actions weaken their respective currencies against the dollar. Since the BOJ surprise announcement on October 31, the USD/JPY has weakened from 108 to 114, while the euro is plumbing a 2-year low against the dollar. While the Fed does not officially consider the currency level, the Yellen team may start to fret about US exports if the dollar continues to surge based on the actions of foreign central banks.

The Handoff

Interestingly the latest risk on rally is built on the premise that the end of the Fed's QE3 has signaled other central banks to step in and do their part for global stimulus. Seemingly on cue, Japan stepped in with another 20 trillion yen from the BOJ and confirmed that the GPIF, the world's largest pension fund, would significantly increase allocations to riskier assets, including nearly doubling its holdings of foreign securities. While the GPIF announcement had been anticipated for weeks, the new BOJ stimulus was a genuine surprise. At the same time, press reports made it clear that PM Abe's government is working on another 3 to 4 trillion yen spending package of its own.

All told it is an impressive effort, and the multi-trillion yen government package may continue to be teased in the press for weeks to come, but that said, this may be the last gasp of stimulus from Japan. The unexpected BOJ stimulus increase was the main driver of the October 31 risk-on rally, but it came in a tight 5 to 4 vote, indicating the policy committee is not entirely comfortable with the plan and that there is little chance of another expansion in the future.

The next signpost for Japan will be its preliminary Q3 GDP data on November 16. The BOJ just cut its fiscal year GDP forecast in half to 0.5% growth, as well as trimming its CPI outlook, acknowledging that reaching the inflation target that is the key yardstick of Abenomics will be more difficult to achieve than previously thought. More discouraging growth data could weigh on the impending decision about whether to go ahead with the second stage of a consumption tax increase in April. The IMF has urged the government to move forward with the tax hike to maintain the credibility of its fiscal framework, but the slower growth seen since the first bite of the tax increase this past spring will give Tokyo much to think about. The decision is slated for December and may be counterbalanced by the fruition of the government spending package.

With Japan seemingly extending itself to its fullest, it may not be long before stimulus addicted markets turn their eyes to the ECB looking for more fuel. In short succession over the summer, ECB President Draghi announced two new major stimulative efforts - the Targeted Long Term Repo Operations (TLTRO) and an ABS/covered bond purchase program dubbed by some as "QE light." Even as these programs are still just getting off the ground, the ECB is feeling definite pressure from markets to go further with a full blown QE program, but that may be stymied by legal limitations preventing the central bank from supporting member nations through direct sovereign bond purchases and the objections of the euro zone's most fiscally prudent members, led by Germany. Those who are waiting for this final and most emphatic manifestation of the 'Draghi Put' may be disappointed, as most indications are that there will not be any ECB QE this year (but maybe in 2015). In the meantime the ECB may tinker with the terms of its TLTRO to improve the results at its next operation (December 11), after a disappointing take-up it is inaugural offering.

Will China Rejoin the Relay?

If Japan and Europe have breathed their last stimulus into the global economy, accommodation junkies may still have a white knight swoop in from other quarters. Since the single major stimulus plan it launched in the early days of the global financial crisis, China has been content to run a series of mini-stimulus programs to keep its growth trajectory right on the 7.5% GDP target. But lately, hitting that target has been getting tougher amid slower industrial growth, a cooling real estate sector, and a relentless anti-corruption campaign that has shaken up business-as-usual.

Through the first three quarters of 2014, Chinese GDP growth is running at 7.4%, just below the official target rate, though the Q3 reading was the slowest quarter since early 2009, suggesting the government's targeted stimulus measures have not yielded the expected results. Officially the China Statistics Bureau is forecasting a stronger Q4 to make up the difference and is still of the belief that growth and inflation figures are close enough to targets that the government can get by with merely fine tuning fiscal policy.

Some deteriorating data may militate against that belief. China's slowdown appears to be concentrated in the real estate sector, which accounts for about 10% of GDP or 20% if you add in related industries. In the last few months, home price appreciation has stalled for the first time in two years and the pace of property sales has slowed markedly (year-to-date total value of property sales are down about 9% year over year through September). Coupled with this, fresh multi-month lows recorded in the latest manufacturing and services PMI readings could bring the People's Bank of China back into action. The PBoC has been relatively quiet in the last two years but if the data continues to decay the central bank could examine a rate cut, which would be the first such easing since mid-2012, the last time it used rate policy to address a perceived slowdown in the rate of economic growth.

The Race Is On

The Fed is done adding stimulus, but the US political landscape may deliver some good mojo to the markets (instead of its usual drag), at least in the short term. The November 4 mid-term elections could put both houses of Congress in the hands of Republicans for the first time since 2006. Given low turn-out in non-Presidential election years and a number of close races, pundits are giving the GOP a better than 70% chance of winning the six additional seats they need to take control of the Senate. Initially markets would probably take this outcome as a positive, and the generally pro-business, pro-energy agenda of the Republicans may give a psychological boost to beleaguered energy stocks in particular, which have been suffering of late due to the swoon in oil prices. A Republican Congress could push through legislation on the Keystone Pipeline, legalization of US oil exports, and a tax amnesty for companies to repatriate overseas earnings, putting the onus on President Obama to use his veto. No matter what happens in the election, the US will still have a divided government for at least two more years, and the pundits will immediately move on to analysis of the 2016 Presidential race while Mr. Obama serves out his lame duck years.

Elsewhere in politics, Europe will face another secession vote, this time in Spain. The rhetoric of the Catalan independence movement has been somewhat blunted after the independence movement was scotched in the UK, but the enclave is still forging ahead with a non-binding reference vote on independence on November 9. A yes vote in the Catalonia referendum could revive concerns about balkanization in Europe, an unneeded distraction for a continent already facing difficult political and economic challenges.

A Slippery Path for Oil

In its own way, OPEC may have made a grab for the stimulus baton too. The steady strengthening of the greenback has had an outsized impact on the commodity markets, leaving WTI crude trading around $80/barrel and Brent crude about $5 higher, the lowest levels since the early days of the global economic crisis. The rapid 20% decline in oil prices is a cause for panic in some smaller OPEC producing countries. Venezuela, fearing the price drop in the commodity that accounts for almost all of its exports could lead to a debt default, clamored for an emergency meeting of the cartel to address the issue, but its call fell on deaf ears. Saudi Arabia -- the powerhouse of OPEC and the only member with enough spare capacity to move the needle -- appears to be content with the current situation. At least one Saudi diplomat suggested that this might be his country's means of providing some global stimulus. Analysts say that if the 20% drop in oil prices sticks, it would boost global consumption and amount to more than $1 trillion in annual stimulus, which in turn would create demand for another half million barrels per day of oil.

The Saudis could have other motives as well. Though current the current price of oil is near Saudi Arabia's budgeted break-even point, rival producers have higher production costs per barrel. The Saudis recently offered price discounts to large Asian customers, indicating that they are less concerned about price than about protecting market share from producers like Russia (which in the face of Ukraine-related sanctions has made strides to ship more crude to East Asia), and Iran, the Saudis religious and political rival. Weaker energy prices have also squeezed the North American fracking industry which has boomed with oil above $100/barrel, but now may have to reevaluate the economic viability of some higher cost wells.

The intentions of the Saudis may be made clear at the November 27 regular meeting of OPEC oil ministers in Vienna. An increasing number of energy analysts are forecasting that Saudi Arabia will relent and agree to a 500 thousand to 1.5 million barrel reduction in the OPEC production ceiling, which might send crude prices back toward the $100 mark, if not above it. The decision may be hinted at in OPEC's Annual World Oil Outlook released on November 6.

Iran could turn out to be another wildcard for energy markets. Negotiations over restraining Iran's nuclear program have been grinding on, with the latest extension in talks setting a November 24 deadline for an agreement. The chief diplomats for both sides have maintained a cautious outlook as this date approaches, indicating that a lot of work still needs to be done to achieve a viable deal. A major sticking point appears to be that Tehran wants sanctions lifted immediately while the US and its allies are proposing a gradual withdrawal. If a deal can be struck, more Iranian oil will eventually get to market, but failure to reach terms might lead the major powers to put more pressure on Iran's oil customers in Asia to reduce their consumption. In addition, Israel, which is already on a short fuse after its most serious confrontation with Hamas in years this summer, might see failed nuclear talks as the signal for it to take military action against nuclear sites in Iran.

Among other commodities, precious metals are also at multiyear lows. Even amidst the geopolitical tensions in the Middle East, Ukraine, and Hong Kong this year gold has not gained an ounce of traction. The chart of the yellow metal is indicating a technical breakdown may be imminent, but things might be looking up for the gold bugs as Switzerland prepares for a referendum on the issue of its gold reserves. If the referendum passes on November 30, the Swiss National Bank will be required to stop selling gold and to increase its gold reserves to 20% of its assets (from the current 7.8%). This would force the central bank to buy over 1,500 tons of gold, or sell close to half of its fiat money reserves, or some combination of the two to boost the percentage weight of gold on its balance sheet. Such drastic changes might imperil the 1.20 ceiling the SNB has imposed on the franc, which nearly reached parity with the euro in mid-2011 just before the currency cap was put in place. The latest polling shows the yes vote has a slight edge.

Far From the Last Mile

QE is not over, it is just evolving. Japan has grabbed the baton, and the BOJ bonanza reignited the risk-on rally. Many are hoping that the ECB will take up QE next, but don't count on it in the near term. However, more stimulus could come from other quarters, ranging from the US Senate to the Saudi oil princes, or China may even pick up the baton again. In all it may be enough to propel a melt up of risk assets into the New Year (though the jury is still l out on whether QE has been as beneficial for Main Street as it has been for the markets).

So what could go wrong? The doomsayers assert that we are bound for a situation where QE becomes a permanent fixture or that all this stimulus is really just 'pushing on a string' and will eventually lead to a calamity that will eclipse the worst days of 2008. The strong dollar trend looks ready to continue, but if it goes too far too fast, it could erode the gains made in the US economic recovery, and further compress oil prices. More importantly, if the ECB and BOJ extraordinary measures don't turn things around soon, it could set up a global deflationary spiral.

Even if the outcomes are not that extreme, the recent bout of market volatility showed things can move quickly, illustrated by disturbingly rapid whoosh lower seen in government bonds and oil. Markets may get unsettled again by a resurgence of the issues that caused the October gyrations. As 2015 creeps closer, thoughts will turn to Fed tightening, especially if improving employment data is met with wage inflation. The geopolitical upsets in Ukraine and Iraq are not fully resolved either, not to mention that the impending flu season will send every hypochondriac in the western world to the hospital screaming Ebola.

In this holiday season, here's to your health, and to hoping the central banks execute a smooth handoff of that baton for at least few more laps.


2: China Non-Manufacturing PMI; China HSBC Final Manufacturing PMI
3: US ISM Manufacturing PMI
4: UK Construction PMI; US Trade Balance; US Factory Orders; US Election Day
5: Various EU Services PMIs; US ISM Non-Manufacturing PMI; BOJ Minutes
6: German Factory Orders; BOE policy statement; ECB policy statement and press conf; OPEC Annual World Oil Outlook
7: US Payrolls and Unemployment
8: China Trade Balance

9: China CPI and PPI
10: China New Loans; UK Manufacturing Production
11: UK Trade Balance
12: EU Industrial Production; BOE Inflation Report
13: China Industrial Production; UK Claimant Count and Unemployment
14: UK CPI and PPI; Euro Zone flash Q3 GDP; US Retail Sales, Prelim University of Michigan Confidence

16: Japan Prelim Q3 GDP
17: US Industrial Production
18: UK Retail Sales; German ZEW Economic Sentiment; US PPI; BOJ Policy Statement (tentative date)
19: BOE Minutes; US Housing Starts & Building Permits; Oct FOMC Minutes; Japan Trade Balance
20: US CPI; US Philly Fed Index; US Existing Home Sales

24: BOJ Minutes; China HSBC Flash Manufacturing PMI; Deadline for Iran Nuclear Deal with Major Powers
25: Various EU Flash Manufacturing PMIs; UK Q3 GDP (2nd reading); German Ifo Business Climate; US Prelim Q3 GDP (2nd reading); US Consumer Confidence
26: German Prelim CPI; US Durable Goods; US New Home Sales
27: German Unemployment; Japan Retail Sales; Tokyo CPI; OPEC Regular Meeting; US CLOSED FOR THANKSGIVING
28: German Retail Sales; Euro Zone Flash CPI Estimate; Euro Zone Unemployment; Chicago PMI

30: China Manufacturing PMI; China HSBC Final Manufacturing PMI; Swiss referendum on gold reserves and immigration issues
1: US ISM Manufacturing PMI
2: UK Construction PMI; China Non-Manufacturing PMI
3: UK Construction PMI; Euro Zone Retail Sales; US ISM Non-Manufacturing PMI
4: BOE policy statement; ECB policy statement and press conf
5: German Factory Orders; US Payrolls and Unemployment; US Factory Orders

8: China Trade Balance (tentative); Japan Final Q3 GDP
9: UK Trade Balance; China CPI and PPI
10: China New Loans; UK Manufacturing Production
11: ECB Targeted LTRO announcement; US Retail Sales
12: China Industrial Production; Euro Zone Industrial Production; Prelim University of Michigan Confidence

15: UK CPI and PPI; US Industrial Production
16: UK Claimant Count and Unemployment; German ZEW Economic Sentiment; BOE Financial Stability Report; US Housing Starts & Building Permits; Japan Trade Balance
17: BOE Minutes; Euro Zone Final CPI; US CPI; FOMC Policy Statement and Press Conference
18: UK Retail Sales; US Philly Fed Index; BOJ Policy Statement (tentative)

22: German Unemployment; US Existing Home Sales; China HSBC Flash Manufacturing PMI
23: German Retail Sales; Various EU Flash Manufacturing PMIs; German Ifo Business Climate; US Final Q3 GDP; US Durable Goods Orders; US New Home Sales
24: BOJ Minutes

29: German Prelim CPI; Japan Retail Sales
30: US Chicago PMI; US Consumer Confidence
31: China Manufacturing PMI