Boring But Important: ECB Relaxes Collateral Rules

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This news hit wires pretty quietly Thursday, but the ECB took action to help solve a major issue that is impeding the recovery in Europe.

One of the problems I and others have been discussing for some time in Europe is the inability for very cheap money (low interest rates) to get into the hands of so- called “SMEs,” or small to medium enterprises.  The idea was supposed to work like this:  The ECB lends money to banks at virtually 0%, and banks provide current loans (mortgages, inventory loans, etc.) as collateral for the funds.  The banks are paying virtually 0% for the money, and they can then turn and lend it to the SMEs (or the real economy) at a higher rate, and everyone wins:  The SMEs get fresh capital to invest and expand, the banks make a spread on the loans, and the ECB helps revive the EU economy.

Here’s what’s been happening instead: Cheap funds from the ECB have been staying on bank balance sheets. It’s not because of the “evil bankers”; it’s because a lot of the ECB’s new rules require greater capital ratios, and the ECB won’t accept certain types of loans as collateral for cash, which smaller commercial banks can then lend out to “SMEs,” which will hopefully stimulate the economy.  So, like most things fiscally speaking in Europe, it was a “one foot in, one foot out” approach, and that’s why it hasn’t worked.

Well, yesterday the ECB took two steps to help change that.  First, they relaxed some of the ratings requirements on certain loans that could be pledged as collateral for cash loans to these central banks.  Second, the ECB realized “haircuts” on asset-backed securities pledged as collateral for loans from the ECB to these commercial banks.

Previously, because asset-backed securities are deemed riskier, if I were a commercial bank and had a 100-million-euro loan from a car dealer secured by the inventory, I could pledge that to the ECB to get fresh capital to lend. But I wouldn’t get 100 million; I’d only get 75 million or 80 million, because the ECB imposed a “haircut” in the loan to insulate it from losses.  (I’m making up the numbers, but it illustrates the point.) Well, that “haircut” made it not worth it to me economically, so I didn’t do it.  Now, with haircuts on asset-backed securities reduced, this is a viable option, and it is one of the better ways to help get all this cheap money in the hands of SMEs (or the “real” economy) and break the capital logjam at the banks.

So, yesterday’s news was positive for two reasons:  First, it’ll help the EU economy.  Second, it implies the ECB is still working on ways to stimulate economic growth in the EU, and it will boost expectations that more plans may be announced at the ECB meeting in August.

Bottom line, though, this is a positive for, first, European banks and, second, the European economy.  And, it’s more of a tailwind on my “long” UK idea (ETF symbol EWU, the iShares MSCI United Kingdom Index).  While it doesn’t really affect the UK, it’s peripherally positive.

Missed Profiting from the Bond Market Selloff? Here’s Your Chance to Get In.

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The key here remains that the equity market continues to get more comfortable with the reality of “tapering.”  Keep in mind that the market broke from its highs almost two months ago on the Hilsenrath WSJ article that said the Fed was game planning its exit, so markets have been adjusting to this new Fed reality, sometimes violently, for 2 plus months.

So, as long as current expectations are generally met:  “Tapering” starting in September, QE ending in mid/early ‘14, then what will decide if this market moves to new highs or not is boring old economic data and earnings.  As long as rallies in bond yields and stocks are no longer mutually exclusive, as they have been since May, and emerging market bonds continue to stabilize (they don’t have to rally, they just have to not implode) then the path of least resistance for the market is higher, as long as the data is “ok”.

1650 is a key level in the S&P 500 and we’re going to open well above it this morning.  A strong close today and tomorrow could bring in momentum buyers off the sidelines and accelerate the rally into the end of the week, so that’s an important level to watch.

The analysis of the Fed minutes yesterday caused a bit of whiplash. Initially, the takeaway from the minutes was that they were “dovish,” and we saw stocks move higher and Treasuries rally/yields fall.

But, that interpretation was incorrect (as is often the case with initial interpretations of anything Fed-related). That’s why there is a popular trading axiom that states “the first move of the market after a Fed event is usually the wrong one.”

What the speed-reading programs and analysts didn’t see—in their “dovish” interpretation—was that, buried in the appendix, was this passage:

“Given their respective economic outlooks, all participants but one judged that it would be appropriate to continue purchasing both agency mortgage-backed securities and longer-term Treasury securities.

“About half of these participants indicated that it likely would be appropriate to end asset purchases late this year. Many other participants anticipated that it likely would be appropriate to continue purchases into 2014.” (Emphasis added).

Remember back to Ben Bernanke’s press conference after the Federal Open Market Committee statement.  What surprised the market was that Bernanke said the broad consensus of the Fed was that QE should end in mid-2014, which was earlier than the consensus thinking at that time. (Consensus was for QE to end in late ’14.)

Well, the “end date” of QE may be closer than “mid” 2014, depending on data, which is trending better since the last Fed meeting.

Of the 19 participants at the meeting, at least one leans toward QE ending immediately.  Of the remaining 18, “about half” thought QE should end later this year, presumably at the December meeting.

That’s another “hawkish” surprise, and we did see the effects of it when Treasuries sold off into the close and the Dollar Index pared some losses.  Now, does that mean QE will end in December?  Probably not, as Bernanke/Yellen and Dudley still dominate the Fed and they are doves.

But,  for all the gaming of the Fed, the takeaway here is that “tapering” remains very much on schedule, and it would appear that the risk is for QE ending sooner than current expectations, rather than later.

So, with regard to the market, the minutes only further reinforced the fact that interest rates are going higher as is the U.S. Dollar, unless economic data turns decidedly worse.  So, in my opinion, today’s Dollar Index decline and Treasury rally is doing nothing other than providing a great entry point to get exposure to the most powerful trends in the market:  Higher rates, which strengthens the bullish case for “short bond” plays like TBF, TBT, SJB, banks, etc.

FOMC Minutes/Bernanke Preview

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The Fed remains critical to the market, so today’s Fed events today will be front-and-center like they always are.  But, whatever the immediate “reaction” to the FOMC minutes and Bernanke, keep in mind that the very broad consensus is that the Fed will begin “tapering” at the September meeting.  That is the baseline expectation.

With regard to the minutes, they have the potential to be a touch hawkish, as there will probably be a Fed official or two who says tapering should start in July.  But, unless there are “many” Fed officials who espouse that view, it won’t change September as the consensus date.

Bernanke’s speech, if he touches on monetary policy at all, will likely be dovish. No doubt he will re-iterate the “tapering is not tightening” refrain.

He’s right, of course, but saying that doesn’t change the fact that tapering will  likely start in September. Unless he says that tapering might not start until ’14, the comments won’t really alter the baseline expectations.

Bottom Line

For all the incremental headlines over the past few days (and this morning) the rally this week is bout investors becoming more comfortable with the “tapering” narrative and the reality of higher interest rates in the future.

The fact that higher stock prices and higher rates no longer appear to be mutually exclusive is bullish for the market, and as long as that continues, expect the path of least resistance to be higher in equities.

 

Was Friday’s Rally A Game changer for the Market?

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Economics

Last Week

Friday’s jobs report capped what was a good week for domestic economic data, and the main takeaway was that Fed “tapering” expectations in September were further cemented by the data.

Looking at the jobs report, it was a pretty “Goldilocks” number.  The June report was a bit better than expectations (195K vs. 161K) but, almost more importantly, we saw a net 70K increase in the May and June figures.  The unemployment rate held steady at 7.6%, but that came with a welcomed increase in the participation rate and employment-to-population ratio.  Overall, this was a very solid report.

As mentioned, the rest of the data from last week was also pretty solid. The final reading on both manufacturing PMIs and the non-manufacturing PMIs were in-line or better than expectations. Plus, evidence continues to build that manufacturing is seeing a bit of an uptick in activity.

So, in the context of “WWFD” (What Will the Fed Do?), the good economic data last week—which generally shows there is no loss of economic momentum from Q1, as many expected there would be—further cements the likelihood that the Fed will taper QE in September.

While the domestic data was good and it implies “less-accommodative” monetary policy going forward, the same cannot be said for the rest of the world.  Outside of the jobs report Friday, the surprisingly dovish European Central Bank and Bank of England meetings Thursday were the biggest events of the week.

Mario Draghi and new BOE Governor Marc Carney both implemented “forward guidance” to emphasize the different directions of monetary policy between the Fed and the ECB and BOE, respectively.  While the Fed looks to taper, both the ECB and BOE remain firmly in easing mode, with a bias toward more accommodation in the future.

Looking at the actual data in Europe, the takeaway from last week is that we are seeing signs of stabilization in the European Union’s economy (small signs, but at least it’s a step in the right direction).  Manufacturing PMIs and EU retail sales both showed improvement, and of particular note were the UK numbers, which continue to get better and better.

Finally, China remains the area of greatest concern, economically speaking.  Manufacturing and composite PMIs both were in-line with pretty low expectations, and it is clear from the data that the Chinese economy is losing momentum.  And, the People’s Bank of China’s recent actions to burst the credit bubble in the property market will only slow growth further.

Seven-percent growth is now the number to watch—if you see expected 2013 GDP growth dip below 7% for China in the coming months (or if a lot of sell-side firms downgrade their growth expectations below 7%) then look for more weakness in China.

Bottom line with data last week was that it 1)Cemented the expectation that the Fed will begin to “taper” QE in September, and 2) Reinforced the monetary-policy divergence between the U.S. and the rest of the world.

So, we can expect recent trends of the higher dollar/lower “everything else” and higher yields to continue until the domestic data becomes soft, or international data improves.

This Week

Focus turns from the “macro” to the “micro” as the economic calendar is very slow this week, and the market’s focus will turn toward earnings.

With little actual data domestically (jobless claims Thursday is the highlight, and PPI Friday is the only other number), the Fed will remain a focal point.

FOMC minutes will be released Wednesday but, given the large amount of communication from Fed presidents over the past two weeks, I’m not sure there’s going to be a lot of additional insight to glean from the minutes.  The market expects “tapering” in September, and I doubt anything in the minutes will alter that expectation. (The risk, if anything, is that they are slightly hawkish.)

There are also multiple Fed speakers this week:  Bernanke Wednesday, Daniel Tarullo Thursday, and James Bullard and John Williams Friday). Their comments bear watching, as I imagine the Fed will continue trying to “talk down” interest rates and reinforce the “tapering is not tightening” PR campaign.  So, expect them to be on balance dovish, but again I doubt any of it will change current market expectations.

It’s a Holiday Shortened Week, but the Economic Data Will be Market Moving

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Economics

Last Week

Last week was a mixed week of generally “second tier” economic data.  Positively, housing data continues to confirm the recovery in the housing market is still accelerating.  New home sales, Case-Shiller and pending home sales all beat expectations, although again the strong data is being taken with a small grain of salt as this doesn’t reflect higher mortgage rates, and next month’s housing data will be very closely watched for any negative effect of these higher rates.

Also last week, manufacturing data continued to imply we may finally be seeing a stabilization of activity in manufacturing, after a several month bleed lower.  Durable goods beat expectations  and new orders for non-defense capital goods excluding aircraft rose 1.1% in May.  That data comes on the heels of decent Empire and Philly Fed manufacturing surveys for June, so there are some signs that manufacturing activity may finally be picking up.

The data wasn’t all good, though, as consumption and personal spending disappointed.  First, the big headline of the week was the surprise drop in Q1 GDP to 1.8% from the previous estimate of 2.4%.  The drop was due to a reduction in PCE (personal spending).  But, that decline was based almost entirely on a reduction in the purchase of healthcare and “other” services (so it wasn’t because retail sales declined sharply).  But, it’s still not a revision that is welcomed by the market.

Then, on Thursday of last week the personal spending numbers for May were in line with expectations, but there was disappointment in the revision of the April data, which went from a positive 0.1% increase from March to a –0.1% decrease.

The takeaway is that while the consumer has been resilient, whether or not consumer spending can stay at current levels remains a worry for the market, given the headwinds of rising healthcare costs and taxes.

This Week

As mentioned, despite there being only 3 1/2 trading days this week, there’s a lot of important economic data packed in.

First, it’s jobs week.  So, we’ll get the ADP and Challenger reports Wednesday, and then the government number Friday.  Obviously, given the changing perceptions of Fed policy over the past few weeks, and resulting market turmoil, the jobs report will be very closely watched.

Second, we get a final look at June PMIs (both manufacturing and services).  Chinese and European manufacturing PMIs for June were released this morning.  The Chinese numbers were weaker than expected, although the focus there is more on liquidity than manufacturing activity at the moment, while the European numbers were little changed from the “flash” estimates of two weeks ago, which implied some stabilization in the EU economy.

Domestically, manufacturing PMIs are released this morning, and then global “composite” PMIs, which combine manufacturing and the service sector, will be released Tuesday night (China) and Wednesday morning (EU & US).

Finally, there are European Central Bank and Bank of England rate decisions Thursday.  There is no change expected from either bank with regards to rates or their QE programs.  But, given turmoil in debt markets recently, comments from Draghi in particular will be closely watched.  At the moment, though, both of these meeting look to be relatively run of the mill.

The important thing to remember this week is that with regards to the economic data, “good is good.”  The Fed seems determined to begin tapering “QE” this fall and based on the rhetoric, it’ll take a steep drop in the economic data to alter that present course.  So, for the rally to survive “tapering” the economic data needs to steadily improve between now and this fall, when accommodation begins to be removed.  1.8% GDP isn’t going to get it done for an equity market up nearly 13% in 6 months.  So, the economic data needs to get decidedly stronger, starting now.

 

Three Scenarios that Could Result in a Big Bond Rally

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What Makes Me Wrong on Bonds?

It’s obvious to anyone reading this report over the past several weeks that I’m a big long-bond bear, that I think we’ve seen the “top” in Treasuries, and that a long decline in bond prices and a higher move in bond yields has begun.

I’m also aware that a “dovish” Bernanke this week could cause a short-term unwinding of the “higher-rates” trade and send TBF and TBT lower, while “yield-proxy” sectors like utilities and telecom and REITs rebound.  But, I believe that any such trade would just provide an excellent entry point for the larger trend of higher rates.

But, like any good trader, I’m constantly thinking about what would happen that would make me wrong about the direction in bonds.  Well, I thought about this over the weekend and there are three things that can happen that would make my opinion in bonds incorrect.

1. Scenario One:  Japanese & Emerging-Market Debt Enter a Crisis Phase. The swings we’ve seen in emerging-market debt and the Japanese yen have, so far, been volatile but contained.  But, if that volatility increases—and people begin to worry that emerging markets or Japan might lose the ability to sell debt and fund themselves—it would create a crisis. And in a crisis, money flows into U.S. Treasuries, as they remain the “safest” and most-liquid asset in the world. It would be the exact same thing that happened when Europe was in the depths of its crisis.  European investors bought Treasuries for return “of” capital, not return “on” capital.

2. Scenario Two:  Dis-Inflation Becomes “De-flation.” Fed President James Bullard has been one of the most-vocal of the Fed presidents voicing his concern for the low inflation readings globally.  Low inflation, in an environment of massive liquidity, reflects a lack of demand for money and potential deflation.  So, if the five-year inflation expectations on TIPS (one of the best measures of expected inflation), continue to decline—then the Fed will almost certainly abandon “tapering” and may even consider “more” QE.

3. Scenario Three:  The Economy Sees A Summer Swoon—Again.  I was speaking to a subscriber last week and he presented a counter argument from another analyst that basically said we’re in for years of 1%-2% GDP growth, low equity returns, and low bond returns.  So, not quite the 20+ year deflation of Japan, but not that much better, either.  In that scenario, there would be no Fed tapering and likely steady or more QE. Economic data will be the key to watch for this potential scenario.

I remain a bond bear and I believe I’m right on bonds, but I wanted these scenarios on paper so I can watch for them.  Having too much confidence in this business is as dangerous as having too little.

We Didn’t Need This: Greek Dysfunction Returns!

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We’ve got to keep an eye on Greece again now that yesterday’s closure of the public broadcasting company by Prime Minister Antonis Samaras has ignited a political crisis. This has significantly increased the chances of a “no-confidence” vote and snap (or, early) elections. (Everyone remember how markets reacted the last time it happened in May of last year?)

The turmoil centers around the closure yesterday of the Greek national broadcasting company, ERT, and the immediate firing of all 2,600 employees.  The decision, as you would expect, made the unions go crazy—there are calls from the broadcasting employees’ union for a strike and there are signs of solidarity from other unions as well.  But, potential strikes aren’t really the concern. (This is Greece after all; they know how to handle a strike.)

The bigger issue here is that Samaras basically closed ERT unilaterally, without really consulting his coalition partners, the PASOK party and Democratic Left.  They have come out and said they are not in support of this and are working on legislation to replace the decision.

Further complicating things is the fact that the closure of ERT is basically being done to comply with Troika demands of 2,000 public sector job cuts by the end of the summer, which are required for the next tranche of bailout cash.  So, anti-European party Syriza is keying off this to generate support.

Again, the danger here is that the Samaras-led government faces a “no-confidence vote” and fails, causing snap elections, which again opens the door to an anti-European group like Syriza gaining control … and then we have a re-igniting of the European crisis.

We’re several steps away from that now, but the situation bears watching. If there is a no-confidence vote and the government fails, expect that to be a macro headwind for risk assets.

 

Why The Plunge In the South African Rand Matters to You

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Away from the yen, the other focus in the currency markets was on the implosion we’re seeing in emerging market currencies.  The Indian rupee hit another all-time low vs. the dollar. The Brazilian real and South African rand hit four-year lows vs. the dollar, and even strong currencies like the Mexican peso got hit yesterday.

The reason for the weakness is this:  Since the Fed went to 0% interest rates and round after round of QE, investors have moved into higher-yielding emerging-market currencies over the past few years.  Well, now with the Fed potentially “tapering” and interest rates in the U.S. rising, investors are reversing the trade, as they no longer need to take the risk of being in emerging markets, as rates are rising here at home.

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Emerging market debt has collapsed since May, and the decline is unnerving
equity investors.  This ETF needs to stabilize before we can sound an “all clear” in stocks.

Well, that’s causing the currencies of those emerging-market countries to drop as investors sell their bonds and reconvert those investments back into dollars.  Basically, “doomsayers” are saying the world’s major central banks, led by the Fed, have created a bubble in emerging-market credit, and now it’s popping.

The question I’m sure you’re asking right now is “Why the hell do I care about emerging-market credit?”  Well, you care because as these currencies and bonds plunge, it’s causing losses in the leveraged hedge funds that have put the trade on. That’s causing them to liquidate other holdings to cover the losses (like stocks and gold, for instance).

Point being, you should care for the same reason everyone should have cared when the mortgage-backed security markets started blowing up in ‘07, ‘08 and eventually led to the takedown of Bear, Lehman, etc.  I’m not saying it’s the same thing here at all—but it’s the leverage and the huge declines that are making people nervous.

So, while it’s not a disaster yet, this unwind out of emerging-market debt and currencies is having an effect on all asset classes.  It’s not anywhere near 1998-style proportions yet (the emerging market debt crisis), but it is unnerving investors, and weighing on other risk assets.  Bottom line is watch the PowerShares Emerging Markets Sovereign Debt ETF (PCY) and the iShares JPMorgan USD Emerging Bond Fund (EMB), the two emerging-market bond ETFs. Emerging-market bonds need to stabilize in order for equity markets to calm down a bit.

Bottom Line

Since the Fed “tapering” narrative began 3+ weeks ago, equity markets have basically been at the mercy of other markets (namely currencies and bonds), and that continued Tuesday.

The volatility in those markets is starting to unnerve investors, as watching major currencies and bonds gyrate around like penny stocks is a bit unsettling.

But so far, this is just part of an adjustment process that is to be expected as the market comes to terms with the prospects of higher interest rates going forward. Unless 1,600 is violated on the S&P 500, I don’t think that there’s any reason to materially reduce equity exposure at this point.

Continuing to focus on the clear trend of higher rates remains, in my opinion, a good place to slowly and methodically add exposure.  To that end, I do want to point out one ETF that rallied more than 1% yesterday and seems to be positioned to capitalize off this bond-market turmoil. The ProShares Short High Yield Bond Fund (SJB), the short junk-bond ETF, doesn’t trade with a lot of volume (90K shares yesterday) but it’s about the only way I know of for non-bond investors to get short exposure to the high-yield market, which is seeing a nasty sell-off as emerging-market debt and other high-yielding bonds get hit.

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Shorting the high yield market has served as a good hedge against equity volatility,
and should continue to do so as long as currency and emerging market bond volatility weigh on stocks.

SJB is a volatile position and not for everyone. But if you’ve got some risk capital to put somewhere, it’s worth a look, as it should continue to benefit during this “adjustment period” and might serve as a good hedge. (It basically is acting like a short position on the market.)

Interest Rates are Headed Higher. Are You Ready?

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Over the past several weeks we’ve been witnessing equities go through an “adjustment period” as the reality of Fed “tapering” and ultimately removing QE sets in.  Because this adjustment is an ongoing process, I don’t know if last week was just a typical correction and now it’s time to get “all in” in equities broadly.

But, the clear takeaway from last week was that Fed “tapering” remains very much on schedule, and as a result we should see continued downward pressure on bonds/upward pressure on rates.

I know that successful investing/trading is best achieved by finding clear trends in sectors & corners of the market, so if stocks will continue to “adjust” to the prospects for lower bonds/higher rates, then let everyone else worry about the “broad” market’s near term direction, while we get incrementally more long things that do well in a rising interest rate environment (some names to consider are: TBF, TBT, SJB, financials, equities broadly, and very selectively, hard asset related sectors and stocks).

So, put bluntly, stop worrying about where how to market is going to adjust to higher rates, and instead just get “long” higher rates – that’s the definitive trend in the market right now. 

Economic data remains critical (it’s the one thing that can de-rail the “tapering” narrative), and the FOMC meeting on the 19th is the next major catalyst.  Nothing really important happens domestically this week, though.  So, as long as Japan behaves, I think we’ll see a continued drift higher in broad markets this week.

This Analysis Could Be the Difference Between Outperformance and Underpeformance.

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“Bad” is Not “Good” Anymore.

Again, all this economic data coming with week is important because the world’s central banks are very, very data-dependent with regard to policy.  As the data goes, so will go markets.  But, and this is important: We are not in a “bad news is good for stocks” environment, especially here in the U.S.  Previously, markets have rallied because bad economic news meant more QE, which had been good for stock prices.  That is no longer true.  The market doesn’t want more stimulus and QE.  (That statement can be made globally, but it’s especially true here in the U.S.)  It is time for the domestic and global economy to turn for the better and for growth to re-engage.  That is the key to sustainably higher equity prices, and that’s why the data is important.

Despite the media reports, one thing that was not the reason for the strength in stocks yesterday was the weak ISM manufacturing PMI.  Again, bad economic news is not good for the market (as it has occasionally been in the past).  More QE isn’t the answer to a sustained rally from here—good economic growth is.  So, bad economic data this week is not good, regardless of the short term market reaction.

That said, the weak economic data yesterday was somewhat dismissed, but that’s mainly because of the looming jobs report Friday, which is far and away the “most important” economic report from a WWFD standpoint (What Will the Fed Do).

Bottom line is nothing much changed yesterday despite continued volatility.  This market remains very resilient and certainly isn’t going to go straight down, and yesterday’s rally is consistent with the choppy trading we’ve seen lately.

To me one of the biggest things that continues to stick out to me is the unwillingness of money managers to at least partially lock in 14% year to date returns on the third day of June, because everyone is so “sure” the market will eventually march higher, and as a result are happy to stay long through any correction.  I continue to think that selectively booking some profits at these levels, while staying broadly long, makes sense from a common sense and contrarian standpoint.