Monetary Policy (management of money supply and interest rates)

I would like to start with Christine Lagarde and her staggering statement during the interview for RTL radio in France on October 30, just two days before she became European Central Bank (ECB) president. For those unfamiliar with Ms Lagarde, she is a French politician and lawyer served as Minister of the Economy, Finance and Industry (2007–2011), Minister of Agriculture and Fishing (2007) and Minister of Commerce (2005–2007) in France. She also was Chairman and Managing Director of the International Monetary Fund (IMF) during 5 July 2011 – 12 September 2019 period.

Currently in the Eurozone, deposit rate is set by the ECB at -0.50% level (yellow line on the below chart), harming savers, especially those (pension funds, insurance companies) who are holding government bonds such as German bunds. When asked about negative rates she said that people should be “happier” to have a job than a higher saving rate. Does that mean people who have been working their entire lives and saving money aside in order to secure worthy retirement will be not able to achieve that anymore? Or to put it differently, will be not allowed to achieve that? The time will show but we have already seen that pension funds struggle to attain their expected returns and many of them invest in more risky assets such as 100-year Argentine government bonds (since 1800 Argentina has defaulted on its sovereign debt eight times!).

source: Holger Zsch├Ąpitz

Under this tweet you can see how the ECB staff together with the FinTwit (Finance Twitter) community welcomed Christine Lagarde in her new role.

In the meantime, Deutsche Bank AG, largest German lender announced a week ago that it will pass negative rates to large corporate clients and wealthy individuals, giving temporary relief for most retail clients. Of course, it is not the first bank deciding on such a move, at the beginning of October Berliner Volksbank, German second-largest cooperative lender, has started to charge retail clients -0.5% rate on deposits exceeding 100,000 euros ($ 110,000). Similar charges have been already implemented in Denmark by Spar Nord Bank A/S, Sydbank A/S as well as Jyske Bank A/S and in Switzerland by UBS, Credit Suisse and Julius Baer. I am going to sum up this paragraph using quote of the former Credit Suisse CEO and UBS Executive Oswald Gruebel: "Negative interest rates are crazy. That means money is not worth anything anymore."

During the week, we have also had another voice of common sense, at least partially. Austrian ECB governor Robert Holzmann told Bloomberg TV that the monetary policy has reached its limit, signalling that European Central Bank is basically out of bullets to spur further growth. However, he argued that it is time for fiscal policy spending (governments action). I think that to solve the problem governments should rather purse lower taxes and more transparency by getting rid of many unnecessary regulation. Find out more about possible solutions in Daniel Lacalle, PhD thread:

Last important thing on the European monetary policy front was the FT (Financial Times) reporting some analysts’ comments about a possibility of larger central bank purchases of green bonds (Green Quantitative Easing) to address climate change. The idea supported by Ms Lagarde has been already criticized by Jens Weidmann, Bundesbank President who said that this type of decisions should be left to politicians instead of unelected central bankers. As Professor Tuomas Malinen rightly tweeted: “There's absolutely no reason for the #ECB to "invest" in Green Bonds. It would just distort that market further and make all reasonable price discovery and capital allocation impossible.”

One thing is certain, Christine Lagarde will have rough first few months in her new job.

United States

Last week brought us 10 Federal Reserve speakers, the largest central bank in the world. Most of them have been reiterating that the U.S. economy is in a good place and the Fed policy is accommodative which in layman terms mean that they are addressing economic slowdown by lowering interest rates and increasing money supply to boost the economy. That is why we have seen third rate cut at the end of October and they are conducting “No QE” or money printing, injecting liquidity to the money market (where commercial banks deal with each other as well as with the Fed).
QE - Quantiative Easing = asset purchases by a central bank on a massive scale using electronically 'printed' money.

One statement, however, deserves more attention and it was by the New York Fed President John Williams who said that in case of a recession Fed will cut interest rates to zero (right now stand at 1.50% level), will use communication (speeches like that one) and asset purchases. He did not mention, what kind of purchases it could be. So far, there have been purchasing only government bonds and mortgage backed securities (MBS or an asset similar to bond which is created from a basket of home loans). It is therefore not excluded, that in case of a recession they will be purchasing also corporate and municipal bonds or even REITs (Real Estate Investment Trusts) and stocks. This statement is so important because from twelve regional Federal Reserve Banks, New York Fed is the largest Reserve Bank in terms of both assets and volume activity, which means it is first among equals. In addition, only the NY Fed has a market desk conducting various market operations.

One of the ongoing operations are on the repo market. To put it simply, the Fed injects liquidity (electronically printed money) to the money market to facilitate functioning of the financial system, the so called “Not QE”. In effect, the U.S. Central Bank balance sheet has moved back above $4 trillion, up $280 billion since August 28. It can be seen on the graph below that there has been only a one time in history when Fed was printing money faster and it was during the Great Financial Crisis (grey area on the chart).

I will not go into details why is it happening because there has been an extensive debate on FinTwit about the topic as well as in the entire finance industry. However, if the problems do not disappear soon and the pace continue, we will see a new Fed balance sheet record by February 2020, as noted by Jim Bianco Research (see the chart).

Together with 20 billion euros of the ECB monthly QE, started November 1 and the recent return of the Chinese Central Bank (People’s Bank of China) to liquidity injections (also money printing) it is not a surprise that the S&P 500 stock index has reached another all time high (also boosted by the ‘trade war optimism’).

source: zerohedge

Blue line on the chart shows Global ‘Liquidity’ Proxy or Global Money Supply which measures M2 money supply for 12 major economies including the U.S., China, the Eurozone and Japan (M2 is a measure of the money supply that contains cash, short-time bank deposits and 24-hour money market funds). It is clearly seen that the more money has been printed the more the S&P 500 has been increasing over the year. “Don’t fight the Fed” works perfectly this year, which is a common believe that the Fed will not let the market falling down.
It is worth to remind that this habit has started on Oct 20, 1987, when Fed Chairman Alan Greenspan said, “The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”, ensuring liquidity injections in order to protect financial system, so and the stock market.
As you can see, it continues to this day.

Trade War between the U.S. and China

The Trade War saga can be compared to Brexit and surely called a never ending story. Constantly repeated headlines and comments from Donald Trump, U.S. and Chinese authorities may confuse even the most careful observers. Unsurprisingly, over the last week it was no different, so let me list those events in chronological order:

1. On Monday some people familiar with internal discussions reported that China wants Donald Trump to remove not only 15% tariff scheduled to go into effect mid-December, which is $160 billion of Chinese goods but also a 15% tariff that was imposed on September 1 on $112 billion goods.

In the next phases China also see 25% tariff on additional $250 billion Chinese goods removed or at least half of it. (Earlier this year Trump was planning to increase the tariff to 30% but he suspended that on October 2015).

2. Also on Monday, Financial Times reported that the U.S. is actually considering whether to withdraw 15% duties on $112 billion of Chinese goods including clothing, appliances and flatscreen monitors.

3. In the meantime, both countries are looking for possible locations of signing a “phase one deal” after cancellation of the Asia-Pacific Economic Cooperation summit in Chile (16-17 November).
On Sunday, November 3, Trump said that a deal could be signed somewhere in the United States. Also U.S. Commerce Secretary Wilbur Ross said that it could be Iowa, Alaska, Hawaii or even China.

4. On Tuesday, editor-in-chief of Chinese and English editions of the Global Times (daily tabloid newspaper under the auspices of the Chinese Communist Party's People's), Xu Xijin tweeted that the tariffs must to be removed in proportion to how much agreement has been reached.

Remember that his voice is basically the voice of Chinese authorities (at least in case of the trade war).

5. And then, also on Tuesday, South China Morning Post wrote that China needs more U.S. commitments if they want Chinese President Xi Jinping to sign a deal in the U.S. Read, removing more tariffs. It was confirmed by Reuters on Wednesday. China has also said that the goal of buying up to $50 billion farm goods per annum over the next two years is unrealistic and allegedly proposed $20 billion.

6. After that, again on Wednesday, one of the White House’s officials said CNBC that the meeting between U.S. and Chinese presidents could be delayed until December because they need to agree on the terms of a deal and a new place for signing. However, White House still believes that an agreement will be reached on November 16.

7. On Thursday the Chinese Ministry of Commerce Gao Feng said that “If China and the US reach a phase one deal, both sides should roll back existing additional tariffs in the same proportion simultaneously.” Emphasizing that economic and trade teams from both countries have been in constant communication.

8. On the same day Edward Lawrence Fox News Correspondent tweeted that “Trade sources from both sides say the US and China still negotiating using the APEC timeframe. They want to have a Phase One deal down on paper by the end of next week. I will let you know if anything changes.”

9. Few hours after Gao Feng speech Reuters reported that White House plan to withdraw tariffs faces “fierce internal opposition” and there is no decision yet.

10. Subsequently, Chinese sources said that China wants all tariffs to be rolled back (proportionally) while progressing through additional phases but the U.S. wants majority of duties to stay “until the Chinese reach certain milestones after the full trade deal is completed”.

11. On early Thursday, Larry Kudlow, Trump’s Economic Adviser, during the interview with Bloomberg said “If there’s a phase one trade deal, there are going to be tariff agreements and concessions,”

12. And then, on late Thursday, White House trade adviser Peter Navarro said: “There is no agreement at this time to remove any of the existing tariffs as a condition of the phase one deal,” “The only person who can make that decision is President Donald J. Trump, and it’s as simple as that.”

13. However, White House Press Secretary Stephanie Grisham said Friday “We’re very optimistic for some kind of a deal, and I imagine if we reach one then some tariffs could be lifted,”

14. During the Friday U.S. stock market trading session President Trump said that he has not agreed to tariff rollback but China “would like” him to do that and that China wants to make trade deal (nothing new though). 

If I had to believe someone in the trade war topic, it would be Donald Trump.

The chart below (Dow Jones Industrial Average Index) summarizes Thursday and Friday news flow (points 7-14)

source: zerohedge

As you can see, there is a lot of uncertainty, but is seems like market still believes in some deal giving it 66% of probability. Remember, however, that on April the odds have been even higher and then, all of a sudden China backtracked.

source: zerohedge

If you want to be up to date with the Trade War News here is the link to Edward Lawrence profile.

Stock Markets

On Tuesday last week, the S&P 500 index in the United States has reached another all-time high, and on Friday closed slightly below that level. As you can see, looking at the longer perspective we can see a really strong upside trend.

On the 5 year chart, it is easier to see that the index is almost 200 points away from its 200-day moving average. This run has been supported by the Fed, ‘trade war optimism’ as well as companies Q3 earnings surprises (beating expectations). As reported by FactSet, 89% of the companies in the S&P 500 have reported actual results for Q3 2019. The percentage of companies reporting actual EPS above estimates (75%) is above the five-year average. As of November 1, 45 companies have reported negative earnings guidance for Q4 2019 and 19 companies positive guidance.

What to expect in the next week? As you can see, Relative Strength Indicator has just crossed 70 mark which signals that the S&P 500 is in overbought territory. In addition, the index is 6.7% above 200-day moving average. It does not mean, however, that it is an opportunity to short this market but it is also not a good place to get in.

Next week, there are two key events to watch which could trigger significant market moves with the more focus on the first one:

1. On Tuesday U.S. lunch time, President Donald Trump speaks to the Economic Club of New York. This event will be closely watched by investors as there is still need for clarity about a ‘phase one’ trade deal.

2. On Wednesday, Federal Reserve Chairman, Jerome Powell gives a testimony to the Congressional Joint Economic Committee, as well as before the House Budget Committee on Thursday. In this case, he will probably confirm the Fed message which has been sent on October 30, after the rate cut. Namely, that the economy is in a good place and the next central bank moves will depend on economic data.

Seems like everything has calmed down for now. Also the market does not see any reason for the Fed action. Probability of the next rate cut by the end of this year is just 8%.

Calm before the storm?

At this point I would like to show some indicators showing extreme optimism which can be perceived as contrarian indicators. If there be some negative shock, news, event then it could trigger market sell-off.

Source: CNN

First is the Fear & Greed index which is currently at levels not seen since 2017, showing extreme greed of investors.

Next is the Call/Put Ratio. Call and Puts are options (or derivatives), call is a bet for a asset price increase, put a bet for a price decrease. As SentimenTrader noted, options traders on the ISE exchange bought 238 calls for every 100 puts today. That's the most since December 2005.

Below you can see VIX (Volatility Index) net speculative positions showing historically record shorts (bets that the market will not experience volatility).

Source: zerohedge and stockcharts

VIX index also called fear index (because it spikes when investors are very uncertain about the market prospects and sell shares in panic) is also at relatively low levels and below 200-day moving average.

So far, everything goes smoothly but some unexpected event could change it. For now, I would watch and stay aside.

World and Europe

Meanwhile, German Dax is 2-3% away from its all time high.

So Europe Stoxx 600 index is:

Source: zerohedge

No wonder then why global stocks are also near a new record and in overbought territory based on Relative Strenght Index, such as the S&P 500 and DAX.


Gold is catching some breath after great run during this year. The yellow metal fell 3.7% this week, the most since November 2016.

Looking for a reason? There may be a few, apart from the ‘trade deal optimism’.

Firstly, market has started to believe that the Fed with their three 0.25% rate cuts and "No QE" flooding market with liquidity may manage the so-called “soft landing”. In other words U.S. may avoid a recession. Secondly, there have been some slight improvement in the economic data across the world which has triggered some bonds sell-off (when bond prices go down, then the yields go up). And many of previously negative yielding bonds now trade with positive yields.

Gold is a non yielding asset, which means that it does not provide any interest or dividend. Thus, the more negative yielding bonds the better for the metal.

Source: zerohedge

Above chart shows the value of global negative-yielding debt (bonds with negative yield) which has fallen below $12 trillion from $17 trillion recorded in the end of August (red line). Gold also initially dropped, then were going sidelines and eventually followed through, recording the worst week since 2016 (gold line).

This has been also confirmed by U.S. bonds which was rightly noticed by The Market Ear Team. TLT (purple line) is Exchanged Traded Fund tracking long-term (20+ year) U.S. Treasury bonds.

I believe, however, that pick up in bond yields could be temporary what is suggested by the chart below.

Blue line is the U.S. 10 year bond yield 13-week change and red line is Citi U.S. economic surprise index measuring economic data positive or negative surprises in the United States (if it is above 0 on the right scale it means that there has been more data releases which has been better than economists’ forecasts than data which has been worse than estimates). These two indicators have quite close relationship and we can see on the chart that the recent positive economic surprises came to an end. If  that continues then yields will likely to follow.

From my point of view, $1400 per ounce could be a good place to start thinking about adding some gold, in the medium term (it should be around its 200-day moving average).

Quick look at the US Dollar Index and WTI Crude Oil

Dollar is trading within moderate ascending channel since mid-2018.

WTI Crude Oil just testing 200-day moving average.

Global Economy Recap – Bonus

1. China is increasing its credit activity:

China credit impulse (a measure of the change in new credit issued as a % of GDP), which leads the real economy by 9 to 12 months, is moving back to positive territory, currently running at minus 0.4% of GDP (chart below).

This business cycle is mainly driven by Chinese debt pilling and other forms of stimulating their economy. Will it work once again? I think you will find the answer in Professor Tuomas Malinen thread:

Meanwhile, Chinese authorities are trying to rescue their banking sector, mainly smaller banks. China has more than 3000 small banks and many of them are struggling with increasing amount of bad loans. Ways to fight these problems: mergers, restructuring, central bank liquidity (money printing). It has to be emphasized that China has also the largest banking system in the world.

2. International Monetary Fund issues another warning over the last several weeks:

"Global debt -- both public and private -- has reached an all-time high of $188 trillion. This amounts to about 230 percent of world output," Georgieva said in a speech to open a two-day conference on debt. This is up from the previous record of $164 trillion in 2016. It is worth to add that it does not include financial corporations’ debt.

3. ‘Sign of a recession?’: CEOs stepping down at levels not seen since 2008
"According to Challenger, Gray & Christmas’ report, 1,332 CEOs have already left their companies, far outstripping the total 1,257 departures by this time in 2008."

Interesting article showing how CEOs running out of their companies amid the longest U.S. Economic Expansion in history.

This coincidences with record divergence between CEO expectations and consumer expectations about the U.S. economy (Deutsche Bank's Analyst Torsten Slok chart). CEOs are much more negative about the future prospets than consumers.

Gray areas = previous recessions.

4. At the end, two warnings about the Eurozone economy (where monetary policy has practically no bullets to fight the slowdown).

First comes from the International Monetary Fund which warned that the monetary policy is almost exhausted and risk is spreading around the region. IMF emphasized that Eurozone needs emergency plans to prepare for the worst, calling for “a synchronized fiscal response” (basically they want European governments to spend more – at the beginning it was explained why it is not the case).

The fact is that German is falling into recession (two consecutive quarters of negative GDP growth) with Italy on a brink of a recession and there is still a lot of uncertainty around Brexit.

Second is a warning from the European Commission: “EU Warns Worst May Be Ahead as Euro-Area Resilience Wanes”

EU chief economist Marco Buti warned in his report that the European economy has been hit hard by the slowdown in global demand and weak trade, apart from domestic issues (policy uncertainty and economic shocks.

Have a great week!

Disclaimer: This content includes only personal opinion and that should not be considered professional financial investment advice.