On Thursday December 3 the European Central Bank will send deposit rates even further into negative territory, increase the amount of bonds that it buys each month, extend its program of asset purchases, and expand the range of assets that it buys—or maybe all of the above.
The financial markets will be waiting to see if central bank President Mario Draghi throws the kitchen sink at the EuroZone’s combined problems of slow growth and even slower inflation or if he keeps some policy options in reserve.
You should watch to see how the currency markets—especially that for the dollar and the euro—behave. Will we see the euro rally and the dollar drop on a sell on the news reaction? Or will the dollar keep climbing against the euro on a belief that a strong dollar is about to get even stronger after the U.S. Federal Reserve raises interest rates?
The euro fell another 0.3% against the dollar today to close at $1.0565. The EuroZone currency fell 4% in November and finished the month down 12.65% for the year.
To me it looks like the market has priced in much of the kitchen sink program and if that’s the case I think it’s likely that we’ll see a bounce in the euro here. There’s strong support for the euro near $1.04, a level that marks the March low for the euro. If Draghi gives traders much of what they expect on December 3, I’d expect to see the euro move up slightly on the theory that all the likely news is priced into the currency pair and that the move to $1.04 isn’t enough to stick around for.
That makes sense to me in the short term, but in the medium to longer term a euro bounce assumes that Draghi’s new dose of the same medicine that hasn’t worked very well to increase inflation and or growth will work this time. That seems questionable to me at best—why should more of the same work now when it hasn’t done much of anything over the last six months?
I’d expect to see a renewed downward trend in the euro not too long after any bounce as the dollar resumes its climb after the Federal Reserve finally raises interest rates in December (current odds better than 70%) or in early 2016.
If you’re looking to put on weak euro/strong dollar trade, I’d wait to see if we get a bounce on the news after Thursday and then look for a resumption of the euro’s decline and the dollar’s rise.
Financial markets in the United States and Europe fell modestly as investors and traders waited to see what happens next after Turkish fighters shot down a Russian war plane near the Turkish-Syrian border. The Turkish military is saying that the Russian plane had entered Turkish airspace and was shot down after repeated warnings. Russia is denying that its plane had violated Turkish airspace and that it was operating against terrorists in Syria.
As of 10 a.m. New York time traders were selling down risky assets—such as the Russian ruble and the Turkish lira, the MSCI Emerging Markets Index, and European equities—although declines are, so far, measured, with the Emerging Markets Index, for example, down just 0.3%. On the other side of the trade, safe haven assets such as the yen and gold have climbed with gold rising 1%. Oil has gained on speculation that something might happen to disrupt production somewhere. U.S. benchmark West Texas Intermediate was up 1.7% this morning.
The situation is full of potential pitfalls. Since Turkey is a NATO member this incident immediately increases tensions between the Western alliance and Russia. Russian planes in operation on this section of the Syrian-Turkish border have been targeting, Turkey and the United States say, Turkmen villages fighting against the Assad regime and not ISIS positions. The Russians have been flying bombing missions in support of an offensive by the Syrian army, Iranian-affiliated militias, and units of Hezbollah, Turkey has protested. The Sunni Muslim Turkmen minority in Syria is regarded by many Turks as ethnically Turkish. Iranian militias are Shia Muslim.
The Turkmen villages facing the Syrian army/Iranian militia/Hezbollah offensive are also seen by the Turkish government as an important buffer zone not just against the Syrian fighting but also against the expansion of Kurdish forces along the Turkish border.
If you think this is a mess, you’re right. The most likely outcome, though, is a step down in tensions short of more military incidents after a wave of intensive diplomacy by countries such as France that are trying to put together a coalition that includes the Russians and the Turks against ISIS. Russia is Turkey’s second largest trading partner and the source of 60% of its natural gas.
These factors don’t mean, however, that we won’t see other incidents in the short-term. (Both Russia’s Putin or Turkey’s Erdoğan are proud nationalists and aren’t known for shrinking from confrontation.)
Any short-term incidents are likely to increase downward pressure on risky assets.
How to trade this situation?
If tensions do ratchet upward and risk assets do sell off, I’d look to buy positions in stocks or bonds or currencies that you’ve been avoiding because they were too pricy. I’d be particularly interested in any sell off in U.S. market favorites on a movement away from risk. I don’t see any reason that these tensions should radically depress the prices of high-PE U.S. stocks such as Netflix (NFLX) or Facebook (FB) but I would note that both are down today by 2.7% and 1.6%.
Oil and gold will both move up if tensions continue but I don’t see those moves as sustainable unless this turns into a much bigger conflict than currently seems likely. You might use the bounce to trim positions that you’ve been looking to sell in these assets.
One of the most interesting non-financial effects to watch is whether this incident has the power to change rhetoric or positions among Republican and Democratic presidential contenders. Will it cause anyone to re-think the dangers and difficulties of imposing a No-Fly zone in Syria? Will it lead to any reconsideration of calls for a coalition of local powers to fight ISIS? Considering how U.S. politics works there days, I’d doubt it.
What a week for potentially market-moving news!
Let me give you a quick run down, ok?
Monday: Beginning today and running through Thursday, the Central Committee of the Chinese Communist Party meets to formulate a new 5-year plan that would go into effect in 2016. Certainly on the agenda are a new target for economic growth, reforms for the country’s huge state-owned enterprises, and goals for continued urbanization, environmental regulation, and registration for China’s migrant workers. The goals aren’t actually released until ratified by the national legislature, which meets in March, and typically they don’t go into official effect until the fall. But while remaining officially unimplemented, many parts of China’s government start to react as soon as the meeting is over. That’s especially true of monetary authorities such as the People’s Bank. China’s central bank cut lending rates at the end of last week in anticipation of this meeting, but there’s still room for more moves on mortgage rates and restrictions, and bond issuance by local governments, just to name two issues. The Shanghai and Shenzhen markets were up modestly overnight (0.5% and 0.68%, respectively) in anticipation of the meeting.
Tuesday: Call it a preview of Thursday’s report on third quarter U.S. GDP growth. Wall Street is expecting a 1.3% drop in orders for durable goods for September. That would be an improvement from an even bigger decline in August. Look to see what the figures ex-aircraft show since a shift in the timing of one or 10 of these big-ticket orders can skew the entire top line of the report. Anything worse than Wall Street’s expectations will color opinion ahead of the GDP report.
Tuesday: It’s Apple (AAPL) day. The company reports revenue and earnings for its fiscal fourth quarter. Key issues will be sales of the new iPhone, where analysts will be looking for any signs of weakness in the launch, and sales in China, where they will be looking for signs that slowing growth in the Chinese economy has cut into sales. Apple CEO Tim Cook has repeatedly said that Apple isn’t seeing problems in its China results—that may have created expectations that could bite the company this quarter. I think Apple’s results this quarter are likely to have more effect on the market as a whole—where investors will look for clues to growth in the Chinese and global economies—than for technology stocks. Still watch for reaction from shares of Apple’s suppliers such as Analog Devices (ADI), Qualcomm (QCOM), and Synaptics (SYNA.)
Tuesday: More on strength or weakness in the U.S. economy when Ford Motor (F) reports third quarter earnings. (General Motors (GM) reported last week and showed a larger-than-expected gain in operating profits in North America.) Of particular interest at Ford will be sales for the company’s new mostly aluminum F-150 pickup truck.
Wednesday: The Federal Reserve’s Open Market Committee will probably do nothing on interest rates, but investors will be intently parsing any Fed comments for clues on what the U.S. central bank might do in December. Look for any change in the post-meeting statement on the Fed’s degree of worry about China now that it looks like that market has stabilized–for the moment, anyway.
Thursday: The U.S. Department of Commerce releases its preliminary estimate of third quarter GDP growth. Economists are looking for a year over year growth rate of just 1.9%, down from a 3.9% rate in the second quarter. The report will certainly move the odds on a December interest rate increase from the Federal Reserve. The odds for a December increase have moved up slightly recently on a decline in volatility in emerging markets.
Friday: The Bank of Japan meets: Will it stand pat on asset purchases and just reiterate recent comments from Governor Haruhiko Kuroda that the current program of quantitative easing is working (despite a lack of economic growth or inflation), or will the bank decide to increase its asset buying? Without some progress toward those two goals, the credibility of Abenomics will continue to erode. A promise last month from Prime Minister Shinzo Abe that the Japanese economy would be 20% larger by 2020 has resulted mostly in derisive laughter.
Ugly earnings by Monsanto today say sector selection will count during third quarter reporting season
The really ugly earnings report delivered today by Monsanto (MON) should go a long way toward clarifying the debate over calendar third quarter earnings. The company announced a loss of 19 cents a share for its fiscal fourth quarter that ended on August 31 and said that earnings would remain weak through 2016. Analysts had expected a loss of 3 cents a share. The company also reported that it cut 2,600 jobs or about 12% of its total workforce.
What’s that you say—you didn’t know there is a debate over earnings for the calendar third quarter? Earnings per share for the stocks in the Standard & Poor’s 500 are projected by Wall Street analysts to fall by 6.9% in the quarter.
End of debate, no?
Well, no. There’s a good possibility that the projected decline in S&P 500 earnings overstates the weakness in the quarter. The index, in comparison to the actual economy, over-weights the energy sector. Which raises the possibility that overall corporate profits—outside the energy sector–are better than projections for the S&P index indicate.
That side of the debate scores some points in the Federal Reserve’s report “Nonfinancial Corporate Business Profits.” In the calendar second quarter, corporate profits by the Fed’s measure climbed 11% year over year. That’s the most since the fourth quarter of 2012. In contrast the S&P 500 showed a decline in corporate profits of 2%, according to Bloomberg.
Goldman Sachs has an explanation for the disparity. The plunge in oil prices, revenue and earnings that is hammering energy company profits is one side of the positive effects of ultra low interest rates, low energy costs, and restrained wage growth has been good for company profits everywhere outside of the energy sector. Income in the third quarter is projected by S&P to grow by 10% or more in telecommunications, technology, consumer discretionary, and health care.
The big wild card for the overall earnings picture is the strong dollar. How will that affect profits for big U.S. exporters?
From the evidence in Monsanto’s report today, companies with big exposure to the negative effects of a strong dollar, with big exposure to commodities markets, and with big exposure to emerging economies are going to show disappointingly weak earnings. Monsanto took a hit as a strong dollar damped sales across Latin America and as the company continued to cut prices (although the worst of that seems to be over.) Monsanto continued to face pressure on its Roundup product from generic glyphosate with farmers looking to save money in the face of commodity price pressures. Brazil, where the economy is in recession, added to the decline in profits.
It would be a good strategy to focus on sectors experiencing solid profit growth and stay away from laggards—but if growth at the laggards is bad enough, it can, history says, take the entire market into a downturn.
Very careful and very selective buying would seem to be in order on dips in the stronger sectors of the market.
So why does the prospect of a quarter-point interest rate increase from the Fed so unnerve financial markets?
So what’s making the U.S. and global markets so nervous?
It’s very clear that markets are worried. The Dow Jones Industrial Average put in a 444-point swing yesterday, September 9, between the high for the trading day and the low. The Standard & Poor’s 500 has closed with a move of 1.3% or more on 11 of the last 14 trading days—including the biggest rally since 2011 and the biggest down day in four years.
Among other worries there’s China. Concern about global growth. Anxiety about collapsing emerging market currencies (Brazil’s real) and economies (Brazil, Russia, South Africa, etc.)
And, of course, the will they/won’t they speculation ahead of the Federal Reserve’s September 17 meeting on interest rates. Will the Fed decide on the first increase in interest rates since 2006? Or will Janet Yellen and company put an increase off until October or December in 2015 or even into 2016?
Which should lead you to ask why a potential interest rate increase of 25 basis points—that’s one-quarter of a percentage point—should produce so much anxiety and such big market swings. It’s not like another quarter of a percentage point is going to have much effect on the real economy. Very few consumers will decide not to buy a car or a house because it will cost them another 25 basis points in interest. And very few CEOs will put off expanding a factory or hiring new workers because short-term interest rates just went from a range of 0% to 0.25% to a range of 0.25% to .50%.
The focus on the Fed decision gets even more puzzling when you consider that the debt markets have already priced in an increase. The forward contracts on the 10-year Treasury notes predict a gradual increase to 2.4% in a year from 2.22% on September 10. The current yield is up from 2.12% on January 2 and from 2.14% six months ago on March 10—but while the markets are projecting higher interest rates than now, they’re hardly projecting run-away interest rate increases. For anyone looking for a mortgage, for example, changes of this magnitude don’t make much of a difference in how much house you can afford or a buy/no buy decision.
So what’s all the tsuris?
Well, you see the Federal Reserve doesn’t have a very good record when it comes to gradual interest rate increases. As much as Janet Yellen and the governors of the Federal Reserve keep saying that interest rate increases will be very gradual because the low rate of visible inflation doesn’t require anything faster, Wall Street and indeed any investor with a memory knows that the Fed has a history of big increases in interest rates once it starts moving the yardsticks.
For example, in June 2004 the Federal Reserve began an interest rate increase with rates at 1%. It ended with short-term rates at 5.25% two years later
The worry isn’t really that increase to 0.50% in the very near term, but the possibility that the Fed, despite its current language, will embark on a long cycle of rate increases.
That possibility is lower than it was at the beginning of 2015 but it certainly hasn’t disappeared. In fact it hasn’t moderated as much as you might imagine given some of the uncertainty in global economies and financial markets.
Back at its March meeting of the Federal Reserve’s Open Market Committee members saw a range of short-term rates for 2016 at 0.25% (one vote) to 3.75% with the largest group of members at 1.5% to 2%. In 2017 the biggest grouping in the projections was a 3% to 4%.
That would be a substantial increase from the current 0% to 0.25% rate in two years, although the end rate would still not be as stiff as the 5.25% of 2006.
By the June meeting interest rate projections had moderated at bit. The highest level projected by any member for 2016 was 3% with the biggest grouping at 1.5%. For 2017 the range ran from 2% to 3.75% with six members at 2.25% to 2.75% and six at 3.5% to 3.75%.
With the historical spread between the short-term rates set by the Federal Reserve and the 10-year Treasury rate set by the market averaging about 2% home buyers would be looking at something like a 4% to 5.75% mortgage rate (since mortgage rates are benchmarked to the 10-year Treasury. At the upper end that would be significantly higher than the 4.05% interest rate on a 30-year mortgage as of September 9.
Of course, the spread between the Fed funds rate and the yield on a 10-year Treasury has been as high as 3.75% in the last decade, according to the St. Louis Federal Reserve Bank. A spread like that would push mortgage rates to 5.75% to 7.50%.
Rates that high would crush the housing market and put a big damper on the economy. And they, along with the strong dollar that goes with higher interest rates, would hit already challenged emerging market currencies.
The Federal Reserve is extremely unlikely to let interest rates get that high in the absence of inflation substantially above its 2% inflation target. Especially since the Fed’s entire policy of quantitative easing has been built on stimulating the housing market through lower mortgage rates.
Still central banks do make policy mistakes.
As we approach the September 17 Fed meeting, an aggressive cycle of interest rate hikes in 2016 is what the market fears rather than that first increase of a quarter of a percentage point.
And no matter what the Fed does in September, October or December, the U.S. central bank will find it hard to put that worry behind it. (Which is one reason to think that the Fed might move in September. A September move, followed by nothing, would convince some in the debt markets that the Fed was serious about moving slowly.)