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.
Call it “Whatever it takes” II.
Today, European Central Bank President Mario Draghi said that the EuroZone central bank “will do what we must to raise inflation as quickly as possible.”
I don’t expect that this promise, made in a speech in Frankfurt, will have the same electric effect as “Whatever it takes” I in July 2012. That promise reversed a plunging euro, pulled the bonds of Spain and Italy back from the brink, and set the stage for a significant recovery in the prices of euro assets.
This time I think the likely market reaction will be positive—that is the euro will move lower as the bank wants (it closed at $1.0656 down 0.68% against the dollar today) and financial assets will move higher (the German DAX is up 0.31% today)—the move will be much more modest. The likely actions from the bank are relatively modest in contrast to past proposals and the problems the central bank faces have proven to be very resistant to the bank’s solutions to date.
After today’s remarks by Draghi pretty much everyone has concluded that the bank will move at its December 3 meeting—even though hardline members of the bank’s board of governors such as Germany’s Jens Weidmann are saying no changes are needed now. The bank’s inflation target of 2% remains a distant dream with the current inflation rate in the EuroZone at just 0.1%.
The policy menu in front of the bank includes an expansion of the current program of bond buying from 60 billion euros a month to 80 billion or so; an extension of the life of the program beyond the current September 2016 limit, and a further drop in the bank deposit rate. In normal times the central bank pays a modest rate of interest on money that banks leave on deposit over night. These days the central bank charges banks that leave their money overnight 0.2%. It’s just about certain that the European Central Bank will take that negative deposit rate even lower to, say a negative 0.3%. Bond yields across the EuroZone are already falling even further into negative territory in anticipation of the central bank’s move. The yield on 2-year German government bonds fell to a record low of a negative 0.389% today.
There is a good possibility that rather than choosing from this policy menu the European Central Bank will implement all of these items. That would still fall well short of a “shock and awe” response to the current mix of extremely low inflation and tepid growth, but at this point it might be the best the European Central Bank can do.
Inflation in China at the consumer level rose in October at just a 1.3% rate year over year. That, the National Bureau of Statistics said on Monday, was the lowest rate since May and well below the 1.6% rate in September. Economists had expected an increase of 1.5
A truckload of implications (or at least five) follows from this number.
First, combined with the disappointing showing on exports and imports in data released over the weekend, it reinforces forecasts of slow growth in the global economy. The fear of slow global growth has led to another day of declines in emerging markets. The iShares MSCI Emerging Markets Index ETF (EEM) was down another 0.38% on Monday.
Second, with inflation in China so low, the People’s Bank of China is relatively free to cut interest rates, reduce bank reserve requirements, and otherwise stimulate growth in the Chinese economy. I think the Chinese markets will start to anticipate some or all of those measures in fairly short order. (Think possible short-term rally.)
Third, with low or no inflation in the global economy, there isn’t anything that I can see that stands in the way of a stronger U.S. dollar. (The U.S. dollar, in fact, hit a six-month high against the euro on November 9).
Fourth, with a stronger dollar and lower global growth expect weaker commodity prices. Oil was up slightly today as of 3 p.m. in New York time after days of decline but copper was down 0.47%.
Fifth, a stronger dollar means more cash flowing into dollar assets, which is likely to damp increases in U.S. interest rates when/if the Federal Reserve moves. The yield on the 10-year U.S. Treasury held steady on Monday at 2.31%.
Busy, very busy weekend on my paid JubakAM.com site this weekend as I tried to make sense of the market reaction to Friday’s disappointing jobs numbers for September.
On Friday, on this free site, I noted that the early sell off in U.S. stocks followed by a strong rally didn’t exactly clarify market sentiment.
In four posts this weekend on my subscription JubakAM.com I 1) laid out a fundamental scenario through the end of 2015 that pointed to a grind lower in U.S. stocks; 2) in a video explained why I think the debt ceiling deadline on November 5 is more of a danger to the markets than the expiration of the temporary funding bill on December 11, 4) projected that the big trend for the week ahead would be the weak dollar as traders speculate on the Fed holding its fire until March or3later, and 4) gave an update on what technical analysts are saying about why this market is still in a downtrend but with signs of hope to the upside.
That’s what I’m worked on at my subscription JubakAM.com site–I think there’s some value to you in passing on the direction of my thinking about the market on that site. Hope so anyway.
And, of course, there’s an ulterior motive: If you decide that you’d like more detail on those posts, I’m hoping that you’ll subscribe to my site at JubakAM.com for $199 a year. (By the way, you can get a full refund during the first seven days if you change your mind for any reason.)
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.)