Central Banks at Center Stage

I'm typing this post with a case of strep throat, so forgive me if my thoughts seem a bit disjointed or otherwise incomprehensible at times. It just so happens that this past weekend was the much-anticipated Oklahoma vs Ohio State football game, which I had the honor to attend. While the main show was indeed the football game, a number of other factors played an equally important role in the experience. This included nearly coming to blows with a very drunken fellow student, an intense storm just prior to the game's original start time, among other things. This week, while central bank decisions are taking center stage, there are a number of factors working on the exterior of the stage still playing a big role in our current economy.

Let's begin with the latest FOMC forecast for the long-term.

Federal Reserve

The infamous dot plot above shows many FOMC members wishing to hike the benchmark interest rate from 0.25-0.50 percentage points to an average 1.25-or-so percentage point interest rate in 2017, a rather ambitious goal given the global struggles to see stronger economic growth. By 2019, most FOMC members would prefer to see the benchmark interest rate somewhere around 2.50 percentage points, again a rather ambitious outlook and one I'm personally wary of, as we're already in/near year 8 of this economic expansion, making it one of the longest on record. A bull can't run forever.

The vote to maintain the current interest rate of 0.25 to 0.50 percentage points landed at 7-3, a pretty strong signal that some members inside the Fed are getting a little antsy with respect to keeping interest rates low, and I agree. The Fed almost seems scared these days, worried that even a minimal jolt to the economy could bring everything crashing down, and thus the best way to keep things steady is to keep interest rates steady. This mindset has created a whole other level of problems alone, but that's a post for another day.

Federal Reserve

Another interesting graph from the Fed's decision yesterday, and one of those exterior factors dancing around central banks, was the projected PCE inflation. I don't have my protractor on me at the moment, but that's nearly a 90-degree angle from observed PCE inflation through 2015 to projected PCE inflation through 2016. The FOMC is essentially expecting inflation to reverse course and start chugging its way back up at this very moment in time. Unfortunately, the FOMC is notorious for being too optimistic on the future of the economy, particularly in the current expansion. When accounting for this, it becomes difficult to see a 2% PCE inflation mark earlier than 2018.

The Federal Reserve isn't the only central bank that had their monetary policy meeting this week; the Bank of Japan also met up.

At their previous meeting, the Bank of Japan announced it would re-evaluate its current monetary policy, which set off concerns amongst investors if this was a warning shot, if the BoJ might stop pushing ahead with negative interest rates and QE. This week, the Bank of Japan came out and modified their policy slightly, now to a yield-curve based goal. The BoJ will now aim to keep 10-year Japanese government bonds around 0%, and while this is still very accommodative monetary policy, it's also a cessation that plunging further into negative interest rates right now, when the benefits are beginning to be questioned, is not the right move. It's part of a larger cessation that the Bank of Japan is running out of tools, something we've all known for a while, but no one really knew when the Bank would begin realizing that. One could effectively argue that this realization moment came at their last meeting, when the BoJ opted to re-evaluate its policy, but carrying through with that re-evaluation into this week's meeting reaffirms that more than incredibly accommodative monetary policy is needed to stimulate the economy.

Central banks will continue taking center stage, perhaps the Romeo and Juliet of this monetary policy opera. However, Mercutio, Tybalt, and Benvolio are also on stage, and while they aren't the main focus right now, you can bet that what they do will influence what the two main characters do. In our case, inflation, equity pricing, bonds, and more play our 'secondary characters', but their influence down the road will prove anything but.

Andrew

Monetary Easing Wells Running Dry?

As a former meteorology major, I found myself intrigued by how steadfast a drought can be. Case in point, the Southwest remains in a deep drought after several years without a good, prolonged rainfall weather set-up. There was even a rumor or two about some water wells running dry in the Northeast as western New York is experiencing a pretty notable drought at this point. It just so happens that the monetary easing wells across the world may be running dry, too: not for a lack of 'water', but a lack of confidence that pulling up more water will further benefit the global economy.

StockCharts.com

A look back at the last month of trading across the Dow Jones Industrial Average shows how large Friday's drop in stocks was. The index shed just under 400 points on the day, closing down just over 2.1%. Other American equities didn't fare any better, with the Nasdaq dropping 2.55% and the S&P 500 closing down 2.45%.

Global bonds took a significant hit worldwide after Friday's apparent broad turning-of-the-tide in central banks, and yields continue to rise as I type this at roughly 2:00 AM on this Monday. European peripherals are looking a bit shaky, too:

Investing.com

Italy's 3-year government bond yield has risen over 117% as of 0700 UTC Monday, but even as I type this sentence about a minute after that screenshot, the yield has jumped to 139% in the last day. Longer-term bonds are generally showing 2% to 10% gains, with bonds beyond 10 years hovering near 3%. 

Elsewhere, Ireland's 10-year government bond has jumped over 30%, Spain's 10-year and 30-year bonds are both up over 2% in the last day, with their 3-year bond up nearly 70% as of this typing at 0704 UTC. Emerging markets have been acknowledged as a substantial part of the bond rally, as the hunt for yield has bled from developed economies into these riskier, but profit-producing bonds. Now, as we see a global bond sell-off continuing on from Friday into this workweek, one can't help but entertain the thought of what the global economy will look like even a month from now if this kind of anxiety over potential central bank hawkishness persists.

Forgive me, I feel like a guest at a party who's been talking for far too long. Let me introduce how we got here. Back on Friday, global markets began to wake up and smell the reality that is the limits to central bank action. The last week or so has seen the European Central Bank, the Bank of Japan, and the Federal Reserve all display increased hawkish tones in their actions. From the ECB, we saw President Mario Draghi refrain from any further monetary easing. The Bank of Japan was found to be in a tough spot, with concerns that it is running out of debt to purchase as part of its monetary easing program. And, to put it all together, usually-dovish Boston Federal Reserve branch president Eric Rosengren indicated it is plausible that normalization in monetary policy is coming much sooner rather than later. Financial markets reacted quickly and in typical knee-jerk fashion.

StockCharts.com

The CBOE's volatility index (VIX) jumped nearly five points on Friday, up about 40% on the day. Given how low volatility has been since July, some form of rebound in volatility was expected. I like to think of this aggressive monetary easing as the equivalent of feeding the financial markets Xanax, in that it calms the markets, makes everything feel all fine and dandy. But now that there's signs central banks may be backing off, it's quite a sobering reminder and a signal that the 'Xanax effect' in the markets isn't invincible.

Already on this Monday morning, Asian markets took a hint from the American markets on Friday and continued the sell-off. The Nikkei 225 fell by nearly 300 points (1.73%), while Hong Kong's Hang Seng index is currently down about 685 points, or 2.85%. Using stock futures, American and European markets will see the slide continue Monday, and further drops are definitely still on the table, especially if the Fed's Lockhart, a typically-dovish member, turns hawkish. 

The fact of the matter is we're in the ~eighth year of this economic expansion, one of our longest in history. Every peak is followed by a valley, and whether or not the valley is coming sooner rather than later, the reluctance of central banks to continue propping up financial markets may hinder any further expansion, should a halt to easing come to fruition. It's time to start seeing how much central banks are willing to conserve the 'water' in their monetary policy wells, because the well's starting to look a bit dry.

Andrew

Technical Foreshocks

I had the pleasure of being woken up this past Saturday by what was yesterday revealed as the strongest earthquake in recorded history in Oklahoma, a magnitude 5.8 on the Richter scale. My door was going back and forth in the doorframe, some of my drawers were pulled out by an inch or two, but no damage.

It does, however, present yet another reminder of what could be coming if fracking, assumed to be the primary cause of increased tectonic activity in Oklahoma, continues. It's this kind of foreshock that we're starting to see in some technical indicators.

TeleTrader

One tool I took to playing around with is the Fibonacci retracements tool from teletrader.com . In a nutshell, there's a significant amount of mathematics behind the Fibonacci sequence and associated 'golden ratio', to the point where scientists generally agree the Fibonacci sequence is found commonly throughout nature in many forms. One of these forms just happens to be the stock market.

I began this retracement from the valley of the Dow Jones Industrial Average during the 2008-2009 financial crisis. I didn't begin the retracement from the lowest point, as you can see, since there is some apparent support right around where I placed the 100.0% line, and that support stuck around from September 2008 until roughly April 2009. I then placed the 0.0% line around where we are now, again right around an area of resistance that the Dow appears to be encountering, and where we are meandering right now in the upper 18,000's.

The cool thing about TeleTrader is when you decide your bottom and top points, it outlines the Fibonacci retracement levels automatically, a nice bonus for those who may be somewhat math-inclined (I was formerly a meteorology major, after all) but don't have the time to calculate all of those levels, like myself. So, when the retracement levels are all drawn out, it becomes apparent that the Fibonacci retracement concept does actually work. I've annotated areas of resistance and support to show how the Dow stuck around areas between two retracement levels, and it's no coincidence how these areas of support and resistance line up incredibly well with the Fibonacci retracement levels. It's not a perfect correlation, as you can see by the 2013 period where support and resistance levels were a little bit away from the Fibonacci levels, but for the remainder of the graph, the shoe more or less fits.

If we're to trust this Fibonacci retracement set, we should be at or just past the peak of our bull market. I personally believe the peak came a handful of months ago, and we're starting to see a slowdown in momentum in equities, as well as remarkably low volatility signaling a level of investor complacency that could cause big trouble if/when a negative surprise shock hits the markets. But that's a whole other post to write about.

TradingView.com

This meat-and-potatoes graphic comes from tradingview.com , which has a cornucopia of technical analysis indicators and indexes and all that fun stuff. We're taking a look at the Dow Jones Industrial Average since around 2002-2003 until present day at the top, the Dow's Momentum index values in the middle, and the Relative Strength Index on the bottom.

As far as this graphic is concerned, at quick glance, things seem just fine and dandy. We're near record highs, the RSI is in a comfortable range (albeit gradually inching upward), and momentum remains positive. However, this is all a bit deceiving, and to illustrate this, we bring in volatility.

TradingView.com

 In the above image we see the Dow Jones Industrial Average from mid-2011 to present day, with the CBOE's Volatility Index superimposed in blue. The horizontal aqua line illustrates the lowest point that the VIX hit this past summer on a weekly scale, closing the week of August 15th at 11.34. For some perspective, that level was last breached in July 2014, and although the index frequently drops near this line, it's rather uncommon to see it go as low as it did this past August.

That tells us that the markets are complacent, as we briefly discussed earlier. This complacency makes for a significant problem in the RSI, which is defined by Investopedia as an index that "compares the magnitude of recent gains and losses over a specified time period to measure speed and change of price movements of a security."
The key phrase there is "recent gains and losses over a specified time period". You'll notice that American equities are trading in a pretty narrow slot right now, as confirmed by low volatility. Hence, recent gains and losses are going to be low, likely artificially lowering the RSI and making it appear that equities are not overbought, when in fact they very well may be.

This volatility issue also hurts the momentum indicator to some degree, as the same issue about recent gains and losses pops up. With minimal movements day-to-day in equities, it's no surprise that the momentum index in the last month or so is oscillating around the zero-line.
These oscillations can give some clues, however. Note how we've started to see lower highs and deeper lows in the momentum index from about 2015 onward, especially back in 2015. We've lately seemed to buck that trend, but I'll be darned if there's no concern over the momentum index hitting levels not seen since the financial crisis, back in 2015. That's a foreshock in a nutshell.

TradingView.com

But hope is not lost! We still have the ADX, the Average Directional Index. This index helps identify the strength of a trend. It doesn't identify if the trend is positive or negative, but shows how strong the trend is. While this index is subject to some of the same limitations imposed on the RSI and Momentum indicators, with how equities are overall not too active, the ADX raises a key point in that there really is no clear trend in the current market. ADX values below 25 are seen as the market either exhibiting a weak trend, or no trend at all, and we've been consistently below 20 in this index since late April! Now, since late April the Dow has gained a good 500-600 points, which is nothing to shake a stick at. But it took us close to 5 months to get there, a lot of dawdling, and a clear indication that there is no real trend. The best trend I can think of is stagnation now that we're likely at the peak or just past the peak of our bull market in equities.

To sum all of that up, while the RSI may be flawed due to a lack of movement, the overall picture of the ADX can provide some context. According to that index, we haven't had a clear trend since the first two months of 2016, when the Dow shed a couple thousand points. Since then, it's just been a meandering climb up to where we are now, the upper 18,000's.

This is a foreshock because the longer we continue without a clear trend, the more wary investors will grow, as more questions are asked about the state of the economy, whether we're peaking the bull market or just starting one. It's plausible that this uneasiness will lead to a climb in volatility, which could set off a chain reaction, but that's one of literally hundreds of possibilities in our current market state.

In sum, much like the increasing occurrence of Oklahoma's earthquakes culminating in a record-5.8 magnitude quake this past Saturday, technical indicators are also sending out foreshocks in the form of Fibonacci retracement red flags, the lack of a clear direction in the markets combined with concerningly-low volatility, and possible hints of less positive momentum in the markets, particularly in late 2015/early 2016. There are fundamentals that are also issuing foreshocks, and one day soon we'll discuss those as well, but for now I'll leave you with an all-too-real paraphrased-excerpt I came across while reading Didier Sornette's "Why Stock Markets Crash: Critical Events in Complex Financial Systems":

Much to the contrary of expectations, stock market crashes arise when economists and analysts are the most positive about the economy and the economy's future. That way, everyone's caught even more off-guard when things suddenly turn south.

Andrew

Trust and the Banking Sector

In my current semester, I have two communications-based classes. The other day, in one of these classes, the professor had us form a circle and take a few minutes to define exactly what trust is, and how trust can be gained or lost. There is no correct definition of trust, of course, as everyone interprets it differently. You may only trust someone after they lay down their life for you, or you may trust them as soon as you first shake hands.

Recounting that class period now, I can't help but think how ravaged the trust between investors and the banking sector has become, but also how ravaged the trust between big banks and the government has become.

Take, for instance, J.P. Morgan Chase (JPM).

Barchart.com

Over the last six months or so, JPM has been through its fair share of ridges and valleys. Perhaps the most pronounced of these oscillations was the Brexit-induced volatility in late June, when the value of J.P. Morgan's stock dropped to just over $57 in intraday trading. Today, we're back up to $67.49 a share as of Friday's close, over three dollars higher than the close immediately prior to the Brexit referendum.

Overall, this chart looks pretty okay to me, and the stats on paper concur. JPM is up nearly 13% in the last six months, and its price-to-earnings ratio is at a comfortable 12.07.
Technical analysis indicators aren't as warm to the idea of placing a Buy sticker on JPM, with the stock's Relative Strength Index at ~70 at Friday's close, right into Overbought territory. Bollinger Bands show JPM grinding along the top band in the last few days, even closing above the upper band three of the last five trading days. It's not insensitive to believe a correction is coming.

But, this is where things get tricky. J.P Morgan's stock could very plausibly stick around these higher levels. We could see repeated intraday breaches of that upper Bollinger Band down the road, and the RSI could easily inch higher. This is the land of broken trust between investors and big banks, big banks and the government, and the government and the investors.

This handy chart I drew up at 3:40 in the morning illustrates how the lack of trust between the three sectors is leading the banking sector to moves irrational moves.

The government, as well as the Federal Reserve, clearly has a problem with investors these days. Time and time again we've heard Fed chairwoman Yellen and other high-ranking officials comment on how the financial markets seem too complacent, purportedly setting the foundation for a benchmark interest rate hike later on in the year. This happened once before, in June, but rate hike chances were eliminated when the United Kingdom voted to leave the EU. Now it's September, and last month at Jackson Hole, Yellen again began painting some more hawkish tones onto her speech, with a handful of other Fed people being more direct and clearly indicating they are ready to raise the benchmark interest rate.
This was all fine and dandy until the ISM Manufacturing PMI number came out this past Thursday. Expectations were for a value somewhere around 52, so there was some egg on some face when the value was released as a 49.4, the lowest in seven months and now into Contraction territory. Almost immediately, the air became thick with the concern that this would be another case of the Fed building up the case for, but not actually being able to hike interest rates. However, calm prevailed until the August jobs report this past Friday, which missed by 29,000 (180k expected, 151k actual) and held the unemployment rate steady at 4.9%. Surprisingly, though, the three benchmark US equities indexes all ended in the black that day. Why? Who knows. All we know is that we're going back around the circle we were in back in June, but this time investors don't seem to be listening all too hard. Equities remain near 52-week, as well as all-time highs, something that will be interpreted by the Fed as complacency but what is really a lack of trust.

Investors aren't too keen on investing in the banking sector. If you managed to figure out the round-about that the Fed has been going around re: hiking interest rates since this past June, congratulations, you can appreciate why there's a general hesitancy to firmly invest in the banking sector.
Profits remain low across the board due to historically-low interest rates, and big-name banks like Deutsche Bank are cutting jobs to compensate for the fall in profits. This has led many banks' shares lower; our JPM example again plays in here, with the bank's share value up a measly 2.21% year-to-date.
For many investors, this is a solid buy sign. The economic recovery continues slowly chugging along, and the overall banking sector is valued pretty okay compared to pretty-overbought defensives. But we aren't seeing a massive rush to the banking sector, and the blame for that is placed squarely on the Fed for inconsistent messages (not solely to their fault), breaking the chain of trust between investors and banks in financial markets.

It's pretty accurate to say that the banking sector doesn't exactly look at the government and Fed with a wink and a smile. The inconsistent Fed messaging has poisoned the trust link here, too, with banks not entirely sure which directions to take internally as the Fed scrambles to find its direction. There's little help coming from hesitant investors, and the government doesn't appear to be about to lay down an Abe-level fiscal stimulus package, leaving it up to the Fed to stimulate the economy and make banks highly-valued again. Of course, the Fed isn't currently doing this, so the banking sector is more or less dead in the water until either investors start wading back into the waters again, or the Fed finally hikes rates like it says it will. Until the latter happens, however, you'll be hard-pressed to find a willingness to trust.



I almost invested in a bank ETF the other day. I started remembering the hawkish Fed speak, anticipated the Manufacturing PMI would be positive, and there weren't any signs to be remarkably pessimistic on non-farm payrolls. Fast-forward to today and we're in another world of uncertainty, albeit not as uncertain as we were immediately post-Brexit (i.e. the yen isn't in the double-digits again). I didn't invest in that ETF, and do not plan to before the FOMC's September meeting, because I have a low amount of trust that the Fed will be able to confidently carry through with their not-so-subtle indications of an impending benchmark rate increase. I also have a low amount of trust in that any rate hike would really help banks- the most recent economic data from last week likely bars any interest rate increases from the current level beyond 50 bps until 2017, and in order for banking sector profits to swell, we'll need more than that.

Trust is hard to gain but easy to lose, and we've got a lot of trust to gain back.

Andrew