US Dollar Outlook, Week Ending 11/3

I'm making a post strictly for the U.S. Dollar this coming week because it seems we're approaching a possible inflection point for the currency. Technical indicators suggesting the dollar's recent rally is looking a bit hot, combined with a week of important economic data, suggest a selling opportunity for the dollar may be imminent.

Source: investing.com

A look at movements in the dollar index futures suggest some further strengthening in the currency is seen for the first day of the workweek, with Asian/Pacific trading starting to rev up as I type this (8:10pm Central Time). Since a relative nadir on October 11th, the dollar index has risen by nearly two index points, from 92.83 to 94.75. The biggest day of gains came on October 26th, with a jump of 1.01 index points. Needless to say, we've been in a bit of an uptrend over the last couple of weeks.

Source: investing.com

From a technical vantage point, the recent dollar rally has flipped the script from what we saw over the summer and earlier this fall, when the dollar was encountering one of its weakest periods in years. Both the pound and euro are starting to look a little too weak against the dollar right now, especially with EUR/USD dipping just barely below 1.16 in early trading to start this workweek.

Source: tradingeconomics.com

In terms of economic data, this week is looking to be a pretty significant one for the U.S. Seen among the high-impact data releases this coming week are a FOMC decision on Wednesday, where expectations are for the benchmark federal funds rate to be held steady at a range of 1.00% to 1.25%.

Source: CME Group

The big question for this meeting is going to be how policymakers view the likelihood of a December rate hike. As shown to the right, market participants view the probability of a rate hike at this week's FOMC meeting as practically nonexistent, but are pricing in a 97.2% chance of a 25 basis point hike in December. In other words, markets are viewing a December rate hike as all but certain, which leaves little room for any big upside dollar moves from this meeting. Instead, any hint of a more dovish shift in FOMC thinking on a December rate hike could hit the dollar and put an end to this recent uptrend.

The Federal Reserve has indicated they are taking into account the behavior of financial markets in their decisions- of course, to what degree is uncertain, but I would be surprised if there was to be any dovish shift. By historical valuations, stocks are indeed expensive, and I personally see the Federal Reserve as willing to turn a blind eye towards soft inflation and hike rates once or twice more to keep a very strong labor market and a frothy stock market in check. This was put on display a bit in the last few months when traders saw Federal Reserve chair Janet Yellen point to a December rate hike as more likely than previously thought.

The fun doesn't stop there, however. The employment report hits the newswires on Friday, 11/3, and everyone will be watching both the unemployment numbers and any hints of wage gains. Similar to last month, job gains numbers (currently forecasted at or over 300,000 jobs) could be volatile as businesses likely bounced back strongly in October after being hit hard in September from two major hurricanes.
Since this could be another volatile report, it wouldn't surprise me to see this week's USD direction be established by the midweek FOMC meeting. As that last sentence implies, though, the potential volatility of the report could also be a scene-setter, but we'll have to wait and see if that actually ends up being the case.

To summarize:

- Watch the 11/1 FOMC report for hints of a more dovish approach to monetary policy- market participants are nearly fully pricing in a December rate hike and USD could become vulnerable in a change of thinking.
- The possibility of another NFP report missing or beating forecasts by a large margin, like last month, is a source of uncertainty and will likely help set the tone for the week's performance of the dollar.

Andrew

Yield Curve Continues to Flatten

The yield curve for U.S. Treasuries continues to flatten, reflecting a dimming of expectations on significant economic boosts from President Trump's proposed reforms, continued thirst for yield globally, the Federal Reserve moving to tighten monetary policy, and some investor anxiety about the apparent separation of stock market prices from underlying fundamentals.

A comparison of the yield curves from May 1, 2017 (lighter blue line) and June 23, 2017 (darker blue line) shows the flattening process that began earlier this year and has continued into the summer. The flatter yield curve can be attributed to four primary causes:

I. Dimming of Expectations of Pro-Growth Reforms
After his election as president and through the first couple months of his presidency, Donald Trump advocated an agenda heavy with reforms that, if implemented as promised, would likely give a substantial short- to medium-term boost to the languishing economy. Some of his most notable campaign ideas included repealing and replacing the Affordable Care Act passed under President Barack Obama, significant tax reform, and substantially relaxing regulations on financial institutions (namely the Dodd-Frank Act). Market participants saw the potential bounty of economic growth that these reforms could bring, and have sent all four major stock market indexes skyrocketing in the time since the November 2016 election.

Stock Index Performance since the 2016 Presidential Election (11/8/2016 to 6/23/2017).
From top to bottom: Dow Jones Industrial Average, S&P 500, Nasdaq Composite, Russell 2000
Chart from stockcharts.com

Roughly five months since President Trump's inauguration, these reforms have not been fully realized as investors had hoped. Some progress has been made on easing regulations on financial institutions, but a significant defeat of the initial new health care bill a couple months back, paired with the newly-released health care bill this past week still garnering skepticism from within the Republican Party shows that any significant health care reform will take some time. Tax reform, another potential Congressional flashpoint, has yet to be proposed as legislation. As the year has gone on it has become apparent to many investors that if Trump's reforms are to be fully implemented as promised (still a very big "if"), it will take notably longer than they had expected. As such, any significant economic boost is still a ways off, and thus inflation expectations have dimmed to levels not seen since just before the 2016 presidential election. Bonds then become more attractive to investors, one reason why the yield curve has once again begun flattening.

II. Continued Global Thirst for Yield
This factor is much more long-term than the first factor we discussed. The search for yield has been intense for years now, amidst this global low-interest-rate environment, and while the global economy is beginning to pick up steam, American long-term debt remains much more attractive to foreign investors than those investors' own domestic sovereign debt.

Worldgovernmentbonds.com

Above is a list of major countries' 10-year bond yields. There are countries like Japan, France, Germany and the U.K., all with easy access to the global financial markets but with sovereign debt yields well below the United States' 10-year yield. Consequentially, as we have seen for a few years now, foreign investors are plowing money into long-term U.S. debt to get those higher yields. In turn, this is also helping keep the long end of the yield curve flat.

III. The Federal Reserve Tightening Monetary Policy
The federal funds rate now stands at a range of 1.00% to 1.25% after three rate increases, each by a quarter of a percentage point, over the last six months by the Federal Open Market Committee. Let's first be clear in recognizing that even despite these increases, a 1.25% federal funds rate is still quite accommodative. It is not the 0.25% that this range ceiling reached at the nadir of this cycle, but a range of 1.00% to 1.25% remains quite accommodative by historic monetary policy standards. The St. Louis Federal Reserve branch's Financial Stress Index also portrays how loose monetary policy remains:

Intriguingly enough, this index has been falling even amidst the FOMC's rate hikes, but that's another discussion for another post. For now, the focus is on the Federal Reserve's tightening of monetary policy (through rate hikes and reducing its $4.5 trillion portfolio of Treasury bonds and mortgage-backed securities, set to begin later this year) sending short-term U.S. Treasury debt yields higher, as typically happens in tightening monetary policy.

It is worth noting that when the Federal Reserve begins allowing its Treasuries to mature and not re-invest to maintain the size of the $4.5 trillion portfolio, longer-term Treasury debt yields are expected to rise somewhat as supply increases in the market without a clear replacement buyer as the FOMC steps away. But again, this is another discussion for another post.

IV. Some Investor Anxiety
Let me first start off and assuage you that this discussion will not be about the CBOE's Volatility Index, or VIX. We are all well aware that the VIX continues to remain incredibly subdued, whether due to complacency or genuine investor confidence in the economy or even a side effect of massive central bank stimulus. There is likely a degree of all three present in where the VIX lies today, but that's not relevant to this section.

Rather, there is some investor anxiety over a culmination of the uncertainty in President Trump's promised reforms from above, weaker economic data as of late that raises questions of if the Federal Reserve may accidentally tighten monetary policy too much and cut off economic growth, very high stock price valuations even in the face of improved corporate earnings, geopolitical tensions (which seem to rise every other day in some aspect), and more. To me, it comes down to substantial risks to the market being at least partially offset by continued strongly accommodative monetary policy by central banks worldwide. I say partially because we have seen some rattled nerves in recent months following bouts of increased uncertainty or tension, but overall this has not been enough to persuade investors to fully dive into haven assets like U.S. Treasuries or gold. Gold is up over $100/ounce from the start of 2017 to 6/23, and the U.S. 10-year Treasury yield has dropped 30 basis points in that same timeframe. Again, these signal some investor anxiety, but not enough to make the stock markets or other riskier assets notably less attractive.

So what's the outlook? Unless Congress can force the most recent health care bill through in the near term, it looks to be more of the same: A gradually flattening yield curve as uncertainty over Trump's promised reforms, tightening monetary policy, an insatiable global thirst for yield, and hints of investor anxiety amidst heightened geopolitical tensions.

Andrew

Yellen's 'High-Pressure Economy' May Pressure Stocks

Janet Yellen laid out her take on current monetary policy in Boston on Friday at a luncheon, describing how a "high-pressure" economy may be necessary in order to boost growth. The speech comes at a time when the Federal Reserve is divided on whether to raise benchmark interest rates this year, or keep them steady at their historically-low levels. (More information on her speech can be found in this link from Reuters).

I have a few concerns about letting inflation run temporarily hot.

FRED - Federal Reserve Bank of St. Louis

Shown above is the civilian unemployment from January 1948 to the most recent data point, September 2016. Shaded gray areas indicate economic recessions. There are two main take aways from this graph:

1. When looking at past economic expansions, a common signal that the expansion is coming to an end is when we start to see the slope of the unemployment rate line go to zero. This was seen prior to the recessions of 1970, somewhat in 1973-1975, again in ~1979 and ~1981, and notably just before the early 1990s recession, the early 2000s recession, and a bit before the Great Recession back in 2008. While one could nitpick and say the slope never did get to zero, merely eyeballing it shows that before recessions, the unemployment curve generally becomes flat, if not close to flat, as the economy reaches full employment.
Taking a look at our current position on the curve, we're right around (if not at) that point where the unemployment line's slope hits zero-ish. The table below illustrates this quite well:

The attached table shows civilian unemployment data from FRED, compared year-over-year for September of each year during the current economic expansion. We began the economic expansion in September 2009 with a change of -0.3% from then until September 2010. The YoY change in the unemployment rate from September 2015 to September 2016 was the smallest change throughout the entire economic expansion when looking at September YoY changes. I haven't run the data for all the months' YoY change, but going through a few more data points, it appears this could very well be the smallest YoY change throughout the entire expansion, including all months' YoY changes.
What does that tell us? Right now, the only thing we can plausibly assert is that the labor market is near full employment, based on how the slope of the unemployment line is getting closer and closer to zero. I don't believe this shows that a recession is barreling our way, primarily because the Fed is keeping monetary policy extremely accommodative and investor sentiment remains more-or-less high, though we saw an unexpected drop on the Consumer Sentiment Index on Friday. However, given the Consumer Sentiment Index is a lagging indicator, and by most other measures the domestic economy is still chugging along, I don't believe a recession is pending in the short-term.

2. Despite claims that the labor market is not yet at full employment, recent recessions indicate it could be. Referring back to the FRED unemployment rate chart, note how the minimum unemployment rate, or at least the point when the slope of the curve begins to flatten to zero, has been creeping up ever since April 2000, when it hit an expansion-low of 3.8%. The expansion-low prior to the Great Recession was 4.4%, hit multiple times from Fall 2006 to Summer 2007. Our expansion-low in our current economic expansion is 4.7%, from May 2016. The gradual uptick in apparent minima with respect to the unemployment rate could be a signal that our labor market is at full employment, in addition to the signal from the flattening slope of the curve.

                    ______________________________________________________________

My other main concern resides in the fact that the stock market is already near record highs, and broke record highs this past summer. Allowing inflation to run hot could create a bubble, if one hasn't already been formed.

Big Charts - Marketwatch

The chart above reflects the DJIA's history through early 1988 or so, on a weekly scale. Note how we are currently just below record highs reached earlier in the summer. Record stock prices generally come about around the peak of a bull market, and it's been my belief for some time that we are either at the peak or just past the peak of this current expansion's bull market. But that's not my primary point of discussion relating to the stock market.

Extraordinarily-accomodative monetary policy in the U.S. for the last many years, and expectations of continued accommodative policy, has led to prolonged risk-on sentiment, as reflected in the record highs for all three major equity indices this past summer, and the near-record-high valuations at present date. Many financial analysts promote the idea that this accommodative policy has led to the 'Central Bankers' Bubble', named after central banks' continued enforcement of such monetary policy that some believe has blown a bubble in more than just one specific asset. To be sure, this is by no means a prevailing opinion, as far as I can tell, and the theory that we are mid-bubble does not stand for all financial analysts. However, I do personally believe that this is the case, at least to some degree, and this is where my concerns over a 'high-pressure economy' come to light again.

In a general sense, inflation is bearish for the stock market. When inflation begins to ramp up, typically the Federal Reserve will act to tighten monetary policy by hiking interest rates, thus placing a more risk-off sentiment across financial markets as investors leave stocks and seek safer investments, like bonds. However, if the Federal Reserve were to maintain low interest rates while allowing inflation to rise, the 'lower-for-longer' concept (the idea that interest rates will stay lower for a longer period of time) that has boosted stock prices over the last few years would persist. Inflation would begin to eat away at the stock market, and at that point the Fed would begin tightening monetary policy, but until then it would be a continuation of low interest rates and more-or-less tepid inflation, until the 'high-pressure economy' kicks in and inflation rises.
Why the worry? With inflation expectations so low, we could be talking about a number of years in a low interest rate, low inflation environment, which would almost certainly blow an equities bubble, if one hasn't already begun forming. Consequentially, if/when inflation reaches a point that the Fed deems as conducive to hiking interest rates, the pullback in stock markets would be far sharper than it would be if the Fed were to hike rates today.

In my eyes, the Fed has dug itself into a hole by maintaining interest rates for so low. To be fair, this was a good choice when you see how steadily the unemployment rate fell. However, good cases could have been made for a rate hike in the last few FOMC meetings, particularly after some FOMC members began taking far more hawkish viewpoints. Then, when they didn't hike, the Fed began losing credibility, but that topic is for another write-up. By allowing a low-inflation, low-interest rate environment to persist, possibly for a prolonged time period (longer than Ms. Yellen believes, as the FOMC is notorious in recent history for being too aggressive in their inflationary expectations), equities would almost certainly enter into a bubble, and if other assets also enter into bubbles as ultra-accommodative monetary policy continues, the pullback if/when tightening occurs could be nasty.

Lucky for us, all of this is hypothetical, and assuming the FOMC goes along with Yellen's ideals. While she posed the high-pressure economy as a 'question that needs more research', it's quite frank that she is looking for every excuse to not hike interest rates, and it's entirely plausible that the chairwoman is able to convince the FOMC to follow suit.

Andrew

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

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