Houston (Fed), We Have A Problem (Problems) – Part 1/2

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12….11…10…9….IGNITION SEQUENCE START….6….5….4….3….2….1….0….ALL ENGINES RUNNING….LIFTOFF….WE HAVE A LIFTOFF!

The Fed finally raised rates after nearly a decade.  On December 16, the Fed decided to raise rates – for the first time since June 2006 – by 0.25%, or 25 basis points. It was widely expected by the markets and I only expected 10bps hike. Well, I was wrong on that.

The Federal Open Market Committee (FOMC) unanimously voted to set the new target range for the federal funds rate at 0.25% to 0.50%, up from 0% to 0.25%. In the statement, the policy makers judged the economy “has been expanding at a moderate pace.” Labor market had shown “further improvement.” Inflation, on the other hand, has continued to “run below Committee’s 2 percent longer-run objective” mainly due to low energy prices.

Remember when the Fed left rates unchanged in September? It was mainly due to low inflation. What’s the difference this time?

In September, the Fed clearly stated “…surveybased measures of longer-term inflation expectations have remained stable.”

Now, the Fed clearly states “…some survey-based measures of longer-term inflation expectations have edged down.”

So…umm…why did they raise rates this time?

Here is a statement comparison from October to December:

Fed Statment Comparation – Oct. to Dec. Source: WSJ
Fed Statement Comparison – Oct. to Dec.
Source: WSJ

On the pace of rate hikes looking forward, the FOMC says:

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

They clearly stated one of the things they look for, which is inflation expectations. But, they also did state that “inflation expectations have edged down.”

It seems to me that the Fed did not decide to raise rates. The markets forced them. Fed Funds Futures predicted about 80% chance of a rate-hike this month. If the Fed did not raise rates, they would have lost their credibility.

I believe the Fed will have to “land” (lower back) rates this year, for the following reasons:

  • Growing Monetary Policy Divergence

On December 3, European Central Bank (ECB) stepped up its stimulus efforts. The central bank decided to lower deposit rates by 0.10% to -0.30%. The purpose of lower deposit rates is to charge banks more to store excess reserves, which stimulates lending. In other words, free money for the people so they can spend more and save less.

ECB also decided to extend Quantitative Easing (QE) program. They will continue to buy 60 billion euros ($65 billion) worth of government bonds and other assets, but until March 2017, six months longer than previously planned, taking the total size to 1.5 trillion euros ($1.6 trillion), from the previous $1.2 trillion euros package size. During the press conference, ECB President Mario Draghi said the asset eligibility would be broadened to include regional and local debt and signaled QE program could be extended further if necessary.

ECB might be running out of ammunition. ECB extending its purchases to regional and local debt raises doubts about its program.

Not only ECB is going the opposite direction of the Fed. Three weeks ago, Bank of Japan (BoJ) announced a fresh round of new stimulus. The move was hardly significant, but it is still a new round of stimulus. The central bank decided to buy more exchange-traded fund (ETF), extend the maturity of bonds it owns to around 7-12 years from previously planned 7-10 years, and increase purchases of risky assets.

I previously stated in “Central Banks Smash: No Growth, No Inflation“,

The extensions of its QE are beginning to become routine or the “new normal”.

Japan's ETF Market - BoJ's holdings Source: Bloomberg
Japan’s ETF Market – BoJ’s holdings
Source: Bloomberg

The move by BoJ exposes the weakness of its past actions. It suggests the bank is also out of ammunition. Already owning 52% or more of the Japan’s ETF market and having a GDP-to-Debt ratio around 245%, it is only a matter of time before Japan’s market crashes. Cracks are already beginning to be shown. I expect the market crash anytime before the end of 2019.

So, what are the side-effects of these growing divergence?

For example, the impact of a US dollar appreciation resulting from a tightening in US monetary policy and the impact of a depreciation in other currencies resulting from easing in its monetary policies. Together, these price changes will shift global demand – away from goods and services produced here in the U.S. and toward those produced abroad. In others words, US goods and services become more expensive abroad, leading to substitution by goods and services in other countries. Thus, it will hurt the sales and profits of U.S. multinationals. To sum up everything that is said in this paragraph, higher U.S. rates relative to rates around the global harms U.S. competitiveness.

  • Emerging Markets

Emerging markets were trouble last year. It is about to get worse.

International Monetary Fund (IMF) decided to include China’s currency, renminbi (RMB) or Yuan, to its Special Drawing Rights (SDR) basket, a basket of reserve currencies. Effective October 1, 2016, the Chinese currency is determined to be “freely usable” and will be included as a fifth currency, along with the U.S. dollar, euro, Japanese yen, and pound sterling, in the SDR basket.

“Freely useable” – not so well defined, is it?

Chinese government or should I say People’s Bank Of China (PBOC), cannot keep its hands off the currency (yuan). It does not want to let market forces take control. They think they can do whatever they want. As time goes on, it is highly unlikely. As market forces take more and more control of its exchange-rate, it will be pushed down, due to weak economic fundamentals and weak outlook.

China, no need to put a wall to keep market forces out. Let the market forces determine the value of your currency. It is only a matter of time before they break down the wall.

In August, China changed the way they value their currency. PBOC, China’s central bank, said it will decide the yuan midpoint rate based on the previous day’s close. In daily trading, the yuan is allowed to move 2% above or below the midpoint rate, which is called the daily fixing. In the past, the central bank used to ignore the daily moves and do whatever they want. Their decision to make the midpoint more market-oriented is a step forward, but they still have a long way to go.

China saw a significant outflows last year. According to Institute of International Finance (IFF), an authoritative tracker of emerging market capital flows, China will post record capital outflows in 2015 of more than $500 billion. The world’s second largest economy is likely to see $150 billion in capital outflow in the fourth quarter of 2015, following the third quarter’s record $225 billion.

Ever since the devaluation in August, PBOC has intervened to prop yuan up. The cost of such intervention is getting expensive. The central bank must spend real money during the trading day to guide the yuan to the level the communists want. Where do they get the cash they need? FX reserves.

China’s foreign-exchange reserves, the world’s largest, declined from a peak of nearly $4 trillion in June 2014 to just below $3.5 trillion now, mainly due to PBOC’s selling of dollars to support yuan. In November, China’s FX (forex) reserves fell $87.2 billion to $3.44 trillion, the lowest since February 2013 and largest since a record monthly drop of $93.9 billion in August. It indicates a pick-up in capital outflows. This justifies increased expectations for yuan depreciation. Since the Fed raised rates last month, I would not be surprised if the capital flight flies higher, leading to a weaker yuan.

China Reserves Source: Capital Economics
China Reserves
Source: Capital Economics

Depreciation of its currency translates into more problems for “outsiders,” including emerging markets (EM). EMs, particularly commodities-linked countries got hit hard last year as China slowed down and commodity prices slumped. EMs will continue to do so this year, 2016.

The anticipation of tightening in the U.S. and straightening dollar put a lot of pressure on EM. EM have seen a lot of significant capital outflows because they carry a lot of dollar denominated debt. According to the October report from IFF, net capital flows to EM was negative last year for the first time in 27 years (1988). Investors are estimated to pull $540 billion from developing markets in 2015. Foreign inflows will fall to $548 billion, about half of 2014 level and lower than levels recorded during the financial crisis in 2008. Foreign investor inflows probably fell to about 2% of GDP in emerging markets last year, down from a record of about 8% in 2007.

Capital Flows to Emerging Markets, Annual Data Source: IFF
Capital Flows to Emerging Markets, Annual Data
Source: IFF, taken from Bloomberg

Also contributing to EM outflows are portfolio flows, “the signs are that outflows are coming from institutional investors as well as retail,” said Charles Collyns, IIF chief economist. Investors in equities and bonds are estimated to have withdrawn $40 billion in the third quarter, the worst quarterly figure since the fourth quarter of 2008.

A weaker yuan will make it harder for its main trading partners, emerging markets and Japan, to be competitive. This will lead to central banks of EM to further weaken their currencies. Japan will have no choice but to keep extending their QE program. And to Europe. And to the U.S.      DOMINO EFFECT

Why are EMs so important? According to RBS Economics, EMs have accounted for 50%-60 of global output and 70% of global economic growth each year since the 2008 crisis.

Emerging Markets Share of Global Economy Source: RBS Economics
Emerging Markets Share of Global Economy
Source: RBS Economics

Some EM investors, if not all, will flee as U.S. rates rise, compounding the economic pain there. Corporate debt in EM economies increased significantly over the past decade. According to IMF’s Global Financial Stability report, the corporate debt of non-financial firms across major EM economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014.

Figure 3.1. Emerging Market Economies Evolving Capital
EM Corporate Debt and Market Cap. Source: IMF – Page 84

When you add China’s debt with EM, the total debt is higher than the market capitalization. The average EM corporate debt-to-GDP ratio has also grown by 26% the same period.

EM Corporate Debt (percent of GDP) - Page 84
EM Corporate Debt (percent of GDP) – Page 84

The speed in the build-up of debt is distressing. According to Standard & Poor’s, corporate defaults in EM last year have hit their highest level since 2009, and are up 40% year-over-year (Y/Y).

Corporate Defaults Source: WSJ
Corporate Defaults
Source: WSJ

According to IFF (article by WSJ), “companies and countries in EMs are due to repay almost $600 billion of debt maturing this year….of which $85 is dollar-denominated. Almost $300 billion of nonfinancial corporate debt will need to be refinanced this year.”

I would not be surprised if EM corporate debt meltdown triggers sovereign defaults. As yuan weakens, Japan will be forced to devalue their currency by introducing me QE which leaves EMs with no choice. EMs will be forced to devalue their currency. Devaluations in EM currencies will make it much harder (it already is) for EM corporate borrowers to service their debt denominated in foreign currencies, due to decline in their income streams. Deterioration of income leads to a capital flight, pushing down the value of the currency even more, which leads to much more capital flight.

Let IMF explain the situation in EM,

“Firms that have borrowed the most stand to endure the sharpest rise in their debt-service costs once interest rates begin to rise in some advanced economies. Furthermore, local currency depreciations associated with rising policy rates in the advanced economies would make it increasingly difficult for emerging market firms to service their foreign currency-denominated debts if they are not hedged adequately. At the same time, lower commodity prices reduce the natural hedge of firms involved in this business.”

According to its Global Financial Stability report, EM companies have an estimated $3 trillion in “overborrowing” loans in the last decade, reflecting a quadrupling of private sector debt between 2004  and 2014.

EM Corporate Bond Composition (Billions of U.S. dollars) - Page 86
EM Corporate Bond Composition
(Billions of U.S. dollars) – Page 86
Private Sector Debt to GDP (Percent - Page 11
Private Sector Debt to GDP
(Percent – Page 11

Rising US rates and a strengthening dollar will make things much worse for EMs. Jose Vinals, financial counsellor and director of the IMF’s Monetary and Capital Markets Department, said in his October article, “Higher leverage of the private sector and greater exposure to global financial conditions have left firms more susceptible to economic downturns, and emerging markets to capital outflows and deteriorating credit quality.”

I believe currency war will only hit “F5” this year and corporate defaults will increase, leading to the early stage of sovereigns’ defaults. I would not be surprised if some companies gets a loan denominated in euros just to pay off the debt denominated in U.S dollars. That’s likely to make things worse.

Those are some of the risks I see that will force the Fed to lower back the rates.  I will address more risks, including lack of liquidity, junk bonds, inventory, etc, in my next article. Thank you.

EXTRA: Market reactions,

EUR/USD:

EUR/USD - Hourly Chart
EUR/USD – Hourly Chart

USD/JPY:

USD/JPY - Hourly
USD/JPY – Hourly

10-Year Treasury Index:

10-Year Treasury Index (TNX on thinkorswim platform) - Hourly
10-Year Treasury Index ( “TNX” on thinkorswim platform) – Hourly

2-Year U.S. Treasury Note Futures:

2-Year U.S. Treasury Note Futures ( "/ZT" on thinkorswim platform) - Hourly
2-Year U.S. Treasury Note Futures ( “/ZT” on thinkorswim platform) – Hourly

Repulsive Jobs Report

Last Friday (October 2), jobs report for September came out way weaker than expected. Non-farm payrolls report shows 142K jobs were added, vs 200K expectations. Unemployment rate stood unchanged at seven-year low of 5.1%. Not only that, but wage gains stalled, labor force shrank, and July and August gains were revised lower.

July job gains were revised lower to 223K from 245K (-22K) and August job gains were revised lower to 136K from 173K (-37K), totaling downward revisions of 59K. Average jobs gains for third quarter is now at 167K, lower than the 2014 average of 260K. So far, job growth has averaged 198K a month this year, compared with an average gain of 260K a month the previous year.

Total Non-Farm Payrolls – Monthly Net Change
Total Non-Farm Payrolls – Monthly Net Change

Unemployment rate stayed at 5.1% only because people stopped looking for work. In other words, they lost confidence in the labor market. 350K people dropped out of the labor force which took labor force participation rate fell to 62.4%, the lowest in 38 years (1977), from 62.6% in the previous three months.

Labor Participation Rate (Source: @ReutersJamie)
Labor Participation Rate (Source: @ReutersJamie)

Wages also showed weakness. Average hourly earnings fell by a penny to $25.09 after rising 9 cents in September. The average workweek declined by 0.1 hour to 34.5 hours.

There are increased worries that global slowdown is weighing on the domestic economy. The repulsive jobs report knocked down the chances of a rate-hike for this year. Federal Funds Rate (FFR) shows less than 10% and less than 35% chance of rate hike in October and December, respectively. Regardless of weak jobs growth, I still expect 0.10% rate-hike this month. But, I don’t expect 25 basis points for the year. If 0.25% were nothing, the Fed would have raised it already. The Federal Open Market Committee (FOMC) will meet on Tuesday-Wednesday, October 27-28.

Weak jobs report seems to point out a weak third quarter GDP growth following a strong rebound in the 2nd quarter. According to final GDP report released on September 25, second quarter grew at an annual pace of 3.9%, vs previous estimate of 3.7%. Advance (1st estimate) GDP report for the third quarter will be released on Thursday, October 29.

In the first quarter, the economy grew only 0.6% because of strong U.S. dollar, low energy prices, West Coast port strike, and the bad weather. Well, winter is approaching. Who’s not to say that the weather will hamper the growth again? The dollar is still strong and the energy prices are still low.

Energy sector continues to struggle. The mining industry – which includes oil and natural-gas drillers — lost 10K jobs last month, totaling 102K losses of jobs since December 2014. Energy companies continue to layoff workers since low energy prices are hurting companies. Energy companies like Chesapeake Energy and ConocoPhillips continues to reduce its workforce and its operations, and cut capital expenditures to offset higher costs.

Earlier in September, the Job Openings and Labor Turnover Survey (JOLTS) report showed that there were 5.8 million job openings in July, a series (series began in December 2000) record and higher than 5.4 million in May, as employers cannot find qualified workers.

It’s likely to get worse in the longer-term because of higher minimum wages. If employers pay higher wages, more people, especially teenagers, are likely to drop out and work. If states and companies continue to raise minimum wages, jobs that require skills such as programming, etc, will not be filled in the United States, but in countries with higher amount of education. That’s why recent minimum wage increases will batter, not help, the U.S. economy in the longer-term.

Reactions to the jobs report:

US markets fell immediately after the report, but rebounded later. 10-year Treasury yield fell below 2%, to the lowest level since April. US Dollar plunged, but recuperated about half of the losses later.

Standard & Poor 500 ETF ("SPY") - Hourly
Standard & Poor 500 ETF (“SPY”) – Hourly

 

10-Year Treasury Index ("TNX") - Hourly
10-Year Treasury Index (“TNX”) – Hourly

 

US Dollar ("/DX") - Hourly
US Dollar (“/DX”) – Hourly

The Fed On Hold…For Now

Last Wednesday (June 17, 2015), Federal Reserve released high anticipated FOMC statement, FOMC Economic Projections, and of course the Federal Funds Rate (interest rate). Federal Open Market Committee (FOMC) kept the interest rates on hold while they decreased their rate projections for 2016 and 2017.

The projections, or “dot plot”, which shows where FOMC members expect interest rates in the future, suggest that there will be one, or two quarter percentage (%) point interest rate increase by the end of the year. In March, the projections suggested more than two quarter percentage increases. That was before they knew that the first quarter of 2015 dragged on the economy…temporarily. 15 of 17 FOMC members believe that the first rate-hike will take place this year, same as March’s projections. Five officials foresee one increase in the rates this year by quarter percentage point, up from 1 official in March. Another five officials foresee 0.50% increase this year, down from seven officials in March. Two officials wants to keep rates unchanged this year. In March, officials did not know if the first quarter slump was temporary or not. They just believed negative economic news were due to “transitory effects” which includes West Port strike, low energy prices, bad weather, and  stronger dollar. Now that we been seeing more positive economic news, many officials believe first quarter slump was temporary.

Officials reduced their median estimate for the federal funds rate by the end of 2016 to 1.625% from 1.875% in March, and to 2.875% by the end of 2017, down from 3.125% in March.

FOMC Economic Projections
FOMC Economic Projections – June 2015 —– Source: Federal Reserve
FOMC Economic Projections - March 2015 ----- Source: Federal Reserve
FOMC Economic Projections – March 2015 —– Source: Federal Reserve

The Fed lowered their economic projections for 2015. They see economic output growth to 1.8% to 2.0%, from 2.3% to 2.7% in March. For 2016, it is seen growing by 2.4% to 2.7%, from 2.3% to 2.7% in March. For 2017, it is seen growing by 2.1% to 2.5%, from 2.0% to 2.4% in March. For 2016 and 2017, it’s essentially the same forecasts. They also changed their forecasts slightly for unemployment rate and inflation.

FOMC Economic Projections - June 2015 ----- Source: Federal Reserve
FOMC Economic Projections – June 2015 —– Source: Federal Reserve

In the statement, Fed policy makers reiterated that they must see “further improvement in the labor market” and be “reasonable confident that inflation will move back to its 2 percent objective over the medium term”. If the labor market continues to improve like they did in May, and inflation continues to improve, I strongly believe we will see rate-hike in July or September. It’s likely to be September because there will be no press conference in July. If the federal funds rate is increased in July, there will so much uncertainty and volatility in the markets because the Fed will not have a chance to explain their actions. However, there still might be rate-hike in July because the Fed wouldn’t want to increase rates too late.

During the press conference, Yellen said “…we have seen some progress. Even so, the Committee judged that economic conditions do not yet warrant an increase in the federal funds rate. While the Committee views the disappointing economic performance in the first quarter as largely transitory, my colleagues and I would like to see more decisive evidence that a moderate pace of economic growth will be sustained, so that conditions in the labor market will continue to improve and inflation will move back to 2 percent.” It shows that the Fed is not confident enough to raise the rates yet. She said that the policy will be “data dependent”. I believe future US economic reports will be positive until December when we might get unfavorable weather again. Bad weather always derails the Fed’s view on the policy because it affects majority of country.

Regarding the US Dollar, or Greenback, Yellen said that the dollar “appears to have largely stabilized” and its significant appreciation is going to continue to drag on the economy for some time to come. The dollar has risen more than 15% against major currencies over the last 12 months.

US markets rose after the Fed announcements while the greenback (US Dollar) slipped. US markets continued to rise the next day.

Standard & Poor 500 ( "SPX" on ThinkorSwim platform) - Hourly
Standard & Poor 500 ( “SPX” on ThinkorSwim platform) – Hourly
US Dollar ( "/DX" on ThinkorSwim platform) - Hourly
US Dollar ( “/DX” on ThinkorSwim platform) – Hourly