inflation Archives - Out of WACC

Post-Brexit: Uncertainty Everywhere, Everything on the Sidelines (Cash Too), and Market Index Copycats

Yes, I know markets have been rallying and S&P 500 has been hitting all-time highs. But, remember Brexit?

In case you forgot, the people of United Kingdom voted to leave European Union on June 23rd. Markets then destroyed more than $3 trillion in paper wealth in the next 2 days (Friday and Monday).

After that, market just shook it off. As Taylor Swift says, “Shake It Off.” “It’s gonna be alright.”

The actual businesses and people in the UK just cannot shake, shake, shake, shake, shake,….it off.

The UK job market went into “freefall” as the number of people appointed to full-time roles plunged for a second successive month in July, according to a survey. An index of permanent positions dropped to 45.4 from 49.3 the previous month, the lowest level since May 2009. A number below 50 indicates a decline in placements (contraction). Employers in the survey cited Brexit-related uncertainty.

The same uncertainty that scared away some investors and sit on cash, including me. 91% of investors made money in July as US markets kept hitting record highs, according to Openfolio, an app that allows you to connect and compare your portfolio to 60,000 other investors. Average cash holdings of these investors grew 25% over the past three months leading up to July.

75% of investors lost money in June as Brexit uncertainly weighted in. The portfolio of the majority of investors are tracked with S&P 500. The problem here can be described by Ron Chernow,

As a bull market continues, almost anything you buy goes up. It makes you feel that investing in stocks is a very easy and safe and that you’re a financial genius.

93% of investors lost money in January as the energy prices plunged and uncertainty in China scared investors.

Investor Average vs. S&P 500 Returns Source: app.openfolio.com

Here’s another quote by Robert Kiyosaki (Rich Dad),

As a bull market turns into a bear market, the new pros turn into optimists, hoping and praying the bear market will become a bull and save them. But as the market remains bearish, the optimists become pessimists, quit the profession, and return to their day jobs. This is when the real professional investors re-enter the market.

I’m naturally contrarian like Bill Ackman. I love going against the crowd. I love Bill Ackman. When I met him, I had no problem keeping my cool after learning my lesson from the Ben Bernanke experience.

Bill Ackman (left) Khojinur Usmonov (right) — Bill Ackman (left)
Khojinur Usmonov (right)

Being contrarian has made me money. It has also got me into “value trap” like buying $TWTR around $34.

The UK labor market survey was released a day after Bank of England cut rates and expanded quantitative easing.

On Thursday (August 4th), Bank of England (BoE) cut rates by 25bps (0.25%) to 0.25%, the lowest since the central bank was founded in 1694 (322 years) and the first cut since March 2009.
- The central bank signaled further cut to the interest rate if the economy deteriorates further, “If the incoming data prove broadly consistent with the August Inflation Report forecast, a majority of members expect to support a further cut in Bank Rate to its effective lower bound at one of the MPC’s forthcoming meetings during the course of the year.” (I’ll address the recent economic reports and BoE’s forecasts later in this article)
- During the press conference, Mark Carney (The Governor of BoE), stated he is not a fan of negative interest rates. He clearly stated that MPC (Monetary Policy Committee) is very clear lower bound is above zero. Options other than NIRP (Negative Interest Rate Policy) are available, “we have other options to provide stimulus if more stimulus were needed.”
- Carney told banks they have “no excuse” not to pass on the rate cut in full to customers. In other words, he’s telling them not to mess with him.
- “With businesses and households, anyone watching, if you have a viable business idea, if you qualify for a mortgage, you should be able to get access to credit.”

With 6-3 vote, they will provide an extra 60 billion pounds ($78 billion) of newly created money by buying government bonds over six months, extending the existing quantitative easing (QE) to 435 billion ($569 billion).
To cushion the blow to banks’ profitability, BoE will provide up to 100 billion pounds ($130 billion) of loans to banks close the base rate of 0.25% under the Term Funding Scheme (TFS). The scheme will charge a penalty rate if banks do not lend.
- “The TFS is a monetary policy instrument. It reinforces the transmission of Bank Rate cuts and reduces the effective lower bound toward zero, it charges a penalty rate if banks reduce net lending, it covers all types of lending, and it is funded by central bank reserves.” (Page 6)
With 8-1 vote, BoE will also buy as much as 10 billion pounds ($13 billion) of corporate bonds in the next 18 months, starting in September. For that, BoE is targeting non-financial investment-grade corporate bonds, issued by “firms making a material contribution to the UK economy” (Page 3)

I did not expect that much of stimulus.

I expect .25% rate-cut by Bank of England. But, not more QE. There's a little chance I think QE will be less than £20bn. $GBPUSD #BoE

— Khojinur Usmonov (@Khojinur30) August 4, 2016

While I was wrong on this one, I was right in July when markets expected rate-cut and expansion of QE.

BoE to hold off tomorrow. Will "wait and see" until August/September to decide due to UK politics and article 50 not triggered. $GBPUSD

— Khojinur Usmonov (@Khojinur30) July 14, 2016

They probably want a stronger pound #GBP before cutting and more QE so inflation risk is reduced, even little. $GBPUSD

— Khojinur Usmonov (@Khojinur30) July 14, 2016

the sharp fall in the exchange rate will, in the short run, put upward pressure on inflation. $GBPUSD $BoE $EURGBP https://t.co/AglY3nPWhh

— Khojinur Usmonov (@Khojinur30) July 14, 2016

Note: I’m always active on Twitter. Follow me, @Khojinur30.

The stimulus comes as recent economic data has been weak. Confidence tumbled. Manufacturing, construction activity, and service-sector all shrank sharply.

Consumer confidence dropped 11 points to -12 in July, the sharpest month-to-month drop (M/M) since March 1990.

GfK Consumer Confidence Index Souce: Trading Economics — GfK Consumer Confidence Index
Souce: Trading Economics

Activity among UK manufacturers contracted at its fastest pace at the start of third quarter. UK manufacturing PMI (Purchasing Mangers’ Index) fell to 48.2 in July, down from 52.4 in June, the lowest levels since February 2013.

Market/CIPS UK Manufacturing PMI Source: Markit/CIPS — Market/CIPS UK Manufacturing PMI
Source: Markit/CIPS

Manufacturing sector accounts for 11% of the UK economy.

UK manufacturing stats:

Employs 2.6 million workers, accounting for 8.20% of the working population.
- “UK manufacturing employment decreased for the seventh straight month in July, the rate of job loss was the second-sharpest for almost three-and-a-half years” the PMI report said.
- It also stated “Weaker inflows of new work and declining volumes of outstanding business also suggest that employment may fall further in coming months.”
Contributes to 10% of GVA (Gross Value Added), which measures how much money is generated through goods and services produced. In 2014, GVA per head on average in the UK was 24,616 pounds ($32,113), growing 3.6% Y/Y.
Accounts for 44% of total exports. Exports alone account for 27.4% of the UK’s GDP (Gross Domestic Product).
- Export orders rose for the second successive month in response to the weaker pound. On July 6th, sterling plunged to $1.2788, the lowest since 1985.
Represents 69% of business research and development (R&D), which accounts for mini 1.67% of the UK’s GDP.

What is also interesting in the PMI report is the input price. Input price inflation rose to a five-year high in July, “reflecting a sterling-induced rise import costs.” Some part of the increase in costs “was passed through to clients.”

Markit/CIPS UK Input Prices Index Source: Markit/CIPS — Markit/CIPS UK Input Prices Index
Source: Markit/CIPS

UK construction industry, accounting for 6.5% (Parliament.uk – PDF download) of the economic output, suffered its sharpest downturn since June 2009 as the sector came under pressure from the uncertainty. UK construction PMI inched down 0.1 to 45.9 last month.

Markit/CIPS UK Construction PMI Source: Markit/CIPS — Markit/CIPS UK Construction PMI
Source: Markit/CIPS

Clients of the construction firms had adopted “wait-and-see” approach to projects rather than curtailing and canceling the projects. The same “wait-and-see” that has caused investors like me to sit on cash (Cash on sidelines).

“Insufficient new work to replace completed projects resulted in a decline in employment numbers for the first time since May 2013” the PMI report stated. The construction industry accounts for 2.1 million jobs, 6.62% of the working population. The industry contributes to 6.5% of GVA.

And services too. UK services PMI plunged to 47.4 in July from 52.3 in June, the first contraction since December 2012 and the fastest rate of decline since March 2009 and the steepest M/M decline (-4.9) since PMIs began in July 1996.

The sector accounts for 78.4% of the UK economic output.

Markit/CIPS UK Services PMI Source: Markit/CIPS — Markit/CIPS UK Services PMI
Source: Markit/CIPS

Not surprisingly, the sentiment of businesses dropped to the lowest since February 2009.

Market/CIPS UK Services PMI Expectations Source: Markit/CIPS — Markit/CIPS UK Services PMI Expectations
Source: Markit/CIPS

Bank of England slashed its growth and increased its inflation forecasts. The central bank slashed its growth forecast for 2017 to 0.8% from initial estimate of 2.3%, making it the biggest downgrade in growth from one inflation report to the next. They now expect inflation to hit 1.9% in 2017, from previous estimate of 1.5%.

For 2018, the economy is expected to grow at 1.8% from previous estimate of 2.3%, and CPI is expected to hit 2.4% from previous estimate of 2.1.

Unemployment is expected to reach 5.4% next year from initial estimate of 4.9%, that is more than 250,000 people losing their job….even after the stimulus.

The bank’s outlook also includes lower income and housing prices to decline a “little” over the next year.

UK house prices fell 1% in July, according to a survey by Halifax, Britain’s biggest mortgage lender. The reports for the next few months will sure be interesting.

Confidence will continue to fall in the coming months as uncertainty will continue to exist and businesses will be extremely cautious with regard to spending, investment and hiring decisions, and people will be cautious with regard to spending.

All these survey conducted shortly after Brexit reflects an initial reaction. What matters now, especially after the new wave of stimulus, is the level of uncertainty and the magnitude of contractions. The three PMIs – manufacturing, construction, and services – accounting for almost 96% of the economic output, does not cover the whole economy as the retail, government and energy sectors (Oh energy), are excluded. However, it is clear the UK economy is slowing and is likely to slow in the coming quarters. Until clouds stop blocking the sun from shining, we won’t have a clear picture of the economy.

Will there be a recession or not? I’m not calling for any recession at the time. I will get a better idea of where the UK economy is heading as we get more data.

Tomorrow (Tuesday):

Manufacturing production.

In two weeks:

Consumer Price Index (CPI) – With data reflected in the PMIs and the amount of stimulus announced by BoE, inflation overshoot is possible. This report in two weeks will only reflect July. We should get better of where inflation is going in September and October.

Jobs report

Retail Sales

In four weeks:

Another manufacturing and construction PMIs. The services PMI comes the week later.

I should make a call on whatever the will be recession after the data and some by mid-September.

Without fiscal stimulus, monetary stimulus alone cannot offset most of the Brexit ills. Philip Hammond, the chancellor, signaled loosening of fiscal policy in October. By then, it just might be too late.

Extra: Bad Karma

Since Brexit (voted for by pensioners) UK 10y yield has plunged from 1.40% to record low 0.65%…decimating pensions pic.twitter.com/CtVUoufWuF

— Jamie McGeever (@ReutersJamie) August 4, 2016

U.S. Labor Market Seriously Injured

Note: Also posted on Seeking Alpha. It can be found here.

April FOMC Meeting Minutes: “It likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.”

Last Friday: 38K jobs created in May, the fewest since September 2010. Way way lower than 123K jobs gained (that number is revised….hold your breath) in April. Way way lower than 159K gain expected.

Labor market was seriously injured in May. The United States added only 38,000 new jobs, the fewest in almost six years. Things get worse. Prior two months reading were revised lower by 59,000. There were 123,000 jobs added in April down from initial estimate of 160,000. Nonfarm payroll for March was revised to 186,000 from 208,000.

Total Non-Farm Payrolls - Monthly Net Change (In Thousands) — Total Non-Farm Payrolls – Monthly Net Change (In Thousands)

Yet, unemployment rate surprisingly dropped by 0.3% to 4.7%, the lowest since November 2007. Hold on a second. How can unemployment rate drop so much if employment decreased so much? More people left the labor force, as confidence in the labor market is cooling down.

The labor force participation rate decreased by 0.2% to 62.6%, near 38-year low, unwinding about two-thirds of the rise between last September and March. A record 94,708,000 Americans were not in the labor force in May, 664,000 more than in April.

Unemployment Rate and Labor Force Participation Rate "Death Cross" — Unemployment Rate and Labor Force Participation Rate “Death Cross”

The report has evaporated the chance of a rate-hike this month from the Federal Reserve. Before the report, the federal funds futures were pricing in 55% chance of a rate-hike. Now, that is less than 5%.

Federal Funds Futures Source: @MktOutperform (Twitter) — Federal Funds Futures
Source: @MktOutperform (Twitter)

The next probable rate-hike prediction is December. As I mentioned in early January, the Federal Reserve will lower back rates this year. Let’s dig deep into the jobs report.

About 35,000 job losses can be connected to a 45-day Verizon strike, which began on April 13. The workers returned to work on Wednesday, June 1st, after unions reached a deal with the telecommunications company on compensation and job security.

Since they were not working and was on a strike, they were counted as unemployed. Without the “Verizon strike effect,” May nonfarm payroll would have shown 73,000 gain, still way below from the prior month and expectations.

Information services employment, which Verizon workers would fall under, declined by 34,000 jobs in May, the first decline since November 2015. The Bureau of Labor Statistics (BLS) even highlighted the impact of the strike, “employment in information decreased due to a strike.” “About 35,000 workers in the telecommunications industry were on strike and not on company payrolls during the survey reference period,” said BLS in the report.

This is not the first time Verizon workers went on a strike. In both 2000 and 2011, information services employment dropped as Verizon workers demanded more benefits. The month after the strikes, the sector’s employment numbers rebounded.

Verizon Strikes & Information Employment Source: @M_McDonough — Verizon Strikes & Information Employment
Source: @M_McDonough (Twitter)

These 35,000 Verizon workers will be added back to the June’s nonfarm payrolls.

The agreement between the unions and the company gives Verizon workers 10.9% increase in pay over four years (contract expired on August 3, 2019), as well as other benefits. That pay raise is way more than stagnant wages across the country.

Average hourly earnings rose by 5 cents (0.2%) to $25.59, following 9 cents (0.4%) increase in April. On a year-over-year (Y/Y) basis, the wage growth was flat for two months, growing by 2.5%.

Average Hourly Earnings and 12-Month Percentage Change "Death Cross" — Average Hourly Earnings and 12-Month Percentage Change “Death Cross”

Unemployment at 4.6% is within the range the Fed considers “full employment.” The average unemployment rate from 1948 (oldest data I could find) to last month is 5.8%. This leads me to believe the unemployment rate is below its natural rate, 5.8%. Then, why is not inflation higher?

According to Phillips curve, inflation should be higher. Inflation has been hovering around 0% and 1% since the end of 2014. So, why is the Phillips curve not really working?

Phillips Curve (Inflation and Unemployment Rate)

If there’s a recession later this year or next year (as some people are forecasting) and the inflation rate is the same as now, we will have a deflationary problem. This time, the deflationary problem will be much worse than they were before. At this time, I am not forecasting anything on recession. If there is one, it will be very interesting how the central banks react to the deflationary pressures, considering the fact that they are running out of ammunition.

I believe Phillips curve is not really working today due to unemployment engineering (like companies do with non-GAAP) and globalization. Workers should not be counted as unemployed because they didn’t look for work in the past four weeks. Instead, it should be three months or more. It gives them more time to think and flush out their savings, if they even have one. Such discouraged workers should be included in the calculation process of unemployment.

Mostly important, globalization has played a big part in the crisis of Phillips curve. Since the financial crisis and light-speed innovation of technology, many companies found ways and more ways to reduce the costs. Since they are battling for customers, they are reducing their prices, keeping inflation low. The trade agreement, Trans-Pacific Partnership (TPP), will keep or even lower inflation further.

The countries included in TPP (China is excluded) account for 36.2% of global economic output and 25.6% for world trade. By eliminating taxes on exports, companies with intense competition, will reduce their prices further. For example, TPP eliminates import taxes up to 70% on U.S. automotive product exports to TPP countries.

The prices of drugs, on the hand other, will continue to increase. TPP increases the protection of drug patents and copyrights, reducing the availability of cheap generics.

Back to the jobs report. Private sector added only 25,000 jobs, the fewest since February 2010. April’s private sector gain was revised down to 130,000 from 171,000. March’s gain was slightly revised down to 167,000 from 184,000. Constructions payrolls dropped by 15,000, the most since December 2013 and the second consecutive month of decline.

The goods producing sector, which includes mining, manufacturing, and construction, shed 36,000 jobs, the most since February 2010. Mining employment continued its downward trend as plunging oil prices penetrated the operations of energy companies, shedding 10,000 jobs in May. Mining employment have dropped by 207,000 since peaking in September 2014, with three-quarters of the losses in support activities.

Temporary-help service jobs shrank by 21,000 and are down by 64,000 so far this year.

Employment and Earnings by Industrial Sector. Percentage of Labor Force sorted: From the highest to lowest. Green colors: Highest in the column Red colors: Lowest in the column — Employment and Earnings by Industrial Sector.
Percentage of Labor Force sorted: From the highest to lowest.
Green colors: Highest in the column
Red colors: Lowest in the column

Retail employment rose 11,400 (Shopping for summer?) after losing jobs in April for the first time since December 2014. Health care added the most jobs, with 45,700. Over the year, health care jobs jumped by 487,000 (Thanks, Obamacare?).

Diffusion index – which measures the breadth of employment across the private sector – collapsed to 51.3%, the lowest since February 2010. A reading of 50 represents that as many industries gained employment as lost employment. If it’s 0, employment of all industries decreased. If it’s 100, employment of all industries increased. That is down from 53.8% in April and 56.3% in March and from the recent peak of 71.2% in November 2014.

Total Private Employment: 1-Month Employment Change and 1-Month Diffusion Index

Further, the number of people employed for part time for economic reasons (involuntary part-time workers), climbed by 468,000 to 6.4 million, the highest since August and the largest jump since September 2012. This level, in addition to other numbers above, suggests slack still in the labor market. It is still high by historical standards.

Part-Time Employment Level for Economic Reasons

These workers are included in the alternative measures of underutilization (U-6) that remained unchanged at 9.7% in May.

There are nearly 1.9 million workers who have been unemployed for more than 26 weeks, down from 2.1 million in April. It’s the lowest since July 2008, but is still high by historical standards.

Three-month average of total nonfarm is down to 116,000 from 181,000 in April. It’s the lowest since July 2012 and is down from 203,000 three-month average during he same period last year. The three-month average of total private is nosedived to 107,000 from 173,000 in April.

The Federal Open Market Committee will meet on June 14-15. They will keep rates on hold, unless they don’t listen to the market like in December. Again, I continue to believe the Fed will lower back rates this year.

The labor market remains in hospital with serious injuries.

Reactions to the jobs report:

U.S. Dollar (greenback):

U.S. Dollar ("/DX" on thinkorswim) — U.S. Dollar (“/DX” on thinkorswim)

Gold:

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

15 seconds and counting

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 “…survey—based 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:

USD/JPY:

10-Year Treasury Index:

2-Year U.S. Treasury Note Futures:

October Jobs Report Strong: It Is Just One Report

On November 6 (Friday), jobs report for October had the winds of 120 miles per hour and blew everyone away. Non-farm payrolls showed 271,000 jobs were added in October, the most gain since December and a huge beatdown on expectations of about 185,000. It’s the best month for job growth so far this year. The report follows two consecutive months (August and September) of weak jobs growth below 160,000.

The total job gains for August and September were revised 12,000 higher. August was revised 17K higher to 153K from 136k, and September was revised -5K lower to 137K from 142K. Over the last 12 months, employment growth had averaged 230K per month, vs. 222K in the same-period of 2014. In 2014, average monthly payrolls was 260K. This year, it is 206K. Not only jobs gains for October were strong, but also unemployment and wages.

Total Non-Farm Payrolls – Monthly Net Change

The unemployment rate dipped 0.1% to 5%, its lowest level since April 2008. Average hourly earnings rose by 9 cents an hour to $25.20. It rose 2.5% year-over-year (Y/Y), the best level since July 2009. For most of the “recovery”, wages has been flat. The increase in earnings is significant for two reasons. More money for employees means more spending (don’t forget debts), which accounts two-thirds of the economy. Second, wage growth might suggest that employers are having trouble finding new workers (should I say “skilled” workers) and they have to pay more to keep its workers and/or to get new skilled workers. This could draw more people back into the labor market, increasing the participation rate. Without the right skills, good luck.

Average Hourly Earnings and Average Weekly Hours

The labor force participation rate remained unchanged at a 38-year (1977) low of 62.4%. The long-term decline in the participation rate is due to the aging of the baby-boom generation and loss of confidence in the jobs market. There hasn’t even been a rebound in participation rate of prime-age Americans (between the ages of 25 and 54).

Unemployment Rate + Labor Force Participation Rate

More than 122 million Americans had full-time jobs at the end of October, the highest since December 2007 (121.6 million).

Immediately after the jobs report, the probability of a rate-hike in December lifted. Fed funds futures currently anticipates about 65% chance of a rate hike next month vs. about 72% immediately after the report and about 55% before the report.

Federal Reserve Chairwoman, Janet Yellen, lately has been saying that December’s Federal Open Market Committee (FOMC) meeting was “live” for a potential rate-hike. While this jobs report is positive, I believe it is too early to jump in on conclusions.

The policymakers should not be too quick to act on one report. In September, the Fed left rates unchanged mainly due to a low inflation. Inflation is still low and we will get a fresh look on Tuesday (November 17) when Consumer Price Index (CPI) is released.

In March, the Fed expressed worries about the strength of the U.S. Dollar, just after the greenback hit above $100 mark. The greenback then tumbled and has never recovered back to $100….yet.

US Dollar ("/DX" on thinkorswim platform) - Daily — US Dollar (“/DX” on thinkorswim platform) – Daily

Right after the jobs report, the dollar skyrocketed and was 40 cents away from hitting $100 mark. It’s currently at $98.88 and there is a very high chance it will go above $100 until December 15, the first day of FOMC meeting.

If the November job numbers does not surprise to the upside (released in December 4), inflation stays low, and the dollar keeps strengthening, I do not believe the Fed will hit the “launch” button for a rate-hike liftoff.

Market Reactions:

US Dollar ("/DX" on thinkorswim platform) - Hourly — US Dollar (“/DX” on thinkorswim platform) – Hourly

S&P 500 Index ("SPX" on thinkorswim platform) - Hourly — S&P 500 Index (“SPX” on thinkorswim platform) – Hourly

Central Banks Smash: No Growth, No Inflation

European Central Bank:

On October 22 (Thursday), European Central Bank (ECB) left rates unchanged, with interests on the main refinancing operations, marginal lending, and deposit rate at 0.05%, 0.30% and -0.20, respectively. But the press conference gave an interesting hint. Mario Draghi, the President of ECB, was most dovish as he could be, “work and assess” (unlike “wait and see” before).

The central bank is preparing to adjust “size, composition and duration” of its Quantitative Easing (QE) program at its December meeting, “the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting”, Draghi said during the press conference. They are already delivering a massive stimulus to the euro area, following decisions taken between June 2014 and March 2015, to cut rates and introduce QE program. In September 2014, ECB cut its interest rate, or deposit rate to -0.20%, a record low. Its 1.1 trillion euros QE program got under way in March with purchases of 60 billion euros a month until at least September 2016.

When ECB cut deposit rate to record low in September 2014, Mr. Draghi blocked the entry to additional cuts, “we are at the lower bound, where technical adjustment are not going to be possible any longer.” (September 2014 press conference). Since then, growth hasn’t improved much and other central banks, such as Sweden and Switzerland, cut their interest rates into much lower territory. Now, another deposit rate-cut is back, “Further lowering of the deposit facility rate was indeed discussed.” Mr. Draghi said during the press conference.

The outlook for growth and inflation remains weak. Mr. Draghi – famous for his “whatever it takes” line – expressed “downside risks” to both economic growth and inflation, mainly from China and emerging markets.

Given the extent to which the central bank provided substantial amount of stimulus, the growth in the euro area has been disappointing. The euro area fell into deflation territory in September after a few months of low inflation. In September, annual inflation fell to 0.1% from 0.1% and 0.2% in August and July, respectively. Its biggest threat to the inflation is energy, which fell 8.9% in September, down from 7.2% and 5.6% in August and July, respectively.

Inflation Rate - Annual Percentage Change Source: Eurostat — Inflation Rate – Annual Percentage Change
Source: Eurostat

Europe’s economy will slow down due to export demand decreasing from China and emerging countries, where a quarter of all euro-zone exports gets shipped to.

As the ECB left the door open for more QE, Euro took a dive. Euro took a deeper dive when Mr. Draghi mentioned that deposit rate-cut was discussed. Deposit rate cut will also weaken the euro if implemented. After the press conference, the exchange rate is already pricing in a rate-cut. Mentions of deposit rate-cut and extra QE sent European markets higher and government bond yields fell across the board. The Euro Stoxx 50 index climbed 2.6%, as probability of more easy money increased. Swiss 10-year yield fell to fresh record low of -0.3% after the ECB press conference. 2-year Italian and Spanish yields went negative for the first time. 2-year German yield hit a record low of -0.32.

Regarding the exchange rate (EUR/USD), I expect it to hit a parity level by mid-February 2016.

As I stated in the previous posts, I expect more quantitative easing by ECB (and Bank of Japan also). I’m expecting ECB to increase its QE program to 85 billion euros a month and extend it until March 2017. When ECB decides to increase and extend the scope of its QE, I also expect deposit rate-cut of 10 basis points.

ECB will be meeting on December 3 when its quarterly forecasts for inflation and economic growth will be released. The only conflict with this meeting is that U.S. Federal Reserve policy makers meets two weeks later. ECB might hold off until the decision of the Fed, but the possibility of that is low.

EUR/USD Reaction:

EUR-USD - ECB Press Conference - Nov 1 2015 — EUR/USD – Hourly Chart

U.S. Federal Reserve:

On October 28 (Wednesday), the Federal Reserve left rates unchanged. The bank was hawkish overall. It signaled that rate-hike is still on the table at its December meeting and dropped previous warnings about the events abroad that poses risks to the U.S. economy.

It does not make sense to drop “~~Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.~~” (September statement) I’m sure the events abroad has its risks (spillover effect) to the U.S. economy and the Fed will keep an eye on them.

In its statement, it said the U.S. economy was expanding at a “moderate pace” as business capital investments and consumer spending rose at “solid rates”, but removed the following “…~~labor market continued to improve~~…” (September statement). The pace of job growth slowed, following weak jobs report in the past several months.

Let’s take a look at the comparison of the Fed statement from September to October, shall we?

Fed Statment Comparation - Sept. to Oct. Source: http://projects.wsj.com/fed-statement-tracker/ — Fed Statment Comparation – Sept. to Oct.
Source: http://projects.wsj.com/fed-statement-tracker/

The Fed badly wants to raise rates this year, but conditions here and abroad does not support its mission. Next Federal Open Market Committee (FOMC) meeting takes place on December 15-16. By then, we will get important economic indicators including jobs report, Gross Domestic Product (GDP), retail spending and Consumer Price Index (CPI). If we don’t see any strong rebound, rate-hike is definitely off the table, including my prediction of 0.10% rate-hike for next month.

The report caused investors to increase the possibility of a rate increase in December. December rate-hike odds rose to almost 50% after the FOMC statement.

Greenback (US Dollar) Reaction:

U.S. Dollar ( "/DX" on thinkorswim platform) - Hourly Chart — U.S. Dollar ( “/DX” on thinkorswim platform) – Hourly Chart

Reserve Bank of New Zealand:

On October 28 (Wednesday), Reserve Bank of New Zealand (RBNZ) left rates unchanged at 2.75% after three consecutive rate-cuts since June. The central bank’s Governor Graeme Wheeler said that at present “it is appropriate to watch and wait.” “The prospects for slower growth in China and East Asia” remains a concern.

Housing market continues to pose financial stability risk. House price inflation is way higher. Median house prices are about nine times the average income. Short supply caused the house prices to increase significantly. “While residential building is accelerating, it will take some time to correct the supply shortfall.” RBNZ said in a statement. Auckland median home prices rose about 25.4% from September 2014 to September 2015, “House price inflation in Auckland remains strong, posing a financial stability risk.”

Further reduction in the Official Cash Rate (OCR) “seems likely” to ensure future CPI inflation settles near the middle of the target range (1 to 3%).

Although RBNZ left rates unchanged, Kiwi (NZD) fell because the central bank sent a dovish tone, “However, the exchange rate has been moving higher since September, which could, if sustained, dampen tradables sector activity and medium-term inflation. This would require a lower interest rate path than would otherwise be the case.” It’s a strong signal that RBNZ will cut rates to 2.5% if Kiwi continues to strengthening. I will be shorting Kiwi every time it strengthens.

“The sharp fall in dairy prices since early 2014 continues to weigh on domestic farm incomes…However, it is too early to say whether these recent improvements will be sustained.” RBNZ said in the statement. Low dairy prices caused RBNZ to cut rates. New Zealand exports of whole milk powder fell 58% in the first nine months of this year, compared with the same period in 2014. But, there’s a good news.

Recent Chinese announcement that it would abolish its one-child policy might just help increase dairy prices, as demand will increase. How? New Zealand is a major dairy exporter to China. Its milk powder and formula industry is likely to benefit from a baby boomlet in China.

NZD/USD Reactions:

NZD/USD - Hourly Chart — NZD/USD – Hourly Chart

Bank of Japan:

On October 30 (Friday), Bank of Japan (BoJ) maintained its monetary policy unchanged and downgraded its growth and inflation projections. BoJ left – by 8-1 majority vote – its QE program at current level of 80 trillion yen (about $660 billion) a year.

BoJ expects to hit its 2% inflation target in late 2016 or early 2017 vs. previous projection of mid-2016. Again and Again. This is the second time BoJ changed its target data. The last revision before this week was in April. It also lowered its growth projections for the current year by 0.5% to 1.2%.

They also lowered projections for Core-CPI, which excludes fresh food but includes energy. They lowered their forecasts for this fiscal year to 0.1%, down from a previous estimate of 0.7%. For the next fiscal year, they expect 1.4%, down from a previous estimate of 1.9%. Just like other central banks, BoJ acknowledged that falling energy prices were hitting them hard.

Low inflation, no economic growth, revisions, revisions, and revisions. Nothing is recovering in Japan.

Haruhiko Kuroda, the governor of BoJ, embarked on aggressive monetary easing in early 2013. So far he hasn’t had much success.

In the second quarter (April-June), Japan’s economy shrank at an annualized 1.2%. Housing spending declined 0.4% in September from 2.8% in August. Core-CPI declined for two straight months, falling 0.1% year-over-year both in September and August. Annual exports only rose 0.6% in September, slowest growth since August 2014, following 3.1% gain in August.

Exports are part of the calculation for Gross Domestic Product (GDP). Another decline in GDP would put Japan into recession, which could force BoJ to ease its monetary policy again. Another recession would be its fourth since the 2008 financial crisis and the second since Shinzo Abe (Abenomics), the Prime Minister of Japan, came to power in December 2012.

Its exports to China, Japan’s second-biggest market after the U.S., fell 3.5% in September. The third-quarter (July-September) GDP report will be released on November 16.

April 2014 sales tax (sales tax increased from 5% to 8%) increase only made things worse in Japan. It failed to boost inflation and weakened consumer sentiment.

In April 2013, BoJ expanded its QQE (or QE), buying financial assets worth 60-70 trillion yen a year, including Exchange Traded Funds (ETF).

QQE stands for Quantitative and Qualitative Easing. Qualitative easing targets certain assets to drive up their prices and drive down their yield, such as ETF. Quantitative Easing targets to drive down interest rates. Possibility of negative interest rates has been shot down by BoJ. But, why trust BoJ for their word? Actions speak louder than words.

In October 2014, BoJ increased the QQE to an annual purchases of 80 trillion yen. When is the next expansion? December?

Did you know that the BoJ owns 52% of Japan’s ETF market?

For over a decade, BoJ’s aggressive monetary easing through asset purchases did not help Japan’s economy. Since 2001, the central bank operated 9 QEs and is currently operating its current 10th QE (or QQE). The extensions of its QE are beginning to become routine or the “new normal.”

Growth and prices are slowing in China, with no inflation in United Kingdom, Euro-zone, and the U.S. The chances that Japan will crawl out of deflation are very slim.

USD/JPY Reaction:

USD/JPY - Hourly Chart — USD/JPY – Hourly Chart

US Market Reactions (ECB and FOMC):

S&P 500 ("SPX") - Hourly Chart — S&P 500 (“SPX”) – Hourly Chart

Next week, both Reserve Bank of Australia (RBA) and Bank of England (BoE) will meet. Will be very interesting to watch.

Another Quantitative Easing In The United States?

Last Thursday (September 17), the Federal Reserve left rates unchanged due to low inflation, recent turmoil in financial markets and in economies abroad, particularly China.

Markets were pricing less than 30% chance of rate-hike and most people in the financial markets were not expecting rate-hike. Well, not me. I was actually expecting ~~0.25%,~~ 10 basis points rate increase, as I stated in my previous post.

“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” Federal Open Market Committee (FOMC) said in statement. They are referring to events that took place in August, that can be described in one word; uncertainty.

Before we go any further, let’s compare the last two Fed statements.

Statement Comparison in PDF

Federal Reserve "Dot Plot" - September 2015 Meeting — Federal Reserve “Dot Plot” – September 2015 Meeting

According to the Fed’s famous “Dot Plot” – that is where committee members think interest rates are going – one committee member, for the first time ever, thinks the U.S needs to move to negative interest rates until the end of 2016.

During the press conference, Janet Yellen – the chairwoman of the Fed – indicated that negative rates were not “seriously considered at all today” and that the policymaker in question was “concerned by the inflation outlook”. The Fed looks at a model “Phillips Curve” which states that inflation and unemployment have a stable and inverse relationship. It hasn’t been working lately.

We know, as of today, both employment and inflation is low, likely due to the fact that many people are not in labor force and they are not included in unemployment calculation and due to low energy prices.

She said something that I found very interesting, “That’s something we’ve seen in several European countries. It’s not something we talked about today. Look. If not– I don’t expect that we’re going to be in the path of providing additional accommodation but if the outlook were to change in a way that most of my colleagues and I do not expect and we found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools and that would be something that we would evaluate in that kind of context.” This shows that even the Fed is uncertain about the future and another quantitative easing is a possibility.

If you want to see the body language from Yellen as she said it, go watch the press conference video. It can be very interesting. Any body language experts here?

The Fed also raised growth forecast for the year and cut unemployment projection.

Federal Reserve Economic Projections - September 2015 Meeting — Federal Reserve Economic Projections – September 2015 Meeting

Yellen expressed that some countries other than China are also danger to the U.S, “…we saw a very substantial downward pressure on oil prices and commodity markets…significant impact on many emerging market economies that are important producers of commodities, as well as more advanced countries including Canada, which is an important trading partner of ours that has been negatively affected by declining commodity prices, declining energy prices….important emerging markets have been negatively affected by those developments. And we’ve seen significant outflows of capital from those countries, pressures on their exchange rates and concerns about their performance going forward. So, a lot of our focus has been on risks around China but not just China, emerging markets, more generally in how they may spill over to the United States.”

Back to “wait and see” mode again. Weak start in the year hammered the chances of rate-hike in June. Now, outsiders hammered the chances of rate-hike in September. Next stop?

If the current situation stays unchanged, I expect rate increase of 0.10% (again) in October (FOMC press conference will be called if the Fed decides to change rates). But, the current situation might get much worse. The bad news might come from China again.

Xi Jinping, China’s president and Communist Party chief, will arrive in the U.S next week to meet President Obama and business leaders. After the meeting when Mr. Xi is back in China, unpredictability arrives.

China would not want to create tension with the U.S before they meet face-to-face. Thus, unpredictability comes in two or three weeks. China might devalue their currency again, by 5% or more. They might even dump much more U.S Treasuries again.

It’s reported that China dumped U.S Treasurys of $83 billion and $94 billion in the month of July and August, respectively. Why would China sell U.S Treasurys? China is in dire need of cash. Capital outflows are increasing substantially and their stock market are declining substantially. China would want to cut its holdings of treasurys to support the yuan.

According to latest data from the U.S Treasury Department, China’s holdings of U.S Treasuries was $1.240 trillion in the end of July (is probably much less now), the smallest since February 2015. In end-June, China held $1.271 trillion. China remains the world’s largest holder of U.S debt. What does that mean for the U.S?

If U.S’s #1 lender stops supporting or stops buying U.S debt, the cost of everything that depends on Treasury rates could rise, putting pressure on the Federal Reserve and prevent the Fed from raising rates. Treasury yields (inverse relationship with prices) are the benchmark that sets the cost of borrowing.

China’s abandonment of U.S Treasury debt is a warning.

Imagine if China’s major trading partner, Japan, joins China in selling U.S Treasuries. Japan is the second-largest holder of U.S. Treasuries, with $1.197 trillion in July. The devaluation of Yuan will make Japanese exports less competitive. Japan’s economy is still suffering despite Abenomics. As I stated in my post “Global Markets Crash + Asian Crisis Part 2“, Abenomics has failed. Soon enough, Japan might also be in dire need of cash and they might start cutting their holdings of U.S Treasuries.

Recently, Standard & Poor’s slashed its ratings on Japanese debt from AA- to A+ because of weak economic growth, blaming Abenomics “…we believe that the government’s economic revival strategy–dubbed “Abenomics”–will not be able to reverse this deterioration in the next two to three years.” According to Standard & Poor, Japan’s Debt/GDP ratio currently stands at 242.4%, a dangerous level for developed country.

I believe Bank of Japan (BoJ) will increase its purchases of government debt to cover the danger of Japan’s Debt/GDP ratio and will sell portion of U.S Treasurys.

We can conclude everything will probably get much worse. The Fed will have no other choice, but to start another round of quantitative easing. In other words, debt monetization, a process of buying Treasury and corporate debt on the open market, increasing money supply. When increasing money supply, interest rates should fall.

The Fed is being held hostage by outsiders, such as China and Brazil. It probably won’t end well for the U.S, promoting another round of Quantitative Easing.

Markets’ reactions to the Fed report:

Gold ("/GC") - Hourly Chart — Gold (“/GC”) – Hourly Chart

Fed Will Hike The Rates By…(Hint: Not 0.25%)

Last Friday (September 4, 2015), non-farm payrolls AKA jobs report for August came out little bit stronger. 173,000 jobs were added in August and the unemployment rate decreased by 0.2% (5.3% in July) to 5.1% (The Fed considers unemployment rate of 5.0% to 5.2% as “full employment”), lowest since April 2008.

Employments numbers for June and July were revised higher. June was revised from 231K to 245K (+14K) and July was revised from 215K to 245K (+30K). With these revisions, employments gains in June and July were 44K higher than previously reported.

Average hourly earnings increased 8 cents or 0.32% (biggest rise in 7 months) to $25.09, a 2.2% gain from a year ago. The average work week increased 0.1 hour, to 34.6 hours. Increasing income will lead to increased spending (demand increases) which leads to increase in Consumer Price Index (CPI) (As demand increases, suppliers will increase the prices of goods and services) which then leads to an increase in inflation, getting closer to Fed’s 2% inflation target (or inflation rockets to the moon, damaging the economy).

Lower oil prices may be holding back wage increases, especially in the energy sector.

While average hourly earnings are slowly growing, recent “positive” changes in the minimum wages – higher minimum wages – will not help earnings/income, but will only mutilate the US economy. While the minimum wage increases may sound like a good thing, but it isn’t. When businesses are forced to pay higher wages to their workers, they may have to increase prices for their goods/services, leading to increase in inflation. Some businesses might lose their market share to low-paying businesses aboard. After businesses adjust their prices to offset wage increases, there’s no actual change in the “buying power” of consumers.

It’s better to let US companies make their own decisions regarding wages. Let the markets lead. Laissez-Faire.

The labor force participation did not move at all, at 62.6% for a third straight month.

So, unemployment decreased and labor force participation stayed unchanged. Here’s the dark side:

261K Americans dropped out of the labor force, pushing total US workers who are not in the labor force to a record of 94 million. The government only counts people as unemployed if they are actively looking for jobs. Those who dropped out of the labor force are not actively looking for jobs. Therefore, real unemployment rate can be and is much higher.

This report was the latest jobs report before the Federal Reserve meets this month to answer “million-dollar” question, rate-hike or not? The Fed will meet on September 16 and 17 to decide whether to raise interest rates for the first time since June 2006.

Rate-hike in June 2015? Well, that did not happen. Rate-hike in September 2015? Well, expectations for the rate-hike were lowered due to uncertainty about China and the health of global economy. But, Yes, there will be a rate-hike this month. ~~No, not 0.25% (or 25 basis points).~~ The Fed will raise the rates by…

…10 basis points or 0.10%…

Q2 GDP revision: 3.7%. Exp. 3.2%, First estimate 2.3%

I still stay with my rate-hike forecast of 0.10% in Sept. https://t.co/u3KUdSGLeE

— Khojinur Usmonov (@Khojinur30) August 27, 2015

0.10% is very reasonable.

On August 27, Preliminary (2nd estimate) Gross Domestic Product (GDP) showed that the US economy grew faster than initially thought in the second quarter. GDP expanded at 3.7% annualized rate instead of the previous estimate (advance estimate) of 2.3%.

This clearly shows a sharp acceleration in US economic growth momentum following a weak start in the year.

Personal Consumption Expenditures (PCE) (Consumer spending), which accounts for two-thirds of US economic activity, grew at a 3.1% in the second quarter following 1.8% growth in first quarter.

Real GDP and PCE- Quarterly % Change (2012 Q1 - 2015 Q2) — Real GDP and PCE- Quarterly % Change (2012 Q1 – 2015 Q2)

PCE price index (inflation measurement) increased at 2.2% annualized rate after declining by -1.9% in the first quarter. Core-PCE (excluding food and energy) increased at 1.8% annualized rate after increasing only 1.0% in the first quarter.

Further revisions for the second quarter are possible when the Department Of Commerce releases its final (third) GDP update on September 25.

Market reactions to the economic reports:

S&P 500 ("SPX") - 15 Min. Chart — S&P 500 (“SPX”) – 15 Min. Chart

U.S. Rate-Hike Impending – Tick Tock

Last Thursday (July 30, 2015), the Bureau of Economic Analysis (BEA) released its advance (1st estimate out of 3) of Gross Domestic Product (GDP) for the second quarter (April, May and June) of the year. It was positive enough to increase the chance of rate-hike in September significantly.

Before we go any further, let’s review what two types of GDP, nominal-dollar terms and real-dollar terms. Current (or nominal-dollar) GDP tallis the value of all goods and services produced in the U.S. using present prices. On the other hand, Real (or chained-dollar) GDP counts only the value of what was physically produced. To clarify the point, suppose a hat-making factory announces that it made $1 million selling hats this year, 11% more than last year. The $1 million represents nominal company sales (or current dollar). However, something is missing. From this future alone, it’s unclear how the factory achieved the extra income. Did it actually sell 11% more hats? Or did it sell the same number of hats as the year before but simply raised prices by 11%? If the factory made more money because it increased the price tag by 11%, then in real (constant-dollar) terms, the true volume of hats sold this year was no greater than last year, at $900,000.

It’s vital to know if the economy grew because the quantity of products sold was greater or whether it was largely the result of price hikes, or inflation. (Source: “The Secrets of Economic Indicators” by Bernard Baumohl)

Real GDP increased at a annualized rate of 2.3%, vs expectations of 2.5%. This is a major acceleration from the first quarter when real GDP increased 0.6% (expansion), revised from -0.2% (contraction). The economy bounced back after a slow start in the beginning of the year.

Real GDP - Quarterly (1Q 2011-2Q 2015) — Real GDP – Quarterly (1Q 2011-2Q 2015)

In the beginning of the year, US economy was hurt, or “walked backwards” due to unfavorable weather, lower energy prices, West Port strike, and stronger dollar. While, the economy has moved beyond the weather and west port strike, – a strong dollar, and lower energy prices will continue to limit growth.

While first quarter was revised upwards, 2011-2014 was revised lower. The economy grew 1.6% in 2011, down from the 2.3% initial reading; 2.2% in 2012, up from the 1.5% initial reading; 1.5% in 2013, down from 1.7%; and 2.4% in 2014, down from 2.7%. From 2011 to 2014, growth was essentially weaker. The economy expanded by an average annual rate of 2%, below initial reading of 2.3%.

Real GDP - Annual (2011-2014) — Real GDP – Annual (2011-2014)

Growth in the second quarter was boosted by consumer spending. Consumer spending grew at a 2.9% rate from a 1.8% in the first quarter. That is a very good sign because real personal consumption expenditures (PFE) AKA consumer spending, accounts for 70% of total GDP. If people are not spending, it spells serious trouble for the economy.

Real exports increased 5.3% in the second quarter, compared to 6% fall in the first quarter. First quarter’s significant drop was due to west port slowdown. The strong dollar has hurt exports but its effects have eased recently…for now. Port delays in the first quarter freed up exports and temporarily increased exports.

Business investment fell 0.6% in the second quarter, from previous 1.6% increase in the first quarter, as energy companies continue to scale back projects amid low oil prices.

Recently, crude oil prices have fallen back to the Earth. On Monday, August 3, crude oil prices hit just above $45 (currently below $45). It will continue to hurt energy companies, causing them to scale back projects and lay-offs. Low gasoline prices, however, would lead consumers to spend money. It’s better to pay off debts first before spending money on “wants”.

Crude Oil ("/CL" on thinkorswim) - Daily — Crude Oil (“/CL” on thinkorswim) – Daily

On Friday (July 31, 2015), Employment Cost Index (ECI) report for the second quarter was released and it was disappointing.

ECI, a broad measure of workers’ wages and benefits, increased 0.2%, smallest gain since records began in the second quarter of 1982, following 0.7% increase in the first quarter. Wages and salaries, which accounts of 70% of compensation costs, also increased 0.2% in the second quarter, the smallest gain on record.

Employment Cost Index (ECI) - Bloomberg Terminal — Employment Cost Index (ECI) – Bloomberg Terminal

The report suggests that slack remains in the labor market. The unemployment rate fell to 5.3% in June – the lowest level since April 2008 – close to the Fed’s target of 5% to 5.2%, which the Fed policy makers consider consistent full employment.

S&P 500’s reaction to both GDP and ECI reports.

S&P 500 ("SPX" on thinkorswim) - Hourly — S&P 500 (“SPX” on thinkorswim) – Hourly

Dollar’s reaction to both GDP and ECI reports.

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

The Federal Reserve are counting on rising wages to boost both the economy and inflation (2% target). On Wednesday, July 29, the Fed said it won’t start lifting rates until there is “some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”

The Fed is monitoring employment, inflation, and wages closely as it moves to closer to raising interest rates from near zero, for the first time since the recession. Raising rates too soon or too late can have its consequences.

The Fed will meet on September 16 and 17. I still believe the Fed will raise rates. If employment, inflation and wage reports are not very strong until September meeting, the Fed might raise the rates by little as 0.10% (10 basis points), instead of 0.25%.

I believe the disappointment of ECI is temporary as more companies are starting to increases wages and more people are slowly entering jobs market. I also believe that GDP continues to be strong. In fact, I believe current Q2 GDP will be revised higher. Preliminary (2nd estimate) of Q2 GDP will be released on Thursday, August 27.

On Friday (August 7), important reading data of US economy will be released, non-farm payrolls AKA jobs report. My guess for employment and unemployment rate is 285K and 5.4%, respectively. I believe wages will stay flat at this time and accelerate in the next few months.

I will take advantage of any pullback in the greenback (US Dollar). Greenback has a room to strengthen more. Currency pairs such as USD/JPY, USD/CAD, I would be long, and I would be short EUR/USD. If you have any questions, feel free to contact me and/or leave comments below. Thank you.

Canada Crisis: Second Rate-Cut Of The Year

On July 15 (Wednesday), Canada’s central bank AKA Bank of Canada (BoC) cut overnight rate by 25 basis points (bps) from 0.75% to 50%. This is the second rate-cut this year. First rate-cut took place in January. Not only rate-cut, but lower growth forecasts.

BoC expects Gross Domestic Product growth to be 1.1% year-over-year (Y/Y) this year, down from its 1.9% forecast in April. Policy makers said that Gross domestic product probably “contracted modestly” in the first half. However, they did not call it recession. ‘‘The lower outlook for Canadian growth has increased the downside risks to inflation,’’ policy makers said.

Bank also reduced the net exports contribution to GDP by 0.8% to 0.6% from 1.4%. A stronger U.S. economy and a weaker Canadian dollar should contribute to higher export growth.

Bank of Canada's July Forecasts. Source. — Bank of Canada’s July Forecasts (Page 14). Source.

There has been a big shift in the inflation tone over the past few months:

April: “Risks to the outlook for inflation are now roughly balanced”

May: “the Bank’s assessment of risks to the inflation profile has not materially changed”

This time (July): “The lower outlook for Canadian growth has increased the downside risks to inflation”

“The Bank anticipates that the economy will return to full capacity and inflation to 2 per cent on a sustained basis in the first half of 2017.” In the April’s forecasts, the bank expected the economy to return to full capacity at the end of 2016. I can tell that the Bank is running scared.

Damages from low oil prices has been extensive. Canada is the world’s fifth-largest oil producer and lower oil prices will definitely not help the economy. The damages from lower oil prices shrank the economy in the first half of the year.

Recently after Iran deal has been reached, oil prices fell sharply. It’s currently trading around $48. If the the deal is finalized, it won’t be very good for Canada economy since Iran might want to double its oil production, leading to much lower oil prices.

The bank also said “Additional monetary stimulus is required at this time to help return the economy to full capacity and inflation sustainably to target.” If conditions get worse, they will cut rates again.

Oil is not the only problem for Canada. Other concerns are potential bubbles in housing and consumer debt.

According to BoC’s Monetary Policy Report (June), “the vulnerability associated with household indebtedness remains important and is expected to edge higher in the near term in response to the ongoing negative impact on incomes from the sharp decline in oil prices and a projected increase in the level of household debt.” (Page 30).

Over the past few years, housing prices in Canada have skyrocketed. Lower borrowing costs will just add fuel to the fire (DEBT + HIGH PRICES IN HOUSING MARKET WITH LOW INTEREST RATES = NOT A GOOD COMBINATION) . There just might be a bubble in the housing market. But, BoC does not think so.

The next BoC meeting is on September 9th, about a week before the U.S. Federal Reserve meeting, the day that many believe lift-off from the zero interest rate policy will take place. CPI and non-farm payrolls data for July and August will decide whatever the Fed will hike or not.

Rate-cuts and plunging commodity prices, especially crude oil, has caused sell-off in Loonie. Ever since the first rate-cut of the year (January), Loonie (CAD) has weakened significantly. With strengthening dollar (USD), USD/CAD has skyrocketed. When looked at monthly chart, USD/CAD has developed ‘Cup and Handle’ formation. While this is a sign to short USD/CAD, I would be very careful because fundamentals for CAD are too weak. If I were to short it, I would put my stop above the resistance line (Bold Red line).

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 – 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