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)
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
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.

Unemployed over 27 weeks
Unemployed over 27 weeks

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:

Gold ("/GC" on thinkorswim)
Gold (“/GC” on thinkorswim)

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

In the previous article, Houston (Fed), We Have A Problem (Problems) – Part 1/2, I addressed two risks (growing monetary policy divergence and emerging markets)  that will force the Fed to “land” (lower back) rates this year. I will address more risks here.

One huge risk that I will not address here, but will address in a future article is “lack of liquidity”. While I was doing research, I came across more information that I expected. I’m still getting more information and I believe it will be a great article. I will give a sneak peek of the article in the bottom of this article.

Junk Bonds, Credit Spreads, Energy, Manufacturing, Earnings Decline:

Earlier last month (December 10, 2015), Third Avenue’s Focused Credit Fund (FCF), a large mutual fund specializing in risky, high-yielding bonds, announced it would block investor redemptions, “no further subscriptions or redemptions will be accepted.” In mid-2014, they had $3.5 billion assets under management (AUM). As of December 31, 2015, they only had AUM of $660.67 million, as investors rushed to get their money back because of weakness in the junk bond market.

Now, investors’ money are being held hostage. “The remaining assets have been placed in a liquidating trust”, said David Barse, CEO of the firm, as the investor requests for redemptions and the “general reduction of liquidity in the fixed income markets” made it impossible for the fund to “create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”

The process is a pain in the ass, “Third Avenue anticipates that the full liquidation process may take up to a year or more.” Again, investors’ money are being held hostage.

This events highlights the danger of “over-investments” into risky areas, high levels of corporate debt, AND the lack of liquidity (will be addressed in a future article). With interest rates hovering around 0 (well, before the rate-hike in December), U.S. companies have rushed to issue debt.

Investors who poses a higher risk appétit can find junk bonds, yielding higher interest rates, to be “useful” for their style and capacity of investment. More rewards for more risks, right?

As the global economy continues to struggle, namely China and emerging markets, yield on junk bonds have been increasing since they are a higher chance of defaulting.

Rising interest rates adversely impact bond prices, pushing their yield of the bond higher (inverse relationship). While increase in rates does not largely affect junk bonds since they have a higher coupon (yield) and shorter maturities (shorter maturity means less price sensitivity to rates), current junk bond market combined the impacts of a stronger dollar and low commodity prices can be extremely adverse and dangerous.

High-yield debt yields, as represented by Bank of America Merrill Lynch U.S. High Yield Master II Effective Yield, have been increasing since mid of last year. It rose from 5.16% (June 23, 2014) to current 9.23%. That’s whopping 78.88% increase, representing the growing risks of junk bond market.

BofA Merrill Lynch U.S. High Yield Master II Effective Yield Source: retrieved from FRED, Federal Reserve Bank of St. Louis
BofA Merrill Lynch U.S. High Yield Master II Effective Yield
Source: retrieved from FRED, Federal Reserve Bank of St. Louis

 

According to Lipper, investors pulled out a total $13.88 billion from high-yield funds in 2015, with $6.29 billion in December alone. As redemptions increase, funds may suffer as high-yields are harder to trade due to its lack of liquidity (will talk more about the major risk of illiquidity in a future article) and funds may have to take an action like the Third Avenue did.

Credit spreads (difference in yield between two bonds of similar maturity but different credit quality) are widening, which possibly signals a wider economic trouble ahead. Widening credit spreads mark growing concerns about the ability of borrowers to service their debt. Not only borrowers will suffer, but also lenders since they lost money.

BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread, representing the credit spread of the high yield bond market as a whole, have been increasing the middle of 2014. It’s currently at 775 (7.75%) basis points (bps).

BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread is currently 1,804bps wide (18.04), a level of highly distressed territory. Credits are defined as distressed when they are trading more than 1,000bps (10%) wide.

BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread AND BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread Source: FRED Economic Data
BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread AND BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread
Source: FRED Economic Data

I believe it will continue to increase this year, reflecting the worsening of the credit conditions that would cause greater concern among investors and policymakers (Hi, Ms. Yellen. Time to reverse the policy?)

iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG), an index composed of U.S. dollar-denominated, high yield corporate bonds, is already down 1.39% year-to-date (YTD) and was down 10.58% in 2015, expressing the increasing uncertainty by the investors, as they pull back their money from high-yielding bonds/ETFs. The exposure of the index to CCC rated bonds, B rated bonds, and BB rated bonds, are 8.88%, 38.73%, and 50.25%, respectively. Stronger U.S. dollar and lower commodity prices are expected (and it will) to hurt the earnings of U.S. companies, increasing the chances of defaults, especially in energy.

iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG)
iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG)

The index’s energy exposure is 9.38%. Recently oil prices plunged to levels under $30. Energy companies borrowed a lot of debt during oil price boom, to increase production (so that they can gain more market share), are now being haunted by their own actions. A lot of energy companies are currently under an extreme pressure to make a dime, as oil prices plunge. According to law firm Haynes and Boone, 42 North American oil and gas producers filed for bankruptcy last year. Those 42 defaults account for approximately $17 billion in cumulative secured (over $9 billion) and unsecured debt (almost $8 billion).

2015 E&P Bankruptcy Filings Source: Law firm Haynes and Boone - Slide 5
2015 E&P Bankruptcy Filings
Source: Law firm Haynes and Boone – Slide 5

Out of those 42 bankruptcy filings, 18 of them come from Texas, a leading state in energy production. According to U.S. Energy Information Administration (EIA), Texas had a capacity of over 5.1 million barrels of crude oil per day and accounted for 29% of total U.S. refining capacity, as of January 2015, and accounted for about 29% of U.S. gas production in 2014.

In 2014, Texas gross domestic product (GDP) increased 5.2% year-over-year (Y/Y), the second greatest change in state GDP after North Dakota. Mining industry accounted for 1.25% increase to GDP, its largest contributor. Texas’s GDP accounted for 9.5% of U.S. total GDP in 2014.

The collapse of energy prices over the past several years are “fracking” down the Texas economy. The Dallas Federal Reserve’s general business activity index “collapsed” to -34.6 in January, the lowest reading since April 2009, when Texas was in recession. Same with company outlook index, it fell to -19.5 in January from -10.5 in December.

Texas Manufacturing Outlook Survey – General Business Conditions Source: Federal Reserve Bank of Dallas
Texas Manufacturing Outlook Survey – General Business Conditions
Source: Federal Reserve Bank of Dallas

The production index – a key measure of state manufacturing conditions – fell all the way from 12.7 in December to -10.2 in January. New orders index fell -9.2 in January from -7 in December.

Texas Manufacturing Outlook Survey – Business Indicators Source: Federal Reserve Bank of Dallas
Texas Manufacturing Outlook Survey – Business Indicators
Source: Federal Reserve Bank of Dallas

Employment Index, on the other hand, sharply dropped to -4.2 in January from 10.9 in December. Texas is a home to many energy giants, such as Schlumberger (NYSE: SLB), Halliburton (NYSE: HAL), Baker Hughes (NYSE: BHI), Exxon Mobil (NYSE:XOM), and ConocoPhillips (NYSE:COP). The companies slashed off tens of thousands of jobs over the past year and cut capex significantly, as the current stressed energy market heavily weighted on them.

In January 21, Schlumberger reported 38.7% decrease in fourth quarter revenue Y/Y, and net income declined substantially to a loss of $989 million, compared with profit of $317 million in the same period of 2014. Texas-based energy giant’s North American region 4th quarter revenue fell 54.79% to $1.9 billion from $4.3 billion in the same quarter of 2014. The company’s earnings announcement warned of a “deepening financial crisis in the E&P industry, and prompted customers to make further cuts to already significantly lower E&P investment levels. Customer budgets were also exhausted early in the quarter, leading to unscheduled and abrupt activity cancellations.” As a result of a weaker quarter and worsening conditions, they plan to lay off 10,000 workers, adding to already laid-off 34,000 workers, or 26% of its original workforce, since November 2014.

On Monday (January 25, 2016), Halliburton reported its fourth quarter earnings. Halliburton’s 4th quarter revenue fell 42% in Y/Y to $5.08 billion, including a 54.4% plunge to $2.1 billion in its North American region, which accounted for 42.4% of total revenue in 4Q.  On a GAAP basis, the Texas-based energy giant (and another one) reported a quarterly net loss of $28 million ($0.03 per share) compared with net income of $9.01 million ($1.06 per share) in the fourth quarter of 2014.

On Thursday (January 28, 2016), Baker Hughes reported a 48.85% decrease in fourth quarter revenue to $3.4 billion from $6.6 billion in the same period of 2014. On GAAP basis, the Texas-based energy giant (and another one) reported a quarterly net loss of $1 billion ($2.35 per share) compared with net income of $663 million ($1.52 per share) in the fourth quarter of 2014. Its North American region revenue fell 65.59% to $1.14 billion in the fourth quarter, compared with $3.30 billion in the fourth quarter of 2014.

Chevron Corp., (NYSE: CVX), California-based energy giant, posted its first loss since the third quarter of 2002 on Friday (January 29, 2016). It reported a fourth quarter loss of $588 million ($0.31 per share), compared with $3.5 billion ($1.85 per share) in the same period of 2014. During the same period, its revenue fell 36.5% to $29.25 billion from $46.09 billion.

Below is a graph by EIA, showing how the cost of debt service for U.S. oil producers has grown since 2012. In the second quarter of 2015, more than 80% of these producers’ cash flow went to service their outstanding debt, leaving very little cash to fund operations, to pay dividends, and to invest for the future. To adjust to those pains, the producers have significantly reduced capital expenditures.

Debt service uses a rising share of U.S. onshore oil producers’ operating cash flow Source: EIA
Debt service uses a rising share of U.S. onshore oil producers’ operating cash flow
Source: EIA

During the end of Q2 2015, oil prices were around $58. It’s currently at $38. Clearly, the situation has only gotten worse.

Both Exxon Mobil and ConocoPhillips will report its fourth quarter earnings next week.


I believe oil prices have hit bottom and it won’t break $27 this year.

Why do I say that?

I believe the market already priced in Iran’s entry into oil war. Recently, hedge fund bearish bets on oil were at all-time high (crowded trade). Crowed trade includes: a large numbers of participants who share similar beliefs and heavy short-term bag holders (speculators). I tend to take advantage of this types of situations.

Not only bearish bets on oil are at all-time high and not only I believe Iran is already priced in, but some OPEC countries, including Nigeria and Venezuela, already started calling for emergency meetings to try to cut production. I’m starting to believe that they can no longer handle the pain. While this is a political game – to gain and preserve more market share – it won’t last long enough to get oil breaking below $27. They can no longer bluff.

For many OPEC members, operating costs are around $30. With slowing global growth, they can’t afford to have even lower oil prices.

Conclusion: Oil has hit bottom and it won’t break below $27 this year. If you disagree with me, feel free to comment below.


Speaking of junk bonds, the energy sector makes up about a fifth of the high-yield bond index. Fitch Ratings forecast the US high yield energy sector default rate to hit 11% this year, “eclipsing the 9.7% rate seen in 1999.”

According to Fitch Ratings, at the beginning of December of last year, “$98 billion of the high yield universe was bid below 50 cents, while $257 billion was bid below 80 cents. The battered energy and metals/mining sectors comprise 78% of the total bid below 50 cents. In addition, 53% percent of energy, metals/mining companies rated ‘B-‘ or lower were bid below 50 at the start of December, compared to 16% at the end of 2014, reflecting the decline in crude oil prices.”

Not only energy companies will suffer, but also banks. The biggest U.S. banks – Morgan Stanley, Citigroup, Bank of America, Goldman Sachs, Wells Fargo, and JPMorgan Chase – have exposure to energy as part of their overall portfolios.

  • Morgan Stanley: Energy exposure assumed at 5% of total loans.
  • Citigroup: Energy exposure assumed at 3.3% of total loans.
  • Bank of America: Energy exposure assumed at 2.4% of total loans.
  • Goldman Sachs: Energy exposure assumed at 2.1% of total loans.
  • Wells Fargo: Energy exposure assumed at 1.9% of total loans.
  • JPMorgan Chase: Energy exposure assumed at 1.6% of total loans.

According to Fitch Ratings, exposure to energy sector were “cited as higher risk segments for the banks.”

The collapse in oil prices, strong U.S. dollar, and weakening global economy “crippled” manufacturers across the country. The Empire State manufacturing index fell to -19.4 in January from -6.2 in December, the lowest level since March 2009. The reading suggests manufacturing sector is slowing down and it raises questions about the outlook for the economy.

Manufacturing is very important to the U.S. economy. According to National Association of Manufacturers (NAM), there are 12.33 million manufacturing workers in the U.S., accounting for 9% of the nation’s workforce. Manufacturers recently contributed $2.18 trillion to the U.S. economy. “Taken alone, manufacturing in the United States would be the ninth-largest economy in the world.” according to NAM. For more facts and details, click here.

The manufacturing index have been below zero since July. Not only did the headline fell, but so did new orders index and shipments index. New orders fell 23.5 in January from -6.2 in December. Shipments fell -14.4 in January from 4.6 in December.

The Empire State Manufacturing Survey Source: Federal Reserve Bank of New York
The Empire State Manufacturing Survey
Source: Federal Reserve Bank of New York

Slump in new orders can shift the production into lower gear and possibly jeopardize jobs. The employment (number of employees) index continued to deteriorate for a fifth consecutive month. The weaknesses in the Empire State indexes suggests that the earnings of manufacturers are under pressure.

According to FactSet, the S&P 500 is expected to report a Y/Y decline in earnings of 5.7% for the fourth quarter. For Q4 2015, the blended earnings decline is -5.8%. A Y/Y decline in earnings for the fourth quarter will mark the first time S&P 500 has reported three consecutive quarters of Y/Y declines in earnings since Q1 2009 through Q3 2009.

For Q1 2016, 33 companies out of S&P 500, so far, have issued negative EPS guidance and 6 companies have issued positive EPS guidance.

Another drag on earnings can be the current inventories to sales ratio. Since early 2012, the ratio has been increasing.

Total Business: Inventories to Sales Ratio Source: Federal Reserve Bank of St. Louis
Total Business: Inventories to Sales Ratio
Source: Federal Reserve Bank of St. Louis

An increasing ratio is a negative sign because it shows companies may be having trouble keeping inventories down and/or sales have slowed. If they have too much of inventories, they may have to discount the products to clear their shelves, dragging on the earnings.

If you have any questions, feel free to contact me and/or leave comments below. Thank you.

Sneak peek of a future article that addresses one huge risk (lack of liquidity):

“With low liquidity in the bond market and increasing HFT transactions in it, the threat is real. Automated trades can trigger extreme price swings and the communication in these automated trades can quickly erode liquidity before you even know it, even though there is a very high volume. While liquidity in the U.S. bond market is high, it’s not high enough to battle the power of the technological progress.”

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?

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

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:

S&P 500 (“SPX”) – Hourly Chart
S&P 500 (“SPX”) – Hourly Chart
US Dollar (“/DX”) – Hourly Chart
US Dollar (“/DX”) – Hourly Chart
Gold ("/GC") - Hourly Chart
Gold (“/GC”) – Hourly Chart
EUR/USD - Hourly Chart
EUR/USD – Hourly Chart