Stocks continue to chop around as we head into the big jobs report this week. But the dollar has been a mover today, so has gold.
Let’s take a look at the chart of gold. It has broken down technically.
You can see the longer term downtrend in gold since it topped out in 2011. And we’ve had a corrective bounce this year, which was contained by this descending trendline. And today we broke the trend that describes this bullish technical correction (i.e. the trend continues lower).
A lot of people own gold. And it’s a very emotional trade. Whenever I talk about negative scenarios for gold, the hate mail is sure to follow.
We’ve talked quite a bit about the drivers of the gold trade. I want to revisit that today.
Gold has been a core trade for a lot of people throughout the crisis period. When Lehman failed in 2008, it shook the world, global credit froze, banks were on the verge of collapse, the global economy was on the brink of implosion—people ran into gold. Gold was a fear–of–the–unknown–outcome trade.
Then the global central banks responded with massive backstops, guarantees, and unprecedented QE programs. The world stabilized, but people ran faster into gold. Gold became a hyperinflation–fear trade.
Gold went on a tear from sub–$700 bucks to over $1,900 following the onset of global QE (led by the Fed).
Gold ran up as high as 182%. That was pricing in 41% annualized inflation at one point (as a dollar for dollar hedge). Of course, inflation didn’t comply.
Still eight years after the Fed’s first round of QE (and massive global responses), we have just 13% cumulative inflation over the period.
So the gold bugs overshot in a big way. We’ve looked at this next chart a few times over the past several months. This tells the story on why inflation hasn’t met the expectations of the “run-away inflation” theorists.
This chart above is the velocity of money. This is the rate at which money circulates through the economy. And you can see to the far right of the chart, it hasn’t been fast. In fact, it’s at historic lows. Banks used cheap/free money from the Fed to recapitalize, not to lend. Borrowers had no appetite to borrow, because they were scarred by unemployment and overindebtedness. Bottom line: we get inflation when people are confident about their financial future, jobs, earning potential…and competing for things, buying today, thinking prices might be higher, or the widget might be gone tomorrow. It’s been the opposite for the past eight years.
When this reality of low-to-no inflation and global economic malaise became clear, even after rounds of Fed QE, there were a LOT of irresponsible people continuing to tout gold as an important place in everyone’s portfolio, even at stratospheric levels. People bought gold at $1900 and have since lost as much as 40% on the value of their investment – an investment that was supposed to “hedge” against inflation.
On that note, today the IMF downgraded U.S. growth estimates for the year from 2.2% to just 1.6% — in a year that many were initially expecting to be a good year, nearing trend growth levels (3%-3.5%). So eight years from the inception of the Fed’s extraordinary policies, the case for gold remains weak and an investment with more risk than reward.
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Oil popped over $3 from the lows of the day (as much as 7%) on news OPEC has agreed to a production cut.
We’ve talked a lot throughout the year about the price of oil. When it collapsed to the $20s, it put the entire energy industry on bankruptcy watch.
Of course, oil bounced sharply from those lows of February as central banks stepped in with a coordinated response to stabilize confidence. Not so coincidentally, oil bottomed the same day the Bank of Japan intervened in the currency markets.
The oil price bust all started back in November of 2014, the evening of Thanksgiving Day, when OPEC pulled the rug out from under the oil market by vowing not to make production cuts, in an attempt to crush the nascent shale industry. At that time, oil was trading around $73.
You can see in this chart, it never saw that price again.
OPEC was successful in heavily damaging the U.S. shale industry through low oil prices, but it has damaged OPEC countries, too.
What will the news of an agreement on a production cut mean?
A policy shift from OPEC can be very powerful. In 1986, the mere hint of an OPEC policy move sent oil up 50% in just 24 hours. And as we discussed earlier in the year, the relationship between the price of oil and stocks this year has been tight. At times, stocks have traded almost tick for tick with oil.
Take a look at this chart.
An oil price back in the $60s would be a catalyst for a big run in stocks into the year end. For a stock market that has been rudderless surrounding a confused Fed and an important election, this oil news could kick it into gear.
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The debate last night was entertaining. It’s sad to see how the media manipulates facts and cherry picks quotes to fit their narrative.
But that’s what they do and it ultimately shapes views for voters, unfortunately.
Today, I want to focus on China and Trump’s comments on China’s currency manipulation. Everyone knows the U.S. has lost jobs to China. Everyone knows China has become the world’s manufacturer. But not everyone knows how they did it.
Is it just because the labor is so cheap? Or is there more to it?
There’s more to it. A lot more.
China’s biggest and most effective tool is and always has been its currency. China ascended to the second largest economy in the world over the past two decades by massively devaluing its currency, and then pegging it at ultra–cheap levels.
Take a look at this chart …
In this chart, the rising line represents a weaker Chinese yuan and a stronger U.S. dollar. You can see from the early 80s to the mid 90s, the value of the yuan declined dramatically, an 82% decline against the dollar. They trashed their currency for economic advantage – and it worked, big time. And it worked because the rest of the world stood by and let it happen.
For the next decade, the Chinese pegged their currency against the dollar at 8.29 yuan per dollar (a dollar buys 8.29 yuan).
With the massive devaluation of the 80s into the early 90s, and then the peg through 2005, the Chinese economy exploded in size. It enabled China to corner the world’s export market, and suck jobs and foreign currency out of the developed world. This is precisely what Donald Trump is alluding to when he says “China is stealing from us.”
Their economy went from $350 billion to $3.5 trillion through 2005, making it the third largest economy in the world.
This next chart is U.S. GDP during the same period. You can see the incredible ground gained by the Chinese on the U.S. through this period of mass currency manipulation.
And because they’ve undercut the world on price, they’ve become the world’s Wal-Mart (sellers to everyone) and have accumulated a mountain for foreign currency as a result. China is the holder of the largest foreign currency reserves in the world, at over $3 trillion dollars (mostly U.S. dollars). What do they do with those dollars? They buy U.S. Treasuries, keeping rates low, so that U.S. consumers can borrow cheap and buy more of their goods – adding to their mountain of currency reserves, adding to their wealth and depleting the U.S. of wealth (and the cycle continues).
The U.S. woke up in 2005, and started threatening tariffs against Chinese goods unless they abandoned their cheap currency policies. China finally conceded (sort of). They agreed to abandon the peg to the dollar, and to start appreciating their currency.
They allowed the currency to strengthen by about 4.5% a year from 2005 through 2013. That might sound good, but that was a drop in the bucket compared to the double digit pace the Chinese economy was growing at through most of that period. Still, the U.S. passively threatened along the way, but allowed it to continue.
With that, the Chinese economy has ascended to the second largest economy in the world now – on pace to the biggest soon (though it still has just an eight of the per capita GDP as the U.S.). But China’s currency is a bigger threat, at this stage, than just the emergence of China as an economic power. The G-20 (the group of the world’s top 20 economies) has had China’s weak currency policy at the top of its list of concerns for a reason.
The current global imbalances are the underlying cause of the global financial crisis, and China’s currency is at the heart of it.
And without a more fairly valued yuan, repairing those imbalances — those lopsided economies too dependent upon either exports or imports — isn’t going to happen. It’s a recipe for more cycles of booms and busts … and with greater frequency.
Are big tariffs the answer? Historically that’s a recipe for disaster, economically and geopolitically.
What’s the solution? I’ve thought that the Bank of Japan will ultimately crush the value of the yen, as the answer to Japan’s multi-decade economic malaise and as an answer to the stagnant global economic recovery. It’s an answer for everyone, except China. A much weaker yen could crush the China threat, by displacing China as the world’s exporter.
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All eyes are on the Presidential debate/face-off tonight. Heading into the event, stocks are lower, yields are lower and the dollar is lower — all a “risk-off” tone.
And the VIX (implied S&P 500 vol/an indicator of uncertainty) has popped higher from the very low levels it had returned to as of Friday. Speculators are out today making bets on a political firework show tonight, and thus betting on more uncertainty in the outcome and in post-election policy making.
If we step back a bit though, given the difficulties in getting through the legislative process, the biggest potential market influence from the election may be more about the prospects of getting a fiscal stimulus package done, rather than the many promises that are made on an campaign trail. Both candidates have been out promising a spending package to boost the economy. And on the heals of a package from Japan, and the unknown risks from Brexit, the idea is becoming more politically palatable.
As we discussed on Friday, the Fed has taken a strategically more pessimistic public view on the economy, in effort to underpin the current economic drivers in place (stability, low rates and incentives to reach for risk).
Following the Fed and BOJ events last week, the 10-year yield is back in the 1.50s and sitting in a big technical level. This will be an important chart to keep an eye on tomorrow.
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Yesterday we talked about the two big central bank events in focus today. Given that the Bank of Japan had an unusual opportunity to decide on policy before the Fed (first at bat this week), I thought the BOJ could steal the show.
Indeed, the BOJ acted. The Fed stood pat. But thus far, the market response has been fairly muted – not exactly a show stealing response. But as we’ve discussed, two key hammers for the BOJ in achieving a turnaround in inflation and the Japanese economy are: 1) a weaker yen, and 2) higher Japanese stocks.
Their latest tweaks should help swing those hammers.
Bernanke wrote a blog post today with his analysis on the moves in Japan. Given he’s met with/advised the BOJ over the past few months, everyone should be perking up to hear his reaction.
Let’s talk about the moves from the BOJ …
One might think that the easy, winning headline for the BOJ (to influence stocks and the yen) would be an increase in the size of its QE program. They kicked off in 2013 announcing purchases of 60 for 70 trillion yen ($800 billion) a year. They upped the ante to 80 trillion yen in October of 2014. On that October announcement, Japanese stocks took off and the yen plunged – two highly desirable outcomes for the BOJ.
But all central bank credibility is in jeopardy at this stage in the global economic recovery. Going back to the well of bigger asset purchases could be dangerous if the market votes heavily against it by buying yen and selling Japanese stocks. After all, following three years of big asset purchases, the BOJ has failed to reach its inflation and economic objectives.
They didn’t take that road (the explicit bigger QE headline). Instead, the BOJ had two big tweaks to its program. First, they announced that they want to control the 10-year government bond yield. They want to peg it at zero.
What does this accomplish? Bernanke says this is effectively QE. Instead of telling us the size of purchase, they’re telling us the price on which they will either or buy or sell to maintain. If the market decides to dump JGB’s, the BOJ could end up buying more (maybe a lot more) than their current 80 trillion yen a year. Bernanke also calls the move to peg rates, a stealth monetary financing of government spending (which can be a stealth debt monetization).
Secondly, the BOJ said today that they want to overshoot their 2% inflation target, which Bernanke argues allows them to execute on their plans until inflation is sustainable.
It all looks like a massive devaluation of the yen scenario plays well with these policy moves in Japan, both as a response to these policies, and a complement to these policies (self-reinforcing). Though the initial response in the currency markets has been a stronger yen.
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Since Friday of last week, there have been a lot of reports on the spike in the VIX. Today I want to talk about the VIX and the performance of major benchmark markets over the past week.
In a world where stability is king, central bankers have been very sensitive to swings in key financial markets, with the idea that confidence and the perception of stability can quickly become unhinged by market moves. When that happens, it becomes a big, viable threat to the global economic recovery and outlook. It can certainly send policy intentions off of the rails (as we’ve seen happen time and time again with the Fed).
Should they be worried?
With the above said, some might think the biggest threat to a Fed move in September (or December) isn’t economic data, but this chart.
Sources: Reuters, Forbes Billionaire’s Portfolio
First, what is the VIX? The VIX is an index that tracks the implied volatility of the S&P 500 index. What is implied volatility? It’s not actual volatility as might be measured by the dispersion of data from is mean.
Implied vol has more to do with the level of certainty that market makers have or don’t have about the future. When big money managers come calling for an option to hedge against potential downside in stocks, a market maker on the floor in Chicago at the CME prices the option with some objective inputs. And the variable input is implied volatility. When uncertainty is rising, the implied volatility value includes some premium over actual volatility. In short, if you’re a market maker and you think there is rising risk for a (as an example) a sharp decline in stocks, you will charge the buyer of that protection more, just as an insurance company would charge a client more for a homeowners policy in an area more included to see hurricanes.
So with that in mind, the implied vol market for the S&P 500 had been very subdued for the past 45 days or so, quickly falling back to complacency levels following the Brexit fears of late June. But since Friday, when market interest rates on government bonds spiked sharply (in the U.S., German, Japan), the VIX spiked from 12 to 20 (a more than 60% move).
That indicates a couple of things: 1) Stock investors were spooked by the move in rates and immediately looked for some downside protection, and 2) market makers aren’t quite as complacent as they appeared when the VIX was muddling along at low levels. They are quick to raise the insurance premium, highly spooked by the risk of a sharp decline in stocks.
But it looks like this recent spike might have more to do with market maker community that is psychologically damaged by the abrupt market moves of the past eight years. Gold is down since Friday – giving the opposite message of what the VIX is giving us about perceived uncertainty (people smell fear, they buy gold). And the S&P 500 has only lost 1.3% from its peak last Friday.
Global markets continue to swing around today. Remember, the past couple of days we’ve looked at the three most important markets in the world right now: U.S., German and Japanese 10-year government bonds.
In recent days, German and Japanese debt have swung back into positive territory. That’s a huge signal for markets, and it’s sustaining today – with German 10-year yields now at +8 basis points, and Japanese yields hanging around the zero line, after six months in negative territory.
Stocks are on the slide again, though. And the volatility index for stocks is surging again. Those two observations alone would have you thinking risk is elevated and perhaps a “calling uncle” stage is upon us and/or coming down the pike, especially if it’s a bubbly bond market. If that’s the case, gold should be screaming. It’s not. Gold is down today, steadily falling over the past five days.
So if you have a penchant for understanding and diagnosing every tick in the markets, as the media does, you will likely be a little confused by the inter-market relationships of the past few days.
That’s been the prevailing message from the Delivering Alpha conference today in New York: Confusion. Delivering Alpha is another high profile, big investor/best ideas conference. There are several conferences throughout the year now that the media covers heavily. And it’s been a platform for big investors to talk their books and, sometimes, get some meaningful follow on support for their positions.
Interestingly, one of the panelist today, Bill Miller, thinks we’ll see continued higher stocks, but lower bonds (i.e. higher yields/rates). Miller is a legendary fund manager. He beat the market 15 consecutive years, from the 90s into the early 2000s.
Miller’s view fits nicely with the themes we talk about here in my daily notes. Still, people are having a hard time understanding the disconnect between this theme and the historical relationship between stocks and bonds.
Let’s talk about why …
Historically, when rates go up, stocks go down — and vice versa. There is an inverse correlation.
This see-saw of capital flow from stocks to bonds tends to happen, in normal times, when stocks are hot and the economy is hot and the Fed responds with a rate hiking cycle. The rate path cools the economy, which puts pressure on stocks. That’s a signal to sell. And rising rates creates a more attractive risk-adjusted return for investors, so money moves out of stocks and into bonds.
But in this world, when the Fed is moving off of the zero line for rates, with the hope of being able to escape emergency policies and slowly normalize rates, they aren’t doing it with the intent of cooling off a hot economy (as would be the motive in normal times). They’re doing it and praying that they don’t cool off or destabilize a sluggishly growing economy. They’re hoping that a slow “normalization” in rates can actually provide some positive influence on the economy, by 1) sending a message to consumers and businesses that the economy is strong enough and robust enough to end emergency level policy. And by 2) restoring some degree of proper function in the financial system via a risk-free yield. Better economic outlook is good for stocks. And historically, when rates are lower than normal (under the long term average of 3% on the Fed Funds rate), P/E multiples run north of 20 – which gives plenty of room for multiple expansion on expected earnings (i.e. supports the bullish stocks case).
That’s why I think stocks go higher and rates go higher in the U.S. I assume that’s why Bill Miller (the legendary fund manager) thinks so too. It all assumes the ECB and the BOJ do their part – carrying the QE torch, which translates to, standing ready to act against any shocks that could derail the global economy.
But even if the Fed is able to carry on with a higher rate path, they continue to walk that fine line, as we discussed yesterday, of managing a slow crawl higher in key benchmark market rates (like the 10-year yield). An abrupt move higher in market rates would undo a lot of economic progress by killing the housing market recovery and resetting consumer loans higher (killing consumer spending and activity).
We headed into the weekend with a market that was spooked by a sharp run up in global yields. On Friday, we looked at the three most important markets in the world at this very moment: U.S. yields, German yields and Japanese yields.
On the latter two, both German and Japanese yields had been deeply in negative yield territory. And the perception of negative rates going deeper (a deflation forever message), had been an anchor, holding down U.S. market rates.
But in just three days, the tide turned. On Friday, German yields closed above the zero line for the first time since June 23rd. Guess what day that was?
Brexit.
And Japanese 10-year yields had traveled as low as 33 basis points. And in a little more than a month, it has all swung back sharply. As of today, yields on Japanese 10-year government debt are back in positive territory – huge news.
So why did stocks rally back sharply today, as much as 2.6% off of the lows of this morning – even as yields continued to tick higher? Why did volatility slide lower (the VIX, as many people like to refer to as, the “fear” index)?
Here’s why.
First, the ugly state of the government bond market, with nearly 12 trillion dollars in negative yield territory as of just last week, served as a warning signal on the global economy. As I’ve discussed before, over the history of Fed QE, when the Fed telegraphed QE, rates went lower. But when they began the actual execution of QE (buying bonds), rates went higher, not lower (contrary to popular expectations). Because the market began pricing in a better economic outlook, given the Fed’s actions.
With that in mind, the ECB and the BOJ have been in full bore QE execution mode, but rates have continued to leak lower.
That sends a confusing, if not cautionary, signal to markets, which is adding to the feedback loop (markets signaling uncertainty = more investor uncertainty = markets signaling uncertainty).
Now, with government bond yields ticking higher, and key Japanese and German debt benchmarks leaving negative yield territory, it should be a boost for sentiment toward the global economic outlook. Thus, we get a sharp bounce back in stocks today, and a less fearful market message.
Keep in mind, even after the move in rates on Friday, we’re still sitting at 1.66% in the U.S. 10-year. Before the Fed pulled the trigger on its first rate hike, in the post-crisis period, the U.S. 10-year was trading around 2.25%. As of last week, it was trading closer to 1.50%. That’s 75 basis points lower, very near record lows, AFTER the Fed’s first attempt to start normalizing rates. Don’t worry, rates are still very, very low.
Still, the biggest risk to the stability of the bond market is, positioning: The bond market is extremely long. If the rate picture swung dramatically and quickly higher, the mere positioning alone (as the longs all ran for the exit door) would exacerbate the spike. That would pump up mortgage rates, and all consumer interest rates, which would grind the economy to a halt and likely destabilize the housing market again. And, of course, the Fed would be stuck with another crisis, and little ammunition.
As Bernanke said last month, the Fed has done damage to their own cause by so aggressively telegraphing a tighter interest rate environment. In that instance, he was referring to the demand destruction caused by the fear of higher rates and a slower economy. But as we discussed above, the Fed also has risk that their hawkish messaging can run market rates up and create the same damage.
Bottom line: The Fed is walking a fine line, which is precisely why they continue to sway on their course, leaning one way, and then having to reverse and shift their weight the other way.
This time last month, the famed oil trader—and oil bull—Andy Hall was dealing with a sub-$40 oil market again. And he was again explaining losses to investors in his multi-billion dollar hedge fund.
A guy that has made a career, and hundreds of millions of dollar in personal wealth, picking tops and bottoms in oil, had entered 2016 coming off his worst year ever. And 2016 started even worse.
I’ve talked about the oil price bust extensively, at the depths of the decline in January and February. While most were glorifying the benefits of a few extra bucks in the pockets of consumers from low gas prices, we walked through the ugly outcome of persistently low oil prices. It would be another global financial crisis, as failing energy companies and defaulting oil producing countries would crush banks, and the dominos would fall from there. Unfortunately, the central banks don’t have the ammunition to pull the world back from the edge of disaster for a second time.
With that, central banks stepped in with more easing in the face of the oil price threat, and oil bounced sharply.
Hall’s fund bounced sharply too, running up nearly 25% for the year, by the end of June. But he gave a lot of it back by the time July ended. And now, again, oil is closer to $40 than $50. Thanks to a report yesterday, that oil supplies were bigger than expected, the price of crude has fallen 10% since Friday of last week.
Hall was the CitigroupC +0.13% oil trader who made billions of dollars for the bank energy trading arm, Phibro, in the early-to mid-2000s. He was one of the first to load up on oil futures in 2002, when oil was sub-$30, on the thesis that a boom in demand was coming from China.
He reportedly made $800 million in profits for Citi in 2005 from his original bullish bet. He then made more than $1 billion in 2008 for the bank, as oil prices soared to $147 a barrel and then abruptly crashed. He profited handsomely from both sides, earning a payout from Citi of more than $100 million.
So he’s a guy that has been very right about turning points, and big trends. And he’s been pounding the table for much higher oil prices. He thinks oil prices are in for a “violent reversal” (higher). With an important OPEC meeting scheduled for later this month, Hall, in a past investor letter, reminded people how powerful an OPEC policy shift can be. In 1986, the mere hint of an OPEC policy move sent oil up 50% in just 24 hours.
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Last Thursday, everyone was awaiting the Friday Jackson Hole speech from Yellen. I suggested that, while all eyes were on Yellen, maybe Kuroda (the head of the BOJ) would steal the show: “he could conjure up some Bernanke style QE3. Not a bad bet to be long USD/JPY and dollar-denominated Nikkei through the weekend (ETF, DBJP or DXJ).”
Indeed, Yellen was short on clarity as we’ve discussed in recent days. As of this afternoon, stocks are now unchanged from Thursday afternoon (just prior to her speech). And the 10-year yield is right where it was before she spoke — and looking like a coin flip on which direction it may break. The pain is lower, so it will probably go lower.
As for Kuroda, he did indeed steal the show, at least in terms of market impact. On Saturday, Kuroda hit the wires saying its negative rate policy was far from reaching the limit and said they would act with more QE or deeper negative rates “without hesitation.” That’s a greenlight for buying Japanese stocks and selling the yen (buying USD/JPY).
The Nikkei is up 1.5% from Friday’s close, and USD/JPY is up 2.7% (yen down).
Was Kuroda telegraphing another big round of fresh QE (as Bernanke did in 2012)? Maybe. He said inflation remains vulnerable in Japan and is responding “differently” (i.e. worse) to shocks like falling oil prices.
Inflation in Japan, even after rounds of unprecedented QE, is back in negative territory and has been for five consecutive months of year-over-year deflation. The U.S. economy looks like its running hot compared to Japan. It’s not a bad bet to expect Japan to act first, with more QE, to pump asset prices, and then the Fed would have a little more breathing room to make another hike (either December) or early next year.
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