Saturday, July 13, 2013

Of central banks, asset bubbles & liquidity traps

This week Ben Bernanke gave the markets back what they wanted just at a time when they were being weaned off of "hopium".  Now the 'junkie" is back "on the stuff".  All the major indexes booked gains of over 2% with the NASDAQ Composite and the NASDAQ 100 clocking gains in excess of 3%.  Even Treasuries popped on the back of Bernanke's comments.

All assets save the US Dollar took off to the upside in the after hours session on Wednesday afternoon as the Fed chairman reassured markets on the continuation of monetary accommodation during a question and answer period after a speech entitled, "The First One Hundred Years of the Federal Reserve: The Policy Record, Lessons Learned and Prospects for the Future", at a conference sponsored by the National Bureau of Economic Research in Cambridge, Massachusetts.

Here's a daily chart of the S&P 500 as of Friday's close:

(click on chart for larger image)
A few take aways:

1. The ascending trend line (white dashed) can be described as almost parabolic.
2. The grey area is the area inclusive of what are technically known as Bollinger Bands.  The index is pushing out of the upper band and normally this is a signal of an over extended market.
3. The two momentum indicators above are flattening meaning the upside momentum is waning.

Let's look at the daily chart of the Nasdaq 100 which represents the top one hundred stocks in terms of capitalization on the NASDAQ:

(click on chart for larger image)
 
This chart manifests the same characteristics as the S&P 500 but the move from the June 24th lows is parabolic and the momentum is reflecting further weakness as the CCI has registered a down tick.
 
Virtually all indexes evince the same attributes as the two charts above.  This doesn't necessarily mean we're due for a correction but it does mean we're getting close to at least a consolidation period and perhaps some type of pullback. 
 
There is some potential market moving economic data which could drive these markets next week but it must be remembered that Bernanke's comments last Wednesday have set a short term mood in the market which can only be shaken by incredible bad economic data. 
 
The Dollar had been on a ferocious rally for some weeks on the prospect that the Fed was going to be scaling back on asset purchases in the very near future.  Some on Wall Street were predicting a twenty billion reduction per month in asset purchases as early as September.  However, Bernanke's remarks dissuaded the market on that assumption and the dollar subsequently tanked.  Here's a daily chart of the Powershares DB US Dollar Bullish Index ETF (UUP) which I'm using as a proxy for the Dollar Index.  It highlights the impact of the Fed chairman's comments better than the Dollar Index itself which trades twenty four hours a day during the trading week:
 
(click on chart for larger image)
 
I circled Wednesday's thru Friday's price action.  The Dollar initially reacted negatively to the release of the FOMC minutes at 2PM EST on Wednesday but there was much confusion on what the minutes portended for the future of monetary policy.  But Mr. Bernanke's comments after hours cleared everything up (?) and as can be seen above UUP promptly fell out of bed on Thursday morning.
 
Gold had been strengthening prior to Wednesday as seen on the chart below of the Gold spot price but received a nice bounce courtesy of "helicopter Ben" on the prospect that inflationary expectations might still actually exist:
 
(click on chart for larger image)
 

And I'm not going to post the chart but the gold miner's had a big week, up 4.06% as measured by the Market Vectors Gold Miners ETF (GDX).  More importantly, I sense the miners are attempting to put in a bottom here.
 
I wrote two weeks ago that I saw the activity in the gold miners as a unique event, extrapolating a possible bottom in gold (http://equitymaven.blogspot.com/2013/06/gold-interest-rates-market-direction.html) only to retract my call in last week's commentary.  But I still sense that the last three weeks price action, especially in the miners, is telling the market something.  I won't put my foot in my mouth again but I'm watching gold and the miners closely.  I believe we're at a very important juncture in the markets and commodities will be giving us the signal on which way the global economy is going in the weeks ahead.  I'll have more on this subject in my analysis.
 
Lastly, even Uncle Sam's debt got a bounce this week as the prospect that the Fed would not be lifting its suppressing hand on the yield curve forced a retreat in yields in the belly to the long end of the curve.  Here's an update on the US Ten Year Treasury Note yield:
 
 
(click on chart for larger image)
 
 I've highlighted the incredible run up in rates from the May 1st intra day low of 1.614% (black arrow) and where the yield closed on Friday (blue arrow) at 2.601%.  The move in yields this week, unless we see follow thru next week, can only be considered a dead cat bounce. 
 
Analysis
 
I found Mr. Bernanke's speech on Wednesday at Cambridge to be fascinating and I recommend the paper to those who wish to understand the history of the Fed.  It can be found here: http://www.federalreserve.gov/newsevents/speech/bernanke20130710a.htm

I believe Mr. Bernanke's paper to be objective and accurate.  I know there are many views on the Fed and many of those views are negative in sentiment.  Mr. Bernanke obviously comes from the perspective that the central bank was and is indispensable in maintaining price stability in our economy and yet he unabashedly identifies past policy mistakes made by the central bank, especially during the Great Depression.

I urge those of my friends and readers who have an antipathy towards the Fed to read the speech if only to understand another position on the necessity of central banks in a fiat currency system. 

There are more than a few authors who have made a ton of money capitalizing on Federal Reserve "conspiracy" theses.  I've come to believe that all history is revisionist.  Unless you have lived through the era that is being written about, you are bound to be influenced by any author's natural predilection on why events occurred. Sorting out conflicting theses by testing whether their consequences have withstood the test of time can assist greatly in sifting thru the historical noise created by authors and writers that have their own agenda (ie. making money). 
 
The big event of the week, as outlined above, was the release of the FOMC minutes from the June meeting on Wednesday which didn't really clarify anything for market participants until Ben Bernanke's comments later that day.
 
But after all that transpired last week, the question has to be asked, did anything fundamentally change from the week before?
 
Well, the prospect that an extension to the present monetary accommodation is in the cards could be identified as a fundamental development but, to me, it is merely the continuation of Fed policy and so is not "fundamental". 
 
Were there any signs of the reflation trade I wrote about last week? (http://equitymaven.blogspot.com/2013/07/a-recovery-without-reflation-trade.html )  Well, the June Producer Price Index (PPI) rose 0.8 percent.  The forecast was for a 0.5 percent rise.  But the rise that beat expectations was largely due to higher energy prices. 
 
Yearly core inflation in manufacturing has been flat at just 1.7% for the past four months, compared with 2.6% in June 2012.
 
 Import prices excluding oil also fell 0.3% in June, the fourth consecutive decline. Non oil import prices are down 1.0% compared to a year ago. In June 2012, those prices were rising at a 0.6% annual rate.
 
The disinflation story in this country is getting so serious that Mr. Bernanke actually mentioned Jim Bullard, the St. Louis Fed governor and former inflation hawk, in his remarks on Wednesday, citing Mr. Bullard's lone dissenting voice that more central bank monetary accommodation (read more asset purchases) may be needed to stem the disinflationary tide.
 
The prevailing view at the Fed is that present disinflationary forces are transitory in nature.  Advocates for this view at the Fed point to recent data showing rising labor costs as well as rising rents and housing prices.  The belief is that these two rising costs will put a floor under prices.  While I may not be able to argue about housing and rent prices I don't know that rising low paying labor costs can put much of a floor under dropping prices. 
 
Industrial commodities did get a pop on Bernanke's remarks but the price action can only be described as a mere "blip" on the reflation radar screen.  Here's an updated daily chart of the Dow Jones UBS Industrial Metals Index ($DJAIN):
 
(click on chart for larger image)
 
 
Did we get any positive signs from the rest of the world that there was something fundamentally changing in the global economic landscape?  Here's a daily chart of the Shanghai Composite Index ($SSEC):
 
 
(click on chart for larger image)
 
Chinese stocks had a better week after Premier Li Keqiang took a cue from Bernanke and Draghi and "managed expectations" when he mentioned the need to stabilize growth on Tuesday, suggesting that country's restrictive economic policy stance may ease in the second half of this year.
 
 
What about the rest of the emerging markets?  This is a weekly chart of the iShares MSCI Emerging Markets ETF:
 
 
(click on chart for larger image)
 
In all objectivity, after the plunge that took place in May after Bernanke's "pop the bubble" speech, the chart could be construed as either constructive or ready for another leg down based on a possible bear flag pattern.
 
 
How about Europe?  European bourses bounced on the Bernanke remarks and many of their charts mimic our stock indexes in that they swooned in May and started recovering in July.  In essence, European stocks are running on fumes, not fundamentals, and are being buoyed by jawboning from the ECB and our Fed. 
 
All this speaks to what I see as a pivotal time for global economies and financial markets.  I submit to my readers that central bank attempts to reflate the global economy have done nothing more than keep the comatose patient alive for the past four years.  Here's a chart, courtesy of the St. Louis Fed, I posted two weeks ago:
 
(click on chart for larger image)
 
This is the velocity of M2 money supply in this country.  M2 is the most popular measure of money supply in our economy and the velocity of money is defined as the rate of turnover in the money supply; that is, the number of times one dollar is used to purchase final goods and services included in GDP.  Question: how can the velocity of money be at it's lowest level since the data has been recorded in the late 1950's when the Fed has pumped the equivalent of over two trillion dollars into the economy?  And since the Fed has turned out to be the "poster child" of central banks since their policy seems to have translated into a recovery in this country, what does that say about other central bank efforts around the world?
 
To me, the moment of truth is arriving.  Either we start to see a change in the chart above and start to see inflationary pressures build in the global economy or we have to come to grips with the concept that central banks have fallen into a liquidity trap where interests rates have been pushed to zero but economic growth is flat to negative. 
 
A comprehensive treatment of a "liquidity trap" is outside the scope of this commentary but I'll add that much has been made of the trillions of dollars on corporate balance sheets and this is a characteristic of a liquidity trap.  Companies and people are unwilling to commit capital because of weak aggregate demand.
 
While no one seems to want to talk about this on the street it seems to be a pretty glaring possibility to me and that's why I'm beginning to have legitimate concerns regarding our recovery, regardless of what our stock market is doing.  Indeed, the performance of equities since the March, 2009 bottom could be the result of the "liquidity trap" as a ZIRP (zero interest rate policy) drives investors into higher risk assets and central bank liquidity finds its way into the market because banks and corporations refuse to put it to work in the real economy.  Central banks continue to blow bubbles!
 
Some may call my thesis outlandish and I'll admit that it is outlandish if we start to see a turnaround in the global economic scene shortly.  Otherwise, this is a real possibility that becomes more real with every passing day.
 
To sum up, here's my bullet points to challenges and solutions:
 
1.  China and the emerging markets, being primarily export driven economies, are "the tail that the dog wags".  And that dog is the consumer based economies in the west. 
 
2.  As long as Europe wallows in recession, US consumption is not enough to fuel a global economic recovery.
 
3.  What we're seeing in the US is some significant momentum toward a serious recovery.  Tax revenues are up which is an important positive indicator of economic activity and job growth, even if the job growth is at McDonald's or your local neighborhood tavern.
 
4.  In order to move from "limping along" to significant and lasting economic growth we need to start seeing positive industrial and import data coming out of the Euro zone.  And to the extent that we fail to see this data in the second half of this year increases the odds that deflationary forces will gather additional momentum in the global economy.
 
 



 
 In the short term, stocks are tired.  I identified the waning momentum above and the technicals suggest a "reversion to the mean" trade.  That does not mean we still can't go higher and we may still get another bounce next week on a host of data, both here and abroad.
 
Chinese GDP coming in on Sunday night will be closely watched after the Chinese projected GDP growth for the second half of the year at only 7%.  Any number under 7.5% will ignite a sell off in Asia that will most likely carry over to Europe and the US.
 
Other data I'll be watching next week:
 
Monday - US Retail Sales and Empire State Mfg Index
Tuesday - Euro zone CPI** & German ZEW Economic sentiment
               - US CPI** & Industrial production
Wednesday - US Housing starts
Thursday - US jobless claims and Philly Fed Business conditions
Friday - German PPI**
 
** Watching for signs that deflationary (Europe) and disinflationary (US) forces are abating.
 
 
 
Have a great week!
 
NOTHING IN THIS COMMENTARY SHOULD BE CONSTRUED AS AN OFFER OR ADVICE TO BUY OR SELL ANY SECURITIES, OPTIONS, FUTURES OR COMMODITIES. THE OPINIONS ARTICULATED ARE ONLY THIS AUTHOR'S WHO IS NOT A REGISTERED INVESTMENT ADVISOR OR BROKER.