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Commodity Bubble Bursts, Yet Still No Financial Contagion

Commodity Bubble Bursts, Yet Still No Financial Contagion
(Dollar Photo Club)

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Monday, 14 March 2016 07:39 AM Current | Bio | Archive


If you just started investing in the S&P 500 for the first time on February 11 of this year, you would be up 10.6% through Friday. It’s just the latest of several relief rallies following panic-attack corrections during the current bull market.

Investors are relieved by the following recent developments:
 
(1) ECB: More of whatever. ECB President Mario Draghi continues to do more of whatever it takes to revive the Eurozone’s economy. In his March 10 press conference, following the release of several surprisingly aggressive measures to do so, he said: “Suppose we had embraced what two years ago I used to call the ‘nein zu Allem’ policy strategy, so do nothing. What would be the counterfactual? [A] disastrous deflation.”

However, Draghi also stated that there are limits to just how much the ECB can do: “Does it mean that we can go as negative [with interest rates] as we want without having any consequences on the banking system? The answer is no.”
 
Last Thursday, the ECB’s Governing Council reloaded the central bank’s bazooka with six different measures detailed in a press release. The highlights of the decision include an increase in the central bank’s asset purchase program from €60 billion to €80 billion starting in April 2016 and the introduction of a new series of four targeted longer-term refinancing operations, “dubbed TLTRO II,” to take place between June 2016 and March 2017.
 
Under the asset purchase program, certain classes of non-bank corporate bonds were added to the ECB’s list of eligible securities. The specifics of this “corporate sector purchase program” were detailed in another press release. Under TLTRO II, banks can borrow for up to four years, as outlined in yet another press release. Initially banks will pay 0.00% interest, the new main benchmark rate. But if the commercial banks meet certain criteria, they will get a bonus of 0.40% annually on the value of the loan after two years, applied retroactively. It’s as if your bank offered you a no-interest loan, plus a free toaster as a bonus. In addition, the interest rates on the main refinancing operations of the euro system and on the marginal lending facility were lowered to 0.00% and 0.25%, respectively.
 
These latest efforts were aimed at further strengthening “the pass-through of the Eurosystem’s asset purchases to the financing conditions of the real economy,” according to Draghi. The concept of the ECB effectively paying banks to borrow from the ECB was introduced to eliminate the burden of negative interest rates on bank profits. It came as a surprise, as the introduction of something similar to the BOJ’s tiered system was more widely expected. But Draghi said that the absence of such a system reflected not only the desire “not to signal that we can go as low as we want, but also the complexity of the [Eurozone’s banking] system.”
 
Negative interest rates were first introduced on June 5, 2014, but failed to boost lending in the Eurozone. A March 10 Bloomberg article titled “Draghi Can Cut Borrowing Costs, But Can’t Make Companies Spend” sums up an important challenge that the ECB is up against. Corporations can already borrow cheaply and might not have the appetite to raise more money to invest.
 
Interestingly, the ECB did succeed in lowering the foreign exchange value of the euro after negative rates were first introduced. So far, the latest round of easing has actually boosted the euro. Unfortunately, whatever relief may come for the Eurozone’s economy from the ECB’s latest desperate measures might be short-lived as the bank runs out of options, though Draghi certainly hasn’t given up on trying to find ways to stretch the limits of monetary policy. Draghi denied that the ECB is considering “helicopter money.”
 
On the positive side, January’s industrial production numbers may be the first hint that the 20% decline in the euro since its May 6, 2014 peak may be providing some stimulus to the Eurozone. There were solid output gains (excluding construction) in Germany (2.9% m/m), Italy (1.9), and France (1.3).
 
Of course, the most immediate bullish impact of the ECB’s latest shock-and-awe extravaganza was a dramatic decline in the cost of insuring bank debt, which caused the EMU MSCI Financials stock price index to jump 5.6% on Friday. That helped to boost the S&P 500 Financials by 2.7% and the S&P 500 Diversified Banks index by 2.8% last Friday. The plunge in all these financial indexes earlier this year contributed to the panic attack that set the stage for the current relief rally.
 
The ECB’s latest moves were opposed by the Bundesbank. The ECB’s Vice President Vítor Constâncio defended the latest actions in a March 11 opinion piece posted on the bank’s website. His main point was reminiscent of former Fed Chairman Bernanke’s reflections in his recently released memoir titled "The Courage to Act." Bernanke’s message was that the Fed did what it had to do during the latest financial crisis while fiscal policymakers in Congress failed to step up. In this instance, the ECB’s VP argued: “To normalise inflation in the euro area we urgently need higher growth that can reduce negative output and unemployment gaps, using all really available policies. If not monetary policy, then what?”
 
Constâncio rationalized: “The G-20 has appealed for the use of other policies, notably fiscal and structural reforms. … More generally, countries that could use fiscal space, won’t; and many that would use it, shouldn’t. … Structural reforms are essential for long-term potential growth, but it is difficult to see how they could spur growth significantly in the next two years ... And as regards their delivery by governments, we should recall the embarrassing results of the G20 plan agreed in Brisbane to generate an additional 2% in world growth via a long concrete list of reforms put forward by the IMF and the OECD. … So if these other policies either can’t or won’t contribute to a significant degree, then not only is it wrong to start talking down monetary policy--it’s actually dangerous.”
 
(2) China: Less capacity. The Chinese government is also committed to doing whatever it takes to transform its economy from manufacturing-led to services-led growth. The draft outline of the latest five-year plan was unveiled on March 5 and will be finalized on March 16, when the national legislature’s annual session draws to a close. It acknowledges that there is too much excess capacity in manufacturing, particularly among state-owned enterprises (SOEs). There are reports that the government intends to reduce employment in the steel, cement, and mining industries by 5-6 million collectively. Funds will be allocated to cushion the hardship of the terminated workers.
 
Meanwhile, industrial production rose 5.4% y/y during February, the lowest since February 2009. The PPI was down 4.9% y/y during February, the 48th consecutive monthly decline. All this confirms that China’s economy is facing some serious challenges, including avoiding massive debt defaults by the downsizing SOEs.
 
Investors must have been relieved to learn last Thursday that the Chinese are planning on converting some of the debts of the SOEs into equity. On March 11, Bloomberg reported, “The swaps would curb bad-loan levels just as they did during the country’s 1990s banking crisis, when about 30 percent of the nation’s 1.4 trillion yuan ($216 billion) of soured credit was resolved through debt-to-equity swaps…. Under China’s current banking law, debt can be swapped for equity if shares were used as collateral for the loan, though banks in this situation must unload the equity within two years. Banks seeking to swap debt for equity that was not used as collateral must obtain approval to do so from the State Council, which is the nation’s cabinet.”
 
By the way, the huge $387 billion jump in bank loans during January seems to have been an aberration, as the pace slowed significantly back to a more “normal” $124 billion last month.
 
(3) Fed: Fewer hikes. Joe and I believe that the panic attack at the start of the year was exacerbated by Fed Vice Chairman Stanley Fischer and FRB-SF President John Williams when they both said that the markets should expect four rate hikes this year, consistent with the December FOMC meeting’s “dot plot.” Both backed off in response to the resulting market turmoil. Now, no one is expecting a rate hike at the March 15-16 meeting. The futures market currently suggests two hikes expected this year. It won’t surprise anyone if the March FOMC meeting’s dot plot for this year shows two to three rate hikes, down from four.
 
Debbie and I won’t be surprised if during her press conference on March 16, Fed Chair Janet Yellen says that she is willing to postpone the next rate hike for a while because the 1.5 million jump in the labor force over the past three months through February shows that there is plenty of slack left in the labor market. That’s confirmed by the slow 2.2% increase in wages. She might say that she is pleased to see that discouraged workers who had dropped out are coming back and that the normalization of the labor market is more important than proceeding willy-nilly with monetary normalization. Of course, normalizing monetary policy later this year might be impeded by the presidential elections. So none-and-done or one-and-done seem like the most likely scenarios for Fed policy this year.
 
(4) Commodities: Fewer gluts
. Investors clearly are relieved that commodity prices seem to have bottomed. Indeed, the CRB raw industrials spot price index actually did so on November 23, while its metals component bottomed on January 13. The price of a barrel of Brent bottomed on January 20 at $27.88, and is up 45% since then.
 
(5) Credit: No dropping shoes. Just as encouraging is that, despite the bursting of the commodity super-cycle bubble, there hasn’t been a financial crisis. The yield spread between corporate junk bonds and US Treasurys did widen dramatically from the most recent low of 253bps on June 23, 2014 to the recent high of 844bps on February 11. However, it is back down to 640bps. In other words, the other shoe hasn’t dropped as many investors had feared, concerned that the plunge in commodity prices would trigger a financial calamity comparable to the crisis of 2008.
 
(6) U.S.: More positive surprises. Another big relief is that widespread fears of a US recession have mostly dissipated as the Citigroup Economic Surprise Index rebounded from a recent low of -55.7 to -9.3 on Friday. On Thursday, we learned that initial unemployment claims fell to only 259,000 during the week of March 5, the lowest since mid-October.
 
(7) Technicals: Brighter picture. Of course, there are still market technicians warning that this is a “dead cat bounce” and a rally in a bear market. They point out that the bull market is actually only six years and two months old since the record high was hit on May 21, 2015, which was 204 trading days ago. In other words, from their perspective, failing to take out that high soon in this relief rally could confirm that a bear market is underway.
 
However, even the bears must concede that the breadth of the market is showing signs of improving. Since February 11, the S&P 500 is up 10.6%, while the equal-weighted S&P 500 is up 13.6%. (By the way, while the former is up 198.9% during the seven-year bull market, the latter is up 280.9%!) The NYSE volume advance/decline line is up 10.4% since the week ended February 12. The S&P 500 Transportation index is up 14.7% since January 25 and back near its 200-day moving average.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.

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EdwardYardeni
Investors are relieved by the following recent developments.
investors, stocks, fed, rates
1960
2016-39-14
Monday, 14 March 2016 07:39 AM
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