Central Bank Trifecta
We are amidst three major Western central banks making statements and possible monetary policy changes. Their statements and decisions can drive volatility into the equity, bond, and currency markets. At one time they were all in unison, but we could see a divergence between the U.S. and her allies across the Pacific (Japan) and the Atlantic (Europe). Last December we saw the Fed take the first Hawkish stance, while the Western central banks continued to ease. That sent a jolt into the equity markets. Again, the central bank’s statements and policy action is driving order flow into or out of the equity and bond markets.
This morning the pre-market futures rocketed higher as the European Central Bank (ECB) announced it cut its primary rate to ZERO and its deposit rate to -.4% (negative interest rates). While initially it seems bullish, there is concerns that taking deposit rates negative will impact banking profits and that could have wider implications.
What is this NIRP?
What does Negative Interest Rate Policy (NIRP) actually mean? Negative deposit interest rates charge banks to deposit money. The hope is that it will spur MORE lending by the banks as to avoid the interest charges by the central bank.
Banks typically deposit their money into the central bank reserve system and receives interest for doing so (currently very little). While interest rates are very low, it is still a small profit on deposits. The theory in lowering interest rates is that it will make borrowing more attractive. Hopefully the banks are encouraged to lend money for higher rates than depositing it in the central bank for very low interest rates.
Taking rates negative, effectively charging the banks to deposit money with their central bank, is like a “tax” or “fine”. It is trying to FORCE the banks to lend more money, rather than depositing and paying the central bank interest.
NIRP could backfire!
In fact a NIRP policy could backfire and further lower the velocity of money (reduce lending). The problem with this NIRP Force Majeure is that banks may not decide to lend, but rather deposit money into other currencies, bonds, or asset classes. A bank (lender) should be the sole decider as to whether it wishes to lend and for what rate it wishes to lend for, since the bank ultimately is assuming the risk (as well as risking their depositors money).
What the central banks and Keynesian theories overlook or perhaps ignore, is that lending and the interest rates associated with lending are based on the assumed risk and its collateral. The interest rate should reflect the risk of the loan and not be arbitrarily set by the hidden hand of central planning Keynesian economic run central banks.
NIRP leads to monetizing debt.
What could further back-fire in this new world of NIRP Force Majeure is that buyers of government debt will be less inclined at negative rates (effectively LOSING money), thus forcing the government to self-fund their own deficit spending. Note that while the Fed has stated that QE has “officially ended”, the Federal Reserve continues to be the largest buyer and holder of US treasuries. So it seems to have ended in name only.
In the previous Market Preview I mentioned that Japan’s move to NIRP will be quickly followed by Europe and others. It is also very possible the US will follow down this road. Japan meets on Tuesday, prior to the US Fed FOMC meeting that starts Tuesday and finishes on Wednesday. While Japan has already “jumped the shark” with NIRP and not expected to take further action just yet, it will certainly echo the ECB that they will do what it takes to boost inflation and their economy – which means more stimulus and perhaps further negative rates.
The ECB and Japan are now in NIRP territory and continue down the Dovish easing road. The US took a semi-Hawkish stand in December with their 25bps rate hike and talked tough, setting the tone that the Fed would raise rates (perhaps 4 times in 2016). This move by the US, including its Hawkish tone, has kept the dollar strong and sent commodity prices (priced in dollars) lower. Then in January we started seeing the exit from the equity markets, as investors began to believe the long bull market – stimulated by low rates and easy money, was over with Fed rate hikes on the horizon. As the market sold off, broad economic data (both domestically and global) reflected an economic slowdown and in some situations recession concerns.
Quickly the Fed’s tone started changing back to Dovish. Even the talk of NIRP was discussed by the Fed and even brought up in Congressional Testimony with Fed Chair Yellen. Several governors said we need to be patient when it came to more rate hikes. As the tone of the Fed changed and the possibility that the Fed may NOT raise rates, help give the market some stability and find a bottom and begin to rally out of its 1st quarter rout.
Next Tuesday and Wednesday will be key for the market to get a glimpse as to what the Fed will do and certainly the tone they will take. We must also remember this is an election year and with the Fed Chair and governors appointed by President Obama (first time since inception that one President was able to appoint all the sitting governors), there is little doubt they will NOT want to rock the boat too much.
I believe they will not raise rates, they will talk about the strong jobs numbers and low U3 unemployment, but then in the same breath talk about the concern about the global economic slowdown. They will pause and see how it goes. They don’t want to sound too hawkish as it will send the market lower and not too dovish that could infer NIRP policies. It’s a tight-rope walk, balancing act, and there actions will affect the market, banking, currencies, and pretty much everything. So better to do nothing and say little, than to take action or talk too Hawkish or Dovish.
The pre-market futures are rallying strongly after the ECB announced their NIRP policy. In effect the market sees the Western allied central banks as boxing in the US Federal Reserve from taking further hawkish action. The Fed raising the rates (tightening / Hawkish) right after the ECB lower rates (lose / Dovish) would send the markets lower, dollar higher, and spur disinflation (deflation concerns). The 10-year yield is down this morning in the 1.89% range.
Effectively the pre-market action in equities and bonds is speculating the Fed will NOT raise rates next week and will tone down their Hawkish rhetoric.
Support & Resistance
Pre-market futures rocketed up over 100 points on the ECB rate cut news, but is starting to come off. I think we can see some sloppy and volatile trading between the 16,900 to 17,200 range as traders position themselves into the FOMC meeting. 17,000 remains a straddle strike.
The tech heavy index is seeing some heavy pre-market volatility, but I suspect that 4200 – 4400 will be the rather wide range as the market continues to absorb earnings and waits for the FOMC statement. Implied volatilities are low relative to the intra-day action in the NDX and MNX, which I find somewhat surprising in this market.
The 2k range is getting a lot of headlines and attention and the question is can we close solidly above it with some volume. Earnings have been mixed, when looking at top-line revenue and sales. China’s dismal export/import numbers is certainly taking its toll as well. The VIX has moved up slightly into the 18.3 range, but the skew is not as steep as it should be heading into the FOMC meeting. I suspect intraday slop trading up into 2010 and as low as 1960, regardless of what ATM weighted implies indicate. It’s a traders market for now.
The Russell stalled out into the 1080-1100 area. We must remember that the broader market got hammered a lot more than the narrower based large caps and has been in a bearish market since July. Broad order flow may have filled in the big caps, but we have seen a larger exodus since late 2015 and early 2016 in the small-caps. The recent rally from the 900s has been strong, but it is starting to fade. 1060 is short term support, with 1040 a larger stop area. Order flow has lightened up this week, but that doesn’t mean the Fed’s FOMC statement may be just the dovish catalyst to send order flow rushing back in.
At the end of the day it is all about the perception of Fed policy, rather than actual Fed policy. From a mathematical objective perspective, nothing has really changed in the last several years.
- Rates remain close to zero.
- Fed continues to purchase treasuries.
- Fed continues to purchase Mortgage Back Securities (MBS)
- Fed continues to expand the money supply
For the most part it has been a marketing and spin game. Cherry picking the big three government headline data points (Labor Report, GDP, and CPI) for marketing purposes and to justify that their policies are working, while (ironically) stating that the Labor market has structural issues and the economic recovery remains fragile – so much so they really can’t END their policies.
So the questions you have to ask yourself are:
- If the headline data (more jobs, lower unemployment, low inflation, and growing GDP) are so great, how come the Fed continues to buy bonds, MBS, print money, and keep rates low?
- How much is our economy dependent on Fed monetary policy to maintain these supposed strong jobs recovery and growing GDP?
- What happens if the Fed stopped buying bonds, MBS, stopped increasing the money supply and raised rates?
- Have we been in a Fed led recovery and how much has the private sector really contributed to the recovery?
For now, as we have been, this is market continues to live and die by Fed monetary policy and short-term action is solely dependent on Fed perception.