The Chairman is set to appear
Near Mnuchin, and both will make clear
Is killing off growth
Thus, action’s required this year
The subtext, though, is that the Chair
Has realized his cupboard is bare
No ammo remains
To prop up the gains
That stocks have made ‘midst much fanfare
Yesterday’s risk-off session may well have set the tone for the week, as there has been precious little rebound yet seen. In addition to the virus story, and the news of large bank misdeeds, the US election story remains a critical factor, although at this point, any impact remains difficult to discern. The one thing that is quite clear is that there is a very stark choice between candidates. Given the prevailing meme that it is going to be a very close election, and the outcome could be in doubt for weeks following November 3rd, and assuming that the market response will be quite different depending on who eventually wins, one cannot blame traders and investors for omitting the issue from their current calculations. While eventually, there is likely to be a significant market response, at this point, it seems there is little to be gained by positioning early.
In the meantime, however, the current administration continues to seek to do what it thinks best for the economy, and today we will get to hear from Chairman Powell, as well as Treasury Secretary Mnuchin, in Congressional testimony. As is always the case in these situations, the text of Powell’s speech has been pre-released and it continues to focus on the one (apparently only) thing that is out of his control, more fiscal stimulus. In his opening remarks he will describe the economy as improving but with still many problems ongoing. He will also explain that monetary stimulus needs the help of fiscal stimulus to be truly effective. In other words, he will explain that the Fed is now ‘pushing on a string’ and if Congress doesn’t enact new stimulus measures, there is little the Fed will be able to do to achieve their statutory goals. Of course, he won’t actually use those words, but that will be the meaning. It is abundantly clear that the Fed’s ability to support the real economy, as opposed to financial markets, has reached its end.
However, it is not just the Fed that has reached its limit, essentially every G10 central bank has reached the limit of effective central banking. It has been argued, and I agree with the sentiment, that the difference between ‘normal’ positive interest rates and the zero and negative rates we currently see around the world is similar to the difference between Newtonian and Quantum mechanics in Physics. In the positive rate environment, things are exactly as they seem. Investment decisions are based on estimated returns, and risk of repayment is factored into the rate charged. There is a concept called the time value of money, where one dollar today is worth more than that same dollar in the future. It is the basis on which Economics, the subject, was formulated. This is akin to Newton’s well-known laws like; Every action has an equal and opposite reaction, or a body in motion will stay in motion unless acted on by another force. They are even, dare I say, intuitive.
But in the zero (or negative) interest rate world, investment decisions are completely different. First, the time value of money doesn’t make sense as it becomes, a dollar today is worth less than a dollar in the future. As well, the addition of forward guidance is self-defeating. After all, if they know that interest rates are going to remain zero for the next three years, what is the hurry for a company to borrow money now? Especially given the extreme lack of demand for so many products. Instead, managements have realized that there is no need to worry about increasing production, they will always be able to do that when demand increases. Rather, their time can be better spent reconfiguring their capital structure to reduce equity (lever up) and show ever increasing EPS growth without risking a poor investment decision. This is akin to the difficulty in understanding the quantum realm, where uncertainty reigns (thank you Heisenberg) and the accuracy of measuring the position (EPS) and momentum (growth) of a particle are inversely related.
The problem is that central bankers are all Newtonians (or Keynesians), and so simply plug zero and negative numbers into their models and expect the same reactions as when they plug in positive numbers. And the output is garbage, which is a key reason they have been unable to stimulate economic activity effectively. Alas, as long as problems persist, central bankers will feel compelled to “do something” when doing nothing may be the best course of action. In the end, look for more monetary stimulus as it is the only tool they have. Unfortunately, its effectiveness has been diminished to near zero, like their interest rates.
In the meantime, a look around markets shows that risk is neither off nor on this morning, but mostly confused. Asian equity markets followed yesterday’s US losses, with declines of around 1% in those markets open. (The Nikkei remained closed). But European bourses have turned modestly higher on the day as the results of some regional elections in Italy have been taken quite positively. There, the League’s Matteo Salvini lost seats to the current government, thus reducing the probability of a toppling government and easing pressure on Italian assets. In fact, the FTSE MIB is the leading gainer today, higher by 1.2%, but we also see the DAX (+1.0%) and CAC (+0.5%) shaking off early losses to turn up. US futures are mixed at this time, although well off the lows seen during the Asia session.
In the bond market, yesterday saw Treasury yields decline about 3 basis points amidst the ongoing risk reduction, but this morning, prices are edging lower and the yield has backed up just about 1bp. In Europe, things have been much more interesting as Italian BTP’s have rallied sharply during the day, with yields now down 3.5 basis points, after opening with a similar sized rise in yields. Bunds, meanwhile, are selling off a bit, as fears of an eruption of Italian trouble recede.
And finally, the dollar, which had been firmer much of the evening, is now ceding much of those gains, and at this hour I would have to describe as mixed. In the G10, NOK (-0.5%) remains under the most pressure as oil prices continue to soften and there is now a controversy brewing with respect to the investment strategy of the Norwegian oil fund. But away from NOK, the G10 is +/- 0.15%, which means it is hard to describe the situation as significant.
In the emerging markets, ZAR (+1.1%) continues to be the most volatile currency around, with daily movements in excess of 1%. It has become, perhaps, the best sentiment gauge out there. When investors are feeling good, ZAR is in demand, and it is quick to be sold in the event that risk is under pressure. CNY (+0.45%) is the next best performer. This is at odds with what appears to be the PBOC’s intentions as they set the fix at a much weaker than expected 6.7872, or 0.4% weaker than yesterday. It seems the PBOC may be getting concerned over the speed with which the renminbi has been rising, as in the end, they cannot afford for the currency to appreciate too far. On the red side of the ledger, KRW and IDR both fell 0.6% last night as risk mitigation was the story at the time.
Aside from Chairman Powell speaking today, we also see Existing Home Sales (exp 6.0M), which if it reaches expectations would be the highest print since 2007. If risk is back in vogue, then I would look for the dollar to continue to edge lower. And you can be sure that Chairman Powell will not do anything to upset that apple cart.
Good luck and stay safe