Traditionally Hawkish Loretta Mester Signals "Stay the Course"

Cleveland Fed President Loretta Mester, in speaking to the Dayton Area Chamber of Commerce this morning, signaled a "stay the course" attitude regarding the Fed's current interest rate policy.  Her speech follows a week of extremely turbulent price action in the markets, raising speculation that volatility in the DOW would influence the Fed's pace of interest rate hikes through the remainder of the year.

The market has currently priced in three interest rate hikes for 2018, and sentiment shows a 77.5% chance of a 25 bps increase following the March 21 FOMC meeting.  Mester, one of the hawkish members of FOMC, said today that she supports a rate increase pace similar to what the Fed pursued in 2017 when they raised interest rates three times over the course of the year. 

Mester dismissed the current market action as little more than the normal correction one would expect after the explosive run-up in stock prices experienced over the past year.  “For now," she said,  "I expect the economy will work through this episode of market turbulence and I have not changed my outlook. In my view, the underlying fundamentals supporting the economy are very sound.”

 Historically, Mester has supported an aggressive interest rate policy, citing fears of a run-up of inflation should the Fed not raise rates quickly enough.  While she expects inflation to rise at an increasing rate, she does not foresee a need to increase the rate at which the Fed raises rates.  It's noteworthy that her remarks come a day before the February release of the closely watched CPI numbers.  Tomorrow's numbers should be a strong signal both for inflation's rate of change and for the aggressiveness the Fed is likely to take for the remainder of 2018.

The consensus for tomorrow's CPI release, according to Econoday is as follows:

	Prior	Consensus	Consensus Range
CPI - M/M change	0.1 %	0.3 %	0.3 % to 0.4 %
CPI - Y/Y change	2.1 %	2.0 %	1.9 % to 2.3 %
CPI less food & energy- M/M change	0.3 %	0.2 %	0.1 % to 0.3 %
CPI less food & energy - Y/Y change	1.8 %	1.7 %	1.7 % to 2.0 %

Numbers that come in stronger that the consensus will add pressure to an already jittery market since it will increase speculation that the Fed will add a fourth rate increase into 2018.  That fourth increase is not currently factored into prices.

Mester also addressed the impact the 2018 tax cuts may have on the economy as a whole.  In her view, she expects the cuts to add between a quarter and a half of a percent to economic growth.  This, she expects, will support an inflationary rate just above the Fed's target of 2.0%.  It should also, in her view, support continued hiring in the private sector.  That will spur an increase in wage growth, the primary factor driving inflation.  (Wage growth in January increase 0.3% over December, and is showing an already strong annual 2.9% hourly rate.)

Scott Anderson, chief economist at Bank of the West in San Francisco, doesn't share the view that inflationary growth is under control.  “The acceleration in average hourly earnings growth punches a hole in the narrative that wage growth remains lackluster.  The Goldilocks view of inflation is being sorely challenged right now.”

Wednesday and Thursday provide a series of economic releases that will signal Fed's direction.  Definitely watch tomorrow's CPI release.  If there's surprise to the upside, expect the market to react negatively in anticipation of a more aggressive interest rate schedule.  But it doesn't end with the CPI.  Watch these releases tomorrow and Thursday for a more complete picture:

• Wed - 8:30 AM - CPI
• Wed - 8:30 AM - Retail Sales
• Thu - 8:30 AM - Jobless Claims
• Thu - 8:30 AM - Philadelphia Fed Business Outlook Survey
• Thu - 8:30 AM - PPI FD
• Thu - 9:15 AM - Industrial Production

 We share Mester's view that the fundamentals of the economy remain strong.  The question, however, is "how strong."  By market open on Thursday, we should have a good idea as to whether the economy is too strong or if it's proceeding at a healthy pace.

Happy Trading.

CPI and PMI Releases Show Strength; Paint Complex 2017 Picture

Thursday, 15 December 2016, saw a plethora of significant economic data releases before the markets opened in the US.  These releases came fast on the heels of the FOMC decision to increase interest rates for only the second time in a decade while also signalling a more hawkish monetary policy that may require an accelerated pace of future rate hikes.  Two of the major releases yesterday, the US Manufacturing PMI and the US Consumer Price Index (CPI) lend credence to the inflationary forecasts set forth by Fed Chair Janet Yellen in her Wednesday press conference. 

Manufacturing experienced a strong surge, hitting a 21-month high.  This surge, however, is still well below peaks set in the post-recession era, indicating there may be plenty of room for growth in the months ahead.

Markit US Manufacturing PMI (seasonally adjusted) Source: IHS Market

US manufacturers reported business conditions improving at the fastest rate since March 2015 with manufacturing output expanding for the seventh consecutive month.  The growth in output was attributed to an increase in sales demand, coupled with a need to replenish inventories. 

One major note of caution was signaled in the report, however.  While new work orders received by manufacturers experienced a rapid rise, the report also stated, "This was overwhelmingly attributed to improving domestic demand conditions.  Meanwhile, export sales were close to stagnation, which contrasted with the modest growth seen on average in the second half of 2016."

The stagnation of export sales as cited is most likely the result of the strong US dollar coupled with extremely weak economic conditions in Europe.  Both will likely have a negative impact on the performance of US stocks with heavy overseas exposure.  This will be exacerbated by rising interest rates in the US, further strengthening the dollar against foreign currencies already experiencing downward pressure.

There are strong signs, however, that inflation may increase at a more rapid pace than currently being forecast by the Fed.  An example of this upward price pressure is seen in the PMI report: Input price inflation accelerated for the third time in the past four months during December. Moreover, the latest increase in average cost burdens was the largest since October 2014. Manufacturers cited higher steel prices in particular, alongside generally rising raw material costs, including oil.

That oil prices will increase in 2017 is a near-given.  Following agreements on oil production cuts from the major exporters, we can anticipate oil price stabilization at least in the high 50s, and possibly into the 60s.  The only downward pressure at the moment is the rising strength of the dollar.  An increase in oil prices will automatically have an inflationary impact on virtually all segments of the economy.  Likewise, as Europe begins to recover, increased demand on US exports will add upward price pressure. What remains to be seen, however, are the potential impacts of any trade-policy changes coming out of the new administration.  Tightened trade policies will likely have a medium-to-long term inflationary impact as well.

This steady growth in price inflation is similarly reflected in yesterday's CPI-U release.  Seasonably adjusted, November saw a 0.2% increase month over month, and the index rose 1.7% for the year.  That's barely below the 2% figure set by FOMC as their inflation target.  The greatest contributor to this rise continues to be the shelter and gasoline indexes.  Shelter rose by 0.3% in November, however the gasoline index rose 2.7%.  That will continue to rise as oil prices normalize in 2017.  The energy index as a whole rose 1.7%.

12-month CPI Not Seasonably Adjusted   Source: Bureau of Labor Statistics

In her post-announcement press conference on Wednesday, Ms. Yellen reaffirmed their inflationary target of 2%, however the way she addressed that was a bit interesting.  She indicated rather emphatically that while the committee was concerned about inflationary levels that are below 2%, they were also very concerned about inflation exceeding 2%.  The implication in her statement was that steps would be taken to prevent any sustained rise above that level.  At present, all signs indicate the economy is moving towards just such a rise.

What I take from all this is that the projection for three rate increases in 2017 may either be an underestimate or one of those increases may see more than the 0.25% target increase to which we have become accustomed.  The pressures on price at the moment feel a bit like a coiled spring, and if any of those downward pressures are removed, the Fed may feel compelled to react swiftly to prevent an uncontrolled rise in inflation.  This will be especially true as the "all items" level rises and returns to a normal level above the "all items less food and energy" line. 

The wildcard for 2017 remains the incoming Congress and Administration.  Consumer confidence is surging at the moment, and when consumers are confident, they buy.  There is anticipation that 2017 will see significant reforms both in regulations and in tax structures.  (I'm less optimistic that such reforms will materialize, however that's a topic for another day.)  That pro-business anticipation is adding to corporate confidence, and just like consumers, when corporations are confident, they also increase spending. 

As we head into the new year, it would be prudent to pay close attention to the various public appearances made by the fed governors.  If inflation is showing signs of increasing beyond the pace they have forecast, our first indications will be in changes in tone from the various FOMC members.  We will also pay close attention to the forward guidance offered in key 1Q17 earnings releases.  An increase in optimism in that guidance will be another signal that higher inflation is on the horizon, and another signal that the Fed may be forced to adopt an even more hawkish policy than they signaled on Wednesday. 

Happy Trading

Markets Adjusting for Rate Hike and Yellen's Hawkish Press Conference

Today's quarter-point increase in the Fed Funds rate came as no surprise to anyone.  What followed, however, was the most hawkish press conference Fed Chair Janet Yellen has delivered in her brief tenure.  The official FOMC Press Release was issued at 14:00 EST.  As expected, the release cites continued strength in the labor market as well as moderate expansion in the overall economy. 
The Fed expects inflation to continue to rise gradually towards their 2% target: "Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further."  Remember that, in Fed Speak, "medium term" is defined as between two and six years.

It's important to note that today's vote to increase rates was unanimous. Up until this point, there were at least three staunch doves voting against any rate hikes.  That it was unanimous signals a shift in the overall tenor of the committee and may be a harbinger of a more aggressive monetary policy going forward.

The significant change in today's policy announcement comes in the forecast for additional rate increases over the next three years.  Prior to today's announcement, the market was anticipating two quarter-point interest rate hikes in 2017.  The signal today, however, is for three.  Now, Ms. Yellen did caution that not all members are on board with that projection.  As a result, we can anticipate more volatility than usual around the monthly key data releases since the market will need to assess how the FOMC members will interpret the data and how that will influence a potential rate hike in March.  We're likely back into a "good news is bad" scenario where positive economic data creates a selloff out of fears of an additional rate hike.

In her post-announcement press conference, Ms. Yellen acknowledged some of the challenges facing the job market while issuing a veiled caution that the political rhetoric may not match the actual causes.  She specifically mentioned increased technology and automation as significant factors in workforce reduction saying, "For decades the pace of technological change in manufacturing has outstripped that of the economy as a whole. So manufacturing firms have found it easier to continue producing by reducing their work forces."  In other words, the problem is not all due to outsourcing and bad trade deals. Changes in the overall technical infrastructure are major contributing factors, and this rapid rate of change will be a fact of life for the foreseeable future.

On several occasions, the questions offered ample opportunity to opine on the President-Elect and the policies of the incoming administration.  To her credit, the Fed Chair refused to take the bait.  Specific to Mr. Trump's statement that he would not reappoint her, she offered, "I do intend to serve out my four-year term. I haven't made any decision about the future. I recognize I might or might not be reappointed. It's a decision I don't have to make and don't have thoughts on at this time."

 She took the opportunity to repeat several times that the independence of the Fed is a concept with which she fully agrees, and also pointed out that the 4 year term of the Fed Chair is not coterminous with the 4 year Presidential Term.  She made it a point of saying that it was setup this way for a reason, and that it was a very solid practice that has served the nation well.

When pressed on the stock market, she stated, “We’re operating under a cloud of uncertainty at the moment.” Her comments were an acknowledgement that the interpretation of the post-election surge in stock prices represented an expectation of lower corporate taxes, lower regulations, and an overall business friendly environment.  That's the popular interpretation of what we're seeing, however it's not an interpretation I share.  Rather, I believe we're seeing the natural market reaction to the resolution of uncertainty - i.e. the extremely contentious US presidential election - coupled with growing consumer confidence heading to the period of a traditional Santa Claus Rally.  In my view, the post-election surge we're seeing would have occurred regardless of the winner.  It's doubtful that there is this much movement based on the anticipation of what Congress will end up doing with taxes and regulations following at least a full year of debate. 

One factor that the market will weigh over the coming weeks is the impact of the new Fed projections for interest rate targets through 2018.  Both years are now tracking higher in projections than they were a day ago. The median projection for 2017 is now 1.375% (up from 1.155%) and 2018 saw a similar increase to 2.125%.  The target for 2019 is 3.00%. 

Interestingly, Ms. Yellen's opening statement made no mention of the global economic environment.  That comes as a bit of surprise on the heels of Mario Draghi's statements in last week's ECB announcement, coupled with the specter of the potential Article 50 Brexit invocation in the first half of 2017.  Her only mention of the historically low comparable price of oil was in the context of it being transitory: "As the transitory influences of earlier declines in energy prices and prices of imports continue to fade, and as the job market strengthens further, we expect overall inflation to rise to 2 percent over the next couple of years."

All three US major stock indexes retreated following Ms. Yellen's press conference.  We can expect to see a bit of volatility over the next few days as the market digests what FOMC has forecast for the coming year.  In addition, be ever mindful of the stock market truism, "buy the election; sell the inauguration."  Of course, volatility provides excellent short-term trading opportunities, so we'll be closely watching what develops as we head into the end of the year.

Happy Trading

Key Points to Watch in Wednesday's FOMC Announcement

As of today's market close, the 30-day Fed Funds Futures have factored in a 95.4% probability of a .25 bps increase in interest rates when the Federal Open Markets Committee (FOMC) releases their December announcement at 14:00 EST on Wednesday.  This would mark the first rate hike since December of last year, and it would raise the Fed Funds rate to a target range of 0.50% to 0.75%.  The market would then settle rates around 0.63%, up from the current 0.38%.  The equities market expects the rate increase and has largely included it in stock prices. 

The actual monetary policy move is of little substance, tomorrow.  What traders and investors will be watching is the tone of the monetary policy announcement coupled with the statements and responses Janet Yellen provides in the post-announcement press conference.  That tone and her responses may significantly move the market heading into tomorrow's close.  Here are some points that we are watching.

• Commentary regarding unemployment.  The most popular number watched by the press and typically referenced by Yellen is the U-3 number which currently sits at 4.6%.  We know that she will reference that number and will likely cite it as an indication that the nation is at "full employment."  In past conferences, however, she has also made passing reference to both the U-6 number (9.3%) and to the Civilian Labor Force Participation Rate (62.7%.)  Those numbers paint a less rosy picture of the employment situation and we'll be watching how Yellen presents either of them in her commentary.
• The next major number we expect the Fed Chair to reference is the Inflation number.  It currently sits at 1.64%, slightly below the Fed target of 2.0%.  Since changes to monetary policy typically take approximately 6-months to have and effect, it's no surprise that the Fed will move ahead of their target.  It's like turning an ocean liner - it takes time to get the behemoth pointing in the right direction.  What we will be watching, however, is her assessment on the rate at which she expects inflation to increase.  This will offer some guidance as to how quickly rates will be increased in 2017.
• We anticipate some commentary, at least in the press conference, regarding potential tax and regulatory changes from the incoming Congress and Administration.  A somewhat adversarial relationship is developing between the President-Elect and the Fed Chair, and the latter has expressed concern in recent weeks over the possible inflationary impact the theoretical domestic policy changes will have on our overall economy. How she references this and the tone she takes will provide more clues into how swiftly the Fed believes they must move in raising interest rates.
• Some reference to "global economic headwinds" will likely be made, and that will most likely occur in both the announcement and in the press conference.  What we will be watching is whether those headwinds are perceived to be holding steady, increasing, or decreasing.  She may put this in the perspective of Brexit as well as the recent ECB announcement.  In the past, the economic conditions in Europe have caused the Fed to take a more cautious approach domestically.  Any improvement in the Fed's perception of those conditions will potentially signal a more hawkish economic policy in the US.
• We must pay careful attention to the phrasing of certain terms.  Once we have the announcement in hand, we need to compare the exact wording with the prior announcement.  Dropping a single word in a phrase can signal a fundamental shift in outlook, so we will need to scrutinize any changes to prior announcement specific to the rate at which the economy is expected to grow.

Current market expectations are for two rate increases in 2017.  These will most likely come in June and December.  At least, that's what the Fed Funds Futures have currently factored into pricing.  From a trading perspective, that is what we are attempting to anticipate.  A more aggressive monetary policy may signal a potential rate increase in the February or March time-frame, and we'll see stocks react accordingly.  Given the current inflation and unemployment levels, it's highly unlikely that the Fed will signal a slower rate of increase, although that more aggressive posture is a distinct possibility.

The final major consideration is something that will not be referenced in tomorrow's announcement, however it's something the markets will have to factor into pricing over the course of the next month.  There are currently two vacancies on the Fed's Board.  These will be filled by the President-Elect, and he will have the ability to make those appointments immediately following his inauguration.  Given that he has already expressed displeasure with the dovish policies set forth by Yellen, it's almost a given that his two appointments will have a hawkish outlook.  Their presence on the board will increase the likelihood of a more rapid normalization of interest rates than we've experienced thus far.  Expect this to be factored into market pricing the closer we get to the inauguration.

Happy Trading.     

Evening Star Signals End of Wave 3 in BOFI

An evening star candle pattern developed over the last three days in BOFI Holdings, Inc. (Nasdaq: BOFI).  The highs of the pattern form a consistent resistance line, and the long wick in yesterday's candle signals short-term trouble ahead on the long side.

BOFI Daily Chart

The stock has been in a flat correction since it's 25 November 2015 4:1 stock split.  As with other financials, signs of life manifested in the post-election exuberance rally starting 9 November 2016, and a short 5-wave impulse appears to be underway.  This wave has taken out the highs of the post-split pattern, however it remains to be seen if this is a longer extended Wave 1 or if it will culminate in a Wave A top.  For the purposes of the swing trader, however, that's largely irrelevant in the short-term.

At least two classic Elliott Wave patterns have completed.  Wave 2 was a well-defined A-B-C flat correction, and from there we're either in the early stages of a Wave 3 or we've just completed Wave 3.  We don't yet know, although other indicators on the chart suggest Wave 3 is over and we're into Wave 4.

Resistance at the high of yesterday's candle appears significant, as does the higher than average volume we recorded on the long red candle that developed.  That pattern increases the significance of the doji star that completed the day before, and is a decidedly strong bearish reversal pattern.

The stock is currently trading at an extreme level above its 10, 20, and 30-day moving averages.  In fact, it's the furthest the stock has ventured from its moving averages on this entire chart. Reversion to the mean implies a retreat is imminent, at least back to the 10-day, although a retreat to the 20-day is more common.

The RSI(9) oscillator is drawing a bearish divergence, not only on the highs, but also on the lows.  While the stock was recording higher lows, the RSI was drawing lower lows.  Now, you'll find some traders that would also place credence in the double top pattern on the RSI.  Personally, I ignore chart patterns like that in the oscillators.  Patterns such as double tops, head and shoulders, trend-line breaks, etc. work on the price charts simply because traders set open and close orders at those levels and they become self-fulfilling prophecies.  That type of stop and limit order potential isn't present with the oscillators to any great degree - at least, not in an automated fashion - so, in my view, the appearance of patterns in oscillators is an interesting trick of the mind, but it's not a trade setup.

The exception to that is the concept of divergence.  The oscillators we use are showing the strength or weakness of trading behavior, so it is certainly significant when an oscillator is not matching the highs and lows being drawn by the stock price.  Divergence doesn't immediately result in a buy or sell order, but it does provide warning signs that a change in trend may be in the offing.

You'll notice that I'm also showing the Slow Stochastic (14,3) oscillator on this chart.  Again, the Slow Stochastic is showing us trend strength or weakness based on the theory that stocks tend to close near their daily highs in an uptrend and near their daily lows in a downtrend.  In this case, we see that the oscillator just crossed its signal line to the bearish side, and did so above the so-called "overbought" line of 80.  The concept of overbought and oversold in these oscillators is an unfortunate misnomer, but since that's the common term for the lines, I use them here.  What's important in this case, is that the crossover signals short-term weakness.  Nothing more.  In fact, you can see that the other two most recent crossovers above 80 were only one or two day moves.  I don't trade on oscillator signals alone, and I don't recommend anyone else do so, either.  They are simply additional data points in our overall analysis arsenal.

Returning to the chart, the key here is the evening star (bearish reversal) and the Elliott Wave count (signalling a potential Wave 4 correction.)  The probability here is a move to the downside.  I've highlighted the target area in green, and that's our short-term play.  Wave 4 should not penetrate the top of Wave 1, so once we hit that area we'll be looking for a bullish reversal and will attempt to play that move as well. Now, Wave 3 is shorter than Wave 1, so we know Wave 5 will be shorter than Wave 3.  (Wave 3 can't be the shortest of 1, 3, and 5.)

Be aware of external events that can impact the market, this week.  The December FOMC meeting is tomorrow, and the market widely expects the Fed to increase interest rates in their 14:00 EST announcement.  That's factored in, and it's part of the reason financial stocks have done so well for the last month.  Pay extremely close attention to both the announcement letter and Fed Chair Janet Yellen's post-announcement press conference, however.  The market, tomorrow, will move based on the forward guidance she sets.  We will be listening for any signal as to the number of rate hikes anticipated in 2017 as well as any statements around anticipated inflation levels and economic growth under the new Administration.  Tomorrow's is a press conference we as traders cannot ignore.  Be prepared for volatility in the closing hours, tomorrow.

Happy Trading.

Is the Dow Rally a New Impulse Wave or a Bull Trap?

The Dow Industrials average has been on a tear since November 7th, rising over 990 points in two-weeks.  The question we have to ask, though, is if we're seeing the start of a new bullish impulse wave or if this represents an end-of-year bull trap.  Let's look at the daily chart:

Dow Industrials Daily Chart

A short but very productive impulse wave started on February 11, 2016, and that wave pushed the market to a high on April 20th.  If we consider that Wave 1, then Wave 2 ran pretty much through the remainder of 2016.  It was a fairly flat consolidation that culminated with a very tight two-month congestion leading up to the US presidential elections.

The current impulse wave - which may very well be Wave 3 - started November 7, the day before the election.  From there, the market surged skyward, gaining 990 points in a week.  This flagpole formed the foundation for a classic pennant pattern that we appear to have broken yesterday.

Now, the rosy interpretation of this chart places a price target at 19,920 for that flagpole pattern, and it should be obtained relatively quickly - no more than a week or two.  Similarly, the target for Elliott Wave 3 is 20,500, and that lines up rather well if the flagpole target ends at a sub-wave consolidation before continuing to the peak. 

All of this is plausible, especially as we head into a period traditionally marked by a Santa Claus Rally.  That's when this could get a bit ugly, though.  The alternation rule states that Wave 2 and Wave 4 must differ in form and time.  Wave 2 was long and relatively flat.  Therefore, Wave 4 must be short and deep.  Expect a very sharp correction that takes out anywhere from 50% to 61.8% of the Wave 3 gains, and expect it to happen very quickly.  That's as much as a 1650 point drop before Wave 5 commences.


Are there other warning signs on the horizon?  Certainly.  The Dow just achieved an all-time high, but it did so on relatively low volume and with two consecutive narrow range bars.  This implies there really wasn't a lot of enthusiasm pushing the rally, and we may shortly see some climactic action as the large investment houses wind down for the holidays.  This rally would have been much more convincing if accompanied by high volume.

There are also a couple of major events on the horizon that could easily turn this rally into a bull trap.  First, it's a near certainty that FOMC will raise interest rates when they meet on December 14.  In fact, the futures market has priced in a 98.2% chance of a rate increase.  Fed Chair Janet Yellen has also signaled an intent to raise rates twice more in 2017 (data permitting, of course.)  So that would likely mean a June and December hike, and that's precisely what you see if you look at the futures market.

In the midst of this slight tightening of US monetary policy, the UK will be moving towards an Article 50 invocation.  Prime Minister May has targeted the end of March for that major milestone, although the UK courts have added a measure of doubt to the timetable.  Whenever it's done, however, it will certainly have a sobering impact on the EU and British markets.  The combination of Brexit and US interest rate hikes will certainly send shock waves through the world markets. 

So, what does all this mean for us as traders?  Well, that we are in a bullish impulse at the moment cannot be doubted.  We're going to continue playing the long side as long as that impulse remains in effect.  Now, Friday's an early close and will be ultra-low volume, so I'll be sitting that one out.  But once the market opens on Monday, my bias will be to the long side.  The closer we get to 19,500 and then 19,900, however, the tighter my stops will be, and the more I'll be watching for sub-wave 4.  That sub-wave and then the actual Wave 4 will be two that we will want to catch to the short side.  Both will be deep, but both will be short, so remain vigilant.  There won't be much of an opportunity to hop into those waves once they are in full swing.

For now, have a Happy Thanksgiving here in the States, enjoy a nice 4-day stretch away from trading, and let's see where the market decides to take us next week.

BoE Cuts Rates, Adds to QE

The UK's Monetary Policy Committee today announced their first interest rate cut in seven years, lowering the benchmark rate to a record low of 0.25%.  The rate cut came as no surprise to markets worldwide, and the MPC vote was 9-0 in favor of the cuts.  What did surprise some, however, was a £170 Billion stimulus that will be introduced via the purchase of Gilts (UK government backed bonds similar to US Treasury Bonds), the purchase of corporate bonds, and a new bank lending program.  That portion of the stimulus package was not expected to coincide with the interest rate cuts.

The FTSE responded positively to the news, finishing the day up 1.56% although the Pound dropped 1.5% versus the US Dollar and 1.3% versus the Euro.  US markets responded with a yawn, finishing the day flat.  The US 10-Year Treasury Yield, however, dropped 2.58% to 1.51.

BoE Governor Mark Carney sounded a pessimistic note in his presentation, stating, “We took these steps because the economic outlook has changed markedly.  Indicators have all fallen sharply, in most cases to levels last seen in the financial crisis, and in some cases to all-time lows."  That's a bit troubling, given the lengthy duration anticipated for the actual Brexit events to unfold.  With the benchmark rate now down to an extreme low, there is very little additional room for the BoE to maneuver should the British economy slow further.

Surprisingly, the MPC signaled the potential for a further rate cut, although Carney assured reporters that the central bank had no intention of bringing rates into negative territory.  That they would consider - and even signal - that rates could drop to near zero, however, indicates the level of concern the committee has over the economic prospects during the Brexit transition.

The fallout from the Brexit vote has manifested more slowly than critics had forecast, but - at least in the UK - it is starting to be felt.  Consumer Confidence is dropping dramatically, and the industrial outlook is starting to decline as well.  The forecast for the UK GDP is now down to 0.8% for 2017, and the Central Bank foresees a strong decline in corporate investment and in the housing markets.  The Pound's weakness is certainly hurting UK imports, and that is having a marked effect on growth potential over the next 18 months.  That import price pressure is expected to have an impact on inflation in 2017, with the central bank forecasting inflation to hit their 2% target in the fourth quarter of 2017 and exceed it throughout 2018.

What all this signals is a period of weakness, uncertainty, and potential market instability in the UK that will likely last through 2018.  With the ECB taking a bit of a "wait and see" attitude mingled with a healthy dose of skepticism a couple of weeks ago, the likelihood of continental fallout is extremely high.  US 10-Year Treasury yields have declined steadily since December, 2015, and are now sitting at the lows last seen in August, 2012.  That represents a significant flight to safety, and with US equities sitting near all-time highs, it's reasonable to conclude that the heavy demand on US treasury bonds is coming from overseas.

There is a limit to how long the US can remain immune to economic weakness in the UK and the EU.  The strong US dollar is having a severe impact on US exports, and that, in turn has a serious impact on US companies that are heavily exposed to Europe.  This is evident in the behavior of the S&P 500 where demand has fallen off over the past few weeks, and the market has gone essentially flat since it reached a record high in mid-July.  With GDP growth down dramatically in Europe, the UK, and the US, prospects for a global recession are mounting as we transition from a tumultuous US presidential election to the uncertainty of a prolonged Brexit negotiation and execution.

Earnings season in the US is almost over, and there is not another FOMC announcement before September 21.  So now we turn our attention to tomorrow's jobs report.  The pattern in the market right now is not encouraging, so the key economic reports over the next few business days may well set the tone for the remainder of August. 

Happy Trading

Showing Only 1.2% Growth, GDP Is Still Anemic

Is there truly an economic recovery in progress?  You'd never know it from the GDP which increased by a mere 1.2% in the quarter ending June 30th.  It continues a very sluggish trend that started in 2014 following what had looked to be a promising post-Great Recession recovery.

Quarterly GDP Growth 2012 to Present

Economists generally consider a range of 2.5% to 3.5% GDP growth to be healthy for the economy.  Lower than 2.5% and corporate profits suffer and with them, job growth also suffers.  Higher than 3.5% and the economy starts to experience inflationary pressures.  Now, that last point is significant in this case since we've been in an extended period of under-inflation.  The Fed mandate to maintain inflation at 2% needs a boost in GDP well above what we're currently experiencing before that target grows within reach.

Low inflation, in this case, translates to lower interest rates.  Following Friday's GDP report, the Fed Funds Futures market reacted sharply, reducing the probability of a September Fed interest rate hike to only 12%, and a December probability dropped to 30%.  As we discussed two days ago, interest rates will be depressed likely right through 2017.

Yesterday's announcement made mention of a slight increase in trade, saying it added about 0.2 percentage points to overall growth.  I've read some analysts point to that figure as evidence that the impact of the strong US dollar has stabilized, however I don't believe that to be the case.  Rather, what's driving the trade growth is a drop in US imports, not an increase in exports.  (Imports are subtracted from the figure, so if imports decline, it has a net positive effect on the trade number.)  Given the strength of the dollar, a reduction in imports is a very bearish signal, indicating a decrease in demand for materials and finished products.

Along those same lines, a major factor in yesterday's anemic announcement was continued reduction in inventory restocking by businesses in the US.  This is the fifth consecutive quarter in which inventory levels have dropped, and it's a further indication that there are strong downward pressures on consumer demand and on corporate sales.  Unlike analysts that are predicting a rapid end to that trend, I see just the opposite.  Until there is a healthy increase in the hourly wage statistics and a healthy increase in the Labor Force Participation Rate, I don't see any major driver for a change in inventory stocking behavior that would add anything of significance to the GDP.

When I consider the economic warnings hidden in the Schlumberger and Union Pacific earnings calls earlier this month, I begin to see a general underlying pattern of slowing growth, slowing demand for commodities and raw materials, and a potential crack in the expected rate of consumer spending over the second half of the year.  For that pattern to reverse, we need to see a weakening of the US Dollar, a dramatic reduction in the number of Americans that are out of work, and a return to a price of oil that provides healthy growth across a wide range of industries.  None of those appear to be on the short-term horizon, which leaves me pessimistic about future growth prospects in 2016 and into the first half of 2017.

FOMC Holds Rates Steady; Details Economic Progress

As expected yesterday, the US Federal Opens Market Committee (FOMC) held interest rates steady with the target range between 0.25% and 0.50%.  One sign of the weakening of the Fed's resolve at maintaining the status quo, however, came with Esther L. George's dissenting vote.  As noted in the formal announcement, the traditionally hawkish George preferred to increase the federal funds rate to 0.50% to 0.75%.  She was outvoted 9-1.

The language and tone of the announcement demonstrated a subtle shift towards a tightening policy, however. Respective to the Fed mandate of maintaining full employment, they said, "Information received since the Federal Open Market Committee met in June indicates that the labor market strengthened and that economic activity has been expanding at a moderate rate. Job gains were strong in June following weak growth in May."  

Given the very robust jobs report in June, that position is not surprising.  Indeed, the standard unemployment level has been sustained below 5% for several months, although it's equally important to note that over 94 million Americans are now unemployed - the highest number since the Labor Force Participation Rate has been maintained. 

If the job market were the only factor under consideration, there's little doubt that the Fed would be moving to raise interest rates.  The stumbling block continues to be inflation.  The all-items CPI for urban consumers is 1%.  The FOMC target, however, is 2%, and there's little indication that inflation will reach that target in the short term.  They acknowledged that yesterday, saying, "Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further." 

They did not define "medium term" in this context, however Janet Yellen defined it in 2009, saying, "From macroanalysis, I consider short term as referring to less than, say, a year or two, medium term as ranging from around two to six years, and long term as anything beyond around six."  Read into that what you will, since the ultimate question will be whether or not the Fed will raise interest rates before inflation reaches the 2% target.  If that target is not anticipated for at least another two years, then we've a long ways to go before we see any monetary tightening.

The June announcements were rife with caution, citing potentially permanent "headwinds" and some rather dire forecasts regarding the global economy. This month's announcement shows a complete reversal of those ominous undertones.  "Near-term risks to the economic outlook have diminished. The Committee continues to closely monitor inflation indicators and global economic and financial developments."

What they classified as "near-term risks" was not expounded upon, however it's reasonable to assume that they are referencing the unknown impacts of Brexit, a strong US dollar, and the prospect of recession in Europe.  While the Brexit impact is certainly moved out into the distant future - at least 2019 or beyond, even if the UK invokes Article 50 next year - and Europe appears to have inched ever so slightly away from recession, I find it hard to dismiss the impact the strong US dollar is having and will continue to have for the foreseeable future.  It's doubtful, however, that the dollar alone will be enough to stay the Fed's hand.

Interestingly, the markets appeared to treat the FOMC release with a yawn.  The Nasdaq Composite was up both yesterday and today, and the S&P 500, while down a hair yesterday, recovered it today to continue it's horizontal correction without giving or gaining any ground. 

Equally interesting, the Fed Fund Futures still show only an 18% chance of a rate hike in September, and the chance of a December hike dropped to 36.8%.  In fact, you have to go all the way out to June 2017 before the chance of an increase even reaches 40%.  Clearly, the market is factoring in very low interest rates for at least the next year.  The 10-year Treasury Yield is still declining, dropping to 1.52% today, which would be another possible indication that rates will continue low for some time.  (It's also a further indication of a flight to safety, which is a warning of potentially troubled times ahead in the equities markets.)

The Fed summed up a very dovish posture once again, stating, "The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run."  That view, however, is not consistent with the "dot plot," an estimation of where FOMC members view interest rates over the next several years.  A solid base of participants forecast one additional rate hike in 2016, however the strongest dot concentration shows two rate hikes, presumably in September and December with the average rate falling between 0.75% and 1% by year end.

The next FOMC meeting is September 21st, so we have almost 8-weeks before the next rate decision is expected.  A lot can happen in 8-weeks, and there will be two more major economic data points available to the Fed before that decision is warranted.  What we as traders need to watch, however, is the potential for good economic news to become bad for the market.  A very strong jobs report, or a healthy uptick in inflation could signal that there is a greater potential for a September rate hike.  That would send stocks tumbling once again, hence the good news is bad phenomenon.  Exercise caution around major data releases since the reaction will be somewhat unpredictable for the time being.

With regards to monetary policy, we now turn our attention to the Bank of England and next Thursday's Monetary Policy Committee announcement.  Stay tuned.

Happy Trading.

ECB Holds Rates Steady; Leaves Door Open for Stimulus Later This Year

The European Central Bank announced this morning that they were holding rates steady, meeting market and analyst expectations for their July meeting.  The main refinancing rate remains at 0%, the deposit rate is steady at minus 0.4%, the marginal lending facility rate at 0.25% and the ECB held their Quantitative Easing position at a monthly €80 Billion.  None of this came as a surprise to world markets which have thus far stabilized since the surprising Brexit vote in June.

Caution was the order of the day as the Central Bank adopted a "wait and see" attitude, postponing any decisions until their September 8th meeting.  There's growing speculation that an increase in Quantitative Easing could be announced then, however in his post-announcement speech Mario Draghi stated, "We confirm that the monthly asset purchases of 80 billion euros are intended to run until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim." 

Haven't we heard that before?  It sounds very similar to the tune sung by the US Federal Open Markets Committee throughout the final year of QE3 here in the States. Essentially, yes they have an end-date, yes there's a fixed amount planned into the process, but oh by the way, that end date will ultimately be data dependent based upon the prospects for normalized inflation, defined both in Europe and in the US as 2%.  With the current rate of inflation in the Eurozone sitting at 0.1% following a year of deflation, that March 2017 target looks like a pipe-dream.

Draghi briefly addressed Brexit in his speech, saying "All we can say is that it is a risk that has materialized and it is a downside risk." This, too, is inline with the wait-and-see attitude that permeated the speech, and it's consistent with the approach being taken in the UK and US.  With the pending start of UK separation delayed until some time in 2017, fears of immediate turmoil have abated and none of the Central Banks are eager to take any action that might upset the tentative stability world economies have experienced over the last 3 weeks.  The word from all of them is that additional data is needed before any action (if action is warranted) can be considered.

With no major policy changes coming out of the ECB this month, the focus will now shift to Janet Yellen and the FOMC announcement on July 27th.  As with the ECB, no policy changes are anticipated in the US either, although the robust reaction of the stock market this month, combined with good corporate earnings and relatively good economic data have analysts anticipating a softening of the extreme dovish tone in their guidance on interest rates.  At this point, the market has factored in a 19.5% probability of a rate hike on September 21, up from 12% a week ago.  A December 14th rate hike probability has jumped to 40%, up from 30% last week.  It will be interesting to check these numbers following Yellen's announcement next week.

For now, it looks like the remainder of the summer will be uneventful from a Central Bank perspective.  That leaves only earnings and economic data to drive the markets, and both have been trending positive for much of July.

Happy Trading.

Bank of England Holds Rates Steady; Signals August Stimulus

Despite market estimates of an 80% chance for a rate cut today, the Bank of England held rates steady at 0.5%.  With new Prime Minister Theresa May signaling a slow and cautious path towards Brexit and also signaling an invocation of Article 50 no earlier than 2017, the central bank's delay in lowering interest rates makes sense. 

Only 2 1/2 weeks have passed since the Brexit vote, and that is an insufficient amount of time to gather enough data to make an informed projection on the economic climate for the next six to twelve months.  The MPC (Monetary Policy Committee) next meets on August 4th, giving them additional time to gauge the reaction and potential impact.

Additionally, despite the immediate reaction worldwide on June 24 and 27, markets in the UK and around the world have since stabilized and, in fact, rebounded significantly.  In the Forex market, the British Pound did indeed take a significant hit against both the Euro and the US Dollar, however the currencies have since stabilized albeit at the lower levels experienced immediately following the vote.

Given the slight trade imbalance the UK currently experiences, that overall drop in the Pound is actually very good for their exports.  It provides an immediate boost to UK-based corporations and, in that context, is a nice stimulus without the Central Bank taking any actions at all.  Coupled with that, initial fears that companies would seek to relocate out of the UK have since abated.  To that point, JP Morgan Chase CEO Jamie Dimon specified in today's earnings call that he had no intention of leaving the UK despite rumors to that effect on June 24th.  Following the initial shock of the vote, we now see other companies taking a step away from the ledge, realizing that the new dynamic offers tremendous opportunity, not peril.

What the Bank of England has done by standing pat is afforded themselves some options later in the year should the British economy weaken to the point where a stimulus in the form of a rate cut becomes necessary.  Lowering that key rate today would have left the Central Bank with no room left to move as the UK approaches what will certainly be a period of uncertainty after they invoke Article 50.  Remember, the BoE already provided a significant stimulus on July 5th when they eased capital requirements for commercial banks, effectively providing a £150 Billion short-term stimulus.

The change in capital requirements on 5 July was seen as a direct attempt to prevent a repeat of the 2008 crisis in which banks ceased lending.  Whether or not that move is sufficient only time will tell, however as of today the signal is that the MPC is thus far satisfied with the short-term results.

Today's decision underscores a strengthening in the overall financial stability of the UK and stands in stark contrast to some dire warnings issued by Governor of the Bank of England Mark Carney just a week ago: “The number of vulnerable households could increase due to a tougher economic outlook and a potential tightening of credit conditions. In particular there is growing evidence that uncertainty about the referendum has delayed major economic decisions, such as business investment, construction and housing market activity.  The UK has entered a period of uncertainty and significant economic adjustment."  The wording is particularly harsh coming from such a prominent member.

There's no word as to what measures the Committee are considering in August, however according to officials there was significant discussion of it in today's meeting: “Most members of the committee expect monetary policy to be loosened in August.  The committee discussed various easing options and combinations thereof. The exact extent of any additional stimulus measures will be based on the committee’s updated forecast, and their composition will take account of any interactions with the financial system.”

The August 4th meeting comes only a week after the US Federal Opens Markets Committee (FOMC) meets.  Fed Chair Janet Yellen typically addresses the economic environment in Europe and the UK in her post-meeting announcement, so it will be worth listening to that release for clues as to any action the Bank of England may feel necessary.  Given the interrelationships between the various central banks and the global impact each of their decisions have, it would be a mistake to focus only on the MPC for guidance as to what the future economic environment may entail.

Also of interest is the next European Central Bank (ECB) meeting, scheduled for 21 July.  Again, listening to Mario Draghi's perspective will add further insight.  It's likely that, between the ECB and FOMC, we should have a fair idea of the direction the Bank of England may take on August 4th.

Happy Trading.

Fed Continues to Signal Patience on Interest Rates

Two of the Federal Reserve presidents that sit on the Federal Open Markets Committee (FOMC) had appearances scheduled this morning.  These one-off speeches are followed by traders, however it's important to bear in mind that they represent the views of the individual voting (or non-voting, in some cases) member and do not represent the FOMC as a whole.  What's more important is following any change in tone respective to the individual.

Dallas Fed President Robert Kaplan confirmed what was reported a couple of days ago related to growth, and said he expects the GDP to continue in the 2% range for the year.  He expressed the view that this growth rate is very slow, and considers boosting growth to be the most important economic issue we are currently facing.  Without going into details, he said that doing so would require some structural changes that are outside of the mandate afforded the Federal Reserve.  That would appear to be a not-so-veiled nudge to Congress related to trade and growth stimuli.

Providing a brief glimpse into the thinking of FOMC as a whole, Kaplan also stated that the Federal Reserve is "very sensitive" to the strength of the US Dollar.  Indeed, this one statement is the best signal we have that interest rates will remain low for the foreseeable future since any rise in rates would further strengthen the dollar to the detriment of US exports and to the earnings of US companies with heavy overseas exposure.  Until the entire Brexit issue is resolved and we start to understand the new dynamic in Europe, it's unlikely that the US dollar will weaken.

Meanwhile, Minneapolis Fed President Neel Kashkari spoke at a Town Hall meeting in Marquette, Michigan.  He directly addressed interest rates, saying, "We feel like we can be patient to let the economy continue to heal before we start moving aggressively to raise rates. We should take our time when we go ahead and start raising rates again. There's not a huge urgency to raise rates because inflation is coming up low."

His wording suggests that he's expressing the views of FOMC, not just his own, and it's consistent with what we've been hearing from the other Fed Presidents over the last couple of weeks.  It's interesting to note Kashkari's focus on inflation, compared to Kaplan's focus on the strength of the dollar.  By definition, a monetary "Hawk" is primarily interested in maintaining inflation at the Fed's mandated 2% target.  A "Dove" by contrast, is focused primarily on unemployment (and other non-inflationary factors) with an interest in maintaining unemployment under 5%.

Kashkari is a newcomer to FOMC, replacing the extremely dovish Narayana Kocherlakota in November, 2015. It's important to note that Minneapolis (and thus, Kashkari) will not be a FOMC voting member until 2017.  Still, hearing Kashkari take a hawkish position focused on inflation gives us some insight into where he will fall in the economic spectrum next year.  (The categorizations of hawks favoring interest rate hikes and doves favoring holding rates low are not accurate categorizations of the terms.)

While Kashkari is currently siding with the doves regarding keeping interest rates low, he also stated that he sees moderate growth ahead.  Whether that's above the 2% cited by Kaplan is unknown, but few would consider that level to be "moderate growth."  He made it a point of saying that he does not foresee a recession and does not believe the Fed will have to ease monetary policy.  (Following the dismal job numbers from May and a decline in the GDP in that period, there was some discussion of lowering interest rates or even introducing a new round of Qualitative Easing, although the June numbers have pushed those thoughts to the background again.  Kashkari clearly rejects the notion of either.)

FOMC holds their next meeting the 26th and 27th of July, with their next announcement scheduled for 2:00 PM on the 27th.  The futures market shows a 0% chance of an interest rate hike in either July or August, and only a 12% chance of a rate hike in either September, October, or November.  The odds of a rate hike jump to 30% in December, however that's more of an indication that anything can happen over the next five months.  We now have some analysts projecting the next rate hike as late as June, 2017.

For short-term traders, it does mean that we will not have artificial volatility over the next couple of months based on interest rate speculation.  It also means that dividend players will have very limited exposure going into 2017.  (Remember, higher interest rates put selling pressure on lower-yield stocks.)  We'll be interested in the FOMC release more as a gauge of what pressures the Fed sees over the next quarter both here and abroad, however at least in the July meeting we don't anticipate any signal that interest rate talk will heat up any time soon.