Market Outlook | June 16, 2014

“The more efficient a force is, the more silent and the more subtle it is.” (Mahatma Gandhi 1869-1948)

Curious timing

As soon as the World Cup started at 4 pm New York time, or when the market closed on Thursday (June 12), there was a market event that stood out. The Bank of England announced that rate hikes might come sooner than widely expected. The timing of the announcement and the timing of the first rate hikes are both mysterious (perhaps Friday’s full moon is one answer). A warning or a prelude? To be determined. The rapid response in the form of a rising Euro affected the mindsets of the foreign exchange participants. Interestingly, a week before, the ECB negative rate action triggered some “dovish” responses, and now the rate hike speculation game lives on, with a little added twist. Similar questions will face the Federal Reserve – certainly there are questions to ponder, from “taper” talk to an unconvincing recovery painted as a success. In coming weeks, this talk of interest rates should dominate the financial punditry.
Here is one example to set the stage for the week.

“Although the Governor [Mark Carney] is still talking about a very gradual rise in UK rates, he appeared to have changed the dovish tone of the forward guidance given by the BoE last year. This has made investors nervous, with many asking whether Fed Chair Janet Yellen may do the same in her press conference on Wednesday. This seems unlikely, because the US economic recovery is still lagging that in the UK. Nevertheless, the parameters within which investors view forward guidance, including the Fed’s ‘dots’ showing the future path for interest rates, may have been somewhat shaken.” (Financial Times, June 15, 2014)

The synchronized global low rate might have the ECB going one way, the Bank of England potentially hiking, the US pondering its next move and Japan still offering the lowest of all yields. Thus, currency markets should provide the first clue and then risk should be reassessed.

Fighting urges

For the market, it has been mainly a one-sided action, where curious and skeptical minds were mocked or lost an audience when the melt-up persisted to endless unchartered territories. Frankly, it all comes down to “don’t fight the Fed,” or any central bank, for that matter. It is the human urge to ride out confidence to the maximum and only natural for novice participants not to walk away while pesky veterans have voiced their displeasure of the risk-reward setup. It’s not pleasant to desperately chase returns and not wise to overpay again and again by assuming history repeats itself. But again, this is normal, and it surely makes markets.

Complacency had been rampant even before the start of the week. Sure, oil price pressures from macro events had been brewing before and are always a possibility. Sure, pullbacks from record multi-year highs do lead to an inevitable price retreat. Of course, the very low volatility and very low 10 year treasury yields were poised for some reversals. Massive moves aside, even a minor price recalibration from extreme ranges was to be expected. The hubris of pundits picked up during the close two Fridays ago (June 6), when the S&P 500 finished on a strong note, with volatility collapsing to new annual lows then. Entering last week, any professional with a mindset of buying shares of large companies, must have at a minimum questioned the odds of further upside gains. Now catalysts are brewing. At the same time, temptations to ride this proven wave are growing, too. But to claim there are no hints of a crisis looming is naïve or an incomplete observation.

The narrative

In the last twelve months, several catalysts have failed to bring down US stock indexes (and emerging markets in 2014, as well): the government shutdown last fall, not-so-impressive earnings results, weakness of smaller cap stock prices, debacle in foreign policy including Ukraine, near-zero headlines GDP, and other worrisome issues. One had to wonder: Why not? One clear answer is in the narrative of the Federal Reserve: the mastery of forcing risk-taking by low interest rate policies, which rewarded those who bet on stocks, which in turn led to very low volatility. Shaking up these dynamics could stem only, it seems, from changes to the Fed narrative. If all real economy and real macro, tangible issues were ignored before, then simple interest rate policies are the driver of investor mindset. “In Fed they do trust” is not a bad statement to explain this bullish cycle. So waiting for Yellen's subtle or direct signal is too vital to other market-moving forces. Dismissing the message of the conductors of the so-called financial orchestra has been deadly for money managers. Thus, the simple narrative that has produced record highs may have a slight tweak, which all must digest.

Article Quotes:

“China is working on plans to launch its own crude oil futures contracts, in a move that could give it a key role in global oil pricing and create a rival to the London and US benchmarks that have dominated the industry for more than three decades. The Shanghai Futures Exchange is planning to extend a pilot programme for crude oil futures that it expects will be the first step in the internationalisation of its Shanghai International Energy Exchange. The country’s leading commodities bourse, which operates in Shanghai’s new Free Trade Zone, was granted regulatory approval by the CSRC last November. As the fifth-largest petroleum producing country in the world and the second-largest consumer, China produced 208m tons of crude oil in 2013 and imported a further 282m tons. But lacking a domestic crude oil futures market, import prices primarily refer to those of the New York Mercantile Exchange’s WTI and the InterContinental Exchange’s Brent crude oil contracts. … The exchange is the latest in a line of Asian firms seeking to align a rising share of consumption with greater influence over global oil prices. Japan, India and the United Arab Emirates have already launched crude oil futures, while the Chicago Mercantile Exchange has taken a stake in the Dubai Mercantile Exchange and the International Securities Exchange recently purchased the Singapore Commodity Exchange.” (IFR June 13, 2014)

“Since China joined the World Trade Organization (WTO) in December 2001, food price fluctuations in China started to be strongly correlated with those in the U.S. Between 1994 and 2001, the correlation was 40 percent. It was 62 percent between 2002 and 2013. Similarly, the correlation between consumer price index (CPI) inflation in the U.S. and China more than doubled from 23 percent between 1994 and 2001 to 59 percent between 2002 and 2013. This pattern of price correlations is interesting because food prices are an important component in the CPI. There are several possible explanations for why the correlations between food prices and between CPI inflation rates in both countries are so strong. The movement of world food prices (and other commodity prices) seems likely to be a reason, since China’s food prices are strongly correlated with world food prices (80 percent correlation between 2002 and 2013). However, the correlation between U.S. food prices and world food prices was not as strong during the same period (34 percent).” (St. Louis Fed, June 9, 2014)

Levels: (Prices as of close June 13, 2014)

S&P 500 Index [1936.16] – June 9 highs stand as the next record-high benchmark at 1955.55, following a 7% or so run since April 11. Above 1900 suggests a comfort zone for bulls. A move below 1800 could spark the first signs of panic, but for now, that’s not on the radar.

Crude (Spot) [$106.91] – Explosive upside move attributed to Iraq-related crisis. Interestingly, for weeks, a catalyst was deeply needed between $100-104. August 2013 highs of $112 may be tested if there is a further market reaction.

Gold [$1265.75] – Stuck. Attempting to regain some momentum around $1250-1300. A bottoming process is developing, and drivers for an upside move are unclear to participants.

DXY – US Dollar Index [80.36] – For more than nine months, no major movement, suggesting the dominance of the status-quo view on interest rates and risk. Unenthused and unconvincing moves for those seeking trend reversal.

US 10 Year Treasury Yields [2.60%] – In the last 12 months, the 10 year yield bottomed around 2.50% twice, and now potentially the third time. A familiar place for near-term observers, which may argue for more upside closer to the 2.70-2.80% range.





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