Market Outlook | July 28, 2014

“Truth indeed rather alleviates than hurts, and will always bear up against falsehood, as oil does above water.” Miguel de Cervantes (1547 - 1616)

Massive Anticipation

The upcoming week may provide clarity on numerous fronts ranging from key economic data to corporate earnings. Much anticipation awaits as record highs have been achieved numerous times by US stock market. At the same time, improvement is expected in the economic data despite weak first quarter GDP. Monthly labor numbers as usual are set to cause a knee-jerk reaction. Meanwhile, the Federal Reserve interest rate decision will draw a large global audience hoping for a different message, hint or tweak. A rising stock market has not told the full story of real economic concerns, but now the perception of improving conditions is picking up momentum. Perception or not, skepticism is plenty and there is no shortage of doubters who have been proven wrong on a call of massive collapse. Extreme views aside, over 800 companies plan to share their quarterly earnings report as sustainability of future growth becomes scrutinized. It is fair to assume that any guidance or hints of future earnings growth will have a suspenseful and sensitive crowd looking to react via buying or selling shares. In a way, stakes are much higher today given the resounding bull market that has taken new highs, this has surprised plenty.

Status-quo Revisited

First, the Fed has preached that the economy is improving. Secondly, the bond market has suggested that economic growth in not impressive as 10-year yields have failed to reach above 3%. Thirdly, the stock market is rosy and powerful while humming to two themes: 1) The lack of options in low rate environment makes US stocks relatively attractive. 2) The combination of cost-cutting and share buy-back (reduction of shares available for purchase) leads to high stock prices. Cost-cutting is not quite organic growth nor is it a symbol of robust economic strength. Finally, a Fed driven rally reduces the fear displayed by the volatility index.

At the same time, the power of the Federal Reserve is in full display; the global engine for driving markets and doubters has not been rewarded. Now, the Fed expects further optimism, not in sentiment or share prices but, in real economy data. Perhaps, if anticipations are too high then disappointments are building up this week where an abundance of data points will be digested, however a new midsummer script awaits for the overall sentiment.

Mounting Catalysts

Foreign events related to Eurozone economy, Middle East power struggle, commodity supply-demand dynamics and sentiment to globalization ahead have all shown signs of being shaky. Despite the very low volatility that has soothed market observers, the pundits on the foreign policy side have witnessed more turbulence in foreign relations highlighted by Ukraine and Russia. Emerging market decline from 2013 still lingers as the Developed Markets Rally is stretching its surprising momentum. Many have wondered, how can financial markets ignore these uncertain behaviors and tensions? Or at least, for how long can key macro events be ignored? Maybe at some point these day-to-day market events become catalysts of noteworthy proportion.

At the end of the day, interest rates and currency reactions may set the tone rather than mild or massive wars that may potentially stir up. The U.S. dollar has shown strength last month; interest rates have appeared to bottom out. And if the U.S. economy improves then both indicators are set to make a statement. Importantly, both the dollar and interest rates should provide the needed tools to unlock the “game-changing” catalysts that are highly sought after. Yet, any disappointment in economic growth is set to stagger the hopeful who have bought into the stronger second half of this year. If earnings do not create some temporary view of positive results then the sentiment could shatter even if the status-quo suggests calmness and the continuation of rising share prices.

In short, the watershed week ahead will spit out tons of data points. Connecting the results and drumming up a new script will be left up to the Fed. But there is not much room for error (or disappointments) to defend the status-quo of low rates, low volatility and higher share prices. The Fed is expected to convince the market that the plan is progressing as desired. The crowd thus far has been rewarded in trusting the Fed, but the old script might be close to worn out. All-time highs and record–highs are equally losing their luster especially without a strong substance to explain the present and future conditions.

Article Quotes

“Bullard then discussed how close the FOMC’s monetary policy settings are to normal. In response to the financial crisis, the FOMC lowered the policy rate to zero and implemented outright asset purchases. While the FOMC began tapering the pace of asset purchases in January 2014, Bullard noted that the two main policy actions have not been reversed so far. That is, the Fed balance sheet is still large and increasing, and the policy rate remains at the zero lower bound. Bullard measured the distance of the monetary policy stance from normal using a simple function that depends on the distance of the policy rate from its normal level and on the distance of the size of the Fed balance sheet relative to GDP from its long-run average. This version puts equal weight on the policy rate and the balance sheet, he noted. In these calculations, the normal level of the policy rate was set at 5.5 percent, the average value of the federal funds rate from January 1975 to March 2014. The long-run average size of the Fed balance sheet as a percent of GDP was set at 7.4 percent, the average value over the same period. “Currently, the function measuring the distance of the policy stance from normal shows a high value, far from pre-crisis levels,” he said. Thus, there is a mismatch. “The macroeconomic goals of the Committee are close to being met. However, the policy settings of the Committee are far from normal,” Bullard said. “While this mismatch is not causing macroeconomic problems today, it takes a long time to normalize policy and the mismatch may cause problems in the years ahead as the economy continues to expand.” (Federal Reserve of St Louis, July 17, 2014)

“We argue here – building on discussions we began during the World Economic Forum Summit on the Global Agenda 2013 – that the rise in global financial-market integration implies an even broader set of drivers of the future roles of international currencies. In particular, we maintain that the set of drivers should include the institutional and regulatory frameworks for financial stability. The emphasis on financial stability is linked with the expanded awareness of governments and international investors of the importance of safety and liquidity of related reserve assets. For a currency to have international reserve status, the related assets must be useable with minimal transaction-price impact, and have relatively stable values in times of stress. If the risk of banking stress or failures is substantial, and the potential fiscal consequences are sizeable, the safety of sovereign assets is compromised exactly at times of financial stress, through the contingent fiscal liabilities related to systemic banking crises. Monies with reserve-currency status therefore need to be ones with low probabilities of twin sovereign and financial crises. Financial stability reforms can – alongside fiscal prudence – help protect the safety and liquidity of sovereign assets, and can hence play a crucial role for reserve-currency status…International capital flows yield many advantages to home and host countries alike. Yet the international monetary system still faces potential challenges stemming from unanticipated volatility in flows, as well as occasionally disruptive spillovers of shocks in centre-country funding conditions to the periphery. With the events around the collapse of Lehman Brothers, disruption in dollar-denominated wholesale funding markets led to retrenchment of international lending activities.” (VOX, July 26, 2014)

Levels: (Prices as of close July 25, 2014)

S&P 500 Index [1978.22] – As all-time highs are only few points removed, traders will ask if the 1980 level is a hurdle for days ahead.

Crude (Spot) [$102.09] – Mainly stuck between $102-104 range. Attempting to stabilize after a strong sell-off in June.

Gold [$1,292.75] – Buyers momentum faded around $1320. Trades closely will watch the action near the 50 and 200 day moving averages. Perhaps, another drop may suggest that $1340 on July 11th is a short-lived rally.

DXY – US Dollar Index [81.02] – The month of July has seen a stronger dollar. From 79.74 to 81.02 may not seem like a big move. However, for this currency index it is quite noteworthy upside move.

US 10 Year Treasury Yields [2.46%] – Last seven trading days have demonstrated that yields are not fragile enough to go below 2.43-2.40% ranges. Perhaps, a bottoming process in anticipation of



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