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Bonds and Currencies Brace for BoE and Fed Rate Hikes

Gary Dorsch
Editor Global Money Trends magazine

Posted Jul 22, 2015

It’s approaching that time of year when traders and central bankers alike depart for long holidays. But this summer is shaping up to be anything but quiet for markets, with betting on a “Greek Exit” from the Euro roiling markets, and Red-chip stocks in China nose diving and requiring unprecedented “Plunge Protection Team” intervention in order to halt the onslaught. After a few weeks of turmoil, the Greek debt crisis has been kicked down the road for another few years, with another EU bailout, and after the Shanghai red-chip index, staged a +10% rebound from its panic bottom lows hit on July 7th, traders now regard these sideshows as “fixed” and under the control of their central planners. With these worries can be put on the back burner for now, it’s back to business as usual, - that is to say, back to investing in heavily manipulated markets, in which extreme emergency policies, such as NIRP, ZIRP, and QE have distorted the pricing of virtually all assets, and where your local central bank has your back.

However, with the Federal Reserve poised to hike short-term interest rates for the first time in nearly a decade, “The actual raising of policy rates could trigger further bouts of volatility, but my best estimate is that the normalization of our policy should prove manageable,” said the Fed’s “Shadow” chief Stanley on May 26th. Fischer gave no time frame for when the Fed will start its first tightening cycle since 2004-06, but he made it clear that higher rates are coming. Still, he warns, communications can be a "tricky business,” and when the Fed does tighten, policymakers are bracing for spillovers to financial markets both at home and abroad. “Some of the world’s more vulnerable economies may find the road to normalization somewhat bumpier,” he added.

The key question hanging over the markets, in general, is whether the Federal Reserve and its Anglo sidekick, the Bank of England <BoE>, will finally begin to hike their short-term interest rates in the months ahead. On June 28th, the Bank for International Settlements, <BIS>, based in Basel, Switzerland, which is an adviser for global central banks, called on the world’s top central banks to start normalizing monetary policy, - either by raising interest rates, or shutting down the printing presses under the guise of “Quantitative Easing,” <QE>, and the sooner the better.

“By keeping rates anchored at these historic, ultra-low levels threatens to inflict serious damage on the financial system and exacerbate market volatility, as well as limiting policymakers’ response to the next recession when it comes,” the BIS warned. “Risk-taking in financial markets has gone on for too long. And the illusion that markets will remain highly liquid has been too pervasive. The likelihood of turbulence will increase further if current extraordinary conditions are spun out. The more one stretches an elastic band, the more violently it snaps back,” (like the recent experience in the Chinese stock markets), warned Claudio Borio, head of the BIS's Monetary and Economic Department.

“Cheap money encourages more debt and creates financial booms and busts that leave lasting scars on the economy. They underpin both the potentially harmful high risk-taking in financial markets, while subduing risk-taking in the real economy, where investment is badly needed. And while increases in interest rates could cause stock prices to fall, - the likelihood of turmoil is only increased by waiting,” the BIS warned. It advises that monetary policy should be normalized with a firm and steady hand. “Near-zero interest rates could become chronic in the world’s major economies unless “a firm hand is used to raise them back to more normal levels.” “More weight should now be attached to the risks of normalizing too late, and too gradually,” the BIS warned. “Restoring more normal conditions will also be essential for facing the next recession, which will no doubt materialize at some point. Of what use is a gun with no bullets left?” the BIS report said.

However, the BIS has routinely made such dire warnings over the past few years, and the major central banks have routinely ignored them. In fact, the Bank of Japan <BoJ> and the European Central Bank <ECB>, are engaged in a full blown currency war over the fate of the Euro /yen exchange rate. Both central banks are printing about $70-billion worth of Euros and yen, and flooding the markets with ultra-cheap liquidity, that is keeping long-term bond yields artificially low, and stock markets artificially high. Neither the BoJ nor the ECB have any plan to roll back the QE-liquidity injections, anytime soon.

US$ wins the Reverse beauty Contest; Moreover, the monetary policies of the big-4 central banks will soon be moving further out of sync. The Fed began to taper its $80-billion per month QE-3 injections back in January 2014, and finally mothballed it on October 31st, 2014. The Bank of England spent £375 billion on purchasing British Gilts and mothballed its QE-injections in Nov 12. And according to recent leaks to the media, both the BoE and the Fed are preparing to follow the advice of the BIS, and will be the first of the G-7 central banks to hike their short term interest rates, in the months ahead.

On the other hand, the global markets will be swimming in a sea of liquidity, as the Bank of Japan <BoJ> and the European Central Bank <ECB> have both reaffirmed this week, that they will continue injecting a combined $140-billion worth of Euros and yen into the world’s money markets in the year ahead. The BoJ is continuing its QQE injections at a rate of ¥6.5-trillion per month, and the ECB is continuing with its first ever QE-1 scheme at a clip of €60-billion per month until the end of Sept ‘16, despite opposition from Germany’s Bundesbank. Together with funneling cheap 4-year, loans to banks, the ECB’s Q€-1 scheme will inject more than €1.1-trillion into the money markets. Currency Carry traders’ eyes are fixated on ECB chief Mario Draghi and the BoJ chief Haruhiko Kuroda who carry around the big bazooka.

A weaker Euro, and a weaker Japanese yen, is precisely what ECB chief Mario Draghi and BoJ chief Haruhiko Kuroda want. It makes local exports to other currency areas cheaper, thereby increasing the competitiveness of German, French, and Japanese Multi-Nationals. At the same time, it increases the price of imports, thus, reducing the threat of deflation at home. If the Euro and yen hadn’t declined so dramatically in the past year, their cost per liter of diesel would be -20% less than it is today.

Thus, with full blown QE-schemes underway in the Euro-zone and Japan, and the BoE and the Fed having kicked the QE-addiction, -- the net result was a sharp increase in the value of the US$ index, measured against a basket of six currencies, climbing +20% higher from a year ago, and at one point reaching the psychological 100-level, its highest in 13-years. Behind the rise, the US$ rose from around ¥101.50 to as high as ¥125.50, while the Euro fell from as high as $1.3650 to as low as $1.0400. With the #1 and #2 Fed officials going on record, and hinting they will comply with the wishes of the BIS, with a few baby-step rate hikes in the months ahead, the US$ index is comfortably perched in the zone with support at the 94-level and resistance at the 100-area. Meanwhile, 1- British pound now buys €1.434 – it’s highest exchange rate in 7-½ years. That is +24% more than the €1.1350 the pound could fetch this time two years ago. If the ECB ends up maintaining its QE program thru Sept ‘16’s scheduled end, the upside target for the pound could be €1.50.

Stronger US$ crushes Commodities; While the US$ was displaying extraordinary strength, and reaching for the 100-level, most of the commodities traded on international exchanges were taking a beating: precious metals, industrial metals, grains, softs, you name it, -were hard hit. In large part, this was a case of a stronger US$ steamrolling the commodity markets. And it was also a matter of oversupply of crude oil due to record US-shale oil production, and a significant slowdown in China’s economy. After almost a decade of growing at about +10% / year, the Chinese economy has slowed to +7% per year according to official statistics, and many private economists estimate China’s economic growth rate has slowed to +5% to +6% annually, the slowest rate recorded since 1990.

China literally props up demand for most of the raw materials that are shipped across the high seas, but especially iron ore, coking and thermal coal, natural rubber, steel and copper, which defined the boom years that were known as the “commodity super-cycle”. Across the board, from industrial metals, natural gas, grains, through to cotton, sugar, and crude oil, prices fell sharply. At its nadir, in March ’15 the Continuous Commodity Index, a basket of 17-equally weighted commodities, nearly fell to the 400-level, and was trading -27% lower compared with a year earlier.

At various times during Q’1 of 2015, the price of Gold had fallen to as low as $1,140 /oz, and was trading -15% lower compared with a year earlier, Silver was down -27%, Copper was off -27% and Iron ore plunged to a 5-year low at $47 /ton, and -60% lower than a year earlier. Few were hit as hard as crude oil prices, with North Sea Brent skidding to as low as $46 /barrel, or -56% lower than a year earlier. The pain was felt across other commodity sectors. Coffee fell to as low as $1.28 /pound, or -33% lower, and Sugar got slammed to $12 /pound, or -36% lower than a year earlier. Corn fell to $3.70 /bushel, or -24% lower, and Soybeans fell below $10 /bushel, or -30% lower than a year earlier. But that was only part of the story. Losses were even bigger when including the total decline most of these classes of commodities suffered from their peaks, generally reached in the spring of 2011.

In turn, the 4-year Bear slide across the commodity sector, especially the Crash in Crude Oil, was noticed by traders in the longer-term bond markets. The yield on the US Treasury’s benchmark 10-year T-note fell to below 2%, and hit low at 1.65% on the last day of January. Britain’s 10-year Gilt yield tumbled to a historic low of 1.50%, and Germany’s 10-year Bund yield nearly fell to zero percent, a few months later. By mid-April, a stunning 53% of all G-7 government debt was yielding 1% or less.

The sharp drop in energy prices depressed the Euro zone’s consumer prices to levels last seen during the global financial crisis, with only tiny Malta and Austria escaping deflation. On an annual basis, prices in the 19 countries using the Euro were -0.6% lower than a year earlier, the EU’s statistics office Eurostat said. Deflation was deepest in Greece in January, followed by Spain, while almost all Euro-zone countries had negative inflation rates. As such, the ECB began its Q€-1 scheme, and in anticipation of QE-1, many bond traders were front running the ECB, - and had driven a stunning €2.2-trillion of European notes to below zero percent (mostly German and French notes). By early April ’15, all of Germany’s debt with a maturity of 7.5-years or less, was yielding less than zero percent.

Bursting of Global Bond Bubble, Starts in Germany, On April 29th, “mystery” sellers began dumping the German 10-year Bund futures, and by the end of the day, the value of the entire Euro-zone bond market had lost €55-billion ($76 billion) in a single day. It was the beginning of a revolt by bond traders against negative interest rates in Europe. In the eye of the storm, was Bill Gross the bond guru, - he hit a raw nerve that rattled the QE front runners, by going as far as to call the 10-year benchmark German Bund “the short of a lifetime” in a Tweet on April 30th. Double-Line Capital’s Jeffrey Gundlach jumped on board, saying he would lever up “100 times” and make a bearish bet against German Bunds. Later that day, Germany experienced a failed auction, it only received €3.65-billion of bids at the five-year note auction, short of its €4-billion sales goal. Adding to the supply pressure, Italy auctioned €8.25-billion of debt, while Portugal sold €2.5-billion of 10-year and 30-year bonds via banks.

As fate would have, the bearish remarks by Mr Gross and Gundlach were just some of the triggers that ignited a mini rout in the German Bund market. A resilient $20 /barrel rebound in crude oil prices was also a key factor that enabled the Bund vigilantes to engineer a sudden and sharp sell-off in top-rated, low-yielding bonds in Frankfurt, and the ripple effects were felt in the bond markets of England, Australia, Canada, Korea, and the US, among other places. At the epicenter of the rapid slide in bond prices was the 10-year German Bund – its yield more than quadrupled to 0.60% in just five days, erasing all the price gains made this year. Investors in longer dated 30-year German Bunds suffered bigger losses of -20% from the bubble peak highs, as its yield ratcheted +100-bps higher to 1.40%, and signaled the passing of the deflation scare. Specific triggers for the downturn in May are hard to identify, but the sudden emergence of “reflation” trades in bonds partly reflected the notion that the ECB’s QE-1 scheme was starting to work far more quickly than even optimists dared hope. Not only have Euro inflation rates stopped contracting, but private sector bank lending is expanding again for the first time in years, the Euro’s M3 money supply growth has turned positive.

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Gary Dorsch
email: editor@sirchartsalot.com
website: www.sirchartsalot.com

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Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group. As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADRs and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called,"Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

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