August 15

Bad News Rally Faces Big Risks

Risky assets traded down to recent lows early last Friday as Barack Obama approved airstrikes to push back the spread of religious militant groups in Iraq. Since those lows, stocks, high yielding currencies and junk bonds have roared back based on a combination of factors.

Fading Geopolitical Risks:
There were constructive headlines out of Russia and Ukraine last Friday and this sentiment has continued into this week. Without getting too deep into the details or tit for tat sanctions war, it looks as if Putin desires to deescalate the situation. Russia has sent an aid convoy to the Ukrainian border and is allowing the Ukrainian border guard to inspect the convoy and transport the goods to where they are needed. The mid east situation remains fluent as the Gaza/Israel cease fires are broken on an ongoing basis, but the market appears calmer at the notion of a US presence. President Obama has signaled a long term involvement in Iraq once again.

Weaker Data:
This week we have seen less than spectacular data out of the United States, Europe and China. Mark Carney was also surprisingly dovish this week showing much less confidence in the UK economy than was originally thought.

Country

Data

Date Reported

Reported Period

Actual

Estimate

Germany

German ZEW

August 12th

August

8.6

18.2

China

China Loans

August 12th

July

385bn

780bn

UK

BoE Inflation Report

August 12th

Q2

Dovish

Neutral

China

Fixed Asset Investment

August 13th

July

17

17.4

China

Retail Sales

August 13th

July

12.2

12.5

USA

Core Retail Sales

August 13th

July

0.1

0.4

Japan

Core Machine Orders

August 13th

June

8.8

15.5

Eurozone

GDP

August 14th

Q2

0

0.1

USA

Jobless Claims

August 14th

Wk of Aug 4

311

307

Low Volume: Volumes have been extremely low. Whether you look at SPYs or S&P e mini futures contracts, the amount of trading going on has returned to the early July levels when measures of implied volatility were at or near all time lows in all major asset classes. August 14th matched the lowest volume of the year on SPYs. DailyFX’s John Kicklighter pointed out that August 14th was the lowest level of non holiday volume in nearly ten years (322mm shares).

Investors are giddy about moderating expectations for rate increases as Carney flip flopped on hikes and US retail sales is seen as solidifying Yellen in her dovish stance. Markets are happy to move money back into the same risk trades that have characterized the last 6 months of market activity; buying US stocks, junk bonds and emerging market debt. This trade has almost become automatic as bad news is seen as a reason for easier policy to continue uninterrupted. This is a dangerous bet for three key reasons.

End Of Quantitative Easing: The Fed is on autopilot to end QE in October with a final cut of $15bn. This is pretty much set in stone, and it is widely accepted that the end of QE is now ‘priced in’. While this may be true, a strongly performing US and UK economy are also ‘priced in’. Markets are essentially betting that the economy will remain within a very slim margin of error that is not weak enough to worry but not strong enough to encourage tightening from the Fed. The last bout of complete fear and risk aversion occurred in the Fall of 2011 when the US economy was slumping and the Fed was seen as walking away from the economy and ‘only’ offering up operation twist as a solution. Markets are not appreciating risks of the US economy slowing while there is no ongoing QE program.

China Risks Building: There has been a string of eyebrow raising numbers out of the Far East this month that markets have taken in stride for now. Services sector sentiment has slowed while imports also came in below expected levels. Both of these reports point to slowing domestic demand. Exports still look very strong reflecting strength in the US and developed markets. The main development to keep an eye on is the pace of Chinese lending, the central bank reported that loans slumped to  last month to 385bn vs 780bn expected. This was the lowest amount of loans since 2008. Market strategists are raising concerns about Chinese banks becoming more risk averse as the property sector faces a very rough time ahead.

No Sovereign ECB QE: European markets really got bulled up after the bad GDP reports. There was even an FT op ed yesterday entitled “Europe Now needs full-blown QE“. Speculation has become rampant about the ECB buying massive amounts of sovereign debt, even though Mario Draghi has never even mentioned this seriously. The ECB is on hold, awaiting to see how its June package of easing measures will work out. The ECB is currently in preliminary stages of a small scale QE program to buy asset backed securities, but the ‘bazooka’ of government bond buying is not coming in my opinion. The central bank faces steep ideological and legal hurdles as there is a pending ruling on its Outright Monetary Transactions (emergency QE) program from the European Court of Justice. Mario Draghi wants a lower Euro and higher inflation, and his recent commentary focuses on a divergence in policy between the Fed and ECB. Basically he expects the Fed to do the hard work, and diverge policy away from the ECB while the ECB does nothing.

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