Across the Curve

Primary Dealer Designation Loses Its Allure

Via Bloomberg :

To see how far the prestige of the U.S. Treasury market’s primary dealers has declined, consider the case of Credit Agricole SA.

For years, France’s third-largest bank courted the Federal Reserve Bank of New York, supplying trade and flows data to demonstrate it was worthy of joining the $13.6 trillion market’s middlemen. The bank also expanded its Treasuries business by adding traders and sales staff and sought out new institutional clients.

By last year, the efforts had brought a primary dealership within reach for a bank that agreed in October to pay $787 million to U.S. regulators to resolve allegations it violated sanctions aimed at Iran and Sudan.

But in the end, even after clearing all those hurdles, the 121-year-old bank concluded that belonging to the bond world’s most elite club — the firms that trade with the Fed and are obligated to bid at U.S. debt auctions — wasn’t worth it. Management alerted staff in May that it wouldn’t pursue the credential, according to people with knowledge of the events who requested anonymity to discuss the process.

Post-crisis regulation and evolving technology are changing the landscape in the benchmark market for global borrowing. Banks once champed at the bit to become primary dealers. Now the role’s perceived benefits have diminished. Today, a handful of firms dominate trading, and a growing share of auction business bypasses dealers altogether. Last year, 10 percent of new Treasuries went to investors who bid directly with the government, up from about 1 percent in 2006, data compiled by Bloomberg show.

“It’s gotten harder for banks to operate a Treasury trading business,” said Kevin McPartland, head of research for market structure and technology at Greenwich Associates, a financial-services consulting firm in Stamford, Connecticut. “Regulation has taken a good amount of profitability out,” he said, not to mention that “as trading becomes more electronic, it’s easier for new participants to enter the business.”

There may be cause for concern if major global banks such as Credit Agricole are losing interest in underwriting U.S. debt. The nation’s borrowing needs are climbing again. Deficits are set to swell amid demands from Social Security and Medicare, and the public debt burden may grow by almost $10 trillion in the next decade, Congressional Budget Office forecasts show.

The network of primary dealers has 23 members today, half its 1988 peak. The firms are designated trading partners of the Fed, helping it carry out policy.

The brokerage arm of Wells Fargo & Co. joined the roster in April, the first addition since 2014. Before Wells Fargo, a U.S.-based dealer hadn’t signed on since MF Global Holdings Ltd. in 2011, and that firm was dropped months later after its collapse.

Profit Questions

What was a good fit for San Francisco-based Wells Fargo — the world’s most valuable bank and one of the biggest U.S. mortgage lenders — may have limited appeal for other firms. Some brokerages say the primary-dealer role has become less profitable because rules introduced after the financial crisis, such as Dodd-Frank and Basel III, have made it costly to hold large inventories of Treasuries.

There’s also increased competition from high-speed trading firms on interdealer platforms. Fewer than half of primary dealers in a survey published last year by Greenwich Associates said they’re actively making markets on these platforms anymore. Among primary dealers, Treasuries trading has become concentrated within the top five, which controlled almost 60 percent of volume done by U.S.-based Treasuries investors last quarter, up from 44 percent in 2005.

“For the marginal players it’s not as profitable, so they’re not as active,” said Craig Pirrong, a finance professor at the University of Houston whose research involves risk management. “Those are the ones you’re going to see dropping out, or substantially reducing their participation.”

New Era

Primary dealers are required to bid for at least their pro rata share of the total issuance at Treasury auctions. At one time, the firms went above and beyond this requirement, comprising the largest buyers by far at auctions.

No longer. Dealers have bought about 32 percent of auctions this year, on pace for a record low, according to data compiled by Bloomberg. While that’s partly a result of the rise in direct bidding, dealers have also been left with less to purchase because of the insatiable demand for Treasuries from investors fleeing about $9 trillion of negative-yielding sovereign debt in places like Japan and Europe. The U.S. is selling $44 billion of three- and 10-year notes Monday. Benchmark 10-year Treasuries yielded 1.69 percent as of 10:28 a.m. in London.

“Auctions reveal what is a common theme in today’s market: the diminution of the primary dealer’s influence,” representatives from Daiwa Capital Markets, a primary dealer, wrote in an April response to a Treasury Department request for information about the market’s evolution.

The department’s request is part of the first government review of the Treasuries market since 1998. Industry participants submitted 52 letters, voicing concerns ranging from the unintended consequences of regulation to the need for further oversight. The Treasury and four other regulators also produced a report last year on the state of the market following an unusual bout of bond-market volatility in October 2014.

To read more about the 52 letters, click here.

It’s not just the U.S. that’s dealing with the waning allure of the primary-dealer role.

Japan’s biggest bank, Bank of Tokyo-Mitsubishi UFJ Ltd., quit its role as one of that nation’s primary dealers in July. In the U.K., Societe Generale SA resigned its post this year, and last year, Credit Suisse Group AG quit being a primary dealer across Europe, citing the burden of trading under new restrictions.

In the U.S., the qualification process for prospective primary dealers entails financial costs related to maintaining trading capacity and complying with reporting rules. Applicants are required to provide material such as risk-assessment models, internal audits, financial reports and tax returns.

Harboring Doubts

Yet even after jumping through those hoops, and after Credit Agricole management signaled to staff that it was on course to win acceptance, executives doubted the merit of the once-coveted designation, two people with knowledge of the process said.

Mary Guzman, a spokeswoman for Credit Agricole in New York, declined to comment, as did Suzanne Elio at the New York Fed.

At Credit Agricole, which is based near Paris, the decision to forgo a primary dealership dovetailed with plans to slash its debt business, according to three people familiar with the situation. Two of those people said management opted to limit U.S. rates trading mostly to European clients. That meant retreating from the pitch made to new clients in preceding years, when sales staff were encouraged to highlight the pending primary dealer status.

The verdict was in: After a years-long pursuit, the bank was leaving the Fed at the altar.

“The bottom line is there’s a lot more aggravation involved in it than there used to be and a lot less profit,” said Edward Yardeni, president of Yardeni Research Inc. in New York, who’s been analyzing the bond market since the 1970s. “The risk-reward is just not worth it.”

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Rising Yields Overseas Are a Problem for US Treasuries

Via Tracy Alloway at Bloomberg:

When Japanese, European, and U.K. government bonds sneeze, U.S. Treasuries catch a cold?

Investors have been eschewing some longer-dated government debt as they fret over the willingness — and ability — of central banks to continue to fan economic growth through unconventional monetary policy such as bond purchase programs.

The skepticism helped send yields on Japanese government bonds and German bunds spiking last week, and on Friday the sell-off reached the U.S. Treasury market, where the benchmark 10-year note posted its worst two-day performance since July as yields jumped 14 basis points.

The rout has sparked a flurry of analyst commentary as the higher U.S. yields haven’t been accompanied by changing expectations of Federal Reserve policy. Instead, analysts at  JPMorgan Chase & Co. suggest the sell-off in U.S. government debt is taking place as higher yields in Japan and Europe make Treasury bonds less attractive by comparison.

“From a medium-term perspective, we are beginning to think the risks around rate levels have begun to shift, for a number of reasons,” JPMorgan analysts led by Jay Barry wrote in a note published late on Friday. “First, developed market central banks have disappointed again, highlighted by [last] week’s lack of action from the European Central Bank. Second, as a corollary, Treasuries no longer appear as attractive to foreign investors compared to home currency bonds as they did earlier this year.”

The so-called yield pickup that foreign investors can expect to earn by selling government bonds in their local currencies to buy 10-year U.S. Treasuries has fallen dramatically thanks to the recent increase in yields and stubbornly negative cross-currency basis swaps that help traders hedge such deals.

For instance, writes JPMorgan, Japanese and European investors could as recently as March have expected to pick-up 80 bps and 50 bps, respectively, by selling their home bonds to buy U.S. Treasuries with a short-term currency hedge.

“But this yield pickup has largely disappeared, as JGB and bund yields have risen, while cross-currency bases have remained quite negative,” the analysts note. “This yield pickup was one large support for the Treasury rally in the first half of 2016, as the Bank of Japan and ECB eased aggressively, while the Fed remained on hold. Going forward, this should be less supportive of foreign demand than it was in [the first half], and recent data already suggest Japanese investment in foreign bonds had started to slow in August.”

Combined with some crowded positioning — JPMorgan’s client survey shows 16 percent net longs, the highest level since June 27, or immediately after the Brexit vote — and a deluge of new supply expected this week when the U.S. Treasury is due to auction $44 billion worth of three- and 10-year notes in an unprecedented Monday sale.

All in all, suggests JPMorgan, the tailwinds for U.S. Treasuries appear to be turning more feeble — if not downright sickly.

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Banking Problems in Italy

Via WSJ:
By Giovanni Legorano
Sept. 11, 2016 6:35 p.m. ET
0 COMMENTS

MILAN—For UniCredit SpA, the summer of discontent for Italy’s banks looks likely to stretch well into the fall—and possibly beyond.

UniCredit, Italy’s largest lender by assets, emerged as one of the weakest big banks in Europe in July’s stress tests, showcasing the failure of its attempts to respond to rock-bottom interest rates and a huge pile of bad loans.

Now, as Jean-Pierre Mustier, the bank’s new chief executive, readies a big-bang plan to revive UniCredit’s fortunes, he faces a series of unpalatable choices: Aggressive action to cut the bank’s €80 billion ($89.9 billion) in bad loans—the largest of any European bank—would force the Milanese bank to raise billions in fresh capital, while an asset sale could help bolster its capital position but would hurt already thin profit.

Meanwhile, the travails of Italy’s No. 3 lender, Banca Monte dei Paschi di Siena SpA, promise to only complicate Mr. Mustier’s job. On Thursday, Monte dei Paschi said its CEO, Fabrizio Viola, had agreed with the bank’s board to resign, in a surprise move that came as that bank works on a plan to shed €28 billion in bad loans.

Troubles at UniCredit, which has a vast business in Germany and Eastern Europe, could threaten not only Italy’s ailing economy but also the continent’s already fragile financial stability.

Britain’s vote to leave the European Union has upended Europe’s status quo, making the financial system more sensitive to shocks. Investors are watching UniCredit closely, as they expect its fate to affect both Italy and potentially other lenders on the continent.

“Fixing UniCredit is of paramount importance for Italy’s banking system, for the country’s economy and for the eurozone,” said Fabio Caldato, a London-based partner at asset manager Olympia Wealth Management.

Like most of its Italian peers, UniCredit has sustained a double whammy of ultralow interest rates—Italian mortgage rates are as low as 1%—and a decade of economic doldrums in Italy, which have helped drive up bad loans and batter profits.
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For several years, the bank responded by gradually raising commissions, selling assets and cutting costs. The push has yielded little. In the past two years, commissions inched up 2% to €7.9 billion for 2015. That failed to offset an 8% drop in net interest income—the difference between interest the bank receives on loans and what it pays on deposits—to €12 billion last year.

As a result, a plan to reach net profit of €5.3 billion in 2018 appears wildly optimistic, with net profit last year at just €1.7 billion. At the same time, the bank has had to write down €24 billion in bad loans in three years.

These problems have conspired to leave UniCredit’s common equity Tier 1 ratio, an important measure of banks’ capital, at 10.51% at the end of the second quarter, just a hair over regulatory requirements of 10% and lower than the 12.7% for its Italian rival Intesa Sanpaolo SpA.

UniCredit ousted its chief executive this spring, hiring Mr. Mustier in June.

With the stock down more than 60% since the start of the year, Mr. Mustier sought to buttress investor confidence in July by announcing two transactions immediately after taking the helm: the sale of 10% stakes in two of the bank’s crown jewels—online broker FinecoBank SpA and Poland’s Bank Pekao SA .

However, a few weeks later, the stress tests showed that a downturn would leave the bank with a dangerously thin capital buffer of just over 7%. The bank’s stock fell 13% in the days after the stress tests. It has picked up since but is still down 55% in the past year.

Now, Mr. Mustier faces some tough choices as he readies a new strategic plan slated before year’s end. First, he plans to fatten UniCredit’s capital cushion by at least €8 billion, according to a person familiar with his thinking.

But the figure could be higher if the bank decides to sell a large chunk of its bad loans in one go—an option investors are pushing for and Mr. Mustier is considering, the person said.

A major move to unload bad loans, perhaps as much as €20 billion, “will be key for a rerating of the stock,” said Vicenzo Longo, a Milan-based strategist at IG Markets.

However, Monte dei Paschi presented a plan in July to sell €28 billion of bad loans at 27% of face value. That has effectively set a new benchmark for the pricing of Italian bad loans. Since UniCredit attributes a higher value to its bad loans, a sale of €20 billion of loans would force it to take €2 billion in write-downs—thus increasing the size of a capital increase.

Mr. Mustier could also sell assets to beef up capital, but such prospects have worsened recently. Turmoil in Turkey would make it hard to sell the bank’s Turkish business. Meanwhile, UniCredit has been in talks to sell its remaining 40% stake in Pekao to Polish insurer PZU SA, but the latter is now interested in buying just 30%, according to people familiar with the situation.

Any capital increase could also collide with Monte dei Paschi’s plans for a €5 billion share sale this winter, amid a market with little appetite for Italian banking shares. Indeed, Monte dei Paschi is considering asking investors to convert riskier bonds into shares to reduce its capital increase.

Finally, Mr. Mustier cannot present his plan until after a national referendum in Italy—likely in late November—that threatens to topple Italian Prime Minister Matteo Renzi’s government and is already unnerving investors.

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Minneapolis Fed President Thinks Monetary Policy Has Reached Limit

Minneapolis Fed President Kashkari thinks that monetary has reached the point where it is no longer effective and he prescribes fiscal policy and structural reforms to spur growth. He made the comments in an essay released on the regional bank’s website (here).

Via Bloomberg:

Matthew Boesler
boes_
September 12, 2016 — 12:01 AM EDT

Minneapolis Fed chief mentions infrastructure investing, taxes
Conveys skepticism about higher inflation target in blog post

The U.S. government should consider fiscal and regulatory reforms to boost economic growth because the scope for low interest rates alone to do so is limited, said Federal Reserve Bank of Minneapolis President Neel Kashkari.

“We are likely seeing a confluence of three fundamental causes all combining to slow the economic recovery: (1) challenging demographics, (2) psychological scarring from the crisis and (3) lackluster technological innovation. Unfortunately, these headwinds aren’t likely to reverse anytime soon on their own,” Kashkari wrote in an essay posted Monday on the website Medium. “Monetary policy is largely doing what it can to support a robust recovery, and what remains are fiscal and regulatory policies.”

The Minneapolis Fed chief said investing in infrastructure while borrowing costs are still near record lows, “simplifying the tax code and making it more consumption-oriented,” and reducing the regulatory burden of businesses are policies with “little downside risk.”

Kashkari also questioned the wisdom of raising the Fed’s inflation target to provide more stimulus — a strategy floated last month by San Francisco Fed chief John Williams among other suggestions to spur growth — saying such a move carries “significant downside risks.”
Credibility Weakened

“If we announced a new higher target, it isn’t clear why anyone would believe that we could hit it,” he wrote. “The Federal Reserve’s credibility could be weakened.”

The U.S. central bank’s policy-setting Federal Open Market Committee meets Sept. 20-21 to discuss its target range for overnight interest rates, which has been left unchanged at 0.25 to 0.5 percent since a hike in December that marked the first in nearly a decade. A slowdown in economic growth, sluggish inflation, and increased uncertainty about the outlook have so far prevented another move.

Kashkari, an FOMC participant who does not vote on decisions this year but will next year, suggested there may be little scope for additional cyclical stimulus stage in the business cycle, and policy makers should instead focus on longer-term solutions.

“Chronically weak demand might have been an important part of the diagnosis for the U.S. economy in the depths of the recession, when many workers and factories were idled,” he wrote. “By 2016, however, the labor market appears closer to normal, which limits how much can be achieved by boosting demand to increase employment further.”

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Early FX

Via Kit Juckes at SocGen:

<http://www.sgmarkets.com/r/?id=h114e6301,184371a2,184371a3&p1=136122&p2=f766528ee1dd43e986166e6778de7138>

Hurricanes form when rising warm, moist air collides with cold air in the atmosphere at the end of summer over oceans. This market correction was triggered by rising expectations that the Fed wants to raise rates again, colliding with long positions in both risk assets and in Treasuries. Friday’s market volatility boosted the US dollar by a little less than 1% on a broad trade-weighted basis, not a big move compared to the moves in bonds equities and in emerging markets. We still like being short GBP/USD, but a significant dollar rally against the major currencies probably needs the market to price in a higher longer-term path for Fed Funds rate in the future, as opposed to speculation about what happens at next week’s FOMC meeting.

At the moment, the market prices end-2017 Fed Funds at about 0.75% (i.e. split between the target being 0.5-0.75, and 0.75-1%). Likewise, as the first chart shows, the move higher in the dollar on Friday was helped by a rise in 10year TIIPS yields to 16bp, but we need to see a far clearer uptrend in real yields to drive it much further. This year’s correction of the dollar’s longer-term uptrend was driven by 10year real yields falling from 0.8% to below zero between January and early July. I am more confident that we have seen the low in real yields for quite some time, than I am about the idea of them moving significantly higher. Which roughly translates into saying that I think the dollar, in terms of the BOE TWI, has found a base at 98, but that may just mean we’re stuck in a 98-102 range for now. This correlates imperfectly with the G10-heavy DXY, but I think the May low is likely to hold and buying against 94-94.5 appeals.

The dollar needs more real yield support to rally

[http://email.sgresearch.com/Content/PublicationPicture/232173/2]

Apart from Eric Rosengren’s comments, and the announcement of the Brainard speech today), there are two important ingredients to the current market nervousness,. The first is the growing sense that the BOJ and ECB are running out of meaningful ammunition. We may get more easing from both, but market participants are doubtful that it will make much difference. That is helping global bond yields to find a base. Secondly, the market is long both equities and Treasuries, something that has echoes of late 2012, when US yields bottomed and the ‘taper tantrum’ was just a few months away. The positioning suggests (to me, anyway) a risk both that any bounce bond markets that comes from weaker equities and risk assets will be modest, and that we are probably set for a period of increased nervousness and choppy markets in general.

CFTC positions – long equities and bonds

[http://email.sgresearch.com/Content/PublicationPicture/232173/3]

There’s nothing significant apart from Fed speakers on the economic calendar today. Before we get to Ms Brainard at 18:15pm, we get two regional fed Governors, Dennis Lockhart at 13:00 and Neel Kashkari at 18:00. After that, we have inflation, unemployment and retail sales data on the UIK on Tuesday,. Wednesday and Thursday, as well as an MPC meeting. US NFIB tomorrow, retail sales, PPI/CPI, Philadelphia Fed index and IP/manufacturing on Thursday and C{I + U-Mich on Friday. Europeans release. ZEW tomorrow, IP on Wednesday and meet to discuss Brexit on Friday. But all of that’s down the road: Today, we wait for MS Brainard, watch to see if a market very long yen can drive it much further (I doubt it), and likewise watch to see if Treasuries get much of a lift from the current volatility again, positioning argues for a small fall in yields, not more).

As well as shorts in GBP/USD, we are long AUD/NZD, but otherwise, biding our time before summoning up the coverage for shorts in NZD/USD and longs in USD/JPY, the other main ways we want to express dollar bullishness at some point (soon).

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Yield Whores Shamed In Mongolia

Via the WSJ:
By Carolyn Cui and
Julie Wernau
Sept. 11, 2016 6:48 p.m. ET

There is nary a corner on Earth where investors won’t journey to find extra yield. But the trip to Mongolia is proving treacherous.

Money managers piled into assets from the world’s most sparsely populated country in past years on the prospects of vast untapped mines rich with copper and gold. Mongolian debt got an additional boost this year, soaring 6% in July, as raw-material prices picked up and investors sought alternatives to low and even negative bond yields in developed countries.

But in August, Mongolia’s finance minister stunned global investors by saying that its government debt would reach 78% of the gross domestic product, far above the country’s 55% target. The revelation triggered a selloff in Mongolia’s markets, with the country’s dollar-denominated debt tumbling 7.7% last month and the nation’s currency falling the most among all its developing-economy peers, before rebounding slightly this month.

“Until recently, Mongolia was a darling of the markets and they couldn’t do anything wrong,” said Bejoy Das Gupta, chief economist for Asia/Pacific at the Institute of International Finance. “But when the hard landing happens, markets adjust very quickly.”

Mongolia is among a handful of countries with once-bright futures that took on massive debt loads during a period of investor enthusiasm for frontier markets. In 2011, the nation was the world’s fastest-growing economy, expanding at a 17% rate as prices of copper, gold and iron ore soared.

Foreign lenders handed over billions of dollars to the government, its banks and mining companies to help extract wealth from underground. Among the bonds’ holders are BlackRock Inc., Franklin Templeton, Goldman Sachs Group Inc. and UBS Global Asset Management, according to the latest holder data from Thomson Reuters. Mongolia’s debt levels swelled 264% in the five years ended 2015, the largest increase in the world during that period, according to Moody’s Investors Service.

But the commodities bust that began in 2011 crimped the country’s growth. Now, the prospect of higher U.S. interest rates, which could make bonds in developing economies less attractive, could worsen a troubled situation.

As of the first quarter, Mongolia’s total debt owed to foreign creditors stood at $22.6 billion, compared with a still tiny $11.8 billion economy. Meanwhile, a $580 million Mongolian bond taken on to help finance a still-unfinished project to connect 21 provinces with roads comes due in 2017, part of $2 billion in maturing public- and private-sector debt in 2017, according to the International Monetary Fund.

Investors are pinning hopes on a vast gold and copper mine that is expected to lead to massive economic growth. In December 2015, the government approved a $4.4 billion financing deal for Rio Tinto PLC’s second phase of the Oyu Tolgoi copper and gold mine, believed to be the world’s largest underdeveloped reserve of copper, concluding a four-year-long negotiation. But delays in the projects have been costly: During the wait, copper prices more than halved.

As the country’s current financial woes deepened, the government resorted to emergency measures. In August, the government said it may soon stop paying its civil servants and the military and raised interest rates by 4.5 percentage points to combat capital outflows.

Moody’s also lowered Mongolia’s sovereign credit rating, sending it further into junk status. Standard & Poor’s made a similar move.

If Mongolia turns to the International Monetary Fund for help, that could prop up investor confidence that it will be able to pay its debt, said Kevin Daly, a portfolio manager at Aberdeen Asset Management, with $9 billion in emerging-market debt under management, including Mongolian bonds. The IMF visited the country in August.

The selloff in Mongolia contrasts with the broad rally in emerging markets. Nearly $80 billion went into emerging markets during the first eight months of this year, the Institute of International Finance said. Emerging-market dollar-denominated debt returned 14.7% this year through August.

But if the Federal Reserve raises interest rates, reducing liquidity in the global financial system, countries that rely on a single commodity or struggle with economic data transparency “represent the first level of risks,” said Jim Barrineau, co-head of emerging markets debt at Schroder Investment Management Ltd., which has £343.8 billion ($456.19 billion) of assets under management.

Copper made up 49% of Mongolia’s exports in 2015, according to the United Nations International Trade Statistics Yearbook.

“Given overall market conditions and the assumptions around the IMF, I think perhaps the investors would continue to give them the benefit of the doubt,” said Kathryn Exum, a sovereign analyst at Gramercy Funds Management LLC. “But from an overall fundamental perspective, it’s too expensive. Mongolia and some of the weaker credits will sell off much more significantly if a hawkish Fed returns.”

Write to Carolyn Cui at [email protected] and Julie Wernau at [email protected]

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FX

Via Brown Brothers Harriman:

Dollar Proves Resilient as Market Rates Rise

It took the market a few days to overcome the shockingly poor non-manufacturing ISM (51.4 vs. 55.5).  However, by the end of the week, the US dollar bulls had regained the upper end.  The September Fed funds futures contract was implying a yield of 41.75 bp, up a quarter of a basis point from the September 2 close.  

Similarly, the 2-year yield was essentially unchanged on the week, while the 10-year yield was up 6 bp on the week and 15 bp from the ISM-inspired low.  At 1.66%, the 10-year yield is at its highest level since the UK referendum.  The Atlanta Fed GDP tracker has the US economy growing 3.3% this quarter, while the NY Fed’s tracker says 2.8%.  This is after the adjustments taking into account this past week’s data, including inventories and the service ISM.  

The US Dollar Index rebounded smartly off the trendline we have been monitoring.  It is drawn off the May, June and August lows.  It caught last week’s low of almost 94.45.  Rebounding before the weekend, it stalled in front of 95.60, nearly meeting a retracement level of the pullback that began at the start of the month.  A move above 95.60 targets the 96.15-96.25 area that contains the August 31 high and the 200-day moving average.  Above there, the July high around 96.50 beckons.  

The euro has fallen for the past four Fridays.  It is an interesting pattern, but the significance is not clear.  Compared with the beginning of this pattern, the euro is about a cent lower.  On the week, the euro finished half a cent higher but had completely unwound the gains scored in response to the ECB lack of fresh action, even extending its buying program, despite the recognized downside risks and the (small) downgrades of the staff forecasts for next year’s growth and inflation.  

A break of $1.12 could spur slippage toward $1.1150-$1.1170, but we suspect the euro will be supported by caution ahead of Fed’s Brainard and what is expected to be a softer US retail sales report.  On the upside, congestion around $1.1250 may hinder strong gains, especially given the proximity of the FOMC meeting.  

Similar to the euro, the dollar has advanced against the yen for the past four Fridays.  The next immediate target is the JPY103.15-JPY103.25 area, and then the recent high a little above JPY104.30.  The technical tone remains vulnerable, though.  The MACDs may cross lower, while the Slow Stochastics have already turned.  The sharp drop in US equities before the weekend will likely weigh on Asian shares at the start of the new week.  The developments in the equity market may, in the first instance, hamper the dollar’s recovery against the yen.  

The apparent resilience of the UK economy, doubts in some quarters that Brexit will ever take place, and conviction that the BOE will not cut rates at this week’s MPC meeting helped lift sterling through the August highs.  It reached $1.3445 before finding new sellers.  The price action reinforces the significance of the $1.35 area cap.   Within the $1.30-$1.35 range that has dominated since the referendum, sterling may encounter initial support in the $1.3160-$1.3180 area.  A month-long up trendline comes in near $1.3240 on September 16.  The technical indicators we use are mixed.  The RSI is heavy, and the MACDs have not crossed but are poised to, and the Slow Stochastics are still headed higher.  

The technical tones of the Australian and Canadian dollars have deteriorated.  The US dollar recovered off the midweek test on CAD1.28 and finished the week near CAD1.3050.   The Canadian dollar’s pre-weekend loss of a little more than 0.8% was the largest loss in over month.  It was sufficient to offset the gains it has registered earlier in the week.  It closed the week with about a 0.4% decline, the most among the high income countries.  The RSI and MACDs suggest additional losses are likely.  The next objective is CAD1.3150.  

The Aussie posted a key downside reversal on September 8 and saw follow-through selling before the weekend.  The nearly two cent was the largest decline over two days since the UK referendum.  Like the Canadian dollar, the Australian dollar’s RSI and MACDs warn of the risk of additional selling over the coming sessions.  A break of the $0.7490-$0.7500 area is needed to boost confidence that a high of some import is in place.  

It looks like participants exaggerated the significance of the sharp drop in oil and gas stockpiles.  To be sure, there was not a sudden adjustment to the oversupply.  Rather, it seemed weather-induced.  Moreover, the odds of an agreement to freeze output are remote at best, given the recent comments from Saudi and Russian officials.  Also, Iran’s ability to recoup the output lost during the embargo has slowed (if not stalled) over the past period.  The October light sweet futures contract has already retraced 38.2% of its gains this month.  The 50% retracement is found near $45.40, and the 61.8% retracement is at $44.60.  On top of its own dynamics, a strengthening of the dollar may also be seen as negative for prices.  

US 10-year Treasury yields appear to be breaking out of the 1.50-1.60% range.  It may take some time for participants to become convinced.  If the range is broken, then the next important level is in the 1.70%-1.75%.  Recall that as recently two months ago, the US 10-year yield was near 1.32%.  It was around 1.66% ahead of the weekend.  An important warning to the bears is that the technical readings seem stretched, and the fact that the December futures contract closed below its lower Bollinger Band may inject caution, especially ahead of Brainard’s speech and the US retail sales report.

From a technical perspective, the S&P 500 looks ugly.  The gap lower before the weekend left a four-day island top in its wake.  Recall that on September 2, the S&P 500 gapped higher, leaving a few cent gap unfilled.  The sharp loss on September 9 brought the S&P 500 to two-month lows.  The RSI and MACDs have weakened.  The S&P 500, like the 10-year note futures, closed below its lower Bollinger Band.  However, narrow trading ranges and low volatility had seen width of the Bollinger Bands narrow considerable, and even a small decline would have pushed it outside the Bands.  

If the gap created by the sharply lower opening on September 9 is a normal gap, it should be filled in the coming sessions.  If it is not filled shortly, the significance of its bearish signal is enhanced.  The initial downside target is in the 2116-2120 range, which corresponds to a 38.2% retracement of the rally since late-June and the 100-day moving average.

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Ms Clinton’s Health and the Markets

Via Bloomberg:

Clinton’s sudden departure from the ceremony in New York and a bystander’s video showing her appearing to stumble as she was helped into a black van by aides and Secret Service agents is sure to resurface health questions. She blamed recent coughing jags on allergies, but Republicans have sought to raise questions about her fitness for office, particularly following a concussion in 2012 that resulted in a blood clot.

“If Clinton’s health becomes a larger factor with regard to voter decision-making, the market may have to recalculate the risk-reward of a regime change in the White House, as Clinton right now is assumed as a continuity from the current administration,” Yousef Abbasi, global market strategist at JonesTrading Institutional Services LLC, said by phone. “Obviously today is another thing that’s going to draw closer attention.”

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Treasury Market Markers

With the big back up in rates it is natural to search for levels at which the markets might hold. I was just checking my notes and I would use pre Brexit levels as a nice way station. I did not do closes on June 23 but I can relay my opening levels. The 2 year traded at .758  basis points  (Friday close .786) and 3s trades at .899 (Friday close .926). The 5 year note changed hands at 1.228 (Friday close1.223) and 7 year notes traded at 1.52 (Friday close 1.513). The 10s traded at 1.72 (Friday close 1.673) and the Long Bond traded at 2.532 (Friday close 2.395).

As you can observe 2s 3s 5s and 7 are essentially at pre Brexit levels while 10s need to travel 5 basis points and bonds need to back up 13 basis points. With supply this week I would expect to see the 10s close to that 1.72 level unless stocks continue their deep sell off.

Regarding stocks I would look to be a buyer near 2100 on the futures contract. On Brexit day I shorted some (one lot here I am) at 2098 late in the afternoon and took them back down 70 points in the ensuing panic.

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Independent Central Banks and the Low Inflation Problem

Via WSJ:
By Tom Fairless
Updated Sept. 11, 2016 1:07 p.m. ET
3 COMMENTS

FRANKFURT—In their battle against high inflation, governments granted significant independence to central banks over recent decades.

Now, some economists argue that same independence could be hampering their ability to combat the current era’s problem: inflation that’s too low.

To safeguard their independence, major central banks may have deployed “second-best” policies that distort financial markets and face diminishing returns, such as negative interest rates and large-scale bond purchases, and shunned potentially more effective tools such as “helicopter money,” argues Joachim Fels, global economic adviser at Pimco.

Helicopter money, which could involve, for example, an increase in public spending or tax cuts financed by the central bank, takes central banks beyond their traditional realm of influencing the price and volume of credit to determining how public money is spent—the domain of elected politicians.

Bank of Japan Gov. Haruhiko Kuroda has warned repeatedly that helicopter money would be an unacceptable intermingling of fiscal and monetary policy. In July, the BOJ disappointed hopes that it might embark on an experiment with helicopter money.

In Europe, Bundesbank President Jens Weidmann has cited similar concerns over the independence of the European Central Bank as a reason not to deploy helicopter money. ECB President Mario Draghi says that the topic hasn’t even been discussed at policy meetings.

The fear is that if governments started to finance their deficits through the money-printing presses, they would succumb to politicians’ desire to spend without raising taxes. The result would, eventually, be higher inflation.

“To be told to increase the balance sheet by x would mean the independence was lost, and the effects on inflationary expectations could be quite dramatic,” said Charles Goodhart, a former member of the Bank of England’s monetary policy committee.

Yet advocates of more cooperation say such risks are exaggerated relative to the benefits that closer cooperation could achieve in today’s circumstances.

During World War II, the Federal Reserve helped finance the U.S. war effort by ensuring that long-term interest rates remained at 2.5%, whatever the size of the fiscal deficit. When that policy ended in 1951, the Fed didn’t reverse its purchases, so that “post facto, a significant proportion of U.S. fiscal deficits from the early 1940s to 1951 was money-financed,” said former British financial regulator Adair Turner in a 2013 lecture.

All that government spending was accompanied by a huge rise in inflation-adjusted economic output, although it also created huge pent-up inflation pressure that erupted once wage and price controls were lifted. Prices shot up 34% between 1945 and 1948, but then inflation reverted to low single digits.

Once the cap on Treasury yields was removed, the Fed “effectively became more independent,” said Alex Cukierman, a member of the Bank of Israel’s Monetary Committee.

In practice, there may be little difference between helicopter money and current policies like quantitative easing, which cover a large swath of current government deficits.

Policies adopted during the recent crisis have also been “subject to a high level of discussion between central banks and governments,” said Mr. Goodhart. “Helicopters have already been flying in huge formations in Japan.”

Most important, today’s circumstances are very different from the past: With interest rates at zero or even negative, central banks simply can’t boost spending or inflation much more by themselves. Mr. Draghi has called, with increasing urgency, for help from other policy makers, including elected officials.

At a news conference Thursday, Mr. Draghi made an unusually direct plea to Germany to spend more to boost the region’s economy.

Asked about helicopter money in June, Fed Chairwoman Janet Yellen said that, in unusual times when the concern is very weak growth or possibly deflation, fiscal and monetary authorities should “not be working at cross-purposes…—but together.”

“Now, whether or not in such extreme circumstances, there might be a case for, let’s say, coordination—close coordination, with the central bank playing a role in financing fiscal policy; this is something that…one might legitimately consider,” Ms. Yellen said.

The difficulty is in finding the right mechanism. Former Fed Chairman Ben Bernanke proposed in April that the Fed could credit a special Treasury account with funds if it assessed such a stimulus was needed to achieve its employment and inflation goals. The U.S. government would then determine how to spend the funds, or could leave them unspent.

In the eurozone, cooperation is complicated by the need for 19 governments to agree among themselves first. One partial solution, suggests Mr. Cukierman, may be to alter the ECB’s charter to focus less on inflation and more on economic activity, like the Fed.

Another possibility: put the onus on governments instead of the ECB. Princeton University economics professor Christopher Sims suggests a eurozone-wide moratorium on the bloc’s debt limits, “to be kept in place until areawide inflation reaches and sustains the target level.”

Greater cooperation with governments would help address another criticism: Central banks are increasingly making decisions that affect the distribution of wealth and income, decisions that belong in the hands of democratically elected governments.

Athanasios Orphanides, a former ECB policy maker, points to the Fed’s decision to support the U.S. housing sector by purchasing large quantities of mortgage-backed debt, and the ECB’s “uneven” support for different eurozone governments.

Thus, if central banks can’t avoid politically controversial actions, the question is how to maximize the benefits of such actions. That might, ironically, involve less independence, not more.

Write to Tom Fairless at [email protected]

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