Tag Archives: QE

Alex Kazmarck of Trade Leader SpotEuro presents analysis of the EUR/USD.

Update

The euro has traded lower during the past two weeks, falling below 1.37 on Friday. The economic schedule this week is light, which would normally lead to less volatile sessions, but with Eastern Ukraine making noise in the geo-political sphere, capturing and barricading in government buildings in protest of the new government, we could see some big moves if America and EU begin to discuss more economic sanctions on Russia. Given the large natural gas reserves and pricing control, Europe is reliant on a good relationship with Russia, so I think it will be unlikely that Europe will rush to support any major economic sanctions. The story that will drive the EUR/USD pair this week will most likely continue to be prospects of QE within the EU with inflation figures from France on Thursday and Germany on Friday. Also, I’m paying close attention to FOMC meeting minutes (Thursday), US PPI figures out on Friday, and G20 meetings Thursday and Friday.

Technicals

The EUR/USD is entering dangerous territory. It hasn’t been able to break above 1.3900 with conviction and has traded back to the 1.3700 level, a very important support level. If the pair breaks below Friday’s low of 1.3673 it could very well continue dropping to the 1.3600 figure with 200 day MA providing good support near the 1.3550 zone. Resistance should come near the 50% retracement level of 1.3810, measuring from March pivot high to Friday’s low.

EUR/USD daily chart - click to enlarge

Conclusion

While I’ve been discussing the prospects for a euro short for some time now, we could see another bounce from 1.3700 and a test of 1.40+ if deflationary fears are eased with higher CPI and PPI figures. ECB VP Constancio said that inflationary figures will improve in April as Easter holiday travels should boost consumption. While there is a lack of confirmation in any direction, fundamentally the US is further ahead in the recovery process and inflationary outlook favors the US Dollar.

The other day figures were released showing ownership and net purchases of US Treasury debt in 2013. There’s a good set of graphs over at The Big Picture. The big headline in all this is that the Fed was far and away the largest net buyer, having account for over 70% of all issuance last year. Of course this is a function of the central bank’s ongoing quantitative easing program.

We should not be surprised by such big figures, and probably should look to see more of the same moving forward. Why? A couple reasons.

First, even though the Fed has begun tapering it is still replacing maturing Treasury securities in its portfolio. That means even if the Fed balance sheet is not expanding as rapidly as before, it is still a big player in the market just because of portfolio turnover.

Second, as the US federal deficit shrinks so too does the amount of Treasury issuance. That means the denominator in the Fed’s fraction of net Treasury purchase will be lower, helping to keep that percentage somewhat inflated. In other words, this is a case where it’s probably not a great idea to be too caught up in these ratios and percentages.

Another interesting element of the report is the ownership data. It shows that even though the Fed owns a whole lot of Treasury debt, it is still only the 3rd largest representative group. The U.S. public owns nearly twice as much, and foreign governments and central banks aren’t very far behind. Combined they account for nearly 70% of outstanding Treasury paper. For the reasons noted above regarding portfolio turnover, the Fed will continue to own a meaningful fraction of the US national debt, and the fraction could even rise a bit.

This supports something I talked about back in August when I described the Fed as basically being a big portfolio manager in the debt market.

Last week the Federal Reserve announced a further $10bln “taper” in its monthly Treasury purchase program, continuing the process of reducing the amount of quantitative easing the central bank is doing. This is something largely expected by the markets, thanks to the commentary they’ve been getting from the likes of Ben Bernanke. The Fed has been signalling that it intends to gradually reduce the size of the QE injections, probably ending them all together at some point this year. There’s a chance we see some change in tone now that the traditionally dovish Janet Yellin is leading the Fed, but most likely it will be the economy and employment that dictate the path forward.

The markets were a bit ho-hum about the taper this time around. There were a few initial reactions, which we so often see these days, but for the most part established patterns are in place and weren’t meaningfully influenced. The taper was anticipated and market participants are on to looking at other things like the economy.

As to the economy, it has to be said the markets aren’t speaking too positively about it. As the chart of 10-year Treasury yields below shows, rates have been working lower since the first Fed taper in December.

10 year bond yields

A drop of about 40 basis points in yields is not something one looks upon as indicative of a market looking for robust economic growth moving forward. Even more so with rates currently still at historically low levels.

We see further reason for concern when looking at the S&P 500 chart.

S&P 500

The fact that we have something of a double-top type of pattern from the December/January peaks is a concern in and of itself. This becomes even more worrisome when we consider how rapidly the market move down to test the December lows. Yes, it has thus far found support there. A strong market, however, would not have fallen that far. My concern is that while we may see some kind of rally develop in the near future, that might just be the precursor to a break below 1770 on the index as a legitimate downtrend develops in the next few weeks.

Interestingly, this is supportive of some of the commentary out of the Fed last week. The move to taper was not indicated as particularly reflective of the idea that the US economy is growing rapidly or that employment is falling precipitously. Neither of those things is happening. And of course there is going to be a group of traders and investors feeling like reduced Q.E. means less support for the economy and thereby weaker prospects moving forward.

Of course the USD likes that less money is being pumped into the system. As I’ve written in recent weeks here and here, the greenback is actually in a good position to benefit from the tapering.

I was taking a look at the Market Profile charts recently and came across an interesting set-up in the gold market. The precious metal has been weakening since summer, largely on the back of speculation that the Fed will begin reducing its securities purchases by way of cutting back on quantitative easing – the so-called “taper”. That is perceived as being a positive for the dollar from the perspective of reducing future supply (and thus inflation risk), which works in the opposite direction for gold, and anything else viewed as an inflation hedge.

Of course, gold has been in a predominantly negative pattern since the latter part of 2012. That said, the last two quarters have shown mainly sideways movement by way of consolidation, as the weekly chart below indicates.

It’s noteworthy that the Bollinger Bands have gotten quite narrow. They aren’t as tight as they got last year, but that’s where the Market Profile perspective might be providing a view of the future.

Last week gold got down to the Point of Control (highest trading activity price) from back in July. Those points tend to be attraction areas, but this one hadn’t been revisited up to now. These levels, once reached, are often points where the market makes a turn after being reached due to a trend move. That could be what we’re seeing now. (click to enlarge)

If gold can hold support and not move below about 1235 it will have a good chance of making a meaningful turn higher. This ties in with what I mentioned about the Bollinger Bands. Such an upside reversal would further the broad consolidation and likely cause the Bands to continue narrowing, moving them toward how tight they got in 2012.

I would not want to be long should gold break last week’s lows, however. That would open up the prospect for at least a retest of the June bottom. With the Bands already showing indications of starting to widen, which tends to signal a new trend, the risk would be for another meaningful leg lower in the overall bear market.

It should be noted, what I’m looking at could fit in quite well with the analysis yesterday by Or Kahana. If the market does work higher in the immediate term, the narrowing of the Bollinger Bands in the weekly time frame caused by such a move would serve the purposes of a long-term downtrend continuation further out. So long as the market doesn’t drive back up through 1400 or so, the long-term bear scenario would be favored.

The Fed was a non-actor at last week’s FOMC meeting. As I noted previously, for at least some folks it was no surprise to see no movement in terms of a taper in October – that December would be the more likely target for something to happen. Since the September non-taper, we have seen US 10 year Note yields working lower. Basically, we’ve seen at least some of the expectations for reduced Fed purchases of Treasury securities being backed out of the market. As the chart below shows, yields are back down into the range they were at during the Summer.

We can see that this retracement in rates has led the Bands to narrow fairly rapidly. The Bands are now in line with their narrowest readings of the last two years. This suggests we are probably not far away from something interesting developing.

What is worth noting is where yields found support just above 2.40%. That’s where the market ranged during the summer. It’s also where the rally peaks from 2011-2012 reached. That makes for a very significant support level. If the market can hold there it will be well positioned to start working higher again and probably take out that 3.0% level again.

There are definitely those looking for that kind of turn. As noted here, the language of the FOMC statement is being viewed as hawkish, indicating a Fed bias toward doing the taper sooner rather than later. This is despite the obvious concerns about the impact of the government shutdown on the economy.

It should be noted, though, that some technicians are looking at the chart above and saying a head-and-shoulders top is forming. Certainly, that could be the case. My concern there is the downside potential of 2.4% being broken looks limited. The early 2013 yield peak is around 2.1%. That’s very likely to be support for any move lower. Personally, all things considered – fundamentally and technically – the best risk/reward play from here is to expect rates to trend higher in the intermediate to longer term.

On Wednesday we got a great example of what happens when the markets – or at least the machines – think they know what’s coming, but get something completely different. As noted by Oanda and Business Insider, and discussed in this space before, the broad expectation was that the Fed would begin tapering back the amount of its month quantitative easing (QE) at the FOMC meeting this week. It was largely seen as a question of how much the taper would be rather than whether there would be one.

As has been well documented in the media, over the last several weeks the markets have been moving in anticipation of the start of the taper this month. Most notably, US yields have been on the rise, with the 10yr Note rate reaching 3.00% just two weeks back. As would generally be expected, rising rates put stocks under pressure (Zero Hedge talks about the linkage between QE and stock prices here). At the same time, the combination of falling asset markets and a stronger USD put emerging markets currencies under pressure.  We got what was a kind of limited risk aversion move in the global markets, and rising gold prices were part of that.

All those moves everyone was getting so excited about in August faded as we rolled into September, though. Stocks turned up, the USD weakened, and gold retraced. In fact, the USD was back testing the August lows even before the FOMC announcement. All this may explain something of what we’ve seen in the markets thus far since the FOMC announcement.

Notice how the USD Index, US 10yr yields, the S&P 500 futures, and Gold respectively in the charts below all had an initial sharp move followed by a flattening out.

It’s going to be very telling how the market progresses from here. Even before the announcement Wednesday there was talk at Business Insider that it was either September or December if the Fed was going to move to taper this year. If the US unemployment rate continues to slide toward the Fed’s 7% target rate, the market is going to expect exactly that to be the case.  And even if the Fed does make the move then (or before), there remains the question as to how they will move, which will have a definite impact on certain markets.

Mish asks the question, though, how important a $10bln/mo reduction in QE actually would be. You’re only talking about a cut in buying of about 12% in a situation where there is already trillions of dollars sloshing around the system. That’s probably a factor in why the markets had already begun reversing course and in why we haven’t seen much continuation, at least thus far. The minimal actual impact of such a cut had already been factored in to the equation.

A few days I ago I wrote a blog post suggesting that we need to be careful reading too much into low Treasury yields.  I’d like to take a little time here to expand on my comments from that piece.

There has been a lot of talk about new historic lows in long-term US yields. We’ve clearly seen a break below the lows put in back during the financial crisis when 10yr yields approached 2% but didn’t break below. As the chart following shows, that break finally happened in 2011, and we’ve since see the market move down to near 1.50%.

The thing that doesn’t get mentioned in all the talk about rates being so low is how much of the long-term Treasury issuance the Fed is holding. The Fed went through two rounds of quantitative easing (QE) where it bought Treasury and mortgage securities. It has been running Operation Twist for the last several months whereby it sells short-term Treasuries (think T-Bills and short-term T-Notes) and buys long-term securities. That’s helped bring the yields on 10- and 30-year securities down.

It is important to keep this in mind for two reasons. The first is fairly obvious. Operation Twist is set to conclude at the end of June. That would remove a major buyer from the market, reducing demand for long-dated Treasuries. Much debate these days revolves around whether the Fed will react to recent weaker economic data to either do more Twist or to initiate QE3, or some other type of easing effort. There are folks looking for something to be announced coming out of this month’s FOMC meeting, but the comments from Fed speakers recently haven’t leaned in that direction (though certainly we could see a change of tone).

The second reason I think we need to keep all the Fed buying in mind is the size of the holdings in long-dated Treasuries the central bank has built up. It’s substantial. The numbers I’ve seen indicate the Fed currently owns about 21% of the total issuance of Treasury coupon securities (T-Notes and T-Bonds). There are fewer long-dated Treasuries outstanding, though, so as you can see from the table below, the Fed actually owns a larger fraction of those securities.

What happens when you shrink the float of a tradable security?

If you answered bigger moves and greater volatility then give yourself a prize. Why? Because when there is less of something available to trade, but volume isn’t reduced on a comparable basis, the market will move more rapidly, both up and down.

Now think about what happens when markets go into “risk-off” mode, as we’ve seen happen lately.  You have a large amount of money flowing into a market which has fewer securities available to purchase. Increased demand combined with decreased availability means rapid price appreciation in those securities, and thus rapidly falling yields. That’s why one needs to be a bit cautious when viewing the recent market moves.

So where from here?

Well, it’s going to depend in part on what the Fed does. Does the central bank continue buying enough long-dated paper to maintain (or increase) its fractional holdings? Or does it stop once Operation Twist is over and hold pat with current holdings, or buy at a slower rate?

The more explosive scenario where yields are concerned is a combination of the Fed slowing or halting its purchases and the risk aversion bid coming out of Treasuries. The Treasury isn’t going to stop auctioning new debt any time soon, so we would end up with greater supply and decreased demand –both from the market and the Fed - that could send rates soaring.

Even if the Fed does keeping buying, the reduced float means we’re likely to continue to experience above volatility jumps on risk-related events for the foreseeable future. The impact of a decline in risk aversion would be a little less impactful, though, because the Fed would still be a demand factor.

I bet right about now Jamie Dimon at JP Morgan is quite pleased to have the Facebook fiasco all over the news to take some of the spotlight off his little derivatives problem. As I write this (Tuesday morning), JPM is up 5% and FB is down nearly the same amount on the day. Personally, I think there’s way too much being made of the whole Facebook IPO story - though I do think the NASDAQ system problems is an interesting story, especially after the BATS failed IPO a little while back - but admittedly the rest of the news has gotten rather stagnant. I actually begged CNBC via Twitter on Friday to talk about something, anything, but Facebook, but struggled to come up with a good alternate subject.

Naturally, there’s a blame game going on as to whose fault it is the stock has taken a dive. We can never really know how things would have turned out if the NASDAQ system had functioned properly, but that won’t prevent folks from trying to do so. Finding someone to blame, of course, is a favorite pastime these days. Traders certainly do it when they take losses. After all, it can’t be my fault I lost money on my position. It must be those evil banks, unethical brokers, or speculators gone wild (unless, of course, they are moving prices the direction I want).  Yes, I am a speculator. Obviously, I’m talking about the other speculators, though – especially the ones with computers faster than mine. Yeah, the high frequency guys. It’s all their fault! They’re preventing me from moving out of the 99% and in to the 1%. Something really needs to be done about them.

Thankfully, today we’ve returned to the on-going back and forth between European central bankers and political leaders over what to do about the mess. It’s kind of refreshing after the all-Facebook-all-the-time chatter. Everybody seems to want Greece to stay in the euro, but it looks like we won’t find out until the middle of June as to whether the Greek people share that view. You’ll notice the German rhetoric on the subject of austerity and whatnot has cooled considerably. Could that be because suddenly they aren’t doing all that great either and the weak euro that’s coming out of all this actually tends to help Germany more than most on the export side of things?

Then there’s the on-going question of whether the US can remain out of the fray and avoid too much in the way of economic damage from all the European issues. I’m moving to England in the fall to start work on a PhD, so you know I’m looking for the dollar to go on a fantastic run higher to make my greenbacks go farther. Unfortunately, the UK retained the pound rather than join the euro. The photo going around of David Cameron with arms raised celebrating Chelsea’s performance against Bayern Munich in the Champions League final on Saturday (at last an English team beat a German one in penalties!)  alongside a much less enthused Angela Merkel could just as easily represent the British feeling about having their own currency through all the mess.  I’m hoping the Bank of England decides to do more QE. That ought to sink the pound.

In the meantime, back to my charts.

Oh look! There’s a cup-and-handle setting up on the weekly USD Index chart. Maybe the markets will help me get cheaper pounds without the QE.

cup and handle USD chart

 

Ain't it always the case that an exchange rate rallies into your trip, then starts falling after you've spent the lion's share of the money? GBP/USD did that to me. It was looking so good early in January when the rate was down the low 1.50s, but by I time I left for my trip to England last week the rate was looking at testing 1.60. What day did the market peak? The day I checked out of my longest hotel stay, of course (insert your favorite string of curse words here).

What's even more annoying is that GBP/USD really looks like it's set up for a tumble.

On the weekly chart below we can see the clear support along the line going back to the lows from September 2010 near 1.5300. That was broken during the last leg down, but the market quickly reversed back higher. It hasn't been able to push those gains to even create a test of the November peak, however, so the pattern of lower highs and lows since the 2011 highs remains in place.

GBPUSD Chart

 

These lower highs are also building a head-and-shoulders type of pattern on the chart. If we consider the peak of the pattern to be about at 1.6735, that gives us over 1400 pips in downside projection using the head-to-neckline measurement. A simple target would thus be about 1.3900. This is quite aggressive given the likely support above 1.4000 based on the 2010 lows, but it does provide a fair bit of scope as to the type of damage that could be done should GBP/USD manage a sustained break of 1.5300.

So what's the catalyst for that kind of action? The BoE has already announced GBP50bln of additional QE. That has largely already been priced in and the market isn't looking for any big additions at this point. The biggest risk factor at this point is a crank back up of the risk-off market psychology that would drive the dollar higher. If we see the S&P 500 fail to overcome the 2011 highs as part of the current rally, that becomes a very real risk.

This couldn't have happened a bit sooner?

 

2 Comments

Asaf did a bit of a ranting in his recent Are you listening to the "Experts" post. That's encouraged me to get something off my own chest as well, something along the same lines.

You see, I spend my day watching the markets and listening to the folks on CNBC trying to explain what's driving the markets. I use the term "trying" intentionally because they certainly aren't getting it right in many cases. The one I keep hearing is that the movement in the dollar is driving the action in the stock market. Stocks rally on a weak dollar. Stocks fall on a strong dollar. Give me a break!

Stocks/Dollar Linkage

Let's first take a look at the rolling 1 month correlation between the stock market and the dollar. The chart below compares the performance of the S&P 500 to that of EUR/USD over the last year.

First thing to notice is that the two markets have swung back and forth between being highly positively correlated (stocks and dollar moving in opposite directions) and pretty negatively correlated (stocks and dollar moving in the same direction) several times. Moreover, in 2010 they haven't held correlations on either side of the range for very long before swinging back in the other direction.

More importantly, though, correlation does not mean causation. Just because US stocks and the dollar are going in opposite direction, as has been harped on so many times in the media, it doesn't mean one is causing the other. It more likely means they are both reacting to the same underlying factors.

The Same Driver, Different Actions

Think about the stock/dollar relationship. What would cause stocks and the dollar to move at the same time? That would be money moving into the dollar from abroad and being invested in the stock market, or the reversal of that process. In either case stocks and the dollar move in the same direction.

Now why would stocks and the dollar move independently? Stocks could move because of action involving money already in dollars – US data, earnings releases, interest rate expectations, etc. The dollar could move because of money being exchanged for trade purposes or investment activity outside stocks (Treasuries, real estate, etc.).

So what have we been seeing in the markets over the last year or so? We've seen risk aversion trading in some cases. That's when money piles into the USD as a safe haven. It doesn't go in to stocks. It goes into Treasuries. At the same time, nervous investors already in dollars are taking money out of stocks and putting them in to safer investments. So what we have is one motivating factor (risk aversion) causing stocks to fall and the dollar to rise basically independent of each other, but in a correlated fashion.

We've also seen the QE trade in the dollar. That's where folks move money out of the dollar for fear that increased money supply via the Fed printing money to purchase securities will lower the greenback's value and lead to inflation. It's simple supply/demand analysis. When you increase the supply of something you decrease its value. QE is seen as increasing the supply of dollars, so the USD's value drops. The QE trade causes money to flow out of the dollar, which means foreign flows (on net) cannot be moving into stocks, so we have no dollar-related reason for stocks to rise. They are moving for their own reasons (better earnings prospects, lower interest rates, etc.), but again, linked to a similar underlying driver.

Follow the Money

My point is this: think these things through. If you are looking at the markets from a fundamental point of view you need to think in terms of the flow of money. Investment flows are a big driver, so you have to understand the implications of different events and development in those terms to really understand what's underpinning the market's action. Follow the money. It's a simple thing folks on CNBC don't seem to be able to do.

=====

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.