Financial markets in the United States and Europe fell modestly as investors and traders waited to see what happens next after Turkish fighters shot down a Russian war plane near the Turkish-Syrian border. The Turkish military is saying that the Russian plane had entered Turkish airspace and was shot down after repeated warnings. Russia is denying that its plane had violated Turkish airspace and that it was operating against terrorists in Syria.
As of 10 a.m. New York time traders were selling down risky assets—such as the Russian ruble and the Turkish lira, the MSCI Emerging Markets Index, and European equities—although declines are, so far, measured, with the Emerging Markets Index, for example, down just 0.3%. On the other side of the trade, safe haven assets such as the yen and gold have climbed with gold rising 1%. Oil has gained on speculation that something might happen to disrupt production somewhere. U.S. benchmark West Texas Intermediate was up 1.7% this morning.
The situation is full of potential pitfalls. Since Turkey is a NATO member this incident immediately increases tensions between the Western alliance and Russia. Russian planes in operation on this section of the Syrian-Turkish border have been targeting, Turkey and the United States say, Turkmen villages fighting against the Assad regime and not ISIS positions. The Russians have been flying bombing missions in support of an offensive by the Syrian army, Iranian-affiliated militias, and units of Hezbollah, Turkey has protested. The Sunni Muslim Turkmen minority in Syria is regarded by many Turks as ethnically Turkish. Iranian militias are Shia Muslim.
The Turkmen villages facing the Syrian army/Iranian militia/Hezbollah offensive are also seen by the Turkish government as an important buffer zone not just against the Syrian fighting but also against the expansion of Kurdish forces along the Turkish border.
If you think this is a mess, you’re right. The most likely outcome, though, is a step down in tensions short of more military incidents after a wave of intensive diplomacy by countries such as France that are trying to put together a coalition that includes the Russians and the Turks against ISIS. Russia is Turkey’s second largest trading partner and the source of 60% of its natural gas.
These factors don’t mean, however, that we won’t see other incidents in the short-term. (Both Russia’s Putin or Turkey’s Erdoğan are proud nationalists and aren’t known for shrinking from confrontation.)
Any short-term incidents are likely to increase downward pressure on risky assets.
How to trade this situation?
If tensions do ratchet upward and risk assets do sell off, I’d look to buy positions in stocks or bonds or currencies that you’ve been avoiding because they were too pricy. I’d be particularly interested in any sell off in U.S. market favorites on a movement away from risk. I don’t see any reason that these tensions should radically depress the prices of high-PE U.S. stocks such as Netflix (NFLX) or Facebook (FB) but I would note that both are down today by 2.7% and 1.6%.
Oil and gold will both move up if tensions continue but I don’t see those moves as sustainable unless this turns into a much bigger conflict than currently seems likely. You might use the bounce to trim positions that you’ve been looking to sell in these assets.
One of the most interesting non-financial effects to watch is whether this incident has the power to change rhetoric or positions among Republican and Democratic presidential contenders. Will it cause anyone to re-think the dangers and difficulties of imposing a No-Fly zone in Syria? Will it lead to any reconsideration of calls for a coalition of local powers to fight ISIS? Considering how U.S. politics works there days, I’d doubt it.
U.S. benchmark crude fell as low as $40.41 a barrel and rose as high as $42.75 today—a range of 5.8% from low to high—on a vague promise from Saudi Arabia, the biggest OPEC producer, that it is ready to work with other producers to stabilize global oil prices.
There’s really nothing different or concrete in the Saudi promise. And there’s certainly nothing like a proposal on how to reconcile soaring OPEC production with reductions in production by non-OPEC producers in the face of the drop in the price of oil forced by those OPEC barrels.
But this is the kind of volatility you get in a market that is dominated by a one-way trade. So many traders are short oil that anything that might somehow support oil prices leads to short covering and a bounce, short-lived in this case, in oil prices. On November 20 the U.S Commodity Futures Trading Commission projected that hedge funds reduced their long positions on crude oil by 17% for the week ended on November 17 from the previous week. Bearish positions rose by 16,246 contracts. On November 23 the InterContinental Exchange reported that hedge funds and other money managers raised their short positions on European benchmark Brent crude by 27,734 contracts to 141,387 lots in the week ended on November 17. That’s the largest number of short positions since October 2014.
Other commodities were less volatile today and more uniformly negative. Copper fell below $4,500 a metric ton for the first time in six years and nickel hit its lowest price in a decade on worries about supply surpluses. Gold futures for February delivery fell 0.9% to $1,066.60 an ounce. Assets in exchange-traded products backed by gold have tumbled to their lowest level since 2009.
Back on March 12, 2015, I added iShares Currency Hedged MSCI Germany ETF (HWG) to my Jubak’s Picks portfolio at a purchase price of $28.11–or at least I thought I did. For reasons that I can’t identify, the buy never made it into the portfolio–although it did get posted on my subscription site JubakAM.com. Today I fixing the omission and entering a buy with my original March 12 price.
Here’s the March 12 post that went with this purchase.
Hedged or unhedged
I’ve spent the week since I wrote http://jubakam.com/2015/03/everything-and-i-mean-everything-you-need-to-know-how-to-invest-in-the-eurozone-now/ on my subscription JubakAM.com site about why putting some money into an ETF focused on a European export-oriented economy such as Germany or Poland was a good way to play the asset purchase program that the European Central Bank announced in detail on Monday, March 9.
I had been inclined to say, “unhedged.” I can easily remember when everything thought the drop in the euro would end at $1.25 or $1.20 or most recently at $1.10 or at parity with the dollar ($1.00.)
The euro closed at $1.0551 today, March 11. If the bottom was $1.00 that was only a further 5.2% drop from here—not a terrible risk—and if the euro were about to rally, then I’d sure like to participate in the bounce.
Now, however, big money managers are talking about this decline in the euro going on into 2017. For example, Deutsche Bank, which was bearish at the euro at the beginning of the year, has gotten even more bearish. The bank is now talking about parity for the euro to the dollar by the end of 2015 and then a continued decline to 85 cents to the euro by 2017.
Yipes. That’s a 19% drop in the euro. Enough of a potential currency loss to wipe out much of any potential gain in share prices.
As of tomorrow March 12 I’m adding iShares Currency Hedged MSCI Germany ETF (HEWG) to my Jubak’s Picks portfolio http://jubakam.com/portfolios/ . (I’m picking this ETF above competitors Wisdom Tree Germany Hedged Equity ETF (DXGE) or Deutsche X-trackers MSCI Germany Hedge Equity ETF (DBGR) because it is about 10 times larger and in this market I’m more comfortable with more liquidity rather than less.) The iShares Hedged Currency MSCI Germany ETF closed at $28.32 on March 11. The expense ratio (with fee waiver) is 0.53% and the ETF yields 1.76%. I calculate a target price of $34 a share by the end of 2015
So why have some big investment houses become so much more negative on the euro lately—and why do I believe them?
It’s a reflection of a deeper study of how the European Central Bank’s program of asset purchases is likely to affect interest rates in the EuroZone. The conclusion is that the plan will send already low rates even lower.
I know that sounds impossible. After all the 2-year German note already yields a negative 0.25% and the 5-year note yields a negative 0.13%.
But it’s not impossible that yields will go lower. It’s actually probable given the structure of the bond market in the EuroZone.
Here’s the problem: Thanks to the EuroZone’s focus on austerity member countries haven’t been issuing much new debt. And they don’t have plans to issue much new debt.
Net issuance of new debt in the EuroZone between now and September 2016—the projected life span of the European Central Bank’s asset purchase program—is projected at just 413 billion euros, according to JPMorgan Chase. I say “just” because the European Central Bank wants to buy 850 billion euros of debt securities. That leaves new supply short of central bank demand by a huge 437 billion euros.
That’s how much the central bank will need to buy in already issued bonds from current owners. To pry them out of the hands of current owners, the European Central Bank will have to offer to pay higher prices—and higher prices translate into lower yields. (Especially since many banks hold these kinds of assets as core parts of a capital bases required by regulators.
The problem will be most acute in the market for German bonds where the bank will be looking to buy 200 billion euros of German government debt and the supply of newly issued debt will be just 6 billion euros during this period.
Getting current bondholders to sell isn’t going to be easy in the case of large institutional holders such as insurance companies and pension funds. These institutions own these bonds because they match projected liabilities in both payout and maturity. Exactly what are these companies supposed to buy to achieve those goals if they do sell their current holdings?
Part of the more negative assessment of the effect of this program of asset purchases on yields and the euro reflects calculations of how quickly asset purchases will reduce the supply of bonds suitable for purchase. The European Central Bank’s plan says that it won’t buy any bond with a negative yield of more than 0.2%. That’s the price that the central bank now charges individual banks to keep deposits in central bank vaults. The negative 0.2% figure is an effort to limit the losses the central bank would take if it buys a bond with a negative yield and yields then wind up climbing. (As they would at some point if this program of asset purchases does indeed increase growth and inflation rates.)
But look how that limit works to reduce supply. Once upon a time—like Tuesday, March 10—the central bank could buy German notes maturing in April 2018, a little more than three years from now. But yields on those notes fell as the price of those notes climbed so that on Tuesday yields fell to a negative 0.23% and these notes were no longer allowable purchases by the central bank.
In effect purchases—or anticipated purchases–by the European Central Bank acted to reduce the supply of bonds available for purchase and to increase the upward pressure on the prices of remaining bonds in the market—with the result that yields on those bonds fell too.
Much of the early worry about this process has focused on the question of whether or not the supply of bonds available for purchase would be exhausted before the program of asset purchases reached an end.
The more recent focus, however, has been on the effect of the asset purchase program on yields now. And the result of this analysis has been to suggest that European bond yields will be in the midst of any even deeper drop just as the U.S. Federal Reserve begins to raise interest rates in June or September.
And that will mean, this analysis says, an even weaker euro than projected earlier.
Of course, there is always the additional possibility that the European Central Bank’s plan won’t work—in which case the central bank will arrive in September 2016 having spent 1 trillion euros on asset purchases with nothing to show for it except deeper negative interest rates on a larger portion of the existing European bond supply.
You can bet the euro would love that.
Call it “Whatever it takes” II.
Today, European Central Bank President Mario Draghi said that the EuroZone central bank “will do what we must to raise inflation as quickly as possible.”
I don’t expect that this promise, made in a speech in Frankfurt, will have the same electric effect as “Whatever it takes” I in July 2012. That promise reversed a plunging euro, pulled the bonds of Spain and Italy back from the brink, and set the stage for a significant recovery in the prices of euro assets.
This time I think the likely market reaction will be positive—that is the euro will move lower as the bank wants (it closed at $1.0656 down 0.68% against the dollar today) and financial assets will move higher (the German DAX is up 0.31% today)—the move will be much more modest. The likely actions from the bank are relatively modest in contrast to past proposals and the problems the central bank faces have proven to be very resistant to the bank’s solutions to date.
After today’s remarks by Draghi pretty much everyone has concluded that the bank will move at its December 3 meeting—even though hardline members of the bank’s board of governors such as Germany’s Jens Weidmann are saying no changes are needed now. The bank’s inflation target of 2% remains a distant dream with the current inflation rate in the EuroZone at just 0.1%.
The policy menu in front of the bank includes an expansion of the current program of bond buying from 60 billion euros a month to 80 billion or so; an extension of the life of the program beyond the current September 2016 limit, and a further drop in the bank deposit rate. In normal times the central bank pays a modest rate of interest on money that banks leave on deposit over night. These days the central bank charges banks that leave their money overnight 0.2%. It’s just about certain that the European Central Bank will take that negative deposit rate even lower to, say a negative 0.3%. Bond yields across the EuroZone are already falling even further into negative territory in anticipation of the central bank’s move. The yield on 2-year German government bonds fell to a record low of a negative 0.389% today.
There is a good possibility that rather than choosing from this policy menu the European Central Bank will implement all of these items. That would still fall well short of a “shock and awe” response to the current mix of extremely low inflation and tepid growth, but at this point it might be the best the European Central Bank can do.
The financial markets this afternoon read the minutes from the Federal Reserve’s October 27-28 meeting and concluded:
- That the Fed will raise interest rates for the first time since 2006 at the October meeting.
- That when the Fed says it will raise rates gradually, it means very slowly indeed.
The increased degree of belief in a December move on interest rates comes from language that the Fed inserted into its October post-meeting statement that “it may well become appropriate” to raise the benchmark lending rate in December. The minutes said that “Members emphasized that this change was intended to convey the sense that, while no decision had been made, it may well become appropriate to initiate the normalization process at the next meeting.”
According to a headcount included in the minutes, some Fed members said that economic conditions for increasing interest rates “had already been met.” Others—“most participants,” the minutes said, estimated that conditions “could well be met” in December. A third group, “some participants,” the minutes noted, “judged it unlikely that the information available by the December meeting would warrant” a rate increase.” In my opinion data since the meeting on the strength of the jobs market and the economy and on inflation have argued in favor of a December move.
Participants in the meeting “generally agreed,” the minutes said, “that it would probably be appropriate to remove policy accommodation gradually.” The minutes added, “It was noted that the beginning of the normalization process relatively soon would make it more likely that the policy trajectory after liftoff could be shallow.” After a staff briefing on the equilibrium real interest rate, Fed members discussed the possibility that the short-run equilibrium interest rate would remain below levels that were normal in previous business cycle expansions.