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posted on 10 January 2017

Macrotides Monthly Market Report 09 January 2017

Written by

Is China a Currency Manipulator?

“The sad truth is that past trade deals have tended to undermine middle-class wages and spurred the export of family-supporting middle-class manufacturing jobs to nations that have lower wages and working standards."

yuan.bundles.340x218

Given the tone of this quote you would think Donald Trump may have said it but you’d be wrong. These words belong to Senator Charles Schumer (D, NY) and were spoken in May 2015 in regard to the Trans Pacific Partnership, which was being promoted by President Obama.

During a May 6, 2015 conference call with reporters, Schumer also said the U.S. should focus on cracking down on trade cheaters like China, who manipulate their currencies to boost their exports and undercut manufacturers. Schumer referenced a study by the liberal Economic Policy Institute (EPI) which showed that currency manipulation and other trade practices had displaced nearly 180,000 New York state jobs between 2005 and 2015.

In 2005 Schumer and Republican Senator Lindsey co-sponsored the first Chinese currency bill naming China as a currency manipulator, so this issue has been brewing for a long time. One of Donald Trump’s campaign themes was calling China

“The single greatest manipulator that’s ever been on this planet."

Trump has pledged that soon after he takes office he will declare China a currency manipulator because China is devaluing the Yuan against the Dollar.

Has China been manipulating its currency and would it be appropriate for Trump to label China a currency manipulator?

welsh.macro.tides.monthly.2017.jan.fig.0

The Chinese Yuan (CNY) increased 25.5% in value versus the Dollar (USD), between January 14, 2007 and July 27, 2015. During the decade Senator Schumer cited China for manipulating its currency, the Dollar dropped more than 25% against the Yuan. New York may have lost 180,000 jobs during that decade but the ‘weakness’ of the Yuan, given it rose 25.5% against the Dollar, wasn’t the main reason.

Maybe a good portion of the jobs that left the state of New York may have been due to New York’s high tax rates and penchant for regulation, two subjects Schumer would prefer not to address.

In recent years the Chinese government has pegged the Yuan’s value to the Dollar. Between May 1, 2014 and July 28, 2015, the Yuan gained 0.8% against the Dollar which showed China’s government was successful in keeping the Yuan pegged to the Dollar.

While the stability of the Yuan sounds innocuous, it wasn’t. Between May 1, 2014 and July 28, 2015, the Dollar soared by more than 26.4% versus the Euro and 58.9% against the Yen. While the Bank of China was successful in holding the Yuan steady with the Dollar, the Yuan soared by 60.8% against the Yen and 26.1% versus the Euro.

welsh.macro.tides.monthly.2017.jan.table

China exports more to the European Union than it does to the U.S., so the increase in Yuan’s value versus the Euro became a significant hurdle for Chinese exporters. With the Yuan’s value increasing more than 60% versus the Japanese Yen, Chinese exporters could not compete with Japanese exporters for China’s share of global trade.

With its economy slowing and export growth shrinking, Chinese policy makers decided to stop pegging the Yuan’s value to the Dollar. In August 2015, China allowed the Yuan to lose more than 4% of its value relative to the Dollar in a few days, which caused global financial markets to swoon.

welsh.macro.tides.monthly.2017.jan.fig.1

Since China’s decision to devalue the Yuan in mid August 2015, the Yuan has lost 10.0% versus the Dollar, but is still up 19.4% against the Euro and 35.9% to the Yen.

China’s shift in its currency policy, after almost a decade of allowing the Yuan to appreciate against the dollar and other currencies, has led Chinese companies and individuals to shift some of their assets out of the Yuan and into the Dollar or other currencies. As the Yuan loses value, the purchasing power of Chinese firms and investors declines, so converting assets into other currencies helps them protect their wealth.

welsh.macro.tides.monthly.2017.jan.fig.2

The outflow of capital from China has accelerated over the last two years and has contributed to the downward pressure on the Yuan. Capital flows were positive as the Yuan rose in value between 2007 and 2014, causing China’s foreign reserves to increase from less than $2 trillion to almost $4 trillion in July 2014. The flow of reserves out of China accelerated after Chinese firms and investors realized the Yuan would continue to lose value.

The People’s Bank of China reported on January 8 that foreign reserves were $3.011 trillion, after $41.08 billion fled the country in December. This marked the sixth month in a row and the most since January 2016. Foreign reserves at $3.011 trillion are the lowest level since March 2011.

welsh.macro.tides.monthly.2017.jan.fig.3

Since the sharp devaluation in the Yuan in August 2015, the Yuan has continued to lose value in a stair step fashion as periods of weakness have been followed by modest rallies. Since November 2013, China’s holdings of U.S. government debt have declined by $210 billion to $1.12 trillion at the end of October. More than half of the decline has occurred over the last six months, as China attempted to manage the decline in the Yuan so that it is orderly. When China liquidates U.S. Treasury notes and bonds, it sells the Dollar and buys the Yuan with the proceeds. By selling the Dollar and buying the Yuan, China is supporting the Yuan, even as it loses value against the Dollar over time.

Since China’s purchases of the Yuan shrinks the amount of Yuan outstanding, it represents a tightening of monetary policy within China. China is attempting to balance a lower Yuan to spur export growth, while allowing a slight tightening of monetary policy to manage an orderly drop in the Yuan.

The task of managing an orderly decline in the Yuan without disrupting China’s domestic economy is no easy task. It would be easier if that were the only challenge facing Chinese policy makers. As I have discussed for the last two years, China has relied too much on debt to power its economic growth since the financial crisis. The level of debt has now reached the point where the law of diminishing returns is at work, since each new dollar (Yuan) of debt is generating less than $0.25 cents of GDP growth.

welsh.macro.tides.monthly.2017.jan.fig.4

New debt is being used to pay off old debt in a game of musical debt chairs that will come to an ugly end when the music stops. China is also dealing with another property bubble in its major cities. Letting the air out of an asset balloon is extraordinarily difficult. The use of housing leverage is far lower in China than it was in the U.S. in 2007, so the banks aren’t exposed like U.S. banks were leading up to the financial crisis in 2008. A decline in housing prices will no doubt add to banks’ rising nonperforming loan problem, but it won’t cripple them.

For the average Chinese investor a decline in housing values will crimp consumer spending, at a time policy makers are hoping domestic consumption can replace China’s reliance on exports and infrastructure spending. With so many balls in the air, China’s juggling act could be overwhelmed at some point and at least one ball is going to drop. My guess is it happens before the end of 2018.

welsh.macro.tides.monthly.2017.jan.fig.5

Irrespective of Senator Schumer’s opinion or Trump's campaign rhetoric, it is difficult to substantiate claims that China has unfairly manipulated its currency. The decline in the Yuan since August 2015 followed a significant period of appreciation versus the Dollar. And it can be reasonably argued that the Yuan was overvalued relative to the Euro and especially the Yen.

If Trump wants to target countries that have manipulated their currency, he need look no further than Japan and the European Union. In late 2012 the Bank of Japan implemented a number of policies intended to lift Japan out of the deflationary funk that had enveloped its economy for more than 20 years. One of the goals was to lower the value of the Yen against the Dollar and other major currencies. Between September 12, 2012 and July 28, 2015 the Yen shed -37.2% of its value against the Dollar, while the Dollar rose 58.9%. The Yen has rebounded modestly since July 2015, but is still down -33.8% since September 2012, and the Dollar is still up over 50%.

In a March 6, 2014 press conference, European Central Bank (ECB) president Mario Draghi said:

“The strengthening of the Euro exchange rate over the past eighteen months has certainly had a significant impact on our low rate of inflation and, given current levels of inflation, is therefore becoming increasingly relevant in our assessment of price stability."

In April 2014 my monthly commentary was titled Macro Strategy Review (MSR) and was published by Forward, a San Francisco mutual fund firm which is now a part of Salient Partners. In the April 2014 MSR, I discussed what the ECB might do to cause the Euro to decline:

“All the ECB may need is for Draghi to state the desire for a lower Euro. Currency traders would be happy to accommodate the ECB’s wishes, since they could sell the Euro short knowing they were doing so with the blessing of the ECB."

After the ECB’s meeting on May 8, 2014, Mario Draghi said:

“The strengthening of the exchange rate in the context of low inflation is a cause for serious concern."

welsh.macro.tides.monthly.2017.jan.fig.6

My assessment of Draghi’s comments was that the ECB wanted the Euro to decline, since a cheaper Euro would increase exports, Euro zone GDP, and help low productivity countries like Italy, Spain, Portugal and France become more competitive globally. I recommended that the Euro could be shorted above 138.00 and was likely to be a profitable trade in the coming year. In April 2015 I recommended covering the short under 106.50, since the Euro was likely to bounce after such a large decline. Since May 2014 the Euro is down -24.6% and the Dollar is up 32.8%.

The declines in the Yen and Euro were intentional and incorporated into the economic policy of Japan and the EU, which sounds like manipulation to me.

The Dollar

Ronald Reagan believed in free trade. In a June 1983 speech he said:

“One economic lesson of the 1930’s is protectionism increases international tensions. We bought less from our trading partners, but then they bought less from us. Economies dried up, world trade contracted by over 60 percent."

In November 1983, Reagan summarized his philosophy on trade in a speech in Tokyo:

“The message I want to leave with everyone here tonight is simple. It’s a lesson history has taught us again and again. Protectionism hurts everyone, but free trade benefits all."

Reagan’s administration launched the Uruguay Round of multi lateral trade negotiations that lowered global tariffs and created the World Trade Organization. Reagan supported and won approval of the U.S. - Canada Free Trade Agreement in 1988.

Reagan believed in free trade, but he was also a pragmatist. In 1983 he approved a five year tariff on Japanese motorcycles. He supported restrictions against Japan, German and Korean imports of steel and auto imports, so he appreciated that a country had to ensure that free trade was also fair. After Reagan was elected in November 1980, the Dollar rallied from under 95.00 to 146.00 in February 1985, an increase of 53.7%. The strong Dollar hurt exports and caused the trade deficit to soar.

welsh.macro.tides.monthly.2017.jan.fig.7

In his weekly radio address on Saturday, September 21, 1985, Reagan responded to Congressional demands for restrictive trade legislation:

“In recent weeks there has been sentiment growing in the Congress for some form of protectionism. On Monday, I will address our absolute commitment to trade that is both free and fair. The answer to our trade problems is not antitrade legislation. It is more economic growth worldwide."

The day after Reagan’s radio address, finance ministers from the U.S., Japan, West Germany, France and Britain announced the Plaza Accord, named after the Plaza Hotel in which the meeting was held. The Plaza Accord represented an agreement by each country to make changes in its’ economic policies and to intervene in currency markets as necessary to bring down the value of the Dollar.

Reagan believed in free trade, but understood that a strong dollar could be too much of a good thing, especially if it cost American jobs.

Many factors influence the strength or weakness of the Dollar. The level and direction of interest rates play a role, as does the amount of the U.S.’s trade and current account deficits. Trade surpluses have been M.I.A. for a long time, but that hasn’t precluded significant Dollar rallies. The economic outlook for the U.S. economy is also a factor. However, even though the U.S. economy was in recession in 1981 and 1982 and in 2009 (shaded areas on chart above), the Dollar rallied smartly. While each of these factors influences the direction of the Dollar, I have found that the level and direction of interest rates, trade and current account surpluses or deficits, or the health of the U.S. economy are not consistently accurate in identifying the trend of the Dollar. They work for awhile, and then they don’t.

Over the last 35 years, one factor has consistently exerted more influence over the Dollar’s trend than any other. The global perception of the sitting President and his administration’s perceived support of a strong Dollar or a weak Dollar has been more consistent than any of the other fundamental influences. Reagan was perceived as a strong leader around the world. After Reagan was elected in November 1980, the Dollar rocketed from 95.0 to 146.0 in February 1985. This increase of more than 50% occurred despite the fact that the federal funds rate fell from 20% in 1981 to under 8% in 1985.

The trade deficit, after being in balance in 1981 when Reagan took office, swelled to 3% of GDP in 1985. When the U.S. agreed to devalue the Dollar in September 1985, the Dollar fell below 90 in 1987. The decline in the dollar occurred even though the U.S. economy continued to grow strongly after 1985.

When Treasury Secretary Robert Rubin said “We believe in a strong Dollar" in the 1990’s during the Clinton administration, the Dollar strengthened from 81.0 to 106.5 in October 2000 (+31.5%), before the election in November. During the period of appreciation, the economy was strong but the federal funds rate was basically flat so the influence from interest rates was negligible.

welsh.macro.tides.monthly.2017.jan.fig.8

On February 16, 2001, Treasury Secretary Paul O’Neill spoke in Palermo Sicily at his first International Economic Conference:

“We are not pursuing, as often said, a policy of a strong Dollar. In my opinion a strong Dollar is the result of a strong economy."

His differentiation from Rubin’s steadfast support of a strong dollar was apparent to currency traders. BNP Paribas thought O’Neill’s comment represented a fundamental shift in policy, while Rabobank International wrote that the currency market would interpret the comment as the U.S. wanting a weaker Dollar. After leaving office in February 2003, O’Neill said:

“I was not supposed to say anything but ‘strong Dollar, strong Doctor’. I argued then and would argue now that the idea of a strong Dollar policy is a vacuous notion."

The Dollar held up until July 2001, when it topped at 121.02 and posted a secondary high of 120.02 in early 2002, primarily due to weakness in the Euro which represents 57.6% of the Dollar index. Between May 2002 and May 2003, the Dollar lost a 21% against the Euro and 9% versus the yen. On May 18, 2003 the Dollar’s descent was given a shove by Treasury Secretary Paul Snow, (who succeeded O’Neill in February 2003). Snow described the Dollar’s fall against other major currencies in the prior year as a “modest" realignment. For currency traders this amounted to a green light to sell the Dollar and they did. Between July 2001 and March 2008 the Dollar declined 42%, falling from 121.0 to 70.0. (Dollar chart, second above)

During the Obama administration the Dollar has been treated with benign neglect as comments by Treasury Secretary Geithner and Jack Lew were supportive but infrequent. In November 2009 Geithner said it was important to maintain a strong Dollar. In October 2010 he offered a somewhat backhanded support for the Dollar:

“It is very important for people to understand that the United States of America and no country around the world can devalue its way to prosperity. It’s not a viable, feasible strategy."

The most notable currency action by the current Treasury Secretary Jack Lew was the decision to replace Andrew Jackson on the $20 bill with abolitionist Harriet Tubman by 2020:

“With this decision, our currency will now tell more of our story and reflect the contributions of women as well as men to our great democracy."

I recount this history since President elect Trump has expressed his support of tariffs as a negotiation tool and his goal of bringing jobs lost to trade back to America. Since the election the Dollar has rallied by more than 7% and is up 12% since a low in early May. On December 30, the Commerce Department reported that exports fell $1.2 billion from October, while imports rose by $2.2 billion. The trade deficit for goods widened to $65.5 billion for November. Through November the 2016 trade deficit was more than $450 billion.

In a May 2016 interview on CNBC, candidate Trump provided his view of the Dollar:

“I love the concept of a strong Dollar, and in many respects obviously I like a strong Dollar. While there are certain benefits, it sounds better to have a strong Dollar than in actuality it is."

This statement provides a valuable insight as to how Trump might respond if the Dollar continues to increase in value in 2017. It suggests that Trump might not hesitate to talk the Dollar down, if he thinks it will help improve U.S. trade competitiveness and bring jobs back to the U.S. When the U.S. wanted the Dollar to fall in 1985 it enlisted the help of our major trading partners to say they would intervene if necessary to bring the Buck down. The currency market is so much larger today than in 1985 that a central bank only needs to convince foreign currency traders to achieve a desired result, especially if it is a decline in a currency.

As I noted in April 2014, all Draghi had to convey was the desire for a lower Euro and currency traders would be happy to accommodate the ECB’s wishes. Currency traders are nihilistic and would embrace shorting the Dollar and the profits it would generate. All Trump has to do is tweet.

If Trump wants to point a finger at countries that have manipulated their currency, he should target Japan and the European Union. Both intentionally devalued their currency relative to the dollar to increase their trade competitiveness far more aggressively than China. The Dollar has gained 50.3% since 2012 against the Yen and is up 32.8% versus the Euro since May 2014.

welsh.macro.tides.monthly.2017.jan.fig.9

Will Trump target two of the United States' strongest allies for trade infractions? I don’t think so, but that doesn’t mean Trump won’t take action to improve the competitive position for U.S. companies. Sometime in 2017, I expect Trump to convey (via a tweet?) to currency traders that the Dollar is too strong and that he will tolerate a weaker Dollar. His comments are likely to be more direct than Mario Draghi’s statements in March 2014 about the Euro and its impact on EU inflation. If this proves true, a reversal of the uptrend in the Dollar, since its low in March 2008, would likely have a meaningful impact on financial markets throughout the world.

The Dollar’s Technical View

The Dollar has rallied strongly in the wake of the election, the Federal Reserve’s decision to increase the Fed funds rate, and the Fed’s forecast of an additional three rate increases during 2017. The consensus of strategists is that the Dollar will continue to rally in coming months. Surveys of currency traders have recently indicated that more than 90% of traders are bullish the Dollar, which means they have already bought the Dollar. The last two times bullish sentiment toward the Dollar exceeded 90% was in March 2015 and January 2016. The Dollar subsequently declined by more than 7% in the months following these two periods of ebullience. As I wrote in the November 28, 2016 Weekly Technical Review (WTR):

“Although the Dollar may push modestly higher going into the Fed meeting or year end, the next bigger move is likely to be down."

In the December 19 WTR I noted

“that the dollar had pushed to a new high after the Fed’s forecast of three rate hikes in 2017, but the Dollar’s RSI was negatively diverging. This suggests the upward momentum is beginning to wane. With year-end right around the corner, the dollar may hold up or push slightly higher. But with so many bulls (over 90%) and momentum showing signs of fatigue, a reversal in the dollar is coming, which is likely to bring the dollar down to 100.00 at a minimum."

The Dollar pushed to a new intra-day high of 103.82 on January 3 and closed at 101.38 on January 5, a decline of -2.35% in less than 3 days.

Click for large image.

More importantly, this potential top needs to be placed in the context of the longer trend of the Dollar, since it bottomed in March 2008. The initial surge off the bottomed carried the Dollar from under 70.00 to above 88.00 in November 2008 (1).

The Dollar then spent more than 2 years consolidating the initial surge and bottomed in April 2011 (2).

The next phase of the Dollar’s bull market has traced out 5 distinct moves up and down labeled 1, 2, 3, 4, and 5, which appears to have completed wave 3 from the March 2008 low with the recent price high. This pattern analysis and the excessive level of bullishness suggest the Dollar could experience a multiweek / month correction.

As discussed at length in the December 7 issue of Macro Tides, the U.S. economy is going to slow in the first quarter, after decelerating in the fourth quarter:

“I think investors will become impatient when they realize the economy is not going to benefit from Trump’s proposed changes until the second half of 2017 at the earliest, and the legislative progress isn’t as smooth as currently expected. If the economy slows a bit in the first quarter, investor’s impatience could become disappointment and lead to a reversal in the market’s that have rallied and declined in the wake of the election. This suggests that financials, small caps, industrials, and oils could experience a bout of profit taking, especially since the capital gains tax rate will act as an incentive to book profits in 2017. The Dollar is also vulnerable to a correction. Conversely, Treasury bond yields have room to fall, utility stocks can rally, and gold and gold stocks could rally sharply."

If the economy slows in the first quarter and expectations of how soon the Fed will increase rates is pushed back, and the number of hikes in 2017 are called into question, the Dollar Index could pull back to 96.00 or so in coming months. Last year the Dollar corrected from a January high until May 3, and this pattern may be repeated in 2017.

welsh.macro.tides.monthly.2017.jan.fig.11

The composition of the Trade Weighted Dollar index is significantly different than the more familiar Dollar index. The Euro carries a weight of 57.6% in the Dollar Index but only 17.1% in the Trade Weighted Dollar (TWD). China represents 21.9% of the TWD, but has no exposure in the Dollar Index, and the Yen’s representation is less than half of its weight in the TWD than the Dollar Index.

Click for large image.

Although the Dollar Index has traded much higher than current levels in 2002, the TWD dollar is just now approaching its 2002 peak. This opens the door for a potential double top near the 2002 high, and is one more reason a top in the Dollar in both indexes is possible.

Federal Reserve

A strong Dollar is a headwind for the U.S. economy, and especially for multi-national corporations in the S&P 500 that derive more than 40% of their revenues from overseas. I suspect this negative impact will become evident as companies report fourth quarter earnings in coming weeks. In the December FOMC minutes, there were 15 references to the Dollar compared to just 7 at the November meeting. Dollar strength causes import prices to fall, which weighs on inflation.

Ironically, a decline in the Dollar would make it easier for the Fed to increase rates in 2017.

China

The next bear market in the U.S. stock market is more likely to be caused by problems that originate outside of the U.S. One candidate is China as policy makers struggle to strike the perfect balance between monetary and fiscal stimulus, and preventing even larger bubbles from forming in real estate and excessive debt. As Chinese bank regulators have attempted to rein in runaway lending in recent years, banks have found ways to circumvent new rules aimed at strengthening bank balance sheets.

Since 2014 banks have increasingly labeled loans as an investment receivable. Whereas a traditional loan requires a bank to set aside a portion of every loan as a reserve to cover loan losses, an investment receivable allows banks to set aside little or nothing for potential losses. This accounting sleight of hand has been widely embraced by Chinese banks since earnings increase as loan loss reserves are lowered.

Since 2011, investment receivables have soared from $334 billion to $2 trillion as of June 30, 2016. As a percent of total loans, investment receivables represent 20%, up from 5% in 2011. According to UBS, Chinese banks could need to raise $20 billion in capital to account for the lower amount of reserves, if the investment receivables were classified as loans.

welsh.macro.tides.monthly.2017.jan.fig.13

The 10% decline in the Yuan since May 2014 has led Chinese companies and wealthy Chinese investors to move money out of China to insulate their wealth from additional depreciation. Since money leaving China puts downward pressure on the Yuan, China has initiated rules to limit outflows. In late November, firms that want to exchange Yuan into dollars need approval for any transaction greater than $5 million.

The introduction of capital controls is not a sign of strength and indicates that policy makers are concerned about the flow of money out of China.

The depreciation of the Yuan and new restrictions on money leaving China has reduced the amount of foreign investment into China. According to the World Bank, foreign investment into China fell to $250 billion in 2015, which was down from 2014 and 14% below 2013. Individuals can move $50,000 a year out of China. When data is reported for outflows in January, it will provide an insight into the level of urgency Chinese investors have about their expectation for further Yuan devaluation.

The Peoples Bank of China (PBOC) has intervened in the foreign currency market in an attempt to slow the decline in the Yuan since the announced devaluation in August 2015. As the PBOC sells dollars and buy Yuan, the amount of Yuan in China’s domestic economy is reduced.

welsh.macro.tides.monthly.2017.jan.fig.14

After the Federal Reserve increased the Federal funds rate at its December 14 meeting, the yield on China’s 10-year government bond soared from 2.7% to 3.4%. The sharpness of the plunge in bond prices caused bond futures to fall 2%, leading to a suspension of trading on December 15. Trading resumed after the PBOC injected $22 billion into the short-term money market. As China’s foreign reserves have fallen from $4 trillion to $3.011 trillion, the ratio of M2 to reserves rose to 7.5 in December from 6.3 at the end of 2015. The IMF recommends that the ratio should be below 5.0. This is yet another sign that China is inexorably moving toward a financial dislocation.

European Union

The European Union will be tested in 2017 as each of its three largest members will select a new leader amid rising populism and anti-immigration fervor. Italy will elect a new prime minister in March, France will go to the polls in April to elect a new president, and Germany will decide in September whether or not to reelect Chancellor Angela Merkel.

On March 15, the Netherlands will elect a new Prime Minister. The leading candidate, Geert Wilders, favors a referendum on the Netherlands’ membership in the EU, and wants to end immigration from Muslim countries.

Given the election surprises in 2016, it seems only reasonable to expect at least one surprise in 2017. Support for remaining in the European Union has eroded in recent years and is likely to deteriorate further as economic growth is uneven between northern and southern countries. Income inequality is a political issue in the United State and is defined by gender and race. In Europe the dividing lines are clear cut and defined by national borders. Disenchantment with the European Union is rising in many EU countries and could lead to an existential moment when the concept of the EU is threatened.

welsh.macro.tides.monthly.2017.jan.fig.15

The European banking system is riddled with $1 trillion in bad loans, with $379 billion concentrated in Italian banks. EU rules, which took effect in 2016, make it almost impossible to use public funds to bailout a failing bank, unless hefty losses are imposed on junior bond holders and equity share holders. The problem is that Italian retail investors hold a sizeable amount of the bonds in the weakest banks. The EU rules are now politically unacceptable, and Italy is looking for a solution so retail investors won’t be forced to incur losses on their bonds. Italy is suggesting retail investors may have been “missold", since they were told the bonds were safe, and now they are not safe. The EU rules contain some flexibility and ‘precautionary recapitalization’ is within the scope of the rules. The problem is that Banca Monte dei Paschi di Siena, Italy’s third largest bank, is encumbered by billions of bad loans, which makes it far sicker than a bank qualifying for a ‘precautionary recapitalization’.

Since bond holders are not allowed to receive government funds directly, Italy is proposing that retail bond holders swap their debt for shares in the ailing bank. The Italian government would then purchase the new bank shares. Miraculously, the bond holders would be made whole and the government wouldn’t have directly purchased the retail bonds! If the powers that be in the European Union (Germany) don’t accept this charade, the EU will be dealing with an Italian style banking crisis in 2017. Even if Italy is allowed to flaunt a bending of EU banking bailout rules, its economy is still dead in the water, as it has been for 16 years.

Just as capital is fleeing China, money is leaving the Eurozone. Through November, Eurozone investors invested $516.5 billion in stocks and bonds outside of the EU, the most since the Euro was introduced in 1999. Ironically, the spread between the 10-year German Bund and the 10-year Treasury bond is the widest since 1989. As long as German yields remain low, international investors are likely to find Treasury bond yields attractive.

Mario Draghi and the ECB will likely announce the curtailment of their QE program, probably sometime in the second half of 2017. If correct, this would likely cause German Bund yields to spike higher and lead to an increase in yields for Treasury Bonds.

Treasury Bonds

In the December 19, 2016 Weekly Technical Review, I thought the stage was set for a decline in bond yields based on negative sentiment:

“The Treasury ETF (TLT) has been grinding lower over the last 13 trading days, and spiked down to 116.80 after the Fed meeting. With less than 10% of trader’s bullish 12 Treasury bonds, and negative sentiment reinforced by the Fed’s forecast of 3 rate hikes in 2017, a decline in yields is coming. A short covering rally could provide TLT a nice lift and get legs, if the economy slows as I expect in the first quarter, and investors realize that inflation and fiscal stimulus may not kick in as quickly as expected. The yield on the 30-year Treasury bond could drop to 2.75% - 2.85% and the 10-year yield may fall to 2.10% - 2.20%. If this comes to pass, TLT has the potential to rally up 127.00 - 129.00."

Since December 15, the yield on the 10-year Treasury has fallen from 2.62% to 2.34% on January 6. As yields spiked higher after the election, the 10- year Treasury yield broke above the green trend line connecting the 2007 yield peak with the high on December 31, 2013 at 3.03%. After the current drop in yields runs its course, the 10-year yield is likely to test 3.0% before the end of 2017.

Click for large image.

It is important to note that the Fed increased its policy rate in December, only after market rates had already moved higher. If the Fed is to increase rates 3 times in 2017, they will act after yields have already gone up. After slowing in the first quarter, the U.S. economy is likely to rebound in the second quarter. This might lead the bond market to price in 2 or 3 rate hikes in the second half of 2017, even before the Fed acts.

If European yields rise, whether it be from higher inflation or the ECB’s cessation of its QE program, yields in the U.S. will rise commensurably. If the yield on the 10-year Treasury bond rises and holds above 3.0% (horizontal red line), it would be the first time since 1981 that a prior intermediate high in yields had been exceeded. This would confirm that the 35 year secular bull market in bonds had ended.

Stocks

The rally in the stock market since the election and the hope that Trump’s elixir of tax cuts, rollback of regulatory burdens enacted since 2008, and fiscal stimulus, are merely a preamble to higher stock prices and has engendered a surge in optimism. In the January 6 weekly survey by Investors Intelligence, 60.2% of those surveyed were bullish and just 18.4% were bearish. The plurality of 41.8% of excess bulls is the highest since May 2015. Sentiment is often early as equity prices can trade higher, until technical indicators show enough deterioration to provide a warning that a correction is likely.

Click for large image.

welsh.macro.tides.monthly.2017.jan.fig.17

Although there was a high level of optimism during the first half of 2014, the S&P continued to rally, until technical warnings appeared before the October shakeout. The DJIA has been hovering just below 20,000 as the market absorbs some 2017 tax related selling. Once this selling pressure is out of the way, I expect the DJIA to push comfortably above 20,000 since some of the expected selling after crossing above a big round number has already occurred.

My guess is a correction will begin in February as signs of the economy slowing become apparent, and dysfunction in Washington disappoints investors. As noted in the December Macro Tides:

“The lag time between when Trump is inaugurated and when the economy will actually benefit from Trump’s economic plan will seem like forever for investors who think the Republicans can merely snap their fingers and make it all happen next month, since they control Congress and the White House. It is going to take a number of quarters before lower individual and corporate tax rates, a reduction in the burden of excessive regulation, and infrastructure spending lift growth as much as expected. The debt ceiling issue could pose a true hurdle for conservative republicans. The discord that is possible from the debate about deficits and existing government debt levels could be the wake-up call that most investors don’t want to get."

Although any correction is likely to be mild i.e. less than 5%, developments from Britain and the issue of Brexit and the vote in the Netherlands could result in a deeper pull back. After a correction, another rally to a new high near 2350 on the S&P 500 is likely, as the economy rebounds in the second quarter and more legislative clarity arrives about tax cuts and the scope of fiscal stimulus.

If a summer time high is accompanied by momentum divergences and other signs of technical weakness, the odds will increase that the bull market from the March 2009 low is ending.

No matter what, with so many global unknowns in the air, the level of volatility seems certain to be higher in 2017 than in 2016.

Gold

I’m bullish gold and gold stocks. Longer term Gold may rally up to $1450 - $1480, if it retraces 50% of the decline from September 2011 at $1920 to the low last December near $1040.

Click for large image.

welsh.macro.tides.monthly.2017.jan.fig.18

Last year’s rally from $1040 to $1380 was wave A, with the decline from the high in August representing wave B. If wave C is equal to wave A, a $340 rally from the recent low at $1125 would carry Gold up to $1465. If the gold stock ETF (GDX) follows the same pattern and retracements, a rally to $37.00 - $39.00 is possible.

Emerging Market

If the Dollar weakens as I expect the Emerging Market ETF (EEM) could follow the same pattern as Gold. While the B wave correction looks complete in Gold, EEM may pull back to $32.00 or so, before the next rally phase begins, if the U.S. stock market falters late in the first quarter. The pattern suggests that EEM could rally to $42.00 - $44.00 during 2017 in a wave C rally.

Jim Welsh @JimWelshMacro

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