Financial Stability Snapshot 14 October 2016
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US private investment dwindles
Private investment is declining as a percentage of GDP. Not a good sign when you consider that a similar decline preceded previous recessions.
Click graph to view full-size image.
Also a concern, when private credit is rising as a percentage of GDP while investment is falling. Crossover of the two lines would indicate that the private sector is borrowing more than it is investing. That is not likely to end well.
Gold: Brief pause at $1250
At present, interest rates are driving gold. How long this will continue is hard to say. It depends on what shocks lie in store for the global financial system. Two pending rolls of the dice are the November 8 elections and negotiations over Britain’s exit from the EU.
Long-term Treasury yields are rising while gold is falling. Expectations of a rate rise after the November election are growing and a test of resistance at 2.0 percent is likely. But a lot depends on continued stability of financial markets.
Spot gold reacted to rising interest rates by breaking support at $1300/ounce, warning of a test of primary support at $1200. A brief pause at medium-term support at $1250 is indicated by a spinning top candlestick, signaling indecision. Support at $1250 is unlikely to hold but the primary up-trend is intact unless support at $1200 is broken.
The ASX All Ordinaries Gold Index broke support at 4500, warning of a primary down-trend. The immediate target is 4000.
Why would the Fed raise interest rates when the economy is slowing?
10-Year Treasury yields have rebounded off their all-time low, shown here on a monthly chart, but remain in a secular down-trend. Only recovery above 3.0 percent (a long way off) would signal that the long-term down-trend has reversed.
The 5-year breakeven inflation rate (5-year Treasury Yield – 5-year TIPS yield) suggests that the long-term outlook for inflation is low. But growth in Hourly Non-Farm Earnings and Core CPI (excluding Food and Energy) has started to rise.
One would expect the Fed to be preparing for another rate increase to tame inflationary pressures. But there are still concerns about the strength of the recovery.
Growth in estimated total weekly Non-Farm Earnings has been declining since early 2015; calculated by multiplying Average Hourly Earnings by Average Weekly Hours and the Total Non-Farm Payroll.
If we examine the breakdown, growth in the Total Non-Farm Payroll is slowing and Average Weekly Hours Worked are declining.
Not what one would expect from a robust recovery.
Fed easing continues
Quantitative easing (QE3) ended in the second half of 2014 after the Fed announced it would taper asset purchases in December 2013. The graph below shows that total assets leveled off at $4.5 trillion and have been maintained at that level since.
But the graph also shows that the Fed continues to drip-feed the financial system by running down excess reserves on deposit from a high of $2.7 trillion in August 2014 to $2.25 trillion in August 2016.
Commercial banks are required to hold certain reserves at the Fed but in times of financial stress will deposit excess reserves at the Fed, when trust in the interbank market breaks down. The Fed commenced paying interest on reserves in October 2008 and increased the rate to 0.50% in December 2015. This has encouraged banks to retain excess reserves at the Fed where they earn a risk-free rate of 0.50%.
By raising or lowering the rate payable on excess reserves the Fed can attract or discourage deposits, tightening or easing the availability of funds in the interbank market. Banks have withdrawn $450 billion in excess reserves over two years, which suggests that they can achieve more attractive risk-reward ratios elsewhere. The Fed has not responded, indicating that they are happy for this back-door easing to continue.
Only when the red and blue lines in the first graph converge will the Fed have commenced monetary tightening. That still appears some way off.
Government aims for wrong target on debt | MacroBusiness
Macrobusiness quotes LF Economics’ submission to the House of Representatives Budget Savings (Omnibus) Bill 2016:
….It is critical policymakers reign in exponentially-growing private sector debts as this consists of a major source of future financial instability. Australia’s household debt to GDP ratio is the highest in the world, at 125% and rising. Ironically, by ignoring private debt expansion which has generated a housing bubble, public debt will inevitably rise to stimulate the economy to counteract the economic downturn when it bursts.
Source: Government aims for wrong target on debt – MacroBusiness
Flattening yield curve & low bank interest margins
The Yield Differential, calculated by subtracting 3-month from 10-year Treasury Yields, is trending lower. This warns that the yield curve is flattening but we are still above the danger area below 1.0 percent.
A flat yield curve squeezes bank interest margins and often precedes a credit contraction.
But there is little sign of slowing credit growth so far.
The St Louis Fed Financial Stress Index (STLFSI) continues to indicate low market stress.
The STLFSI measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together.
Gold respects support
10-Year Treasury yields are retracing to test the recent support level at 1.60 percent but the trend remains upward.
The Chinese Yuan is easing against the US Dollar, with USDCNY in a gradual up-trend as the PBOC manages the decline in order to conserve foreign reserves. This is likely to alleviate immediate selling pressure on the Yuan, both from capital flight and borrowers covering on Dollar-denominated loans.
Spot gold respected support at $1300/ounce. Breakout above the falling wedge (and resistance at $1350) would signal another advance.
* Target calculation: 1375 + ( 1375 – 1300 ) = 1450
Rising interest rates and low inflation are bearish for gold but uncertainty over US elections, Europe/Brexit, and the path of the Chinese economy contribute to bullish sentiment.
Gold stocks serve as a useful counter-balance to growth stocks in a portfolio. If there are positive outcomes and a return to economic stability, growth stocks will do well and gold is likely to underperform. If there is instability and growth stocks do poorly, gold stocks are likely to outperform.
Warning sign of China bank crisis | Business Insider
From Engen Tham, Reuters:
Excessive credit growth in China is signaling an increasing risk of a banking crisis in the next three years, a report from the Bank for International Settlements says.
The credit-to-gross-domestic-product gap, an early warning of financial overheating, hit 30.1 in China in the first quarter of this year, the financial watchdog said in a review of international banking and financial markets published Sunday.
Any level above 10 signals a crisis “occurs in any of the three years ahead,” the BIS said. China’s indicator is way above the second-highest level of 12.1 for Canada and the highest of the countries assessed by the BIS….
From the BIS:
The credit-to-GDP gap captures the build-up of excessive credit in a reduced-form fashion. It is defined as the difference between the credit-to-GDP ratio and its long-run trend, and it has been found to be a useful early warning indicator of financial crises.
In the BIS Table of credit-to-GDP gaps, Hong Kong was second highest at 18.1. Chile (15.7), Singapore (14.8), Thailand (14.5), Saudi Arabia (14.0) and Belgium (12.2) are higher than Canada (12.1). Australia (4.5), USA (-9.9) and UK (-27.0) are far lower. In fact, UK looks like a credit contraction.
Source: Credit-to-GDP warning sign of bank crisis China – Business Insider
Bob Doll: Equities Appear More Attractive than Other Asset Classes | Nuveen
From Bob Doll’s weekly newsletter:
The strong patch of summer U.S. economic data may have ended. Following weak Institute for Supply Management readings in previous weeks, August retail sales declined 0.3%. This marks the first pullback since March, and bears watching for a broader downtrend into September…..
Corporate earnings expectations are climbing slowly. Following a modest second quarter improvement, analyst expectations for future quarters have climbed in recent weeks…..
Equities may continue to climb in 2016, based on historical trends. Strategy group Fundstrat shows that since 1940, when stock prices increased more than 5% by mid-September, 87% of the time they rallied further in the last three-and-a-half months of the year. As of Friday’s close on September 16, the S&P 500 Index is up 6.3%….
As you can see from Bob’s commentary, there seems to be a divergence between economic data (retail sales in this case) and technicals which tend to be more focused on the earnings expectations. I have seen something similar.
Retail sales have fallen in July/August but of greater concern is the longer-term down-trend. Continued growth below core CPI would warn of a contraction in real terms.
Light Vehicle Sales are also below trend, reinforcing the down-turn in consumer outlook.
The decline in sales is reinforced by the decline in growth of average weekly earnings (all employees).
Technicals, on the other hand, remain reasonably strong for the present. Until declining sales impact on corporate earnings.