Wednesday, November 29, 2017

Bitcoins Roars Past $10,000



With Bitcoin (BTC) continuing its amazing run past $10,000, many will be wondering if the chaos will ever stop. In less than a month, BTC's value grew from around $6,000 to touch $11,000 on November 29th, 2017 to fall back below $10,000 in the same day. The gain has BTC's market capitalization rapidly approaching $200 billion, greater than most companies listed on the NYSE. In the span of a year, the cryptocurrency has established itself as one of the major financial markets in the world unifying interested investors behind a decentralized currency that has seen both support and opposition. Nevertheless, the media attention and allure of huge short-term capital gains has surely done its job in attracting new players.Volume over the past day is almost $6.5 billion on the massive BTC gains; this is up almost 10,000 percent from a year which saw a volume of just $65 million. With a volume of this magnitude fueling BTC market growth, one might wonder if the trend can continue when the crowd thins out.

"Even if you believe in bitcoin, the velocity of the move is a sign that it is parabolic. And parabolic moves don't last," Cramer from CNBC weighed in early Wednesday morning. It's completely rational to assume the inevitable, that the rally will eventually taper off and end in consolidation or worse. However, the key is to sense the timing in the market which could be short-term or long-term. One chart that provides an interesting view of the extreme growth in BTC is the logarithmic view of the price.


The logarithmic chart suggests that investors became increasingly attracted by the increase in the growth rate of an investment in BTC. This phenomenon is mostly seen in securities like new small-cap companies in an industry with prospects for major expansion, think semiconductors over the past two years. These investment opportunities typically break down when the growth of the rate of returns normalize and start to drop. Investors then rotate their capital into investment opportunities that they see as more profitable. This will no doubt occur in BTC markets as the currency surpasses its speculative pricing period. In 2014, BTC had a noticeably bad year pushing a lot of investors out of the market to find better investments. Volume dropped -56.6 percent and market cap dropped -52.4 percent based on weekly averages at the beginning and the end of the year. If a similar trend develops in the current BTC market, the losses would be devastating and could be an impetus for systemic weakness in other financial markets. The chaos continues. Investor be wary.

Getting Greedy with Goldy #1

Welcome to the first installment of “Getting Greedy with Goldy”. Every Sunday, I’ll post a quick hits look at potential turnaround plays for the next 5-10 trading days. I’m your author and guide to the reversal play world, Morgan Goldman. All you need to know is that I’m the old man of the crew, and I’ve been around the block a few times.

First up on the list, we’ll look at my current play, JCI.  JCI reported poor earnings and plunged from around $41 a share in early November to a 52 week low of $34.51.  From there, it quickly found support and began to move back up.  I recognized the bounce off an overreaction to poor earnings and purchased a position of 283 shares on 11/17 for a total of $10,282.32.

As of the close of market on 11/28, JCI trades for $38.38 and that position is worth $10,872.86, a return of 5.74% in 7 trading days, including the slow Thanksgiving week.  I’ll ride this train until it bounces off a resistance point ($39.50 or so) or breaks trend line in a reasonable way.  My stop loss is currently set at $37.82.

As always, Getting Greedy with Goldy is meant as entertainment, and any losses you incur are your own fault.   Remember that fundamentals of trading still apply, cut your losers fast, and ride your winners.

Onto this weeks’ potential plays!


GE – General Electric


I know, I know.  “Goldy, are you crazy?  The worst performing stock in the whole god business besides DRYS?”  Yeah, yeah.  Hear me out.  It’s clearly found a bottom at least short-term, which mitigates a lot of the risk.  The div cut hurts for sure, but who cares about income investors?  Go buy some bonds, grandpa.  It’s already begun to show the technical signs of a turn with MACD having converged and flipped, and RSI is still low.  Your potential upside is decent, with the nearest point of resistance being at $19.08 at the 20 day SMA. If it punches through that, you could see it climb back up towards the 50 day SMA, however, I doubt it has that much room to run with the overall bearish sentiment dominating the company.

Goldy’s Greedy.  Set your stop loss at $18.18, exit if it bounces off $19, otherwise, sell when RSI spikes or MACD signals a breakdown.  If it runs for a while, watch for a separation off the upper Bollinger Band and dump when that happens.

Potential profit; 4-6%.



SRCL – Stericycle




“Goldy, this company is literally trash!”  Who cares, kids!  We’re about technicals here, not fundamentals.  Go play with the smart kids in the big boys' pool if you want fundamentals.  We’re trying to get rich or eat ramen for the next 8 years trying.

Just look at the reversal here.  So juicy.  MACD is swinging positive, the stock has already added a couple percentage points, RSI is still lower than your grandfathers’ sack in a sauna, and we’ve got plenty of room before we hit either the 50-day or 200-day SMA.  Potential like this doesn’t come every day, especially not with such a pretty chart.

Goldy’s Greedy.  Put your stop loss 1.1% under your cost basis, and let ‘er ride.  Watch for resistance, as always, at 20-day SMA, then 50.  Should go right through the 20-day like a hot knife through butter, and ride up to the 50-day.  Watch for a bounce off the 20-day SMA, that would be bad news bears!

Potential profit; 8-10%.

TWX – Time Warner




“Goldy, Trump hates these guys, in the age of Trumpty Dumpty, why should I go against the establishment?  Aren’t you all about riding with winners?”

Historical precedent suggests the TWX-T merger will go through.  When’s the last time you can remember the DOJ blocking a merger of companies that operated mostly in two different business sectors?  Always play the odds, and the odds here suggest the merger will go through and the recent selloff will be long forgotten when the tendie train rolls in.  Technical aspects are also lining up strongly in favor of a reversal, as this reversal is already underway.  MACD has converged and flipped, RSI is already moving up off the deep bottom, and the general trend is upwards.

Goldy’s Greedy.  Put your stop loss at just over 1% under your cost basis, and see where it goes.  20-day SMA shouldn’t be a problem, and we could easily see a push back up to the gap at 92.  If it rides through that, 97-98 is a likely target price to get out if it runs out of steam.

Potential profit: 8-12%.

ESL – Esterline Tech Corp



“Goldy, I’ve never heard of these guys.  How does one justify investing in something they don’t know about?”  What did I tell you guys about fundamental investing?  Bye Felicia.

MACD hasn’t converged yet, but it’s closer than you’ve ever been to getting your cherry popped.  RSI is through the floor low at 23.  The drop from the 200-day SMA of $90/share has clipped off 20% of the market capitalization.  I don’t care what’s happened, that’s an overreaction unless you were conspiring with Al Qaeda or the DOJ is talking about breaking your company into pieces.  Or you “invested” in Biotech, you degenerate.

Goldy’s Greedy, but not quite yet.  This bun needs a few more days in the oven for confirmation.  Watch for the breakout over the next 5 days. Set your stop loss at about 2% back, and let ‘er rip.  Given the nature of the breakdown, I’d expect strong resistance around $74, but if ESL can move that, I could see $80ish pretty easily.


Potential profit: 3-11%.

Wednesday, April 12, 2017

Is There a Bear in the Auto Industry?

A fresh new set of auto sales data has come out in the beginning of August detailing the past month's activity in the buying and selling of motor vehicles. As expected, auto stocks traded lower when the disappointing results were revealed. According to Reuters, shares of General Motor (GM), Fiat Chrysler (FCHA), and Ford (F) traded more that 3 percent lower last week. Reports of March light vehicle sales at about 16.6 million where analyst expectations had drifted slightly above 17 million. Since the financial crisis, automakers have enjoyed a steep expansion in auto sales, but in the past couple of months, that expansion has stopped.

Data from Quantopian and Bureau of Economic Analysis
In 2011, a global auto industry exchange traded fund (CARZ) was created to follow the price movement of some of the largest automobile companies in the world. GM and Ford account for over 15 percent of the fund's holdings with Toyota and Honda (both of which rely on U.S. demand) making the ETF very sensitive to auto sales in the United States. After its birth in 2011, CARZ saw a steep incline in its price as light vehicle sales grew steadily. As demand in the industry started to show some slack, the price dipped in 2015 and early 2016. The current dive in auto consumption has CARZ down about 4.7 percent in the last 20 trading days.


With sales starting to slow, there has been an incline in inventory that has left the U.S. auto suppliers in a pickle. Overall, production and imports of cars need to be falling to keep the industry in equilibrium in order to maintain a stable price. Domestic production, in the past 12 months, has fallen just over 14.3 percent while the declines in imports from Canada and Mexico are less significant (and very volatile). This conveys an interesting political signal that suggests Trump's domestic manufacturing goals. After demanding U.S. auto companies to move their manufacturing bases inside the country in his first days as the President, these initial data suggest his protests have been futile. Another interesting observation is to note that inventories haven't seen as significant a move as U.S. production has in the last two years. In fact, inventories have always oscillated within 2.0 and 3.0 with only the latest data peaking about 3.0. The abrupt change in inventories could be a drag on prices which, combined with falling sales, could weigh heavily on automakers' bottom lines.

Data from Bureau of Labor Statistics

From the Bureau of Labor Statistics, consumer price index (CPI) data for automobiles, both used and new can be viewed over the past ten years. The CPI for both used and new vehicles has stayed relatively flat from 2012 to now after recovering from a dip caused by a lapse in demand during the financial crisis. For new and used vehicles, prices recovered above their pre-crisis levels in 2010 with more volatility in used car prices. In fact, it seems as if the most of the fluctuations in the overall auto CPI are caused by movement in used CPI. According to this data, automakers selling new cars have enjoyed stable, increasing prices with used car prices inflated beyond their 2007 levels. Perhaps, over the past six years, this phenomenon led consumers to believe that purchasing a new car over a used car was the smarter decision. Thinking practically, used car demand growth post-crisis makes sense because consumers who needed a vehicle might not have had the discretionary funding to purchase an entirely new car. But as demand strengthened, prices rose, and consumers calmed, new auto sales grew. It is possible that now we are observing demand for the "cheaper" used autos grow replacing demand for new autos. This might explain why U.S. production has trailed off while inventories have continued to rise. It is also interesting to note that, according to Reuters, consumer discounts were $441 higher per vehicle than a year ago, a sign that companies were trying to compete with cheaper used cars on the market.



Post-crisis, an interesting trend in used car CPI and light vehicle sales data can be identified. Using data from 2010 on, one can observe a strong negative correlation between used car CPI and new light vehicle sales as reported by the Bureau of Labor Statistics. With a correlation coefficient of -0.73 and a statistically significant p-value, the data suggests that as used cars get more expensive relative to new cars (signaling heavier demand) new light vehicle sales are smaller. When CPI growth for used cars decreases relative to new car CPI growth, sales are likely to be higher for new vehicles. As far as timing goes, the current trends suggest that auto sales lead normalized used car CPI slightly as it troughed about a year and a half before used car CPI peaked.


Some interesting regressions suggest that a strong negative correlation exists between used car CPI and the monthly price of CarMax. A weaker negative regression can be found between used car CPI and Ford's stock price. This may suggest that KMX stock price moves more strongly with used car CPI changes than the rest of the auto industry, but this conclusion may be all. Due to the reflation of the post-crisis economy, any correlation with a growing stock price can be a bit skewed. In the end, these two statistical connections are probably not significant despite having low p-values.

This article was written using Quantopian's IPython platform. The Python code can be downloaded here: .py .ipynb

Saturday, April 8, 2017

The Federal Reserve Decides to Diet

In a press conference on April 5th, 2017, Federal Reserve officials announced their desire to start reducing the size of the Federal Reserve's balance sheet this year. Since the financial crisis in 2008, the size balance sheet has grown to $4.5 trillion worth of bonds and other assets bought up during the period of quantitative easing following the crash of the financial system. In the latest Fed minutes voiced this idea saying, "Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee's reinvestment policy would likely be appropriate later this year." Since 2009, the members of the Federal Reserve have used various techniques to maintain loose policy as the economy reflated. Lately, though, these mouthpieces have been used to institute a "normalization" policy that will allow interest rates to rise while keeping intentions expansionary.

from Federal Reserve
In 2007, arguably the last year of the period called "The Great Moderation," the Federal Reserve's balance sheet was below $1 trillion and consisted of mostly Treasury assets used to manipulate interest rates through open market operations. As the crisis unfolded, Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson saw it necessary for the United States' central bank to buy up the assets that had become worthless due to mortgage defaults. This unconventional intervention in the financial markets, called "quantitative easing," slowed to a stop in the early 2010's, but by then, the balance sheet had more than tripled. The average increase per year over the past 10 years was about 25 percent.


The chart above shows different asset classes within the Fed's balance sheet accounting for general securities, securities purchased through liquid facilities, and securities purchased to support specific institutions. Growth in the last two was only significant during the financial crisis and was quickly wound down when financial markets return to normal. The assets from credit facilities included purchases by the Term Action Credit, Commercial Paper Funding, Central Bank Liquidity Swaps, and Term Asset-Backed Securities Loan programs. These "liquid facilities" were put in place to create demand in the markets for mortgage-backed securities (MBS), commercial paper (CP), and currency, in particular, the dollar. Even though these programs have been largely inactive since 2010, they ushered in a long period of quantitative easing.


Looking closer at the 3 year period around the financial crisis reveals a jump in the activity of the liquid facilities that spurred the growth of the Federal Reserve's balance sheet. Two of these programs saw activity before the fall of Lehman Bros in late 2008, the Term Auction Credit (TAF) program and Central Bank Liquidity Swaps. These credit facilities are no longer being used and haven't been since around 2011, but some of the assets still linger on the balance sheet. Most of those assets are loans supplied by these programs (mostly Term Asset-Backed Securities Loan Facility) in which credit facilities were provided for banks with the MBS put up as collateral.

Unwinding a balance sheet of an assortment of $4.5 trillion assets is a very complicated process. With such careful decisions being made about interest rate hikes, the Federal Reserve has shown how important they think timing is in monetary policy. Their stance will be no different this time around. In an article from the Brookings Institute, Ben Bernanke refers to the Fed's most recent discussion of how to unwind the balance sheet released in September 2014 suggesting that, "the balance sheet will ultimately be reduced, not by sales of assets that the Fed holds, but by ceasing or phasing out the Fed’s current practice of replacing or rolling over maturing assets (“reinvestment”)." This makes sense. Federal Chairwoman Janet Yellen has assured us that she doesn't intend to shock the markets with what her board does, and so far, she has not disappointed. With that in mind, investors shouldn't be expecting a smaller Fed for a while. In fact, the process may end up being a non-issue with conventional monetary policy changes always occupying the spotlight. The Federal Reserve hasn't actually decided on how to go about the unwinding yet, but investors can expect a very tame approach in the end.

During the press conference in April, the stock market saw a reversal in the day's trading reflecting a bearish response to the unwinding balance sheet. Although the process will be gradual, there will still be fundamental adjustments in financial markets. Investors can expect most of these adjustments to be made in the bond and short-term lending markets with equities being less affected. If anything, the effects of an unwinding balance sheet will be harmonious with the Fed's plan of slowly increasing interest rates, both long and short term.

from Quantopian

The correlation between the growth in the Federal Reserve's balance sheet and the performance of both long and short term Treasury and corporate bonds is quite strong. Using SHY (Short-term Treasuries), IEF (Long-term Treasuries), CSJ (Short-term corporate), and CLY (Long-term corporate) price trends, a connection can be made between the return of these exchange traded funds and the expansion of the Federal Reserve's balance sheet. With correlation coefficients above 0.80, a strong positive correlation is confirmed at a statistically significant level. The corporate bond ETFs saw correlations that were a bit stronger with the correlation coefficient of CSJ, the fund following short-term corporate bonds, recording an R-squared value of 0.93. From this analysis, one can expect these funds to underperform when the Federal Reserve begins the unwinding process. As interest rates and bond yields start to rise, prices will fall, and this trend will be accelerated with the Federal Reserve reducing demand in those markets. With the speech having reintroduced the issue, market expectations should start to affect the changes in the bond market, and a reaction will be evident soon enough.

The article and charts were written in Python in an IPython Notebook. You can download the code here: .py .ipynb

Saturday, March 18, 2017

American Health Care Act: Shifting the Structure of Health Care

Last week, the Congressional Budget Office (CBO) released their cost estimates for the American Health Care Act. The piece of legislature is looking to be passed in the House of Representatives but is struggling to obtain the support to pass it. Speaker Paul Ryan recently said that his bill would need to change to secure the votes it needs to pass. The CBO report has done its part to affect the bill’s popularity and proven it deserves some review.

The federal budget deficit continues to be one of the divisive issues in the two-party system with Republicans and Democrats blaming the opposition for its death of financial accountability. When the CBO mentions that the bill will reduce federal deficits by $337 billion, ears perk up. In a ten-year period, estimates predict that $1.2 trillion of spending would be erased with most that reduction coming from $880 billion in federal outlays for Medicaid. Much of the opposition to the bill comes at this point where the program that supports those who have the most trouble obtaining health care threatens to be gutted.

The legislature seeks to give the states more power over their own spending forcing the populations of each individual state to be subject to the local political environment. The bill does this by switching to a lump-sum allocation plan. Liberal opposition to this change claims that this will hurt Medicaid members in conservative states which predict that governments in these states will be stingy with these funds. The CBO sees a 17 percent drop in Medicaid enrollment compared to the 2026 estimate for the current law. The lower enrollment will be responsible for the majority of the spending declines with cuts to the federal matching rates being the second largest factor affecting spending.

The new legislature will also cut out the individual mandate penalty as it was one of the contentious points of the bill. The CBO notes that the revenue lost from removing the individual mandate will exceed the savings from lower enrollment. The removal of the individual mandate would result in an interesting exchange of government revenues for higher disposable income. The idea is that consumers are more efficient with their money because the government is disassociated from their preferences, but the logic is not flawless. In reality, the average consumer underestimates his need for insurance and is often overconfidence with how healthy he is or how likely things are to happen to him. Nevertheless, the reductions in Medicaid spending show that the Republican party still believes that the private sector is better off making financial decisions.

Second to the Medicaid cuts, reductions of $673 billion in healthcare subsidies including tax credit for premium assistant and cost-sharing will be implemented. Not only are the cost structures being revised, but the timing of the payment is being pushed back to tax season. The CBO finds that, for households with income exceeding the 150 percent of the federal poverty line, younger people would pay less towards their premiums than older people. For that reason, the CBO sees younger than older individuals enrolling into the new program.  The new legislature looks to capitalize on the wealth of the older generation to allow the new health care law to be cheaper than the last.



The chart above shows CBO estimates under the current and new laws for a 21-year old, 40-year old, and a 64-year old. Based on net premium paid for individuals at 175 percent of the poverty line, the current law has the same rate across ages, but the new law would have the 64-year old premium over 5 times higher than the younger individuals. The age trend, again, holds for individuals with higher annual income (450 percent of the poverty line). Overall, estimates for premiums have increased significantly for older individuals to finance lower premiums for the younger population.

The strategy of leveraging the premiums of the older population to finance lower premiums for the younger population is most likely supported by the fact that individuals over 55 have, on average, higher net wealth than the younger. Moving money out of Medicaid and into support for the non-group insurance market is another indirect way of pushing the burden of the cost of healthcare on the older generation who have the highest enrollment in the program.

Besides these major changes, the plan includes a few other notables. Planned Parenthood funding would be more or less cut completely. The actuarial values of the plans would be allowed to be reduced permitting insurers to cover less of the costs that are required under the current law. The establishment of the Patient and State Stability Fund would help disruptions in the stability of the market.

Voting on the plan will continue through the first half of the year, but currently, there is enough opposition to keep it from being passed. A macroeconomic analysis was not provided by the CBO as more analysis was needed, but it seems clear that the higher premiums would cause a drag on consumption especially in the oldest demographics.

Sunday, November 13, 2016

Chart of the Day: OPEC Price, Output, and Revenue

While doing some research for my book earlier this month, I came across an interesting graphic created by Dermot Gately in his paper "Lessons from the 1986 Oil Price Collapse." The chart provided a useful perspective on the equilibrium price of a barrel of oil during a period where OPEC sought to control the price by cutting production after it fell to lows in the 1970's. Revenue levels for the oil cartel declined to almost $50 billion endangering the health of many economies that relied on its natural resources for survival.  As more members began to feel the pain of tighter trade balances, more support for a supply cut forced the hand of the swing producer, Saudi Arabia. The price control worked until 1986 when prices crashed again.

From Gately's "Lessons from the 1986 Oil Price Collapse"

Gately's chart plots output, price, and revenue on a graphical space that can be pictured as a curve in three-dimensional space, but, for informational purposes, it relies on level curves to make its point. The display is also set up to reflect the structure of a standard supply and demand graph with price on the y-axis and output on the x-axis, and this allows us to theorize about an equilibrium if the data provides some structure to the behavior of the market. Because OPEC acts as a cartel with quasi-monopolistic powers, plotting its output alone is sufficient. 

At first glance, I noticed that the behavior of the OPEC output movement appeared cyclical from 1970 to 1986. With the exception of a kink in the late 1970's, the trend in the market appears to mirror a positive feedback loop in which price and OPEC output respond to each other's movement with revenue level accelerating the shifts. As prices grew from 1973 to 1974, OPEC kept output levels high to take advantage of higher revenue. In 1980, prices peaked after the global supply of oil had grown from the growth of production in North America and OPEC. In response, the cartel attempted to cut production to cushion the fall to a low in 1986. Prices would bottom out later that decade and, encouraged by low revenue levels, OPEC would add to output in anticipation of a higher equilibrium price. Saudi Arabia's data reflects the same kind of trend but with more inelastic output changes. From 1970-1973 and 1980-1985, the Middle Eastern nation had the most flexibility in its output policy. The years following the shifts in production were defined by dramatic moves in price suggesting that OPEC's swing producer had an enormous amount of control over the pricing mechanism. Although, is was still susceptible to the cyclical trend because its government relied on oil revenues to keep the country operating.

But 1986 is history, and if one reads more and more about the behavior of 20th century OPEC, it becomes quite predictable amidst the countless number of regional conflicts and price control tactics. Using the behavior in this period as a predictor of what should or could happen in the most recent oil glut of 2014-2015 has proven to be useless. This is most likely caused by the growth of non-OPEC supply, particularly the North American shale producers. Nevertheless, OPEC actions still have some effects on the markets, but, overall, the effects are muted. To investigate the fundamental picture, I recreated the chart above to track the movement of price and output in relation to revenue from 2000-2015 using Gately's style.


Based on price data from OPEC's Statistical Review adjusted for inflation and exchange rates and daily output figures from the Monthly Oil Market Reports, I was able to map the two series over some revenue isoquants calculated by multiplying price and output together. The behavior that is observed between 2000-2016 is very different from that of 1970-1986 with a circular figure turning into a curve that appears to trend linearly over time (as shown by the purple trendline). We have a gradual increase in OPEC output accompanied by a quasi-proportional increase in the price of oil up until 2008. The financial crisis occurs producing a slight deviation from the trend which reaches its peak, in both price and output, in 2012. Based on a linear regression analysis, we can develop a theoretical supply function that appears to define OPEC price policy from 2000-2012. So have we observed a deviation from the monopolistic behavior we saw in the previous graph? Not exactly.

The oil cartel is taking advantage of the inelastic qualities of petroleum demand to secure the best price for each barrel they produce. Because OPEC member nations need to reach these higher revenue levels to support the growing costs of government and higher rates of inflation in the 2000's, they seek to optimize policy to be as far right on the supply function as possible. In order to do this, OPEC made use of the regional conflict in Iraq and demand growth in emerging economies to achieve its goal, but there would be residual consequences. Remember how higher revenue levels would accelerate the trend in the opposite direction as producers seek to maximize output to reach even higher revenue levels? Well, the trend of price leading up to 2012 sparked a new set of producers to optimize and, in the end, flourish. North American shale producers reaching untapped reserves and pumping them quickly challenged OPEC for its market share causing the green line to drop to where the awkward looking 2015 data point falls. Here, the market has changed as OPEC's monopolistic powers are threatened by this surging source of output. This new competition can be modeled by a shifting of the purple supply curve so that to intersects the 2015 data point. The oil cartel now has less control over its revenue streams.

The new pricing mechanism in the current market will not allow a trend like that of the early 2000's to develop. For that reason, OPEC has been wary in trying to influence the market with an output freeze (or an outright cut). While that cut in the 1970's would have supported price, one in 2016 would be met by an increase in North American shale output. Saudi Arabia hinted at this shift in power when it announced a sale of 5 percent of Aramco stake in the U.S. markets with the goal of financing an investment fund that would reduce the country's reliance on fossil fuel income in the long run. Suddenly, OPEC looks useless despite calls for action by investors have suggested otherwise. At the moment, only a Saudi Arabian-Russian agreement looks to have any major effect on the price of oil, but based on economic circumstances in both countries, neither can risk a drop in output being negated by an increase in North American production. In the end, I see OPEC countries being forced to come to terms with a new oil market. After all, renewable energy is getting cheap, and there is clearly a global preference for those energy sources.  

Friday, November 4, 2016

Normalization Versus Rate Hike Policy

The steadfast Federal Reserve is at it again. After a meeting on November 2nd, the committee of ten concluded with the federal funds rate and the discount rate held steady at the status quo. In the release, they say that “the case for an increase in the federal funds rate has continued to strengthen,” but of course, confidence wasn’t strong enough for the economy to off of low-interest rate life support. Three hesitant words stuck out to in particular: the labor market is expected to “strengthen somewhat further,” economic activity well grow “at a moderate pace,” and market risks “appear roughly balanced.” To me, these filler words indicate that the Federal Reserve recognizes the signs of a cyclical peak and seeks to diffuse tension in an economy that is moving flatly. The S&P 500, Dow Jones Industrial Average, and Nasdaq indices are trending at all-time highs, valuations continue to rise, and economic numbers paint an ambivalent picture of the economy. It’s not hard to conclude that we’re reaching a cyclical top after considering the fact that a seven-year bull market has pushed us to this top.

During a bull market, central banks typically raise interest rates to keep in check a rising level of inflation, but the Great Recession lead to a recovery that suggested typical monetary policy should be abandoned. Instead, policies like global quantitative easing and cheap debt were held in place to support a recovery. A divergent strategy has forced the Federal Reserve, along with the rest of the world’s central banks, into uncharted waters where it elected to keep the status quo. Companies liked that, but weird things started happening with inflation. An oil price shock caused half the world to develop symptoms of deflation, and rate hikes in this scenario would only hurt world markets.
Needless to say, the Federal Reserve finds itself in a very “un-normal” position where it must protect investors from a bubble while also shielding the economy from deflationary pains. In order to do this, the FOMC committee has elected to move in the direction of a “normalization” policy. When I first heard this term from one of the Fed member’s speeches, I just assumed “normalization” meant “rate hike,” but there is a distinction between the two that the Fed has intentionally signaled. While both involve increasing interest rates, a rate hike policy has a bearish connotation that suggests an abrupt shift in rates while normalization implies a more neutral move towards a clear target indicated by the central bank.


The key driver of the use of “normalization” language is the lapse in the recovery of inflation after the Great Recession. The chart above shows how a series of three periods of quantitative easing lead to a decline in the inflation rate from 3.77% annually in 2011 to -0.20% in early 2015. The FOMC first signaled that inflation was not where it wanted to be in the release following the December 2012 meeting by saying, “Inflation has been running somewhat below the Committee’s long-run objective.” Ever since then, the issue of inflation has risen to the top of the Fed’s list of priorities and has consistently been the reason why rates were held low. “Normalization” is the “solution” to this problem of nagging deflationary pressures, and I say “solution” carefully because this policy only works if markets respond the right way.



As evidenced by USD and Treasury yield movements at the conclusion of an FOMC meeting, investors like to jump the gun when it comes to reacting to a monetary policy updates. Normalization seeks to avoid the volatility associated with these movements, so the Fed acts in an extremely slow manner. In fact, they will set medium-term plans for the next three year and purposely act slower than what they projected. For example, projections from the December 2015 meeting suggested that four rate hikes would be a plausible way to move forward in 2016. Seven out of eight meetings later, the Fed has yet to raise even rates even once. In doing this, the Federal Reserve is manipulating expectations so that investors trade like four rate hikes are in play. When the meetings actually do come around, expectations are gradually dropped and the markets perceive the lack of rate hikes as accommodative policy. When rates are increased in December 2016, the markets’ reaction shouldn’t be decisively bearish. “Rate hike” policy suggests that markets should expect a rise in interest rates, and the Federal Reserve will follow through on these intentions. This distinction is necessary if a 2 percent inflation target is to hold any legitimacy. Only through normalization policy could the Federal Reserve massage inflation rates to their liking; a clear rate hike agenda is deflationary and would yield different results.


An agenda that is contractionary on purpose would be very dangerous in the current global monetary condition where central banks across developed and emerging economies have failed to move in a coordinated manner. The BIS released the charts above showing how central banks have been forced to respond to local inflationary effects. In Europe and Japan, negative yields have been introduced to combat stagnate growth and deflation while developing countries like Brazil, Colombia, South Africa, and India have set rates higher to tame inflation rates above the respective bank’s inflation target. This environment differs drastically with the coordination that was required to repair the damage of the financial crisis. If the Federal Reserve chooses a “rate hike” policy which could upset measures being taken in countries troubled by deflation, it could send negative shockwaves in the foreign exchange and capital markets. Adopting “normalization” would put the Federal Reserve more in line with foreign central banks who are attempting their own forms of careful normalization, and consequently, would calm volatility in equity and bond markets that is being caused by shifting investor expectations.

From BBVA

The Federal Reserve has shown its preference for normalization policy by choosing the appropriate signaling and maintaining global monetary coordination. Going forward, the Fed will deviate farther from rate hike policy by ensuring that the differences in timing are evident. In May 2015, BBVA published some interesting research on timing differences in normalization and tightening (rate hike) policies. A comparison of “past tightening cycles” shows that the length of low rates and the expected length of tightening period is projected to surpass the five other cycles that have occurred in the past 35 years. According to basis point per month calculations, this cycle of “tightening” will occur 31 percent slower than the slowest cycle in 1999. These numbers were published in 2015, and since then, the actual rate of increase has been about 1.3 basis points per month. Even if the Federal Reserve had held to its policy projections in December 2015 (25 basis point increase in Dec 2015 and four 25 basis point increases in 2016), the basis point per month increase would be 6, significantly lower than what investors expected at the time of this paper’s publication.


With such a clear difference in the uptrends of these tightening cycles, it seems clear that the Federal Reserve is trying to implement a different policy framework. BBVA even identified this shift toward tightening suggesting that “’normalization’ is defined as an increase in the Fed funds rate at a point when monetary policy could be assessed as loose.” Even if Janet Yellen and her FOMC cohorts have successfully aligned expectations, coordination, and timing with a policy considered “normalizing,” can we be sure that it will work?

There’s really no way to tell. Markets only have one rate hike under their belt, and that instance led to a sell-off at the beginning of 2016 that threatened to turn into a full-on bear market. Expectations say another 25 basis point rate hike is in the cards for December, so will a similar reaction greet 2017? Once again, it’s a toss-up. One year ago oil prices were significantly more volatile, but the UK had not left the European Union. Growth rates in the United States appear to have stabilized with the most recent GDP figure of 2.9 percent surprising positively, but the Eurozone and Japan had sunk deeper into negative interest rates. The economy is no replica of what it was a year ago, but only a few structural shifts make it distinct.


As far as predictions go, I see a rate hike in December confirming the Federal Reserve’s commitment to “normalization” rather than “rate hike” policy. In that meeting, it will project another three or four 25 basis point rate hikes in 2017, but, like in 2016, that will be an overshoot of its actual path. If markets respond bearishly to the December hike (like this year), the Fed might squeeze in two 25 basis point but one is more likely. If the economy shows improvement and earnings season at the end of 2016 isn’t a total bust, we might see two to three rate hikes. However, the amount of rate hikes in 2017 will always be at least one less than what is projected. This is essential in case the FOMC committee needs to pull out a “bullish surprise” of holding out one meeting so as to avoid any contractionary moves.