David Fuller and Eoin Treacy's Comment of the Day
Category - General

    Please note I am away on holiday until August 1st

    I would like to extend my special thanks to subscribers and friends of FullerTreacyMoney for submitting a number of articles for your kind consideration over the course of the next few weeks. I think subscribers will be pleasantly surprised with their contributions. 

    U.S. Fed's chairman outsources 'neutral' rate decision to the yield curve

    Thanks to Niru Devani for her second article this week.

    A long term subscriber to FullerTreacyMoney, Niru began her career in the financial markets 30 years ago as a trainee fund manager. After spending 14 years in the fixed income sector, she moved to managing commodities and global macro funds. Niru now manages both hers and her families' pension funds and other savings. She also likes to trade. She says, ‘My enthusiasm for my profession is even stronger now and I enjoy the fact that I am constantly learning new things.’

    During a two day testimony to the Senate Banking Committee that ended yesterday, Fed Chairman Jerome Powell said that he runs policy according to what is in front of him and uses a slow, steady approach to keep policy from becoming too restrictive. He is fully cognisant of the risks ahead, be it inflation accelerating from fiscal stimulus or growth decelerating because of trade uncertainty. He rates the chances of both outcomes 50/50, so he isn’t going to react to either until they become actual rather than potential risks.

    What the FOMC is doing is to steadily raise rates, that is, the price of short-term money so that it is better aligned with growth. It will continue with that policy until it sees risks to growth from this path. Two further rate hikes are expected this year. Real growth remains strong although new housing growth is flattening out, but construction is still expected to rise on a year-on-year basis. As the chairman said, the economy was growing at a “solid pace”, that the unemployment rate was expected to fall further, that the recent pickup in inflation, toward the Fed’s 2% target, was “encouraging”.

    The Fed’s first aim is to get interest rates up to their “neutral” level, and then see how the economy is performing. What rate constitutes neutral is a matter of spirited debate among FOMC members. Powell weighed in on the subject during the Q&A portion of his testimony by saying he has  effectively outsourced the resolution of the debate to the credit markets. He will take his cue as to whether the Fed has reached neutral from the shape of the yield curve. This means that as long both the economic news and the yield curve remain positive,  the Fed will keep raising rates.

    It is of course nothing new that the interest rate setting committee watches the bond markets and the yield curve very closely. However, it is the communication style of the current head of Federal Reserve that is a lot more open and direct compared to his predecessors, especially Alan Greenspan who was a master of obfuscation.

    The eventual challenge to the Fed’s policy management will come when core inflation is drifting higher while growth is weakening around the edges because of trade disruptions. Assuming the yield curve is still positive by year-end, the question will be whether the Fed changes tack to counter trade-induced slower growth or stays the course to stem inflation – which, by that time, will probably be testing its tolerance threshold. The most likely scenario is that the Fed is likely to hold true to form and go on fighting inflation, which should mean that growth in 2019 will be slower but still positive in the Fed’s view. As it has a dual mandate, it has to balance its inflation fighting credentials with promoting a supportive policy mix for growth.

    During his testimony, there was no talk about the reduction of the Fed’s balance sheet, which is odd considering the IOER*/fed funds spread is generating a lot of comment and leading some to conclude that quantitative tightening will end sooner than anticipated. The issue is that because the Fed pays interest on reserves, bank deposits at the central bank consist of both the Fed’s reserve requirements and the capital requirements of Basel III. This raises the question of how useful is the normal analysis of reserves at the Fed. The wider issue is one of bank capital adequacy. Powell was pressed about this but avoided answering. No doubt we will hear more on the subject the next time he appears in front of the Senate.

    *interest rate on excess reserves

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    Some thoughts on the Dollar

    Our second guest contributor today is Mikhail Overchenko. Mikhail has been working at the leading Russian business daily Vedomosti, co-founded by Financial Times and The Wall Street Journal, since its launch in 1999. He is a longtime foreign news editor, specializing in economics, markets and finance. 

    Following recent discussion here on surprising dollar strength this year, I would like to add a factor that wasn’t mentioned. Writing some 18 months ago a story about Donald Trump’s possible policies (I am a journalist), I mentioned that his idea to bring US corporate profits back home could lead to dollar appreciation. Because we had similar example not long ago. George W. Bush’s American Jobs Creation Act of 2004 allowed companies to bring foreign profits to US while paying significantly lower tax. He hoped that they would invest these funds at home but they mostly bought back their shares, paid dividends and did mergers and acquisition (they seem to do the same now). 

    So, in 2005 US companies repatriated approximately $300 billion. This resulted in almost 13% growth of dollar vs euro as well as of Dollar Index that year. As you can see on the chart, this was the most significant correction during overall dollar long-term bear trend of 2001-2008. 

    While obviously there are other factors in play that determine currencies’ dynamics, the factor of repatriation of profits seems to prevail and possibly will continue to play a significant role till the end of the year.

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    Please note I am away on holiday until August 1st

    I would like to extend my special thanks to subscribers and friends of FullerTreacyMoney for submitting a number of articles for your kind consideration over the course of the next few weeks. I think subscribers will be pleasantly surprised with their contributions. 

    Is Netflix the chink in the Armour of the FAANGs?

    Thanks to Niru Devani for this article, which I’m sure will be of interest to the Collective.

    A long term subscriber to FullerTreacyMoney, Niru began her career in the financial markets 30 years ago as a trainee fund manager. After spending 14 years in the fixed income sector, she moved to managing commodities and global macro funds. Niru now manages both hers and her families' pension funds and other savings. She also likes to trade. She says, ‘My enthusiasm for my profession is even stronger now and I enjoy the fact that I am constantly learning new things.’

    Netflix fell by 14% in after-hours trading yesterday following their results announcement which were below expectations. The company reported subscriber growth of over 5.1 million, one million below market forecast although the headline earnings per share at 7% beat consensus forecasts. Netflix also warned that it was seeing stiff competition. The Nasdaq 100 index also lost 125 points from the highs made just a couple of days ago.

    Of all the FAANG stocks which comprise Facebook, Amazon, Apple, Netflix and Google, Netflix has always looked very similar to the dotcom stocks from the 1998/2000 period. As Eoin has commented on before, it relies on junk-rated debt for funding and the barriers to entry in its market are low. In the last five years, it has been enormously successful and this year alone, it had more than doubled before yesterday’s fall. However, it is burning a lot of cash and Amazon is also trying to steal its market share.  

    The FAANGs have dominated the market since the presidential election and the technology sector now forms 25% of the S&P 500 index. Momentum investors and passive funds have significant allocation to the FAANG stocks. For example, there are 145 ETFs that are long of Amazon and 450 ETFs long of this group.

    The group has wobbled before and has been on the verge of a correction, the most recent episode being during Facebook’s data privacy problems earlier this earlier. Sceptics have tried to call the end to the ascent of these stocks and of the technology sector in general. But they have defied the bears. We know that the technology sector per se has huge growth potential in the medium and long term. However, Netflix looks very extended relative to the trend mean even after this reaction post its results. More broadly, it has certainly focussed even more attention on the members of this select group.

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    Please note I will be away on holiday until August 1st

    I would like to extend my special thanks to subscribers and friends of FullerTreacyMoney for submitting a number of articles for your kind consideration over the course of the next few weeks. I think subscribers will be pleasantly surprised with their contributions.