The Daily Prophet: Fed Has Markets Right Where It Needs Them

Connecting the dots in global markets.

Could things get any better for the Federal Reserve? Central bank officials on Wednesday are widely expected to reaffirm their plan to raise interest rates again before year-end and announce that they will start shrinking the $4.7 trillion balance sheet in October. Rather than panicking and sending markets in a tizzy, investors are taking it all in stride.

U.S. stocks are record highs, 10-year Treasury yields are near the lows of the year, corporate credit spreads are at about all-time lows and the dollar has weakened. Taken together, these variables are helping to keep the economic expansion on track while putting to rest -- at least for now -- fears that Fed tightening and balance-sheet tapering would be a disaster for markets. While some would say investors are complacent, and Fed officials have indicated that they feel financial conditions may be too easy, markets are clearly responding to a Goldilocks-like environment where the economy is neither too hot nor too cold and inflation is under control. As such, the betting is that the Fed continues to remove the punchbowl ever so slowly.

While the U.S. may be pulling back, the economists at Bloomberg Intelligence note that the balance sheets at the world’s major central banks -- the Fed, European Central Bank, Bank of Japan and Bank of England -- have expanded by $10.5 trillion since 2008, and will likely swell by an additional $1.1 trillion through the end of 2018, further juicing markets. "What interest rates are anchored by is what we call the new neutral, which is the idea that policy rates globally will stay low for some time because of long-term structural forces such as demographics, slow credit growth (and) low productivity," Anthony Crescenzi, a money manager at Pacific Investment Management Co., told Bloomberg Television.

The surprising rally in U.S. Treasuries this year is largely credited to slower inflation, the inability of the Trump administration to get any of its major pro-growth policies off the ground and rising geopolitical risks. Less talked about, but probably just as important, is the big buying spree by China. The Treasury Department said late Monday that China's holdings of U.S. government debt rose $107.6 billion through the first seven months of the year, already making 2017 the biggest year for purchases by the Asian nation since its holdings expanded by $265.3 billion in 2010. China in June regained its position as the largest foreign holder of U.S. Treasuries, supplanting Japan, which held the spot for eight months. Overall foreign holdings of Treasuries are on the rise, increasing $244 billion this year to $6.25 trillion after shrinking in 2016 and 2015. Markets should take comfort from the fact that foreign demand for U.S. bonds is picking up just as the Fed is about to pull back from its purchases. 

It seems like almost every day there's a new superlative to describe the tranquil nature of equities. So, here's another: Even as it edges ever higher into unchartered territory, the U.S. stock market has never been this quiet. The S&P 500 Index’s intraday price swings averaged 0.3 percent in the five days ending Monday, the smallest in data going back to 1982, according to Bloomberg News' Lu Wang. To JC O’Hara, an analyst who watches charts to predict security moves at FBN Securities, that's a bullish sign. “Stocks cannot go down materially when the ranges are this narrow,” he wrote in a research note. Here's another one for the bulls: stocks have yet to reach “excessive overvaluation,” according to Edward Yardeni, the head of Yardeni Research. He cited a gauge that begins with the S&P 500 earnings yield, or the inverse of the price-earnings ratio, and subtracts year-to-year percentage changes in consumer prices to arrive at a real yield. Lower readings mean higher valuations, and vice versa, according to Bloomberg News' David Wilson.

The calling of snap elections by government leaders, although generally regarded as altruistic, is a risky bet. The move can just as easily put new authorities in control as it could solidify the power of the person in charge. Brexit anyone? So there's sure to be lots of focus on whether Japanese Prime Minister Shinzo Abe follows through on his idea to hold early balloting after returning from a U.S. trip on Sept. 22. A victory would ensure the continuation of Abenomics, the recipe of mega monetary easing, flexible fiscal policy and selective deregulation that’s helped Japan’s economy sustain its longest sustained expansion since before the global crisis, according to Bloomberg News' Masaki Kondo. Futures tied to the Nikkei 225 Stock Average climbed by the most since May on Tuesday as Tokyo markets reopened after a long weekend, and 10-year government-bond futures dropped as the yen retreated on the election talk. Should he win, Abe would get to pick the next leaders of the Bank of Japan, after choosing the current group that’s overseen a welcomed slide in the currency.

Tungsten isn't a commodity most people are familiar with, but it's one of the most critical materials for the Western world’s economy and defense industries -- and its price is gapping higher at a faster pace than just about any other raw material. Used to harden steel in ballistic missiles and in drill bits, tungsten has surged more than 50 percent in the last two months amid growing concern about supply cutbacks in China, where about 80 percent of the metal comes from, according to Bloomberg News' Thomas Biesheuvel. China is clamping down on polluting mines and enforcing production quotas. The European Union classifies tungsten as a “critical” commodity and the British Geological Survey places it at the top of its supply-risk list of materials needed to maintain the U.K.’s economy and lifestyle. It became a flash point in 2012 when then-President Barack Obama filed a complaint to the World Trade Organization against Chinese supply curbs. China’s Ministry of Industry and Information Technology issued an edict on June 6 saying producers should stick to output quotas and that those without quotas, or which exceed the quotas, should halt production.

In an age of forward guidance, when central banks attempt to flag their every move far in advance, it seems that most Fed meetings become a bit of a letdown in terms of market action. Wednesday should be no different, as the odds of the central bank surprising markets and doing something totally unexpected like raising rates is virtually nil. That said, there could be some volatility in markets in response to any revisions the Fed may do to its economic and financial projections, otherwise known as the "dot plot." Also, this is one of those meetings where there will be a press conference with Chair Janet Yellen, and she is bound to be asked about her thoughts on a possible second term when her current one ends in February.  

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Mnuchin's in Spotlight and the Glare Is Harsh: Albert R. Hunt

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