The Daily Prophet: Fed Have You Down? JPMorgan Has a Pick-Me-Up

Connecting the dots in global markets.

To understand whether the Federal Reserve's plan to start shrinking its $4.5 trillion balance sheet next month will be a disaster for the bond market, you must first understand what has been driving the rally in fixed-income assets. On that point, JPMorgan has an interesting take that should offer some reassurance.

The firm's strategists noted in a research report that, in many ways, the rally in equities helps explain the surprising positive performance of bond markets. That's because the more stock prices appreciate, the more investors need to buy bonds to prevent their equity weighting from rising too much or to hedge their equity risk. In other words, the gains in equities are feeding the bond rally, preventing bond markets from selling off even in a "risk on" environment. This year's bond-fund buying is tracking at a record annualized pace of $928 billion, which would surpass the previous high of $849 billion in 2012, the JPMorgan analysts note. Yes, lower equity market gains in the future should slow the pace of bond-fund purchases, but only to about $600 billion or so next year, the firm figures. That would still exceed the $400 billion that would roll off the Fed's balance sheet between October and the end of 2018.

FTN Financial looks at it from another angle. The firm says the Fed bought all those trillions of dollars of bonds with money borrowed by banks, which shows up as excess reserves on its balance sheet that it pays interest on to the banks. When the bonds held by the Fed mature, the proceeds will be returned to the banks from which it borrowed, causing excess reserves to be reduced on a one-for-one basis. The important thing to know is that the banks used excess reserves to meet strict capital and leverage requirements. Now, they will have to find something else -- likely Treasuries and agency debt -- to meet these requirements. A true virtuous circle.

For one day, at least, the dollar bulls were able to show their faces in public. It's well known that the greenback has had an unexpectedly bad 2017, amid a slowdown in U.S. inflation, turmoil in Washington and a resurgence in Europe's economy. Rather than rising as forecast, the Bloomberg Dollar Spot Index crumbled 9.69 percent this year through Tuesday. But thanks to the Fed's hawkish leanings Wednesday and its comments that Hurricanes Harvey and Irma won't dissuade it from raising rates one more time this year and three times in 2018, the dollar was at one point enjoying its biggest one-day gain since January, before easing back a bit in late trading. Whether this marks a turning point for the dollar remains to be seen, as some strategists simply chalked the gains up to investors who had been betting on further weakness reversing some of those trades. Commodity Futures Trading Commission data show the market is more bearish on th dollar than anytime since early 2013. "The market has been caught wrong-footed in assuming that the Fed wouldn’t be raising rates again this year,” Bipan Rai, a currency and macro strategist at CIBC, wrote in an e-mail.

Although everyone expected the Fed to announce plans to start shrinking its balance sheet and raise interest rates one more time this year, most stocks didn't take the news well. But, there's always an exception, and on Wednesday it was the shares of financials. The prospect of higher rates can be good for financials because it generally means that the difference between a bank's cost of funds and the rates at which it can lend that money gets wider. That helped the Financial Select Sector SPDR Fund, the largest ETF tracking the financial sector, to rise for a third day to close at its highest level since 2007. Even before the Fed's statement, options traders were positioned for gains, according to Bloomberg News' Elena Popina. The ratio of outstanding calls to puts in the fund had increased to 1, the highest level this year. The price relationship between the put and call options known as skew shows a similar picture. The cost of options hedging against a 10 percent drop in the ETF is near a one-month low relative to bullish contracts.

Raw materials are having their best quarter since the period ended June 30, 2016, aided by a global synchronized economic recovery.  The Bloomberg Commodities Index is up 3.66 since the end of June, with the Organization for Economic Cooperation and Development predicting that worldwide gross domestic product will expand 3.5 percent this year and 3.7 percent in 2018, from 3.1 percent in 2016. Citigroup is one firm that expects the rally to continue, especially in oil and metals, according to Bloomberg News' Jasmine Ng and Sharon Cho. “Overall, we expect strong performance to continue through year-end, with the oil complex perhaps joining, if not replacing, the strong performance of the China-related commodities and the precious metals,” Citigroup said. “After a stormy summer, crude should end the year on a high.”  The bank has been consistently bullish about commodities. In July 2016, it said it was positive as global growth chugged along and investors plowed more cash into funds. Last month, the bank said markets from metals to iron were tightening globally as China pressed on with supply-side reforms. 

This is the kind of economic boost that Colombia would probably rather avoid. A falling currency in general make a nation's exports more competitive, but in the case of Colombia's peso its decline is serving mainly to boost shipments of cocaine, according to Bloomberg News' Oscar Medina. The amount of land planted with coca, the raw material for making the drug, has tripled over the last three years, to 146,000 hectares. Some of the reasons for this include the end of aerial spraying with weedkiller, the peace process with Marxist rebels and a drop in the price of gold, which cut the profits in illegal mining, the mafia’s other big earner. Vice President Oscar Naranjo, formerly head of the national police, this week floated another theory in an interview with El Tiempo newspaper. “One of the fundamental reasons for the growth has to do with the weakening of the peso,” he said. “This in an attractive incentive for the mafias, to promote planting and production of more coca.” The weaker currency has kept prices up for Colombian coca farmers amid the surge in output. Although the price of a kilo of coca paste, an unrefined form of cocaine produced by the farmers, fell to $621 in 2016 from $1,011 in 2013, according to the United Nations Office on Drugs and Crime, it remained stable in local terms at around 1.9 million pesos.

The initial jobless claims data on Thursday will take on added importance this week, and not just because the number of U.S. citizens seeking unemployment insurance is forecast to rise to 300,000 for the first time since early 2015. The thing to know is that the data coincides with the survey week for the all-important monthly jobs numbers, meaning there could be some negative impact on jobs created, the unemployment rate and wages when that report is released on Oct. 5. Jobless claims data have been, and will continue to be, distorted by Hurricanes Harvey and Irma for a few weeks, according to the economists at Bloomberg Intelligence.

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