In this brief excerpt from The Macro Show this morning, Hedgeye CEO Keith McCullough weighs in with his unique take on the beleagured U.K. currency.
In this brief excerpt from The Macro Show this morning, Hedgeye CEO Keith McCullough weighs in with his unique take on the beleagured U.K. currency.
Editor's Note: Below is a Hedgeye Guest Contributor research note written by Stefan Wieler for Goldmoney Insights. A brief note on our contributor policy. While this column does not necessarily reflect the opinion of Hedgeye, suffice to say, we often concur with our contributors' conclusions. In the piece below, Wieler writes "A loss in confidence in the monetary system could have a far bigger impact on gold prices than changes in real-interest rates and longer dated energy prices alone."
In the Referendum of the United Kingdom's membership of the European Union, 52% voted for leave, causing shockwaves through financial markets and a rally in gold. Using our gold price framework, we look at the impact on the price drivers for gold going forward.
Against the latest polls before the referendum, and seemingly against the expectations of the City and financial markets in general, nearly 52% of the UK voters voted to leave the European Union. This has come as a massive shock to the markets, with the GBP down 8.4% at the time of writing (over 10% at some point overnight), and equity and commodity markets crashing. Gold began to rally immediately after the first results revealed that the share of leave voters have been hugely underestimated and has rallied to USD1324/ozt, a 13.6% % gain against the GBP.
While only time will tell what the eventual economic implications will be, one thing is already for sure: The reality of BREXIT is shaking financial markets at the core. Asian and European equity markets closed with huge losses, commodity prices tumbled and currency markets are in disarray. We haven’t seen market moves like this since the credit crisis.
However, as we have written before, this is not 2008 – at least not for gold. In early 2008, gold dropped from a high of $1003/ozt on March 14, 2008 to a low of $712/ozt on November 12, 2008 while the S&P 500 lost over 30%. This time the situation couldn't be more different in our view. Rather, the three core drivers of the gold price are today firmly in gold's favor, and the price outlook is skewed to the upside.
In this report we outline what the result of the vote means for gold prices going forward, using our proprietary gold price framework we have introduced last year (see Gold Price Framework Vol. 1: Price Model, October 8, 2015).
In our model we have identified three main drivers for the price of gold: Real-interest rates, central bank policy and longer-dated energy prices. In our view BREXIT will have an impact on all 3 drivers in a positive way, adding support to gold prices going forward.
As a reaction to the result, central banks will likely adopt much more dovish policies. The enormous volatility caused by the vote shows that markets have been in a very fragile state all along. This means that the likelihood that the FED will be able to raise rates in July has vanished in our view and the outlook for further hikes in 2016 and 2017 is now at risk.
We have long argued that the FED will have a hard time raising rates to their desired target of 3.25% at the end of the cycle (which still is well below historical norm). Depending on the severity of the market reaction to the outcome of the vote over the coming weeks, it could well be that the FED will not be able to raise rates any further.
Real-interest rates already began to price this in, dropping to the lowest levels since 2013 and at the brink to falling into negative territory again. As a result, gold prices shot up sharply (see Figure 1).
Figure 1: USD Real-interest rates collapsed as a result of the vote, pushing gold sharply higher
Gold USD/ozt (LHS), 10-year TIPS yield, %, inverted (RHS)
Source: Bloomberg, Goldmoney Research
But real-interest rates are unlikely to stop here. Before the recovery from -0.9% in 2012 back to +0.8% by the end of 2015, real-interest rates had been in a steady downward trend for 30 years. Even if the FED had succeeded raising rates again to 3.25% while maintaining inflation at 2%, realized real-interest rates would have only reached 1.25% at the peak. Any monetary policy reaction to a renewed economic recession would have inevitably pushed rates into negative territory again and to new lows.
With the outcome of the referendum however, it has become very unlikely in our view that the FED can raise rates anytime soon, meaning that interest rates will be much lower at the beginning of the next economic downturn. There is now a distinct chance that they will not be higher than they are right now at 0.375%.
This means that real-interest rates will most likely make new lows during the next down-cycle. It also means that the biggest risk to the gold price, a meaningful increase in the FED funds rate, is much less likely. Hence the referendum has set a floor on the price in our view.
The immediate impact of the vote was that energy prices sold off hard. But it was mainly spot prices that go hit while longer dated prices haven’t meaningfully sold off. The reason is that speculative positions in WTI and Brent were close to all-time highs before the vote (see Figure 2). These positions tend to be in the front of the curve and have pushed time-spreads well beyond what is currently warranted by inventories (see Something’s got to give in the oil market, May 3, 2016). The leave vote caused massive sell-off in risky assets, and naturally oil was hit too with front end prices down 6% overnight.
Figure 2: As speculative positions in oil where near all-time highs, front-end prices sold off sharply with the general market sell-off after the vote
Million barrels, WTI (LHS), Brent (RHS)
Source: Bloomberg, Goldmoney Research
The risk to energy prices is that in the aftermath of the vote, global economic growth slows down, which would push the clean-up of the oil market further back in time. We currently expect that global inventories peak in late summer and then decline relatively quickly. A delay in the normalization of stocks would put a lot of downward pressure on front end prices as the curve is currently already pricing in that inventories are normalized.
Importantly, the back-end of the curve (which drives gold prices) would not be affected by such a price move in the front. However, if central banks revert to more drastic measures (like NIRP in the US or more QE) and this is seen by the market as creating inflation in real assets, we expect longer dated prices to actually rise.
Measureable changes in real interest rates, central bank policy and longer-dated energy prices can explain most of the changes in the gold price in the past. However, we can also think of new drivers that impact the gold price going forward, something we haven’t experienced yet. One risk is that the leave vote is the starting shot of something much bigger. The panicking reaction of the financial markets is a clear signal that the monetary foundations stand on extremely shaky ground. Nowhere is this more visible than in the European banks.
As our colleague Alasdair McLeod writes in his recent report (see Brexit is getting the blame, June 16, 2016):
“Caught in the middle of these imbalances are the private sector banks. Because of the scale of these problems, it is no longer a patch-and-mend issue, but a serious systemic problem. The European banking system has been struggling for survival ever since the Lehman crisis, reflected in the dismal performance of share prices for nearly all the major banks.”
”The other evidence of banking woes is the flight of investment capital into government bonds from cash and deposits held within the banking system, so much so that Germany’s 10-year bond now carries a negative redemption yield. The flight into tangible bonds is so pronounced, that €400bn of investment grade corporate bonds are also on negative redemption yields.
Market commentators are blaming this on fear of Brexit, but one look at the financial condition of the European banks tells us a different story. The banks must be struggling with deposit contraction on their balance sheets, fuelled by a combination of negative interest rates and systemic fears, at a time when their loan books are burdened with bad and irrecoverable debts.
It looks like the modern equivalent of an old-fashioned run on the banking system, led by the pension and insurance companies, which are becoming increasingly concerned about leaving balances with the banks.”
A loss in confidence in the monetary system could have a far bigger impact on gold prices than changes in real-interest rates and longer dated energy prices alone.
Takeaway: Friday's 65% jump in total equity market volume, on a big down day for stocks, bucked the 2016 trend.
During a day of post-Brexit duck and cover, total equity market volume was up 65% versus the one month average. Here's analysis from Hedgeye CEO Keith McCullough on The Macro Show earlier this morning:
"Look at the volume on Friday. Whoa!
How many times have we heard people say, 'Keith, why are you using volume? It doesn’t matter today because the market didn’t go down yet.' That was the same question we heard when U.S. equity beta was at the December high, and at the two June highs.
But look at what the market does on down days. Volume was up 65% versus the one month average. That's huge. Essentially, the liquidity is nowhere to be found unless you have a down day. This is the reality. This is what happens when you let markets clear, volume appears, in a big way. So the less intelligent chart chasing monkeys kept saying rallies on decelerating volume didn’t matter.
Risk happens slowly, then all at once…"
By way of contrast, take a look at total equity market volume Thursday (6/23), pre-Brexit, when the S&P 500 was up +1.3%.
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Takeaway: As our CEO Keith McCullough is fond of saying, "Risk happens slowly at first, then all at once."
Below is a collection of interesting links and insights from today's news with analysis filtered through our macro lens. This installment discusses the $2 trillion+ stock carnage post Brexit, the "risky trinity" warnings from the Bank for International Settlements, an analysis of Brexit voter demographics, and the latest from global central planners.
This past Friday's post-Brexit selloff was ... drumroll please ... the worst day ever for global equities. Literally. According to Reuters, "The $2.08 trillion wiped off global equity markets on Friday after Britain voted to leave the European Union was the biggest daily loss ever, trumping the Lehman Brothers bankruptcy during the 2008 financial crisis and the Black Monday stock market crash of 1987, according to Standard & Poor's Dow Jones Indices." Today's market action isn't exactly inspiring confidence with global markets getting hit hard across the board.
Bottom line: So much for the whole "there is no alternative" to stocks narrative. We've been suggesting a steady diet of Long Bonds (TLT), Utilities (XLU) and Gold (GLD) to our subscribers.
On Sunday, the Bank for International Settlements (BIS) warned of a "risky trinity" of conditions. (And no... the central bank watchdog wasn't talking about Brexit.) In its annual report, the BIS warns of: "Productivity growth that is unusually low, global debt levels that are historically high, and room for policy manoeuvre that is remarkably narrow. A key sign of these discomforting conditions is the persistence of exceptionally low interest rates, which have actually fallen further since last year."
Bottom line: To which we say, welcome aboard! As our subscribers are well aware, we've been warning about global #GrowthSlowing for quite some time now. Our cartoonist Bob Rich has been all over this.
Voting data crunched by the Financial Times reveals that "Remain" votes came from areas with a high concentration of "degree-educated people" who had higher incomes and were generally older. Another interesting correlation is that "Leave" voters generally hailed from regions most economically dependent on the European Union.
The chart below shows "share of Leave vote" to "percentage of region's GDP exported to the EU." This suggests that for a large contingent of British voters the European Union experiment had been largely underwhelming.
Global central banks stand ready to cooperate to stem post-Brexit bleeding, according to the Bank for International Settlements. "Central banks have acted swiftly in the past, they stand ready to act again, and they have the tools," BIS head Jaime Caruana said in the text of a speech to be delivered on Sunday.
The Bank of England has offered to provide over 250 billion pounds in addition to "substantial" access to foreign currency to relieve pressured markets, BoE head Mark Carney said. Meanwhile, "The Federal Reserve is prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy."
And via Bloomberg, "China weakened its currency fixing by the most since last August as global market turmoil spurred by Britain’s vote to leave the European Union sent the dollar surging. The People’s Bank of China set the reference rate 0.9 percent weaker at 6.6375 a dollar."
Bottom line: One of our top themes remains a loss of faith in the power of central planners. #BeliefSystem breakdown. It's been (and remains) a gigantic market and economic risk.
Today, following an emergency meeting between Japanese government and Bank of Japan officials, "Prime Minister Shinzo Abe instructed the Finance Ministry and the Bank of Japan to ensure the stability of financial markets and take steps if necessary," according to The Japan Times. Unnamed sources say the "government is ready to provide the economy fiscal support, with an eye on expanding planned stimulus steps to total more than ¥10 trillion."
Bottom line: See takeaway above for our view of the breakdown in faith of central planners.
RYAN RELEASES “BETTER WAY” TAX PROPOSAL
Lost in the fallout of the Brexit vote or even the Democratic sit-in on the floor of the U.S. House of Representatives regarding gun control was Friday's release of the Republican's long-awaited blueprint on tax reform, a 35-page document outlining what the tax code would look like if Speaker Paul Ryan had his way. A few observations before diving in...
So, what's in it? Perhaps the most headline-grabbing elements of the plan are the proposed new tax rates: a corporate rate of 20%; a pass-through business rate of 25%; and individual rates of 12%, 25%, and 33% (without identifying the income thresholds).
While not proposing a change to the mortgage interest or charitable deductions, the proposal scraps the remainder of most itemized deductions and instead increases the standard deduction. And on the business side, the blueprint calls for a shift to a territorial tax system while proposing a border adjustment tax on products, services, and intangibles imported into the U.S. Importantly, the blueprint calls for 100% first-year expensing for businesses while removing many business-related deductions and credits from the code, including interest deductibility.
So what does it all mean? In our estimation, it's worth noting how much energy and resources House Republicans and Speaker Ryan are devoting to this rollout, even if it's not receiving much play. Of course, Ryan is a former Chairman of both the Budget and Ways and Means Committees; and though in releasing this blueprint he characterized it as a start to a conversation, we're quite certain what he unveiled is a clear indication of where Ryan's baseline negotiation will be with the next president (and perhaps next Senate majority leader and chairman of Senate Finance Committee). What is crystal clear from this blueprint -- one of six such task force reports the GOP produced over the last month, and probably the one most ripe for deal-making with a potential Clinton presidency -- is that this particular one is more than a messaging document; for Ryan, tax reform is his lodestar, and with this blueprint he wrote his latest chapter.
Takeaway: Equity markets reacted violently to Brexit, but our broader set of risk measures, while mostly negative, were far less impacted.
Our risk monitor is an interesting animal in that it typically signals risk emerging in non-equities arenas before that risk is reflected in equity prices. Sometimes, however, it works in reverse. Equities get whipsawed, but the various risk monitor signals we track, while directionally consistent, can be characterized as "not impressed". Looking across the different signals this past week, one would assume that nothing overly significant happened. In fact, you'd be hard pressed to point to anything especially out of the ordinary. Either this means Brexit has smaller ramifications than what was priced into equities or these other signals are the lagging indicator(s).
It's obviously difficult to answer this question as no one seems to have a firm grasp on Brexit's longer-term implications for US economic growth, European economic growth, British economic growth, etc. From our vantage point, the big risk facing US investors is not Brexit, but the clear and present deterioration in credit quality and conditions in the US lending market. The lending cycle is very much in its twilight with numerous red flags beginning to arise. We think this should be where investors are focused.
Our heatmap below is mostly negative across all durations.
Financial Risk Monitor Summary
• Short-term(WoW): Negative / 3 of 13 improved / 4 out of 13 worsened / 6 of 13 unchanged
• Intermediate-term(WoW): Negative / 3 of 13 improved / 7 out of 13 worsened / 3 of 13 unchanged
• Long-term(WoW): Negative / 2 of 13 improved / 3 out of 13 worsened / 8 of 13 unchanged
1. U.S. Financial CDS – Swaps widened for 8 out of 13 domestic financial institutions. Although equity valuations reacted extremely negatively to the Brexit vote, most financials CDS outside large moneycenters seem to either indicate a delayed reaction or that default risk has not risen much. Moneycenter CDS widened by an average 2 bps while consumer finance and insurance companies' CDS tightened by an average -1 bps. On the other hand, outside financials, both the investment grade and high yield North American CDS indices at the bottom of the following table widened notably, by 4 bps to 87 and by 7 bps to 459 respectively.
Tightened the most WoW: MET, COF, PRU
Widened the most WoW: JPM, HIG, BAC
Widened the least WoW: GNW, MBI, AGO
Widened the most MoM: MS, JPM, GS
2. European Financial CDS – Financials swaps mostly widened in Europe last week as investors recognized the economic implications of the Brexit vote. The median CDS widened significantly, increasing by +9bps to 145.
3. Asian Financial CDS – While bank CDS in Japan were mostly flat last week, 2 out of 3 Indian banks saw CDS widen, and all 3 Chinese banks saw their CDS widen.
4. Sovereign CDS – Sovereign swaps mostly widened over last week. Post-Brexit vote, investors are most concerned with Italy and Spain, where CDS widened by +25 bps to 173 and by +23 bps to 129, respectively.
5. Emerging Market Sovereign CDS – Emerging market swaps mostly widened last week, although movement was fairly mild. The median EM CDS widened by only 1 bps to 189.
6. High Yield (YTM) Monitor – High Yield rates fell 9 bps last week, ending the week at 7.18% versus 7.26% the prior week.
7. Leveraged Loan Index Monitor – The Leveraged Loan Index fell 6.0 points last week, ending at 1895.
8. TED Spread Monitor – The TED spread was unchanged last week at 39 bps.
9. CRB Commodity Price Index – The CRB index fell -1.6%, ending the week at 189 versus 192 the prior week. As compared with the prior month, commodity prices have increased 1.4%. We generally regard changes in commodity prices on the margin as having meaningful consumption implications.
10. Euribor-OIS Spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread widened by 3 bps to 11 bps.
11. Chinese Interbank Rate (Shifon Index) – The Shifon Index rose 3 basis points last week, ending the week at 2.04% versus last week’s print of 2.01%. The Shifon Index measures banks’ overnight lending rates to one another, a gauge of systemic stress in the Chinese banking system.
12. Chinese Steel – Steel prices in China rose 0.4% last week, or 10 yuan/ton, to 2349 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity and, by extension, the health of the Chinese economy.
13. Chinese Non-Performing Loans – Chinese non-performing loans amount to 1,392 billion Yuan as of March 31, 2016, which is up +41.7% year over year. Given the growing focus on China's debt growth and the potential fallout, we've decided to begin tracking loan quality. Note: this data is only updated quarterly.
14. Chinese Credit Outstanding – Chinese credit outstanding amounts to 149.5 trillion RMB as of May 31, 2016 (data released 6/15/2016), which is up +15.5 trillion RMB or +11.5% year over year. Month-over-month, credit is up +553 billion RMB or +0.4%. Note: this data is only updated monthly.
15. 2-10 Spread – Last week the 2-10 spread widened to 93 bps, 2 bps wider than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.
16. CDOR-OIS Spread – The CDOR-OIS spread is the Canadian equivalent of the Euribor-OIS spread. It is the difference between the Canadian interbank lending rate and overnight indexed swaps, and it measures bank counterparty risk in Canada. The CDOR-OIS spread tightened by 1 bps to 39 bps.
Joshua Steiner, CFA
Jonathan Casteleyn, CFA, CMT
Patrick Staudt, CFA
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.