How To Know If Yellen Failed

by: Ivan Martchev

There is no doubt that last week's FOMC statement was hailed as dovish. Both bonds and stocks rallied after the Fed made a note of international risks, which I take as them being worried about China. They more or less implied that they are willing to let inflation run for a while rather than tighten prematurely.

At the time of the December 2015 Fed rate hike, many market participants thought the Fed was signaling four rate hikes in 2016. Now there is a consensus for two rates hikes. Perhaps the Fed is afraid of making an embarrassing U-turn and so they are calibrating expectations lower for the time being. Still, I think that any rate hikes in 2016 would be a big mistake.

Thirty Day Fed Funds - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The December 2016 Fed funds futures contract settled on Friday at 99.40. That ZQZ16 price implies a fed funds rate at 60 basis points (100 less 99.40). The present fed funds target rate is ¼ - ½ % and the effective fed funds rate settled at 0.38% on Friday. So the ZQZ16 fed funds futures contract implies at least one more rate hike by December 2016, even though this is an actively-traded financial instrument. Those market-based probabilities may change, as that same contract was calling for a rate cut a month ago.

I think more rate hikes would be a mistake as I think we have a global deflationary problem at a time when most market observers are worried about inflation. Market participants have had these misguided worries for a long time. On November 1, 2013, I penned a piece for Marketwatch called, "How to Know if Bernanke Failed." In it I explained that the greatest monetary experiment on the face of the planet - i.e., quantitative easing - cannot necessarily be celebrated as a success since it has not yet been unwound.

At the time, I wrote that few investors outside of the Federal Reserve understand quantitative easing. I gave an example of how mainstream economics research firms were making a fundamental mistake in the interpretation of the effects of QE. Many market observers think that because money multipliers and monetary velocities have dropped, the Fed was drawing a "lucky straw," since QE was working, at least for the time being. As I said then, this implied that as the velocity of money and the credit multiplier simply revert to the mean on their own, there will be trouble on the interest-rate and inflation fronts.

So, where is inflation today?

It is nowhere to be found.

Total Monetary Base Chart

Most observers think that because of the explosion of the monetary base, which is a function of QE, there will be a hyperinflationary outcome. I won't bore you with the mechanics, but the more QE the Fed does, the more the monetary base goes up. The trouble is that most observers do not realize that as long as the Fed pays interest on excess reserves at a rate higher than the fed funds rate, those excess reserves (that are part of the monetary base, pictured above) do not multiply in the financial system. Excess reserves are never lent in the fed funds market as excess reserve interest paid by the Fed is always higher - on purpose.

In other words, the QE money has no credit multiplier. This is all by design, so it is the Fed that controls the monetary velocities and the credit multiplier in the U.S. financial system. It is not a stroke of luck.

Velocity of M1 Money Stock Chart

Due to the dovish stance by the Federal reserve, as exhibited in their March 16 FOMC statement, the U.S. dollar also sold off and commodities continued their rebound with the front-month May 2016 WTI crude oil futures closing at $41.14/bbl. on Friday. As I have elaborated previously, I believe this is a seasonal rebound in oil. The oil price is also heavily inversely correlated with the Broad Trade-Weighted Dollar Index, which was down on the week as the seasonal oil rebound continues.

Crude Oil Prices - West Texas Intermediate versus Trade Weighted United States Dollar Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I have heard it said many times recently that "the dollar has not done anything for a year" and "the dollar has probably topped out." The Broad Trade-Weighted Dollar Index hit a multi-year high of 126.23 on January 20, when oil was first testing $26. (The components of this index are the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile, and Colombia.) It is natural for the U.S. dollar to be inversely correlated to oil as many competing currencies in the broad dollar index are commodity-based currencies.

Saudi Arabia Riyal versus Chinese Yuan Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I think the Broad Trade Weighted Dollar has not topped out, since I believe (1) this is only a seasonal rebound in oil which will test the February lows again after the seasonal demand factors fade away and 2) several of the pegged currencies in the index are likely to be devalued. Two good examples where a devaluation is coming is the Chinese yuan and Saudi Arabia riyal, and they are somewhat correlated.

I think the Chinese will devalue the yuan (as they did in 1994 by 34%) as their banking system is not operating properly due to the busted credit bubble there, as I have explained numerous times over the past year. I think the Saudis may have to devalue the riyal too, even though it has been hard-pegged to $3.75 for over 25 years with very few variations in the exchange rate. The decline in the oil price is wreaking havoc in Saudi finances and if the riyal were free floating it would have looked more like the Russian ruble, rather than a "pancake." A devaluation for the Saudi riyal may simply be a matter of time as the hard landing in China I envision may drive down the oil price to a fresh low.

United States Dollar versus Russian Ruble Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As I noted on November 1, 2013, a good yardstick to judge if Bernanke has failed is if the U.S. goes into deflation, pushing the 10-year Treasury yield to a fresh all-time low. Since Janet Yellen has continued the policies of Ben Bernanke, the same yardstick applies to her. On February 11, 2016, the 10-year Treasury yield came down to 1.57%, which was 18 basis points away from the all-time low of 1.39%, set in 2012. I don't recall another instance when long-term Treasury yields dropped by about 75 basis point so soon after a fed rate hike. I took that as bond traders voting with their checkbooks against more rate hikes.

I think we have better than even odds of a new low in 10-year Treasury yields by the end of this year as a Chinese devaluation is a high probability event, which I believe will be highly deflationary for the global economy.

Can Stock Markets Disappear?

Some once-thriving stock markets have historically disappeared. The vibrant stock market in Russia at the beginning of the 20th century disappeared after the 1917 Revolution, even though it was resurrected after the dissolution of the Soviet Union. There was no restitution of property rights in Russia, unlike so many other Eastern Bloc countries; so for all intents and purposes, the whole 1917 Russian stock market was wiped out. There have been many similar cases where there has been a revolutionary end to markets.

Cyprus Stock Market versus Greece Stock Market Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The trouble is that some recent markets have disappeared for practical purposes, without a revolution. A case in point is the Cyprus stock market. The Cyprus market (as denoted by the Cyprus General Index) reached an all-time high of 5518.50 in October of 2007 and a record low of 63.85 in February of 2016 according to data from the Cyprus Stock Exchange For statistical aficionados, this is a decline of 98.84%. Granted, this is not technically disappearance; the stock market is still "there," but for all intents and purposes this is a wipeout. Keep in mind that Cyprus uses the euro, so currency devaluation is not an issue for these stocks; economic mismanagement is.

Its larger cousin, the Greek stock market, is faring little better. Historically, the Greek stock market (as denominated by the Athens Stock Exchange General Index) reached an all-time high of 6355.04 in September of 1999, according to data from the Athens Stock Exchange. Last Friday it closed at 548.68. From the all-time high, that stock market benchmark index is down 91.4%. Greece is certainly better off than Cyprus, but that's putting it graciously.

In the case of Greece, it is again economic mismanagement, in my opinion, as the banking system was beginning to function somewhat normally when radical left-wing Syriza came to power in January 2015 and caused yet another bank run. (For more of my comments on Syriza, read the July 7, 2015 Marketmail "Gruyere Souvlaki.") Greek bank stocks have for all intents and purposes gone the way of Cyprus stocks with numerous reverse splits and recapitalizations that have wiped out their shareholders.

National Bank of Greece Stock Market Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The reverse split effect can be seen in the chart of the National Bank of Greece (OTCPK:NBGGY) ADR, above, but others like Piraeus Bank that don't have ADRs look similarly dismal when quoted in Greek terms. (Please note: Ivan Martchev does not currently hold a position in NBGGY. Navellier & Associates does not currently own a position in NBGGY for any client portfolios).

As can be seen in Cyprus and Greece, one does not need a revolution for stocks to go the way of the dinosaur. The key ingredient is economic mismanagement on a grand scale.

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