Having skipped the annual Jackson Hole symposium, citing pressing duties, ECB Chairman Mario Draghi released the details of the central bank's eagerly anticipated bond buying program last week. After promising to do "whatever it takes," will the Outright Monetary Transactions be enough to do the job? Will the Fed expand its balance sheet? While there are good reasons to be skeptical for the longer term, in the short term the markets responded quite favorably. Let's break down the numbers:
Stocks: U.S. equities participated in a broad global rally following Thursday's ECB announcement. Prior to Thursday the short holiday week saw share prices drift broadly downward, with the Dow Industrials briefly trading below 13,000 and the S&P 500 below 1,400. By Friday's close the major indexes had all recorded solid weekly gains, led by the Russell 2000 with an advance of more than 3.7%. The S&P 500 and the NASDAQ went to new year to date highs, while the Dow and Russell came up just short. The severely lagging Dow Transports and Utilities also participated, although both remain beneath their 50 day moving averages; the Transports are beneath the 200 day as well.
S&P sector action was uniformly positive, led by the cyclical sectors. The financials and materials logged gains of more than 3.5%, while only the defensive utilities and consumer staples gained less than 1%. Our twelve major foreign indexes were also uniformly positive - including the deeply slumping Shanghai Composite. Several of them tested and bounced off of primary moving averages: Brazil's Bovespa, Russia's RTS Index, and South Korea's Seoul Composite off the 50 day; London's FTSE, Canada's TSX, and Australia's ASX All Ordinaries off the 200 day.
Bonds: U.S. Treasury yields saw quite a bit of volatility over the course of the week, as a variety of mixed signals came from the global economy; beyond the pinned short end, the entire yield curve shifted higher. The long bond, which had closed the prior week with a yield under 2.7%, finished above 2.8%. Prices of higher grade bonds generally fell across all sectors, while lower grade corporates were bid higher. Popular junk bond funds HYG and JNK went to new 52 week highs, while the long term Treasury fund TLT broke back down through its 50 day moving average.
Commodities: The CRB commodity index posted its sixth weekly gain, its tenth in the last eleven. Gold continued to rally, pushing past $1,700, and silver kept pace. Copper broke out of its recent trading range, and topped its 200 day, thanks likely to the announcement of the RMB 1 trillion infrastructure initiative from China. However crude oil did not participate - West Texas intermediate failed to get through the 200 day MA for a third week. Natural gas continued to trade in a narrow band under $3. Grains were mostly flat and softs were mostly…soft.
Currencies: The U.S. dollar index broke down through its 200 day MA on Friday. The weak employment report led to increased speculation that the FOMC, which meets next week, would embark on a new round of easing, perhaps buying mortgage backed securities in order to hold down rates and stimulate the economy. The euro rallied from under $1.26 to close above $1.28, as the ECB held rates steady and indicated that its new bond buying program would be fully sterilized. Sterling too rallied smartly, topping $1.60, as BOE also held the line on rates. The Canadian dollar went to a new year to date high, while the Aussie broke its recent slide against the greenback.
We have mentioned the ECB's new OMT program, above. Let's take a quick look at some of the key details. I believe there are three points to emphasize. First, the size of the program is unlimited, while the purchases are to be fully sterilized. This sounds good, but could prove difficult to sustain in the long run. Second, the ECB will not have seniority to private creditors - a very positive point for the banks and other institutional holders of sovereign debt. Finally, and perhaps most importantly, is the "conditionality" of the program: member states must request help, going through the EFSF/ESM mechanism, and commit to what will amount to austerity programs. This final point was not enough to appease the dissenting Bundesbank, yet it maintains the element of uncertainty that continues to surround the entire European debt crisis.
Last week's economic calendar did little to change the slow growth outlook. The ISM manufacturing index came in under 50 again, but the services index surprised to the upside. The widely heralded disappointment in private payrolls was accompanied by flat hourly earnings and a slight contraction in the hourly work week. Next week's economic calendar will be dominated by the FOMC. In corporate news, Intel's reduced revenue outlook added to the gloomy PC outlook. Next week's Apple event could be a significant moment for the tech sector.
Stocks: In last weekend's article I noted that the "bulls appear to have the Fed on their side." The market has responded favorably to the ECB, and also appears to have priced in some kind of accommodation from the Fed. While I agree that fighting central bankers is a bad idea, investors might want to wait for the actual FOMC meeting, because any disappointment could be difficult for the market. While continuing to be cautiously positive on equities, the coming week holds a significant amount of event risk.
One of the significant elements of last week's market action was the moves in the major bank stocks. I previously called attention to the "pari passu" status of the ECB in the new bond program, which means that private holders will not be subordinated. This had an immediate and strongly favorable impact on major bank shares. Morgan Stanley (NYSE:MS) and Deutsche Bank (NYSE:DB) gained nearly 14%, B of A (NYSE:BAC) and Goldman (NYSE:GS) more than 10%, Citi (NYSE:C) nearly 8%, JP Morgan (NYSE:JPM) nearly 6%. I am bullish on the big banks here; we bought shares of BAC when it was priced for extinction, taking the Fed at its word when they told us no more big banks would be allowed to fail. I still like the stock here, and could add to positions we are holding for the long term.
Bonds: The risk off rotation of the past week drove down prices on higher grade bonds, as noted above. We have also seen the yield spread between junk and the higher grades narrow quite a bit. The junk bond trade, like most of the other bond trades, is looking awfully crowded. I have been an advocate for this trade, and we maintain a significant allocation to HYG in the income portfolio. Every so often I feel compelled to remind investors how risky this strategy can be. We're reaching for yield here, and monitoring carefully. While still not finding Treasuries at all attractive, I am looking for a correction in the prices of investment grade corporates as an opportunity to rotate into higher quality at reasonable yields, as well as continuing to look for a floor in utility stocks to replace some riskier fixed income positions.
Commodities: In recent articles I have written that gold is the only commodity play I like, and indeed the only one we currently own. Gold is a little bit extended at this point, as is silver, so I would not be inclined to chase them here. A pullback into the $1,680 - 1,700 area would not surprise me. A successful re-test of that price band, or even the 200 day MA around $1,650 - 1,660 would seem like a more attractive entry point. However, like equities, the metals appear to have priced in a high probability of a new easing initiative from the Fed. If they disappoint, we could see this rally reverse quickly. More broadly, commodities are not showing a great deal of strength here, with oil repeatedly failing to get through the 200 day on the WTI spot. I am avoiding funds with a large allocation to oil futures.
Currencies: In last weekend's article I wrote that "a break down through the current level on the dollar index would be surprising, and from a technical view could open up much lower levels." We have seen that break down, thanks in no small part to major foreign central banks holding rates steady, and the aforementioned intent of the ECB to sterilize its new purchases. With the market expecting the Fed to ease, this has driven the dollar down against most of the major currencies. Here again, if the Fed disappoints, we could see the dollar index firm up. Technically, the dollar is quite extended to the downside in the short term; it is already back to the top of the range that held through most of the first half of this year. However there is no obvious near term support on the chart. We'll be watching to see what the coming week brings.