ECB Provides Stimulus

Super Mario Does It Again

The European Central Bank (ECB) and its head banker, Mario Draghi, unveiled a series of new measures by expanding their quantitative easing package and cutting its benchmark interest rates to record lows. The ECB raised the amount of bonds the eurozone’s central bankers buy each month under their quantitative easing (QE) program from €60bn to €80bn. Their purchasing program added corporate bonds to their program of buying government debt, asset-backed securities and covered bonds. The ECB also cut its deposit rate by 10 basis points to -0.4%. The negative interest rate means that banks now have to pay to park their cash with the central bank.

Government bond yields %
The graphic above shows how interest rates are going negative across the
board in Europe. Never a good sign.

Quantitative Easing and Market Prices

The purchasing of corporate debt by the ECB is designed to propel stocks and bond prices higher to create a “wealth effect” so that consumers will eventually go out and spend money on goods and services. But QE provides no tax relief or help in growing the Euro zone which means that this experiment will end badly as it creates a mis-allocation of capital (think asset bubbles). Even with 619 global interest rate cuts, $10.4 trillion in central bank asset purchases, and $9 trillion in global government debt yielding 0% or less, there is little sign of a boost in GDP or earnings globally.

Asset class returns
This graphic highlights returns in stock prices with and without the QE spigot turned on by central banks around the globe.

Quantitative Easing Has Its Consequences

Low interest rates provided by the Federal Reserve have changed the behavior of US corporations as seen in the graphic below. Low interest rates provided by the Federal Reserve (Greenspan era) after the tech crisis created a big incentive for companies to issue debt to buy back their own stock. In the 1990s the amount of this activity was relatively moderate as yields on 10 year treasuries were yielding 6-8%. This behavior continued until the financial and real estate crisis and we are seeing a repeat of this activity for the past several years.

Buybacks funded by debt

Instead of investing in new factories or increasing research and development budgets for future growth, corporations have chosen to buy paper – their own stock. If you look at pre-2000 as a “normalized” buyback activity then you can see the distortion field of low interest rates and QE has on the behavior of publicly traded corporations. Just imagine how much money could have been re-invested into the US economy if interest rates were allowed to reach an equilibrium level without the interference of the Federal Reserve. The worst part is the borrowing used to make stock purchases instead of just using internally generated cash flow. The consequence? Lower growth rates for years to come and the potential for higher default rates in the next recession.

Market Snippets

  • Chinese export data released this week looked terrible and tumbled the most in 6 years.
China Exports and Imports (YoY)
  • Atlantic City is close to defaulting on its debt by April or May if the state of New Jersey does not bail out its finances.
  • West Texas Crude Oil is not only +10% in the last week, it’s +37% in the last month! However, we currently have the highest inventory levels since 1930.
  • From HedgEYE: The next major catalyst for oil from a policy perspective is likely to be a proposed OPEC meeting in Russia on March 20th to discuss an output freeze. As Potomac Research has noted, next to nothing will come out of this meeting (if it even occurs) and really the major harbinger for those that are bullish on the price of oil is the fact that Iran’s sole focus is to ramp product and take back share. We think Iran will continue to beat expectations on its ability to increase production and is likely to get to 700,000+ barrels a day of exports this year. Currently, supply in the U.S. is running up +20% y-o-y!
  • According to Moody’s, in the year-to-date there have been 18 defaults with half in the energy sector. Last year at this point, there were 11 defaults with 1 in the energy sector. A harbinger of things to come?
Oil bulls beware supply

One Down, Three to go..

The ECB announced last week and next week we have the following:

  • Bank of Japan (BOJ): 3/15
  • Federal Reserve (FOMC): 3/16
  • Bank of England (BOE): 3/17

Odds are we get more stimulus and the Fed backs away from raising interest rates. However, the recovery in oil prices and stocks over the last few weeks may give the Fed enough confidence to raise interest rates or imply that rates will be raised later this year. This is the environment we live in and it can be very confusing.

So let’s review that chart on the S&P 500:

S&P 500
S&P 500

As you can see, the market has had one small pullback before thrusting above the 200 day moving average. Guess which day that happened? Yep, the day after the ECB announced their stimulus plans. The market also began filling the gap on the chart that was created in early January – charts have a habit of filling gaps, by the way. You will also notice the relative strength index shows we are in overbought territory so a correction could be around the corner. Clearly, nobody wants to be short ahead of three central banks announcements and options expiration.

There’s just ONE more thing….

Let’s not forget options expiration on Friday. The areas shaded in blue from @northmantrader show that markets have been ramping higher into options expiration so let’s keep that in mind while we watch how markets react to the central bank announcements this week.

OPEX front run rallies

Please reach out to me if there is anything you want to discuss about the markets or your portfolio. I am here to help all my clients while I protect your capital in these uncertain markets. At some point, the stock market will look better and provide many good investment opportunities. Until then, its best to play defense.

Paul McCarthy

Mr. McCarthy is the President and founder of Kisco Capital.