Cue The Applause

Cue the applause.  Markets continue to applaud for the Fed and solid earnings logging another positive day for stocks… and bonds.  Strong earnings and a lack of negative news out of Washington cleared the way for equities to continue to trade up with some of the indexes on or over their long term trend lines.


1) Trump’s highly anticipated State of the Union speech left very little for traders to use for their investment theses.  The President’s speech focused on unity… on his terms and did not appear to offer any new suggestions on how to end the impasse over border security AKA “the wall” leaving traders wondering if the temporary government budget can be made permanent before expiring next week.  Trump offered no significant strategic changes that would have any major impact on industry and overnight markets largely shrugged.

2) Earnings continue to delight investors.  Yesterday continued the trend of earnings beats with a majority of reporters beating Wall Street expectations.  While we are experiencing another quarter of double digit earnings growth, poor guidance has analysts expecting a decline in year-over-year earnings of around -0.8% for the first quarter.  This marks the first expected contraction since 2016.

3) The Federal Reserve’s new policy continues to be the backstop for most investors.  Fed governor speaking, musing, and writing is in full swing and all continue to send winks to the equity markets. Bond traders too continue to respond to the Fed’s less-than-glowing view of the global economy and hints of balance sheet policy change.

Washington operatives were busy preparing for the long-awaited State of the Union speech yesterday making it a quiet news and leak day.  Additionally, Asian markets were largely closed for the Lunar New Year.  This left traders to focus on what is really important, the stocks themselves and with earnings continuing to exceed expectations stocks continued their upward march.  The S&P500 rose by +0.47%, the Dow Jones Industrial Average climbed by +0.68%, the Russell 2000 trade up by +0.18%, and the NASDAQ 100 jumped by +0.91%. The more speculative growth stocks that make up the NASDAQ 100 continue to outpace the broader markets indicating the speculative nature of the move.  Looking at charts 4, 6, 7, and 8 in my attached daily chartbook you will note that the Dow Jones industrial average is above its 200 day simple moving average while the S&P 500 and the NASDAQ 100 are just below the important trend line.  The small cap Russell is making headway but still has some ground to make up before crossing over the moving average, however it did break over a bearish trend line in late January and it continues to stay above it.  Recall that the 200 day simple moving average is a primary indicator utilized by many quant-based traders (though they would never admit it). To learn more about moving averages, read my note on the subject here:  .  Crude oil continues to hold up in the mid 50’s range and is getting considerable resistance at $55 as well as the Fibonacci line at $55.56 (see chart 11 in my attached daily chartbook).  Oil around $50 remains a comfortable level for domestic producers who can earn a profit at that level, but even more importantly the level is not too high to spark fears of inflation.  Recall that the Fed has attributed their ability to have patience because inflation appears under control.  They have also noted that the decline in crude oil prices have probably been a factor in muting inflation.  It is therefore important to keep a close eye on the commodity. Bonds continue to have a mind of their own trading up along with equities in yesterday’s session.  The ten year yield to maturity declined a second day in a row to 2.68% as bond traders seem to be responding to Fed overtures of halting the balance sheet runoff.  As the Fed Balance Sheet has become a real factor since Powell’s comments I thought that I would delve a bit more into the topic.  It is, after all, geek-out Wednesday.

The Federal Reserve’s balance sheet was at one time a subject only discussed by the geekiest of Fed watchers, economics professors, and bond traders (not the ones who frequented Suspenders or Harry’s at Hannover, but the ones who used slide rulers).  That changed with the financial crisis after which the Federal Reserve used its balance sheet aggressively as a tool for stimulus.  It was the birth of Quantitative Easing, or QE.  Before we get into that let’s discuss what the balance sheet actually is. Many are familiar with a corporate balance sheet which essentially details an entity’s assets and liabilities.  In the case of the Federal Reserve Bank, its assets consist of securities that it has purchased in the open market.  The Fed essentially controls the money supply of the country using its balance sheet.  The Fed utilizes its discount or repo window to withdraw or inject money into the economy.  For example, the Fed will conduct Repo’s, or Repurchase Agreements, which means they will loan out money and take treasury securities as collateral with non-government counter parties. Wow, what does that really mean?  It can simply be thought of as the Fed is buying treasuries and paying dollars and the dollars that go out to pay for the treasuries increase the money supply. Increasing the money supply has stimulative effect on the economy.  The Fed can theoretically inject an infinite amount of money which is where the term “printing money” comes from.  The Fed, in essence, creates cash and puts it into circulation by buying things from the public.  It is important not to forget however, that one of the primary functions of the Fed is to maintain the liquidity of the US Banking system and the Fed extends term loans to member banks as part of its regular operations.  A term loan to a member bank is also an asset on the balance sheet and can be thought of as another type of injection into the money supply.  Traditionally, the Fed used open market operations to maintain its interest rate targets.  For example, when the Fed funds rate begins to drift upward, the Fed will inject money by conducting repo’s creating supply and causing the rate to ease back.  Conversely if the rate begins to go below the target, the Fed will conduct Matched-sale Purchase Agreements (the opposite of a repo) in which the Fed reduces supply bringing the rate back up to target.  The Fed also has liabilities, which is a more obscure concept, but at a high level, the Fed lists all outstanding currency as liability.  If a member bank deposits cash with the Fed, the liability decreases and conversely if a member bank requests cash to make hard payments, the transfer of cash will increase the Fed’s liabilities.   So now it should be clear how the assets of the Fed go up and down based on its activity.  The size of the Fed’s balance sheet can be monitored by observing the weekly H.4.1 report issued by the bank every Thursday.  Following the financial crisis that began in late 2007, the Fed had to jump into action and ease monetary policy aggressively.  In addition to lowering interest rates they injected large amounts of money into the money supply to increase liquidity and provide stimulus.  By late in 2008, the Fed began its first aggressive build up of assets in an effort to stabilize the economy by directly purchasing mortgage backed securities, treasuries, and bank debt.  This process was nicknamed QE1 and was followed by two more quantitative easing events in the years to follow.  Now that you know how the balance sheet works you can appreciate the fact that the assets on the Fed balance sheet grew from $858 billion in the months before the crisis to around $4.5 trillion at its height, following QE3 in 2014.  Yep, and wow!  You may remember that the Fed announced that it would begin to taper it’s quantitative easing in 2013 causing what is now remembered as the “taper tantrum” in which stocks and bonds plummeted in response to the announcement.  As the economy improved, the Fed began the policy of what is referred to as normalization in which they would slowly begin to raise interest rates and bring down the assets of the balance sheet.  Bringing down the level of assets on the balance sheet, also referred to as runoff, can occur in two primary ways: selling securities and letting securities mature without replacing them.  Remember that this is essentially reducing the money supply and has a tightening effect.  The Fed has essentially been methodically reducing, unwinding, and running off its balance sheet since 2015 and when Chairman Powell announced that the Fed is considering slowing down or halting the process in response to “global economic cross currents”… well the markets applaud, especially the bond markets.  Remember that decreasing supply results in prices going up.  So now you know why there has been so much focus on the balance sheet in the past few months.

Today, we have little in the way of economic releases, as scheduled productivity numbers will not be released as a result of the recent shutdown.  We will have a day to reflect on the State of The Union speech from last night as well as the solid post-bell releases from the likes of Disney and Snapchat which both beat.  We will also get a number of pre-market releases including GM and Eli Lilly, which will set the tone of the session ahead.  Post-close we will get Prudential and Met Life amongst others.

daily chartbook 2019-02-06

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