Emerging Market Balance of Payments, Current Account Deficit, And Banks

One can look at drivers of growth and earnings over last couple of years. Where developed country huge GDP's have gone almost up, or flat and into decline, emerging markets have been the investment vehicles for U.S. dollars. These dollars have now come to end.

Yet, we see drivers of money finally finding a last death in a U.S. stock market. Like a Frankenstein monster, this stock market refuses to see comparative pricing levels. Bubbles....who really cares at this point. Entire proposition of a cycle exhausting comes from real time data.

China, a major global driver, is obviously running by a different tune, a different set of monetary policy. China, by the way, has been hesitant in bringing new accommodative monetary measures. They seem very internally focused amid growth rates that now disappoint, if not show "new sprouts of growth". Investors really have to be more astute and see direction, instead of sprouts.

Major emerging markets are now in current account and cash flow deficit, together with falling currency values. This means these falling markets have higher foreign debt exposure, versus their currency values when these foreign loans were garnered to finance past growth. Simple proposition now days is these emerging markets have an overhang of debt, owed in foreign dollars, when their native dollars pay back less of foreign debt every day.

Add to this increases in current account deficits and developing capital/financial account deficits in emerging markets, and these countries are reliant on cashed in U.S dollars. That is, these markets have declining net income, but growing reserve currency values. Sure, these reserve currencies, brought by foreign investments cashing in, can help support their native currency. But, after substantial declines in native currency, these markets will use all of their foreign currency reserves to maintain a balance against foreign debt. One must realize, foreign currency denominated debt in these countries is how financing of investment occurred.

Once foreign currency reserves are exhausted to support foreign debt amid declining native economies and currency values, a currency crises arises. As always, given time, an emerging country shows its interconnection in a system of global finance.  80's Latin America, 90's was Asia. Great Recession?

Developed country banks generally are divergent with European banks, which look weak as cats, where U.S. banks look strong. Europe in general remains in recession, U.S. only avoids recession due to a strategic cash lockup in U.S banks.

Markets currently see money only from a banking perspective....huge earnings growth from financial sector recently. Biggest investment of last four years, being emerging markets, is now convincingly turning against itself.

Major question right now is why oil is high, equating to levels of when emerging markets had positive balance of payment numbers. Emerging markets are now cash flow negative, and oil is currently in speculation....on the wrong side.

With Brent and WTI almost at parity, and no major plays on global delivery, it's unfounded speculation hanging over from reversing a couple pipelines into the Gulf of Mexico.

Q2 Economic Performance Improved, But Q3 Could See Headwinds

Is The Glass Half Full Or Half Empty

We enter Q2 earnings season in an awkward fashion amid conflicting indications and risks. Second quarter activity saw a boom in interest rates starting in May and only relaxing of late. Associated with this are the record dollars flowing out of bond funds pushing down prices and lifting yields. Then we saw a U.S. dollar gyration spiking down through May, and then spiking up through June. Stocks saw the future of tapered QE in later May and into June, but are making new highs currently in July. Developing country currencies fell against the U.S. dollar while China's economy stepped back.

Some have attributed increasing interest rates to increasing demand driven by growth. Others say interest increases are due to excess liquidity that hasn't spurred demand, but rather increased systemic market risk once the liquidity tap is turned off. It appears both arguments have foundation. But the latter argument has more "real life" support over the other.

Q1 saw lackluster economic performance among indicators. GDP started at a decent 2.4% growth, but inevitably was revised to reflect indicators ending up at 1.8%. For many, this was not surprising given data out of China, Q4 Japan recessionary pressure and of course Europe.

Q2 Started With Weak April Data, Except Housing

April started weaker off of March's minor rally. Dallas Fed Manufacturing Survey, for instance, pulled a positive 7.4 points in March for business activity and a good 9.4 for production. But when April came, the floor fell with business activity at -15.6....real pessimism....and production -.5 points.  Construction spending in April fell -1.7% against a March gain of 1.5% with public outlays leading a decline. Retail sales were abysmal and import/export prices showed deflation. April's factory orders data (reflecting March activity) were down -4.8%.

April's other Fed regional indexes also demonstrated disappointment in manufacturing. Of the regional indexes that were positive, they were only hanging on while others remained in contraction. Durable goods orders were all negative and industrial production was teetering to negative.

Only silver lining was the Fed's $40B per month purchases of mortgage backed securities. Contrasting pessimistic data was April's existing home sales, up 10.3% in March and 9.7% in April year over year. Median time for an existing home to stay on the market for sale fell to 42 days from 62 days in March. Banks were obviously producing mortgages to feed the Fed. Pricing advanced 6.2% in March and another 4.8% in April with annual pricing up 11%.

New home sales witnessed similar results with sales up 2.3% in April despite constrained demand. Demand against supply saw new home prices rise 14.9% annually in April. Appears that while mortgage lending was occurring, construction loans to builders remained tight.

Consumer sentiment also elevated in April probably due to more friends of friends buying houses and employment improving. Employment situation report of April exceeded expectations adding 165,000 jobs in April. Market expected 153, 000 jobs to be added while March saw only 138,000 new jobs. Also a factor is the dangerously euphoric equities market. IRA's and 401(k)'s increase giving a feeling of improved retirement security. But euphoric parties come to an end.

Despite other economic indicators, homes and consumer sentiment advanced in April. This dynamic carried through to May and is now seen in June data being revealed today in July. Further, the positives in homes and consumer sentiment are penetrating other indicators positively. Domestic demand has picked up.

May's Housing Data Continued, Other Indicators Improved and Interest Rates Shot Up

Firstly, May saw interest rates start an aggressive increase with spreads between high yield and investment grade widening. U.S. dollar strolled up to the 84.40 level by mid May only to crash into 80.60 by mid June. May 22 saw Fed FOMC minutes that shook equities down, only for deep drops come Bernanke's post FOMC press conference of June 19. That event dramatically dropped equities. All the while, money flowed out of developing currencies, and therefore markets. There interest rates are being cut, while U.S. interest rates increase.

For economic indicators, May saw productivity and cost indicators look better, factory orders (reflecting April) gained 1% against a previous -4.7% loss. Retail sales showed a 4.3% gain year over year with auto sales being important as always with a gain of 1.8% for a second consecutive monthly advance. Industrial production held its own at 0, avoiding more declines. Durable goods orders grew. Interestingly, essentially all Fed regional manufacturing indexes picked up considerably, save for Kansas City, perhaps due to some devastating tornadoes.

Employment advanced with an additional 175,00 jobs versus market expectations of only adding 167,000. But a tenaciously high unemployment rate didn't relent and stayed at 7.6%.

Real source of raising all ships in May is, of course, homes. Existing home sales advanced 12.9% year over year and beat market expectations by 180,000 ending up at 5.18M versus April's 4.97M. This amounted to a highest sales rate since 2009's home purchase stimulus credit. Prices went up 15.4% year over year, perhaps too much, though supply showed a respectable increase over April.

New home sales are similar. Sales of new homes grew in May to 476,000 versus prior month of 466,000 and market expectations of growth at only 460,000. New home supply increased by builders apparently finding additional funding ability to better balance supply with supply going to 4.1 months in May versus 4.0 months in April. Despite a moderate fall of 3.2% in new homes prices in May, perhaps due to elevated pricing, year over year pricing showed a 10.3% gain against April's 14.9%.

Consumer sentiment advanced going from April of 76.4 to May's 83.7, with the market expecting 78.0. Suggestion is increasing home values, people buying homes again and perhaps a more stable jobs market.

Ending Q2, Starting Q3 Data Looks Strong, But Caution Due to Mortgage Rates And Weakened Forward Looking Housing Data

Entering June involved all the dynamics mentioned above, but bolstered by Fed members convincing markets of dovishness. This occurred essentially by June 25, when equities started a climb, after getting spooked on June 19 by Bernanke's remarks . The U.S. dollar started its climb off its bottom on June 19. Meanwhile, between June 17 and 25, the 10 year treasury yield spiked up. Indicated is division in markets and growing weight on dollar and interest rate movements versus a progressively unconvincing rise in equities.

Current economic indicators show optimistic propositions. Employment reveals a gain of 195,000 jobs for the most recent report, demonstrating a three month real advance in numbers. Industrial production is up, along with capacity utilization and manufacturing. Fed regional manufacturing indexes look very good so far with Empire State at a positive 9.46 points and new orders positive though softer than last month at 3.77. Philadelphia Fed Survey is at a strong 19.8 points with new orders a convincing 10.2 positive points.

Threat to what appears to be leading this economic advance is a fall for June, reported in July, of housing starts and permits. Housing starts were an adjusted 928M in May with June coming in lower at 836M, when the market wanted to see an advance of 951M. June's starts to home construction is down 9.9% month over month versus an increase of 8.9% in May. Still, housing starts stay vigorous at a 10.4% increase year over year. Permits for home building also disappointed on July 17th with the report showing June's numbers at 911M versus May's 985M and a market expectation of a high 990M.

Q2's economic rise was Fed money eventually trickling down to real home purchases. All of this was accomplished by banks ensuring strict Basil III reserves while also loaning on mortgages. Consumers became more confident due to rising home values and perhaps stock invested accounts. This dynamic punched through into other indicators of U.S. domestic demand. Result is currently growing strength in domestic demand. This occurs while global demand is weak.

While domestic demand appears to be gaining strength, cause for demand essentially originates out of housing. Unconventional Fed intervention explains advances in housing markets. Increases in demand outside of housing are now only starting and, therefore, do not explain increasing interest rates. A fragile economic environment that hasn't really found broad based support despite Fed intervention probably more so explains rising rates.

Weakness to watch is a fall in housing starts and permits. Caution comes from increasing mortgage rates, bank risk aversion and poor global economic performance. If Q2 trends continue into Q3, hopefully some stable economic growth will take hold.

 

J.P. Morgan Shareholder Vote, Remembering Whale Trades

Given the stockholder proxy now confronting voters, it seems appropriate to recall circumstances for JPM. I wrote this piece at the time, but delayed its publication on this space. Banks have been kicked around like a can on a common street. Still, banks supply funding for basic activities, to more complex endeavors. I've always enjoyed Jamie Dimon's moxie. In the U.S., we have a Wall Street and a Main Street. The two meet often. When they meet, you want a banker on your side with a back-bone...even if it's institutionalized.

Once, J.P. Morgan Senate Hearings Explored a London Whale Tale

U.S. Senate hearing today revealed considerable information into the J.P. Morgan Chase "Whale Trade". A fundamental discovery is that of the $6B loss, much of it consisted of excess deposits at the bank that weren't being used for loans to businesses and individuals. Due to deposit money being used, FDIC insured funds were put at risk.

Information out of the Senate hearing today makes the Whale Trade look like a hedge that became its own position. Appears that this hedge was losing so much money, hedging the hedge became a net loss.

Trouble appears to come from the hedge position being a synthetic credit derivative securing a core position. Most derivatives tend to make market movements at faster rates than the security from which they are born. Simple stock options are a derivative. A synthetic is essentially a derivative on a derivative among counterparties to the underlying or core security.

Once a gain is realized in a derivative of an underlying security, the gain is typically in multiples of the underlying's move. Same applies for losses. Derivatives can typically be characterized as put or call positions against an underlying position. A synthetic position is more like a put or call on an underlying derivative of an underlying security.

Changes In Value At Risk Reduced Real Risk, By Appearances

Real problem for JPM is their Value at Risk model (VaR) and how the limits of this model were exceeded during the Whale Trade. Once exceeded, JPM came up with a new VaR model that reduced the "appearance" of risk exposure by 50%.

This move made their positions on their prodigal synthetic derivative hedge, that refused to come home with its losses, look smaller in terms of overall firm risk. Reality now seems that this model wasn't "sufficiently" back tested against the old VaR model. Without sufficient back testing, the new model could look arbitrary to regulators. Perhaps, hind sight is 20/20.

Adding to issues is an apparently contemporaneous development wherein daily profit & loss statements from JPM to their chief regulator, Office of the Comptroller of the Currency (OCC), were suspended. Despite reports having been routinely delivered previously, these reports were suspended for two weeks at what I'm sure is a peripety of this drama.

Suspending daily profit/loss statements to OCC also appears to include major confusion over the extent of losses. Not only was JPM's VaR changed, but representations of the loss made to OCC put the amount at $550M in Q1, 2012.  However, internal memoranda indicated the loss to be around $719M.

What Happened To Risk Management, And How To Capture It Too Late

JPM is a seasoned firm, defined by Securities Exchange Commission rules. Such an incongruity in numbers indicates a break in reporting structures. When reports start to deviate, there is a level of "free lancing", or rogue activity occurring.....somewhere. Corporate structures must then isolate the problem and capture causation. In so doing, corporate must first understand the problem's origin, its nature, then quantify or value the problem, and then control the problem.

Evidently pursuing such a process, it looks like JPM isolated the problem, perhaps apparent in their change in VaR models. This only allowed the problem to grow. By decreasing the value at risk, the huge Whale Trade became smaller. With it being smaller, more money could be committed to correct the hedge, growing it into a frighteningly high risk synthetic derivative core position.

JPM witness statements seem to confirm such a proposition. By April, the firm was indicating an internal loss of $1.2B, despite a previous OCC report of $580M. JPM's chief of CIO at the time stated that she understood OCC was receiving mark to market reports with daily profit and loss statements. All the while, she didn't know of suspending reports for two weeks to OCC.

Passing the buck...At some point, less senior personnel have to know what is going on. If not, more senior personnel will get an "all is well" indication. Next obvious question is the pressure of performance.

G-20 Greenlight for Currency Depreciation, A Redlight for U.S. Inflation, and Need for QE Decision in March

G-20'S BALANCING ACT BETWEEN PAST AND PRESENT

Last week's G-20 meeting introduced a new way of acceptably characterizing currency values. Essential message was currency movements resulting from controlling inflation/deflation or otherwise executing monetary policy mandates is acceptable. Not acceptable is currency manipulation motivated by seeking competitive advantage to only increase exports.

 

Such a position statement found balance between past G-7 member activities that resulted in currency devaluations such as U.S. and current devaluations such as Japan and Britain. With this balance also comes the awkward matter of China's almost widening range in floating its currency against the dollar. Then of course, we have a Swiss Frank that put a ceiling against the euro.

 

Past currency appreciations against other currency depreciation sets the stage for what we now see. 2010 through early 2011 saw a remarkable period for currency and equity pricing. May through June in 2010 saw the U.S. dollar start a nose dive in devaluation, from a DXY (dollar against a basket of currencies) value of some 89.00 down to around 73.00 by May 2011. A very significant period of depreciation, for the global reserve currency.

A STAGE FOR TODAY'S CURRENCY DEPRECIATION: PRIOR OTHER COUNTRY APPRECIATION

 

Accounting for U.S. dollar depreciation was primarily exceptional monetary policy easing for a second time by the Fed. This QE2 round was well anticipated by markets demonstrated through optimal positioning prior to announcements, with such positioning being signaled by currencies. Namely, where U.S. QE 1 stopped in March 2010 and equities went volatile, U.S. dollar started a considerable appreciation but went into a depreciation about three months before S&P's escalator ride up starting just prior to September 2010. In 2010, Fed spoke of QE2 at their Jackson Hole meeting, explaining the premature market movement.

 

During the same period, Japanese yen began an export hindering appreciation. This appreciation actually started in 2008 reflecting the yen as a safe haven asset against U.S. near financial collapse. Most noted is the May through June 2010 period. During this period, while a U.S. dollar devalued along with concurrent U.S. quantitative easing, a yen steeply appreciated and sustained its appreciated value until recently. Currently, the yen breaks support routinely, finding lows.

 

Same dynamic can be seen on charts for British pound. But, while the pound appreciated considerably in 2010 and into 2011, it has from 2011 until recently traded in a range. Now, pound has broke very long term support of around 1.5401 to find itself currently at 1.5230. A move of depreciation perhaps.

 

Australian dollar is getting impatient, along with its economy for a break down of its currency. But this is also a currency that experienced considerable appreciation in the same time frames as previously described currencies. Still, it hasn't depreciated like a yen or pound. New Zealand fits this role. In fact, just last week, New Zealand's central bank suggested its currency to be over valued.

 

Understanding all currencies mentioned above provides a basis for G-20 propositions of valuing currencies. That is, rounds of U.S. QE and rounds of other country QE. But what country has the strongest currency influence with commodities, interest rates and risk appetite. These combinations provide major explanations for other currencies now devaluing.

 

Due to U.S. dollars being the reserve currency and commodities priced in U.S. dollars, should the U.S. dollar dive, commodity prices increase in U.S. dollar terms.

OTHER COUNTRY DILEMMA: COMPARATIVELY CHEAP BUT RISING COMMODITY PRICES AMID MILD TO NO GDP GROWTH, OR FALLING EXPORTS

Reason for sustained to rising commodity prices against a falling dollar is a commodity will remain in demand in a global market against a falling U.S. dollar. Commodity demand results from two major influences: 1) fundamental economic demand coming from consumers and businesses needing the product, especially when dollar denominated commodity imports for countries become comparatively cheaper due to currency translation; and 2) risk appetite for buying up commodity futures, instead of holding the U.S. dollar.

This explains comparative values, or a divergence, against U.S. dollar values and global commodity values. When foreign currencies appreciate against U.S. dollars, their imports of U.S. dollar  denominated commodities are cheaper. On the other hand, their exports more expensive.

 

For U.S., despite a drop in the U.S. dollar and increases in commodity prices, we didn't see inflationary growth. Appreciation of foreign currencies is perhaps why supply and demand smoothed to prevent U.S. inflation. That is, inventories in commodities didn't increase associated with a global decline in U.S. dollar denominated asset demand. Instead, demand stayed fairly steady until an inflection point was reached in fundamental demand for the commodity. Driven by export declines.

PROPOSITIONS FOR FED DEBATING QE IN MARCH

 

That inflection point now appears to be where currency appreciation offsetting increasing commodity prices started to damage other country export potential. That time being second half 2012.

Right now, despite current U.S. QE activity, U.S. dollar isn't declining as with past QE, indicating hesitation for risk. Still, equity and commodity markets are rising consistent with past QE. Raising a warning flag is yen and pound currency depreciation. Yet to be determined is whether a race to the bottom will occur.

Some of the various currency depreciations we see now come from dollar appreciation, despite QE. Balance this with credit spreads wanting to expand, and a consistent 2012 reduction on corporate earnings expectations, and we get what looks today to be a short term pricing conundrum. Perhaps revealed by Fed agenda for its meeting in March 

 

 

  

Fiscal Plan B Fails House Approval, Ball is now with President

Most recent report on U.S. efforts to address its budget or fiscal cliff shows continued hardship, despite irrational market optimism. For a couple of weeks, President and Speaker of the House John Boehner have been discussing differences in desired fiscal direction. In so doing, both have realized mostly differences, and not common ground.

Boehner announced a Plan B. He took it to a vote in the House tonight and it failed. Obviously Boehner was looking for strength in his own majority party  to push a lead on fiscal policy in the House of Representatives.

Revenue bills must originate and be passed in the House of Representatives. They can't come from the Senate. Revenue bills, or budget setting, are essentially between House of Representatives by passing a bill, and the President by signing it into law. Senate can make changes, but the idea must pass the House of Representatives first.

What's more, President of the U.S. can't dictate to the House of Representatives a revenue bill. Rather, game starts in the House of Representatives, with all knowing that President has veto power. Typically, as a result, negotiations start with the House and President, certainly when the current Democrat Senate is inclined to follow their Democrat President.

When U.S. has a Democrat President and Senate, but a Republican House of Representatives, the obvious negotiation is between the House and the President.

Leader of the House of Representatives is Speaker of the House, John Boehner. Mr. Boehner was elected by a majority of the House, being Republicans.

Though Mr. Boehner's vote failed in the House, ball is now completely and squarely in President Obama's court to propose something that can pass a first hurdle, being the House of Representatives. Even Boehner's plan B didn't pass the House.  Suggested is a substantial width of chasm between House and President expectations.

Looks like President Obama must now realize power over national purse strings held by House of Representatives. To move government requires such realization of balance of power. Election is over, now its governing.

What is degrading to processes of governing is media characterizing an act of compromise as an act of "caving". Recalls base talk shows with lots of violent behavior displayed on set, which only excites crowds to finally encourage self-perceived protagonists, or martyrs.

But how long will it take to close this balance of power chasm, especially given a Christmas recess in the House. Checks and balances were intended to slow action, but more so with social policy as opposed to budgets. Budgets historically haven't proven this difficult.

Continued negotiations remain invited and open among all parties.

Obviously, past market confidence will fail and show declines in equities and an increasing dollar, with suspected correlations. If not, market sees a ghost in fog.

U.S. Expands QE3, But Markets are Disappointed, by being Underwhelmed

Seeing today’s market activity, one becomes concerned with market responses to central bank activity. Federal Reserve today concluded their two day meeting with an announcement turning convinced speculation into what was already convincing.

That is, Fed said it would roll its “operation twist” into some $45B/month in treasury purchases. This becomes a new round of treasury purchases not seen since conclusion of QE2, in 2011. Interesting also is Fed’s tying monetary policy to a 6.5% unemployment rate, as opposed to particular dates. Seems far more logical.

What disappoints is equity responses today when Fed announced additional easing. Dow jumped up in a cheer, but closed down by three points. Currencies, namely U.S. dollar and euro, went into normal correlation with U.S. dollar down and euro up. But ended showing some sign of risk hesitation.

Overall, U.S. markets have demonstrated sound and positive responses to global central bank easing announcements. Generally leading major U.S. equity advance in recent past have been Fed’s September QE3 announcement and ECB’S Outright Monetary Transaction of September as well. Also creating equity increases was ECB's Long Term Refinancing Operation (LTRO) brought in December and expanded in February. Markets went up consistently with all these announcements.

Today, we have existing Fed purchases of mortgage backed securities (MBS), expanded into Operation Twist money going into treasury purchases starting in January. For ECB, they’ve expanded LTRO twice, and announced their Outright Market Transactions in September.

But today, in response to expanded U.S. asset purchases, equities either fell, or remained unchanged in U.S. A disappointment, at least for me.

While all central banking efforts have maintained asset prices, fundamentals for companies have not improved proportionate to central bank liquidity infusions. Or, for the matter, Europe’s LTRO and improvement for bank balance sheets.

Simply stated for companies, only about 40% beat revenue expectations, after expectations were cut several times.  Q3 earnings season saw some surprising disappointment, with Apple and Google, together with McDonalds and Caterpillar…to name a few. Look at S&P or Dow charts through Q3 earning’s season.

When European Union is in GDP contraction, and Japan joins in recession, little space exists for U.S. decoupling.

Essential is improvement in demand and willingness to invest. A U.S. budget starts confidence in growth. Especially where U.S. shows GDP growth currently.

CURRENCY/EQUITY ASSET PRICING CORRELATIONS PART II: AUGUST TO OCTOBER

Equity and Currency Pricing are Looking More Normal, but Currencies also Show Caution

Currency/equity prices showed a noted divergence late last week. S&P went up where euro went down and U.S. dollar went up. Going into this week, risk appetite seems more in play with currencies. But interesting to note is 1.3000 appears to be key resistance for euro and 80 key support for U.S. dollar. Today, Equities are showing strength, but currencies seem less convicted.

Euro’s daily chart shows moderate price increases for Monday and Tuesday. However, MACD histogram continues to weaken with the indicator threatening to turn down. For U.S. dollar, it’s in decline, but its MACD histogram also seems week. Equities, in contrast, simply look strong.

Looking at these asset correlations, one can see decided influences that drove pricing among the three assets. Any divergence in past correlations raises a warning and indicates potential of a change in dynamics, or one asset class front running the others.

Below is a continuation of last article “Currency/Equity Asset Pricing Correlations Part I: July to August.”

Last article looked at July through August market activity among U.S. dollar, euro and equities. Notable were ECB negotiations with Germany. While negotiations initially were framed by public comments and affirmed by markets, an agreed policy was announced in September.

Looking at September, August’s developments came to fruition.

ECB and Fed Comments Brought Cautious Optimism to Markets, But German Comments Confused Markets

After Mario Draghi’s remarks of doing what it takes on July 26, markets found optimism in August due to expressed ECB commitments. Markets held an optimistic caution with release of Fed minutes on August 22.

Until August 22, equity markets moved up on an escalator, with slow steps made every day. On August 2, S&P closed at 1,365, and on August 20, S&P closed up 1,418. Same time period, euro and U.S. dollar proved unconvinced and moved sideways.

Day before release of Fed minutes, August 21 saw S&P drop from a four year high closing at 1,413 and Chicago Board of Exchange equity volatility index (VIX) gained 7% ending at 15.02. Where equities fell and VIX indicated larger declines ahead, U.S. dollar looked decidedly risk on opening at 82.46 to close down bullishly at 81.91. Euro demonstrated a rise breaking its drift.

Early on August 21, equities started a rally on reports that ECB would start buying Spanish and Italian debt. Also encouraging was German Chancellor Angela Merkel remarked that Germany would do whatever it could to support the euro, mirroring ECB’ Mario Draghi’s statement of July 26.

Dashing rallying equities was a Deutsche Bundesbank statement critical of both Draghi’s and Merkel’s remarks. German Central Bank said it was hesitant to engage in euro system sovereign bond purchases with such purchasing posing a risk to stability.

Apparent Consequences of Confused German, European Direction

Close of trade on August 21 saw market participants walk off the field confused over conflicting remarks. Equities took the conflict to hart and went risk off. Currencies saw a brighter side and went risk on with dollar declines and euro advances.

August 22 didn’t revive equities, as otherwise expected. But currencies continued in bullish fashion. Federal Reserve minutes of their July meeting were released. Minutes revealed a consensus to engage in a new QE program soon should no economic improvement develop. This comment made QE almost assured, save a miracle in economic indicators. Given trends in economic indicators, no miracle could reasonably be foreseen.

Despite Fed assurances, equities declined on August 22 and VIX increased. From there, equities went into a mild downward slump until September 6. U.S. dollar on August 22 fell .42 points and euro took off upward.

Euro closed on August 20 at 1.2347 and opened August 21 gapping up to 1.2436, up some .89 pips. By August 22, euro closed at 1.2529.

U.S. dollar then began a slight rise reflecting a mild decline in equities. Euro however engaged in a sideways bullish push up. Overall indications suggest market confusion due to conflicting remarks, but confusion was optimistically skewed given currency movement.

Euro Strength Foretold Market Response to ECB and Fed Easing Announcements

September’s policy statements from central banks kicked off a rally that would gird markets until Q3’s earnings season.

Simply stated, ECB and other European stakeholders worked out an approach despite previously confusing statements. On September 6, ECB announced their Outright Monetary Transactions (OMT). In order to activate such bond purchasing, ECB explained that a country must first request assistance. Thereby the country would subject itself to fiscal review and necessary austerity. Still S&P leaped up opening at 1,403 and closing at 1,432, up 29 points.

Euro experienced a major gap up in overnight trade and opened September 7 in U.S at 1.2704 to close up some 111 pips at 1.2815. U.S. Dollar relaxed finding itself down at 80.25 from an opening of 81.04.

Further juicing a bullish market was a September 13 Fed announcement revealing its $40B/month in mortgage backed securities (MBS), without a time frame. All markets, currency and equity alike, responded in bullish fashion.

Market Euphoria Turned into Sobriety Due to Limitations of Easing Prospects

September 17 marked an S&P multiyear high, a euro high and a U.S. dollar low. Leading to September 17 was a four day bull party for markets resulting from a September 12 German high court decision approving Germany’s participation in Europe’s European Stabilization Mechanism.

September 17 witnessed an end to a party fueled by central bank announcements and a critical German high court decision. On September 17, Dow fell .3% down to 13,553, S&P fell .3% to 1,461 and VIX increased .6% closing at 14.59.

Breaking up a bull party appears to be reality setting in on ECB OMT transactions. Markets realized no major bond buying would occur in Europe. In fact, for bond buying to trigger, it became evident European countries would have to sacrifice sovereignty in exchange for assistance. Also, for Fed announcement, MBS purchases implied bank responsibility to create mortgages in order to create MBS’s, thereby feeding Fed purchases.

Come October, central bank propositions were known and expectations started to price in. From September 17 to October 18, U.S. dollar trended up, euro formed a cup and S&P failed at a triple top.

Q3 Earnings Season Turned Sobriety into Depression and Banks Disappointed with Good Earnings But Bad Interest Margins

Essential reality set in prior to an expected disappointing Q3 earnings season. Reality revealed that ECB efforts would only be triggered upon country request. Meaning markets would not see any immediate bond buying by ECB. Greek experience juxtaposed against Spain to tell hesitation of countries requesting ECB assistance. Still Spanish and Italian bonds cooled.

For U.S., Fed’s QE3 wasn’t an open purchase of assets as in last two QE experiences. Rather, with QE 3 being restricted to MBS, banks realized that they needed to create mortgages to feed the MBS purchasing machine over time. Troubling for this proposition was realized as banks released earnings in Q3. One phrase cooled U.S. equities against QE3: Net Interest Margin.

With Net interest margin having been in decline, and higher earning securities obviously coming to maturity, issuing new mortgages at very cheap interest looked challenging for bank income. Suggested was/is banks must make up difference in margin with fees, service charges or trading. But Dodd-Frank legislation restricts other revenue stream capacity.

Apparent to markets was a Fed effort to grow U.S. economic propositions by growing real-estate. But to do so, banks remain a cautious partner due to interest margins. ECB’s OMT exist only once called upon by a particular country.