Notes From Underground

It has been a few days since the ECB announced its intentions. There was no surprise as President Draghi met market expectations by beginning a NON-TAPER, cutting QE by 30 billion euros beginning in January 2018. So as we considered the outcome of PACE and DURATION, the ECB cut the pace in half and extended the program by nine months to September 2018. The most significant piece of the Draghi press conference was his persistence on making the composition of future purchases. It seems that the ECB will utilize the European corporate bond market to meet its requirement and stay true to its CAPITAL KEY. By buying more corporate debt the ECB will find enough German assets to buy. The major problem for the European markets is that UNLIKE the U.S. financial system, European banks are a much more important actor as they provide far more corporate loans on a percentage basis of GDP than U.S. banks. The U.S. financial system relied to a far greater extent on issuing bonds. We have previously discussed the absurd chart showing European high yield debt to have a lower interest rate than 10-year U.S. Treasuries.

Look for European corporations as well as other international borrowers to issue euro-denominated debt as they seek to take advantage of the ECB’s printing press. A major signal for this view will be if the British/French agree to the building of the nuclear reactor at Hinkley Point in the U.K, Brexit be damned. Ultra-cheap financing will ease the negative feelings from the June 2016 British vote.

The markets initially tried to rally the EURO upon the “taper” headline but failed because the DURATION was explained to be open-ended. The euro dropped almost 2% during a 24-hour period and the DAX rallied to all-time highs as Germany received the flows from global/domestic investors. Germany is deemed the safest and most stable as Catalonia, Czech, Northern Italian and Austrian votes. Germany the engine of European economic growth is the ultimate repository of equity investment as its two-year note (SCHATZ) carries a NEGATIVE 70 basis point yield.

Over the weekend MNI revealed that there were five dissenting votes to the open-ended nature of the ECB’s plan. I have not seen this confirmed but it makes the coming year more difficult for Draghi if the rumor is true. The ECB president was very forthright in explaining that if the inflation data failed to rise the ECB Governing Council had TOTAL DISCRETION to increase the QE program. Also, the ECB will keep interest rates negative even as the amount of bond purchases decrease. From a trading perspective it was interesting to see that the DAX and EURO had minimal price reaction to the headlines, verifying that the market consensus on ECB decision was successfully fed into the media.

***Dow Jones news headlined an article Tuesday titled, “Swiss National Bank Hits Jackpot With 3Q Profit of $33 Billion.” As the newswire reported, the profit was equal to about 5% of its GDP, compared to the Fed’s $93 billion of profit on its bond portfolio in 2016 was only equal to 0.5% of GDP. Maybe we should turn fiscal policy over to the SNB. The SNB’s “profit was lifted by a trio of positive forces: Low bond yields preserved the value of its foreign bonds; higher equity prices raised the value of SNB holdings … and the weaker Swiss currency made those foreign assets worth more in franc terms.”

This article certainly reflects that the SNB stands to make a great investment if its three-person governing board can figure out a way to extricate itself without destroying the value of its portfolio. The international feedback loop of global central bank QE programs has provided the SNB with a massive windfall. Let’s see the exit strategy, especially as the ECB has revealed that it will stay loose for longer. This will be a potential indicator of market disruption. The Swiss may wish to take direction from Shakespeare: Exit, stage left, pursued by a bear.

***CNBC ran a story on Friday  about the COPPER-GOLD ratio. It cited Jeff Gundlach’s opinion (I agree with for the most part) who said “when copper is rising and gold is falling, the economic backdrop is relatively healthy and inflation may soon follow.” This has been a theme of many but the recent moves may have more to Chinese influences than genuine economic growth. Before CNBC story, Reuters published a piece by Meng and Melanie Burton titled, “Bullish Copper Bets, Fueling Rally: Source.” Readers of NOTES are well aware that I have little regard for unnamed sources but this piqued my interest.

The Oct. 24 Reuters story said a private Chinese coal company had amassed 35% of the open interest in copper contracts on the Shanghai Futures Exchange. The clearing firm is Gelin Dahua and the position is nearly $3 billion. It’s not certain if notional or actual but it does say it is equivalent to 70,000 contracts spread across the first-half of 2018. Chinese concerns have used commodities as collateral so the run-up in prices may be more financial engineering than actual usage in an effort to support its collateral. These types of play make the copper/gold ratio less valuable as an economic indicator, especially as the ultra-low interest rates have provided the backdrop for potential commodity squeezes.

I have raised the issue of the divergence between copper and silver prices many times. If the COPPER rally was genuine the GOLD/SILVER ratio should be falling as SILVER, like COPPER, has industry usages. I wonder if the Chinese investors plan to put SILVER on their radar screens. Remember the HUNT brothers almost cornered the global silver market with a mere $1 BILLION in capital. In the time of negative interest rates every conceivable financial manipulation is in play. Until the markets return to positive real yields on short-term money to spook investors all asset classes are capable of acts of levitation.

Tags: China, copper, ECB, Euro, Mario Draghi, QE, silver, SNB

This entry was posted on October 31, 2017 at 6:12 pm and is filed under copper, ECB. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.