International Selection 10:17 - März 6th 2015

«Draghi is going to make the same mistake as the Fed»

James Bianco, President of Bianco Research, cautions about the unintended consequences of the new European stimulus program and doesn’t think that the Federal Reserve is going to raise interest rates this year.

Mario Draghi is going all in. On Monday, the President About James Biancoof the European Central Bank will launch a bold bond buying program to stimulate the economy. «I don’t think it will work that way» doubts James Bianco, leaning over a bowl of cereal and sipping on a large glass of OJ. To be sure, the influential market strategist from Chicago who is highly regarded among institutional investors expects the massive liquidity infusion to drive up European stock markets.

But by doing so, the ECB is going to make the same mistake as the Federal Reserve in the US and catalyze social tensions, Bianco fears. In contrast to the mainstream on Wall Street, the unconventional thinker does not believe that the Fed will raise interest rates this year. In addition to that, Bianco spots an especially dangerous development in the energy sector. Despite the burst of the huge oil bubble, investors have built on to their positions, he warns and draws worrisome parallels to earlier excesses in the housing market.

Mr. Bianco, the Federal Reserve has initiated the countdown to liftoff. When will Fed chief Janet Yellen raise interest rates for the first time since the financial crisis?
When you talk about the Fed there are two things you need to discuss: What will they do and what should they do? I think what they will do is they are going to hold off and not raise rates this year. My unconventional argument is that the Fed is much more concerned about financial stability than they let on.

That is a nice way of saying that they are afraid they are going to raise rates, the stock market goes down and it is all Yellen’s fault and she gets yelled at. They will raise rates when zero interest rate policy is perceived as a problem. It is not perceived to be a problem now because inflation is low. But the day comes when the market is selling off and the perception is that it’s because the Fed is too easy. Only then will they raise rates.

What does that mean for the Fed’s next policy meeting in mid-March?
I think that the March meeting is going to be the most important meeting of the year. Because, as we go through the year, the data is going to get worse. It’s not going to get bad and I am not calling for a recession. But the data is going to do what it has done since 2010. It is going to get people to slam their fists on the desks and go: «God, it’s just not good.»

It is just average-to-below average and that is going to make it harder for the Fed to justify raising rates in March, April, May and June than in January, February and March. So it comes really down to the March meeting and if they do not take the window at that meeting to set up a rate hike then there is not going to be a rate hike – and the market seems to agree with that.

What do you mean by that?
Wall Street is telling us that Yellen was more hawkish in her last testimony before Congress and it is all set that the Fed is going to raise rates in June. But that is not the way the market was reacting. The market has actually pushed the odds of a rate hike further away from June. Fed Funds Futures are now pricing in a first rate hike out in October and they are moving away from the Fed from September to October to December.

How do you explain this discrepancy?
There are a couple of possible explanations: At the end of QE1 in 2010 and at the end of QE2 in 2011 we went through similar episodes. The Fed started hinting when we are going to get the first rate hike but the market priced in even more quantitative easing.

It is almost as if the market was like this big, demanding child. It demanded «you give me more» and eventually the Fed did. So there is that conflict. And in the past, whenever there was that conflict the Fed was always afraid to upset the market. So they want to raise rates but they are very afraid at every step that if they go too far it is met poorly.

And what is the second explanation?
It is possible that the market is saying that the Fed will raise rates in June but the next day you wake up nothing will happen. T-bill yields, the Funds Rate, commercial paper won’t move. They will be at exactly the same level that they were at before and nothing will have changed. So maybe the Fed Fund Futures contract is right to price in no movement in June even though the Fed is going to raise rates.

How can that be?
The Fed Funds market is a market where the banks trade reserves with each other. But because of quantitative easing every bank is way over reserved and nobody needs to buy. Therefore, the Fed Funds market essentially does not exist. But the Fed has made a decision that they are still going to target the Fed Funds Rate because it is too complicated to tell everybody that they now focus on  interest on excess reserves and on reverse repos.

Nobody understands that. I’m not even sure the Fed understands it. So that could be the other thing the market is telling us: «The Fed is going to raise rates by raising the rate on reverse repos and raising interest on excess reserves. But guess what: We do not think it is going to change anything. The Fed is just going to wind up paying more money to the banks to do nothing.»

Why is the Fed so concerned about the stock market? For instance, the S&P 500 (SP500 2141.16 -0.01%) has nearly tripled since the low of the financial crisis. So shouldn’t some kind of correction be bearable?
The day after QE2 came out in November 2010, former Fed Chairman Ben Bernanke famously wrote an op-ed article in the «Washington Post». He said that the purpose of quantitative easing is to drive financial assets higher and to create a wealth effect that will then trickle down to help the economy go forward. But I have argued it does not work that way.

Why not?
Largely because of Milton Friedman’s argument about the permanent income hypothesis: You own an asset and it goes up in price and you perceive it as permanent. So you think of it as an addition to your income and you spend more. The great example of this has been home prices in the US before 2006.

But today, if you own an asset, say stocks or a home, and it went up in price, you do not perceive it as permanent. You fear it could go back down and you spend none of that money. You are not going to alter your investment decisions or your business decisions. That is why the QE-programs did not work. The goal of the Fed was to push up asset prices. With that in mind, they do not want asset prices to go down because they think it will create a reverse wealth effect. QE has been all about pushing up markets and they are not going to throw that to the wind.

You have been one of the first in the investment community to correctly predict that QE2 is going to heat up the stock market. Is this also true for the European QE-program which is starting this month?
Sure, just look at the German Dax (DAX 10710.73 0.09%). It’s up 17% this year whereas the S&P 500 is up 2%. A lot of European stocks have really taken off in the wake of the European QE. It’s going to do the same thing that it did in the US: It’s going to drive asset prices higher. Except now, they are driving yields to negative. They are driving them below zero to get people to go out in the risk curve. So by pushing up asset prices ECB president Draghi is going to make the same mistake as the Fed.

How come?
The program will push up asset prices but it won’t necessarily create jobs and GDP growth. And to that end it will create more strife within the central bank. In the US as an outgrowth of that, culturally we had the Occupy Wall Street movement and we created the phrase «the one percent». So the wealthy own equities and assets and they are benefiting from QE. And that is going to create a lot of unhappiness because if you are not in the one percent you do not own a lot of assets. You are relying on a middle class job and you really are suffering.

Here is my new favorite example: The website TrueCar pointed out that average cars that cost 33’000 $ or less last year in total number of unit sales went up 4%. Cars that cost 50’000 $ were up 30% and cars that cost 70’000 $ or more were up 50% in sales. So if your business is selling 120’000 $ electric cars like Tesla you had a fantastic year. But if your business is selling 22’000 $ Toyota Corollas it was a very, very difficult year for you.

What are the consequences of that?
If Europe is not careful they are going to wind up with the same problem. This program does very, very well for the wealthy in the rich sections of Rome or Madrid.  But in the suburbs where the poor live it is going to create a lot of tension.

Originally, you started your career as a market technician. What goes through your mind when you  look at a chart of the stock market right now?
With the S&P 500, the pattern looks to be fairly good. But I have argued that the US stock market is going to struggle this year. What has been bothering me are valuations and earnings: For the fourth quarter, year over year earnings growth is 4%. But Apple (AAPL 116.6 -0.39%) is almost half of that number. Without Apple you are down to around 2%.

And here is where the story gets really interesting: Estimates for first quarter earnings are down at negative 4.5%. And even if you exclude the energy sector it is still at 3% which is not very good. The second quarter looks almost identical to this and 2015 is down to around 2% according to Bloomberg. So earnings really are not good and that is reflective in the disappointing growth of the economy.

And what about valuations?
Wall Street’s favorite metric, the forward P/E ratio, is above 17 right now. This is the highest level in eleven years. Over the last 40 years, only in the bubble period of 2000 the forward P/E ratio was higher. So if you ask a typical fund manager when he would generically sell the stock market he would probably say: «When earnings are declining, interest rates are rising and the economy is slowing.» That is exactly what we have right now. But all of a sudden, no one wants to believe it and no one wants to sell.

On the other hand, one reason for the rich valuation is the earnings breakdown in the energy sector.
Energy is really getting blown apart and that is hurting. I hear a lot of people say: «Well, it’s just energy.» But if you go with that argument I use a school metaphor: If I get an F in math and Cs and Bs in everything else, I am not a good student. Energy is not a marginal sector in this country. It is too important to say it does not matter.

At least, oil prices seem to have found some kind of a bottom lately. Do you think the worst is over?
Since 2008 everybody has been on bubble watch. Well, we had a bubble and it blew up: It is called energy. The problem or the beauty of bubbles is that nobody knows where they are and nobody knows when they blow up. This is like housing circa 2006: We did not know that this was a busted bubble till it was all over with. I think that crude oil is a busted bubble and it has some typical characteristics of a bubble: Leverage, since there has been a lot of borrowing in the energy sector and a refusal to believe what has been happening.

So what is happening next?
Even though falling gas prices is a good thing  you can have too much of a good thing. On the other side, the negatives could be just as big if not bigger. Energy sector stocks have bottomed for the moment around the middle of December and they kind of hovering around. But investments in energy shares are almost back to the highs we saw back in June. Very few people left and almost everyone is betting that energy is going to rebound.

Also (ALSN 88.4 1.26%), as the spot price of crude oil collapsed 60% this winter, investors have piled into crude oil ETFs. In July, when crude oil was still over $100 per barrel, $2.5 billion of assets were in crude oil ETFs. Now, with the price near $50, these assets are approaching $7 billion. So investors have parabolically bought while the oil price was collapsing. That worries me. I do not think I have ever seen a case where a market has fallen by half in five months while the speculators were buying into that market.

How dangerous is it?
Investors have bought a falling knife. That is why I am saying you have to be careful. But no one believes this. In the US, the production numbers are at a generation high at over 9 Million barrels per day. We have not slowed down production at all. We are making new highs in crude oil production and everybody has bought into the decline. No one sold.

This is a recipe for $40, $30 or $20 oil – or whatever it takes to make people realize that they have made a terrible mistake and that they will lose money. So oil is going to have to go somewhere where everybody just capitulates like crazy, just gets out of this stuff and tells me why it can never go back up again – and then you have the next rally.

Where do you spot better opportunities for investors?
The Fed does not move, the economy stays below average, the earnings numbers are continuing to disappoint and the ECB does its own QE-program: All that feeds into a bond market rally in the US.

That story has been in place and that story will remain in place for a while longer. Also, there is a shift out of Europe into the US. You can sell your ten year German Bonds and when you pick up US treasuries you can pick up 170 basis points. That is why I think rates in the US are going to stay low for a lot longer than people think.

But since the end of January yields on US treasuries already have gone up quite a bit.
On January 30th, the yield on thirty year government bonds hit 2,22% which was a new all-time low. The yield on ten year treasuries was at 1,63%. So its low is still in the summer of 2012 with 1,37%. But if my forecast plays out I still think we are going to go through 1,37% this year or at least go to it.

About James BiancoJames Bianco is President of Bianco Research, an affiliate of the institutional research and brokerage firm Arbor Research & Trading. Since 1990, he produces unique and original insights into movements in the financial markets. His commentaries are primarily devoted to the fixed income markets with special emphasis on money flow characteristics of primary dealers, mutual funds, hedge funds, futures traders, banks, and institutional investors.

Prior to founding Bianco Research, he spent five years in New York City with several prominent investment banking firms. He was a Market Strategist in equity and fixed income research at UBS Securities and Equity Technical Analyst at First Boston and Shearson Lehman Brothers. He is a Chartered Market Technician (CMT) and a member of the Market Technicians Association (MTA), where he served as a national Vice-President and Chairman of the MTA's 1996 annual seminar.

Mr. Bianco is married with four children and resides in Chicago. He has a Bachelor of Science degree in Finance from Marquette University (1984) and an MBA from Fordham University (1989). He is a passionate sports fan and is rooting for the Chicago White Sox.

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