Buckle Up

On Friday of last week, the principal driver of early morning price weakness and volatility was the death of Iranian General Soleimani at the hands of a US military drone strike. That volatility took equity markets lower in the early going with the S&P 500 off as much as 1.1%. Markets did recover a measure of lost ground in afternoon trading. The Nasdaq and Dow Industrials both lost 0.8% on the session while the S&P 500 gave back 0.7%. Volume was mixed and markets remain in a confirmed uptrend.

Few would dispute U.S. General David Petraeus’s assessment of former Iranian General Soleimani as “our most significant and evil adversary in the greater Middle East.” That notwithstanding, the death of Soleimani last week awakened what had been a degree of dormancy as it relates to volatility in global markets – across asset classes.

Though the sell-off that materialized at the weekend was certainly fueled by geopolitical uncertainty, the initial bout of weakness was also compounded by weaker than expected manufacturing data. On the economic data front last week, the ISM manufacturing index for December came in below 50 (47.2) for the fifth consecutive month – fueling concerns over the state of U.S. manufacturing. While U.S. equity markets sold off on Friday, gold (+2.1%) and crude oil (+5.08%) leaped – along with the CBOE Volatility Index VIX (+12.54%).

The price action across all asset classes spoke directly to a risk-off trade. Though the Dow Industrials only lost .81% on the session, or 233.92 points, it had been 350 points lower earlier in the day. Naturally, a risk-off trade is going to channel investor appetite into treasuries as well as the aforementioned gold and VIX. On Friday treasuries were bid – driving yields lower. The 10-year yield dropped 4.741% to close out trading at 1.788%. Friday’s drop-in rates, as a result of the risk-off trade, has the potential of disrupting what had been a steepening yield curve through much of Q4, 2019.

If the nature of our involvement in the Middle East is any road map for the future, last week’s events are not likely to be the end of this long-simmering standoff between the United States and Iran. I would expect there to be ramifications far and wide for both the geopolitical terrain and also for markets. These geopolitical themes could well put a chill in our long-running equity market bull run. That said, I am not among those calling for a sharp pullback or correction in equity prices.

Repo mayhem – is there a long term solution?

By injecting tens of billions of liquidity into the overnight market from September through the end of 2019 in the form of daily and longer-term repo loans, as well as outright purchases of Treasury bills, the Fed was able to assure investors that there was enough cash in the system to prevent market rates from moving substantially higher at year-end. The move by the Fed was successful but reversed the long-held policy position of reducing the Fed’s total assets in a post “Great Recession” world. And though successful in its efforts to calm markets, the intervention does not provide for a roadmap forward that speaks to asset reduction – much less a method by which the Fed can normalize repo operations in the longer term. Make no mistake about it, both of these themes are top of mind for investors.

To a large degree, the repo squeeze was triggered by a drop in the banking system’s reserve levels. As a result, most on the street are expecting a focus by the Fed on banking reserve levels with an eye on raising them as we move forward. As of 1/1/20, banks had $1.5tn. in cash reserves at the Fed – up from $1.3tn. when this operation started in September.

This week’s highlights:

On Tuesday morning we receive the international trade data for November. This trade data is comprised of both tangible goods and services. Econoday consensus is calling for a sharp contraction in the trade deficit from October’s better than expected $-47.2 B to $-43.9 B. In that event, it would be difficult to argue with the effectiveness of the Trump administration’s trade posture, and not only with China.

The EIA Petroleum Status Report for the week ending 1/3/20 is released on Wednesday at 10:30 am. Last week’s release reflected a sharp draw on crude inventories (-11.5 M bbl.). Gasoline (+3.2 M bbl.) and distillate (+8.8 M bbl.) inventories expanded in the period.

Weekly Jobless claims data for the week ending 1/4/20 is released at 8:30 am on Thursday. Though there has been a degree of volatility on this weekly reading recently, the 4-week moving average continues to reflect a healthy employment market – standing at 233.25 K.

The most significant economic data point due for release this week comes on Friday at 8:30 am – the Employment Report for December. As you remember, November’s Employment Report was significantly stronger than consensus – coming in with a monthly gain of 266,000. Econoday consensus is looking for a more tame reading of 160,000 for December. The unemployment rate is expected to remain unchanged at 3.5%. A tick lower in private payrolls and a stagnant reading for the manufacturing sector should contribute to a reading that reflects more modest monthly gains in the U.S. labor market.

Flickr photo: by seftonbillington
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