Wednesday June 7

Stocks rose slightly today ahead of a very eventful day tomorrow. The S&P 500 and the Dow Jones each rose 0.2% to 2,433 and 21,173 respectively. The KBW Bank index added 1.2% as interest rates rose and utilities gained 0.4%. The EIA Petroleum Status report showed that crude oil inventories unexpectedly rose by 3.3 million barrels last week which brings inventories to higher than the level last year. It also snapped an eight week streak of declining inventories. That sent oil prices lower as the energy sector fell 1.6% to drag down stock prices more broadly. Investors today also took note of reports that the ECB when it meets tomorrow is going to downwardly revise its inflation forecast which could increase expectations for a dovish statement tomorrow. In the US interest rates rose sold off after a strong rally over the last two days. The 2 year Treasury yield rose 1bp to 1.31%. The ten year Treasury yield rose 4bp to 2.18%. Accordingly 2yr vs 10yr bear steepened to 0.87%. The dollar was mixed on the day against peers. USD fell 0.2% against EUR to $1.1264. USD rose 0.1% against JPY to Y109.8. USD was barely changed against GBP and finished at $1.2958. Oil prices had a tough day. WTI fell 5% to $45.78. Brent fell 3.9% to $48.16.

Santander purchased struggling Spanish bank Banco Popular after European regulatory authorities deemed the bank “likely to fail.” Regulators orchestrated the sale and Santander purchased the company for EUR 1 per share. This was the first test for Europe’s Single Resolution Board, which was established after the financial crisis to orchestrate bank failures without imposing losses on taxpayers. In this situation losses were imposed on shareholders and the most junior debtholders of Banco Popular. AT1 bonds and AT2 bonds were established in the wake of the financial crisis, and they are structured such that they count towards a bank’s capital ratios, however if certain metrics fall below key levels investors may miss coupon payments, be wiped out entirely, or be forced to convert to equity. They represent the most junior debt security banks issue in Europe. Investors in Banco Popular AT1 bonds were wiped out entirely, and investors in AT2 debt were forced to convert to equity before the sale went through at EUR 1 per share. In this case the bonds functioned as they were supposed to by preventing taxpayers from paying for the failure of the bank. It is also a healthy sign that there wasn’t much sign of contagion in the market for this debt. Early last year when Deutsche Bank was facing concerns that it wouldn’t be able to make a coupon payment on its AT1 bonds, there was a lockup in the market and the primary market dried up. This time around however that hasn’t been the case as banks have been able to issue bonds leading up to this failure. PIMCO was the largest holder by far of Banco Popular’s AT1 bonds that faced losses.

One of the economists being mentioned as a possible Trump pick for the Federal Reserve Board of Governors is Marvin Goodfriend. He has some unconventional views, being a proponent of negative interest rates as well as an exchange rate between physical and electronic currency in efforts to fight deflation. Some analysts have labeled him as being hawkish, given that he opposes slow and predictable rate hikes as well as the Fed’s buying of MBS. However some aspects of his view make him seem more dovish than Janet Yellen and Stanley Fischer, both of whom were perceived to be dovish when their time at the Fed began. Currently both Yellen and Fischer are proponents of raising interest rates so as to not fall behind the curve on inflation given that the labor market is increasingly tightening. In the current environment that would make them lean towards the hawkish side. However based on past speeches, papers, and accounts from students in his classes Goodfriend does not seem to be as strong of a believer in the relationship between unemployment and inflation. He also opposes slow and predictable interest rate hikes such as the one going on now, and in 2004 he argued that similar actions led banks to take in excessive risks. Instead he seems to be a proponent of raising rates more rapidly in a much shorter time frame. Goodfriend also seems to subscribe to the idea that the best predictor for inflation is recent inflation, and given that inflation has run persistently low over the past few years it seems like he would take a dovish stance in this environment. A student from one of his prior classes recalls that he was against the 2015 rate hike. If Goodfriend is tapped by Trump to join the board of governors, it will add a dovish influence to the FOMC.

Some investors are concerned about the level of high correlations in markets right now and the fact that many asset classes seem to be rallying all at once. Stocks, bonds, gold, and assets such as bitcoin have all experienced notable rallies this year. At the same time the Goldman Sachs Financial Conditions Index indicates relaxed financial conditions with a lot of liquidity in the system. Historically low interest rates which are driving money into riskier assets could be behind this development. A weaker dollar may also be contributing to these movements as well. Additionally it poses a problem when all asset classes are moving in the same direction like this because it takes away from diversification characteristics that many investors rely on to reduce risk. The combination of recovering economic growth, accommodative central banks, and low inflation has been bullish for many asset classes. However it could also be conducive to complacency and if all asset classes turn around at the same time investors may not have anywhere to turn for safety.

Wednesday June 7

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