2014 Forecast

THE BIG PICTURE

We've been in a bull market across all developed countries. In the United States this bull market was triggered by FED's asset buying program, called Quantitative Easing (QE), and in Europe by Mario Draghi's declarations of summer 2012. Ultra-aggressive FED's monetary policy allowed significantly improve american real estate market, generate GDP growth, bring stock market to historical highs and return confidence in the world's biggest economy. Europe has followed the same trend relying on a one single Mario Draghi's statement that "....ECB is ready to do whatever it takes to preserve the euro and believe me, it will be enough". Since then nothing has really been done but Europe believed that in the worst case scenario ECB will be here to support Europe and euro. PIIGS government bond rates fell, stock market rose and the broad economic sentiment improved. The similar declarations have been made in Japan where the prime minter is trying to fight deflation. As in Europe these declarations where not followed by actions but drove yen to its lowest levels. The emergent markets are performed poorly this year. The slowdown of the external demand makes Asian economies to cut their growth forecasts. A lot of investors are considering Europe more attractive changing investment flow direction from Asia to Europe and driving euro to its surprisingly high levels.

Analysis

Last years the most of economic improvements have been relying on the actions and/or promises of the central banks. In my opinion it has been the most important driver for all developed and (indirectly) emerging economies. Best economic indicators were reported by the countries where the central banks were the most aggressive. I have a mixed opinion on the FED's monetary policy as it allowed to avoid economic collapse and brought the rates lower. On the other hand it has pumped a new stock market bubble in the US and probably in some other US-dependent markets.

As many other investors I believe that FED will gradually taper the quantitative easing through 2014. This process will have a world wide economic impact. I also believe that american corporations are likely to miss more and more often the consensus and review their outlooks to more pessimistic. This can have an impact on the american stock market.

I'm still expecting an action from ECB in terms of monetary easing. I'm surprised that it didn't happen earlier regardless continuous euro's strengthening, deflation risks, unresolved debt problems, credit crunch for small the business and South Europe still struggling with a huge unemployment. I can explain this phenomena only by last year's election in Germany who is historically reluctant to the currency's devaluation approach. I'm repeating my concerns about France. Fortunately these concerns aren't shared by markets..... yet?

United Kingdom looks the most attractive so far. Ambitious reforms led by David Cameron are led to lower unemployment, even more attractive investment climate, very good visibility for businesses and safety for capital.

Japan's prime minister is keen on taking out the 3rd largest economy from 20 years deflation, so I believe that quantitative easing declarations and may be actions will multiply bringing the yen lower.

Emerging markets are very low but they are also very dependent on the developed economies. Russia looks particularly risky with a near-zero GDP growth and the risks of recession in the coming year.

STOCK MARKET

United States

As mentioned earlier I have a mixed opinion on FED's policy. I think that may be FED has gone too far with its quantitative easing and it should have stopped security buying earlier (for example in the beginning of 2013). Anyway were they wrong or not we have now a bubble on the american stock market. In my opinion it can burst at any moment and can be triggered by any event. I think that on January the 1st of 2014 the most of investors are realizing that the market needs to purge but none knows when it will happen. If speculations would continue through the beginning of 2014 the burst can be painful.

Positioning: I've taken a short S&P 500 position. I'll keep it until the market would purge at least of 10% from its current level.

Europe (Euro zone)

Technically Europe and the US are strongly correlated and I'm not expecting any rally in European stocks through 2014 unless ECB would take aggressive quantitative easing actions. In the latter scenario Europe is likely to outperform US but in case of bubble burst in the US stock market I'm struggling to imagine a profitable year in Europe.

Fundamentally Europe is still living with its old problems. EBC has reassured investors giving time to fix system drawbacks but nothing significant has been done so far on the political level. Spain is constantly reporting on "progress" achieved last year but the situation is still dramatic with 25% unemployment, very fragile banking system and huge sovereign debt. The only real improvement I can see is Ireland. But in my previous posts I have already mentioned that in my opinion Ireland has never been as fragile as other PIIGS because of its extremely liberal tax policy.
As last year I'm emphasizing attention on France. I have been wrong so far but still sticking to my opinion that it hides a huge risk for euro-zone. French economy is performing slightly better than its southern neighbors but economy is struggling of a very heavy social model impossible to finance without extending deficit gap already far beyond Europe required limits. French government, led by the most unpopular president of the 5th Republic, François Hollande, seems unable to overhaul heavy socialist system relying on overtaxed citizens and corporations. Latest UN statistics show that France has lost 77% of foreign investments last year. To reform the country the government has to take unpopular actions which could lead to social tensions and likely to give more and more influence to the euroscepticism.

But the main point about France is that any single doubt on the french debt would trigger broad sell off on the markets. The country is impossible to bail-out neither by European Union nor by IMF in case if it would struggle to refinance its debt on the market. Germany has clearly stated that it won't participate in such bail-outs with German tax payers money. So I keep praying that such a scenario will never happen.

Positioning: Except a short derivative to hedge my stock picking positions, I don't have any macro bets on the European market this year. I consider it as too dependent on the external events and political decisions that can be hardly foreseen. In case of any tension on the french debt I'll pass short quite aggressively.

Emerging Markets

Tapering of the FED's quantitative easing could lead investors to withdraw from the emerging markets. On the other hand the emerging markets are cheap and further down trend is likely to create a lot of opportunities. China is less dependent on the US than earlier and can partially rely on its own internal consumption.
Russia is struggling to generate growth with its commodities over exposed economy. Internal demand is satisfied by imported goods as domestic industry is very weak and uncompetitive. Foreign capital withdraw continues since the beginning of 2013 and is likely to accelerate along with FED's tapering. Country has a very bad outlook even with oil prices remaining high but in case of significant tensions on the oil market the consequences can become dramatic for Russia.

Positioning:

• Since the beginning of the last year I'm holding an ETF on China's stock market where I'm obviously loosing money. As long as I didn't allocate a lot to this position I prefer to keep it as I'm quite confident in China in the long run.
• I have an short position on the Russian market which I bought in the mid-2013. I'll definitely keep it as I expect a lot of bad news for Russia in the coming year.
• I'm currently buying Korean Stock Index. I'm not in position yet waiting for lower prices to enter.

INTEREST RATES

I'm expecting interest rates to increase on the US bonds for all maturities. The FED's tapering would reduce the demand on the US Treasuries driving rates higher. I'll change my opinion in case of severe stock market slump while investors are likely to move to the "safe-haven" and start buying US Treasuries and German Bunds.

Since mid-2012 I have been expecting higher rates on the french OAT but they are still remaining on the very low levels. My conviction is nevertheless the same - french debt is risky. So I'm betting on higher rates for the french government bonds.

I'm neutral on the German Bunds as in my opinion they are unlikely to raise especially in the context of higher market risks I'm expecting for the year 2014.

Positioning:

• I have a big short position on the US bonds as I'm expecting interest rates increase following FED's tapering. I'll close this position once the Treasury would reach 3.5% and I'll keep this position even in case of market slump accepting some lateral loses.
• I have a small short position on french OAT as I'm convinced that rates are too low but I'm not sure of timing when exactly they would rise.

CURRENCIES

Eur/Usd

This pair seems overpriced to me. ECB has been much less aggressive with its quantitative easing policy than the US and Japan. Many investors are expecting Draghi to take firm actions to ease financing in euro-zone and bring the currency rate lower to facilitate exporting. As mentioned earlier I don't understand why ECB didn't do it earlier but it might have some internal reasons may be related to German election. Anyway I don't see any reason why such a huge exchange rate would last in the long run. Another argument that FED's tapering is likely to increase the value of the US dollar against other currencies. In case of market crash dollar is quite secure as well as it is often considered as a "safe-haven" investment. For me there are enough arguments to short this pair.

Usd/Jpy

I'm expecting yen to weaken through 2014. The government gave clear indication of the policy it will implement and I don't see any reason why it would step back on it. In case of market crash, yen can be considered as a "safe-haven" investment what would strengthen this currency against others. However in this case the dollar is likely to get stronger too balancing pair's rate. To summarize I'm not expecting yen to fall in 2014.

Russian Ruble

Shorting of the Russian ruble is my strongest conviction since mid-2013. No growth, weak domestic industry, major part of GDP is in dollars and the social system became expensive while "good days" leaves no choice other than currency's devaluation. Devaluation may be smooth thanks to the currency reserves accumulated since beginning of the century. I'll write a separated article on the situation in Russia that I'm watching closely.

Positioning:

• EUR/USD: I have an aggressive short position.
• USD/JPY: I have a small long position that I'll increase but without taking excessive risks.
• USD/RUB and EUR/RUB: I have a huge long position as I'm expecting ruble to fall.

COMMODITIES

Oil

In my opinion the oil is on its long term down trend. My opinion is backed by slower oil demand from developed countries and China, Iran is likely to enter to the oil market in the coming years, developed countries are switching more and more to the alternative energy sources, exploration of the shale gas is developing in many countries, electric and hybrid cars are becoming more and more popular. Some political events can drive oil prices higher for some periods of time but I'll consider it as an opportunity to take a short position.

Gold

As I mentioned in other articles, I'm considering gold as a highly speculative asset that doesn't produce any return, and even generates saving fees. In my opinion it is incredibly difficult to define a "fair price" for the gold which is the main parameter for any fundamental investor. So for me there is no expensive or cheap gold as it has only market price defined by speculators.

I was shorting gold from 1400 USD per once levels and I sold my last short position by the end of 2013 at around 1200 USD. I'm not planning to speculate on the gold this year.

Positioning: Since the beginning of the 2014 I have started taking long term short positions on the oil.

Central Banks regulation and Interest Rates

Very often in financial media we hear people talking about Central Bank bringing Interest Rates higher or lower and the impact of these rates on the broad economy, mortgage rates, consumer loans etc. Let's look deeper into macro interest rates to better understand how do they affect our day to day life and the real economic sectors. Let's take a typical statement that we can come across reading through WSJ pages: "FED cuts rates by 0.25 point to reach record low of 0.50%". What does it mean? It may seem confusing as if tomorrow you would go to your local bank to apply for a mortgage your rates will be much higher. Let's try to understand what really happens and why this difference exists.

Government bonds

Bond Price vs Interest Rate

Governments to satisfy their budget needs as social security, defense, education etc. collect taxes and other state revenues which are usually not enough to cover all liabilities so they have to borrow money from investors. For that they issue Government Bonds with various maturities. In the United States they are called T-Bonds (Treasuries), in France - OAT, in Germany - Bunds etc. Bonds issued by highly rated countries are considered as an ultra-safe investment and their interest rates are close to risk-free rates. Government bonds are debt securities and are traded on the market. When any bond is traded it has a market price and interest rate. Both are linearly correlated, so when bond's price is going up the interest rate goes down. Therefore to bring the interest rate lower we need just start buying more bonds on the market increasing demand. To bring the rate lower we would obviously do the opposite it means sell bonds on the market. This is standard supply and demand rule. Remember well this relationship as it will be important later for understanding this article!

Commercial Banks

Walking down your city center you will certainly see several cash machines of well known local banks. Depending on the country you are living in examples can be City Group, Wells Fargo, Bank of America, HSBC, Barclays, BNP Paribas, Société Générale etc. All these banks are Commercial Banks operating in your country. Their traditional business is to finance individuals and corporations. To achieve this goal they are taking deposits from ones to give loans to others. Commercial bank lends money to an individual or corporation for a fixed or floating rate. In both cases this rate will be negotiated between the bank and its client within some interval of rates proposed by this concrete bank. Without going into details I'll just say that rate will be indirectly correlated to the current government bonds rate. It doesn't mean that it will be equal or close to this rate but when government bond rate increases the commercial bank's rates will increase too. I'll write an article explaining this relationship later.

Central Bank

Central Bank is a special type of bank that can be seen as a "bank of the banks". This definition may appear confusing as central bank's role goes far beyond of taking deposits and lending money out. Firstly central bank is an institution that manages a country's money supply, oversees the commercial banking system and acts as a lender of last resort to the commercial banks during financial crisis. As long as central bank possesses a monopoly of printing national currency its financing capacities are by definition unlimited. Thus the bankruptcy of the central bank is structurally impossible. In the most of developed countries the governments are controlling their central banks. The exception is United States where central bank (or Federal Reserve or FED) is a private company with a secret list of shareholders and the president of the bank is appointed by the president of the United States. In my opinion the word "bank" isn't applicable to the concept of the "central bank", as its primary role is regulation and not financing. Indeed it fulfills its financial role only in critical situations when regulation did not work properly.

Central Bank's regulation

As mentioned earlier one of the key roles of the central bank is to manage money supply. Money supply doesn't necessary mean "printing money" but more generally it refers to the amount of money available to the economy or amount of money available to the commercial banks financing this economy (individuals and corporations).

Typically central bank can increase money supply when GDP growth is slowing down, interest rates are too high, inflation is lower than its target level (creating a risk of deflation) or when currency rate is considered as unacceptable. On the other hand it can decrease money supply when there is a risk of a bubble on the real estate and/or capital market, interest rates are too low, inflation is far above its target level and/or again currency rates are considered unsatisfactory.

To regulate money supply central bank basically has 2 options:

1. Alter the reserve requirement.
2. Influence current interest rates on the market using OMO.

Reserve Requirement

Commercial banking system is very important and a bankruptcy of a significant commercial bank can have substantial consequences for the broad financial system. This is where central bank comes into play. To accomplish its regulatory role the central bank sets reserve requirement. Reserve requirement is an amount of capital that commercial banks have to put aside for each loan they are lending out. The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's money supply by changing the amount of funds available for commercial banks to make loans with.



Example:
Bank of America (BoA) lends out 100 000 USD and the reserve requirement set by the FED is of 10%, then 10 000 USD must be put to reserves and cannot be used for other loans. This amount can either be kept as cash or deposited to central bank.

Scenario 1: Increase reserve requirement to bring rates higher
FED brings reserve requirement to 20%. BoA would put 20 000$ aside for the same loan and this amount would "sleep" on the central bank's deposits producing a tiny interest rate. So BoA would have less money to lend out. As long as the reserve requirement affects all commercial banks then there will be less money available to the broad economy financed by these banks. When money supply decreases and the demand remain constant then, following supply and demand rule, the "price of money" will be higher. The "price of money" is Interest Rate. The objective of the central bank is achieved!
Scenario 2: Decrease reserve requirement to bring rates lower
FED brings reserve requirement to 5%. BoA would put only 5 000$ aside for the same loan. So BoA would have more money available to lend out. As consequence the broad economy would have more capital available too. When money supply increases and the demand remain constant then, following supply and demand rule, the "price of money" or Interest Rates will be lower. The objective of the central bank is achieved!

NOTE: Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves. They generally prefer to use Open Market Operations (buying and selling government-issued bonds) to implement their monetary policy (see below).

Open Market Operation (OMO)

Another option to alter money supply will be direct government bonds market intervention in order to technically affect the supply and demand. As mentioned earlier the rates paid on the government bonds indirectly affect loan rates proposed by commercial banks.

Scenario 1: Bring Interest Rates lower

Central bank will start buying government bonds on the market (probably with newly printed money if it wants to increase money in circulation) bringing the prices higher. As discussed earlier higher bond price means lower rate. The objective of the central bank is achieved!

Scenario 2: Bring Interest Rates higher

Just the opposite, central bank will start selling government bonds on the market bringing the prices lower and rates higher. The objective of the central bank is achieved!

CONCLUSION

Let's return to our original question what means the statement "FED cuts rates by 0.25 point to reach record low of 0.50%"? Usually the matter concerns target rate. Paradoxically this rate is the most often mentioned in the media but it is the less meaningful. Basically it refers to the rate to which the central bank will "push" short term government bonds on the market. We can also translate this statement that central bank is planning to increase money supply or inject liquidity.

Important to understand that such a statement doesn't mean that all commercial banks will now borrow money at central bank itself for a lower rate but that only means the intention of the central bank to push down interest rates proposed by commercial banks.