Yellen’s Task

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The Federal Reserve used their policy announcement and the press conference following the announcement to alter their method of forward guidance. Previously, it had been the hard line 6.5 per cent unemployment target that would lead to a culmination of the third round of quantitative easing. Unfortunately, as the employment rate has fallen, and the overall labour market hasn’t improved accordingly, there has been a realization that the employment rate is not a sufficient stand-alone measure for the labour market. Thus, the Fed has had to abandon this with a more qualitative approach. This creates a problem for those invested in these markets, for it has been Fed policy providing direction. With a more qualitative approach to guidance, the result will be more ambiguous policy statements from the Federal Reserve’s Federal Open Market Committee (FOMC), and it will potentially lead to greater market volatility from the Fed as their guidance is open to misinterpretation.

One of the touted accomplishments of Janet Yellen’s predecessor, Ben Bernanke, was that he played a role in making the Federal Reserve a more transparent institution. One action in particular was lengthening the FOMC statement that was released after each meeting giving investors and analysts a more detailed approach to how policy is conducted. This was a stark difference to much briefer statements from the Greenspan era that left much to speculation. The importance of this measure though was to eliminate potential shocks to the market. This is why the US Federal Reserve finds themselves between a rock and hard place, and potentially risk reverting back to their old ways with a less definitive approach.

A qualitative guidance approach allows the US Central Bank to act in a more discretionary manner as they do not run the risk of failing to meet predetermined objectives. The consequence will be less clarity from the Fed, which implies the possibility of bigger shocks or surprises for the markets. Former PIMCO CEO Mohammed El-Erian suggests equities sold off following the Fed statement due to an uncertainty premium, which can be thought of as the market pricing a discount for a much vaguer policy outlook. But the uncertainty looks beyond the termination of QE as there are questions surrounding the overall efficacy associated with the Fed’s past course, and this is given QE could be terminated before the labour market is fully repaired.

It is difficult to refute that quantitative easing provided some form of benefit to the US economy; one in particular was supressing the longer end of the yield curve, which was of particular benefit to a troubled mortgage market. But with the Fed’s dual mandate of stable inflation of 2 per cent as well as maintaining full employment, the abandonment of QE before achieving success in that regard is an admission of the Fed’s shortcomings. And part of the problems is inherent in the American labour market. Long-term unemployed are structural issues, and unfortunately record low policy rates will not provide a solution to this problem. That’s part of the reason the FOMC is forced to take this path of paring back QE.

Janet Yellen’s key task will be to conventionalize the role of the US Fed. Her greatest risk is that as long as these markets continue to be driven by the guidance her institution provides as a more ambiguous approach will lead to much greater volatility. The only hope is that markets can move off the life support provided by central bank easing, and back towards being driven by fundamentals. In this case, central bankers can go back to operating in the shadows.

“Putin is Playing Chess, Obama is Playing Marbles”

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Financial markets are at the whim of how events will unfold in Ukraine. Equity markets looked poised to breakout off of Friday’s job numbers, but pared back their early gains. Given gold’s failed attempts to breakout past key resistance levels, it previously looked under pressure; however, the metal ended up maintaining a positive finish to the week as its geopolitical safe haven bid ensued. As well, Friday’s sell off in US treasuries sent yields on the 10 year bond to its highest level since January, despite the dollar seeing regained strength as it is geopolitical tensions that are keeping the markets at bay.

The uncertainty with the situation in Ukraine is clearly what is restraining markets this week and potentially in days ahead. US jobs data ultimately guaranteed the US Federal Reserve’s tapering path of 10 billion a month in purchases of treasuries and mortgage backed securities by their next meeting (March 18-19). Implications of this lead to both a strong US dollar and strong equity markets. But the threat of economic sanctions on Russia is what has market participants questioning the potential impact on Western economies.

Questioning the impact on Western Economies is about all we can do, because trying to determine whether or not economic sanctions are imposed on Russia or Russian oligarchs doesn’t address the severity of how long a situation like this can play out and what will actually amount. Some well documented statistics have highlighted the European Union’s reliance on Russian energy, and also Russia’s mutual benefit of having the EU as a trading partner. By some estimates, Europe imported 30 percent of their gas from Russia in 2013, and the reason Ukraine is so important is because approximately half of the EU imports came through pipelines via Ukraine. It’s the conundrum that Western Europe and Ukraine face should Russia do what they did in 2009 cutting off supplies to Ukraine, which affected gas en route to Europe. There is breathing room given European inventories are 11 percent higher than average this time of year.

Over the last week, a number of American politicians and commentators have made calls on Washington to export American Natural Gas to the European Union. Although that sounds like a solution, it takes an overly simplistic view of the US energy sector and how they export the commodity. To be brief, just because the US has come into a glut of the natural resource doesn’t mean that it’s on a tanker ship headed across the Atlantic. The simplicity of the argument is highlighted by the fact that the US and EU do not have a free trade agreement in place. Only one export terminal has been approved on the Eastern seaboard and is not scheduled to complete until late 2015. Any further projects require regulatory, safety, and environmental approval from a multitude of government agencies. Let’s not forget the fact that North American natural gas is more interested in an Asian market where it can attract a higher premium. And the very reason the US government limits free trade of their natural resources is to supress domestic prices from the global market price.

Energy prices are the concern of the global economy. A shock to global prices at this point is not expected. However, a sustained increase in oil prices always leads to a recession, and that is the reason financial markets are wavering. Given a response from the Obama administration to this crisis that led one Congressman to suggest, “Putin is playing chess while Obama is playing marbles,” the global economy can still be thankful for one thing. Europe is facing a mild winter.

Manipulation in the Markets

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Bloomberg reported on a study this past week that points to decades of manipulation in the gold market. Whether there is credence to this study is something that is yet to be proven, but it highlights periods of suspicious trading activity around the time when the London Bullion Market Association fixes the price of gold every day. It also ads support to the notion that the way the price of gold is fixed is archaic in nature.

We have to begin with a bit of background. The London Bullion Market is not the one we commonly think of in North America. In North American trading hours we are often focused on the New York Mercantile Exchange, commonly referred to as the Comex. The London Market in 2013 saw close to 76 percent of gold trading in terms of volume in 2013, whereas Comex volumes were closer to 16.5 percent. Numbers for London are quite often best estimates because not all clearing is actually reported. Regardless of volume, research into which market leads the price of gold is inconclusive between the two. Despite London dwarfing all other markets, volume does not necessarily mean influence.

Twice a day in London, the price of gold is fixed. It’s done so for many reasons, some being settling client orders who purchase or sell based on that fix. Clients may be precious metal dealers, mining companies, or jewellers. The fix is also used by financial institutions for portfolio valuation. To fix the price, five member bullion banks come together to determine a price. The member banks are Scotia-Mocatta, Barclays, Deutsche Bank (who recently announced they were giving up their seat), HSBC, and Société Générale. They hold a conference call where they offer their book of client good ‘till cancelled orders along with their own orders. Once they have a price where they can settle within 50 kilos matching buyers and sellers, the price is fixed.

The potential issue with the gold fix is that member banks that participate are not restricted from proprietary trading (trading for their own positions) and are not restricted from trading derivatives markets (like the Comex) while the conference call is underway. As well, the banks continue to take client orders while the call is taking place. It becomes a problem of adverse information as the five members have insight into the direction of the market before all other market participants, and the author of the study seems to suggest collusion between the five banks in terms of manipulating the price.

The motivation for the research paper comes from suspicious trading activity seen on the Comex in a brief period during the conference call of the second fix and following publication of the London Fix. Nothing has been proven at this point, but the researcher making the observations has also been credited for research that unveiled potential manipulation in the setting of the LIBOR. A probe that has led to banks being penalized along with the traders participating in that rate setting process.

It is more a story of potential corruption amongst bankers than manipulating the price of gold. For a brief moment, perhaps five minutes, there is opportunity of making excess profit by knowing the direction of the market, before the market itself has time to adjust. And stories of late show it is not just the gold market and the LIBOR scandal, over the last year there have been probes into the currency markets showing evidence of rate rigging. Unfortunately though, these markets are so vast, ethics seems to be the only regulation that can guide these particular people in power, and clearly that does not always work.