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What’s Fed’s swap line? And how does it affect the balance sheet?
One of the first symptoms of the Covid-19 turmoil in March was a global dollar shortage, but an aggressive Fed response helped to avert the credit crunch. One of the side effects of this move was rapid expansion of the balance sheet however, the latest data from the Fed indicated that this trend has started to reverse. Various financial media cited lowering demand for the Fed’s swap lines as the major source of decline. In this article, we will try to figure out what was the exact reason why the balance sheet started to deflate last week.

Let’s start from key definitions. What is the Fed’s swap line? It’s an agreement between the Fed and other central bank on a mutual exchange of currencies for some predetermined period of time. A swap contract involves two transactions (“swaps”) – direct and reverse. The direct swap occurs when the Fed lends USD to the foreign central bank taking foreign currency as “collateral”. Conversely, the Fed exchanges foreign currency back for USD. Since the Fed’s counterparty is usually a large foreign central bank and exchange rate for direct and reverse swap is fixed, the Fed bears no credit or currency risk. A swap line is not free though, the Fed charges some interest on it.

The Fed has been providing short-term and medium-term swap lines for 7 and 84 days.

Direct swap leads to an increase in the Fed balance sheet while reverse swap results in a decline. Ignoring interest income, a swap line transaction with the ECB in the amount of 100 USD will be reflected in the balance sheet as follows:



Moments of time t and t + 1 are the dates of the forward and reverse swaps.

“Waning” 100 USD in the Fed’s liabilities in reverse leg of the swap may look odd because it creates impression that the Fed “destroys” USD. But that’s just how it works! Recall that US Dollars is a liability only for the Fed (asset for all others), so basically destroying USD (selling something on the asset side) the Fed basically “redeems” its debt!

In the table above, we can see which swap line transactions inflate and deflate the balance sheet.

Last week, we saw the news that the Fed’s balance sheet declined for the first time in several months thanks to lowering demand from foreign central banks for the Fed’s currency swaps:



However, it was stated slightly incorrectly, as reduction in demand is not the only source of decline. Let’s discuss why.

Based on the data on operations (https://apps.newyorkfed.org/markets/autorates/fxswap – Operation Results), demand for swap lines peaked in early March. The size of the swap agreements was the highest but started to decline later. The “hungriest” was the Bank of Japan, which borrowed a lot of USD through this credit facility for the medium term (84 days).

Maturity dates for those large March USD borrowings (i.e. reverse swaps) fell precisely for the middle of June. As we have already seen from the analysis above, reverse swaps have a deflating effect on the balance sheet. In other words, the Fed’s balance declined not only because foreign Central Banks reduced demand for currency swaps but also because the turn has come for the largest reverse swaps.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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Oil Prices at 3.5 month High as OPEC+ deal Compliance Improves
Oil prices continued advance on Tuesday, Brent gained $2 rising to $43 per barrel, the highest level since early March. Obviously, sentiment in the market remains positive, thanks to the fact that constructive rhetoric from the OPEC, regarding compliance of several participants, has finally appeared.

One of the weak links in the OPEC+ deal is the lack of enforcement mechanism which creates incentives for some participants to deviate.
However, progress on this matter was outlined last week, as individual participants to the agreement began to inform OPEC about how, when and how much they would reduce output. The traditional “hack worker” Iraq and Kazakhstan provided the organization with details of how they would cut output. Nigeria also outlined plans to cap production. Obviously, all this information cements the deal and increases the likelihood that compliance will be high.

Recall that extended version of the OPEC+ deal implies output cap of 9.7 million bpd until the end of July.
Russian energy minister Novak said the $40-50 range is now fair for oil. Although such an oil price is acceptable for the Russian budget, some OPEC members will not be happy if prices stay at this level for a long time (due to the higher oil price set into the budget), so they will probably want more expensive oil. These fundamentally justified disagreements give rise to an interesting situation by the end date of the agreement, as instead of cooperation, a competition may emerge again, pulling producers back into the price war.
Also, API data on US oil reserves are expected today. It is expected that inventories rose 2 million barrels last week. A steady increase in reserves may indicate that low oil prices failed to destroy the US oil sector and it is restoring production along with rising prices.

Oil prices


Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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Gold’s Renewed Momentum Hints Markets are Worried about US Inflation
Gold’s renewed momentum was one of the most notable market events this week, sending price to a new 2020 high:

Gold’s Renewed Momentum


It looks like bulls and bears argued for two months about the direction as the price stalled in the range between key levels of $1680 – $1745. Finally, sellers capitulated. Last month, around May 18, a failed breakout took place – it is clear that the price failed to gain a foothold above the upper bound.

Now the chances that the breakout is successful are much greater. We can see that there was a rebound from the ex-resistance converting it into support. Also, higher low followed in the price action adding evidence to the truth of breakout. Such behavior tells us that the market has come to consensus about the validity of the breakthrough – sellers realized they made a mistake betting that resistance would hold, buyers became more confident that their decision to buy was right.

Breakout from a range is usually the signal of initiation of a trend. As the gold price quitted 2-month range, the base scenario is now bullish trend with next target at $1800.

The function of gold as protection from falling real interest rate suggests that the driver for the rally could be some upward shift in US inflation expectations. And indeed, one of the inflation expectation metrics (5y5y inflation swap) has risen to 1.62%, the highest level since mid-April:

Gold’s Renewed Momentum


The breakthrough in gold price (red curve) coincided with the acceleration of inflation expectations in the US.

The market can discount too much inflation risk in the United States, including because of the confidence of the key “expectations-setter” – the Fed, which is confident that the net effect of the coronacrisis and subsequent stimulus is disinflationary. However, data for May on the labor market, retail sales, real estate and car sales slowly prove the opposite.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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Infection Spike in Texas and California Creates “Asymmetric” Expectations About new Lockdowns
Large speculators’ bet on the fall of S&P 500 has risen to the highest level since early 2016, shows weekly CFTC update:



The chart shows that net position of large speculators in the S&P 500 futures (long – short positions) has been steadily declining over the past three and a half months and has exceeded -40K contracts. In other words, speculators have been building up short positions for almost the entire period of the “bear rally”. The lack of consensus on the part of professional market participants is certainly alarming.

It should be noted that in the United States the epidemiological situation is exacerbating, which, for example, can be seen from the sharp increase in the number of new cases in California or Texas:



The number of new confirmed cases in Texas



Number of new confirmed cases in California

Naturally, this cannot leave investors indifferent, especially in the light of reports that Texas has already started to “count free beds”. This leads to weakness in the US stock markets relative to European equities, obviously due to “asymmetric” expectations of new lockdowns in the US and in the EU. European stocks are rising today, but expectations for the US market remain negative which is reflected in S&P500 futures loss on Wednesday.

A further decline in US stock indices and strengthening of USD are expected due to expectations that infection spike may continue to gain traction. The bullish view on gold that we discussed in yesterday remains fully intact due to worsening news background.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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US Unemployment Claims: Still no Welcome News in June Despite Rebound in May
Getting ready for the June NFP release, which will probably shed some light on the striking employment gains in May, we continue to keep tab on the behavior of more frequent labor market indicators – initial and continuing unemployment claims in the US. For the fourth consecutive week, a drop in layoffs has been more “sticky” than expected:



Weekly rise of layoffs in June appears to be consistently higher than the forecast. But in time of permanent monetary and fiscal stimulus, bad economic news are good news for the market: the weaker is recovery the more likely is extension of the lost income coverage scheme which expires at the end of July.

Continuing claims declined from 20.3M to 19.5M but WoW changes are not quite consistent with the story of massive rebound after the reopening:



Still, declining number is a good signal because it shows that people are returning to work. However, actual number can be higher this week due to a reporting feature of some states: for example, Florida and California send the data every two weeks and there was no data on unemployment claims this week.

As of June 6, the number of claims for all income insurance programs (unemployment benefits, pandemic payments, etc.) amounted to about 30.5 million. The first important requirement to be eligible for receiving the social payments is that a person have to lose a job during pandemic. However, in order to take into account constraints on job search opportunities arising from the pandemic, the government relaxed another important condition – the need to look for a job. Recall that for a person to be unemployed two conditions must be met – lose a job and be in active search for a work. As a result, a large part of unemployed can be out of reach of BLS precisely because of the flaw in accounting, that’s why the number of people who receive benefits can be more accurate measure of the unemployed than official BLS unemployment estimate. Currently it is 13.3%, while 30.5M claims is about 20% of the workforce.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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Will SPX Resume the Rally After the Storm of Covid-19 Headlines?
On Monday, the struggle continues to unfold between positive macro data and signals of the “second wave” which can be challenging to dismiss. Asian markets closed in deep red while European stocks are trading slightly below the opening in response to reports that some US states are reviewing plans to lift lockdowns or partially reinstate them.

A 6% increase in industrial profits in China in May YoY looks like an encouraging macro update, however details of the report show that growth concentrated in technological sector while other sectors lagged behind. In addition, reduced costs accounted for the better part of the profit growth, which of course includes increased layoffs and wage cuts which puts dent on consumer spending outlook in the month ahead.

The COT update from last Friday showed that large speculators sharply reduced short positions in S&P500 futures:



In June, the biggest net short position on S&P500 (long positions – short positions) was around -40K contracts, the lowest level since early 2016. As of last Tuesday, there was a sharp turnaround: the number of bets on decline fell by 28.7K contracts. However, bets on the rally of the index fell as well, albeit slightly, by 2.8K contracts.

Swift liquidation of short positions suggests that some market participants are finally dropping their “second dip” prediction, which in turn adds arguments that we may see the next leg of the rally after proper consolidation near the level of 3000 points. Nevertheless, the rally is currently being hindered by a “storm” of headlines about a second wave of Covid-19 and negative shocks in the form that some states are making adjustments to lockdown removal plans.

As for the other “hot spots” of the Covid-19 pandemic, the accelerating number of new cases in India is striking:



Over the past two weeks, the number of new cases per day has doubled – from 10K to 20K. Growth is concentrated in five large states (Delhi, Gujarat, Maharashtra, etc.), which account for 43% of GDP. Such a development of the situation prompts us not only to revise down the country’s GDP forecast, but also the forecast for oil consumption, as India accounts for 4.81% of world oil consumption (3rd place in the world).

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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Fed’s Targeted QE Keeps Credit Markets Under Full Control
Despite positive developments in the US economy since the start of lifting lockdowns, Fed Chairman Jeremy Powell reiterated his dismal warning on Monday: extraordinary uncertainty reigns in the prospects for economic recovery. This uncertainty is generated mainly by the fact that economic projections strongly depend on the success of pandemic suppression and the government’s readiness to lend helping hand again in the form of new fiscal injections.

Powell’s statement, in fact, carries a call for taking signals of a second virus outbreak in earnest, but recent explosive growth in the number of new cases in some US states last week failed to convince bulls to ease grip. Optimism, as we see, triumphed after a slight hitch at the start of trading session on Monday: European and American indices closed in green, although the threat of new partial lockdowns in the US loomed on the horizon.

Analysts at Morgan Stanley said that despite the fact that the threat of a second outbreak exists, governments are more attuned to it compared with the first outbreak, they also realized the full power of fiscal “bazooka”, and the Fed, demonstrating unlimited depth of its balance sheet, leaves no chance for development of a credit crisis.
The Fed really hands out credit guarantees on every US credit market, announcing various credit facilities.



Basically, they are all a kind of a targeted QE – depressing interest rates on the markets where the risk of their outbreak (and subsequent spillover to other credit markets if the state is fragile). It should be noted that the program of direct lending of the Fed to small and medium enterprises has not yet been enacted (the so-called Main Street Credit Facility). The program itself is a powerful signal that interest rates for these borrowers will remain at an acceptable level (as well as the market value of their debts), which should stimulate banks to expand lending to this group of lenders.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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Gold Hits $1800 but Ultra-dovish Fed Suggests it isn’t the Limit
U.S. Senate unanimously voted on Tuesday to extend a key stimulus maneuver – Paycheck Protection Program. The goal of this program was to offer cheap loans for firms which want to save jobs. Initially it was expected that the program would be completed before the end of June, but Senate’s to extend it suggests that a wave of layoffs waits the economy without credit support. US stock markets welcomed the decision of the government to extend the program, SPX added 1.5%.

The program could account for some distortions in May NFP report since firms has strong incentive to delay layoffs or even boost hiring. The extension of the program means that the real trend in unemployment may be also masked in July.

Last week we discussed prospects of the Gold rally to $1800 level, which was successfully completed on Tuesday:



The price of gold has risen to the highest since 2012 amid falling real interest rate in the US and expectations that this trend will continue. This week, these expectations were fueled by a gloomy warning by the Fed’s Powell. Despite positive changes in eco data in May and June, Powell said that significant uncertainty continues to reign in the prospects for economic recovery.

Translating this into the language of concrete actions, the Fed may soon begin to target the yield curve – affect government bond market in such a way that the price of bonds of some maturity (medium to long-term) will fluctuate in a narrow band. In other words, control their yield. Decreased uncertainty about medium and long-term rates should boost lending for respective terms. Today we expect release of the Minutes of the past Fed meeting, which should shed light on intentions of the US central bank to further ease monetary policy, including targeting the yield curve.

In this regard, gold has a room for appreciation above $1800 because it becomes increasingly clear that the Fed will ease more depressing yields further.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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How Long will the Fed Keep Interest Rates low?
The minutes of the Fed meeting in June showed that officials want to give more certainty to investors about the path of interest rates. More specifically, the Central Bank is exploring the possibility of “tying” low interest rates to some goal, like achieving certain macroeconomic goal. For example, keep rates at current level until unemployment drops to 4%. This idea is not new and is similar to a pledge to keep rates low until inflation reaches some target, but we can say now that officials want to make a stronger statement.

For the US dollar, such Fed stance is clearly a downside risk, since by tying the policy to a macroeconomic event, the Fed loses opportunity to respond flexibly to the “unforeseen” accelerated recovery of economic activity (as it usually does). Of course, we have to take into account monetary policy of other central banks. Dollar decline will be more pronounced if other central banks choose to remain flexible and less categorical (i.e. less dovish) in their guidance for markets.

US crude oil stocks declined 7.1 million barrels, beating forecast of 0.71 million barrels, showed the latest report from the EIA. As oil prices continue to drift into profitable zone for US oil producers, they have more incentive to increase output, hence reduction of stocks could be achieved due to the outflow of oil from the inventories exceeding inflow. In other words, oil demand in the United States can be recovering faster than production, which is essential sign of expansion. Oil prices advanced by 1.5% on Thursday thanks to the positive EIA update and are likely to extend gains, pricing in expectations of more signals that the US economic recovery is gaining traction.

Sweeping reaction by the European government to prevent spillover from falling incomes on consumption seem to have been crowned with success: retail sales in Germany rose 3.8% in May against the forecast of -3.5%. Government countermeasures to retain jobs apparently were also successful – the number of unemployed increased by 69K in June, beating forecast of 120K.

Unexpected pickup activity of the manufacturing sector in the United States prompts us to revise outlook of recovery in manufacturing sector as well. ISM production PMI rose to 52.6 points in June, Markit PMI – to 49.8 points. Both indicators beat forecasts.

There was a little disappointment in the ADP jobs report, which estimated gain in jobs at 2.369 million with a forecast of 3 million new jobs. Government schemes to avoid layoffs in the form of cheap liquidity sources like PPP loans which helped to offset declining sales volume on demand for labor contributed significantly to the boost in employment in May.

All states in the US continued phasing out lockdowns in June, so it’s reasonable to expect that while this process continues, the number of jobs will increase. Given the available information about the quarantine removal process, even big surprise in jobs count may be discounted by investors, although markets may not be ready for a weak report. Payrolls are expected to show 3.5M gain in June.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 76% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 

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June NFP report: Returning Workers Back is one Thing, it’s Another Thing to Keep Them
So yesterday we saw another big surprise in the US macro data: June Payrolls jumped 4.8M (3.2M exp), unemployment fell to 11.1%. However, these two indicators do not reveal the whole picture. It should be borne in mind that 31.5 million people continue to receive benefits, and the number of employed is 15M lower than in February. In addition, as some states began to partially reinstate lockdowns, numbers in July may be worse.



The report did not make a serious impression on the market, as the states continued to remove lockdowns in June and this process naturally leads to reopening of firms and return of workers back to work. Therefore, it’s more correct to talk about restarting old jobs. However, returning workers to their workplaces is one thing, it is another thing to keep them with a reduced sales volume. Time will tell.

Even after strong job growth in June, employment in the US economy is still lower than the February level by 14.66 million. Extended unemployment benefits cover the income gap, but this scheme will be valid only until July 31, and it is unlikely that these 14.66 million will return to work by August. As a result, some shock of consumption is a time bomb for the US economy.

Unemployment fell from 13.3% to 11.1% but given that more than 31 million people continue to receive benefits, the official figure may underestimate the true number of unemployed.

The hotel industry and leisure made the largest contribution to payrolls (+2.088Mjobs), retail grew by 740K, education and healthcare added 568K jobs.

“Sticky” initial and continuing unemployment claims in the last week of June is also worrying development. Initial claims again increased more than forecast (1.425M with a forecast of 1.35M), continuing claims remained at 19.2M with a forecast of 19M, slightly higher compared to the previous week:



Homebase data indicates gradual increase in layoffs in small businesses. Some of them could take advantage of PPP loans (which the government basically agreed to forgive) and now, after they spent the money, they decided to start firing staff. According to the National Federation of Independent Enterprises, 14% of respondents said they used the loan, but they would have to start firing workers because demand has not recovered to the level before the coronacrisis. The data once again points to the importance of the wage protection program offered by the government in containing a wave of layoffs. It is obvious that state support is effectively delaying the onset of true fallout from the lockdowns and it’s really hard to predict how far in this direction the government can go.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 76% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
 
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