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US Retail sales join Chinese data to hint about early stage of global recovery
US retail sales unexpectedly recovered in March at the fastest rate in a year and a half, offsetting a gloomy February with the fall by 1.7%. As the March data shows, the structure of aggregate consumption saw exceedingly favourable shift, namely, consumers spent more on car purchases. This rebound could point to the improvement in household expectations regarding the size and stability of future income, but still with only one observation such a conjecture remains a shallow speculation. Although car sales tend to be volatile by nature and thus considered unreliable, the positive monthly change in March comes right in time to support the assumption about rebound of economic activity in the second quarter.



However, in January, car sales pulled consumption down, apparently due to seasonal exhaustion after New Year’s spending.

Broad retail sales indicator rose by 1.6% in March compared with February. Core sales also rose adding 1%.

From the interesting details of retail sales report, it can be noted that all four of the largest items of consumer spending posted an increase compared with the same month last year and February:

  • Cars and spare parts – + 3.8%
  • Food and drinks – + 1.0%
  • Restaurants – + 0.8%
  • Online purchases – +1.2% and +11.6% compared with March 2018.


Positive data further attracted buyers to the dollar, after the US currency went into the lead against the main opponents during the London session on Thursday:



Unemployment in the US is likely to continue to test historical lows in April, as shown by unemployment benefits data. The number of initial claims for benefits has dropped to its lowest level in 50 years (192K) and it is completely unclear how this fails to translate into the consumer inflation.

Large downward risks to the American economy, hovered in the air, are fading from view. Given that the data from China indicated fast recovery, the trading theme of the next week should be “the search for yield”.
 

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Why is backwardation possible in the futures market?
In one of my recent articles about the oil market, I stated that the withdrawal of waivers for consumers of Iranian oil could lead to a compensating effect on the part of the US supply, which the latest API report on commercial reserves in the US seemed to reflect. In the weekly report dated April 23, the API estimated the growth of reserves at 6.9M barrels with a forecast of -3.9M barrels, which naturally forced buyers to moderate their appetite. It also called for review of the medium-term consequences of White House “harsh” decision against Iran, which may have muted impact on the world supply considering rivalry between US producers OPEC and Russia.



The growth of US stockpiles occurs against the background of “ugly” futures price curve for US manufacturers where contracts for more distanced delivery are cheaper than contracts for the near term (state of backwardation). In this state of the market, it seems that it would be more profitable for American producers not to accumulate reserves, but to sell oil on the spot market, which should lead to a decrease in reserves and, accordingly, their ability to influence futures prices.

Within the framework of non-arbitrage theory of pricing, with deterministic rate and not counting storage costs, futures price is simply an expression of the opportunity cost of holding money (that is, a reflection of lost profit between investing now and in the future):



Where F and S are futures and spot prices for a good at time t, r is a continuously compounded interest rate. The question naturally arises about the possibility of F < S, i.e. backwardation, because then the interest rate r must be negative, which looks impossible.

This, at first glance, contradiction is resolved through an analysis of the state of current vs. future reserves of the good. In the context of contango, when stocks are now higher than in the future, the owner of the goods has a low incentive to sell the goods now, i.e. expects price to rise in the future. In this case, F> S. However, in the case of low stocks now, and expectations of their increase in the future (lower price in the future), i.e. in the state of backwardation, the so-called convenience yieldarises – an implicit yield, which I would call the “opportunity cost of selling a scarce commodity”. It should also be noted that if during contango the deficit in the future can be filled through the increased sale of futures contracts, in case of backwardation, you can’t borrow supplies from the future using derivatives. Accordingly, the futures price formula is correct with additional term:



Where c is convenience yield, which can be expressed as an advantage in the form of maintaining current customer satisfaction (since the amount of the is scarce on the market!), ensuring uninterrupted supply, or expecting for an increase in demand for the good on the spot market, etc.

The IEA’s announcement on Tuesday effectively downgraded the value of retiring Iran from the competitive market, stating that world reserves are adequate to demand, and spare global oil production capacity is currently sufficient (to counteract the supply shocks).

Most of the new supply comes from the United States, where crude oil production increased by 2 million barrels from 2018 to 12 million barrels, making the US the largest oil producer, leaving Russia and Saudi Arabia behind. The IEA predicts that in 2019, oil supplies from the United States will increase by 1.6 million barrels.

One sign that US is gradually taking over OPEC’s share was recent delivery of the first tanker to Indonesia, a major Asian oil consumer which was a traditional OPEC customer.
 

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South Korea: World Growth Must Wait!
One of the brightest stars in terms of global growth unexpectedly faded, with South Korean GDP falling by 0.3% in Q1. Posting its worst performance in almost a decade:



The economy grew by 1.0% in Q4, 2018 alongside an expected a rebound of 0.3% in the subsequent quarter. Hopes were dashed however due to weak foreign demand for South Korean exports and diminishing domestic consumption. Retail sales declined sharply in February due to the early celebration of the Lunar New Year. Apart from the seasonal factor however, there was also a structural weakening when compared to the average value for January-February with the same period last year.

When assessing the implications for the global economy, it should be noted that the country exported fewer semiconductor elements, refined petroleum products and passenger cars. Exports declined in February and fell short of forecasts in March, indicating a continuing trend towards weakening external demand during these two months. Sources of weak foreign demand arose from the largest trading partners, such as China, USA, Hong Kong and Japan, which is all well documented in their domestic data. Channels of transmission foreign demand slack into domestic consumption were capacity utilization, which contracted in March, deterring from expansion on business investments, as well as an increase in the ratio of inventories-to-shipments of the exporters.



Source: Korean Development Institute

Industrial production in February fell by 1.4% MoM, the service sector showed zero growth. In the medium-term trend, assessing the change in indicators in annual terms, the situation also looks alarming. Waning momentum in manufacturing and mining arose became especially distinct in early 2019 while the services sector has been stagnating for a long time.



Shares of companies producing semiconductor elements, amid the decline in exports, raise doubts about the rationality of valuation, as the price is rising while EPS falls:



The South Korean government has pledged to increase fiscal momentum with an additional package of spending of $5.9 billion, in addition to the record budget set for 2019. According to their calculations, this will lead to additional GDP growth of 0.1% and creation of 73,000 jobs. With the failure of the first quarter, the government’s targets for 2.6% to 2.7% GDP growth are beginning to look excessively ambitious, unless, of course, a miracle occurs in export activity.

The country, with a high share of economic and implicit political power belonging to industrial conglomerates called Chaebol, ranks 11th in terms of the size of the economy and has been growing at one of the highest rates after the Great Depression.
 

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Fight fire with fire: Chinese banks issue more loans to combat effects of bad debts
After a crushing blow inflicted by Google (shares fell by 6% on the earnings report) Nasdaq futures suffered from additional pressure after Chinese PMI report release, which showed that manufacturing activity in April failed to develop the March impulse.



The rebound in March set the stage for expectations that Chinese economy will enter the second quarter with the claim on recovery after dismal winter, but April data were a big disappointment. Both productive and services sector have torn the groundwork of March, broad activity indices decreased from 50.5 to 50.1 and from 54.8 to 54.3, respectively. The estimate of production activity from Caixin, which adds more weigh to small enterprises in the index formula, also decreased from 50.8 to 50.2 points, contrary to the forecast of 50.9 points.

The decline embraced all components of the index what brought additional damage to hawkish beliefs on the markets. The leading index of new orders declined slightly, remaining in the expansion zone. However, the index of new export orders fell below 50 points, indicating a cooling in external demand.

The output component fell along with the urban unemployment component. In March, the unemployment rate navigated to the 74-month low, before the labor market cooled in April. The inventory index returned to negative territory, the goods delivery time index strengthened, indicating an acceleration of capital turnover for producers.

The pressure in prices of manufactured goods and other costs declined showed corresponding index, which of course means a less favorable outlook for consumer inflation. The balance of incentives for tightening vs. additional credit easing for the Chinese government should remain at the same level, or perhaps slightly shift in favor of counter-cyclicality (more easing).

A wait-and-see attitude may not be completely comfortable to the government when taking into account curious fact that the weak economy in 1Q, the massive infusion of liquidity (4.6 trillion yuan in January) coincided with increased ratio of bad loans to the highest level almost for three years:



At the same time, despite the slowdown in the economy, which is usually accompanied by the reduction of attractive borrowers and the growth of defaults, Chinese banks, in unison with the Central Bank, almost doubled the issuance of loans in the first quarter compared to Q4 2018:



A brilliant example of what a low level of independence in the decisions have large Chinese banks. Fight fire with fire!

The lagging of China’s banking sector shares from the ShComp broad index (19% vs. 23% YTD) may just be a concern about the increase of bad loan provisions, which, of course, will have a negative impact on EPS.

According to a survey by China Orient Asset Management (one of four state-owned companies managing bad debts), 45% of the 202 surveyed managers of Chinese banks believe that bad loans will update the record in 2019.

The implications for the rest of the world are the implicit boost to risk appetite due to the fact that the Chinese economy should remain afloat, because quickly stopping support for banks, drowning in bad credit, can be hardly included in the government plans.
 

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More than simply a trade truce
The signs of softening stance of the White House in talks with China before the two leaders met at the G-20 summit (Trump’s phone call to Xi, reports about “extended ” meeting), to the general surprise, were not empty speculations, but a forerunner to extending the truce. The results of the meeting between Trump and Xi set a new vector of cooperation between the two states, as Trump accepted some Chinese demands, such as extending pause in tariff escalation and easing of pressure on Huawei. Markets welcomed this decision by increasing the demand for risky assets, the dollar strengthened, the yield on 10-year notes rose, and SPX futures began trading with a positive gap at around 2975 points.

And if the tariff truce was within the range of expected scenarios, then the removal of some restrictions on Huawei prompted China to return to the negotiating table, which considered attacks on the Chinese telecom giant as forcing to negotiate with a “gun pointed to its head”. China, in exchange for easing sanctions on Huawei agreed to increase purchases of agricultural products in unspecified amount. Its manufacturers in the United States suffer huge losses, hit by the millstones of the tariff war.

The chance of a rate cut by 50 bp in July keeps declining, according to futures trading with interest rate as an underlying asset, but the market remains confident that the Fed will lower the rate in July by at least 25 bp.



Asian stock markets got the biggest relief from the Trump-Xi decision. The Japanese Nikkei jumped by 2.1%, the Chinese CSI 300 by 2.6%, as the pause in the exchange of tariffs will allow firms to expand the horizon of production planning, which should add confidence to Chinese firms in decisions to boost hiring and capital investments.

The official index of manufacturing activity in China fell to 49.4 points in June, remaining in the contraction territory for the third month, the data showed on Monday. The activity index of China’s factories, calculated by Caixin, dropped to 49.4 points, the worst since January of this year. Manufacturing PMI includes several sub-indices, such as output, new orders, input and output prices, delivery time of raw materials by suppliers, inventories, employment, etc. Despite the decline in the component of new orders (from 49.8 to 49.6 points), and hiring (from 47.0 to 46.9 points) the positive part of the report was a rebound in activity of small enterprises from 47.8 to 48.3 points:



Recall that small enterprises in China endured greatest pain from the tariff war since the combination of slowdown in growth and credit crunch led to credit tightening especially to this type of firms. Banks are willing to lend to large enterprises, seeking to maintain “healthy” assets on the balance sheet because of increasing probability of default by corporate borrowers. By this, they effectively block the channel of cheap liquidity opened by the Central Bank, intended for small firms.

It is not known whether the Chinese authorities will keep pause before new stimulus measures (favoured by the outcome of the Osaka meeting), but with the deterioration of the manufacturing sector, the likelihood of expanding support measures is increasing, which should support risk appetite not only in the Chinese stock market, but also abroad in the form of lower demand for “safe havens”.

European data increased pressure on the euro. Activity indices in production in Italy, France and Germany continued to fall. Unemployment in Germany fell by 1K, the unemployment rate in the Eurozone fell more strongly than expectations to 7.5%. EURUSD is heading to 1.13 level, losing almost half of percent today.
 

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Saudi Arabia Under Pressure as the “Oil Market Goes Green”
Oil prices renewed their decline, maintaining the bearish tone set on Monday. US producers are gradually resuming oil production in the Gulf of Mexico after Hurricane Barry, in what serves as the basis for downbeat expectations for API and EIA inventory updates this week.

The rebound of Chinese economy in June, particularly in industrial production and retail sales, left a light imprint of buying activity in oil prices on Monday. However, it failed to gain a foothold, as the forecast for global economic growth (and therefore oil consumption) remains flimsy. This is further evidenced by the dovish stance of the ECB and Fed, ready to combat recession, while American oil producers are ramping up production, maintaining concerns about the glut.

On January 1, 2020, the International Maritime Organization will enforce new standards for ship fuel, designed to significantly reduce emissions of harmful gases into the atmosphere. This will be one of the biggest shifts in the oil market, as ships burn about 3 million barrels of high sulfur oil every day. These new standards will obviously create an excess of “dirty” fuels on the market and increased demand for standards-compliant fuels.

The allowable sulphur content is planned to be reduced from the current 3.5% to 0.5%. The average sulfur concentration now stands at 2.7% with a very low percentage of ships currently sticking to the new emission norms. The profits of refineries that focus on refining dirty oil will be under pressure, and this is especially true for companies in Saudi Arabia. Below is the matrix of oil grades in two ways – by density and sulfur content:



Also, for ships that are not going to switch to clean fuel, it is possible to use special installations that reduce the content of harmful substances in emissions.

The market is also under pressure due to discouraging reports from the EIA, which sees no end in sight to the potential for growth in US oil production. According to the latest forecasts, production in seven major fields will grow by 49K in August to a record 8.55 million barrels per day. The total production in the United States now exceeds 12 million barrels and is expected to rise further.



On Monday, the volume of suspended capacity in the Gulf of Mexico was 1.3 M barrels per day. On a selected day from Sunday to Monday, producers restored production to 80K barrels per day however, the recovery rate is expected to increase. Capacity utilization on some platforms reaches only 31%. Workers of more than 280 drilling platforms were evacuated but they are expected to return to their jobs in a few days after the storm leaves the region.

Risk Warning: Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.
 

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US and Vietnam: from “Best Friends” to Trade Rivals?
Next possible leg of the trade war may affect countries that have emerged victorious at the expense of first victims. This assumption is explained by the fact that losing the accumulated trade and economic advantage is more expensive for any economy than simply missing it out – and Trump understands this perfectly well. Already very attractive for the US president is the ability to knock out concessions from China’s small neighbour, Vietnam, which is seen as one of the main beneficiaries of the transformation of the supply chains in the trade between the US and China:



Trump just needs to make a threat, but can Vietnam avoid this or a new trade front with an East Asian country is only a matter of time?

First, it is worth remembering that in May, the US Treasury Department included Vietnam in the list of potential currency manipulators, which gives Trump a formal pretext for imposing tariffs on Vietnamese goods if the fact of deliberate devaluation is proved. This threat has already led to the introduction of 400% of the tariffs on steel imports from Vietnam, which was produced in South Korea or Taiwan. Thus, the role of the country as an “unwitting accomplice” is being blocked, also serving as a warning that the connivance of the authorities will be punished specifically with tariffs on Vietnamese goods.

And there is a reason for this. For example, there are allegations that Chinese goods are “rebranding” in Vietnam and exported to the United States under the guise of Vietnamese goods. The rise of exports from China to Vietnam and from Vietnam to the United States indicates that there may be a phenomenon that US officials call “transshipment”:



As can be seen, China’s exports of key goods to the United States have shrunk along the “short route” and have grown along the “long route” through Vietnam.

If the United States introduces 25% tariffs on imports from Vietnam, considering that the severity of misconduct is commensurate with Chinese, then according to some estimates, this could lead to a reduction in export volumes by 25% and a loss of 1% of GDP. The United States continues to be Vietnam’s main trading partner, and vice versa, the share of US exports to Vietnam, especially in terms of agricultural products, has risen sharply:



Last month, Trump stunned the Vietnamese authorities with statements that Vietnam was “the worst abuser in the trade of everybody” and “fairness in trade with Vietnam may even be less than with China.” Back in 2016, after entering the presidency, Trump made similar complaints, but the contract for Boeing purchases of several billion dollars and the trend to strengthen alliances with China’s neighbours, in the opinion of the Vietnamese authorities, have become a reliable dam protecting the country from criticism of the POTUS. But it was not there. Trump expressed discontent with the explosive growth of Vietnam’s trade surplus with the United States, which in the first five months of this year reached $21.6 billion, almost doubling compared to the same period last year.

Several sources claim that Vietnam made several promises to Washington related to trade, and Trump’s recent criticism can only accelerate their implementation. For example, the development of a law on the creation of three free economic zones, which, according to fears of local firms, could go under the control of China, was suspended indefinitely, demonstrating to Washington that the trend of rapprochement with a neighbour was interrupted. Nevertheless, Vietnam is also working on a “spare airfield”, having entered into the Trans-Pacific Agreement (from which the United States left) and signed a free trade agreement with the European Union. Together they can mitigate damage from possible US sanctions.

Thus, the chances of introducing trade tariffs against Vietnam will directly depend on:

  1. Dynamics of transshipment operations, where Vietnam serves as a gasket between China’s exporters and US importers. The lack of repression and conniving routes – loopholes is likely to provoke a new wave of criticism from Trump.
  2. Vietnam surplus with the United States. The main item of US exports to Vietnam is agricultural products (4 billion dollars in 2018). If purchases will grow at a faster pace, it can be assumed that countries have agreed on something.
  3. Cooperation in the military sphere. In terms of concrete numbers, this should be increased purchases of American weapons and equipment. This should be a more reliable signal of preference for cooperation with the United States to balancing between the interests of superpowers (i.e. US and China and probably Russia).
 

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Market discounts retail sales data focusing on the Fed comments as July meeting looms
Greenback posted surprisingly muted response to strong US retail sales on Tuesday, despite of actual figures printing almost twice higher than the estimates. Some traders went on vacation, the rest opted to focus on the Fed’s comments, so the mix of lowered trading volumes and weakened importance of the “hard data” only helped Dollar to sustain gains slightly above 97 level during the trading session on Wednesday.

Retail sales in the control group grew by 0.7%, more than twice as high as expectations (0.3%), retail sales metrics including/not including goods with volatile prices indicated a steady rise of consumer spending in June. Car sales for the second month in a row make a positive contribution to sales, probably due to a seasonal increase in summer trips.



Powell, speaking in Paris, attempted to refine his subtle guidance to July meeting, keeping market focus on the risks of decline in inflation expectations and their “deanchoring”, fall in market-based compensation for inflation, which require more policy accommodation. At the same time, the Fed opts to discount traditional fundamental data, showing its concern the expectations. Powell’s comments boosted the odds of 50 bp rate cut to 31%.

At the same time, Powell managed to convince the market that the Fed will be able to support inflation. Market-based metrics of inflation expectations have turned into growth from the end of June:



It can be seen from the chart that the main risks are currently perceived to stem from US bilateral trade relations as the inflation expectations tumbled exactly after the announcement of new tariffs on China goods in May. This was also repeatedly stated by Powell. On the other hand, the decline inflation expectations in May could be a market foresight of the new round of credit easing in response to exacerbation of tariff tensions, in which case the Fed turns out to be led, reacting to short-term market whim, instead of spotting genuine trend in the economy.

However, for the late phase of expansion, which the US economy is supposedly in, the “hard” data tends to lag (since crises start with a sharp change in expectations in response to a shock), therefore, the Fed needs to “diversify” the sources of information in order to stick to the proclaimed “data dependency” policy in early 2019.

In my opinion, the rate cut by 50 bp is difficult to consider a commensurate “precautionary measure” in response to economic changes, where retail sales and the labour market are growing at a fairly steady pace. A strong stimulus signal from the ECB next week will reduce the risks of a further “slowdown in growth abroad” (one of the reasons for the Fed’s concerns, along with the trade war), and US GDP data on Friday may contain a positive surprise as shown by NFP and retail sales. All this may limit dollar sales.
 

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Policy Bias in China: Fighting with Credit Leverage or Adding more Stimulus?
A key gauge of the debt burden in Chinese economy exceeded 300% of GDP, the Institute of International Finance reported. Beijing was forced to maintain the trajectory of undesirable debt growth, increasing monetary and fiscal support in response to shocks in foreign trade, weakening foreign demand and activity in production and services sectors. Big tax cuts and following decline in state revenues has led to the need to ease restrictions on the issue of special purpose bonds by municipal governments in order to keep a stable pace of investment in infrastructure projects. This fueled growth of the national debt to 50.5% of GDP in 1Q 2018:



Chinese government increased quotas on the issuance of special purpose bonds by 59% compared with 2018. But in May local governments filled the quota by only 40%, issuing debt at quite an even pace. Recall that such bonds are paid off with the project revenues, and not from the taxes collected. Raising funds for unprofitable projects and higher risk credit on such bonds imply that local governments are risking facing with increase in borrowing costs in case they make an investment mistake.

The liabilities of the three main types of economic agents – the state, firms and households amounted to 303% of GDP in the first quarter of 2019, compared with 297% in the same period last year. The IIF report also showed that the debt burden grew at an accelerated pace in many countries after the trade tensions escalated.

While the authorities’ efforts to combat financing through informal channels (i.e., shadow banking) led to decline in much-inflated corporate debt in the non-financial sector from 158.3% to 155.6%, borrowing in other sectors has increased. Changes in the size liabilities can uncover more underlying processes if divided in four broad components: government debt, household debt, the financial sector, and the non-financial sector. By comparing changes of debt in each sector with the same period last year and the values for given period with safe standards globally, we can try to make a qualitative conclusion about the policy bias: towards fighting leverage or increasing stimulus.

Below is a diagram showing the debt-to-GDP ratio by sector for the first quarter of 2019, as well as a change from the same period last year:



The most rapidly growing debt was household debt (from 49.7% to 54%), and debt in the non-financial sector, which is the “main customer” of shadow money markets, slightly decreased from 158.3% to 155.6%. Three of four sectors (except non-financial one) are having quite safe levels of debt when comparing it with world average. Despite conflicting rumors about the course of fiscal and monetary intervention, Chinese authorities, as can be seen, managed to combine prudently stimulus measures with restrictions on shadow financing (reducing debt burden in the riskiest sector and increase it in those where it is reasonable).

At the same time, the value of China’s total debt in absolute terms exceeded $40 trillion dollars, which is almost 15% of the global debt.
 

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Fed Williams’ “Brilliant Failure” in Communication Sparked jolt on the Markets
After it became clear that the Fed is going to cut rates in July, market expectations had a room to develop only towards the most bearish outcome (50 bp cut), pressuring dollar and pushing safe heavens and bonds higher. Yet another run-of-the-mill John Williams speech on Thursday became a sheer surprise, aiding bearish rumors to thrive with the following “recipe” to combat next recession:

First, take swift action when faced with adverse economic conditions”

“Second, keep interest rates lower for longer.”

And third, adapt monetary policy strategies to succeed in the context of low r-star and the ZLB.”

(it is not entirely clear what Williams meant by adapting).

The first two statements were enough to promptly change the market consensus to the rate cut by 50 bp. However, the Fed representative later issued a statement a la “it was a joke” as the unwelcome jump in market expectations prematurely limited the room for maneuver. There are still two weeks before the FOMC meeting, taking into account the incoming data, the unpredictable Trump, the ECB decision and other events, eventually only 25 bp cut can be justified, which will disappoint markets and cause volatility. These are completely unnecessary policy costs for the Fed and Williams in this regard was too much outspoken and unusually plain in his statements.

Williams sounded so ominous that the odds for 50 bp rate cut jumped from 30 to 70%! The Fed spokesman “ran to the first reporter he could find” to report a communication failure, stating that “Williams recapped 20 years of academic research in his speech. It was not about his views in monetary policy and upcoming decisions” Well, if this is so, then Williams simply has an “outstanding ability” to pick time and topic for speech. Or… was it intended open mouth operation?



As a result, the chances of two outcomes of the July meeting became equal, but the imprint on the foreign exchange market and safe assets remained. Gold reached a five-year high, trading on Friday at around $1,445 per troy ounce, the yield on 10-year US T-notes was down to 2.026%. The reaction of the dollar was less pronounced, a small amplitude of the fall says that there is no place to run. Oil is rising due to exacerbating tensions in the Strait of Hormuz and expectations of the Fed’s easing policy, but one should keep abreast of US negotiations with Iran, the news about which appeared recently. Therefore, the rally in oil prices may be fragile, as it is now due solely to temporary factors. The cryptocurrency market also rose, following the rally in fixed income markets of developed economies, but Congress’s reluctance to share monetary power with the Facebook cryptocurrency project suggests that the legal status of decentralized cryptocurrencies as a fundamental growth driver can be forgotten for the near term.
 
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