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Atlanta Fed Lockhart Ambiguity And GLD

Summary Lockhart will be a new voting FOMC member this year and his first speech of 2015 starts off with a bullish note which justifies rates normalization. Strategic ambiguity of rate hikes in the middle of the year and Lockhart worries about mixed signals in first half of 2015. On mixed reading and to be on the safe side, Lockhart will advocate a later FOMC rate hike and downplays the importance of actual rate hikes. Lockhart concedes that the FOMC Majority view of liftoff date might be earlier than his preference and is willing to be different. GLD short position should be pared down on increased uncertainty over the outlook on FOMC tendency and supported by recent GLD price direction. Changing FOMC Landscape The shortcut in investment is to ask for an answer as if these answers are pre-determined at the back of the textbook. This is the path towards mediocre investment results at best, losing investment results at worst. The investment landscape is fluid and ever changing. The best example would be the Federal Open Market Committee (FOMC) which would be deciding on the first liftoff of Federal Funds Rates and the market consensus would be in the middle of 2015. The FOMC has emphasized again and again that the exact date of liftoff are data dependent. The general market agreement is that the recovery since 2009 to 2014 has been excellent in the United States and the data dependent refers to U.S. economic data for the first half of 2015 given the soft global growth conditions. Another change for the start of 2015 is the changing voting members of the FOMC itself. The regional presidents of Dallas, Minneapolis, Cleveland and Philadelphia will make way for the regional presidents of Chicago, Richmond, Atlanta and San Francisco. Lockhart Bullishness and Support of Rates Normalization In this article, we will focus on the recent speech of Atlanta President Dennis Lockhart given to the Rotary Club of Atlanta on 12 January 2015. As he will have a deciding vote in the FOMC this year, this speech adds on a new significance and his opinions matter more now. His opinions are not easily discernible from his speech and it contains both hawkish and dovish elements in it. Both sides will be presented in this article and I will leave it to readers to decide for themselves before I present my opinion and recommended actions. It has been said that everyone is entitled to their own opinions but not to their own facts. At the beginning of this speech, Lockhart mentioned the strong recovery of the U.S. from 2009 to 2014: As I look back on 2014 and look ahead to 2015, I can comfortably assert that, more and more, the U.S. economy is hitting on all cylinders. The recovery that began in 2009 is well-advanced, and we are getting closer to a point where the Fed’s Federal Open Market Committee (FOMC), the body that formulates monetary policy, can begin a process of normalizing the interest-rate environment. That process will begin with so-called “liftoff”-that is, the first increase in the policy rate. (click to enlarge) Lockhart’s assessment can be backed up from the chart above. The United States GDP growth is indicated by the solid line and the left hand side growth scale while Europe is represented by the dotted line and the right hand side growth scale. The U.S. growth is strong by itself as seen from the -6% recovery in the depth of the crisis to 5% for the third quarter of 2015. The full year growth for 2014 is expected to come in at more than 4%. Europe in contrast dropped by almost -3% and its growth is still below 1% in 2014 after 5 years. Strategic Ambiguity of Actual Rate Hikes While this forms the basis for the normalization of interest rates by the Fed, we are still unsure when the actual liftoff date will be and on the pace of the increase of interest rates. The pace refers to whether the next increase will be the normal 25 basis points or will the FOMC surprise the market with a 50 basis points increase. This is not addressed in Lockhart speech but interested readers can refer to my 2 part articles, here and here . Lockhart speech does give us a time frame for his expected next rate hike which he deploys the use of strategic ambiguity purposely in the quote below: If that is indeed the case, I believe the first action to raise interest rates will in all likelihood be justified by the middle of the year. The phrase “middle of the year” is admittedly not very precise. That’s purposeful on my part. This would represent the mid point of his desired window of the next rate hike from the 16-17 June 2015 to 28-29 July 2015 meetings. However, Lockhart has made it clear that this is not entirely clear as it would depend greatly on the ‘noise’ or mixed reading in the market. He has made it clear that even though he sees that the market has made a strong recovery at the very start of the speech, he is not keen to jump start the liftoff unless he has a clear picture of the recovery in the first half of 2015. This would mean that the economic data for the first 3 months of 2015 will be crucial to Lockhart given the time lag of economic report which can be from 1 to 2 months. Lockhart’s Slightly Dovish Tendencies If the economic reading remains to be mixed or ‘noisy’ as he calls it, then he will be tempted to delay his vote until the third quarter of 2015 or further. Indeed he downplayed the importance of the actual month of the liftoff taking the long term view that over the long term, the actual date of the liftoff wouldn’t matter. If Lockhart started his speech on a bullish note cheering the recovery of the economy ever since 2009, he ended with a slightly dovish note, he noted that there are economic fundamentals that are not yet resolved despite the economy recovery. The economic recovery did not fully address the issues of long term fiscal challenges, the strength and prospects of the workforce, skill, capacity and health of the workforce (which may explain the falling wage pressures despite the drop in unemployment; more people are finding work in low skill and lowly paid jobs), infrastructure quality and innovation funding. While Lockhart acknowledge that these challenges are beyond the reach of monetary policy, monetary policy has a role to play to facilitate the recovery of these economic fundamentals. To me, this is the most dovish aspect of Lockhart’s speech. Of course, these economic fundamentals do not have direct connection with the Fed’s mandates of price stability, maximum employment and financial stability. The primary gauge for price stability is the inflation figures, unemployment rate for maximum employment and the lack of bad news for financial stability. Of course, the Fed can use wage pressures to force up inflation and we will be in for a long period of accommodation but this will put a strain on its financial stability mandate. In its recent December 2014 press conference, the Fed has made it clear that they are willing to wait until 2017 to reach their 2% inflation target. Hence it would appear that even when the Fed is urging patience in its next rate hike, it is also showing patience in achieving its inflation target. FOMC Majority View This is repeated again in Lockhart speech in a slightly different form: The key liftoff decision criteria ought to be closely linked to the FOMC’s two principal policy objectives-maximum employment and low and stable inflation. In my view, the biggest factor influencing the actual timing of a liftoff decision should be the Committee’s confidence that these objectives will be achieved in an acceptable timeframe and, especially, that inflation will move at deliberate speed toward the target of 2 percent per annum. Lockhart is aware that his view on the timing of the liftoff may be different from the majority view of the FOMC. Influential members of the FOMC such as FOMC Vice Chair William Dudley and Fed Vice Chair and FOMC Member Stanley Fischer had indicated last month of their more bullish outlook for the economy. Conclusion and Investment Action My conclusion is that Lockhart is signaling a slightly less bullish tendency to hike rates overall despite his bullish opening statements to his speech. The first quarter of 2015 will be crucial to his decision to raise rates in the June and July 2015 FOMC meetings. We saw a record of 3 dissents in the December 2014 meeting by the regional presidents of Dallas (Fisher) and Philadelphia (Plosser) in the bullish camp and Minneapolis (Kocherlakota) in the dovish camp. All 3 regional presidents will be rotated out of the FOMC this year and will lose their vote. The upcoming FOMC leanings are still unknown and we will know soon on 28 January 2015. Given the uncertainty of the FOMC leanings and this slightly dovish but unclear tendency of this new FOMC voter, one should stay on the sidelines until there is clarity from the FOMC meeting later this month. The SPDR Gold Trust ETF (NYSEARCA: GLD ) is heavily influenced by the FOMC meeting as a gauge of the direction of further inflation trends. GLD is used as a inflation hedge and it will likely appreciate when there is threat of higher inflation. Europe is in the edge of deflation and it remains to be seen that Japan will be successful in fighting deflation. The only major source of inflation would come from the United States and the Fed has indicated its willingness to endure below target inflation until 2017. The case for a bearish GLD comes from the tightening of the Fed rates which will increase investment cost and reduce inflation. Although we know that the FOMC will raise rates sooner or later, it is the timing that will affect the short term price action of GLD. Although my view slightly biased towards earlier, this speech has pushed it slightly to later. Hence the more prudent approach will be to wait and watch the next FOMC by the sidelines for more clarity before deciding our next move. (click to enlarge) We can see the market uncertainty in the price of GLD as seen in the chart above. We have seen nascent strength in GLD in the past 6 trading days. This could represent the market pricing in the possibility of a later rate hike than the June 2015 rate hike with the possibility of third or fourth quarter rate hike. This could also mean that GLD is ranging in uncertainty as it awaits new trading signals. GLD remains the best instrument to trade the price of gold despite critics disillusion with GLD by pointing out on the red flags in its prospectus with regards to audit issues which has been repeatedly mentioned in the comments page in my past articles. GLD has a market capitalization of $28.08 billion and last daily transaction volume of 8.3 million. This is the most liquid equity on the New York Stock Exchange that you can find for trading fluctuations in gold prices. For investors who have accumulated short positions on GLD from my previous opinion pieces, this is the time to pare them down until further clarity can be found at the end of the month.

QGBR Is An Interesting ETF For Foreign Exposure

Summary I’m taking a look at QGBR as a candidate for inclusion in my ETF portfolio. The expense ratio relative to the diversification within the ETF is not very good. The extremely low correlation with other major funds (like SPY) is great, but is probably just the result of poor liquidity distorting trading data. Low volume makes commission free trading on the ETF a requirement to even consider it. I’m not assessing any tax impacts. Investors should check their own situation for tax exposure. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the SPDR® MSCI United Kingdom Quality Mix ETF (NYSEARCA: QGBR ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. What does QGBR do? QGBR attempts to track the total return of the MSCI UK Quality Mix Index. Normally at least 80% of the assets are invested in funds included in this index, but there appears to be some leeway under unusual market conditions. QGBR falls under the category of “Miscellaneous Region”. Does QGBR provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. I start with an ANOVA table: (click to enlarge) The correlation is only 32%, which is incredible for modern portfolio theory. Extremely low levels of correlation are wonderful for establishing a more stable portfolio. However, this may reflect the poor liquidity distorting the reported closing price. Standard deviation of daily returns (dividend adjusted, measured since June 2014) The standard deviation is fairly acceptable. For QGBR it is .8570%. For SPY, it is 0.7232% for the same period. SPY usually beats other ETFs in this regard, so that is not a major concern. Major risks The ETF suffers from absurdly low volume. The average volume at times is less than 500 shares per day, which is a major liquidity risk. Investors needing liquidity should avoid this risk. Going through the closing values on a day by day basis shows the problem is even worse. It was very common for the closing value to be identical for several days at a time. While it is possible that shares were traded at that price, it is also possible that this represents a day in which no shares traded hands. The resulting value for the daily return, 0.00%, could cause the standard deviation and correlation that are calculated to be substantially less than the real values. Investors need to be aware of this risk when considering the security. I plan to rebalance my ETF portfolio frequently, but the funds will be in a retirement portfolio that I will not have access to for a long time. Investors that need more liquid securities should avoid this market. Mixing it with SPY I also run comparisons on the standard deviation of daily returns for the portfolio assuming that the portfolio is combined with the S&P 500. For research, I assume daily rebalancing because it dramatically simplifies the math. With a 50/50 weighting in a portfolio holding only SPY and QGBR, the standard deviation of daily returns across the entire portfolio is 0.6429%. With 80% in SPY and 20% in QGBR, the standard deviation of the portfolio would have been .6538%. If an investor wanted to use QGBR as a supplement to their portfolio, the standard deviation across the portfolio with 95% in SPY and 5% in QGBR would have been .7019%. Why I use standard deviation of daily returns I don’t believe historical returns have predictive power for future returns, but I do believe historical values for standard deviations of returns relative to other ETFs have some predictive power on future risks and correlations. Yield & Taxes The SEC yield is 3.21%. That appears to be a very favorable yield. For retiring investors the yield may be tempting, but remember that this is not a very liquid security. I’m not a CPA or CFP, so I’m not assessing any tax impacts. Expense Ratio The ETF is posting .30% for an expense ratio. I want diversification, I want stability, and I don’t want to pay for them. The expense ratio on this fund is a tiny bit higher than I want to pay for equity securities, but not high enough to make me eliminate it from consideration. Market to NAV The ETF is at a .91% premium to NAV currently. Premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. I would only consider using this ETF with limit orders and no commissions on trading. Largest Holdings The diversification within the ETF is pretty bad. There were 7 companies that were each more than 3% of the total holdings. Diversification costs money. I want the expense ratio to be covering the costs of acquiring a more diverse set of securities. (click to enlarge) Conclusion I’m currently screening a large volume of ETFs for my own portfolio. The portfolio I’m building is through Schwab, so I’m able to trade QGBR with no commissions. I have a strong preference for researching ETFs that are free to trade in my account, so most of my research will be on ETFs that fall under the “ETF OneSource” program. I’m interested in QGBR because of the very low correlation, but I’ll need more data before I feel comfortable coming to a conclusion. My general premise at this point is that the stock is so absurdly illiquid that the statistics are substantially misleading it. I think investors should be very wary of buying into any assets with such a painfully low level of liquidity. Before investing, I would probably record the bid-ask spreads at several times throughout the day on several days and compare those values to the NAV at the end of the day. I might consider a small position in the ETF, but even with no liquidity needs I would want to make sure I didn’t get taken for a ride on the entry price. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.