January 31, 2016 Reverse Course

Risk/Reward Vol. 293

This will edition is truncated due to the birth of our eighth grandchild, Graham Michael McClement. Mother and son are doing well. Barb and I have had fun caring for his sisters while Amanda and Todd stay with Graham in the hospital. He comes home today.

With the surprise announcement on Friday that the Bank of Japan (Japan's central bank, like our Federal Reserve) is going to charge interest to Japan's money central banks for maintaining excess reserves, the US stock markets skyrocketed on Friday. The Dow Jones Industrial Average and the S&P 500 each rose over 2% salvaging what otherwise would have been a disappointing week. But even Friday's performance could not rescue January. US stock markets suffered their worst month since 2009.

So why did the BOJ announcement have such a whopping impact on US markets? Here is the answer. The move by the BOJ will encourage its large, money center banks to reduce the amount of funds held in reserve and to lend those reserve funds to customers at low rates. After all, charging any rate of interest is better than paying interest to keep money in reserve.. With the BOJ joining the European Central Bank and other central banks world wide in charging as opposed to paying interest on excess reserves (like the Federal Reserve does) pressure will mount on the Federal Reserve to reverse course and to either postpone its scheduled quarterly 25 basis point rate increases in 2016 or, even more drastically, to reverse the bump in rates that it implemented in December. If it does not reverse course, the Fed will be out of step with every other central bank. This would cause the value of the dollar to rise in relation to other currencies; hurting US exports and lessening even further the consumption of oil which is denominated worldwide in US dollars. If the Fed does reverse course, it will cheapen the cost of credit. Cheap credit encourages corporations to borrow money which they have used in recent times to fund stock buy backs. Stock buy backs buoy stock prices. The stock markets rose on Friday in anticipation of the Fed reversing course.

Adding to the stock market rise was news on Friday that the crude oil rig count in the US fell again last week. The number of rigs has fallen 68% since the high mark reported in October 2014. Fewer rigs means lower production, and lower production means higher prices. Thus, oil futures rose. As noted last week, recently, higher oil prices have equated to higher stock prices. In the past 20 trading days there has been a 95% correlation between the price of crude and S&P 500.