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Novum Alpha - Daily Analysis 25 May 2021 (10-Minute Read)

A terrific Tuesday to you as the threat of tough taxes gets taken down by congressional Democrats wary at alienating voters in the runup to the 2022 midterm elections.


In brief (TL:DR)

  • U.S. stocks closed higher on Monday, with the blue-chip Dow Jones Industrial Average (+0.54%), S&P 500 (+0.99%) and tech-centric Nasdaq Composite (+1.41%) all higher and investors rotating back into tech stocks which had been previously oversold.
  • Asian stocks climbed Tuesday after technology shares spurred a Wall Street rally as Federal Reserve officials tried to soothe concerns about inflation.
  • The U.S. 10-year Treasury yield edged up to 1.61% (yields generally rise when bond prices fall) as risk appetite returned. 
  • The dollar was stable following a retreat.
  • Oil rose with July 2021 contracts for WTI Crude Oil (Nymex) (+0.29%) at US$66.24 after Iran said that gaps remain in negotiations aimed at reaching a deal to end U.S. sanctions on its crude.
  • Gold dipped with August 2021 contracts for Gold (Comex) (-0.48%) at US$1,877.60 as investors opted for equities. 
  • Bitcoin (+9.55%) rebounded sharply to US$38,785 as trading in the week saw more signs of institutional acceptance, if not adoption of cryptocurrencies while inflows into exchanges slowed (inflows suggest that investors are looking to sell Bitcoin in anticipation of lower prices). 

In today's issue...

  1. What is the Policy Rate and why should you care?  
  2. U.S. Tax Hikes May Have to Take a Hike
  3. Financial Assets Shrug Off Last Week's Cryptocurrency Crash

Market Overview

Turns out that passing legislation, even when you're the President of the United States isn't as easy as it may appear. 
The Biden administration is scrambling to get its ambitious tax and spend program watered down as jittery congressional Democrats eye the upcoming 2022 midterm elections, with fears that its slim majority may be undermined further, especially as taxes are likely to prove unpopular even as the economy is barely recovering. 
In Asia, stocks trumped Tuesday's performance, buoyed by a recovery in tech stocks on Wall Street bag with Tokyo's Nikkei 225 (+0.58%), Sydney’s ASX 200 (+0.71%), Hong Kong's Hang Seng Index (+0.80%) and Seoul's Kospi Index (+0.67%) all up sharply in the morning trading session. 

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1. What is the Policy Rate and why should you care?

  • U.S. Federal Reserve is starting to lose grip over the policy rate and the ability to set short-term interest rates 
  • Threat of policy rate slipping because of massive amounts of liquidity in the financial system means that at some point the Fed will need to consider either increasing rates or cutting purchases, which will be bad for markets accustomed to stimulus 
The policy rate is a short term reference rate set by a central bank, think of it as the soldier that stands in the corner of a parade square, everyone else takes reference from that soldier to form up a marching contingent - the policy rate then is exactly like that.
But more than that, the policy rate also signals a central bank’s monetary stance, a low rate is considered “dovish” and a higher rate is “hawkish,” low rates encourage borrowing, which is generally good for markets, and higher rates indicate tightening monetary policy.
And now that you’re acquainted with the meaning of policy rates, here’s why you should care – the U.S. Federal Reserve is starting to lose control of its policy rate.
With a flood of cash sloshing through the U.S. financial system, the Fed is finding it increasingly challenging to maintain its once tight control of its policy rate.
Short-term interest rates have plummeted to historic lows since the start of this year as financial institutions flush with cash compete to lend it out in ultra-low risk vehicles such as U.S. Treasuries, maturing in the near future, so-called repurchase agreements.
Part of the surge in liquidity is of course due to the Fed’s US$120 billion monthly asset purchase program, where it hoovers up mortgage-backed securities as well as U.S. government debt, the other is a marked shift from safe bank deposits to more risky, but higher yielding money market funds.
The U.S. Treasury has also pulled back on its issuance of short-term U.S. Treasury Bills which mature in one year or less, reducing the supply of a key security used for storing cash that yields more than a bank deposit.  
The Fed has already raised the amount of cash that financial institutions can park with the central bank from US$30 billion to US$80 billion, in order to drain excess liquidity from the financial system and slow the downward drift in short-term rates.
In addition, the Fed could also increase the interest paid to banks on reserves held with the Fed, or increasing the rate the Fed pays in its reverse repo program, both of which could suck some more excess liquidity in the financial system, but when these moves are made, the number of options left behind starts to dramatically decrease.
Demand for safe places to stuff cash has increased so much that the federal funds rate now hovers at 0.06%, well to the lower end of the Fed's target range of 0.0% to 0.25% and some analysts are suggesting that a sustained tick lower to 0.05% could prompt action from the Fed to either ease back asset purchases or possibly even raise rates ahead of schedule.
Either move will not bode well for markets which have been punch drunk on liquidity and gorging on risk.   

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2. U.S. Tax Hikes May Have to Take a Hike

  • U.S. congressional Democrats waver on Biden's ambitious tax hikes, with the likelihood that the tax package will be heavily watered down before being passed 
  • Biden's infrastructure plan as part of a broader tax and spend proposal could hurt Democrats at the upcoming midterms in 2022 and Democrats at risk of losing their seats in shaky districts will recall how many lost their seats when Obama tried a similar tact in 2010 
With midterm elections on the horizon, congressional Democrats are starting to wilt in the face of the Biden administration’s ambitious tax hikes, much to the relief of Wall Street.
Weeks after U.S. President Joe Biden pitched the first major set of tax increases since 1993, Biden’s colleagues in Congress started to waver, as the thought of being voted out at the midterms hangs over them like a dark cloud.
And it looks like Biden’s proposed tax hikes may be watered down regardless, with rumors that congressional staff are already paring down the ideas being floated by the Biden administration and fine-tuning them so that they are workable from both policy and political standpoints.
With some 8 million Americans still out of work, Democrats are worried that their slim majority in the House could come under challenge, especially if Republicans carry the torch of criticizing higher taxes for damaging the nascent economic recovery.
House Democrats will no doubt be thinking about the success the Republicans had in tarring the Obama administration’s tax and spend plans at the 2010 midterm elections, which saw the biggest swing since 1938, and which saw the Democratic majority in the House heavily whittled away.
Fortunately for companies, Biden’s proposal to increase corporate taxes to 28% from 21% has already hit an early roadblock, with moderate Democratic Senator Joe Manchin of West Virginia expressing a preference for 25%.
Talks on a bipartisan infrastructure deal also showed no signs of progress as well last week, increasing the likelihood of a Democrat-only push for Biden’s US$4 trillion in spending and tax proposals.
As is typical in Washington, the final raft of tax hikes will be half-baked, without the teeth that Biden may have intended, but not satisfying the Republicans either, who would rather see the status quo preserved.
That in and of itself would be a victory for investors, with corporate profits less in danger of being handed a heavy tax burden. 


3. Financial Assets Shrug Off Last Week's Cryptocurrency Crash

  • Financial markets globally clocked gains last week, even as Bitcoin and other cryptocurrencies tumbled 
  • Cryptocurrency markets are still too small to have significant spillover effect on financial markets, but broader acceptance may change that dynamic 
While mayhem may have been the order of business in the cryptocurrency markets last week, it clearly didn’t affect the financial markets, reinforcing how early  the nascent digital asset class is in terms of development. 
Even as cryptocurrencies plunged by over 40%, their worst fall since the onset of the pandemic last March, the MSCI global equity index actually edged up last week while U.S. Treasuries and the dollar were largely steady.
And while the market cap of cryptocurrencies is estimated to have plunged by between US$800 billion to US$1 trillion last week, those losses were mostly contained within the digital asset space and saw no spillover into traditional financial markets.
But that should hardly come as a surprise as few traditional investors would have put all their eggs into the cryptocurrency basket.
And in a recent interview with cryptocurrency media CoinDesk, billionaire hedge fund manager Ray Dalio acknowledged that the cryptocurrency market is still very small and therefore doesn’t pose any real risks to the broader markets, yet, adding,
“I think Bitcoin’s greatest risk is its success. Right now, it’s not that big a deal.”
“As it becomes a bigger deal and more of a threat, let’s say people want to sell their bonds and want to buy Bitcoin and they want to do that in a bigger way…they (policy makers) lose control over that, and that’s an existential risk.”
“So, the more we create savings in it (Bitcoin) the more you might say, I’d rather have Bitcoin than the bond. Personally, I’d rather have Bitcoin than a bond.”
Last week, a report from blockchain analytics firm Chainalysis, showed that over half of the US$410 billion spent on acquiring Bitcoin holdings occurred in the past year alone and some analysts are warning that a Bitcoin rout could eventually have wider repercussions on financial markets.
Managing Director of global macro strategy at Medley Global Advisors in New York Ben Emons wrote in a note recently that Bitcoin is “firming its grip on markets through volatility, liquidity and correlation,” adding that the potential for “financial contagion should Bitcoin drop well below US$20,000 cannot be dismissed.” 

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May 25, 2021

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