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2017-10-30 Week - Changing Markets and Central Banks

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This Week

The BOJ will give markets an early taste of the moves to come later in the week.

The FOMC may do something stupid like a surprise rate change. Most likely, however, the language of their statement will indicate that they will gently drain liquidity from the market so that they do not scare the oblivious speculators.

Non-Farm Payrolls may be a catalyst for a move lower. Extreme numbers, especially negative numbers, have caused markets to buy-the-bad-news in the past. This buying has been on expectations that the FOMC will continue to support the market.

The market will now have to face the question:

If the Fed is following a hands-off approach to markets, are bad numbers still good news OR is bad news just bad news? We will likely know by the end of the week.

Changing Markets and Central Banks

Markets are about to change. To survive as a trader, you must be able to recognize when markets are changing and anticipate their moves. Central banks have been in control of these markets for the last 10 years but are about to drain the liquidity from the market. This mountain of money has left a market addicted to the slush fund of central banks. When these banks remove that liquidity, markets are going to change drastically. The only question is then: Soft landing or financial collapse?

Central banks have been pumping money into the system through bond buying programs. The ECB has curtailed their bond buying, and estimates indicate that their balance sheet will be moving negative by 2019. The FOMC is also decreasing their bond buying while letting existing bonds expire. Central bankers act in unison, without independent action. Even China and Russia are shifting assets to hedge against rising interest rates. Without another central bank taking up the slack and providing liquidity, there is no balance in the market, so the move will be to a contraction of the world economy.

Low interest rates take money from those that save and give it to those that risk. This has meant that the super-rich have had cheap credit to invest. This has increased the super-rich wealth exponentially while the rest of the population struggles to pay their rent. Assets like stock and property preform very well in a low interest rate environment because speculation drives demand. In a high interest rate environment, there will be a contraction in those asset prices.

A contraction in cheap money means that business will need to find places to cut costs rather than borrowing their way to higher share prices. Corporations have been able to issue bonds at low rates while buying their own shares to boost the bonuses of the board of directors. But at higher rates, these corporations will not be able to afford the interest on their own bonds which will lower asset valuations. Stock PE will move lower, creating more risk for share prices. As markets contract, real people will be laid off their jobs as companies try to cut staff and expenses to stay afloat. This means that these same companies will be spending less money, further contracting the amount of money available within the financial system.

Corporations will struggle, and likely have mass layoffs before they off-shore their production. Corporations will be moving to lower cost environments (moving overseas) as they struggle to cut input costs. This will take many low end jobs with them, farther depressing the low end of the social-economic spectrum. This will produce more unemployed willing to take lower rates for the same work. As the bulk of population struggle to feed themselves, this will drive rental rates lower and likely collapse car sales numbers as credit becomes harder to get.

This contraction will also drive tax revenue lower, creating more government defaults in struggling urban centers. This will increase the cost of government credit, causing higher bond interest payments. This will then limit government spending on infrastructure repair which will cause infrastructure collapse. This infrastructure collapse will create much higher costs for repair and maintenance which will drain money from these government budgets, farther exacerbating the problems.

The purchasing power of currency (USD/EUR/YEN/etc.) will decrease as hard assets become scarce. Lower labor costs does not translate into cheaper products when most of the manufactured goods come from overseas. Instead, it means that many struggling producers leave the market, which allows for the companies that remain to gouge on prices. This can be seen from the soaring prices of medication because this market lacks competition (and can buy all the legislation it wants). It will soon move to other asset classes like food production.

As interest rates soar, there will be a shift in market leaders. Hedge funds and managed funds will again be able to break even on lower risk investments. Leveraged funds, especially those banking on massive derivatives contracts, will find many counter parties in default which will nullify many of their gains. Banks that have been leverage trading on higher markets will find it harder to make money, so their traders will just take on more risk (it is not their money that they are gambling). This will again necessitate another round of bailouts by the government for companies that are deemed Too-Big-To-Fail.

The market will not collapse this week (most likely), so there is some time to move assets to lower risk investments. As the move starts, it will look like a soft landing is possible; however this is not the case. Leverage is massive in this market, and highly leveraged positions move markets faster than expected. This is especially true in low volume markets (like derivative markets) because when traders panic sell, those on the other side of the trade ride that panic to the ground. As a trader, avoid getting caught in a market with vanishing liquidity but make your counterparties pay hard.

Trading the Changing Market

Here is what I see the new market will do:

- Interest rates will rise. This will increase the cost of borrowing.

- Real estate prices will move lower, especially in overvalued and speculative markets.

- Share prices will drop as money drains from the system. This will start slow and continue lower along a longer time frame. High volatility will occur as markets recalibrate themselves to the new stability levels relative to available funding.

- New car sales will plummet. Used car credit will collapse. This will take many jobs with it.

- Credit default will surge. Debt laden people and corporations will be going bankrupt wiping asset value from the market. This will wash the market will low cost supply of used goods, farther depressing asset prices.

- High risk bonds will default as interest payments outstrip corporate or government ability to pay. This will again see a collapse of risk industries like oil fracking. It will see a collapse of risk market bonds like the PIIGS (Portugal, Italy, Ireland, Greece, Spain), Venezuela, etc.

- Cost of production will increase. Scarcity of investment in raw materials will skew the market to existing raw material production. This limited supply will increase in cost, creating higher cost goods and materials.

- (Longer term) Investment will flow into the mining sector to increase supply. This is why the mining industry is a 20 year cycle. That cycle is about to reverse from the current cycle downturn.

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YOU ARE AN ADULT and must make your own decisions. ONLY YOU know what level of experience you possess. ONLY YOU know what level of risk you are willing to take. ONLY YOU know what your financial goals are, and to what lengths you are prepared to go to meet those goals. You will be the one to wear your losses, so trade with caution and do your own research.

Henry Ledyard is an independent trader. He has NO affiliations with banks, brokerages, funds, trading houses or markets. He trades for himself and posts trading ideas merely to share information. He does NOT want your money, advice or opinions. He does NOT want your unsolicited emails. If you require further financial advice, seek it elsewhere. Henry`s opinions should be considered as addled as his blog site:

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About the author

Henry Ledyard is a futures and options trader with over 20 years of trading experience and over 10 years of experience in trading futures. Henry Ledyard holds multiple degrees: BE Electrical Engineering, BS Physics, and BA Visual Arts. He has worked as a prop-trader (AU bonds, USA bonds) but found the bond market not conducive to his trading style. He currently trades for himself, and has no associations with any brokerage or firms. He has no boss and seeks no money for his information and trade ideas.

Henry’s trading focus is primarily on futures with longer term trades (hours to days) in tangibles (commodities and equities) with a real world bias. This is because high frequency trading algorithms are in control of much of the arbitrage trades and short term volatility.

Henry is predominantly a chart reader who looks for direction changes to enter and exit markets and is not a trend follower or scalper (much). His trade ideas are based on broader market forces creating opportunity while focusing on over-sold or over-bought moves. To make money in markets, he has to combine timing, direction and risk which can be a challenge (and may not suit your trading style). He is not an FX trader, nor stock trader (mostly) and tries to avoid bond markets except as a spread for other trades. He also avoids ETFs and many derivative products because of exaggerated leveraged moves.

Henry is based in Sydney, Australia and normally trades EU pre-market through the USA session with the occasional eye to Asia trade for indicators of direction.

The trade ideas expressed by Henry are places he sees potential for profit and may be as addlepated as his blog site:

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