Strap in for October — The Fun Has Only Begun

Following a string of high-profile events that included a Federal Open Market Committee (FOMC) policy meeting, a Bank of Japan (BOJ) policy meeting, an OPEC meeting, end-of-the-quarter window dressing and a no-holds-barred U.S. Presidential debate, one would have thought that the skies for the stock and bond markets might have cleared somewhat heading into October. Well, investors aren’t going to be that lucky amid a few new uncertainties that have to be considered in the next few weeks.

However, as of late last week, it was becoming clear that the appetite for risk-on equity exposure was on the rise. Though the markets saw a spike in volatility, by Friday it was somewhat overlooked considering the S&P 500 added 0.2% for the week.

Index Started Week Ended Week Change % Change YTD %
DJIA 18261.45 18308.15 46.70 0.3 5.1
Nasdaq 5305.75 5312.00 6.25 0.1 6.1
S&P 500 2164.69 2168.27 3.58 0.2 6.1
Russell 2000 1254.62 1251.65 -2.97 -0.2 10.2

As for rate hike expectations, they ended the week higher after August Core PCE Prices declined 0.1% even though other inflation measures trended up in August. The implied probability of a rate hike at the December meeting climbed to 55.7% by the end of the week, up from last week’s 54.2%, according to the fed funds futures market. The yield on the 10-year Treasury Note closed out the week where it began, right at 1.61% after plunging to 1.55% on the fluid Deutsche Bank stream of headlines.

Futures Expiry: December 2016

Futures Price: 99.515

Previous Day

Volume: 8,962

Open Interest: 99,733

Target Rate (bps) Current Probability % Previous Day Probability %
25-50 38.3 48.0
50-75 55.7 48.1
75-100 5.9 3.9

Deutsche Bank: The German Fly in the Global Ointment

The wild and wooly trading week began with a decline in shares of German banking giant Deutsche Bank that was driven by renewed concerns about Deutsche Bank’s capital standing. German Chancellor Angela Merkel said that the bank would not be eligible for state aid if it were to experience a capital shortfall. This drove up concerns that something may indeed be wrong at Deutsche Bank.

The stock remained in focus throughout the week, leading another market-wide swoon on Thursday amid reports that some firms that clear trades with Deutsche Bank had reduced their positions and withdrawn some excess cash. The stock ended Thursday with a 6.7% decline, weighing on sentiment in the broader market.

A turnaround in Deutsche Bank and the market developed on Friday when bank CEO John Cryan sent a letter to employees, assuring them of the bank’s health. The stock rallied out of the gate on Friday, receiving another boost after Agence France-Presse (AFP), the French press agency, reported that the bank is nearing a $5.40 billion settlement with the Justice Department, down from the $14 billion that was originally sought by the Department of Justice.

Deutsche Bank headquarters, Frankfurt

Naturally, Deutsche Bank has refused to comment on speculation around the level of the DoJ fine. That means if the DoJ makes no announcement in the ensuing days after this published report, any buying spree in DB may promptly turn into another sell-off in the banking company’s shares. As a reminder, there were “fixes” galore in 2008, and rumors sent Lehman stock soaring in the six weeks before its final share price meltdown.

This is one stock retail investors should avoid, regardless of how “cheap” it looks. There is real potential of a Lehman Brothers 2.0 sequel shaping up and, if so, there is systemic risk to the European banking system that will require either a government sponsored or European Central Bank (ECB) sponsored bailout. Negative interest rates are only adding to the DB’s woes to its high risk loan portfolio and extreme leverage in the derivatives markets.

German national weekly newspaper Die Zeit reports that the German government and financial authorities are preparing a rescue plan for Deutsche Bank. It suggested a rescue plan would come into force if Deutsche Bank needed extra capital and was not able to raise it on the open market. The paper also added that the government would take a stake in Deutsche Bank in the worst case scenario.

Source: Bloomberg Credit 10-1-16

The German flagship bank’s value has more than halved this year after it posted its first full-year loss since 2008 in January. The International Monetary Fund also warned in June that Deutsche’s links to the world’s largest lenders make it a bigger potential risk to the wider financial system than any other global bank. Any further headlines of elevated counterparty risk will serve as more downside fuel to the fire that will only rattle markets around the globe.

We’re at a point where a bailout of some form is probably more of a question of when and not if, which only opens wider the gate of moral hazard to the ECB and other banking bodies. If DB is bailed out, every bank that has mismanaged its affairs will be in line for a deal, led by the Italians. It is one big hot mess. But rest assured, if DB does reach the point of no return, it will be saved, because it is ‘way too big to fail’ in the eyes of central bankers. And when that bailout is finally announced, markets will likely rally and rally big. And with two more presidential debates between Hillary Clinton and Donald Trump all teed up, to say that we live in crazy times is indeed an understatement.

Thank goodness for earnings season. Despite the unknown factors surrounding DB and the election, few things cut and clarify our portfolios like reporting season. It is where the rubber meets the road for great dividend-paying stocks and high-yield assets. Click here to learn how my Cash Machine investment newsletter custom tailors our three portfolios to meet the demands of every income investor.

In case you missed it, I encourage you to read my e-letter column from last week about how taking the Fed at face value in its statements has impacted the market.