Novum Digital Asset Alpha – Weekend Edition 22-23 August 2020 (8-Minute Read)

Waltzing into the weekend and I hope that it’s been working out well for you so far! 

In brief (TL:DR)

  • American stocks ended the week higher on Friday with tech stocks continuing to lead, as the S&P 500 (+0.34%), tech-heavy Nasdaq Composite (+0.42%) and blue-chip Dow Jones Industrial Average (+0.69%) all finished up. 
  • Asian stocks took their cue from Wall Street and ended the week in the green. 
  • U.S. 10-year Treasuries continued to advance, as yields slid to 0.639% from 0.653% in the previous session (yields generally fall as prices rise).  
  • Oil slipped with WTI Crude Oil (Nymex) (-1.12%) at US$42.34 from US$42.58 a day earlier. 
  • The dollar rose on growing signs that the U.S. Federal Reserve will not deploy yield control (which will make long term debt cheaper), forcing Washington to be more circumspect about deploying additional debt and potentially stalling stimulus from Congress. 
  • Gold continued to slide with Gold (Comex) (-0.26%) at US$1,947.00 from US$1,952.20 in the previous session on the back of a strengthening dollar. 
  • Bitcoin (-3.07%) slid along with the broader market in dollar-denominated assets and now heads into the weekend at US$11,500 (GMT 0200), as outflows from exchanges continue to lead inflows, albeit at a slower pace (outflows typically signal a willingness on Bitcoin investors to hold the cryptocurrency for future appreciation).

In today’s issue…

  1. Is The Fed Throttling Back Too Soon?
  2. Together In Electric Dreams – Betting on Chinese Teslas 
  3. Cryptocurrencies Get European Flavor as Bitcoin Pulls Back to US$11,500

Market Overview

Governments trying to quell the coronavirus pandemic seem to be playing a game of whack-a-mole.
Just as things seem to be settling in one region, another hotspot picks up. 
 
And as coronavirus case numbers in Florida stabilized, with deaths declining in Arizona and the fewest number hospitalized in New York, Europe is flaring up again, with a coronavirus resurgence in Italy and Spain. 
 
But now that lockdowns have largely been lifted, there is little appetite for governments anywhere to start imposing the stringent restrictions that helped control the spread earlier in the year. 
 
Nonetheless data on Thursday showed an unexpected increase in new weekly applications for unemployment benefits, a troubling sign that the American labor market’s recovery may be cooling, amid continuing disruptions from the coronavirus pandemic. 
 
With government bonds offering yields well below expected inflation levels, investors in recent months have been flooding into risky assets, from stocks to cryptocurrencies, in search of higher returns. 
 
But as Fed meeting minutes revealed a reluctance to undertake yield control (a pledge to buy up Treasuries for as long as it takes to keep long term borrowing rates low), commodities such as gold and Bitcoin were the first to pull back. 
 
While equity markets are probably not a good mirror for the broader economy right now, sans federal intervention, markets will be in for a rough ride in the coming weeks, and that, in and of itself, may put pressure on the Fed to post some positive statements about shoring up the economy in other ways. 
 
Welcome to the weekend! 

1. Is The Fed Throttling Back Too Soon?

  • U.S. Federal Reserve meeting minutes reveal an unwillingness to adopt yield control to ensure long term borrowing costs of federal government remains low
  • Yield control reluctance may reduce the size of any further stimulus package coming out of Congress and put renewed pressure on the American economy, stocks have yet to catch up to the news, but commodities and dollar-denominated assets were first to cave on a stronger greenback 
The U.S. Federal Reserve is in an unenviable position.
 
The American economy is in bad shape.
 
Despite a record stock market, driven up primarily by unprecedented fiscal and monetary policy measures, the boffins at the Fed (as revealed by minutes of their latest meeting) are unsure what to do next. 
 
Unemployment claims are up, but the stock market is threatening to enter deeper into bubble territory and that’s driven the Fed to shelve plans for yield control. 
 
Up till fairly recently, when it wasn’t clear that coronavirus case numbers would be coming under control anytime soon, the Fed had pledged unlimited financial asset purchases to sustain market liquidity and in essence acting as a buyer of last resort. 
 
However with yield control, the Fed focuses primarily on the price of bonds instead of the amount of liquidity in the market, meaning that the central bank will pledge to purchase Treasuries to keep federal borrowing at a specific target price, reducing long term rates as bond prices are inversely related to yields. 
 
Yield control means that the Fed will buy up as many bonds as it needs to, to keep the federal government’s long term borrowing costs low, and by extension, interest rates in general low.  
 
But there’s a problem with that – it encourages short term risk-taking behavior. 
 
Because it costs more in real terms to hold low yield longer-term debt, investors, hungry for yield will start chasing returns in the short term, inflating the prices of all manner of risk assets, from commodities to cryptocurrencies. 
 
With the S&P 500 having set an all-time record, erasing all of the losses for this year, there are signs that the Fed is concerned over bubble risks – even cyclical stocks, those most exposed to the vagaries of the pandemic are making a comeback. 
 
Given that the pace of economic recovery is not at all clear, the short term Fed pullback should be viewed positively from the viewpoint of fiscal responsibility and for now at least, the markets don’t seem to have noticed – it’s unclear how long that obliviousness will last. 
 
And stocks may be in for a correction when investors finally catch on to a drying up of the Fed’s gravy train. 
Meanwhile, in a Chinese electric vehicle factory…

2. Together In Electric Dreams – Betting on Chinese Teslas

  • An S&P index tracking larger Chinese automobile and component makers rose 30% in the year through Wednesday, versus an 8.5% increase for the equivalent global index
  • Investors hunting for the next Chinese Tesla may be in for a rude shock as many are operating with “borrowed” technology (and money) and have no expertise in either automobile or electric vehicle manufacture, trading on hype and bleeding money at an alarming rate  
Chances are when you ask an American what a smartphone is, they’ll point to an iPhone, ask a Chinese and they’ll point to a Huawei.
 
Social media for the Chinese means WeChat and for Americans it’s Facebook (-0.74%). 
 
So naturally when it comes to electric cars, China needs their own version of the Tesla (+2.41%). 
 
At least that’s what investors seem to be betting on. 
 
Perhaps inspired by Tesla’s historic price surge last week, investors are sending the stocks of Chinese electric automakers soaring as well. 
 
American depository receipts of Nio (+2.47%), China’s best-known automaker that focuses solely on electric vehicles, have more than tripled this year, while rival Li Auto (+1.83%), raised some US$1.1 billion last month in a widely oversubscribed IPO in the U.S., that has seen its shares gain some 36% since.
 
But just like the dotcom bubble overplayed and oversold the internet, electric vehicle makers may be overbought as well. 
 
Take for instance Evergrande Health Industry (+0.67%) , a subsidiary of property developer China Evergrande Group (-0.52%) that has been turned (almost overnight) into an electric vehicle maker.
 
Shares in the Hong Kong listed unit, which has unveiled 6 electric car models but has yet to sell any, have soared, giving the electric vehicle startup a valuation of US$27.2 billion, near that of automotive legend Ford Motor Company (-1.19%). 
 
Investors are betting that China’s automobile market, which is also the world’s largest, will rebound alongside the broader Chinese economy. 
 
Retail passenger car sales in China rose 7.7% year-on-year in July, while wholesale electric vehicle sales surged 19.3% compared to a year ago. 
 
Beijing has also been supportive of the electric vehicle industry, which has helped to push Chinese electric vehicle companies to lofty valuations. 
 
According to Chinese state-owned Xinhua News Agency, Chinese authorities have a goal of making a quarter of all vehicle sales electric by 2025, up from an earlier target of 20%. 
 
Legacy automakers have struggled so far to adapt their existing production facilities towards electrifying their vehicle ranges, and that has provided an opportunity for electric vehicle startups, especially in China. 
 
But not all electric vehicle startups are made equal.
 
Many are using hammered-together technology “borrowed” from various sources and pushing out essentially Frankenstein electric cars, of dubious durability.
 
Others are operating at massive losses, losing money for every electric vehicle sold.   
 
And with valuations getting frothy, many investors who have valued early-stage Chinese electric vehicle manufacturers like the next Tesla, may be in for a rude shock when the batteries run out of their price rallies. 

3. Cryptocurrencies Get European Flavor as Bitcoin Pulls Back to US$11,500

  • E.U. set to roll out cryptocurrency legislation by the end of this year, which should provide greater certainty for European investors, as well as cryptocurrency exchange security 
  • Bitcoin’s short term pullback and consolidation a function of a rising dollar and profit-taking, macro outlook remains unchanged 
You can’t truly feel invested in something, until you’ve named it. That’s why as humans, we’ve taken to naming everything, from boats to cars, money to each other. 
 
And so for European investors, cryptocurrencies, from a legal standpoint have till date existed as persona non grata, traded in hushed whispers and a taboo topic in polite company. 
 
But that may all be set to change as a European Union Commission is finally set to complete the legal framework for cryptocurrencies in the fourth quarter of this year, providing legal certainty for digital assets, the absence of which has been a significant barrier to wider investor interest. 
 
The E.U. legislation, which will provide legal certainty for the status of cryptocurrencies not covered by existing E.U. financial services law is expected to cover: 
 
  • definitions for all types of cryptocurrencies, including stablecoins and security tokens;
  • changes to the Markets In Financial Instruments Directive II (MiFID II Directive 2014/65/EU) to include cryptocurrencies and other digital assets; and
  • a regime for blockchain-based platforms.
 
Interestingly, the proposed legislation includes specifics about how blockchain-based market structures should be regulated which will no doubt provide welcome respite to traders.
 
Currently the operation of cryptocurrency exchanges is not well covered in the E.U. and investors have had to deal with numerous exchange failures and regulatory certainty will go a long way towards encouraging greater participation, particularly from the retail markets. 
 
But if the cryptocurrency markets were buoyed by the developments, that didn’t reflect on price performance as a rising dollar has put downward pressure on Bitcoin and other risk assets in general. 
 
After a breathtaking rally that saw Bitcoin surge well past US$12,000 in the past week, the benchmark cryptocurrency has pulled back on profit-taking and has come under some pressure towards the end of the week after the Fed’s meeting minutes were revealed. 
 
With little sign of stimulus coming from Washington and with the Fed not committing to yield control dovetailing with lower coronavirus case numbers in the U.S., a stronger dollar has weighed on sentiment for Bitcoin and gold. 
 
Typically, concerns over the strength of the U.S. economy would see the dollar slide and stimulus measures would also see a strengthening of inflation hedges such as gold and Bitcoin. 
 
But the longer term macro factors which point towards concerns over inflation and currency debasement are still very much intact. 
 
A short term pullback can be seen as a consolidation phase, and the next real level of resistance is still US$13,800. 

Novum Digital Asset Alpha is a digital asset quantitative trading firm.

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