All normal as Canadian stocks break out

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What a difference a week can make. All summer the mid-cap oriented INK Canadian (CIN) Insider Index had been trading in a range between 1,150 and 1,180. It was never able to fully break free of its 200-day moving average leaving sceptics to wonder if Canadian stocks were doomed for a year of poor performance on the back of poor oil markets and housing worries.

Last week the Index once again tried to muster the strength to breakout finishing at 1,190. This was the second time in a month it had pushed through 1,180, but this time it might be for real.

The Index continued to gain early in the week, but the key test was Wednesday when the Federal Reserve was set to announce its plan to begin winding down its balance sheet. The Fed did not disappoint, and neither did the INK CIN Index. The US central bank indicated that it will start the process of gradually reducing QE securities (bonds and mortgage debt) next month. According to Reuters, once ramped up the Fed's portfolio could shrink by $150 billion a quarter.

The Index rallied on the news and closed near the highs of the day at 1,206.

The move over the past few days has been so strong that the Index is now approaching short-term overbought territory, closing above the upper Bollinger Band of 1202 along with an RSI near 70. While an INK CIN pullback to catch its breath would not be a surprise, the fundamental back drop for Canadian stocks looks encouraging.

With respect to monetary policy, the move by the Fed to dispose of some QE securities will have the effect of removing some excess bank reserves from the system. If banks decide to replace those reserves with short-term Treasuries, that will dampen short-term interest rates. This is just the opposite of what happened during the Fed's Operation Twist (when the Fed pushed up short rates and dampened long rates). In our view, it is no coincidence that commodities struggled in wake of Operation Twist and subsequent QE as effective short-term rates were higher than what they otherwise would have been due to the Fed paying interest on bank reserves.

On balance, the Fed is trying to lead the world back to a period of normal monetary policy where central banks are not holding bonds and other assets above what is needed to administer conventional monetary policy. At this point, the unwinding of QE securities may well be a positive for commodities provided the Fed does not tighten too fast. Given the Fed's median dot plot projections, it may already be hinting that rates will start to come back down again by 2020. This can be seen in the Bloomberg chart below where the green line representing the median Fed Funds forecast of FOMC participants starts to dip at 2020.

 

Source Bloomberg's  David Ingles‏ @DavidInglesTV

The other benefit for the Canadian market is a steeper yield curve. Disappearing bank reserves will put downward pressure on short rates, while the winddown of Fed bond reinvesting may put pressure on bond prices leading to higher long-term rates. That outcome would be a positive for rate-sensitive Canadian stocks including insurance companies, banks and, to a lesser extent, consumer lenders such as INK CIN member goeasy (INK Edge outlook: Sunny; GSY). Although REITs may find the environment a bit more challenging, insider sentiment in the group is soaring. We will discuss why that might be happening in our market report next Monday.

INK outlook categories are designed to identify groups of stocks that have the potential to out- or under-perform the market. However, any individual stock could surprise on the up or downside. As such, outlook categories are not meant to be stock-specific recommendations. For background on our INK Edge outlook, please visit our FAQ #5 at INKResearch.com.

 

 

 

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