Meltdown

If you have been waiting for the market to send you “warning signals”, then you can stop waiting because it is happening right in front of your eyes.

"In theory, investors can exit an open-ended mutual fund or an ETF at will. But the growing popularity of these funds forces them to invest in an ever larger share of less liquid bonds. If everyone wants to exit at once, prices could fall very far, very fast. A lucky few may get out in time. Others will probably get trampled."

Over the last five years, we have developed an unhealthy obsession with the Federal Reserve, in particular, and central banks, in general, and there is plenty of blame to go around. Investors have abdicated their responsibilities for assessing growth, cash flows and value, and taken to watching the Fed and wondering what it is going to do next, as if that were the primary driver of stock prices. The Fed has happily accepted the role of market puppet master, with Federal Bank governors seeking celebrity status, and piping up about inflation, the level of stock prices and interest rate policy. We don't know what will happen at the FOMC meeting, but we hope that it announces an end to it's "interest rate magic show."

In a word, the official unemployment rate is now in what has been the macroeconomic end zone for the past 45 years. Might this suggest that the emergency is over and done? Self-evidently, the only “incoming” information that can matter between now and next Wednesday is the stock market averages.  If the Fed takes no action in September, it’s hard to imagine any economic or jobs report that wouldn’t support ZIRP or near-ZIRP in the minds of the money printers and the Wall Street gamblers they pleasure.

"August Sucks," concludes MIT Quant guru Andrew Lo, reflecting on the systematic-trading strategy effects on markets, and it's not going to get better any time soon. As he explains to Bloomberg, "algorithmic trading is speeding up the reaction times of these participants, so that’s the choppiness of the market. Everybody can move to the left side of the boat and the right side of the boat now within minutes as opposed to hours or days." As we have noted many time, Lo explains how "crowded trades have got to the point of alpha becoming beta," warning that volatility-targeting strategies (such as Risk-Parity) are not only "exaggerating the moves," but he cautions omniously reminiscent of the August 2007 quant crash, "I think they are creating volatility of volatility."

We all know the global economy is slowing, so why would stocks soar from here? The basic answer is simple: The Fed has no choice, because this game is now for all the marbles.

The data point everyone has been waiting on is out and, just as we tipped weeks ago, China liquidated nearly $100 billion in USD assets during the month of August in support of the yuan.

The centrally-planned house of cards is finally starting to shake uncontrollably.

China’s islanding building on the four-mile-long and two-mile-wide Subi Reef in the South China Sea has put The US in a tight spot. To protect its ally from China’s aggression, The US will be left with little choice but to constrain China by military means. However, the US won't directly engage China in the war in the foreseeable future, because the US dominates China with its superior naval and air force and the only way for China to level the playing field is to apply nuclear weapons. The nuclear nature of Sino-American warfare will make both the world no.1 and no.2 economy the fallen giants.  So there is a possibility that The US might use its oil weapon instead to strike at the core of China’s weakness - it’s huge dependence on oil import.

The EIA released a report this week that showed that there would be little effect on gasoline prices if the U.S. government lifted the ban on crude oil exports. In fact, gasoline prices could even fall because refined product prices are linked to Brent much more than WTI, so more supplies on the international market would push down Brent prices. The report lends credence to the legislative campaign on Capitol Hill to scrap the ban, a movement that is picking up steam. On the other hand, although few noticed, the EIA report also said that the refining industry could lose $22 billion per year if the ban is removed. So far, many members of Congress have been reluctant to weigh in on this issue for exactly that reason: it pits drillers against refiners, both of which are powerful political players.

"The room to ease policy further, i.e., to adopt counter-cyclical policies, is now much more limited than in the past. To the contrary, in some cases monetary tightening may be needed (despite weaker real business cycles) in order to continue to attract foreign capital, anchor domestic currencies and preserve the integrity of the respective inflation targeting frameworks. Hence, we may soon enter a period of weaker FX and higher policy and market rates: i.e., market dynamics that would resemble more the 1997 Asian Financial Crisis."

The situation in Brazil is deteriorating rapidly after finance minister Joaquim Levy canceled a G20 appearance in Turkey (irony) and convened a meeting with embattled President Dilma Rousseff. FX traders fear a worst case scenario involving Levy's exit. Meanwhile, former President Luiz Inacio Lula da Silva is en route to Brasilia tonight to meet with Rousseff one-on-one. 

The US economy was not “decoupled” in the slightest during the expansion of the great global monetary boom that has now crested. Nor will it uncouple during the deflationary bust that must necessarily ensue. The ultimate worldwide hit to US exports is evident in the 20% drop in shipments to Brazil, and that’s just for starters because its economic depression is just getting underway. Likewise, the panicked flight of hot dollars from Brazil now besetting the global financial markets is only indicative of the turmoil to come as the massive “dollar short” unwinds on a global basis. So this is not a retest. We are in the midst of an unprecedented global deflation. A real live bear market is once again at hand.

If so, then any entity or investor who is using aggressive leverage in US Dollars will be at risk of imploding.