Simplifying Market Noise
Confused by the market? You are not alone with irrational and "Fear of Missing Out" momentum trades and (not so great) sector re(un)rotation all that matters (as has been the case for years with fundamentals not relevant for about 24 months now), so here are some tips from Scotiabank's Guy Haselmann who believes "market noise can be simplified into the following: QE= risk on, End of QE=risk off. QE is now half way toward ending, so now is the time to adjust. The fact that…… EM central banks are hiking, China is attacking its credit bubble, and Japan hiked its VAT tax while the “third arrow” is M.I.A., are also reasons to de-risk. If sanctions on Russia expand to products or industries, then real problems to EU growth will arise. This is something to watch carefully."
Some additional perspective from Haselmann:
Yellen’s words are a calming smoke screen. I found no comfort in the fact that Yellen said that there are few signs of bubbles or the FOMC will provide further accommodation. If the FOMC believed there were bubbles, they would not tell us. In addition, its track record for identifying bubbles is terrible. Just about every question yesterday dealt with income inequality – much the result of Fed policy “goosing” markets. She seemed somewhat uncomfortable with the persistence of this line of questioning and finally admitted to froth in High Yield.
Yellen wants us to focus on the “accommodation” that they will continue to provide. She does not want the market to focus on the fact that the level of that accommodation is shrinking. In this light, she can get markets to continue to chase risk as they exit from QE, rather than potentially be responsible for causing a market crash. The FOMC is saying what they have to say in order to avoid bigger problems. I believe this is a bit of a smoke-screen. Investors should use this opportunity to de-risk and unwind those Fed-piggy-backing trades that have been so successful over the past several years. At the end of the day, the Fed has no idea what they will be doing in 2015, so it all goes back to the first sentence of this note.
For the past few years, everyone has had on the same crowded trades, but the policy pivots mentioned above mean that it is now time to re-balance. The ‘herd’ has been over-weight equities, long carry, long credit, and short duration and treasuries. These exposures are popular, because there is such widespread belief in the Fed’s ‘hopes and prayers’ for an improving economy and a gradual return to a normalized monetary policy. These positions are also popular because CAPM (the Capital Asset Pricing Model) has been flipped upside down where equities are viewed as having upside, while ‘safe’ Treasuries are believed to have poor risk/reward characteristics. In other words, the upside for Treasuries is capped at par which makes each successive lower basis point more difficult; while simultaneously, the downside grows due to interest rate risk.
Yet, exceptionally low global rates are telling us something and investors are just starting to look past the next two quarters of strong-ish US GDP forecasts toward the uncertainties surrounding the global economy, inflationary expectations and the Fed exit (and China’s exit) difficulties.
Huge divergences between NASDAQ/Russell and S&P and Dow are warning signs. Betas are coming down. Defensive sectors are vastly outperforming. Markets feel like they are in the midst of asset allocation adjustments. Mortgages are flying (this is a carry trade with less beta).
Adjustment to benchmarks when market liquidity is so poor can mean outsized price movements. For many portfolios it is not, and has not, been about valuations. Rather, portfolio decisions have been more about relative value and piggy-backing off of the Fed’s accommodation with alarmingly less regard to whether those exposures adequately reward the PM. Over the next few months, markets will be about positions and the adjustments that are likely to take place due to changing policies.
Today’s 30 Year Auction
I can see accounts use today's 30 year auction to re-balance. Given the lack of liquidity in the back end of the Treasury market, refundings (like today’s auction) can be the best place to purchase large amounts of on-the-run duration securities. Furthermore, the month of May begins the best seasonal period for Treasuries of the year.
The catalysts to de-risk have arrived. Fed piggy-backing trades have reached the ninth inning. Too much good news is priced-in. Lofty prices, crowded trades, and retracting Fed have skewed the risk/reward distributions. There are fewer marginal buyers of risky assets left compared with the number of potential sellers who materialize from rebalancing, profit monetization, or those who may chase to switch from lofty financial assets into real assets.
Tomorrow it is Victoria Day in Europe, and there is an Eastern Ukraine referendum on Sunday, which are both expected to bring heightened problems to the Ukrainian situation. I wonder if this is one reason why Putin softened his tone yesterday, i.e., to try to distance himself from what may happen in the next few days, and to look as if he actually tried to ease tensions.
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