Via Scotiabank's Guy Haselmann,
The current market environment means that prices of securities can move wildly and to previously unforeseen and unexpected levels. For many, P&L management and financial survival will trump economic valuation. Capital is flowing quickly in a market place rife with compromised market depth. It also follows a multi-year period where the Fed had given the green light to rampant market speculation; thereby, propagating herd-like positions which are in the initial stages of unwind. This will take time. As I have been warning, investors should not underestimate just how low long-dated Treasury yields can fall.
Below is a summary of some facts and thoughts (not a comprehensive list):
The Russian Ruble is the worst performing currency in the world losing about 60% of its value this year. The Norwegian Krone is down 20%. The Turkish Lira hit an all-time low of 2.41 last night.
In dollar terms, the Russian Micex Benchmark Equity Index is down over 30%... this month!!
Russian corporations and banks have an estimated $135 billion of foreign currency debt that needs to be repaid by the end of 2015. With the ruble 60% weaker, refinancing will be monumentally challenging. Defaults will impact banks and investors – the level of contagion is uncertain.
Large intervention in the Ruble currency markets yesterday had little effect. In a desperate move to halt the plummeting Ruble, the Central Bank of the Russian Federation hiked rates from 10.5 to 17%. This also had little immediate impact as the currency is down 10% overnight, a bounce from the lows of down 20%. Capital controls are the likely next step.
Venezuela 5yr CDS is pricing a 97% chance of default.
Greece has (the first round of) a Presidential election tomorrow. A failure to gain 180 votes or a strong showing by Syriza may cause a steep widening of EU periphery spreads currently priced to perfection.
EU periphery rates are at low levels and at historically tight spreads to Germany partially due to expectations of the ECB initiating sovereign QE next months. Again, valuations appear to have this fully priced in. Yet, here are some quotes over night from the Bundesbank President Weidmann:
- *WEIDMANN SAYS DON'T EXPECT QE MIRACLE AS EFFECTS WOULD BE MUTE
- *WEIDMANN SAYS BALANCE-SHEET TARGET NOT SENSIBLE POLICY STRATEGY
- *WEIDMANN SEES `WHOLE ROW' OF ECONOMIC REASONS AGAINST QE
- *WEIDMANN: CURRENT DEVELOPMENTS DON'T WARRANT POLICY RESPONSE
The energy industry is highly-capital intensive. US energy companies have more than $200 billion of junk bonds outstanding, not including large amounts of bank debt. (Our energy analyst Jerod Lenderman wrote a note this morning about the Oil Market)
The FT has a front page article about how plunging crude prices threaten $1 trillion worth of energy projects.
The High in Junk Bonds was in June. The HYG (High Yield ETF) is down 9% since that time and down 4% this month. The high in the S&P was on December 5th. Such divergences have historically acted as a warning sign for equities.
IN CONCLUSION: I could extend the list of bullet points for many more pages, but the overall conclusion that market turmoil and volatility will be here to say has been made.
So, what does this mean for the Fed meeting tomorrow?
I believe the Fed is best served to focus on the domestic economy and not delay the path to policy exit, due to overseas troubles, and foreign economic and political mismanagement. The US economy is improving and showing plenty of signs of normalization. I believe the FOMC should try to instill confidence by acknowledging this domestic economic improvement, while down-playing concerns aboard.
There is never a good time to remove accommodation and waiting may only delay the inevitable, potentially make the ultimate fall-out even worse. The drop in oil is a boon to the US consumer and elevates disposable income.
The Fed should increase its flexibility by removing the forward guidance language, and mitigate that action by adding language that they are watching developments closely, will act accordingly (and that rates will only move slowly, as outlined in my “Sooner, but Slower” note from Oct 23 [10]).
So, how should active accounts tactically trade the market until then?
Global capital is moving. Portfolios are adjusting exposures after years of over-extended risk to piggy-back off of central bank stimulus in an attempt to beat peers and benchmarks. The high point of stimulus is behind us. Global central banks followed Fed rates down toward zero and the G-5 provided $13 trillion in QE balance sheet expansion. The arsenal has already been depleted.
US QE has now ended. Forward guidance is likely to end tomorrow and a rate hike looms. BoJ QQE is beginning to be challenged as ineffective. ECB QE promises are also beginning to be questioned. The central bank ‘put’ is now weaker and farther out-of-the-money.
Geo-political and economic uncertainties are high and rising. Portfolios recognize the need to become more conservative and protect against downside risk. Cash equivalents and Treasuries are the clear winners.
As I stated last Monday, “I would not underestimate just how low Treasury yields can fall”, but that is now tactically true until 1:45 PM tomorrow. Since I still expect a hawkish Fed and a removal of the Forward Guidance language, it will be tactically prudent to leg from a long into a flattening trade just in front of the meeting. I believe a hawkish Fed will flatten the curve quite a bit. Much can happen between now and tomorrow afternoon, as market movements will be dictated by positions and safety. At 2:00 PM tomorrow the focus will shift to being all about the Fed.
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Turmoil
