When a problem comes along
You must whip it
Before the cream sets out too long
You must whip it
When something’s goin’ wrong
You must whip it – Devo
Did anyone get the license plate of the truck that hit the bulls last Thursday? If not, maybe you managed to catch a glimpse of it when it backed over the bears on Friday. I have it on good authority the driver was an Italian by the name of Mario Draghi. Mario’s German buddies managed to sober him up for a press conference Thursday but by Friday he was in New York and back on the sauce. Meanwhile, Janet Yellen spent the week explaining why she was going to take the ladle out of the punchbowl before Santa gets down the chimney. By the end of the week, traders were getting whiplash treatment and stocks were right back where they started.
The market came into last week positioned for a big new dollop of monetary easing from the ECB. With the Fed poised to hike and the ECB ready to ease, the obvious trade was short Euros and long US dollars, most often in the form of US Treasuries but with a few FANG stocks and a call on the DAX thrown in for good measure. After last month’s meeting Draghi hinted that more easing was on the way and traders took him at his word. One wonders, with the benefit of hindsight, why he wasn’t questioned more about why he didn’t just ease at that last meeting. It seems obvious now that he wasn’t having any luck convincing the rest of the ECB to go along with his punchbowl spiking ways. And by the rest of the ECB, I mean the Germans who have an innate bias against anything that might turn into too much fun.
So, when Draghi offered up his weak tea of slightly more negative interest rates and a six month extension of QE, all those short Euro/long Dollar trades suddenly looked rather crowded, foolish and not such a sure thing after all. And just like that, with visions of their already reduced bonuses dancing in their heads, traders started buying Euros, selling Treasuries and basically getting the heck out, price be damned. By the end of the day, the Euro was up four handles from 105 to 109, Treasuries were sucking for air and the Dow was down 250 points because…well just because.
As Friday dawned all awaited the November employment report to gauge whether the FOMC would still be in a hiking mood come December 16th. Earlier in the week, the manufacturing ISM posted at 48.6 – sub 50 means the manufacturing sector is contracting – and combined with some dovish cooing from a couple of FOMC members had people wondering if the Fed would really get off zero this month. The employment report was typical of the series lately, posting an as expected or so 211k; not great, not bad but nothing that the labor market watching Yellen would fret about. That wasn’t enough for more than a mild rebound until Draghi’s speech to the Economic Club of New York. He averred that, “no doubt” the ECB would step up stimulus if needed. He didn’t define “needed” but stock traders didn’t wait for clarification. I guess, more accurately, the algorithms that do all the trading today didn’t wait for clarification. Who or whatever heard Draghi’s monetary dog whistle knew what it meant or what they wanted or hoped it to mean and stood on the buy button all afternoon.
After all the central banker drama was complete the Dow had traversed a nearly 500 point range to end up less than 50 points from where it started. Which seems quite appropriate since there wasn’t much change in the fundamental backdrop of the markets. That ISM report earlier in the week did nothing but confirm what we all knew already. The manufacturing/industrial side of the US economy is weakening. That trend isn’t news to us and hopefully not to the FOMC but the ISM’s predictive track record isn’t that great and it was unlikely to change Yellen’s mind.
The other data released last week did nothing to change the trends that have persisted all year. The auto sector reported another gangbuster month. The service sector continued to expand. Manufacturing data was weak. Imports and exports continued to contract and employment was positive but uninspiring. There was no change in the economic outlook for Europe either where a nascent cyclical recovery likely has little to do with the ECB’s actions, past, present or future.
The market volatility last week was a byproduct of the open mouth policies of the world’s central banks. Forward guidance, intended to make monetary policy predictable and markets less volatile, creates confusion. Traders hang on every word, position themselves accordingly and get whipsawed when reality doesn’t align with expectations. Investors don’t know whether they should pay attention or not. The idea that monetary policy should be predictable was always based on a false premise. Forward guidance only works if central banks can predict the future course of the economy. Absent a working crystal ball, forward guidance adds to the considerable uncertainty that is inherent in all markets.
As hard as it is sometimes, investors need to tune out the central bankers. Concentrate on the indicators that have provided accurate guidance in the past. As stated above the ISM isn’t one of those and while it does provide some extra information it isn’t anything on which to base investment or monetary policy. There are instances of recessions starting with the ISM above the 50 level that divides expansion and contraction. There are also plenty of instances of readings below 50 being nothing more than transitory noise. Having said that, a reading below 49 such as we got last week, has led to, about 1/3 of the time, a recession in short order. So, one shouldn’t ignore it but context is important.
Of more importance is the developing credit crunch. It is notable I think that junk bonds did not join the stock rally Friday. Credit spreads did narrow a bit last week as Treasuries took a hit on the ECB disappointment but the trend is still wider. More meaningful, I think, is that the damage in credit markets has spread well beyond the energy sector. S&P reported $180 billion of distressed junk bonds from 228 companies in November and a distress ratio of 20.1%, the highest since 2009. (Distressed bonds’ yield 1000 basis points than comparable Treasuries.) The oil and gas sector represents just 37% of the total. Metals and mining is second and together those two sectors represent 53% of the total. Restaurants, media, technology, chemicals, consumer products and financials make up the rest of the top 8. As I said, it isn’t just energy.
We can see the stress in dividends as well. Dividend cuts in November were 50% oil and mining, 23% finance, 18% manufacturing and 9% shipping. That’s a pretty diverse group affected not just by falling oil prices but global economic weakness.
The Fed seems set on hiking rates this month and there are good arguments in favor of doing so. But we shouldn’t pretend that there will be no cost, no economic or market consequence for doing so. Market liquidity has already waned starting with the taper tantrum and continuing through the actual tapering and end of QE. Believe what you want but markets have spoken; the tightening cycle started long ago and the first rate hike is just the latest move. It seems inconsequential, a mere 25 basis points, but then the last hike in the last tightening cycle, in the fall of 2006, was only a quarter point too. Not only that but we have no idea how effective the Fed’s plan for hiking rates will be. We have to assume that if they are successful in raising the Fed Funds rate that it will reduce liquidity further. How much is anyone’s guess.
As we approach the Fed meeting expect markets to get more volatile. While the odds favor a move, it isn’t a sure thing until it is actually done. We found out last week what happens when forward guidance turns out to be forward misdirection. All those traders who thought they had a sure thing, who assumed that Draghi wouldn’t dare disappoint the market, got whipped. Whipped good.
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ZH: Just remember what happened the last time The Fed hiked into a recession... We are talking of course, about the infamous RRR-hike of 1936-1937, which took place smack in the middle of the Great Recession. Here is what happened then, as we described previously in June.
[No episode is more comparable to what is about to happen] than what happened in the US in 1937, smack in the middle of the Great Depression. This is the only time in US history which is analogous to what the Fed will attempt to do, and not only because short rates collapsed to zero between 1929-36 but because the Fed’s balance sheet jumped from 5% to 20% of GDP to offset the Great Depression.
Just like now.
Then, briefly, the economy started to improve superficially, just like now, and as a result the Fed tightened in a series of three steps between Aug’36 & May’37, doubling reserve requirements from $3bn to $6bn, causing 3-month rates to jump from 0.1% in Dec’36 to 0.7% in April’37.
Here is a detailed narrative of precisely what happened from a recent Bridgewater note:
The first tightening in August 1936 did not hurt stock prices or the economy, as is typical.
The tightening of monetary policy was intensified by currency devaluations by France and Switzerland, which chose not to move in lock-step with the US tightening. The demand for dollars increased. By late 1936, the President and other policy makers became increasingly concerned by gold inflows (which allowed faster money and credit growth).
The economy remained strong going into early 1937. The stock market was still rising, industrial production remained strong, and inflation had ticked up to around 5%. The second tightening came in March of 1937 and the third one came in May. While neither the Fed nor the Treasury anticipated that the increase in required reserves combined with the sterilization program would push rates higher, the tighter money and reduced liquidity led to a sell-off in bonds, a rise in the short rate, and a sell-off in stocks. Following the second increase in reserves in March 1937, both the short-term rate and the bond yield spiked.
Stocks also fell that month nearly 10%. They bottomed a year later, in March of 1938, declining more than 50%!
Or, as Bank of America summarizes it: "The Fed exit strategy completely failed as the money supply immediately contracted; Fed tightening in H1’37 was followed in H2’37 by a severe recession and a 49% collapse in the Dow Jones."
As can be seen on the above, in 1938, the stock market began to recover some. However, despite the easing stocks didn't fully regain their 1937 highs until the end of the war nearly a decade later.
It needed a world war for that.
But wait, the Fed hiked only to ease? That's right: in response to the second increase in reserves that March, Treasury Secretary Morgenthau was furious and argued that the Fed should offset the "panic" through open market operations to make net purchases of bonds. Also known now as QE. He ordered the Treasury into the market to purchase bonds itself.