Up and Down Wall Street
Rout Reveals Monetary Policy Dependence
Unwinding carry trades, the absence of PBOC action and the expectation of Fed hikes weigh heavily on stocks.
By Randall W. Forsyth
Updated Aug. 24, 2015 12:25 p.m. ET
The global collapse of all risk assets -- not just stocks but also commodities and high-yield debt -- shows the markets’ unhealthy dependence on monetary policy to prop up prices.
The failure of the People’s Bank of China (PBOC) to fulfill widespread expectations of strong, substantive monetary actions helped precipitate the latest 8.5% collapse Monday in the Shanghai Composite, the biggest since 2007. That plunge continued to spread around the globe with the close of trading in Asia with European stocks down massively and a steep drop at the opening of New York trading.
Meanwhile, expectations are fading that the Federal Reserve will initiate an interest rate hike next month, which has been the conventional wisdom among Fed watchers. Short-term Treasury yields are down sharply in reaction, much more so proportionately than longer-dated ones, while the dollar actually is lower in what otherwise is a flight to quality.
In China, one of the most stalwart bulls threw in the towel early Monday in the absence of actions by Chinese authorities to support the stock market.
Reorient Capital research director and chief China economist Steve Wang wrote in a note to clients of the Hong Kong-based firm of a confidence crisis, especially with the failure of the Shanghai Composite to hold the psychologically important 3500 level:
“These developments suggest market confidence has vanished as state buying has thinned. Unless renewed support from the government emerges, we advise investors to reduce long positions until a clearer market bottom has been established.”
What’s more, Wang points the stock-market plunge has resulted in a bump-up in interbank interest rates, exacerbating the stress on the financial sector. But the PBOC has been “surprisingly conservative” in its routine open-market conditions. “The other monetary tools to inject liquidity also were sparsely applied,” he adds.
The conundrum is that in order to prevent a more severe plunge in the yuan since its devaluation earlier this month, the Chinese monetary authorities have been relatively stingy.
That’s at a time when the stock collapse suggests the need for aggressive expansionary action.
Meanwhile, by one criterion, the Fed has been engaging in a stealth tightening since the beginning of the year. The central bank’s balance sheet had quintupled in size from the initial quantitative easing in reaction to the financial crisis in 2008 through the final phase, QE3, which ended last fall. Since the turn of the year, the Fed’s balance sheet has shrunk slightly.
While it’s down just $8 billion out of a $4.449 trillion total as of last Wednesday, the more important point is the balance sheet has stopped expanding. As of late June, while the stocks were near their highs, Wilshire Associates calculated the value of U.S. equities were up some 226% from March 2009, when QE1 began. Since the announcement of QE2 in August 2010, U.S. stocks had gained 104%. And since September 2012 when QE3 was launched, stocks had been up 49%. Since the Fed’s balance started shrinking since the turn of the year, U.S. stocks were down 4.15% as of Friday.
The clearest sign of global illiquidity is the wholesale sell-off in a broad array of commodities, a highly sensitive barometer of both financial and business conditions. That owes much to the slowdown in China’s economy, which the collapse in metals and petroleum suggests is far worse than that country’s official statistics suggest. And, as noted, the policy responses there have been lacking as well.
What’s fascinating is that the dollar is declining against the euro and the Japanese yen in a reverse of the typical moves in a market rout. One implication is that those currencies have been the main funding for carry trades, in which traders borrow in one currency to finance positions in other, higher yielding assets.
Borrowing in a currency that is expected to fall is a key component of this strategy since it would reduce the cost of the liability. And with the European Central Bank and the Bank of Japan engaging in QE (and the Fed presumed to be about to tighten), borrowing in euros and yen, which were expected to decline, was the obvious trade.
When the carry trade is unwound, however, the reverse happens. The player has to buy back the funding currency, which may be driving the euro and yen sharply higher. The common currency is up to $1.17 from $1.14 last evening and a low $1.05 earlier in the year. The yen has strengthened massively, to 118 to the dollar from 123.50 Friday and over 125 at around the time of China’s devaluation on Aug. 11.
The heavy, indiscriminate selling suggests desperate attempts to cover losing positions, dumping all manner of high-flying tech and biotech stocks along with stocks without outrageous valuations, such as Apple ( AAPL. )
Another tell: the relatively tepid rally at the long end of the Treasury market. The 10-year yield is just under 2% while the 30-year bond yield is down to 2.68%. As noted in this week’s Up and Down Wall Street column in Barron’s print edition, fixed-income holdings may be liquidated to rebalance larger institutional portfolios as stocks decline. Moreover, in the spirit of sell what you can sell, highly liquid Treasuries also provide a ready source of cash.
The worldwide market rout makes a Fed hike in September an increasing long shot. In addition to mechanical assessments of economic data, the Fed also takes into account what it euphemistically calls “financial conditions.”
That point was made earlier this year by New York Fed President William Dudley. In a speech last April, he said that, were the markets fail to tighten in tandem with the central bank’s policies -- as happened in the middle of the last decade when long-term interest rates held steady in the face of 17 hikes at the short end -- the Fed would tighten more.
Conversely, the former Goldman Sachs chief U.S. economist added: “if financial conditions tighten a lot – bond yields go up a lot, stock prices go down a lot, credit spreads widen, then presumably we are going to slow down or even pause for a while.”
The latter describes the present situation, especially in the corporate bond market, where yield spreads have widened markedly for both investment-grade and junk credits.
But, in the absence of more aggressive stimulative actions from China and the removal of the risk of a rate hike by the Fed, the markets remain under pressure. That speaks to their dependence on monetary policy.