Unambiguous Signals Disregarded

Doug Nolan


May 20 – Bloomberg (Susanne Walker Barton): “Treasuries fell, heading for their biggest weekly drop since November, as Federal Reserve officials indicated they’re considering a June interest-rate increase should economic data remain steady… A measure of volatility in the $13.4 trillion Treasury market rose Thursday to the highest level in more than a month. Investors were caught off guard by the hawkish tone of Fed communications, lulled into complacency amid signs of sluggish global economic growth.”

I’ll assume the FOMC would prefer to boost rates another 25 bps. They seek to at least appear on a path of “normalization,” dissatisfied with the “one and done” tag. Perhaps they have also become more attentive to the risks associated with prolonged near-zero rates for banks, insurance companies, money funds and the financial industry more generally. Recent economic data would tend to support a more hawkish bent, with a firming of GDP and inflation trajectories. I’ll stick with the theme that currently the key economic dynamic is neither growth or recession, but instead major imbalances and various boom and bust dynamics.

Members of the FOMC have voiced unease with market expectations having of late diverged from Fed thinking. The Fed expects a series of rate increases, yet the markets anticipate little movement on rates. The FOMC is “data dependent,” and sees economic fundamentals supporting a move toward a somewhat more normalized rate environment. Markets, on the other hand, see global market fragility and a Federal Reserve held hostage by unstable securities markets (and a “risk off”-induced “tightening of financial conditions”). The markets’ perspective is certainly supported by the Fed’s repeated skittish responses to any evolving “risk off” dynamic.

I’ll be surprised if the Fed boosts rates next month. And even after this week’s price adjustment, the markets are still pricing only a 30% probability of a June rate hike. As analysts have pointed out, the Fed meets just days before the big “Brexit” vote in the UK. More important to my analysis, I expect heightened global market fragilities to manifest by June 15th.

The EM fragility theme gathers support by the week. Losing 1% Thursday, the MSCI Emerging Markets ETF (EEM) posted a fourth straight weekly decline (down 0.2%). EEM has now dropped 8.7% from April 19th trading highs, in the process giving back all the 2016 advance. Worse yet, bond investors are turning skittish, joining their equities and currencies cohorts.

From Reuters (Sujata Rao): “Emerging assets have taken a dive too and BAML said emerging debt funds had seen their first outflows in 13 weeks, shedding $38 million. Emerging equities lost a far bigger $1.6 billion - their third straight week of outflows.”

May 20 – Bloomberg (Benjamin Bain): “Mexico’s financial stability is hanging in the balance as the peso’s tumble prompts a dangerous acceleration in outflows from the nation’s bonds, according to BNP Paribas SA. A pullback by foreigners is particularly worrisome for authorities, who have often cited peso bond holdings by international investors as a sign of stability… The extra yield that investors demand to hold Mexican government peso debt rather than U.S. Treasuries has surged this month and the securities have lost 8.8% in dollar terms…”

Talk that “Mexico’s financial stability is hanging in the balance” should be taken seriously.

Mexico has been an EM investor/speculator darling. It’s worth noting that Mexico’s current account deficit jumped to 2.8% of GDP last year (up from 2014’s 1.9%) to the largest ratio in 17 years. Mexico’s external debt has doubled since 2013 (to $170bn), while the country’s international reserve holdings were little changed ($178bn) over this same period. The Mexican economy is expected to grow only about 2% this year, pressured by low crude prices.

The Mexican peso declined 1.0% this week, trading to the lowest level since February. The peso has dropped 7% against the dollar so far this month. Mexican stocks were hit 1.8% on Thursday. Mexico’s 10-year bond yields were up 26 bps over the past month.

The South African rand, another fundamentally vulnerable EM currency, dropped 1.5% this week to a two-month low. The Russian ruble sank 2.1%. The Colombian peso fell 2.0% to a one-month low. Brazil’s Bovespa equities index sank 3.7%. Turkish stocks were down 1.9%.

When market attention returns to heavy debt loads and latent fragilities, Asia underperforms.

The trading week saw Asian currencies under pressure almost across the board. The South Korean won fell 1.6% to a two-month low, while the Indonesian rupiah dropped 2.1% to a three-month low. Currencies in Malaysia, Indonesia, Thailand and Singapore were all down about 1%. China’s yuan slipped 0.3% to a 10-week low versus the dollar.

India’s rupee fell 1.0% to a three-month low, as Indian stocks declined 0.7%. Indian stocks now trade about 14% below 2015 highs. Many have viewed India as the new China: years of unlimited potential growth. And integral to the bull case has been hundreds of billions of potential infrastructure spending. With a new pro-reform and pro-business Prime Minister, the sky was to be India’s limit.

But India’s economic boom is increasingly vulnerable. The country runs a Current Account Deficit and is susceptible to any deterioration in international investor confidence. The banking sector is suspect. India is also suffering from drought and problematic food inflation. Reserve Bank of India Governor Raghuram Rajan has inspired global confidence, but he is now under attack from politicians who would prefer to scrap the central bank’s inflation mandate.

May 20 – Bloomberg (Vrishti Beniwal and Bibhudatta Pradhan): “The Indian lawmaker leading a charge to oust central bank Governor Raghuram Rajan says he’s backed by the ‘overwhelming majority’ of Prime Minister Narendra Modi’s party, raising risks for investors in Asia’s third-largest economy. Subramanian Swamy, a member of Modi’s ruling Bharatiya Janata Party and a rival to Finance Minister Arun Jaitley, wrote a letter to the prime minister earlier this week calling for Rajan to either be fired or dismissed when his term ends in September.”

In a world of endless QE, liquidity abundance and resulting investor confidence, India’s massive financing needs appear manageable. But QE has not worked as global policymakers anticipated. The BOJ has printed a Trillion, yet a 25% decline from last year’s highs has Japanese stocks benefiting little from unprecedented money printing. The situation in Europe is similar: European stock markets have little to show from the ECB’s Trillion of new “money.”

And in both cases, consumer price inflation has proven impervious to an additional Trillion. In the past, the inflationists would invariably claim that monetary stimulus was not working as prescribed only because it was not being used in sufficient quantities. These days, only the fanatics refuse to accept that QE is not very effective – while coming with huge risks. And after betting the ranch on QE, there is today no consensus as to what to try next.

May 20 – Reuters (Leika Kihara and Stanley White): “A rift on fiscal policy and currencies has set the stage for G7 advanced economies to agree on a ‘go-your-own-way’ response to address risks hindering global economic growth at their finance leaders' gathering that kicked off on Friday. Japan backed away from its previous calls for coordinated fiscal action to jump-start global growth with Finance Minister Taro Aso saying on Friday that while some G7 countries can deploy more fiscal stimulus, others cannot ‘due to their own situations.’ That chimed with Washington's stance made clear by a senior U.S. Treasury official that there was no ‘one-size-fits-all’ for the right mix of monetary, fiscal and structural policies.”

Friday from the Wall Street Journal: “U.S. and Japan Heading for Standoff on Yen Devaluation,” and from Reuters: “Japan, U.S. remain at loggerheads over yen policy.” What a far cry from Dr. Bernanke’s “enrich-thy-neighbor” (as opposed to “beggar-thy-neighbor”) that he previously used to describe the Bank of Japan’s aggressive monetary stimulus and devaluation. The theory and experiment just didn’t play out as expected. Proponents, however, persist with the “things are still a lot better than they would have been without QE.” The much more important issue is how in the world are central banks to now extricate themselves from deeply flawed policies that have so destabilized global finance? Are this week’s rising Treasury yields partially explained by renewed fears of EM central bank liquidations?

I believe historians (and many others) will look back at this period and struggle to comprehend how such Unambiguous Signals were Disregarded: Declining equities and commodities prices in the face of massive QE; out-of-control debt growth in China; EM financial and economic travails; competitive devaluations and wild currency market volatility; unfathomable global bond yields; sinking global bank stocks; hedge fund struggles in the face of aggressive monetary stimulus; U.S. political upheaval (deep divisions, Trump, Bernie, etc.); rising geopolitical pressure across the globe; and tensions between the U.S. and China heading to the boiling point. The VIX jumped to 17.6 Thursday afternoon, near a two-month high.

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