Rude Awaking Coming

Doug Nolan


There's little satisfaction writing the CBB after a big down week in the markets. Motivation seems easier to come by after up weeks, perhaps my defiant streak kicking in. I find myself especially melancholy at the end of this week. There's a Rude Awaking Coming - perhaps it's finally starting to unfold.

Many will compare this week's market downdraft to the bout of market tumult back in early-February. At the time, I likened the blowup of some short volatility products to the June 2017 failure of two Bear Stearns structured Credit funds - an episode marking the beginning of the end for subprime and the greater mortgage finance Bubble. First cracks in vulnerable Bubbles. Back in 2007, it took 15 months for the initial fissure to develop into the "worst financial crisis since the Great Depression."

I posited some months back that tumult in the emerging markets marked the second phase of unfolding crisis dynamics. I have argued that the global government finance Bubble, history's greatest Bubble, has been pierced at the "periphery." More recently, the analytical focus has been on "Periphery to Core Crisis Dynamics." I've chronicled de-risking/deleveraging dynamics making headway toward the "Core." This week the "Core" became fully enveloped, as the unfolding global crisis entered a critical third phase.

Today's backdrop is altogether different than that of February. For one, back in February "money" was flow readily into the emerging markets - too much of it "hot money." "Risk on" was still dominant early in the year. Speculative leverage was expanding, with resulting liquidity abundance on an unprecedented global basis. With such a powerful global liquidity backdrop, a fleeting dislocation in U.S. equities proved no impediment to the hard-charging U.S. bull market. Indeed, global liquidity rushed into U.S. securities markets, fueling powerful speculation blow-off dynamics.

February market instability did, however, mark a key inflection point for risk embracement at the "Periphery." And the combination of acutely vulnerable Bubbles at the "Periphery" and blow-off dynamics at the "Core" proved highly destabilizing. The dollar rally helped push EM currencies over the cliff, while booming markets and economic activity in the U.S. pressured both the Fed and market yields. The upshot was a rather abrupt tightening of financial conditions for the emerging markets that, ironically, spurred a dangerous late-cycle Terminal Phase of speculative excess and resulting loose financial conditions in the U.S.

In stark contrast to February's robust financial conditions, the global liquidity backdrop these days is acutely fragile. Rather than the risk embracement environment from early in the year, risk aversion holds sway. On a global basis, speculative dynamics are dominated by de-risking and deleveraging. Liquidity is being destroyed instead of created, and it is anything but clear in my mind how the unfolding tightening of financial conditions would be reversed.

It is not only the speculative backdrop that has experienced momentous change. The Fed has liquidated about $250bn of its holdings since February. Both the ECB and BOJ have significantly reduced monthly QE liquidity injections from earlier in the year. The Fed has increased rates three times for a total of 75 bps. Rates were hiked to 60% in Argentina and 24% in Turkey. Throughout the emerging markets, central banks have been raising rates.

Global bond yields are much higher than in early-February. Argentine 10-year yields have surged 360 bps to 9.66%. Yields are up 685 bps in Turkey (21.1%), 340 bps in Pakistan (11.56%), 326 bps in Lebanon, 250 bps in Indonesia, 157 bps in Russia, 152 bps in Hungary, 114 bps in Brazil, 112 bps in Philippines, 105 bps in Peru, 82 bps in South Africa, 72 bps in Colombia and 56 bps in Mexico. And these are sovereign yields. Corporate debt has performed even worse, with notable weakness in Asian high-yield and dollar-denominated corporates more generally. And it's not as if European finance is sound. Italian 10-year yields have jumped 160 bps to 3.58%. This ongoing spike in global yields has certainly placed intense pressure on leveraged speculation.

Here at home, after trading as high as 3.26% in Monday's session, 10-year Treasury yields ended the week down seven bps to 3.16%. Yields were at 2.84% on February 2nd and then dropped to 2.71% during a tumultuous day for equities on February 5th. WTI crude traded down to $55 in February.

The Bloomberg Barclays US Corporate High Yield index began February at 5.78%, jumped to 6.36% by February 9th and then dropped back below 6.00% in April. And after reaching 6.54% in early July, yields declined to as low as 6.17% last Tuesday (10/2). This index saw yields surge 22 bps this week to 6.63%, the high going back to 2016.

It's my view that enormous amounts of leverage have accumulated throughout U.S. corporate Credit over this prolonged period of easy "money." It appears "Risk Off" dynamics attained important momentum in the U.S. corporate market this week.

October 12 - Bloomberg (Cecile Gutscher): "Nervous money managers fled from corporate bonds like never before in an exodus that outpaced stocks. Record outflows hit funds that buy investment-grade debt…, according to Bank of America Corp. strategists citing EPFR Global data. The redemptions totaled $7.5 billion in the week through Oct. 10. By comparison, investors pulled $1.4 billion from equity portfolios during the period, while government and Treasuries actually saw inflows… High-grade bond gauges have also suffered the steepest losses of all the Bloomberg Barclays indexes in this month's market meltdown."

As is generally the case, news and analysis follow market direction. With the market breaking to the downside, attention turns to the Federal Reserve and the unfolding trade war with China. Last Wednesday, with the market at record highs, pundits were celebrating the robust U.S. economy. What a difference a week makes.

I've received numerous emails over recent months questioning the supportive comments I've directed at Chairman Powell. This historic Bubble inflated throughout the watches of Drs. Greenspan, Bernanke and Yellen. Powell will surely be the scapegoat when things fall apart. The President has wasted no time in pointing fingers. It has to be the first time a central bank has been lambasted for gradually raising rates to a loco 2.25%.

October 10 - Bloomberg (Justin Sink and Shannon Pettypiece): "President Donald Trump slammed the Federal Reserve as 'going loco' for its interest-rate increases this year in comments hours after the worst U.S. stock market sell-off since February. Trump said… the market plunge wasn't because of his trade conflict with China: 'That wasn't it. The problem I have is with the Fed,' he said. 'The Fed is going wild. They're raising interest rates and it's ridiculous.' 'That's not the problem,' he said of the trade standoff. 'The problem in my opinion is the Fed,' he added. 'The Fed is going loco.' His latest criticism of the central bank began earlier Wednesday as he arrived in Pennsylvania for a campaign rally. 'They're so tight. I think the Fed has gone crazy,' the president said."

We're now, in real time, witnessing the inevitable dilemma created when a central bank falls "behind the curve." And keep in mind that rising asset prices are contemporary finance's prevailing type of inflation (inflationary manifestation). Leaving rates so low for such a long period of time was responsible for inflating myriad major Bubbles. And now central bankers face the high-risk proposition of normalizing rates in an acutely fragile Bubble backdrop. The bulls, of course, believe it would be negligent for a central bank not to reduce rates when the markets find themselves in a bit of trouble. Continuing to raise rates would be gross negligence; a show of total incompetence; and so on. President Trump wants to pin blame on Fed rate hikes, seemingly with no recollection of the "big fat ugly Bubble" he would herald on the campaign trail.

I'll assume that short rates will be heading back to zero - and that more QE will be forthcoming. But that's of little help for today's increasingly illiquid markets. Markets in the near-term have a problem: central bankers are not at the edge of their seats fretting a market meltdown. Dr. Bernanke had a persistently weak stomach, fearful his entire monetary experiment would come crashing down upon him at any time. Markets were similarly confident that a risk averse chair Yellen wouldn't dare try anything that might put global markets at risk.

So inflating Bubbles were left to run wild, market participants ever confident that the greater Bubbles inflated the more averse central bankers would be to removing the punchbowl. Monetary madness stretched out for way too long. The job of returning central banking to some semblance of normality is left to Chairman Powell. It's a thankless job; a winless job. It is deeply unfair - and I would argue disturbing - to see him setup to be the villain. I believe deeply that monetary inflation is the enemy of the people. Responsible central banking is not.

It would not be surprising if the Fed Chairman and central bankers, more generally, are not at this point overly concerned with the current bout of market instability. After all, markets have over recent years taken these types of selloffs in stride, "buying opportunities" as markets quickly bounced back to ever-higher new records. Besides, aren't speculative markets overdue for a wakeup call? Markets fear that central bankers lack fear.

Hedging and option-related selling surely played a significant role in this week's downdraft. And with expiration next Friday, expect option-related trading to play a major role well into next week - either up or down. Repeatedly we've seen expiration-week rallies destroy put value. If market strength does force a self-reinforcing reversal of hedges into expiration, the bulls will see the rally as evidence of a market on sound footing (the week was notable for the amount of bullish pontification in the face of an unbullish market reality).

But don't be fooled by fleeting option-related buy programs and the appearance of abundant liquidity. The backdrop is changing. Importantly, de-risking/deleveraging dynamics have arrived at the "Core." They have not only made it to the "Core," they've afflicted a vulnerable "Core" in a global backdrop of waning central bank liquidity, rising short-term rates and surging market yields.

"Risk Off" has become a global phenomenon - de-risking/deleveraging within a backdrop of central banks hoping to move beyond years of repeated market liquidity backstop operations. Moreover, it is a backdrop of highly divisive politics and troubling geopolitics. It is a worrying backdrop of escalating populism, nationalism and protectionism - that will matter now that markets are faltering.

I tell my wife that "it's over" just to hear her laugh. "How many times have you said that?," she'll say. With a chuckle, I respond, "This time I mean it." We shared a little laugh together, but this time I wasn't kidding. I do vividly recall thinking "it's over" in the summer of 2012, not anticipating that the German's would tolerate Draghi's "whatever it takes" unlimited "money" printing operations. And I similarly recall thinking "it's over" with China's Bubble at the precipice in early-2016. I guess I should have anticipated China's "national team," along with a ratcheting up of QE from the BOJ and ECB and an abrupt postponement of Fed "normalization" (after one tiny baby step).

I think "It's over" because all these market bailouts ensured things turned really crazy - and I believe this time around it's going to take central bankers longer to respond. I sense little appetite for another round of concerted global "money" printing operations. The focus is on domestic issues rather than some global agenda.

And market structure has become acutely vulnerable. Trillions in perceived safe and liquid ETFs. Trillions in a hedge fund industry struggling with performance and susceptible to huge outflows. Hundreds of Trillions of derivatives susceptible to market dislocation and illiquidity. Too much derivative market "insurance" that risks fomenting an avalanche of self-feeding sell orders. And let's not forget the maladjusted U.S. economic structure that will function surprisingly poorly in a backdrop of tighter financial conditions and sinking securities markets.

In particular, it was an ominous week for the two great intertwined Bubbles, illustrated by the Shanghai Composite's and S&P500's respective 7.6% and 4.1% declines. I could go on and on, but I find it all sad and frustrating.


The world economy

The next recession

Toxic politics and constrained central banks could make the next downturn hard to escape.


JUST a year ago the world was enjoying a synchronised economic acceleration. In 2017 growth rose in every big advanced economy except Britain, and in most emerging ones. Global trade was surging and America booming; China’s slide into deflation had been quelled; even the euro zone was thriving. In 2018 the story is very different. This week stockmarkets tumbled across the globe as investors worried, for the second time this year, about slowing growth and the effects of tighter American monetary policy. Those fears are well-founded.

The world economy’s problem in 2018 has been uneven momentum (see article). In America President Donald Trump’s tax cuts have helped lift annualised quarterly growth above 4%. Unemployment is at its lowest since 1969. Yet the IMF thinks growth will slow this year in every other big advanced economy. And emerging markets are in trouble.

This divergence between America and the rest means divergent monetary policies, too. The Federal Reserve has raised interest rates eight times since December 2015. The European Central Bank (ECB) is still a long way from its first increase. In Japan rates are negative.

China, the principal target of Mr Trump’s trade war, relaxed monetary policy this week in response to a weakening economy. When interest rates rise in America but nowhere else, the dollar strengthens. That makes it harder for emerging markets to repay their dollar debts. A rising greenback has already helped propel Argentina and Turkey into trouble; this week Pakistan asked the IMF for a bail-out.

Emerging markets account for 59% of the world’s output (measured by purchasing power), up from 43% just two decades ago, when the Asian financial crisis hit. Their problems could soon wash back onto America’s shores, just as Uncle Sam’s domestic boom starts to peter out. The rest of the world could be in a worse state by then, too, if Italy’s budget difficulties do not abate or China suffers a sharp slowdown.

Cutting-room floors

The good news is that banking systems are more resilient than a decade ago, when the crisis struck. The chance of a downturn as severe as the one that struck then is low. Emerging markets are inflicting losses on investors, but in the main their real economies seem to be holding up. The trade war has yet to cause serious harm, even in China. If America’s boom gives way to a shallow recession as fiscal stimulus diminishes and rates rise, that would not be unusual after a decade of growth.

Yet this is where the bad news comes in. As our special report this week sets out, the rich world in particular is ill-prepared to deal with even a mild recession. That is partly because the policy arsenal is still depleted from fighting the last downturn. In the past half-century, the Fed has typically cut interest rates by five or so percentage points in a downturn. Today it has less than half that room before it reaches zero; the euro zone and Japan have no room at all.

Policymakers have other options, of course. Central banks could use the now-familiar policy of quantitative easing (QE), the purchase of securities with newly created central-bank reserves. The efficacy of QE is debated, but if that does not work, they could try more radical, untested approaches, such as giving money directly to individuals. Governments can boost spending, too. Even countries with large debt burdens can benefit from fiscal stimulus during recessions.

The question is whether using these weapons is politically acceptable. Central banks will enter the next recession with balance-sheets that are already swollen by historical standards—the Fed’s is worth 20% of GDP. Opponents of QE say that it distorts markets and inflates asset bubbles, among other things. No matter that these views are largely misguided; fresh bouts of QE would attract even closer scrutiny than last time. The constraints are particularly tight in the euro zone, where the ECB is limited to buying 33% of any country’s public debt.

Spending ceilings

Fiscal stimulus would also attract political opposition, regardless of the economic arguments. The euro zone is again the most worrying case, if only because Germans and other northern Europeans fear that they will be left with unpaid debts if a country defaults. Its restrictions on borrowing are designed to restrain profligacy, but they also curb the potential for stimulus. America is more willing to spend, but it has recently increased its deficit to over 4% of GDP with the economy already running hot. If it needs to widen the deficit still further to counter a recession, expect a political fight.

Politics is an even greater obstacle to international action. Unprecedented cross-border co-operation was needed to fend off the crisis in 2008. But the rise of populists will complicate the task of working together. The Fed’s swap lines with other central banks, which let them borrow dollars from America, might be a flashpoint. And falling currencies may feed trade tensions. This week Steve Mnuchin, the treasury secretary, warned China against “competitive devaluations”. Mr Trump’s belief in the harm caused by trade deficits is mistaken when growth is strong. But when demand is short, protectionism is a more tempting way to stimulate the economy.

Timely action could avert some of these dangers. Central banks could have new targets that make it harder to oppose action during and after a crisis. If they established a commitment ahead of time to make up lost ground when inflation undershoots or growth disappoints, expectations of a catch-up boom could provide an automatic stimulus in any downturn.

Alternatively, raising the inflation target today could over time push up interest rates, giving more room for rate cuts. Future fiscal stimulus could be baked in now by increasing the potency of “automatic stabilisers”—spending on unemployment insurance, say, which goes up as economies sag. The euro zone could relax its fiscal rules to allow for more stimulus.

Pre-emptive action calls for initiative from politicians, which is conspicuously absent. This week’s market volatility suggests time could be short. The world should start preparing now for the next recession, while it still can.


Why the Stock Market Went Loco

By Randall W. Forsyth

Why the Stock Market Went Loco
LightRocket via Getty Images


Is this it?

That was the question on investors’ minds after a 1,300-point plunge in the Dow Jones Industrial Average on Wednesday and Thursday. “It,” of course, is a correction, or worse, in what had been a steady, nearly unstoppable ascent in the U.S. stock market.

While the decline was arrested for the moment Friday, the major averages ended the week with their steepest losses since the week ended March 23. The Dow ended down 4.2%, the S&P 500 fell 4.1%, and the Nasdaq Composite lost 3.7%. That was a far sight better than the 7.6% plunge in the Shanghai Composite but in line with declines in other bourses, from the Stoxx Europe 600 to Australia’s S&P/ASX 200 to Japan’s Nikkei and South Korea’s Kospi.

What turned the U.S. markets around Friday—when the Dow and the S&P 500 managed to pop more than 1% and the Nasdaq Composite bounced over 2%—wasn’t much clearer than what set off the slide. Market Semiotics’ Woody Dorsey says that his proprietary sentiment polling found a bullish reading of absolute zero on Thursday, a contrarian indication that “panic” would be short-lived.

Though it’s rather unsatisfying, Jason Trennert, who heads Strategas Research, said the proximate cause for the market’s dip reflected mainly a desire to book profits in the big winners, notably the FAANG stocks. But there was some “solace” in the absence of pressure from the corporate credit markets. “We all learned the hard way in 2007” about the dangers posed by widening credit spreads, which warned of the financial crisis that lay ahead, he adds.

Cliff Noreen, deputy chief investment officer at MassMutual also notes that the investment-grade and high-yield bond markets performed pretty well, relative to stocks. The iShares iBoxx $ Investment Grade Corporate Bondexchange-traded fund (ticker: LQD) gained 0.5% on the week, while the iShares iBoxx $ High Yield Corporate BondETF (HYG) dipped just 0.3%. The corporate credit sector wasn’t leading the equity markets lower, as it sometimes does.

That doesn’t mean the bull market is ready to resume its run, however. Doug Ramsey, chief investment officer of the Leuthold Group, thinks the Sept. 20 high for the S&P 500 of 2930.75 may well mark the peak for the year, and perhaps even for the historic run that began in March 2009.  


For confirmation of that, he’s looking for a breakdown in the leadership themes that have defined this bull market: growth stocks over value; U.S. assets over foreign assets; financial assets over real assets; and the relative strength in momentum stocks, which, as Ben Levisohn writes in the Trader column, has already begun to break down. If those other three “paw prints” of the bear are sighted, the beast’s return will be confirmed, Ramsey concludes.
Have interest rates ever been such an object of intense, well, interest? Over the past four decades, a span that has seen record-high rates (for the U.S.) above 20% and record-low ones of zero, it’s hard to recall another time when the price of money commanded so much attention from so many quarters.

That would include President Donald Trump, who amplified his tirade against the Federal Reserve this past week. “Crazy,” “loco,” and “out of control” was how he described the central bank’s policy of raising its short-term interest rate target. While adding that he wouldn’t “fire” Fed Chairman Jerome Powell, the president also declared, “I think I know about it better than they do” in assessing monetary policy, recalling his 2016 campaign boast that “I know more about ISIS than the generals do.”

Fed policy is still “accommodative,” in Powell’s words, even though that description was omitted from the latest Federal Open Market Committee policy statement. “Accommodative” aptly describes the recently raised federal-funds rate target range of 2% to 2.25%, which is negative in real terms after deducting the 2.7% year-over-year increase in the consumer-price index. In other words, it’s money for less than nothing, for an economy that is far from being in dire straits. The FOMC’s “dot plots” of future fed-funds rates anticipate four more quarter-point increases by the end of 2019, which is hardly Draconian.

What roiled the stock market this past week wasn’t the short-term rate targets set by the Fed, but the longer-term yields set by the bond market. Treasury yields, in particular, have been on an upward march the past month for both fundamental and technical reasons. What’s more important is that the interrelationship between the bond and stock markets appears to be undergoing a basic shift.

Quite simply, the Treasury market no longer has the stock market’s back. That represents a “regime change,” in the words of James Bianco, head of Bianco Research in Chicago. He described that term here earlier this year and expanded upon it at the Grant’s Interest Rate Observer conference in New York last Tuesday.

Since around the turn of the century, stocks and bonds have been negatively correlated; in other words, if equities would zig, bonds would usually zag. A drop in stocks and other “risk assets,” such as junk bonds, would raise expectations of lower interest rates, so Treasury securities’ prices would rise.

This negative correlation has held during what has been a deflationary period since the late 1990s, or since the dot-com bust, and especially since the financial crisis, Bianco explained this past week. But now, “markets are transitioning from a deflation mindset to an inflation mindset,” so the correlation is breaking down.

The last time stock and bond prices moved in tandem was from the late 1960s through much of the 1990s. The inflationary 1970s saw simultaneous bear markets in stocks and bonds, as interest rates soared. The great bull markets of the 1980s and 1990s saw bond yields decline from record highs, which lifted stocks.

This past week’s sharp drop in stocks followed Treasury yields’ breakout above their previous highs for the year, with the benchmark 10-year note surging as high as 3.231% on Oct. 5 and the 30-year bond also hitting 3.405%.

Like Sherlock Holmes’ dog that didn’t bark, the long end of the Treasury market didn’t see prices rise and yields slip while stocks were in full retreat Wednesday. The Treasury market sent yields down a bit on Thursday, while stocks continued their slide, but that is a far cry from the bond rally that once was automatic when stocks sold off.

That reliable relationship was critical to two popular investing strategies of the past two decades: the venerable 60/40 stock/bond portfolio and so-called risk parity, which leverages lower-volatility bonds to produce returns like riskier stocks.

A shift in the relationship would have major implications, which became apparent in the recent simultaneous backup in bonds and stocks. Billions of dollars in institutional portfolios, from pensions to endowments, are predicated on the recent history that a stake in high-grade bonds like Treasuries would protect them from a downturn in risk assets. It seems as if it’s different this time.

Another, more technical aspect is also driving up bond yields, and it has the potential for triggering a crisis along the lines of the one of a decade ago.

David P. Goldman, who headed credit research on Wall Street while the housing bubble inflated, details the dangers in an Asia Times blog post that asks, “Has the derivatives volcano already begun to erupt?”

Investors abroad hedge the currency risk of their purchases of higher-yield dollar assets by going to their banks to swap greenbacks for local currencies. The banks borrow dollars for euros and yen, and sell the dollars in the forward market. But there’s a problem.

“European banks are running out of borrowing capacity,” Goldman writes. “After five years of negative short-term rates, their profitability is low, their stock prices are falling, and their credit is deteriorating. They can no longer borrow the dollars required to construct the hedges that local investors need.”

The Bank for International Settlements estimates that non-U.S. banks owe $10.7 trillion—with a T—in dollars, which doesn’t show up on their balance sheets. The BIS estimates that these foreign-exchange swaps total $13 trillion to $14 trillion.

The banking system may no longer be able to support such flows, Goldman says. “In a volatile market, European banks might not be able to roll over nearly $11 trillion of short-term obligations—and might default.”

“If overseas investors can’t recycle the half-trillion U.S. current account deficit into dollar-based securities because the banking system can’t profit from the foreign exchange hedges, U.S. yields will rise, perhaps sharply,” he writes. Still, he doubts that European governments would let their banks default on their dollar obligations, preferring to arrange “shotgun mergers and emergency capitalizations.”

In sum, stock markets may be reacting to the realization that interest rates might not provide the cure for whatever ails them.


Crushed and fried

Asia is not immune to emerging-market woe

Currencies and stockmarkets have tumbled, though growth rates are solid



THERE are many ways to defend a currency. Ayam Geprek Juara, an Indonesian restaurant chain that serves crushed fried chicken, has offered free meals this month to customers who can show they have sold dollars for rupiah that day. The restaurant has provided more than 80 meals to these “rupiah warriors”, according to Reuters, a news agency.

Perhaps it should extend the offer to the staff of Bank Indonesia, the country’s central bank, which is only about 20 minutes away from one of the restaurant’s branches. To defend the rupiah, it has been selling billions of dollars of foreign-currency reserves, which have fallen from over $125bn in January to less than $112bn in August. Despite these sales, and four interest-rate rises since May, the rupiah has lost almost 10% of its value against the dollar this year, returning to levels last seen during the Asian financial crisis of 1997-98.

India’s rupee has fared even worse, reaching a record low against the dollar. And even where Asia’s currencies have remained steady, its stockmarkets have faltered. Hong Kong’s Hang Seng index fell by 20% from late January to September 12th, meeting one definition of a “bear market”. Mainland China’s markets are struggling.

A person returning from Mars would assume that something horrible had happened in the region, says Chris Wood of CLSA, a brokerage. But in fact Asia’s emerging economies are enjoying a happy spell of respectable growth and stable consumer prices. Only Pakistan has a combined trade and fiscal deficit as devilish as Turkey’s or Argentina’s. And not even Pakistan has anything like their double-digit rates of inflation. India’s GDP grew by over 8% last quarter, compared with a year earlier. Indonesia’s expanded by over 5% (as it almost always does). And China’s grew by over 6% (as it always does). Nor is a widespread slowdown expected this quarter.



The trade war has soured the mood in China and Hong Kong. But China’s exports to America still grew by over 13% in August, and the Canton trade fair was at its busiest for six years, according to the Institute of International Finance, an industry group. Many American customers are obviously keen to shop before the broader tariffs take effect. Some of China’s neighbours, especially Vietnam, believe they can win the trade war by taking in its refugees: the manufacturers that move out of China to escape tariffs.

India and Indonesia are largely insulated from the trade war, thanks to the strength of their domestic demand. But that same strength leaves them exposed to two other dangers—the higher oil price and America’s remorseless monetary tightening. India’s oil-import bill for the past five months was more than 50% higher than a year ago. Its current-account deficit could widen to 3% of GDP this fiscal year (which ends in March), according to some forecasts. Indonesia’s could expand similarly.

These gaps would be easy to finance if foreign investors were in an indulgent mood. But they are not. As American interest rates have risen, emerging markets have looked less rewarding and more dangerous by comparison.

In response India’s government is tweaking taxes and regulations to attract more foreign capital and fewer foreign goods. It will, for example, suspend a tax on rupee-denominated “masala” bonds sold outside India. It has also decided to curb imports of inessential items, without yet specifying what those may be.

In Indonesia the government is encouraging state firms to dilute imported fuel with biodiesel, extracted from local palm oil. It has delayed big infrastructure projects. And it has increased import tariffs on over 1,000 goods, including perfume, stuffed toys and tomato ketchup. The life of a rupiah warrior is not without sacrifices.

In theory, such ad hoc measures should be redundant in two economies that have embraced flexible exchange rates. If the trade deficit is unsustainable, a floating currency is supposed to weaken, thereby discouraging imports (and encouraging exports) automatically. By this logic, the declining rupee and rupiah will eventually resolve the problem they reflect.

But Indonesia worries that its foreign-currency debts will be harder to sustain with a weaker rupiah. These debts amount to about 28% of GDP, far below Turkey’s and Argentina’s totals, but are still too large to ignore. Moreover, about 40% of its rupiah-denominated government bonds are held by foreigners, according to Joseph Incalcaterra of HSBC, a bank. That “presents a sizeable outflow risk,” he says, which is one reason why Indonesia’s central bank has raised interest rates faster than India’s.

Both countries also worry that falls in the currency will beget further falls. After fighting the rupiah’s slide in 2013, Chatib Basri, Indonesia’s finance minister at the time, argued that a sharp drop in the currency would have revived memories of the crisis in 1997 and led to investor panic.

That wobble in 2013 followed some stray remarks from America’s Federal Reserve, which suggested it might soon slow its asset purchases. The subsequent spike in Treasury yields caused turmoil in emerging markets and threatened America’s fragile recovery, prompting the Fed to clarify and soften its position. The more recent increase in Treasury yields is different. It reflects a robust American expansion, reinforced by generous corporate-tax cuts. This time, there is little reason to expect a rethink at the Fed. America does not feel emerging markets’ pain.

Asia has long dreamed of “decoupling” from America so it can prosper even when the world’s biggest market does not. Instead, it is suffering even when America is not. And partly because America is not.


Why rising bond yields are no obstacle for the US stock market

The disconnect between them can last as long as economic growth remains robust

John Authers



These are trying times for the “Fed Model”. This is not necessarily a problem for the Federal Reserve, and perhaps should not be surprising, but it does show that some assumptions that have long been taken for granted now need to be questioned.

The Fed Model, for the uninitiated, is the name given to the theory that bond yields will move in line with earnings yields on stocks. The earnings yield is the inverse of the price/earnings ratio, and so effectively shows the “yield” or percentage return you might expect to get in terms of earnings from stocks.

In itself, there is nothing wrong with the idea. Investors have a choice between bonds and stocks. If the yield on bonds rises, then stocks will need a higher yield to compete with them. Thus, prices will need to go down. It follows that higher bond yields are bad for stocks.

But this week, US bond yields have risen sharply — and the response of the stock market has been to set another record. Not only that, but the higher yields should attract money into the US, and so push the dollar upwards — and yet the dollar has sharply weakened. This at least shows that the Fed Model is not as immutable as the laws of physics. It is worth going into deeper detail.

The idea that bond yields drove stock valuations was labelled the “Fed Model” because Alan Greenspan at times appeared to be applying it while giving testimony when he was in charge of the Fed in the 1990s. For two decades, roughly throughout the 1980s and 1990s, the relationship seemed firm; armed with the Fed Model, plenty of investors stayed invested for the great bull market of the 1990s.
 he problem is that the relationship broke down completely during the dotcom bubble, when stocks became insanely expensive despite belated attempts by the Greenspan Fed to tighten conditions. Since then the two lines on the chart have had almost nothing in common with each other. As Andrew Smithers once pointed out in these pages, it was probably more accurate, given the full history, to say that there never was a relationship.

Despite this, there are clear reasons why a sharp rise in bond yields, all else equal, should be bad for stocks. Quite apart from encouraging investors to switch from stocks to bonds, rising interest rates also make it harder to service debts and to raise capital, which might both be reasons for share prices to go on.

Fed Model psychology was on display earlier this year as US and world stocks enjoyed a euphoric surge following the cut in US corporate tax. Then bond yields rose, data on the labour market suggested inflationary pressures were back, implying higher interest rates and even higher bond yields in future, and stocks fell.

Outside the US, most markets have barely started to recover. Even in the US, it took more than six months for them to regain their peak. From this, it is fair to infer that many equity market investors still find rising bond yields very scary. In the past few weeks, we have had data suggesting that the US labour market might overheat, and a rally in US bond yields. That rise has outstripped rises in yields for bonds of other countries.

So why is it different this time, for both stocks and the dollar? The higher yields have even coexisted with a slight recovery for emerging market currencies.

This is a very recent turnround. During September, the correlation between the strength of the dollar against key trading partners, and the spread of Treasury yields over German Bund yields, has been strongly negative. For the year until September, it had been strongly positive, according to BNY Mellon.

Marvin Loh of BNY Mellon suggests that this combination of circumstances could show growing concerns about a rising US deficit and inflation (which would weaken the dollar and push up bond yields, but might prompt investors to buy stocks as an inflation hedge). Or it could suggest that other central banks will quickly catch up with the Fed. But “it is hard to see all how all these stretched relationships can exist harmoniously for an extended period of time”.

Another possibility is that we need to ask what caused bond yields to rise. Logically, if people are optimistic about the economy, and comfortable taking risk, then they will sell bonds to buy other securities — and push up yields in the process. Rising bond yields can be a sign of returning risk appetite and optimism for the economy.

This is the possibility suggested by Alan Ruskin of Deutsche, and it makes eminent sense. He suggests that risk is indeed driving yields, and it is also prompting investors to buy emerging market currencies. In such circumstances, higher bond yields can coexist with a weaker dollar and strong stocks.

At present, worries about deflation have been put aside, there is confidence that the world is back in a healthily reflationary state, and that is bad for the dollar. As Mr Ruskin puts it: “When the world gets disinflationary, the dollar does well; when the world looks more reflationary, the dollar does poorly.”

The question now becomes why we have seen the return of risk appetite. First, the sheer strength of the US jobs market implies not only more inflation and higher rates but also growth. And the latest developments in the trade conflagration have arguably been less dire than had reasonably been feared.

If this latest move has been driven by optimism, it follows that optimism needs to be confirmed.
If the US labour market keeps strengthening and trade tensions subside, the odd disjunction in markets can continue. Should the Fed continue tightening and trade tariffs begin to bite into the economy, however, the Fed Model could reassert itself, and higher bond yields would be greeted by cheaper stocks.