lunes, 23 de diciembre de 2013

lunes, diciembre 23, 2013

Dovish or Hawkish

 

December 20, 2013



Fed provides impetus for year-end equities mark-up, while things deteriorate in China.

Where to begin The Bernanke Fed commenced the first step toward reining in the unprecedented expansion of our central bank’s balance sheet. Equities loved it. The Dow Jones Industrial Average surged 293 points on the Fed announcement, while the S&P 500 gained 1.66% to trade to a new all-time high. A Wall Street Journal blog headline read: “Fed’s ‘Very Dovish Tapering’ Spurs Rally.”

It was a curious market response. U.S. equities surged on a “dovishFed, while the Treasury market seemed to view the Fed move in morehawkishlight. Ten-year Treasury yields rose 3 bps this week to 2.89%, the high since September. More interestingly, a notable curve flattening saw five-year Treasury yields surge 15 bps to 1.68%. Even two-year yields rose 5 bps to 0.38%.

Emerging markets (EM) also reacted cautiously to the “dovishnews. A Friday headline from Bloomberg: “Emerging Stocks Head for Longest Weekly Losing Streak Since June.” Notably, Chinese stocks were hammered. The Shanghai Composite was hit for 5%, suffering a 9-day losing streak called the longest since 1994.

Key EM currencies were under heavy selling pressure. The Turkish lira was hit for 2.5% this week, the Brazilian real 2.4%, the Argentine peso 2.1% and the Mexican peso 0.7%. Asian currencies were also under notable pressure. The Thai baht declined 1.7%, the Malaysian ringgit 1.6%, the Taiwanese dollar 1.1%, the Indonesia rupiah 0.9%, the Singapore dollar 0.9%, the Japanese yen 0.9%, the South Korean won 0.8% and the Philippine peso 0.8%.

Turkish (lira) 10-year sovereign bond yields surged 57 bps this week to 9.92%, the high since the summer crisis period. Brazil’s (real) 10-year yields jumped 41 bps to 13.20%. Reminiscent of May/June, market yields were generally on the rise around the globe.

Why would U.S. stocks respond so differently to the Fed’s taper than Treasuries, EM and global market yields? The “Core vs. Peripheryanalytical framework continues to be of value. A key speculative dynamic has been in play for much of 2013: In a world awash in QE liquidity, cracks in Treasury bond and EM Bubbles spur coreBubble excess in equities and corporate debt. An intensely speculative equities market can look to another 10 months and, presumably, another $500bn of QE and see sufficient liquidity to keep the game going. Treasury and EM markets, having already suffered in spite of the Fed’s Trillion dollar liquidity injections, see liquidity waning with the beginning of the end to the Fed’s historic balance sheet expansion.

The FOMC statement and Bernanke’s press conference were both generally viewed as “dovish.” The Fed providedcandy” with its extended forward guidance. There was significant focus on below-target inflation, which has become music to the speculators’ ears (“QE forever!”). Amazingly, the Fed has essentially promised markets that short-rates will be held near zero for the minimum of a couple more years. The Fed believes (hopes) such guidance will anchor long-term yields as it winds down its aggressive balance sheet expansion (QE). Hard to believe it’ll be that easy.

December 18 - MarketNews International (Steven Beckner): “In his presumably final press conference as Federal Reserve Chairman Ben Bernanke extolled the ongoing benefits of large-scale asset purchases, but he also recognized their limits. Yes, he said in response to a question from MNI, bond buying has its benefits and will continue to support the economy even as it is scaled back, but it also has its costs and its risks. That is a significant recognition on the part of the soon-to-retire chairman… [Beckner questioning Bernanke] ‘To what extent has that calculation already changed? To what extent did that effect today’s decision? And going forward, looking on the cost side,... to what extent will...threats to financial stability come in to play as well as the potential for losses on the Fed’s own portfolio?’ Bernanke began his reply by repeating that the FOMC thinks of asset purchases as ‘a secondary tool behind interest rate policy. And we do think that the cost benefit ratio particularly as the assets on the balance sheet get large that it moves in a way that's less favorable.’ Among the costs are ‘managing the exit from thatlarge balance sheet, he said.”

My own view is that QE3 has gone altogether differently than how top Fed officials anticipated. In particular, Treasury yields have moved higher, while a speculative melt-up in equities has spurred renewed Bubble concerns. Some of Bernanke’s comments suggested growing caution: “We look at the possibility that asset purchases have led to bubbly pricing in certain markets or in excessive leverage or excessive risk taking.” There was as well a notable degree of humility: “I think, for example, that an important difference between asset purchases and interest rate policy is that asset purchases work by affecting what is called a term premium which is essentially the additional part of the interest rate which investors require as compensation for holding longer term securities. We don’t understand very well what moves the term premium…”

More than affecting the term structure of interest rates, QE3 has fueled major equities market inflation while stoking destabilizing speculation. One could argue that QE eased what would have been a quite problematic (faltering Bubble) reversal of flows out of fixed income funds, instruments and related products. On the cost side, Fed liquidity largely financed 2013’s great rotation” from bonds to bubbling stocks (along with corporate debt). Essentially, systemic Bubble risk was compounded.

For 2014, it’s reasonable for the apprehensive bond market to fear continuing outflows in a backdrop of waning QE. Meanwhile, the ebullient stock market can rejoice in its status as the best (only?) game in town in a world where the global pool of speculative financecommanded by trend-following and performance-chasing dynamics - is measured in the multi-Trillions (and counting).

From Bernanke comments and the FOMC statement, I discerned subtle confirmation of what I believe is a desire within the Fed system to end its experiment in massive asset purchases. Of course, they seek to gingerly manage this key inflection point in monetary policy/history. But, in true Bubble Dynamic form, “gingerly” is tantamount to a green light for market Bubble speculation. You’re either willing to remove the punchbowl or you’re not. Telling the intoxicated you’re going to modestly reduce the alcohol content of their drinks and then shut the bar down completely in a few hours is not likely to elicit the desired behavior (unless you’re fine with drunkenness).

Meanwhile, stocks continue with their speculative moonshot, in the process further widening the major divergence that has developed between inflated asset prices and uncertain global economic prospects. Perhaps the Fed remains in denial. But the benefits of QE have become minimal at best, while the rapidly escalating costs include a powerful stock market Bubble. ConventionalBubbleanalysis focuses on valuation. I focus instead on market dynamics and the propensity for Bubble markets to become more unwieldy over time, especially when accommodated by loose monetary policy. Our misguided central bank has, once again, nurtured a major problem.

Interestingly, chairman Bernanke was very specific that the QE wind-down would be dependent upon economic performance. I didn’t hear reference to the Fed being willing to “push backagainst a “tightening of financial conditions.” There is a subtle but perhaps very important distinction to be made.

When the markets responded negatively to the Fed’s initial (back in May) move to prepare the marketplace for tapering, Bernanke and other Fed officials immediately backtracked. The markets took this as a yet another signal that the Fed would use ongoing and open-ended QE as necessary to backstop the markets. This market perception was bolstered by the inclusion of a “tightening of financial conditionsreference in the FOMC’s September meeting statement. I read this as code for “markets we have your back.” These code words have gone missing.

Truth be told, promising a liquidity backstop to highly-speculative markets is a dangerous, risky business. I believe the Fed has come to better appreciate this dynamic in late-2013 and has subtly begun to adjust the way in which it addresses this key issue. If I am correct, this is a major policy development. From my analytical perspective, the perception of a liquidity backstop can have a profound impact on risk-taking in the markets, especially by the hedge funds and others within the leveraged speculating community.

Let’s return to the issue of “forward guidance.” The Fed now wants to shift policy focus away from asset purchases and back to managing interest rates and market rate expectations. This sounds reasonable enough, and the big market operators are for now content to play along. But market prices are determined by the preponderance of liquidity inflows versus outflows. “Moneydrives markets. Fedmoney” has for a while now been the powerful force dominating both asset prices and market dynamics. So let there be no doubt, there will be profound market impacts if the Fed follows through with its plan to wind down its “moneyprinting operations. Moreover, there will be major market ramifications if the Fed is less freely willing to commit to backstopping the markets. These major market impacts encompass domestic as well as international markets.

Importantly, prospects for reduced global liquidity will continue to impact the “marginalborrower, the marginal markets and the marginal economies (at the “periphery”). After about five years of “terminal phase Bubble excess, EM financial and economic fragilities are today, and for the foreseeable future, a serious issue. There was confirmation of this thesis back in May and June. There is added confirmation of late. The reversal of flows away from EM will be an ongoing problematic issue. Moreover, this faltering Bubble dynamic is compounded by the magnetic-pull of Fed and BOJ-induceddevelopedequities market Bubbles.

And asmoney” (“hot” and otherwise) packs up to exit EM, “developingcentral banks on the margin turn sellers of Treasuries, bunds and sovereign debt more generally. Global yields are pushed higher. One should not understate the market importance of a reversal of fortunes for EM central banks, after they bolstered markets with Trillions of debt purchases over recent years. And with irrepressible EM central bank buying no longer supporting global bond prices, the status of the Fed’s market backstop becomes absolutely critical. If the Federal Reserve is indeed moving to cap its balance sheet, the risk vs. reward calculus has been altered for leveraging in global fixed income. And if an inflating stock market Bubble pressures the Fed into action, this as well has major ramifications for leveraged speculation throughout globalbondmarkets.

December 20 – Financial Times (Simon Rabinovitch): “An emergency cash injection by the Chinese central bank failed to calm the country’s lenders as money market rates climbed to dangerously high levels. Analysts cited a variety of technical factors for the tightness in the Chinese financial system, but the sudden run-up in rates was an uncomfortable echo of a cash crunch that rattled global markets earlier this year. Investors were alarmed at the potential for a repeat of that squeeze. The Shanghai Composite, the country’s main equities index, fell 2%. The nine-day decline for Chinese stocks is their worst losing streak in nearly two decades. Concerns focused on the rates at which Chinese banks lend to each other. The seven-day bond repurchase rate, a key gauge of short-term liquidity, was emblematic of their reluctance to part with cash. It averaged 7.6% in morning trading on Friday, its highest since the crunch that hit China in late June. That was up 100 bps from Thursday and far above the 4.3% level at which it traded just a week ago. The sharp increase occurred despite the central bank’s highly unusual decision to conduct a ‘short-term liquidity operation on Thursday… The China Business Newsreported that the short-term injection was worth Rmb200bn ($33bn), a large amountLu Ting, an economist with Bank of America Merrill Lynch, said China’s financial system was entering a new era and policy makers were struggling to adapt. ‘The PBoC is faced with some serious challenges . . . and is confused,’ he said. ‘The PBoC finds it much more likely than before to make [operational] mistakes.’”

Global markets convulsed back in May/June as the Fed moved to prepare the world for less QE and Chinese officials finally decided to more forcefully clampdown on China’s runaway Credit and asset Bubbles. Respective domestic fragilities coupled with global fragilities saw both the Fed and Chinese in quicktighteningretreat. And in both cases Bubble excesses bounced right back stronger and more unwieldy than ever. Global markets now must again face the prospect of major uncertainties, as the Fed and Chinese make a second attempt at confronting Bubble issues. The bullish consensus view holds that the markets have moved beyond taper fears. In response, I’ll sayfollow the ‘money’” and fear what is unfolding in China.

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