Markets are confused. But why?
Confusion is a word we have invented for an order which is not understood – Henry Miller
Why are markets so confused? I am slightly perplexed at why the market has such a hard time comprehending and adjusting to the subtle changes made by the Fed over the last two FOMC meetings. To me the Fed's actions appear rather straightforward and logical, and this may be a good thing for markets and the next recovery phase.
Three conclusions should be drawn from the latest FOMC text and press conference:
1. Chairman Bernanke is done as Chairman – He had enough class in the press conference this week to make sure everything was about monetary policy and the job at hand rather than a focus on his own agenda and persona. Let me also for the record state this: I have never been a friend of Bernanke's theories and stewardship during this crisis – he has taken the US directly into a debt trap with the false premise of the "wealth effect" based on super-easy money. But I do respect his integrity, even his firm belief in his agenda, and at all times he has been measured in his communication and shown great respect for the office of the Chairman of the Federal Reserve. His predecessor Greenspan made the FOMC into a personal PR campaign for his own brilliance (or lack thereof). Chairman Bernanke has re-established the "office of Chairman" to its rightful position. Who comes next is a totally different story and scary if any of the prominent names mentioned thus far are nominated. (Likely candidates to succeed Fed's Bernanke in 2014)
2. Inflation undershooting with no policy response is the hidden message in Fed policy: Inflation in the US is undershooting its target and showing a falling trend. "Officially", the Fed sees this as transitory and a mean-reverting process, but in historic context this is "an issue" which would have been addressed by an increase in asset purchases and forward guidance. Instead, the Fed's projections are for a PCE inflation in the range of 0.8% to 1.2% (from 1.3% to 1.7% in March) for 2013. Signalling no anticipation of an additional policy response despite the lowering of inflation forecasts means the Fed is clearly sending a signal: something is rotten in the state of the markets! It is clear that the Fed now feels that the "wealth effect" has been too vigorous in asset markets and that we are in an early stages of an asset bubble. And the last thing you want to do when asset markets are overheating is to over-react to a falling inflation rate, hence the lack of a policy response signal despite huge noise from St. Lois Fed's Bullard (link: Bernanke ignores low inflation. Market doesn't)
3. Changing regulatory frame-work. Few people realize how 'dramatic' the Dodd-Frank Wall Street reform and consumer protection act was for the Federal Reserve. Dodd-Frank increased the Fed's regulatory power under Title III – Transfer of powers to the comptroller, the FDIC and the FED which among other practical changes meant there is now a new position on the Board of Governors, the "Vice Chairman for Supervision". Clearly when you have regulatory responsibilities for bank holding companies (read: too big to fail banks) – and when you think the market is getting irrationally exuberant in its valuations, you want to reign in the froth or "reach for yield" before it becomes excessive or even dangerous. The fact that the Fed is now directly responsible for the banks they support through super easy money makes them less prone to continue this game of extend-and-pretend relative to how they would have behaved without this increased power. Note also that the Federal Reserve on May 13 announced that stress tests from the largest 18 US bank holding companies must be submitted no later than July 5.
Another development along the same lines should have you worried about the potential for deflating asset prices: U.S Weighs doubling leverage standard for biggest banks. Yes, indeed: "The standard would increase the amount of capital the lenders must hold to 6 percent of total assets, regardless of their risk. It's twice the level set by global banking supervisors." This is critical for markets.
So putting all of the above together, what other conclusions can we draw?
- A Margin call is under way due to the changing regulatory framework: Even the policy makers are saying now that asset bubbles must be prevented from growing too large, which means a deleveraging environment.
- Who's the next Fed chairman? This is all unfolding as we are rapidly reaching the transition period to a new Fed chairman. Who will that be? Bernanke got us into the debt trap – who will take us out? Markets don't like uncertainty.
- Normalization from extremely easy money to easy money. I'm convinced that by the end of Q3/beginning of Q4 the Federal Reserve will start trying to put the genie back in its bottle, but it will be too late – it's already escaped. Monetary policy is now moving towards normalization. I expect Fed asset purchase tapering to begin by October with more volatility and the concomitant bloated VaR to follow.
Then of course, we need to put this into the global macro context to see how this affects other economic and market themes:
4. Asia's current account surplus is under pressure – coming from a level of 5-7% of GDP in 2005/2007, it's now at 1% and still falling. I see Japan and China going into actual deficits over the next two years – meaning dis-saving, and drawing down the balance of savings overseas, which means less US and OAT (French bond) buying but also a total stop for a global recycling of capital from Asia into deficit ridden governments globally. This means the recent rise in interest rates is just as much about less "free floating capital" from trade as from less "potential" printing from the major global central banks. This will mean a higher marginal cost of capital and a drive towards more balanced global economies.
5. The commodity Super Cycle is on hold (if not at full stop). This is mainly a China story. China has driven half of all commodity buying in the world in the last five years. China is now slowing down due to a number of factors: a credit and house bubble, an anti-corruption drive to reduce the speculative/capital flight trading between Hong Kong and China (which reduces trade and hence growth), an outdated business model which is now in its 34th year. The country is also in need of a serious overhaul to address corruption, the lack of quality health care and a lack of investment assets. The world is starting to realize China is transitioning to 4-5% growth range rather than the 6-8% which is officially declared (Electricity consumption was up a mere 4.3% in Q1 – normally a good peg). This means serious reform needs in "one trick pony" economies like: Australia, South Africa, Malaysia, Brazil, Mexico and other resource driven economies.
6. Overconfidence in recent economic and policy action. All change – Last station – All change.. was a piece I wrote on how when the market is overconfident it tends to overleverage through the use of value-at-risk (VaR) models.
VaR starts to bloat when an impulse, like a failed QE program from Japan, increases volatility. Volatility is the first derivative of price, i.e: fast moving prices make the VaR numbers bigger (more volatility equals more risk). This in turn sees risk managers telling traders to reduce risk, which makes the prices move even more quickly and even discontinuously. The big moves in JGB's and USDJPY will also mean that volatility spills over into other markets as various as Emerging market debt and coffee futures as volatility is nearly always contagious.
The market deals extremely poorly with paradigm shifts or cycle changes. One reason for this is that there has been no need for any strategy except: Just-buy-the-dip. This may have ended and that could be the best signal to the markets since the global financial crisis started. Sorry to be the messenger, but the only way for investors to understand risk and leverage is by having them lose money.
Essentially then, the balance of this year could be an exercise in re-educating the market to long lost concepts like: loss, risk, inter-market correlations, and price discovery. I will even predict that high frequency trading systems will suffer, so will momentum based trading and most interestingly, also long only funds. Why? Because at the end of the day they are all built on the same premise: predictable policy actions, financial oppression, and no true price discovery. We could be in for a summer of discontent as policy measures and markets return try to search out a new paradigm. This will be good news for all us.
Strategy
This month has been the best month in the last ten years for Alpha trading, but more importantly, I think the themes above will play for a long time so I will remain with broader themes:
· We have seen the low in yield and yield-risk spreads. The marginal cost of capital will rise. The new target is the top of the long-term channel (see below)
· The US is the best of the worst in growth, innovation and job creation leading to a stronger US dollar and general outperformance in equities. The US is the new growth leader globally and US Dollar the long currency of choice
· Emerging markets are going through a major re-focus as they lose momentum from the lack of growth from China. It's good news long-term but impeding short-term.
· Europe is one bad election away from a wake-up call for the European idea. The odds of a Greece or Cyprus upset late in the game is 50/50. Europe will underperform in all assets. Complacency and massive under-estimation of the challenges from the lack of capital in banks, high unemployment, true magnitude of the deficits and real growth is profound throughout Europe among policy makers, politicians and other investment banks as well.
These themes above are the reality. These are not moving targets. A current account number can't be altered overnight by policy action, neither can a short fall in tax revenue. The fact is that many economies are fully stretched with no policy action possible. The central banks have already printed too much of the money they don't have nor have the collateral to justify. And over the last six months everyone has been manipulating currencies so that we are back to square one with no net benefit. Reforms are coming not because anyone wants them – or even can find political will for them, but because there are no alternatives. Again - why are we so confused? It's quite simple.
The fact that the new paradigm is bringing back market reality has me, for the first time in a long time, smiling all the way home for the week-end. I wish you all safe travels,
Steen
Med venlig hilsen | Best regards
Steen Jakobsen | Chief Economist
Saxo Bank A/S | Philip Heymans Allé 15 | DK-2900 Hellerup
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