“Rules are for the obedience of fools and the guidance
of wise men.” Douglas
Bader
Misguided Calmness
As the Fed chatter and massive obsession continued
last week, the battle between the Central bank and bond markets continued to
play out. The Federal Reserve continues to operate with public relation tactics,
sending out an army of economists to “talk-up” the financial markets and
economic conditions. Once again, a rate-hike is on the table, stirring up
headlines, but the skeptical crowd is smelling some desperation. Others sense
an election year has its own nuanced story and impact to the Fed’s reactions.
Some have all types of explanations, but
the mystery of how this cycle ends lives on. It is a mystery
that’s been contained with near-term calmness, but the “quiet” bullish run is
justifiably reaching questionable ranges despite no visible signs of
worries.
For a long-while, the bond markets have been skeptical
about US growth and fundamental economic expansion. As US 10 year yields remain
below 2%, the concept of a rate-hike has not been taken too seriously as the
data is murky. Further improvement in
economic data, less fear of recession and some additional revival in the energy
sector can provide a further boost for rate-hike justification. Yet,
strong growth is not clear-cut, mixed data fails to tell the whole story
and the status-quo is actually making participants more anxious.
The debate whether
to raise or not to raise interest rates has turned to more of a theatrical
spectacle for financial media and investors' circles. However, the
last few years have showcased a tangible pattern of low to negative
interest rates, subdued volatility and increased demand for “riskier assets”.
Within this context, the Fed faces a skeptical crowd, unimpressive economic growth and a stock
market that’s not quite cheap. Altering messages from the Central bank have
stirred enough confusion and created a doubt of creditability, but has not
harmed shareholders and bulls significantly. In fact, the bears have
capitulated various times as the Federal Reserve attempts to strong-arm the
audience into their thesis.
In or Out.
At this stage of the rally, investors are facing a
critical question: Whether or not to chase returns in equity markets as the
S&P 500 index flirts with all time highs. As the stock rally continues,
there is pressure mounting for investors to feel the urge to jump along with the
trend. However, there is a risk of assets topping. The warning is there, but the
event itself has yet to occur.
Nonetheless, still there is
escalating risk in abiding by Yellen & Co’s plans and views.
How many times have markets heard of a chance of a
rate-hike? Last year symbolic rate-hike was not quite earth shattering or
convincing. Seriously, there is a credibility problem. Equity markets and
other assets have appreciated to make headline splashes, but the substance-light
rally is under scrutiny. The Fed, entangled between near-empty promises
and loss of credibility, is trying to manage the same bubble it created. Calling
a market top for experts has been a brutal exercise, and hedge funds have under-performed,
especially with volatility muted. However, it's the invisible that's more
worrisome than the more visible market-related headlines. The Fed's bluff is
tiring investors, so much so that they
may question if they are with the Fed or willing to sit on the sidelines.
Short-term Digestion
The Dollar strength will be watched closely in the
near-term as it relates to rate hike chatter. Asian markets and EM currencies
will be evaluated closely as well for some clues. China’s weakness is being revealed slowly;
and US banks are another source that may look at rate-hikes favorably, assuming
shareholders believe it’ll actually happen. Amazingly, Yellen's speech itself
is enough to stir further speculations on pending actions. Unless, there is a
notable market move, most bulls may feel less compelled to sell, especially in
a world where Eurozone remains grim, Asia’s growth is not impressive and other
markets are still feeling the commodity price readjustments.
Short-term over-reactions and under-reactions can
create more confusion rather than clarity. Thus, the next few weeks ahead
are tricky from an analytical point of view, but investors must have a firm
stance before making a move.
It should be reiterated that to listen and to trust Central Banks
narrative is ultimately a choice. Investors have the choice to double down on
the Fed's narrative or reduce exposure to Fed-driven markets. More than
speculation, courage is one way to dodge major bullets from a risk perspective.
Some sparks of rising volatility were seen last week in VIX (Volatility index
for stocks). Short-lived or not is another matter, but for now staying
disciplined and not overreacting to each new piece of data is a valuable
approach.
Article Quotes:
“China’s banks are set to be the biggest losers in the
sweeping bailouts of the country’s steel and coal industries. Local governments
hoping to save their steel mills and coal miners have announced a series of
restructuring plans, enlisting the banks to take the hit by improving the terms
of the loans or swapping them for bonds or equity in the struggling groups. The
reliance on the banking system to shoulder the burden comes at an inopportune
moment, with China’s banks already mired in bad debt — about Rmb15tn ($2.25tn),
or 19 per cent of total commercial lending by some accounts. Profit growth at the banks has
also fallen over the past two years and could deteriorate further as many of
the country’s largest industrial players renege on loans for better
state-brokered deals…. The contentious debt-for-equity programme announced earlier this year, in
which banks will be asked to swap debt in exchange for equity in ailing
companies, would help the banks remove bad debt from their loan books in the
near term.” (Financial
Times August 28, 2016)
“In recent years, bond yields have been behaving in
strange ways. The yields on many government bonds have fallen to historically
low levels; in some countries, like Germany and Japan, some have actually
turned negative. An investor who pays €100 for a 10-year German government bond
will receive less than €100 back if he holds that bond until it matures. Such
weirdness looks even more bizarre in Japan, where the government has racked up
debt worth nearly 250% of GDP: an obligation one might expect to dent
confidence in the government’s credit. Some investors blame central banks for
these oddities; they have been printing money and buying bonds (raising the
price and pushing down the yield) in order to encourage firms to do more
borrowing and investing. Others blame a shortage of safe assets, like
government bonds, which are increasingly used as collateral in banking systems
and as the savings vehicles of choice in emerging markets. Still others
see in low yields a sign that the long-run growth potential of the world
economy is declining. The debate cannot easily be resolved. But
freakishly low yields do suggest that something strange has happened to
financial markets, to the global economy, or to both.” (The Economist, August 24, 2016)
Key Levels: (Prices as of Close: August 26, 2016)
S&P 500 Index [2,169.04] – August 15, 2016 highs of 2,193.81 set the
near-term barometer. This is a very mild short-term pullback in recent trading
sessions. More stronger selling is needed to suggest a pending shift in trend.
Crude (Spot) [$47.67] – A very sharp rise from August 3rd
lows ($39.19) to August 19 highs ($48.75). The suspense remains
regarding Crude price's ability to stay above $40, especially after a quick
run-up.
Gold [$1,318.15] – Heavy
resistance is forming around $1,350. Investors recall Gold’s inability to
surpass $1,400 in 2014, which remains a psychological hurdle for gold bugs.
DXY – US Dollar Index [96.19] – Most of this year, the dollar has not
maintained the same similar strength as before, but it has stabilized around
94. Some signs of a turn are developing but further evidence is needed.
US 10 Year Treasury Yields [1.62%] –
After breaking below 1.70% in June, yields have attempted to climb up as
the bond markets fully rejected the “growth” stories. Now investors await a
climb back to 1.70%.
Dear Readers:
The positions and strategies discussed on MarketTakers
are offered for entertainment purposes only, and they are in no way intended to
serve as personal investing advice. Readers should not make any investment
decisions without first conducting their own, thorough due diligence. Readers
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