Cold Feet

Bernanke is getting cold feet
Bond buying he may soon complete
So it’s no surprise
That bond yields did rise
And stocks beat a hasty retreat

In case anyone doubted that the reason equity markets around the world have performed as well as they have over the past two years was directly attributed to the massive liquidity infusion by central banks, those doubts have been erased.  The entire idea behind QE has always been to force investors out of bonds and into riskier assets.  (The underlying premise was that banks would lend the money out to business for expansion, but that’s not really what happened).  Now that Bernanke has intimated conditions may soon lead to the end of QE, it was inevitable that this is how things would play out in the markets.  It doesn’t seem to matter that every time a policy change is made by a central bank, especially the inflection from easing to tightening or vice versa, markets respond with significant volatility.  Central bankers just don’t seem to get it.  The reason for this disconnect between market behavior and central bank desires is that central bankers are traditionally academicians, with little or no market experience, and quite frankly, they simply don’t understand how markets respond to news.  Traders don’t wait around for the eventual changes in the economy to materialize; they adjust their positions at the first hint of a change.  Trading too early is generally a much better error than trading too late.  And this is also why markets tend to trade far beyond any sense of fundamentals.  So if we don’t get some further ‘clarification’ from other Fed members soon, notably Yellen or Dudley, that there is no imminent change in the pace of QE, this market condition can extend quite a bit further.  Higher US yields, lower US stock prices and a rallying US dollar, just like yesterday, will be the norm.  That has been my underlying belief for several months, and I see no reason to change that view.  (Of course if we do get that clarification, look for even more volatility as markets reverse course to some extent.)

Let’s look briefly at just how far things have moved in the past two days:



















These are quite substantial movements for a 2-day period, and this increase in volatility is likely to be seen far more frequently as the transition from infinite monetary ease to ‘normal’ monetary policy proceeds.  The market is going to be highly sensitive to comments from all central bankers.  But it is also going to be highly sensitive to US data, because Chairman Ben has made it clear that data is the key.  If growth achieves their forecasts (which have been raised to 3.0-3.5% for 2014), they are going to stop buying bonds and let them start rolling off.

Today’s US data upcoming is as follows:

Initial Claims


Philly Fed


Existing Home Sales


Leading Indicators


I think that the first 3 have the opportunity to move markets.  Indications of a better labor market are key, but if the Philly Fed follows the Empire Mfg number, which was much better than expected, and the Housing market continues to show strength, traders are going to be abandoning bonds pretty aggressively.  In fact, in these transitional periods, cash is the best thing to hold, and my guess is that is where we will see investors heading.

Data overseas had limited impact on the FX markets as all eyes remain on Bernanke, but the picture in most places remains bleak.  China’s HSBC PMI data was much weaker than expected at 48.3, and tightening monetary conditions continue to plague the markets there.  Adding this to the Fed change has helped AUD to be the worst performer in the G10 space.  My earlier estimates of 0.90 may be too timid.

In Europe the PMI data for German Mfg was disappointing at 48.7, but its services data was better than expected at 51.3.  In the EU as a whole, the PMI Composite was modestly better than expected at 48.9, still indicating extremely low growth, but edging toward a positive outlook.

The only truly positive story remains the UK, where Retail Sales were up a much better than expected 2.1% in May, continuing the improving economic data there.  It should be no surprise that the pound has been the best performer of all European currencies over the past sessions, as its macro story remains the best of the bunch.

For today the market is likely to continue with its volatile ways.  I believe the trend for dollar strength will underlie most movements, especially in the emerging markets, but I am reluctant to believe that another 2% is in the cards for the rest of the day.  But over the next several weeks, there is ample time for a much stronger dollar.  Do not be looking for other central bankers to stop the USD strength, but do not be surprised if in the emerging market space we see interventions to try to moderate the volatility.  For all you payables hedgers, your time is going to come in the not too distant future, and quite frankly, another layer of hedges after recent moves would not be a bad idea.

Good luck