Misguided Efforts

We all know a banker named Ben
As part of a group of old men
Who used all their weight
To try to inflate
Large bubbles in stocks, bonds and yen

But markets of late have decided
Those efforts have been quite misguided
So stock markets fall
And bonds hit the wall
While currency moves are one-sided

It seems that all the carefully constructed theories about how central bankers should be doing their jobs, including the idea that just because interest rates were cut to zero didn’t prevent those same central banks from easing policy further, are starting to come undone of late. Guidance, the next step after QE, has become all the rage in the central bank community, but it seems to be losing its effectiveness. It all began when Bernanke uttered the famous word “taper” as part of an answer to a Congressman’s question back in May. Suddenly, the idea that the Fed would print money forever was dashed and markets have been responding ever since. Yesterday, 10 year Treasuries traded at their highest yield in 30 months, and while they have rebounded a bit this morning, this move still has legs. We are watching EMG equity markets get decimated, led by Indonesia down more than 20% from its recent peak. EMG currencies are falling dramatically. INR traded to new all-time lows (dollar highs) overnight, and the folks in Sao Paolo are really starting to get nervous about the BRL’s weakness (new 4+ year lows yesterday again). I have seen the BRL movie before and it doesn’t end well for the Real. At the same time what is so interesting, is that all the G10 currencies are holding up very well. If you think back to 2008, what we saw was that investors fled from every currency and asset class that wasn’t US Treasuries, and the price movements seen then were quite clear. That was the period where we coined the term risk-on/risk-off. It was a simple paradigm and easy for everyone to trade. But that is not what is going on in these markets. In fact, these seem far more reminiscent of the Asia Crisis of 1997 than the Financial Crisis of 2008. The constant refrain is that funds are flowing out of emerging markets, both direct investment and equity and fixed income securities, and heading back to the developed world. While that is certainly true, at this point the question is, just how much more of this will occur? My sense is that we have a lot more selling to come.

So let’s look at the far less interesting G3 currencies for a moment. The euro continues to perform well, edging up toward 1.34 for the third time in the past three months. If it cannot break that level convincingly, I think the technicians are going to have a field day calling for a major reversal lower. As I wrote yesterday, though, even with the taper of QE assumed, the Fed’s balance sheet is growing much more rapidly than the ECB’s, which actually seems to be shrinking a bit. I continue to believe this is one of the underlying drivers of the euro’s recent surprisingly strong performance, and it doesn’t seem like it will change in the near term. In fact, yesterday the Bundesbank, playing to its home audience, was explicit in its comments that the ECB’s pledge of low rates for an extended period didn’t mean that rates couldn’t be raised to combat inflation. Now, there don’t seem to be many inflationary pressures in Europe right now, but the Germans have always been hyper vigilant on the issue. The problem for the ECB, and especially for Signor Draghi, is that the Bundesbank continues to muddy the message he is trying to convey. This goes back to the idea that markets are running out of patience with guidance by central banks and want to see actions. But in this context, if the ECB’s actions are of the balance sheet shrinking variety, then the euro will remain underpinned despite all the problems with the economies in its member countries. The ECB has always been more constrained by its mandate than the other big central banks, and right now, that seems to be a key euro support.

In the UK, the market has also shown some doubts about Governor Carney’s promised guidance as he left himself too many opt-outs of the low rates for a long time thesis. So, the combination of an economy that has been producing surprisingly better economic results and doubts about the central bank’s willingness to keep rates at rock bottom levels has led to support for the pound. In fact, over the course of the past 6 weeks, from just after the time that Carney stepped in, the pound has rallied almost 6% a better performance than the euro or any other G10 currency other than the CHF (barely).

Finally, in Japan, we have seen very little in the way of movement lately. While the longer term view for the yen remains for a much weaker currency, the market is waiting for more actions, this time by the Abe government, to implement the promised, and desperately needed, structural changes to labor laws, and agricultural subsidies. Of course the politics of those moves were always going to be difficult, but perhaps given Abe’s commanding strength in both housed of government there, he will be able to get things done. In the meantime, Kuroda-san has not turned off the printing press and his promise of ¥7 Trillion of JGB buying per month is doing its job to expand the BOJ balance sheet. Remember, Kuroda’s target is to double the money supply over his first 2 years. Further yen weakness will come.

The overnight data was not of the market moving variety nor will today’s US data do anything. At this point, all eyes remain on the FOMC minutes to be released tomorrow at 2:00pm here in NY. Until then, look for EMG currencies to continue to suffer and majors to range trade.

Good luck