June 21, 2013

Shocked and awed markets still reeling after FOMC meeting

Fed policy shift not impressing the liquidity-addicted capital markets as volatility and risk-aversion rise across the board.

The past few days have really been sensational in terms of market moves. We have seen (almost) unprecedented moves in all asset classes following the FOMC meeting last Wednesday. In our recent article 'The Fed has pencilled in a shift of QE policy - but can the markets bear it?' we proposed the idea that quantitative easing is here to stay despite Fed comments and despite fancy charts and predictions from highly-educated Fed economists. Market reaction to the FOMC is backing up our view that the financial markets as we know them are, to a large extent, dysfunctional. Some would say; broken.

The argument that equity markets have reached their recent highs on the back of an economic recovery backed up by improving fundamentals such as falling unemployment, retail sales and stable inflation is simply not valid. The optimists were given a shock as months of asset appreciation was wiped out in days on the back of expectations that the liquidity taps may soon stop. The reasoning behind this view is that asset prices are not reflecting their true value due to market intervention, manipulation and management by central banks. For all those critics who suggest that the S&P, Dow, FTSE, DAX, CAC, Nikkei and SCI indices reached pre-2008 highs on the back of 'fundamentals', 'strong earnings growth' and strong market recoveries should take a look at the chart below.

Global equity markets, commodities, bonds and FX have are all mostly speculative and do not reflect the true reality - that most developed countries are overburdened with huge debt (and increasing) that was first created and surfaced in the private sector (2001-2008) but has since been transferred over to the public sector (2008-present). By transferring Trillions of dollars in private debt over to governments under the guise of 'too-big-to-fail', policymakers have plotted a course towards greater central bank dependency because national budgets are simply too small and volatile to pay off a derivatives bubble that has been growing for a decade rather than shrinking. The GFC has not passed and we are not 5 years into a recovery - instead, we are watching a malaise that has taken 5 years to metastasize from a localised, sector specific debt problem (banking/insurance/housing in the US and G20) to a global, all sector encompassing structural failure.

Some market analysts/commentators still believe that the subdued economic environment we're currently seeing is a cyclical phenomenon i.e. the business cycle will recover, spending/investment will pick up eventually, growth will ensue, interest rates will rise etc. That is wishful thinking.

Just by the events of this week (and by looking at previous central bank actions) it is clear that the economic problems in the developed world are structural. Markets are not allocating resources according to demand and supply because that demand and supply is being manipulated, adjusted and controlled. This is occurring on all scales. Central banks are manipulating the demand/supply of money to assist ailing banks. Ailing banks are manipulating LIBOR rates, asset prices, derivatives markets to protect their balance sheets and profitability. The huge sums of money spent on asset purchases and QE are going to support dysfunctional banks rather than stimulating investment. Those banks are using the additional capital to speculate in a variety of markets and assets and helping asset prices to rise to unsustainable highs.

Summary of post FOMC market movements - carnage in all asset classes:

  • All equity indices around the world are sharply lower over the past 2 days. The weekly falls have been the heaviest for almost 2 years
  • Precious metals such as Gold and Silver as well as Copper have suffered their largest one-two day declines in 20 months
  • AAA and corporate credit spreads have widened by their highest margin in 2 years
  • Emerging market currencies such as the Mexican Peso and Commodity currencies such as AUD, NZD and CAD have fallen by their highest margin in 20 months against USD
  • S&P futures had the heaviest volumes in almost 2 years as they fell by almost 700 points since Wednesday (-4.4%)
  • US Treasuries did well to record modest gains as safe-haven demand surged (in 2008 even Treasuries declined as investors sold everything in favour of cash. We may be about to witness this in the coming weeks)
  • The VIX Index broke above 21% yesterday - its highest close this year

Source: Reuters & ZeroHedge
If seen in this light, it becomes easy to see what is happening in the markets right now. We're seeing severe across the board declines in all asset classes in eerie similarity to market declines seen in 2008. The extreme parabolic decline in Gold because of panic USD buying is very reminiscent of the rush to USD in 2008. From our perspective, the market moves being seen this week are indicating a realisation amongst market participants that infinite QE will either cause a huge collapse or create permanent currency debasement with new measures being invented each time to keep the status-quo going (QE, Operation Twist, bail-ins and so on).

Investors are also being reminded that EU event risk has not gone away. The IMF only yesterday threatened to block funding to Greece subject to yet more conditions being accepted. Greece is notably missing its Troika goals and the issue is becoming increasingly critical as fears of an impasse rise. As the FT reported yesterday, the IMF is preparing to suspend aid payments to Greece over what it claims is a 4bn EUR shortfall that has opened up. Higher than expected budget shortfalls, rising bond yields on Greek government debt and a stuttering privatisation programme has spurred the IMF to warn EU officials that these problems will force theIMF to stop aid payments by the end of July 2013. Equity markets are already reacting to this re-awakening of EU event risk alongside sharp declines in EUR/JPY.

This creates more political uncertainty as several Greek policymakers may now resign, calls for fresh elections, new coalitions, more public unrest and eventually when an agreement is reached - it only takes a few weeks or months for it to unravel due to 'overly optimistic' estimates or lower than expected GDP growth. This series of events has happened numerous times, repeating themselves in several EU countries such as Greece, Portugal and Ireland.

As a cherry on top the credit bubble in China continues to expand and raising the threat level for all leveraged, speculative market participants.

Commissioned by Think Forex