This market is so schizophrenic: It can’t get its responses to the same stimuli right.
Back in December, when the Federal Reserve announced the beginning of the end of the greatest monetary policy experiment in human history — reducing its ongoing bond purchase program down $10 billion to $75 billion — the market roared higher in a multiweek end-of-year melt-up that belied the months of worry about the taper.
But Wednesday, the opposite happened. Stocks careened lower as investors, in horror, sold and sold hard in response to another $10 billion taper.
The explanation is that the December surge was a head fake fueled by complacent investors ignoring the risks that a reduction, albeit very small, in the flow of ultra-cheap money into the global financial system would have after years of growing dependency. The truth is Ben Bernanke, in his last policy meeting as chairman, has left as his legacy a 1997-style currency crisis. Here’s why.
For years, as the Fed has kept interest rates low and expanded its monetary base from $800 billion pre-crisis to nearly $4 trillion now, cash has flowed into higher-yielding investments overseas. The same dynamic also was supported by similar efforts by the Bank of Japan. This strategy, known as a carry trade, was piled into and leveraged up by hedge funds chasing returns.
And for a while, it worked great. The bond prices of troubled eurozone countries soared, putting an end to the debt crisis there and fears of a Greek exit from the currency union. Countries like Rwanda tapped into the easy credit, issuing its first international bond last spring with a 10-year note yielding less than 7%. And China and other emerging economies used cheap credit to bolster economic growth and exports.
The game went on too long. A bubble formed, and it was vulnerable to a slightest change in the flow of cheap money.
It’s an eerie repeat of what happened nearly 20 years ago.
Back in 1997 — after interest rates dropped between 1995 and 1996 as the Greenspan Fed reacted to a classic mid-cycle slowdown in the economy (analogous to the launch of QE3 in September 2012) — the Fed responded to a faster-than-expected drop in the unemployment rate with a small interest-rate hike.
(It should also be noted that the Japanese had significantly devalued the yen then, as now, in an effort to restore vitality to their economy. It didn’t really work, but it did further weaken the economies of smaller, export-oriented economies in the region. And it provided another carry trade currency for traders until it started going vertical in early 1997.)
Within two months, Thailand’s currency was under attack as its government desperately defended, and eventually abandoned, its fixed exchange rate. The contagion spread, pulling in Malaysia, the Philippines, Singapore, Indonesia, South Korea and eventually Russia.
The pickle was this: As the Fed ever-so-slightly reduced the flow of cheap money, it caused investors to close their carry trade by selling foreign assets, selling foreign currencies and buying dollars. The yen’s rise also forced carry trades to close. Since the trade was so popular, there was a stampede to get out.
For the countries involved, it was a no-win situation:
- Stock prices were falling, bond prices were falling raising interest rates, and inflation was rising as import prices increase due to a weakening currency.
- To stabilize their currencies, they needed to raise interest rates harshly.
- But higher interest rates would further choke off growth, hit bond prices and weaken stocks as profits dropped and credit defaults rose.
Eventually the crisis ended after international bailouts via the International Monetary Fund were arranged, the Fed reversed course and lowered interest rates in 1998, and the Japanese cut rates to 0%.
It’s all playing out again. Countries like Peru, Argentina and Turkey are suffering capital outflows — draining their foreign exchange reserves and weakening their currencies. Over the last 48 hours, we’ve seen surprise interest rate hikes from India, South Africa and a whopping 4.25-percentage-point hike to 12% by Turkey’s central bank, which set off a rally in the futures market Wednesday morning.
But the crisis deepens. The lira reversed its gains as traders realized what the negative consequences will be of the rate hike. The iShares MSCI Turkey ETF (TUR) remains under pressure.
And this all brings us back to the Fed: Bernanke waited far too long to taper. He chickened out after markets recoiled in May when he started hinting that the taper was coming. He chickened out in September, when the market was prepared for the taper, because they thought the unemployment rate was too high.
All of this only encouraged carry traders to dive in deeper, making markets more vulnerable. Remember that all of this volatility and turmoil, which is now ensnaring Russia ahead of the Sochi Winter Games, is being caused by a drop in the Fed’s monthly bond purchases from $85 billion to $65 million — keeping the monetary base, shown above, on its vertical trajectory.
Just imagine what would happen if QE3 was stopped altogether. Or if, heaven forbid, they raised short-term interest rates from the 0% level they’ve been at since 2008.
The situation is so far from normal, I don’t know how we get back. And temptation will be to put the taper on hold, and let the currency crisis fade leaving structural problems — like China’s troubled shadow banking system — unresolved.
Like any bubble, the longer it grows, the more painful the fallout.
For now, I continue to recommend clients maintain a defensive positioning focusing on U.S. Treasury bonds as well as opportunistic short positions in areas like big tech. I added a short in Yahoo (YHOO) ahead of disappointing Q4 earnings, and the position is now up more than 6%. My position in the Direxion 3x Treasury Bond Bull (TMF) is up 10.2% since it was added to my Edge Letter Sample Portfolio on Jan. 10.
Anthony Mirhaydari is founder of the Edge, an investment advisory newsletter, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he has recommended TMF and YHOO short to his clients.