The saying goes that it’s a 6 lane highway into emerging markets and a bumpy one road out. We might have to adopt that expression here, but apply it rather to all high yield Dollar and non-Dollar assets that have been bid in the grand reach for yield, including crude and associated business lines. Equities lead consensus on the street and the continued push to all time highs has disguised the disconcerting price action in crude, foreign exchange and high yield. It is time we address that price action here, even if it remains a side note in monetary policy minutes.
What we are witnessing, and what the crude move and foreign exchange is telling us, is that the market is unwinding positions and reallocating portfolios at once. Let’s take a step back and look at the process logically. Every single time the US monetary authority has spoken of higher rates, after a little volatility and Fed-speak backtracking, markets have dismissed it. If volatility spilled over and impacted economic data or home prices, the monetary authority would step in. In the US QE1 was followed by QE2 and then QE3- the latest including an outright purchase of not only Treasuries, but mortgage backed securities as well. In China, a brief decline in home prices brought about renewed infrastructure spending, further keeping emerging markets and commodities bid. In Japan, a full fledged- almost all out- endeavor to devalue the Yen, boost asset prices and fight deflation remains underway while in Europe calls for QE continue following rate cuts, LTROs, negative deposit rates and a recent asset purchase program. Additionally, the Financial Times reported this summer what was long suspected by operators on the street: “A cluster of central banking investors has become major players on world equity markets.”
On the whole, things since the crisis have remained consistently inconsistent, but market participants have continued to position themselves with the understanding that (1) US rates would remain low and (2) an implicit backstop is always around the corner- a force ready to suppress volatility, keep asset prices bid and inspire confidence in risk taking endeavors. Not only that, but a guarantee of low rates out of the premier, safe haven currency monetary authority has prompted one of the largest borrowing of greenbacks to buy higher yielding assets in history. The amount of Dollars borrowed for this endeavor are staggering, including loans from banks abroad totaling over 3 trillion USD. As recently as this summer we saw the trend push speculative positioning to all time highs, with market participants even piling into assets that drove the last crisis.
In recent months, something has changed. Looking at Fed Funds futures contacts we see that rate hike expectations have not faded (yet) as they would have previously. At the same time equities have remained bid and data (at least on the payroll front) has been improving. The market is taking rate hikes out of the Fed seriously this time. Whether the monetary authority realizes this or not, in seriously hinting at higher rates, they are triggering a massive USD short squeeze, commencing a process by which investors holding higher yielding assets in USD denominated debt are caught on the wrong side. This energy move does not stand alone; it is rather a domino in the process.
The recent move in crude is a testament to the massive portfolio reallocations taking place under these conditions. The portfolio of the last five years is in direct conflict with the portfolio of the next five years under the assumption that a rate hike cycle in the US begins while the rest of the world lags. Regardless if the rate hike cycle sustains itself (it didn’t last time), market participants cannot wait and find out. Participants see what the Fed is saying (‘the market is under-appreciating the rate hike timeline’) and managers have no choice but to actually take this seriously and reallocate their portfolios accordingly. Even for those who do not believe the rate hike cycle will occur, they are currently being caught on the wrong side of one of the largest moves we have seen in some time, both on a percentage and value basis. Such unwinding exasperates the move and prompts everyone to hop on board or be subject to an expensive hedging bill or call from the margin desk. This set of circumstances constitutes a paradigm shift.
As a fund manager, why would it be desired to hold commodities that deliver no yield in an environment of rising rates (damaging to asset prices)? Why would commodities that deliver no yield wish to be held in an environment where the currency it is priced in (USD) is set to appreciate in value as US rates supposedly rise? Plain and simple here, crude is a product priced in a currency that is set to appreciate, with a central bank responsible for that currency on a policy path diverging in a hawkish manner from all others. It is a product that appreciates when demand, and thus global growth, overshoots expectations (in other words not the current case).
Over the last 6 months euphoric and overextended markets have actually, at least in the US, been met with the start of some strong economic data. Has the economic data improved based on strong fundamentals, or has the economic data only just improved after five years of low rates and incentives to take risk? If the latter, what will rate hikes mean for economic data when it disrupts the market side that likely drove it (or at least gave it confidence)? If rate hike expectations fade out of the US with an increase in volatility or disruption in asset prices, how will global markets respond when all participants attempt to shift allocation in the opposite direction once more, forcing some to liquidate and others to move to the sidelines as to wait out volatility? Or, if this is the real sustainable deal here and revolving credit and the money multiplier are set to expand, how will the Fed reduce the money supply without throwing the global economy into a recession?
These are the questions the investment community (and monetary authorities) face, but are not asking or fully appreciating. Market participants are asking what is driving the move in crude, rather than seeing where the move is coming from, seeing that it is a symptom of much larger fundamentals.
In 2006 the US was an economy that had both an overheated economy and overextended market. When- at the final hour- the Federal Reserve began to adopt a rate hike bias, the house of cards fell apart. Now, through five years of volatility suppression and the refusal to tolerate unbid risk assets, we seem to be going into a rate hike where markets are overextended, but the economy is just starting to print a few decent quarters of data. As history tells us, the further we diverge from the mean, the faster and farther we fall when portfolios rebalance (or volatility prompts a run for the exit). Once again, this move in energy is not taking place in a vacuum. While the cause of this crude move is debated, what is missing from the debate is the origin driving it- an unstable reallocation by all parties at once after five years of low rates and purposely undisturbed reach for yield.
Read part 1 here: http://www.project-firefly.com/node/18803
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