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Episode 33

The fed flinches

Published on: June 17, 2020 • Duration: 18 minutes

This week we look at how the Fed flinched at the first decent wobble in the equity market. With price discovery distorted, what should investors be watching for clues about growth? In the Chatter, we look at how the Fed’s balance sheet is still a key determinant of equity performance. In the Whisper, we look at how Hertz will try and raise funds from the retail community.

  • [00:00:00] Many assets have displayed a high level of volatility in recent sessions, so it's perhaps inevitable that the Fed would step in again to soothe markets. U.S. bond yields have been trapped in a narrow range, though they have attempted to break higher in the last couple of weeks. There are very few assets that are not being manipulated in some way, but it may be the bond market that will give the clearest indication of where we're headed next. That's The Big Conversation. 

    [00:00:30] When the Fed outlined its corporate bond buying program on Monday 15th of January, it was updating a plan that had been announced a few months ago. There was not much that was new in terms of size, but it helped calm markets after a few days of volatility, which was further aided by the reiteration of a one trillion fiscal infrastructure scheme. In a world where price discovery is constantly distorted by these interventions, it becomes increasingly difficult to read clear signs from asset price moves. Last week we talked about the short term signals from the Australian dollar and the oil price, which we update in the next section. though both have rebounded with other risk assets in the last couple of days. 

    [00:01:05] Perhaps the key market to watch is still the US bond market. Though even here, there is a lot of second guessing to be made in a market which is also distorted by direct central bank intervention. And the bond market can also give false signals. The rapid decline in bond yields last year led to an inversion of the US government bond curve. But only just. An inversion is where, for instance, yields at the two year maturity are higher than bond yields at the 10 year maturity. Longer dated bonds are considered to have a higher risk than short dated bonds, and so therefore under normal circumstances they would be expected to have a high yield. Inversions and then a re-steepening have always preceded the recessions of the last 40 years. And we are having a recession today. But this recession is on the back of the unexpected appearance of Covid-19 and the aggressive response of governments in locking down their economies. And this is not what the inversion of the yield curve was implying last year. In fact, that minor inversion of the yield curve last year was on the back of long dated bond yields, declining more rapidly than shorter dated yields. All the other inversions that preceded the recessions from the early 1980s had seen the yield curve invert because of a sharp rise in yields at the front end or the shorter dated part of the curve, e.g. from the two year point in the curve where yields moved higher in response to the US Federal Reserve raising rates in order to cool down excessive growth or excessive leverage in the economy. In 2000, it was the excesses of the equity market and from 2006 to 2008 it was the housing and credit market. But last year's dramatic decline in bond yields was driven by the long end of the curve from which we've got an inversion, and because of which many investors positioned for an imminent recession. In January of this year, however, many growth indicators were starting to tick higher before Covid struck. If bond markets are equally susceptible to the distortions of central bank intervention as are equity markets, then why would we use them as an indicator of macro economic health? Well, the principal reason is that although most central banks are trying to stop bond yields, rising yields will fall if real growth slows and the risk of insolvency at the corporate household level rises. That remains one of the primary macro economic downside risks in the near to medium term. It would certainly appear to be a greater risk than a return of growth, because of that materialized, then governments would presumably be able to step back from some of their most aggressive forms of accommodation. Now we have seen yields in the 10 year and the 30 year, particularly the 30 year, move higher in anticipation of issuance and also the potential inflationary impact that a combined fiscal and monetary stimulus could create. The 5 year to 30 year part of the curve had started re-steepening last year, even though it never inverted like it had prior to the recessions of 1991, 2000 and 2008. Furthermore, it's not always the case that central banks are determined to keep a lid on yields. Japan introduced its own yield curve control in 2016 in order to stop their yields falling and to try and prevent returns for the pension industry being hit even harder than they already were. The Reserve Bank of Australia has already capped its three year bond yields at 25 basis points. And although the US has only threatened to use a form of yield curve control to complement its forward guidance on rates, they did use yield curve control during the Second World War in order to keep yields from rising at a time when the national debt had expanded and to pay for the war effort. So a precedent has been set. But what is notable today is how bonds have really hardly shifted. The U.S 10 year did have a short lived move towards one percent a couple of weeks ago, but has now returned to the previous range. But when we look at the two year and the five year yields, we can see that they have begun flirting with the lows again, though, not quite breaking down. If they roll over that would imply that the deflationary impact of demand destruction, i.e., a shift away from liquidity towards insolvency fears, is starting to be priced into the market even as the equity market appears to price in a rosier picture. As we've discussed in previous episodes, equities are being price of flows rather than fundamentals. Bond yields may also be capped by these flows, but they are free to naturally move lower if the outlook remains subdued. Prior to the Fed's most recent intervention, bond yields were edging towards the outlook of insolvency. Given that most central banks are now forecasting that interest rates will stay on hold for a couple of years, their actions are implying no growth. Even the US 10 year looks like it will have downward pressure on its yield. The 10 year yield trended lower through the last period of zero interest rates that included the taper tantrum of 2013. Therefore, what are the big levels to watch? For the 5 year yield, it looks to be around 26 basis points, is the main level. For the U.S. 2 year it's around 13 basis points. Even if the Fed refuses to take its target rate into negative territory, bond yields are still freely floating to the downside, i.e bond prices themselves can go higher. In fact, we saw in the euro zone the bond yields nudged into negative territory about a year before the ECB decided to implement its own negative interest rate strategy. But what would be the implications for risk assets if bond yields take another leg lower from here? Well, if bond yields break down again, then we can expect further relative weakness from emerging markets. The ratio of the S&P 500 versus the MSCI Emerging Market Index has been following the move in 10 year yields. In this case, the charts of the U.S. 10 year yield is inverted. But since the equity lows at the end of 2018, the S&P has been outperforming when yields are falling. If rising yields reflect a better outlook for growth, then emerging market currencies would be expected to outperform the dollar in that environment. They have a high beta to growth and this would put them in the lower part of the U.S. dollar smile that we talked about last week, where the U.S. dollar is on the back foot when global growth is picking up. Therefore, if bond yields are trying to fall, emerging market and commodity currencies would be expected to weaken again. We were beginning to see this with the recent weakness in the Australian dollar, which had previously led the move higher in risk assets from March, rallying well before the JP Morgan Emerging Market Currency Index broke higher last month. We can also see how this might impact across the commodity space, although the following chart is the absolute performance of the emerging market rather than its relative performance versus the S&P 500, we can expect commodities to pullback as well if emerging market risk is under pressure. This chart shows one of the major components of the MSCI Emerging Market Index, Korea. The KOSPI 200 and copper futures have moved in lockstep. If bond yields fall and the S&P outperforms, it will probably be in an environment of falling commodity prices as well. South Korean exports in May were confirmed at twenty three point seven percent, a negligible bounce from the April figure of minus twenty five point five percent. In a week's time we get the data for the first 20 days in June. If this has failed to show any significant uptick, then it would be a clear indication the real demand is taking much longer to pick up than originally thought. Korea has handled the crisis well, but has remained relatively open and it is still dependent on international demand. The Korean Won still looks at risk of weakening further versus the U.S. dollar, not notwithstanding the recent uptick in geopolitical tensions. The USD Won is coilling on the edge of a long term trend. Lower bond yields would be indicative of lower global growth, which would have an impact on the open exporting economy like South Korea. If corporate cash flows weaken, then this could undermine some of the structured product flows out of Korea and into other asset markets, which some analysts think had been one of the sources of pre market buying in U.S. equities. Although there's been very little to derail the U.S. equity prices recently, a decline in these foreign flows alongside lowered buyback levels from U.S. corporates, a decline of 401K pension flows could leave retail investors and re-leveraging of the shadow banking system as the only buyers. The shadow banking system, effectively a number of hedge funds who have market making operations, are probably already close to their maximum risk limits. So whilst we've got used to the gyrations in the oil price in the U.S. equity market, it would be a decline in bond yields that would most likely signify the next leg in global risk. Now, that doesn't mean a negative for equities per say, but it clearly favors the US over other emerging markets. It may be that the 26 basis point level on the US five year yield is one of the most important levels to watch across all global assets. 

    [00:10:02] In last week's episode of The Big Conversation, we looked at some of the real economy assets for signs that the broader risk rally could be due a breather. Since then, most of these pulled back significantly and the deterioration in the risk environment has prompted a response from the Fed. Copper had reached a significant retracement level. Crude oil had almost filled the gap that opened up at the beginning of the price war, and the Australian dollar, had started to show significant signs of weakness, even though other currencies were still strengthening versus the U.S. dollar. Crude oil has had a drop of 14 percent since last week, although it hardly shows on the chart given the magnitude of the moves in April. The Aussie dollar has extended its reversal though it has now bounced off the lows. The Aussie is still the one to watch. This is one of the first moves from the lows in March, with this rally leading emerging market currencies by some way. Although it bounced aggressively off the lows during Monday's trading we still need to watch this for signs of underperformance. Its reversal lower last week preceded the sharp pullback in U.S. equities. The S&P futures had dropped as much as eight percent over three days, whilst the Russell 2000, which is a better macro play, fell 13 percent. So far, most of these moves have simply retraced within the rising trend channel, therefore, what should we be watching from here? For the Russell, the key levels are a combination of the lower end of the trend channel and the 38 percent key Fibonacci retracement, which comes in around about 13 20 on the cash index. We would expect the Russell 2000 to underperform the other major indices if a downswing were to take hold. The S&P 500 e-mini future is less clearly defined in a trend channel. And the first major support is still some way off, around about 2830, which is a 38 percent support. If this is broken, we should prepare for further downside with target levels around 2500 (the key 50 percent level) and 2580. But the Fed appear to be determined to prevent this. In Europe, the leadership on the downside in the recent pullback had been from the same sectors that had led the initial move down in March, which were leisure, autos and banks. The eurozone banks have belatedly moved off an intraday all time low on May 14th 20-20 to gain nearly 50 percent into the middle of last week. Fifty seven on the index is a level of support to watch. Through that, we can expect another retest of the all time lows. As outlined in the main section, the US 5 year yield is right back at its key support level. A break below 26 basis points would imply that the bond market continues to see significant weakness ahead - in line with the macro - but obviously wildly different from the performance of the equity market. What matters for the equity market is what happens to the Fed's balance sheet. The Fed have painted themselves into a corner. Last week we saw the first substantial drop on the S&P for a number of weeks. Last week also saw the Fed's balance sheet expand by the smallest amount since the crisis began - at three billion dollars only - we could argue that the balance sheet didn't really expand at all. The Fed needs to continue juicing the market with the balance sheet or risk losing the positive sentiment that the equity market has been providing, even though most people know that the equity market has been completely disconnected from reality over the last few weeks with the S&P 500 price earnings ratio revisiting the levels that were last seen during the dot com era. And as we mentioned last week, the quarterly equity expiry takes place on Friday. The expiry may explain some of the recent pickup in volatility as market makers manage their inventory. And the excesses of this should roll off by early next week. And there can be some overhang in positioning that needs to be worked out of the system, even after the June contracts have expired. But if the Australian dollar is still on the back foot and bond yields are testing the bottom of the range, then equities will come under pressure unless the Fed return with yet more accommodation, which then risks the multiple moral hazards that we touch on in the next section. 

    [00:14:15] Last week, the bankrupt car hire company Hertz was given approval by a bankruptcy court to sell new shares. The prospectus suggests they will try and raise around 500 million dollars substantially below the one billion dollars that was approved by the court. Under normal circumstances, companies that are locked in bankruptcy proceedings would try and secure loans that have restrictions or penalties attached to them. Issuing shares is not normally an option because most companies in such a position would have their equity valued at close to nothing. But as we discussed last week, sectors and companies that have been struggling have seen huge levels of interest from retail accounts. The cruise operator, Carnival and American Airlines have like Hertz seen a huge uptick in volumes since the March lows. Most of this volume has been attributable to the renewed interest from the retail investment community in a trading binge that has borne comparisons to the influx of retail traders during the dot com boom twenty years ago. The ratio of call buying versus put buying from the small trader category recently reached ten to one. This is twice the record set near the market peak in February this year and nearly five times the highs set over the previous 20 years, including the peak of the dot com boom in 2000. A further source of market froth could be because of how these retail orders are often routed into the market. According to the SECC filings from the discount broker Robin Hood, for the fourth quarter 2019, 100 percent of total customer orders were non-direct orders, i.e., they were not specifically instructed to be routed to any particular venue for execution. These non-directed customer orders were generally shared among five execution platforms, such as high frequency traders who pay the broker for these orders to be sent to them. They will provide liquidity for execution, but it maybe that they also use the information to help build momentum in some of these names. This can work to both the upside and the downside. As you've just seen with the recent dip, the equity markets are still prone to wild swings. Volatility of volatility, the VVIX, recently reached 170 on an intraday basis. This is the fourth highest reading in five years. The VIX itself is touch 44, although this is dwarfed by the most recent episode, this is still indicative of a market that has not come close to settling into a rhythm despite the new all time high on the Nasdaq and the S&P 500 recovering most of its losses. Compare current levels, however, with those pre-Covid. If anything, the combination of a bankrupt company that is being allowed to tap into retail investors, who are having their orders channeled through high frequency trading platforms in a market that is shown there can still be aggressive downswings as well as upward momentum, is a reminder that both traders and investors in this market need to have a very strong risk appetite or they need to be glued to screens. At around 40 volatility, the VIX is telling us that price action can quickly move through all but the widest of stop losses and can even get through these levels, making risk management an essential element of all investment portfolios at this juncture. At least Hertz warned us in their prospectus that equity investors will probably be completely wiped out unless there was a significant and rapid and currently unanticipated improvement in business conditions. In a nutshell, that pretty much describes the difference between the US equity market and the real economy.