Bears beware: the Fed has listened to the primordial scream of world markets

By Ambrose Evans-Pritchard

The Telegraph, London
Sunday, January 6, 2019

https://www.telegraph.co.uk/business/2019/01/06/bears-beware-fed-has-lis…

The US Federal Reserve has called off the hounds. China has abandoned efforts to purge financial excess, reverting to stimulus on multiple fronts.

Policy pirouettes by the world’s twin superpowers mark a critical moment in the tightening cycle, with sweeping implications for global asset markets and for the health of the international economy over the next year.

The shift in Washington — assuming it is more than a rhetorical feint — is the more potent of the two.

It has echoes of the Fed retreat in early 2016 when China’s currency scare threatened to spin out of control. On that occasion the Yellen Fed came to the rescue and shelved plans for higher interest rates, launching a 25 percent surge in the MSCI index of world equities over the following twelve months.

A turbo-charged variant of this happened in late 1998 following the East Asia crisis and Russia’s default. The Greenspan Fed rushed through emergency rate cuts, igniting the final leg of the explosive dotcom boom.

It is too early to judge whether this is a comparable turning point but there is no doubt that current Fed chairman Jay Powell went out of his way to soothe markets on Friday, pointedly invoking the 2016 episode. The message could hardly have been clearer.

He vowed to shift gears “quickly” if need be. The Fed “wouldn’t hesitate” to suspend quantitative tightening (QT) if circumstances deteriorate.

This was a far cry from his comment before Christmas that the Fed’s pre-set plan to shrink the balance sheet by $50 billion a month was on “autopilot” — even though half the world was by then in flames. In the US itself the Goldman Sachs Financial Conditions Index had jumped 100 basis points since early October.

The new line is clearly a concerted Fed message. A day earlier Robert Kaplan from the Dallas branch said he was watching “very, very carefully” lest QT causes liquidity to evaporate and leads to a crunch.

It is the reassurance that skittish investors have been waiting for after a $20 trillion slide in global equities and signs of seizure in the credit markets. The S&P 500 index of equities roared 3.4 percent within hours. January suddenly feels different.

Bank of America’s Michael Hartnett issued a tactical buy alert for the first time since the Brexit referendum in June 2016. His Bull & Bear Indicator’ had earlier dropped to an “extreme” pessimism reading, a level that typically leads to a snap-back rally in risk assets over the following three months. It did not work in 2008 however. Markets continued crashing.

Mr Hartnett said Wall Street and global markets have not yet seen the “big low” of 2019. Panic capitulation still lies ahead as the profit cycle turns. But for the brave and nimble he recommends a short-term foray into Chinese and German equities, energy stocks, US small cap stocks, and emerging market currencies, all deemed “very oversold.”

In supporting chorus, the Chinese have cut the required reserve ratio for banks a fifth time. Local governments have been ordered to pull forward new bond issuance. Beijing’s Central Economic Work Conference before Christmas was a paean to stimulus. Deleveraging be damned.

This comes too late to stop a “recession with Chinese characteristics” in early 2019. Berenberg Bank thinks the true growth rate has fallen to 3 percent. A Renmin University professor cited closed-door research suggesting that it may even be negative. His lecture went viral on the web before censors shut it down.

Capital Economics says it will take several months for the new stimulus to reach China’s real economy. This time recovery will be weaker than in past episodes. Debt saturation — and stalled reform — has choked the economy. It expects growth to bottom out at 4 percent in the second quarter based on proxy measures.

China is no longer the global Wunderkind of the early 2000s but at least investors can glimpse light at the end of the latest tunnel.

It is the Fed that matters most. For the last year it has been draining dollar liquidity mercilessly, both by shrinking the balance sheet and by raising rates. The “broad” dollar index has soared to an 18-year high.

The squeeze has been slow torture for a world financial system that has never been more dollarized or more sensitive to US borrowing costs, especially in those emerging markets that were flooded — nolens volens — with cheap dollar debt during the QE years.

Turkey and Argentina were the prime casualties of 2018, but South Africa, The Philippines, Indonesia, India, Mexico, and in its way China have all suffered.

Offshore dollar debts worldwide have ballooned to $12.8 trillion (BIS data). Roughly $4 trillion of contracts outside the US are priced off three-month Libor rates alone, which have doubled over the last year.

The strains reached breaking point in the fourth quarter. Dollar funding markets in Asia and Europe began to dry up. High-yield credit spreads have surged by over 260 basis points in Europe, where bank stocks have been in free-fall.

The dangerous anomaly at the heart of global finance is that the Fed’s actions have an extremely powerful effect on everybody, yet it sets policy for internal conditions of America’s closed and now relatively diminished economy. The World Bank says emerging markets have grown to 59 percent of GDP (PPP basis).

The extra twist this time is that Fed has had to cope with Donald Trump’s late–cycle blitz of fiscal stimulus and the risks — abating — of overheating. America has been drastically misaligned with the world.

Sooner or later the “blowback” was going to reach the US itself. Wall Street’s rout last month was the worst December since the depths of the Great Depression in 1931.

The Fed was in danger of losing credibility at its pre-Christmas meeting. Its “dot plots” were signalling two rate rises in 2019 while the futures markets were pricing in a rate cut and mounting recession risk.

The US yield curve — the Fed’s own warning indicator — was as flat as a pancake and had inverted by ten basis points along the two to five year maturity range.

Jobs growth was holding up but employment turns late in the cycle. It is rarely gives much prior warning. More ominous was a collapse in the growth rate of real M1 money for businesses. It had turned negative for the first time since the onset of the Lehman crisis.

The refusal to shift ground on the reversal of QE had become a neuralgic issue for markets. The tones of Olympian certainty from Fed staff that it was “like watching paint dry” were simply not believable.

No central bank has ever tried to exit QE on such a scale before. There is deep confusion over how QE works and how it interacts with the financial system.

Monetarists accuse Fed officials of ignoring the “quantity theory of money” anchored even in the works of John Maynard Keynes, relying instead on incoherent “creditist” assumptions.

Tim Duy from Fed Watch said the institution has been “slave to its models” and made a serious error in December but at least that error was “retrievable.” Jay Powell may have pulled back just in time.

The central question now facing markets is whether the Fed is merely tweaking its message or is preparing to halt the tightening cycle altogether, a move that would send the dollar tumbling and act as powerful global stimulus. If that happens the tourniquet effect’ of the last year will go into reverse and emerging markets can breath again.

Hans Redeker, currency chief at Morgan Stanley, said the great dollar rally is over. It has become clear over the Autumn that America itself cannot handle rising real yields since US corporate debt ratios are at a record high.

Japanese investors are starting to unwind some of their $2 trillion of US dollar assets as the cost of currency hedges renders the carry trade’ into US money markets unprofitable. “They are sitting on loss-making assets so they have to liquidate,” he said.

Wild moves in the yen last week were a sign of the shifting flows. When this process gathers pace the dollar typically goes into a fast and accelerating downward slide. This in turn sets off a recovery in gold, oil, commodities, and battered markets in Asia, Latin America, and Africa.

“When the US dollar starts to weaken, the world is happy again,” said Mr Redeker.

A US-China trade deal would clinch the argument and set off a roaring spring rally. Bears beware.