We have begged for monetary policy normalization for years, and still do, but the Fed, fearful of undoing the unsustainable climate it has created, will find tightening enormously difficult. Tightening now appears way out of step with reality. It would be like orchestrating a global margin call whether it knows it or not. The long Treasury bond and commodities have been screaming this for months. While it is moving to a less easy policy, major trading partners like those in the EU and Japan, responding to the currency war we started, are as loose as they have ever been. That is an historic juxtaposition of policies that cannot be underestimated. The resulting 23% rally in the dollar since last summer is putting huge strains on the levered financial system. At the same time, the economy has slowed to a slower crawl and earnings estimates are being cut dramatically.
The Fed can talk about raising rates all that it wants and equity markets can follow that “bouncing ball” all that they desire, but dollars are already becoming more scarce. In the world of currency wars in which we reside, all that matters is that if a non-U.S. entity borrowed dollars during the money printing (and trillions were lent), then it now owes over 20% more and its interest payments are over 20% higher than a year ago. Ouch! Given the enormous leverage in the system, for many borrowers the pain is likely much higher than those percentages imply.
Still, somehow, stocks are viewed as a warm and pleasant island where these bitter currency winds do not blow with the same ferocity of our east coast winter. This is in spite of the fact that earnings for the S&P 500 sank 5% last quarter. With negative interest rates becoming quite common and finding high quality paper north of even 0.5% a tough task, frustrating is not a strong enough word to describe the environment that the deciders have concocted to save the financial system that keeps them in control. For instance, roughly one quarter of sovereign debt in the EU trades at a negative rate and German bunds yield 0.20% or so. Meanwhile, we remain concerned by all of the sovereign credit risk on the balance sheets of the European banks just as it seems to be a 50-50 proposition as to whether Greece defaults and leaves the EU to its own devices.
If the going gets tough, don’t look for heroics from bank trading desks that are reducing capital once devoted to providing customer liquidity. Regulatory changes and lower profitability are to blame for that. Also, the high frequency trading crowd might just be long gone or their fancy computers simply turned off when bids are really needed. We talked about “winks and nods” last month and maybe the most significant common perception is that the frantic quoting on small lots with little transaction volume that we witness every trading day will somehow, some way enable price levitation to continue indefinitely. We are skeptical. That the regulators have not policed this chicanery known as “spoofing” more fervently is no surprise because it helps paint a nice tape. Anything goes if it makes us “feel” better. After all, with the stroke of a pen, the accounting regulators decided in 2009 that assets no longer had to be marked to market on bank balance sheets, so why not extend that thought to market making.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.