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Balancing The World On The Head of a Pin


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Do you get the feeling sometimes that the global financial system and economy has been one gigantic, leveraged, long-only commodity trade funded by the Federal Reserve with zero interest rates and an artificially low U.S. Dollar since 2010? If so, you are not alone! It now appears that the last few weeks of financial market price action are showing the demise of this gigantic trade. Or if not the demise, then at least the clear evidence that this is and has been the state of affairs for at least five years. Federal Reserve Vice-Chairman Stanley Fischer said something very interesting last night:

“While the dollar’s appreciation and foreign weakness have been a sizable shock, the U.S. economy appears to be weathering them reasonably well. Monetary policy has played a key role in achieving these outcomes through deferring liftoff relative to what was expected a little over a year ago.”

While I think he is being a bit premature in his assessment of how the U.S. economy is handling the appreciating dollar (still appreciating, by the way), I think what the Vice Chairman is saying, not just to the United States but also to the world is, “We gave you an extra year of free room and board to get yourself sorted, and now it’s time to pack your stuff and get out!”

Unfortunately, as I’ve been saying for the past few weeks, the world is not ready for the appreciating USD that comes when the Fed raises rates, even just once, as the rest of the world eases. Commodities (industrial metals and energy), the engine of global growth for the past six years are getting hit with a triple whammy.

  1. Demand for commodities has fallen off since China stopped consuming them at a pace that was just unsustainable.

  2. Supply has increased as producers do what producers do when the price of their commodity goes up sharply. First, the number of producers goes up exponentially. Then, they ramp up production until they eventually create too much supply.

  3. The final blow: the currency in which these commodities are priced in, USD, is appreciating rapidly as the Fed’s monetary policy threatens to diverge from the rest of the world’s major central bank’s policies.

As far as the global economy being in one giant, leveraged long-only commodity trade, when it looked like the Fed was going to defer “liftoff” well into 2016, the USD weakened, commodities rallied (even with the terrible supply/demand technical), and risk assets soared. Now that it looks like “liftoff” is next month, the USD appreciates, commodities are dropping at an alarming rate[1], and risk assets from emerging markets, to global stocks[2] to high yield bonds are getting pounded. Even investment grade U.S. corporate bonds wobbled a bit yesterday. Up until yesterday, the market was dealing with tremendous new issue supply—$62 billion so far in November—extremely well. Yesterday, as $7.65 billion launched, the price action post-launch appeared to say, “No mas.”

I believe if the Fed persists in raising the Fed Funds Effective Rate at their December 16th meeting, they are making a policy mistake. Under this scenario, risk assets should continue to perform poorly into this meeting date. The chaos will be significant. Luckily, from chaos comes opportunity. The proverbial babies get thrown out with the bath water. We continue to find excellent stories in the municipal space that are cheap to comparable duration risk assets, even before taking into account their tax exempt status. The long end, (10 years and out) is the cheapest part of the municipal curve. This is good because, while duration has gotten battered the last few weeks, if the Fed goes, I think the long end of the yield curve performs the best as already weak inflation meets policy tightening. Therefore, in the case of long dated municipals, especially those with 7–10 first call structures, you get gains from duration and from municipal/treasury spread tightening.  

 

 [1] The Thomson Reuters/Core Commodity CRB Commodity Index has fallen from 195 to 186 since the October 28th Fed meeting, when the FOMC statement pointed hawkishly to a hike at the December 16th meeting

 [2] Yesterday the S&P broke through its 200-day moving average with the 100-day moving average of 2,035 in striking distance

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