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The Wing Beat of a Butterfly

butterfly-effect.jpgWe’ve all heard of “The Butterfly Effect,” which is the concept that if a butterfly flaps its wings on one side of the world, weather on the other side of the world will be affected. I believe that we have reached this situation in the global financial markets. I recently wrote about the concept of one condition that exists today whereby all risk assets have become, more or less, through their near perfect correlation to oil, perfectly correlated to one another. A funny thing happened this week that reinforced my belief.

Investors (which includes some very large banks) with exposure to Latin America (LATAM) emerging markets were using the Mexican Peso as a “proxy hedge” for all their LATAM currency risk. They used it because it was relatively the most liquid hedge available, and cheapest and easiest to borrow. As a result, the Mexican Peso (MXN) has weakened a whopping 31% in the last 18 months, and 11% since year-end 2015. What is really perverse is while Mexico struggles with the crash in crude oil, their economy, as a whole, has been doing pretty well. Nevertheless, because the MXN became “the hedge,” the nation’s currency has become one of the worst-performing emerging market currencies in the game. Therefore, in the middle of an economic slowdown, Mexicans are watching the value of their currency plummet and the cost of their U.S. Dollar debt skyrocket.

On Wednesday, the Mexican Central Bank, Banixco, instituted a surprise 50 basis point hike to their benchmark rate (from 3.25% to3.75%) and obliterated the shorts. The currency had its biggest one-day rally in five years. What is especially painful is that the currencies investors hedged with the MXN didn’t go up even half as much as the MXN itself. Some didn’t go up at all. So that’s hedge up (bad) and hedged position flat (bad). Investors lost a nice chunk of money, and that is the reason why many “Global Macro” hedge funds are going the way of the dodo bird. To add insult to injury, Mexico had to raise rates in a global slowdown (bad) to stabilize their currency which had been destabilized because it was too liquid! Trades such as these are placed all over the globe. Investors in many risk assets have to sell what they can because what they own has zero liquidity.

To put this in the “Wing Beat of a Butterfly” perspective, a group of U.S. shale producers drilled and fracked a few thousand wells too many and upset the Saudis. The Saudis responded by ramping up production to smack-down the shale producers, which in turn hurt emerging markets. As a result, investors and global banks were forced to sell the one thing they could hedge with in size, the MXN; this has increased the price of a middle class Mexican family’s Sunday dinner by 20%! It’s all just one big trade, and in my opinion, the sooner we accept this, the “easier” it is to trade these markets.

This past week, the global financial markets proved the correlation of one theory again as we spent the first three days watching global equities and oil demonstrate impressive short cover rallies off of hope that a production freeze was being implemented between Saudi Arabia and Russia. There was also optimism that the European Central Bank (ECB) and the Bank of Japan (BOJ) stood ready to provide more stimulus. However, as the hope of an oil deal faded (it was a big reach), global equities sold back off with oil. The bit of good news was that the violent short cover rally that the production freeze news sparked did some damage to crude shorts. As part of what I think is a bottoming-out process, the burn this week should make those who wish to short oil show some respect, as opposed to selling away without fear. That is important, in my opinion. With regard to the ECB and BOJ; unfortunately, with benchmark lending rates already negative, they have taken the term “pushing on a string” to new heights. Faith in those institutions has fallen to new lows.

We’ve stated before: it’s not enough for the market to take the Federal Reserve (Fed) off the table; the Fed has to take themselves off the table as well. While Federal Open Market Committee (FOMC) voters would never just come right out and say it, they are doing the best they can to communicate this message. On Wednesday night, Federal Reserve Bank President of St. Louis, James Bullard (one of the important moderate FOMC voters), said, “I regard it as unwise to continue a normalization strategy in an environment of declining market-based inflation expectations.”

So, in what appears to be a very tough year ahead for investors, at least we have potentially two positive developments. The first is the beginning of a bottoming-out process for crude oil, and the second is the Fed moving away from hiking rates in 2016. At least we have that going for us.

Member SIPC & FINRA. Advisory services offered throughSWBC Investment Company, a Registered Investment Advisor.

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