Currency Wars – A Safer Market Commentary

Currency Wars

Foreign exchange volatility is not new in modern finance; though, relatively speaking, it has been reasonably muted in recent decades compared to preceding ones. Uncertainty around foreign exchange suppresses business investment in that the ability to repay debt from a capital project cannot be quantified when the value of the currency it will be paid back in is unstable and subject to massive fluctuation in value. It would be like trying to set a weight loss goal, but you know the scale you will use to measure results is significantly unreliable (in both directions); there is no real point in getting serious about the diet and exercise unless a working scale can be found. Risk assets all benefitted when a coordinated effort was made (worldwide) to limit the volatility of currency movement.

The reasonably smooth ride in global currencies has not come without exceptions. In 1987, Treasury Secretary, James Baker, said the U.S. would not cooperate with other countries creating divergent rate policy from our own. The next day was Black Monday, October 1987. We know of the global distress created in 1997 when the Thai Baht lost its peg to the U.S. dollar. The Russian Ruble created a similar spike in volatility in August of 1998. More recently, China’s seeming abandonment of its Yuan support in August 2015 caused a spike in capital outflows and tremendous anxiety in global risk assets.

The Fed

I have seen a lot in 33 years. Never before have I seen a Fed rate cut that didn’t work.

Rate cuts always work! Except this one. The market quickly decided it wasn’t enough.

The bond market says the Fed’s rate cut wasn’t enough. This is likely to cause a recession. I don’t think people appreciate how much of a disaster this is, and I’m pretty sure the stock market top is in. The good news is we have a portfolio that’s set to do well in a bear market.

Please, do not look to the stock market for your economic cues. Stocks can do anything for a variety of random reasons. The bond market is usually a more reliable indicator of economic health, and, in this case, the yield curve flattened massively after the meeting—a full 7 basis points in 2-year Treasuries/10-year Treasuries.

Argentina

Two years ago, Argentina sold a 100 year bond…..AND it was 3X oversubscribed! I said to you then that whoever bought those bonds have lost their minds since Argentina defaults like clockwork every 15 to 20 years. Well, here we go again:

In the wake of President Mauricio Macri’s stunning rout in primary elections over the weekend, investors dumped its stocks, bonds, and currency en masse in a selloff that left much of Wall Street wondering whether the crisis-prone country was headed for yet another default.

The upset, widely seen as a preview of October’s presidential vote, threw the doors open to the very real possibility a more protectionist government will take power come December and unravel the hard-won gains that Macri made to regain the trust of the international markets. It deepened worries his populist opponent, Alberto Fernandez, and running mate, former president Cristina Fernandez de Kirchner, will try to renegotiate its debts as well as its agreements with the International Monetary Fund. The country has billions in foreign-currency debt due over the coming year.

“The market is starting to price in default,” said Edwin Gutierrez, the London-based head of emerging-market sovereign debt at Aberdeen Asset Management. “The market is unwilling to give Fernandez the benefit of the doubt.”

Credit-default swaps now show that traders are pricing in a 75% chance that Argentina will suspend debt payments in the next five years. On Friday, the likelihood was just 49%. Its dollar-denominated government bonds lost roughly 25% on average, pushing down prices to as low as 55 cents on the dollar. Yields on shorter-maturity notes soared past 35%.

The peso tumbled as much as 25% to a record-low 60 per dollar Monday, and the Merval stock index lost the most ever in intraday trading.

The Argentine peso keeps tumbling, breaching 60 to the dollar. The currency is down 37% month-to-date.

Corporate Debt is a Problem

Corporate debt has reached alarming levels.

Mexico

This year, Mexico replaced China as the US’ top trading partner. Canada is now second, and China is third.

The US-Canada-Mexico trading bloc is now larger than the European Union in both population and GDP and has avoided the EU’s seemingly endless tensions.

The importance of U.S.-Mexico trade may surprise some. In the minds of many Americans, Mexico is still a third world country, whose largest export is poor people looking for jobs. Truth is, Mexico has the 15th largest economy in the world measured in U.S. dollars. Australia ranks just one spot above Mexico, and countries like Spain, South Korea, and Canada are not too far ahead either. Measured in purchasing power parity, however, Mexico ranks as the 11th largest economy in the world. PPP measures economic activity against the ability of a country’s currency to buy goods.

Bond Market

By this point, you have probably heard that $15 trillion of bonds are trading with negative yields, which represents 25% of all sovereign bonds outstanding. But, I want to focus on the low yields here in the US, specifically the 10-year Treasury. We’re not in uncharted territory here.

Here is the 10-year Treasury in 2012 with a 1.4% yield:

And again in 2016 with a low of 1.4% yield:

Both of those times (and I remember this quite clearly), people were bullish on bonds and said that yields were going lower. Instead, they rocketed higher. They said that the deflation/disinflation that we were experiencing was unstoppable, and a whole bunch of other stuff, that turned out not to happen.

Just remember, if you think things are stupid now, they will probably get more stupid. You can put that on my tombstone.

Prior to 2000, bond yields and stock prices usually trended in opposite directions. As a result, falling bond yields were usually good for stocks. After 2000, however, that relationship changed. Since 2000, bond yields and stocks became more closely correlated. That change meant that falling bond yields since 2000 have usually been bad for stock prices.

The red circles, however, show three instances when rising bond yields resulted in lower stock prices. They include the stock meltdown during 1987, during 1990 in the months leading up to the first Iraq war, and the so-called “stealth bear market” of 1994. In all three instances, a downturn in bond yields helped resume the secular uptrend in stock prices.

Prior to 2000, bond yields and stocks usually trended in the opposite directions. Chart 2 shows them trending in the same direction during 2000 and the two decades since then. By comparing the red circles, the chart shows a downturn in the 30-Year Yield during 2000 preceding a similar downturn in stock prices later that year. [Yields peaked during January; the Nasdaq peaked during March; and the S&P 500 that August]. The second set of circles show bond yields peaking earlier than stocks during 2007 (yields peaked during June and the S&P that October). Another downturn in yields during 2011 coincided with stock weakness. And the period between 2014 and 2015. The latest downturn started late last year and the 30-Year Yield has fallen this week to the lowest in history. So far, that has had a mildly negative impact on stock prices. But if history is any guide, falling bond yields aren’t a good sign.

Market Data

Over the last 10 years, the S&P 500 has had daily moves of 3% or more just 19 times… Out of those 19 one-day declines, 16 of them have occurred within a broader market correction – essentially a market decline of 10% to 20%. And again, this sample was just from the last 10 years, during one of the strongest bull markets in history. The chart below shows all the 3% or more one-day drops in the S&P 500 during the last 10 years.

• The Fed doesn’t meet for another five weeks, so we won’t know its plans with interest rates until then.
• Corporate earnings season is mostly done.
• Stocks plunged on Wednesday, with the most common excuse being renewed fears of recession due to a further inversion in the Treasury yield curve. Between various maturities, 60% of the curve is now inverted.
•   Large and small failures. The drop on Wednesday was enough to push the Dow Industrials below its 200-day average, joining the small-cap Russell 2000 index.
•   Safe haven bulls. Volatility in stocks has prompted investors to favor safe havens like gold and the Japanese yen.
• The yield curve has inverted.  This marks the first time this spread has inverted since the 2008-2009 financial crisis. According to history, the “clock” is now ticking for the recession.
• Less than three weeks ago, financial stocks within the S&P 500 were within spitting distance of a fresh 52-week high. Now they’re mired in a correction, having pulled back more than 10% from their high.
• Bonds again. For TLT, the 10-day Optix is the 2nd-highest in its history. The other, August 10, 2011, saw TLT drop 2.5% over the next two weeks.