Saturday, January 25, 2014

Reflation Wavers & Liquidity Traps Revisited

Bad economic data out of China, a Chinese trust on the brink of bankruptcy, a meltdown in the Turkish Lira, violent protests in the Ukraine and a plummeting Argentine Peso all served to turn sentiment in our markets, culminating in a vicious sell off on Thursday and Friday.  I'll be addressing the issues surrounding the currency crises that seemingly popped out of nowhere this week (they were actually brewing for a long time) in my analysis below.  But the fact that issues in the FOREX (Foreign Exchange) precipitated the sell off conjured up fears of the 1997  Asian Currency Crisis and reignited the "Armageddon scenario" mentality in some.  Nonetheless, the sell off was orderly and there was no panic on the floor of the NYSE while stocks slid into the close on Friday.

Let's survey some charts because there was some short to intermediate term technical damage to stocks this week.

Here's a daily chart of the S&P 500:


(click on chart for larger image)

The S&P decisively penetrated the first support line on the chart on Friday morning and never looked back.  It closed on it's absolute lows on the day; not a good harbinger for next week.  On Friday afternoon, after the close, the S&P E-mini Futures contract dropped an additional 10 points to close the weekend at 1780.  For the week, the S&P finished down 2.63%.  Momentum as measured by RSI (top panel) broke the 40 level to the downside which signals bearish momentum.

With the momentum clearly on the sell side and the ugly day we had on Friday I feel comfortable saying we will easily test the second support line above at around the 1770 level and we could get a wash out to the 1740 level.  As I stated in recent commentaries, the "bull" is still intact down to 1740.  If it pierces that level then we need to reassess the health of the market.

Since we haven't seen weakness like this in our market for awhile it's easy to get caught up in the fear and panic that normally effects investors who can't see "the forest for the trees".  Although I do believe that the price action this week speaks to unresolved and potentially dangerous issues in the global economy we must remember that US stocks are barely 3% off their all time highs.  The following weekly chart of the Wilshire 5000 Index which is the total US stock market serves to put this week into perspective:

(click on chart for larger image)

Additionally, the CBOE Volatility Index ($VIX) did skyrocket over 45% this week to 18.14. For readers not familiar with the VIX it is known as the "fear gauge" and it measures the markets expectation for volatility over the next thirty days.  The VIX is counter intuitive.  That is, as stocks rise the VIX drops and as stocks weaken the VIX rises.   Here's a daily chart of the VIX:

(click on chart for larger image)

Most of the increase in the index was on Friday as can be seen on the chart above.  However, when we look at a long term view of the VIX we can see that this week's activity is barely a "blip" on the radar screen:

(click on chart for larger image)

It will take a bit more pressure from the "bears" to unhinge the "bull" in this market.


The stock market demise was the Treasury market's boon as rates declined measurably this week.  The Ten Year yield dropped 3.25% from the previous week to close at 2.735%.  Here's a weekly chart of the Ten Year yield to give my readers a wider perspective on where we are at in the Treasury market:

(click on chart for larger image)

The yield is sitting on a resistance turned support line established from the mid 2007 highs in yields.  

The Treasury market will be pivotal in assisting us in determining whether what we are presently experiencing is nothing more than a much needed correction or whether the currency issues that are popping up around the globe are signaling a more systemic threat to the global financial system.

Gold responded appropriately to the currency gyrations in Thailand, Turkey and Argentina and we got a pop in the yellow metal this week after it appeared to make a double top at the 1250 level.  Here's a daily chart of spot gold:

(click on chart for a larger image)

Interestingly, gold barely budged while equities sold off on Friday,denoting waning momentum (see top panel).  I believe there's a much greater message in this price action which dovetails into my thesis about why this market possibly nose-dived this week.  I'll be covering this below.

Major commodity indexes were higher on the week mostly on the back of an enormous surge in natural gas prices:

(click on chart for larger image)

NATGAS surged to $5.16/cubic feet, the highest price since 2010.  But industrial commodities were mostly down on the week as measured by the Dow Jones UBS Industrial Metals Index ($DJAIN):

(click on chart for larger image)

As I've been documenting for over a year, the commodity complex, outside of a NATGAS, grain or softs that spike due to weather, is dead in the water.  This is another factor that I believe supports the thesis I'll articulate below.

Steel, highly correlated with Chinese economic activity, swooned this week as well:

(click on chart for larger image)


I haven't posted a chart on a currency for quite awhile but this chart is instructive in that it reflects a close correlation between the Japanese Yen and equities which I've addressed in a number of previous commentaries:

(click on chart for larger image)

This is a US Dollar/Japanese Yen cross ratio (white line) with the S&P behind it (yellow area).  Notice the tight correlation in that whenever USD was strengthening against the Yen, stocks were moving higher and when the Yen strengthened against the Dollar stocks weakened.  This is because as market participants move to a "risk off" trade, they tend to move into the Yen as a "safe haven".  This phenomena has been going on for a few years and it is still prevalent today but I thought I would share it with my readers because you can usually trade on this correlation.

Analysis

Those who regularly read my commentaries know I've trumpeted deflationary concerns constantly for the better part of the last year.  I've always admitted that the ultimate deflationary thesis coming to fruition was a minority scenario.  However, I always posited that it was a greater possibility than many would admit.

A more widely popular view has always been that the FED "floated all boats" when it commenced QE1 in the depths of the GFC (Great Financial Crisis) and has kept those boats floating ever since. Many have different opinions regarding the outcome of this "great experiment" and the efficacy of Fed policy.  While many, including I, have always maintained that the implementation of extraordinary monetary measures were necessary to prevent a total meltdown of the global financial system, there are others who always felt that the system should have been allowed to work out those excesses unencumbered by central bank intervention.  Moreover, many have felt that when it was time for the market to have the "training wheels" taken off, there would be a day of reckoning.  

I, myself, reserved judgement on the latter simply because I understood that the intention of the central bank was always to buy time in the hope that the extraordinary implementation of stimulus would give not only our economy, but by default, since we are the linchpin of the global economy, the global economy time to heal.  If the real economy could somehow gain positive traction with the assistance of massive stimulus then, indeed, the experiment would have been effective.

I do believe that our economy has benefited from FED policy but their employment targets cannot be reached purely through monetary stimulus and the four trillion dollars of Treasuries and MBS on their balance sheet has had no impact on the disinflationary trend in our economy.  I submit to my readers that a structural unemployment problem has been established in the US economy and this is feeding the disinflation we are seeing in this country.

 Fed monetary policy has also had a great impact on the global economy.  And the effects of this policy are most pronounced in Emerging Markets.  The avalanche of US Dollars into the global financial system along with a resurgent China over the past five years were the fuel for emerging market economic growth and prosperity.  Massive Fed liquidity drove down interest rates to extremely low levels for these countries, allowing them to borrow cheaply to finance their prosperity.  So, five years later  the Fed has started to take their foot off the gas pedal and various pundits are now saying that the seemingly isolated currency crises that are now popping up have nothing to do with the Fed unwinding their stimulus or at best, is only obtusely connected to the plight of these seemingly isolated and troubled economies.  With all due respect to these folks, I believe they are wrong.

One need not do anything more than put a timeline on the last nine months of an emerging market currencies chart to see that Fed policy is "the dog" that is waging the emerging market's "tail".

Here's a chart of the Wisdom Tree Emerging Markets Currency Fund (CEW):

(click on chart for larger image)

In the chart above, I've highlighted the major events regarding the tapering discussion and implementation that the market sensed was coming as early as May, 2013.  The correlation between the Fed's signals and EM currencies cannot be denied.  

The argument by those who are downplaying the seemingly isolated currency issues in the nations I've cited above is that, outside of Turkey, these are small economies that do not have much impact on the global economy.  But we're starting to see the currencies of seemingly stable economies, like Poland and Mexico, starting to show signs of strain.  US Dollar denominated EM bonds are also coming under pressure.

Turkey is especially caught in a quandary.  They need to defend the slide in their currency by raising interest rates but political pressures make that a very unpopular move (read revolution).  More importantly, the severely weakened Liri could cause balance sheet pressures as  Turkish companies have large foreign debt exposures.  This will inevitably impact foreign lenders and financial institutions, especially in Europe.

Behind all this is a backdrop of insidious deflation that central banks have been trying to bury under a mountain of fiat currency for five years.  Parts of the globe are in serious disinflationary situations or are in outright deflation (witness the European southern periphery).  As stated above, I was surprised that we did not get a surge in gold on Friday in the face of all the currency problems the market was facing but the precious metal had no momentum going into the sell off.  This was significant for me and I believe indicative of the overriding deflationary pressures that are prevalent in the financial system.

The Fed is taking away the punch bowl but it appears that the party is not ready for it to depart.  The great central bank experiment may be in the balance and the message of Emerging Markets and our stock market this week may be that "Junior" is not ready to have the training wheels taken off.  

There will be two keys to knowing whether the thesis I posited is correct.  Watch Treasuries!  A persistent rally in the coming weeks across our yield curve but especially in the 10 and 30 year with rates consistently going lower will be a signal that there will be further bloodshed in equities.

Additionally, here's another verification (or lack thereof) of my thesis:

(click on chart for larger image)

This is a ratio chart showing the relationship between the iShares JP Morgan USD Emerging Market Bond Fund (EMB) and the iShares Barclays Seven to Ten Year Treasury Bond Fund (IEF).  Understanding the relationship is simple.  When the chart is rising Emerging Market bonds are outperforming Treasuries as investors are willing to leave the safety of Uncle Sam's debt for riskier "paper".  And when the ratio is falling there is an aversion to risk as investors leave riskier debt for the safest "paper" in the world.  This chart is not my idea but it was in an article that  Michael Gayed of Pension Partners wrote for Marketwatch on 12/23/2013  

We have a busy economic reporting schedule next week, both here and abroad, but with the market sell off on Friday all eyes will be on the FOMC meeting on Tuesday and Wednesday with the subsequent announcement on Tuesday afternoon at 2PM.  It was widely expected before the sell off that the FED would reduce the pace of their asset purchases by another 10 billion dollars this month.  On Friday there were some who thought the Fed would back off this month.

I believe they may still taper.  Clearly, the efficacy of QE has run its course and at this point the Fed is pushing on a string.  To hold off reducing QE by another 10 billion now is tantamount to acquiescing to a heroin addict by giving him his much needed fix. 

It has also been said that the Fed does not factor in foreign or international factors when making policy decisions.  I would hope that they do as a general crisis in the Asian currency block could have profound and negative implications for the global economy as well.

In the current emotional state the market finds itself in, it will not take kindly to the Fed taking another 10 billion off the table and conversely, if they delay the taper we might meet with an initial rally but I believe the realization would soon set in that we've been caught in some kind of liquidity trap and this will not bode well for stocks in 2014.

Of course, if this is just the beginning of the much needed correction we've all been waiting for then everything I've stated above is for naught.  But I've given you the two signals I'm watching that will help us ascertain the viability of my thesis.

Have a great week!