The Federal Reserve released the minutes from the July 26-27 meeting. The market was waiting on baited breath for something, anything to cause a ruckus. The VIX Index, or Fear Index, was up 1.07 at one point, to 13.71. After the release of the minutes though, it crumpled down to 12.19. Most of you are well aware of the extreme amount of VIX short positions held by hedge funds last week, which precipitated some caustic remarks on my behalf, because there really is very little downside left in the index. Please feel free to refer to my previous post for more on the historical perspective.
In addition, the US stock indices have given back some of the gains of the month. Upon release, indices rallied in response to what is quite simply a continuation of the “lower for longer” narrative. Given the tepid growth of the US economy, I have long believed it would behoove the Federal Reserve to leave rates where they lay, until growth and inflation get a little more heated. It has been a long haul since the financial crisis and the deflationary pressures have done their damage, numbing the psyche of companies that should be investing more to grow organically, instead of cutting costs and buying back stock to maintain earnings per share ratios.
Lately, many participants and analysts are frustrated by the lack of confidence or assertiveness the Fed is exhibiting. It isn’t so much frustration with the rate itself, it is the communication which convey a sense of utter helplessness of policy makers. When the forecasts used by central bankers consistently exceed real economic data, it damages their credibility. It becomes quite comical when market participants seem to have a better idea of the timing of a rate hike. Imagine that, financial markets making decisions for the most enlightened economists in our country. Are the central bankers dispensable?
Indeed, I am just being facetious. What makes this whole story more frustrating is that the election is approaching in the US and the Fed WILL NOT raise rates before then. January is the template the Fed is using when projecting market reaction. One of its two principal responsibilities is price stability and if there is anything that I have learned about politics in this election season, an increase in rates before the election will be used as fodder for the Trump campaign. It has become quite obvious that the elite would rather not have president that is a loose cannon. No need to get into specifics, everyone knows the issues and events. The status quo is the preferred path right now.
Sadly, if inflation and growth run a little hot, you know what will happen. Nobody will be able to contain the howling: “The Fed is behind the curve and playing catch up!” So, the circus continues on its merry-go-round until eventually the music stops playing and the clowns drop to the ground from exhaustion.
I must confess, I thought the music was about to stop in September 2015, then again in August of 2015 and again in January of this year. Any knucklehead that hedged against a full-fledged market crash in 2014 (like me), and the following few months, got their heads handed to them on a platter. In August of 2015, the combination of a sideways trading S&P 500 and a VIX index in the low teens was indicating such a level of complacency in the stock market, that to load up on VIX call options was like taking candy from a child. In the weeks that followed, smart traders made approximately 2000% in those options.
This past January wasn’t as easy to time options on the VIX, since they were already quite volatile in the weeks leading to the end of year, driven by the increase in target rate of the Fed, to 1/4 – 1/2 percent on December 16th. The premiums were so high that making money was a near impossibility.
Here we are again, with the VIX close to historical minimums. It is important to note that in comparison to the set up in August of 2015, the stock indices have been slowly churning upwards, instead of remaining relatively flat. Mark Yusko of Morgan Creek Management often highlights graphical relationships that depict a break in positive correlation as alligator jaws, that should eventually snap shut. Theoretically, it is possible for the VIX to rise when equities are rising, but that is EXTREMELY rare. Therefore, the most likely outcome is that equities should reverse direction. Should…if not, it only confirms that this is a very hated rally in stocks.
To what extent? Looking into my crystal ball, it is as cloudy as the Panamanian sky during rainy season. So many things seem to be out of sorts, yet equities continue to slowly climb the wall of worry, when they should have already crashed into it. US companies continue to hoard money overseas and lever up on these low rates.
Meanwhile, some emerging market currencies seem to have stabilized to such an extent that they are drawing investment funds into their countries. The Mexican Peso refuses to go past 19 MXN/USD, the Brazilean Real has impressively reversed course since breaking the 4 BRL/USD barrier and the South African Rand has recovered 20.4% of its value since plunging to 16.8 ZAR/USD in January.
Without looking at the capital flows, these reversals in FX are signs of a global re-balancing occurring as we speak. The US Dollar Index is so heavily weighted by the Euro and Japanese Yen that many analysts under-appreciate the distribution towards other higher yielding currencies. Does it represent a frenetic search for yield, escaping the low and negative yielding bonds of developed markets? This is a possibility and the flow can easily reverse as soon as unseen risks appear in the host countries.
Such is the beauty of globalization, which seems to be going through some growing pains. The wealth created in the latest economic cycle did not include large swaths of the middle or lower classes. The revolt against the elite began with the Arab Spring and has resulted in a horrific situation in Venezuela. Yet, globalization has opened more doors that it has closed and it is time that the excesses of the few are curtailed.
In my conversations with clients, I often like to use the rubber band analogy. Stretch it between your index and thumb, then pull on it. It will reverberate between extremes initially, quickly slowing down to a minor vibration and then it will remain still. Such is the action and reaction to human events. We learn.
Emerging market assets led the recovery out of the financial crisis. It may well be occurring again. Only time will tell. What is obvious to me is that emerging markets are riding the proverbial seventh wave at the moment. It is still unknown what would cause it to break early. The US and Europe rode on the earlier waves and are now trying to paddle back out. Only sound risk management will protect investors from the “Black Swan” events that may arise from this economic experiment with ZIRP and NIRP. In the meantime, clients still require positive absolute returns (shameless plug).