Gold News

Code Word "Volatility"

Few traders know the Fed is already draining liquidity with reverse repo's...
 
A SHARP sell-off in the global stock markets so far this year has left many small investors a bit puzzled and panicky, and unsure how to react, writes Gary Dorsch, editor of the Global Money Trends newsletter.
 
Retail investors in the US, who watched the from the sidelines in a state of disbelief as the "Least Loved" bull market on Wall Street continued to climb to new all-time highs, finally decided to throw in the towel in the second half of 2013, and jumped aboard the bullish bandwagon.
 
The late converts plowed $175 billion of their savings into US equity funds, helping to push the S&P 500 Index to an all-time high at the 1,850 level. They gave little thought that maybe the "Least Loved" bull had climbed "too far and too fast" after gaining 175% from the Great Recession low.
 
January is usually a bullish month for US stocks. So when the Dow Jones Industrials stumbled out of the gate, sliding 7% so far this year, it raised a warning flag. It means that 2014 will be a volatile year.
 
On Wall Street, the word "Volatility" is code for sharp declines in the market place that are expected to happen frequently. Even if the US stock market recoups its early losses in the months ahead, it could come under renewed selling pressure again. In other words, the investing landscape has become more treacherous.
 
That's especially true because the S&P 500 index's bull market is fast approaching its fifth birthday on 9th March. And at 59 months old today, the "Least Loved" bull rally is 4 months beyond the median age of the Top 12 bull markets in history.
 
As it enters its retirement years, this bull run becomes frail, and more vulnerable to unexpected shocks. Traders that study cycles have also noted that the S&P 500 index hasn't suffered a correction of 10% or more for 30 months. That's remarkable, since historically, 10% corrections happen about 20 months apart, on average.
 
Not to forget the stock market will have to deal with the Fed's dialing back its high octane liquidity injections, a policy shift that will force the QE-addicted stock market to stand on its own two feet. Most traders are completely unaware that the Fed has already started draining excess liquidity on a daily basis, through reverse repo operations. On Feb 4th, the Fed drained $106 billion at 3-basis points from 60 bidders. Thus, the Fed is partly sterilizing its QE injections, which in turn, is helping to support the US Dollar's exchange rate.
 
Still, investors can expect the "Plunge Protection Team" (PPT) to intervene in the stock index futures markets, whenever panic selling erupts, in order to prevent a disorderly slide from turning into a horrific crash.
 
On February 3rd, the Dow Jones Industrials plummeted 326 points – continuing the steep sell-off from January. The Dow has shed more than 1,200 points, and its year to date losses total 7.4%, while the broader S&P 500 index plunged to the 1,742 level, and is down about 6% – the most it has fallen since its initial Taper Tantrum was unveiled in late May- June of 2013.
 
The Perma-Bulls on US equities were caught of guard as were the latecomers to the QE-party, and were surprised by the sharp pullback, because their radar screens weren't focused on the downturn in the Emerging currency markets.
 
A trend in motion will stay in motion, until some major outside force knocks it off its course. But while it's best to ride the gravy train for as long as possible, contrarians are also mindful to spot the contradictions between the mix of macro-economic data and the mix of the global markets.
 
Such was the case in the fourth quarter of 2013, when a wide mismatch was unfolding. Most notably – there was a sharp slide in the exchange rates of the Australian and Canadian Dollars and the Emerging market currencies, versus the value of the US Dollar, and other the other side of the equation, Yen carry traders were bidding up the exchange traded funds linked to the German DAX, Japan's Nikkei, and the US stock market indexes.
 
In hindsight, the widening divergence was unsustainable. But contradictions between the real economy and the market can be long lasting. "The market can stay irrational longer than you can stay solvent," John Maynard Keynes once said. So the macro-trader was patiently waiting for a notable change in sentiment before placing a contrarian bet.
 
Market sentiment can change instantly and without warning. As is typical in a bear raid, an eight-day slide in the S&P 500 index wiped out the gains over the previous 67 trading days.
 
The catalyst for the sharp pullbacks in the German, Japanese, and US stock markets was the meltdown in the exotic Emerging currencies and even currencies with AAA bond ratings. Since 1st May 2013 the Turkish Lira has plunged 22% lower, South Africa's Rand tumbled 20%, Brazil's Real tumbled 18%, Chile's Peso fell 16%, and the Russian Rouble fell 12% against the US Dollar. The Aussie and the Canada's Loonie tumbled 15% and 9% respectively.
 
There was also a notable unwinding of the "Yen carry" trade, against the Euro and US Dollar. The Bank of Japan (BoJ) is nursing a Yen carry trade [where speculators borrow in a low-interest-rate currency and park those funds in a better-paying currency or assets, relying on the exchange rate staying favorable] that contains hundreds of billions of leveraged bets. 
 
Global investors pulled $15 billion from the emerging-market stocks and $36 billion from emerging-market bond funds in the second half of 2013. But these trades are just a drop in the bucket, compared to the $4 trillion of foreign funds that was plowed into the emerging markets since the Bank of England (BoE) and the Fed began their QE-schemes in March of 2009.
 
It's estimated that $440 billion of the BoE's and the Fed's "hot money" flowed into emerging market bonds, equities and liquid instruments that can be sold quickly. So with the US Fed slowly tightening the money spigots, life will be more difficult for the "Fragile Seven" emerging countries – Argentina, Brazil, India, Indonesia, Turkey Russia, and South Africa – that account for over 17% of global GDP.
 
Recently, central banks in Asia and Latin America were forced to jack-up their interest rates to stave off currency collapses and a wholesale exodus of foreign investors. Brazil, Turkey, India and South Africa hiked interest rates in January, but whether these steps will steady the currencies is unclear.
 
However, one thing is sure – economic growth, the emerging countries' main trump card over their richer peers, will take a hit, as a result of the recent upward spiral in their local bond yields.

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.

 

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