Stock Market

Four Ifs by Fed, Two Ifs by Me? Why the Reserve Board Will Likely keep Its Interest Rate Powder Relatively Dry in 2016

Since announcing last December that it would increase by .25 percent the range of its base interest rate for overnight lending for nearly a decade, the US Federal Reserve has signaled in multiple ways its intent to continue such increases four times during the course of this year. Initially, this intent was signaled by the release, in conjunction with its last 2015 meeting, of the “central tendency” of the projections of the rate-setting “Open Market Committee” participants (the now famous “dot plots” on a graph). Those plots showed that, disregarding the highest and lowest projections, the middle of the pack of opinion was represented by a path of four rate increases of .25 percent each by the start of 2017. While this would be a slower than usual pace of rate increases by past Fed standards, it would nonetheless bring the base rate to a range of 1.25 – 1.50 percent, essentially a full point higher than where the range stands today.

Ever since then, the US financial markets have more or less indicated their displeasure with this “tendency” in the best way they can to get attention. Bond markets rallied with prices higher and interest rates lower, reflecting a conviction among market participants that economic conditions have veered downward with deflation, rather than moving in the direction of continued modest expansion and 2 percent inflation projected by the Fed at its December meeting. Lately, a number of market participants are going even further and predicting the onset of a US recession (two or more consecutive quarters of negative movement in GDP), which would certainly argue for more, not less, Fed “accommodation” to the market–either in the form of another round of quantitative easing in bond purchases to pump lendable money out to banks, or course-reversing decreases in the base interest rate (for which the Fed has only marginal room at best before “going negative,” as Europe has.

Regardless of whether the bond market is right in suggesting a recessionary case, the equity market, which has been at odds with bond market expectations for most of the last few years, has also been shooting flares at the Fed’s intentions in very dramatic fashion. Indeed, there is simply no historical precedent for the precipitous drop in US equities since the first trading day of the year, when on average an investor lost $16 for every $1000 in the market and has kept on losing money ever since through the first two weeks of the year.

There are, of course, multiple rationales for the equity market correction (a 10 percent drop or more), the second in six months. Indeed, some of the reasons are the same as occurred in August: data showing a serious decline in the Chinese export economy, and a precipitous devaluation of the Chinese currency in the context of continued relative strength of the US dollar, as well as the partially-related continuing decline in the price of oil in view of increased current and anticipated market supply and weakening Chinese and emerging market demand, which also led to a drop in the pace of US manufacturing! In addition, there was a perception in some market quarters that the Federal Reserve might take steps to increase interest rates in September, while the US economy was showing signs of increasingly vulnerability to foreign emerging market damage, caused by the rising value of the US dollar against their currencies (exacerbated by the drop on the Chinese yuan) and the ensuing flight of capital from their economies–which would be made worse by such an increase.

Ironically, the decision of the Fed to hold off an expected September rate increase was roundly criticized in some quarters because the Fed expressly cited global economic conditions potentially threatening the US recovery as one of its reasons for deferring the first increase at that time. These critics said the Fed has no business taking foreign situations into account to the extent that it seemed to be adding a “third mandate” in terms of global financial market stability to its list of responsibilities.

Now, the Fed was never adopting a third mandate to work for foreign countries. Its September focus on negative Chinese and global economic trends was quite obviously because of the potential US-side effects of those negatives on the Fed’s statutory twin mandates–optimal employment and stable prices! Indeed, today’s Fed critics are adopting that very same perspective the Fed was criticized for back in September, urging the Fed to most certainly pay heed to the adverse developments in the Chinese and emerging market economies because they may be leading to a global recession that will be imported along with attendant deflation to the US.

Nonetheless, in the past week, both Vice Chair Stanley Fischer and New York Federal Reserve Bank President William Dudley went out of their way in public remarks to assert that the projected four rate increases this year were still “in the ballpark” and definitely on the table, notwithstanding the offshore negatives. Yet the minutes of the Fed’s Open Market Committee’s December meeting, released January 6, reveal the Fed itself was divided and unsure of the direction of the US economy, citing “significant concern about the still low readings on actual inflation” and “risks present in in the inflation outlook.” These concerns would now seem to be increased by the continuing drop of the current market price of oil to levels below $30 per barrel, not seen since 2003.

Coincidentally, the same Business Section of The New York Times that offered the headlines “Oil Prices Decline More than 5 Percent as Stockpiles Increase,” and “New Fears of a Slowdown in China Spur Selling” (January 7, 2016) also contained the article titled “Minutes Indicate That Fed Still Has Inflation Doubts.” The story noted questions about how much farther Fed officials are willing to raise rates without clear evidence the pace of inflation is also rising. Fortune Magazine had a similar take on the Fed’s divided state of mind.

In the coming days and weeks, there will be multiple data points to be considered before the Fed’s coming January and March meetings (nobody expects a rate increase in January, but the “four more hikes” play call virtually requires one in March) by a Federal Reserve that has promised its interest rates decisions going forward will be “data dependent,” regardless of their dot-plot projections: fourth-quarter 2015 GDP (currently within 1 percent or less of recession levels in most forecasts); January and February employment reports; manufacturing and service business trajectory; consumer spending levels; retail and housing sales; and, of course, producer and consumer price levels. A generally centrist Fed official, St. Louis Reserve Bank President James Bullard, while not directly contradicting the “four more in 2016” rate rise track, did note the potential impact of falling oil prices on the Fed’s 2 percent inflation target. This note may well imply that such incoming data will prove to be more important than the dot-plot projections of four rate increases this year, especially because of the effects of further downturns in China on the drivers of that data, such as the price of oil and the prospects for currency-related, deflationary discounts on products imported to the US.

But there have been very few mentions of another factor that could tip the balance against four or more rate increase this year: 2016 is a presidential election year. The Fed meets only eight times a year, so four increases would average one increase every other meeting. Assuming the incoming data causes a March deferral, that would leave only six for four, right into the teeth of the nominating and final election campaign. George H. W. Bush famously blamed his re-election loss in 1992 on the Fed’s Alan Greenspan, for his resistance to cutting interest rates faster during the recession preceding the vote.

The Fed certainly would want to avoid a mistake in terms of excessive interest rate increases that tip the economy into recession (that’s why its public statements hedge with respect to “data dependence”). But it would also not want to be perceived to tip the election to one candidate or another; let’s just call that “date dependence”–the date of the election! The prediction here is that this year will see two rate increases at most: one in April or later, and the other after the election in December.

For the moment, Chinese GDP data has come in at 6.9 percent for 2015, down .4 percent from the prior year and in line with reduced expectation, stabilized by retail sales growth of 11.1 percent year over year (just short of estimates), while manufacturing contributions continued to tumble as expected.

These numbers reflect an overall 25-year low in GDP, but also suggest a level of stabilization that left markets in Asia marginally positive, with Shanghai up slightly as well. What remains to be seen is whether these numbers will in turn stabilize the US markets enough for the Fed to jump ahead with a .25 percent increase in March. And that would seem to turn on whether the strong employment data averages of 284,000 net new jobs in Q4 2015 will persist, and whether there emerges actual (not just projected) upward inflation data in Q1 2016. The sense here is “no” on both counts–and that might mean the US equity market could even turn upward, as it did eventually after last September’s Fed flinch.

The Bond Market Disagrees With The Fed: So What’s New About That?

The US Federal Reserve through its Chair Janet Yellen has been making clear in recent meetings and speeches that the “federal funds” overnight interest rate (close to zero) is going to be with us for a “considerable” period of time, possibly lasting until 2016, so long as unemployment stays above and inflation stays below the Fed’s targets of “full employment” around 94.5% and “core” inflation of around 2%. Just now both bond market professionals and the Fed know we are below each target by about 100 basis points (1/100th of a percent). But that’s where any agreement between them ends and where the bond market begins its latest quarrel with the Fed. 

Bond traders always seem to think they know more than the Fed about money and the economy. Just listen to Rick Santelli on CNBC any day of the week: nothing new there. What’s new is the bond market seems to waver between two completely opposite assessments of why the Fed is wrong, both of which cannot be true: (1) that the economy is far weaker than the Fed gives it credit for (and is flirting with recession); and (2) that the economy is far stronger than the Fed realizes (and is flirting with inflation).  Just now the first premise seems to be winning out, but the second always lurks under the surface. The combination makes bond prices a spurious guide to equity investors.

Yet commentator after commentator on CNBC and elsewhere keep warning the equity market that “the bond market is trying to tell us something” important. Rick Santelli went so far as to say that the bond rate “yield curve” is forecasting a new US recession. For a while, equity markets seemed to be intensely listening to its schizophrenic financial neighbor: every time the price of ten-year Treasury notes retreated (causing interest rate yields to fall) during the course of recent trading day, the equity market sold off very noticeably.

If the ten-year rallied and yields temporarily fell, equities would broadly rally in price also, even stopping for the moment the precipitous slide in the market value of so-called “momentum” growth companies in biotech and “new tech” areas like social and internet media, cloud computing, enhanced data security and even electric cars. These stocks had rapidly fallen out of favor with the onset of a rash of IPO’s and secondary offerings and insider sales in these sectors, with investors rotating away from them to so-called “value” stocks with far lower P/E ratios (and far lower earnings growth). This is in part under sway of the Fed’s bond market critics who argue that its Quantitative Easing (QE) programs have actually held back a more normal “return” to robust growth and that, as QE finally stops, the emerging strong economy will “lift all boats,” even heretofore growth laggards like Cisco and Intel. Why risk money on the high beta highfliers when you can get more from a quick pop from the “Dogs of NASDAQ” with less downside risk (since they are down so far already).

Sounds logical, but you have to buy both premises: that the economy will be coming back gangbusters, and that the likes of Cisco and Oracle can regain market share leadership from the newcomers like Salesforce.com and Workday and that have beaten them in the market during the tough years we have just come through.  And you also have to disagree, of course, with the notion that the current bond market pricing is forecasting a recession, which would be a reason to get into cash, not a Cisco.

The Fed has announced both the tapered end of QE by the end of this fall and its intention to continue, however, with highly accommodative interest rate restraint until late 2015 at the earliest to give the economy the best chance to reach both its healthy employment and inflation targets by 2016. Bond traders seem to think both policies are wrong: that, on “free market’ principles, QE should already have been ended and that short term interest rates should be…here things get interesting….raised sooner  rather than later because credit trading is not yet normalized but nonetheless should for now trade lower because the economy is actually in worse shape than the Fed realizes, at both the short end and the long end. Which makes for the classic ‘flattening of the yield curve” that often predicts recession! In short, bond traders seem to have seen Steve Martin’s “The Man With Two Brains” so often they have forgotten it was a comedy. And these are the folks the equity markets are supposed to pay attention to?

But could it possibly be that the Fed, not the bond market, that has its head straight? That the Fed realizes that the “weather deniers” in the bond pits are wrong to dismiss any relationship of the past winter’s excesses  to December through February shortfalls in retail sales, construction activity and factory orders (all of which interim trends clearly have reversed in March according to actual data)? That the Fed realizes that a flight to Treasuries has been triggered far more by the crisis in Ukraine than by the bond trader mantra that the economic sky is falling in the US? That the Fed, moreover, has been able to pull off the tapered end of QE without the massive run-up in ten-year Treasury rates (that would have killed the slowly-emerging housing/mortgage recovery) feared last summer when QE tapering was first mooted by Chairman Bernanke. Indeed, money has flowed into Treasuries – perhaps more by happenstance (think Putin) than design, but better to be lucky than scared in most aspects of life.

In their defense, bond traders argue that QE has failed because interest rates actually went up during its heyday. But the Fed was not looking to drive down rates.  It understood that longer term interest rates would rise with the economic recovery it was trying to stimulate by holding short-term interest rates down. It simply was using QE III to keep that increase within reasonable limits –-which even bond traders would have to agree it did.

Ever since the Great Recession hit, bond traders’ many apologists have criticized every single move the Fed has made, predicting both doom (rampant inflation) and gloom (a return to recession) – two phenomena that rarely, if ever, accompany each other! Perhaps the equity markets should indeed watch the bond markets carefully, not for ancient wisdom, but for signs of such inherent incoherence, and act accordingly. Maybe the Fed after all has the more correct and balanced view —  that the economy is getting better, but needs more help to get really well, and the bond traders just need to get over it.

By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.

 

 

 

 

 

 

 

 

 

 

 

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April Showers Hit Markets: Bring An Umbrella To Trade

Previously published on The Huffington Post

Forces at work from Tokyo to Kiev have been roiling the US stock market for a couple of week. But the financial sushi that is now on the menu in Japan, and Russia’s “Crimea of the Century” are only part of the story.

Japan is trying at long last to revive its moribund and literally “deflated” economy by a combination of easy money (to spur needed domestic inflation, weaken the yen and grow exports), structural reforms and a major sales tax increase to reduce the overwhelming level of government debt brought about by decades of fruitless “stimulus” overspending on unneeded infrastructure. Sounds good. But traders in the US have come to fear that Japan’s Fed is not pumping out easy money fast enough to offset the tax increase, which in turn will slow rather than stimulate the Japanese economy and cause the yen to rise undermining the traders’ so-called ‘carry trade’ – borrowing cheap yen to convert into dollar equities thus boosting US equity prices. If everyone unwinds the “carry” at once – as has been occurring recently – equities fall hard, especially while the US Federal Reserve is slowly but surely unwinding its own extraordinary quantitative easing program. The whole scenario also threatens the positive outlook for enhanced global economic growth that we started this year with, further undercutting equities.

The Russian invasion and annexing of Crimea has gradually added to global growth worries and equity jitters, but obviously not because of any financially strategic characteristics of Crimea. With a US president facing political pressure to prove he can ‘stand up to Putin’ from a public that nonetheless has utterly no stomach for military intervention in Ukraine, the only “weapons” available are economic sanctions of the “this will hurt me more than it hurts you” variety. The “personal” sanctions against Putin’s oligarch cronies are not the equity traders’ problem. But moving to the next level of sanctions on trade with Russia, ultimately including energy products like oil and gas, would impose pain for the entire European economy, which has enough troubles of its own from the Eurozone crisis hangover.

Other sources of energy imports, including from the US, can’t possibly come through fast enough to spare Europe a recession if Russia further destabilizes the eastern Ukraine or even invades and the West is forced to go to “DefCon 4” level trade sanctions. As a result, nervous traders are watching the Ukraine/Russia border even more closely than the CIA. (Why didn’t they borrow some of NSA’s tricks and snoop the Vlad-phone before Putin made his move?)

In the midst of these growth-threatening circumstances, along came 60-Minutes worth of Michael Lewis’ latest exposure of Wall Street excess (“The Flash Boys”) undermining confidence just when confidence is what investors need most. Lewis revealed in plain English the millisecond advantage high-speed, computer-driven traders have enjoyed –- with the profit-related connivance of the major stock exchanges and the unwitting assistance of SEC market reformers – allowing them to jump ahead of buy or sell “market” orders from you or me or the biggest institutional traders to make gazillions of risk-free penny profits by forcing us to pay more than what our computer screens tell us is the “market’ piece. Simple, computer-elegant, virtually un-measurable and probably legal front-running.

While the Lewis book no doubt caused some 60-Minute retail investors to pull their money out of stocks, professional traders haven’t really been moved to dump equities by the notion that their customers are being nano-skimmed. They are more concerned by Lewis’s reminder of the power of computer-driven trades set to algorithms that can trigger massive and sudden market sell orders based on momentary and even accidental extraordinary price changes in single stocks or ETF’s.

The famous “Flash Crash” a couple of years ago was just such an event. The Lewis book effectively underscores the fact that we can’t get really get to the bottom of the chain of events that actually caused that sudden market collapse because our trade monitoring devices can’t get down to the millisecond level. The ‘pings” of such trades simply are undecipherable with current market-policing technology – they are effectively lost in the vast Indian Ocean of dark- pool private exchanges that sprang up in response to the regulatory reforms designed to open up the stock exchange oligopoly to more competition and thereby lower “spreads” between bid and ask prices. It did so, but to so a fine degree of fault that traders can’t really tell that their pockets are being picked. (By the way, the flash crash happened in May, so no surprise that equity traders start to get nervous memories in April.)

Finally, the “rotating correction’ – from bio-techs to cloud computing to big data and finally to anything with a high P/E multiple – that has rolled through the equity markets in the first week of April was triggered by a couple of oddly interpreted events. First, Congressman Henry Waxman of California (a retiring but not shy Democrat) and a couple of his Party colleagues wrote a letter to Gilead asking why the company was charging $1000 per pill ($84,000 per full treatment) for the newly approved and highly effective Hepatitis C drug. Note Waxman is a Democrat and thus virtually impotent in the Tea Party dominated House of Representatives. But never mind. Traders dumped Gilead like a failed Phase III trial and took the whole biotech world down with it purportedly on fear that there was a serious threat to drug pricing going forward. Nonsense – at least from the government. But when the largest pharmacy benefits manager, Express Scripts, took up the same cause this week, the threat at least looked a little more real. No doubt many biotechs were trading in bubble-land — but not particularly Gilead.

Then a couple of high-flying technology and biotech companies had the gall to do a secondary offering in the midst of a great run for IPO’s in the same sectors over the first quarter and into early April. Our beloved equity traders are supposedly strong free-market capitalism advocates, who urge our politicians to keep the tax breaks in place for the venture capitalists who deserve the rewards of their successful investment because they are such prolific ‘job creators.”

But when the VC’s have the nerve to cash in those chips with secondary offering of their own shares that dare dilute the sleepy traders by surprise — somehow they didn’t notice those stocks were also at bubble-land prices – there is hell to pay for the rest of the shareholders, as those traders joined the secondary sellers in unloading their own inflated shares, taking profits and continuing to sell down if only to preserve capital for a later run.

Many market commentators broadly praised this “multiple correction” as portending an overall return to a more “normalized” trading environment without the extreme multiple expansion of the last couple of years that some prominent voices believe is more attributable to the Fed’s money than the companies’ revenues or even their profitability (which for some as yet is non-existent). But more than a few healthy babies have been thrown out with this bath. Warning to the commentators: be careful what you wash for!

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By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.

Finally, The End Of The Five-Year Armageddon Trade?

For the past several years, beginning with the collapse of the US housing finance market in 2008, debt and equity markets worldwide have been subject to periodic shocks and jolts that have given rise to what’s now known as the “Armageddon Trade.”

Reminiscent of the market positioning that occurred in advance of “Y2K” at the turn of the new century, a bevy of commentators took turns predicting that the market crashes that were triggered by the collapse of the securitization market for mortgage debt were about to be triggered again by various “black swan” (i.e., odds of happening conventionally, perceived like winning Power Ball) events either in America or overseas. This would lead to gigantic losses for security holders with “long” positions, and, of course, tremendous gains for short sellers who would have two ways to win. One, if those black swan events actually occurred, and two, if they could convince enough people that they would, so that they would dump their stocks and bonds in a “pre-fire” fire sale into the willing hands of the shorts when the alleged “crisis” was seen to have passed.

Of course, the Armageddon Trade talk was buttressed by actual occurrences that nobody predicted in their scope and impact.  The near death experience of the American mortgage banking and investment banking industries really did happen, along with the fall of Lehman Brothers, the distressed sales of Bear Stearns, Merrill Lynch, Countrywide Mortgage, Wachovia Bank, and Washington Mutual, the resignations of the heads of Citibank, AIG, Bank of America and other financial giants accompanying their bailouts by US taxpayers, and the bailout/bankruptcies of GM and Chrysler.

If all this destruction of wealth could happen in the world’s most important economy with its global reserve currency, then was it so hard to believe that Greece would default? Or that Germany would abandon the Euro? Or that the Euro would collapse to arithmetic parity with the US dollar or worse? Or that the European Central Bank would prove too weak to act decisively? Or that Italy, Spain and Portugal would follow Ireland and Iceland into virtual receiverships along with their banking institutions? Or that France would finally succumb to its excesses? Or that China would collapse into recession? Or that the US would default on its outstanding debt as a result of the new political Tea Party mistaking the so-called “debt ceiling” law for a credit card limit? Or that the US government would actually shut down for weeks to satisfy the same minority Tea Party and their talk radio sponsors?

As it happened, however, none of these confidently predicted Armageddon events actually happened, dealing a blow to the credibility of the “Chicken Little” school of market sentiment. Instead, US stocks climbed 20-30% in 2013, depending on your choice of scoreboard. Yet as the new year began, the bad news bears put together a new disaster scenario to encourage the investment winners of the past year to take advantage of the “selling opportunity” while they still could, thereby driving down stock prices and rushing money into Treasuries, which were increasing rather than decreasing in value despite the Fed’s December decision to begin tapering its own debt securities purchases. The bears had of course positioned themselves in Treasuries in advance of their latest Armageddon call.

This time around, however, the doomsayers had to weave a much more complex and interrelated, cumulative case for the end of the world as we know it. This included pointing to the following. China was slowing toward a hard landing, based on one month’s PMI data in advance of an earlier than usual Chinese New Year, which always depressed economic activity temporarily. Another imminent “Lehman moment” collapse in China of their “shadow-banking” trust loan finance sector because the collapse of coal prices would not support repayment. A slowdown in US hiring (by some but not all measurers) and retail sales (for some but not all vendors), obviously temporarily impacted by unusually severe winter weather in two-thirds of the country. The potential for a rolling emerging market currency collapse brought on by runs against the Argentinian, Turkish and Hungarian currencies, which in global GDP terms do not amount to a hill of beans, plus a new Italian government crisis. And finally a protracted fight in the US Congress over the extension of the debt ceiling through the 2014 election cycle brought on by the Tea Party caucus in the House and Ted Cruz in the Senate.

This 2014 doomsday scenario succeeded initially in driving a “semi-correction” of 5% in equity values and concomitant rally in ten-year Treasury note values. The cable TV financial networks rallied to the correction cause (if only because they had been calling for one all during 2013 to no avail), bringing on a host of guest commentators predicting a 20% correction (S&P down to 1480), a new bear market, and even a return to recession negative GDP growth this year with the impending collapse of global finance and all commodity markets except gold. Many of them saw it coming in the supposed “weak volume” recovery of 2013 – it would prove a false dawn, as one prophesized.

But as the old prophet Bob Dylan put it even in his Super Bowl commercial, “things have changed.” The markets got smart. They looked under the hood of the global economy found problems, but not crises that couldn’t be handled by the powers that be. China bailed out a weak trust bank, proving they learned the Lehman lesson. That country’s trade figures improved in January, presaging stabilization in manufacturing while the government pursues economic reforms to reign in excess lending – good things that will help prevent crises. Italy had a relatively smooth transition to more energetic and popular leadership (learning the Berlusconi lesson). The House and Senate extended the debt ceiling, no strings, no filibusters (learning the Gallup Poll lesson) and the merging market central banks acted quickly to face reality of currency runs, proving they learned the Thailand lesson.

In short: plenty of worry for the famous wall that markets often climb, but no Armageddon’s on the horizon. Maybe we can get back to “normalcy” after all, even with increased market “volume” more to the upside. Even with that supposed crisis sign, low volume proves to be a fraud.  As Bloomberg has reported, trading volume measured in shares has indeed been down over the past five years, by 27%.  But the average price of shares is way up for the same period (from $24 to $77, well over double!). So volume measured in total market value has actually grown by a third over that period.  Score one for grade school arithmetic. Chicken Littles, it seems, just can’t do the math!

By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University

Previously published on http://www.huffingtonpost.com/terry-connelly/finally-the-end-of-the-fi_b_4809501.html

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education

THE ‘WAG THE DOG’ MARKET; STOCK MANIPULATION MADE EASY

THE ‘WAG THE DOG’ MARKET; STOCK MANIPULATION MADE EASY

The American stock market has been beset by a spike in volatility and downward pressure since the beginning of the year. Some of the riptide declines began with the unexpectedly light employment report for last December, issued early in January. While private research reports had documented net job increases well above the 200,000 or so that had been reported by the Labor Department over recent months, the government estimated only 74,000 were added. For those market speculators waiting all 2013 for the oft-predicted 10% downward correction in stock prices that would give them a chance to get in to the market after missing its 30% increase over the year, the disappointing jobs report offered their first chance to send their minions onto cable TV to promote the well-worn “sky is falling” thesis that would lead investors to quickly “take profits” and get out of the markets “while they still can.”

This ploy amounted to just another well-promoted renewal of the “Armageddon trade” that spooked investors – and opened doors to speculators to buy stocks cheap before the inevitable snap-back when Armageddon forgot to happen in 2009, 2010, 2011, and 2012 (based on doomsday scenarios for the Euro, the European “PIIGS” states, China and even the US).  This time investors – fooled not just once but four times by the chicken-little game –didn’t swallow the jobs report whole and refused to panic.  This was  largely because the dismal report was found to be based on statistics collected for only one week in December, and the coldest one at that – which artificially held down all sorts of employment but only temporarily.

But the speculators soon got another gift that keeps on giving – this time from the always volatile “emerging market” sector overseas – specifically in this case, the rapid depreciation of the currencies of Argentina and Turkey, which had been living beyond their means for years but only recently exposed as such by the Fed’s December decision to begin “tapering” the monthly money-printing that had found its way to the hot-return markets like those two countries, among others. Black market rates for exchanging the Turkish lira and the Argentine peso into dollars spiked precipitously, their Central Banks rushed to raise local interest rates and adjust exchange rates to counter the panic in the streets. Then speculators rushed in first to the currency markets to pressure the country authorities further to test where even more tumultuous – and profitable –breaks could be triggered! But the speculators also quickly saw that there was an even bigger game in play, and one they could play on a very low-cost/high returns basis – namely, playing the whole US stock market against itself for a quick buck on the short side with a relatively very small investment, just like in the good old days of the Euro-panic of 2010 through 2012.

The initial US market reaction to the Argentine-Turkey tango – which gave the speculators their renewed opening – was a flight to the quality of treasuries, which took the ten-year note up to levels that reversed the ‘normalizing’ price decrease (and rate increase) expected in the wake of the Fed’s tapering and mimicked a pattern usually associated with the onset of recession fears. Then came multiple 100+ declines in equity markets as they picked up the ‘all is not well” scenario laid out on cable coverage starving for something that looked like dramatic change. All this manufactured doom and gloom has created a perfect scenario for the speculators’ favorite playbook. Here’s how it works:

A big problem in a really consequential market, like a collapse in Chinese growth, would merit a drastic equity market response, more than even the 10% correction that short sellers and the many hedge funds that missed the 2013 rally altogether because of their antipathy to any “Obama’ market or whatever. But that’s reality; speculators deal in fantasy. Chinese GDP is equal to a large percentage of US GDP, more than the top ten US states combined. But Argentina, Turkey, Hungary – that’s a whole other story. Argentina’s GDP is just the size of Arizona and Missouri combined; Turkey’s is the same as Virginia’s and North Carolina’s combined.  And Hungary is supposed to be an earth-shaking currency problem? Its GDP is the same size as Kentucky’s.  But these global minnows allow the speculative whales to play an ultra-efficient market manipulation game at very low cost.

The “sky is falling” speculators just briefly “invest” a relatively small amount of their dollars to take a market position that drives down these little countries’ currencies even farther, take a mega-short position in the Dow or S&P averages. Then like the Armageddon psychology promoted by the cable TV “experts”, do the rest of the work for them, driving down equities to return big and quick short-position profits that more than make up for the losses incurred on currency manipulation, and opening the opportunity to buy favored equities – which they know will not be hurt by a Hungarian devaluation or whatever – on the cheap for 2014.

They played the same game back in the day when Greece or Spain were going to bring down the Euro, or the world: a few bucks pushed to spike the rate for “Credit Default Swap” insurance on Spanish debt, for example, could be relied on to drive down the entire global equity market, at least for a few days. Panicking equity investors gave up perfectly good positions as the TV folks quickly marshaled their forces to cover the coming global market calamity (which of course never happened), the speculators sold out their CDS positions at a loss but reaped a harvest of short-sale profits and then bought in cheap to reap the later equity rallies of 2010, 2011, 2012 and 2013.

Spain and Greece, however small in their own right, were at least tethered to a really significant currency and the Euro-bloc economy. But Turkey, Argentina, Hungary – they are really the tail that now wags the global equity market dog.

Market suckers have been taken in by these speculative games for four years running; why should 2014 be any different, especially with CNBC cheering them on by not explaining what’s really going on? Sure Armageddon talk ups the ratings, but maybe CNBC should ask itself: when we succeed in scaring everybody but the speculators and hedge funds out of the market, who’s going to be left to watch us?

 

For Once, a Consequential Fed Meeting

Wednesday’s conclusion of the first Fed meeting of 2012 may herald a new working majority at the Board more closely aligned with Chairrman Ben Bernanke’s view of the economy and the role of the Fed in supporting employement as well as restraining inflation. What would be the consequences?

First, the identification  of an inflation rate of 2% , give or take a few basis points, as the specific target of Fed policy. Secondly, related to that objective, a new transparency with respect to the individual expectation of the Reserve  Board members as to the likely course of interest rates over the next several quarters and indeed as far out as 2014. This will not be revealed by name but by a sort of collective range of projections, dropping off the highs and the lows to try to contain market speculation as to who on the Board  specifically is the high or the low. Thirdly, related to these projections, would be a change in the language of the Fed’s starement heretofore guaranteeing low interest rates through mid-2013 — words will be added to in effect EXTEND the period of low rates into 2014. And finally, there may even be an initiation of a form of QE3 — the Fed’ s version of stimulus — this time focused squarely on the housing market by way of extending the Fed’s purchases of bonds from Treasuries to mortgage-backed securities.

All four of these actions may not be reflected in the official post-meeting statement ,and some may come out shortly after the meeting. But any one of these four actions would lead the financial markets to anticipate the other three in due course. The main concern, if and when the entire policy package comes together, is whether the markets will somehow misinterpret the Fed’s “new transparency” in ways which the Fed does not intend and would soon have to correct, especially in the face of continued market nervousness about the Euro debt crisis. (The US markets simply have yet to understand that all negotiations continue on to the next Euro “Summit” —  because no side can politically or financially afford to leave an impression that they gave in too soon – this is all that is really going on with the Greek debt issue.)

It’s Still A Greek Haircut — Short Back and Sides

Here’s what’s going on with the European Debt Crisis, and particularly the Greek bond “haircut” negotiations; the fact that the barbershop closed over the long three-day weekend is of much more moment than the Standard & Poor’s downgrade of most Eurozone sovereign credits, which was widely anticipated by the financial markets (we should have guessed they would do it on Friday the 13th).

Here’s the deal:

Greece owes more money to its bondholders than it can ever afford to pay off, so the Eurozone “leaders” came to an agreement with the representatives of the major bank holders of Greek bonds back in December that the holders  would take a 50% haircut on the face value of their holdings in an exchange of those securities for new Greek bonds of considerably longer duration; but they deferred setting the  exact terms of exchange, including importantly the interest rate they would be paid on the new longer term debt  That rate — if set too low – would of course constitute an even deeper ‘haircut’ on the total value of their  holdings.

Most of the banking institutions holding  Greek sovereign debt can ill afford write-down on their balance sheet beyond 50%, which would put them in potential need for financial bailouts from their governments (the same governments S & P just downgraded, in part because of this very risk. But of course these governments would also have to pony- up more money to Greece if the interest rate is set so high on the new bonds that Greece can’t afford to pay the it off when due! It is this “balance of terror” that negotiators in December  felt would  lead to a rational, face-saving (as well as other-parts -of -the-anatomy-saving) deal on the interest rate that all parties could live with, by now.

Most of these bank holders bought the debt early on, but only some have the protection of hedges with credit default swaps, which would  theoretically (depending on the solvency of the counter-party) pay 100% of face value if Greece forced a haircut by legislation and thereby actually “defaulted”. The existing bonds are governed by Greek  law, which Greece could at least try to change to force harsher terms on the holders. Thus  the banks are  being “asked”   to choose between getting 50% or less of face value by “voluntary’ agreement, or, in a some but not all cases, take their chances on getting 100% through their CDS “insurance” under circumstances where the whole financial system might nonetheless collapse (a la Lehman) around them — and their insurers — because a forced conversion would likely foreshadow  a disorderly Greek default, which is exactly what most everyone has been trying to avoid! look like a voluntary haircut deal to me.

But now come some  hedge funds (the only lower form on the financial system’s Tree of Life apparently lower than Bain & Company in a Newt Gingrich taxonomy) that bought up Greek sovereign debt a the current market rate of t20-25% of face value, looking to cash in on the 50% haircut deal that they thought  would be a 100% windfall for themselves. And they have the Gaul (some of them may be French) to be so upset by the low interest rate Greece proposes to pay on their new bonds (with a push from the IMF,  Greece’s lender of last resort, which loves its own pocket book more than the hedge funds’ for sure) that they are threatening to walk away from any “voluntary” deal — I guess because just a 75% profit in a couple months isn’t enough). Greece being aware of this has threatened to change Greek law on the hedgies to force them to go along with a haircut deal struck with a majority of holders (the banks stuck, as described above,  between a rock and a hard place), knowing that this amounts to a default that could bring down the whole Euro house —  including Greece, as their Finance Minister well knows. The hedge funds seem tempted to bet that, rather than see that event happen, even the new Iron Lady of Europe, Frau Merkel, will come up with the  dough to let Greece pay a high enough  interest rate on the new bonds to keep the hedgies in hedge heaven.

Do we see any public spirited citizens in the room? This is not the first time the hedge funds or the Greeks  have played chicken with the world economy. My guess is that sometime in the next week Merkel will politely but firmly tell them  to stop the games or go to hell (namely, back to the drachma). This posture  worked in December with a slightly different cast of characters, and it worked with Berlusconi. But we may have a return to the wilder market days of last fall for a few moments this coming week or two before the dust settles. The effects of S&P’s downgrades can wait on this, because the too-easy ‘solution’ of letting Greece default is too much like the pre-Lehman “moral hazard’ talk that caused us all the trouble in the first place.Because if Greece is the new Lehman, then Italy, or Spain, or even France, is the next AIG, Merrill Lynch, or Bank of America, with or without further downgrades. But definitely without the lender of last resort that the Fed and the US Congress were able to be…unless the Iron Lady takes off the leash she holds on the ECB — dream on hedgies!