Busy, very busy weekend on my paid JubakAM.com site this weekend as I tried to make sense of the market reaction to Friday’s disappointing jobs numbers for September.
On Friday, on this free site, I noted that the early sell off in U.S. stocks followed by a strong rally didn’t exactly clarify market sentiment.
In four posts this weekend on my subscription JubakAM.com I 1) laid out a fundamental scenario through the end of 2015 that pointed to a grind lower in U.S. stocks; 2) in a video explained why I think the debt ceiling deadline on November 5 is more of a danger to the markets than the expiration of the temporary funding bill on December 11, 4) projected that the big trend for the week ahead would be the weak dollar as traders speculate on the Fed holding its fire until March or3later, and 4) gave an update on what technical analysts are saying about why this market is still in a downtrend but with signs of hope to the upside.
That’s what I’m worked on at my subscription JubakAM.com site–I think there’s some value to you in passing on the direction of my thinking about the market on that site. Hope so anyway.
And, of course, there’s an ulterior motive: If you decide that you’d like more detail on those posts, I’m hoping that you’ll subscribe to my site at JubakAM.com for $199 a year. (By the way, you can get a full refund during the first seven days if you change your mind for any reason.)
So why does the prospect of a quarter-point interest rate increase from the Fed so unnerve financial markets?
So what’s making the U.S. and global markets so nervous?
It’s very clear that markets are worried. The Dow Jones Industrial Average put in a 444-point swing yesterday, September 9, between the high for the trading day and the low. The Standard & Poor’s 500 has closed with a move of 1.3% or more on 11 of the last 14 trading days—including the biggest rally since 2011 and the biggest down day in four years.
Among other worries there’s China. Concern about global growth. Anxiety about collapsing emerging market currencies (Brazil’s real) and economies (Brazil, Russia, South Africa, etc.)
And, of course, the will they/won’t they speculation ahead of the Federal Reserve’s September 17 meeting on interest rates. Will the Fed decide on the first increase in interest rates since 2006? Or will Janet Yellen and company put an increase off until October or December in 2015 or even into 2016?
Which should lead you to ask why a potential interest rate increase of 25 basis points—that’s one-quarter of a percentage point—should produce so much anxiety and such big market swings. It’s not like another quarter of a percentage point is going to have much effect on the real economy. Very few consumers will decide not to buy a car or a house because it will cost them another 25 basis points in interest. And very few CEOs will put off expanding a factory or hiring new workers because short-term interest rates just went from a range of 0% to 0.25% to a range of 0.25% to .50%.
The focus on the Fed decision gets even more puzzling when you consider that the debt markets have already priced in an increase. The forward contracts on the 10-year Treasury notes predict a gradual increase to 2.4% in a year from 2.22% on September 10. The current yield is up from 2.12% on January 2 and from 2.14% six months ago on March 10—but while the markets are projecting higher interest rates than now, they’re hardly projecting run-away interest rate increases. For anyone looking for a mortgage, for example, changes of this magnitude don’t make much of a difference in how much house you can afford or a buy/no buy decision.
So what’s all the tsuris?
Well, you see the Federal Reserve doesn’t have a very good record when it comes to gradual interest rate increases. As much as Janet Yellen and the governors of the Federal Reserve keep saying that interest rate increases will be very gradual because the low rate of visible inflation doesn’t require anything faster, Wall Street and indeed any investor with a memory knows that the Fed has a history of big increases in interest rates once it starts moving the yardsticks.
For example, in June 2004 the Federal Reserve began an interest rate increase with rates at 1%. It ended with short-term rates at 5.25% two years later
The worry isn’t really that increase to 0.50% in the very near term, but the possibility that the Fed, despite its current language, will embark on a long cycle of rate increases.
That possibility is lower than it was at the beginning of 2015 but it certainly hasn’t disappeared. In fact it hasn’t moderated as much as you might imagine given some of the uncertainty in global economies and financial markets.
Back at its March meeting of the Federal Reserve’s Open Market Committee members saw a range of short-term rates for 2016 at 0.25% (one vote) to 3.75% with the largest group of members at 1.5% to 2%. In 2017 the biggest grouping in the projections was a 3% to 4%.
That would be a substantial increase from the current 0% to 0.25% rate in two years, although the end rate would still not be as stiff as the 5.25% of 2006.
By the June meeting interest rate projections had moderated at bit. The highest level projected by any member for 2016 was 3% with the biggest grouping at 1.5%. For 2017 the range ran from 2% to 3.75% with six members at 2.25% to 2.75% and six at 3.5% to 3.75%.
With the historical spread between the short-term rates set by the Federal Reserve and the 10-year Treasury rate set by the market averaging about 2% home buyers would be looking at something like a 4% to 5.75% mortgage rate (since mortgage rates are benchmarked to the 10-year Treasury. At the upper end that would be significantly higher than the 4.05% interest rate on a 30-year mortgage as of September 9.
Of course, the spread between the Fed funds rate and the yield on a 10-year Treasury has been as high as 3.75% in the last decade, according to the St. Louis Federal Reserve Bank. A spread like that would push mortgage rates to 5.75% to 7.50%.
Rates that high would crush the housing market and put a big damper on the economy. And they, along with the strong dollar that goes with higher interest rates, would hit already challenged emerging market currencies.
The Federal Reserve is extremely unlikely to let interest rates get that high in the absence of inflation substantially above its 2% inflation target. Especially since the Fed’s entire policy of quantitative easing has been built on stimulating the housing market through lower mortgage rates.
Still central banks do make policy mistakes.
As we approach the September 17 Fed meeting, an aggressive cycle of interest rate hikes in 2016 is what the market fears rather than that first increase of a quarter of a percentage point.
And no matter what the Fed does in September, October or December, the U.S. central bank will find it hard to put that worry behind it. (Which is one reason to think that the Fed might move in September. A September move, followed by nothing, would convince some in the debt markets that the Fed was serious about moving slowly.)
Even when the Japanese economy looked to be strengthening and Asian car markets were healthy, shares of Toyota Motors (TM) were closely aligned with the rise and fall of the Japanese yen.
For example, from the yen’s local low on October 16, 2014 to today’s (July 16) price, the Japanese currency climbed 16.6% against the U.S. dollar. In the same period from the same October 16 local low, shares of Toyota gained 23.3%.
Now, however, that the yen is more likely to fall than rise, and when the Japanese economy has stalled (again) and car sales to Asia are slowing, I can’t think of a reason to hold Toyota in the short-term. As of today, July 16, I’m selling the ADRs (American Depositary Receipts) of Toyota out of my Jubak Picks portfolio. I have a gain on this position of 37.8% since I added it to the portfolio on February 5, 2013.
Yesterday, the Bank of Japan cut its forecasts for growth in the fiscal year ending in March 2016 to 1.7% from 2%. The bank reduced its inflation projection to 0.7% for the fiscal year from 0.8%.
The lower forecasts—and the rapid reductions in growth estimates for the quarter that ended in June from an earlier consensus at 1% annual growth—are a big setback for Abenomics, the effort by Prime Minister Shinzo Abe to revive growth and inflation by weakening the yen by massive purchases of government debt. The Greek debt crisis and the bear market in Chinese stocks set off a stampede into the yen as a safe haven from market turmoil. That move overwhelmed moves by the Bank of Japan, which, to be accurate, didn’t do much to fight the recent appreciation of the yen.
To the degree that the Greek debt crisis and the Chinese bear market move to the back burner, the rush into the yen will slow. And with Federal Reserve chair Janet Yellen holding fast to an increase in U.S. interest rates this year, I think the likelihood is that investors and traders will see a reversal in the yen strength sometime in the next few months.
That will put downward pressure for U.S. investors in any unhedged positions in Japanese assets. In the case of Toyota I’d rather sit that pressure out as the yen moves back toward 110 or lower as fears recede and a Fed move gets more likely.
There’s even a good chance that the strength in the yen will bite Toyota’s next earnings report, due on August 8. When Toyota released is fiscal year results in early May, the company forecast a yen at 115 to the dollar for the fiscal year that ends in March 2017. I think that’s a reasonable forecast for the entire year, but there’s certainly a good chance that the August 8 results will show a stronger yen or at least fears of a stronger yen.
I would be looking to see if I can rebuy Toyota on a decline in the yen to 110 or lower—assuming that auto sales don’t deteriorate further in the key North American and European markets.
The Federal Reserve’s decision not to begin tapering off its monthly $85 billion in purchases of Treasuries and mortgage-backed securities sent the dollar even lower against most global currencies. Today, September 19, the Dollar Index fell to a seven-month low. The dollar fell against the currencies of most U.S. trading partners—except Japan. And it looks like the dollar will stay under pressure for at least the next few sessions.
The big question is how long this trend lasts. If you think it will run for a while, then you want to join in on the rally in emerging market stocks that has accompanied the rally in emerging market currencies such as the rupee and real. If you think the run is getting a little over-extended—the euro is, after all at levels against the dollar that have marked resistance in the past BUT and it has recently broken above resistance at $1.345 to close today above $1.35—then this is a time to take some profits.
A lot will depend, in my opinion, on how big a scare Washington politics throws into global financial markets. I can’t imagine overseas investors rushing to move into dollars in the face of rhetoric threatening a government shutdown and a default on U.S. debt. I’d say current trends could hold for a couple of weeks yet, but I wouldn’t be rushing to add new positions that depend on dollar weakness right here
The one currency that is running against the weak dollar tide is the Japanese yen. The yen initially climbed on the Fed’s no taper decision—rising to 97.75 on the news—but then fell all the way back to 99 yen to the dollar and finished today at 99.42. (Remember that since the yen is quoted in yen to the dollar, a higher number is a sign of a weak yen and a smaller number means the yen is getting stronger.) The thinking seems to be that the recent Japanese trade deficit will push the Bank of Japan to further weaken the yen in order to boost Japanese exports. I continue to think that the yen will finish 2013 at weaker levels than current trading and that leads me to continue to hold positions in Japanese stocks such as Toyota Motor (TM) and Mitsubishi UFJ Financial Group (MTU). Both stocks are members of my Jubak’s Picks portfolio http://jubakpicks.com/the-jubak-picks/
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did own shares of both Mitsubishi UFJ Financial and Toyota Motor as of the end of June. For a complete list of the fund’s holdings as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
Do you know the facts of life of the global currency market right now?
Is the U.S. dollar headed up or down over the next few weeks? How about the Japanese yen? Is the Indian rupee and the Turkish lira and the South African rand headed into a crisis? How about the Brazilian real?
I’m asking because right now global cash flows—into some developed markets and out of most emerging markets—are driving the prices of global stocks and bonds. The effects of those cash flows are being expressed in the prices of currencies such as the dollar and the real. The movements of those currencies are both the expression of those cash flows—the way that they’re being turned into rallies and corrections in the financial markets—and, increasingly, the fundamental driver for price movements in those markets as the ups and downs of currencies cause changes in monetary policies in countries such as Brazil and India. And finally, if you’re trying to figure out where the bottom is for Asia’s emerging markets—which entered official bear market territory this past week when the iShares MSCI South East Asia Index fell to a 21% drop from the peak on May 8—I think understanding the likely currency moves over the next quarter or two is a key. (That index tracks the markets in Singapore, Thailand, Malaysia, the Philippines, and Indonesia.
So here’s my take on what you need to know about global currencies in 10 easy trends.
- In the short run the U.S. dollar is likely to get stronger against most global currencies. That’s because the gradual end of the Federal Reserve’s program to purchase $85 billion a month in Treasuries and mortgage-backed assets—possibly as early as the Federal Open Market Committee’s September 18 meeting–will push U.S interest rates at least slightly higher. With the rest of the developed world’s central banks still in stimulus mode (Japan) or in do-nothing mode (Europe), that means traders and investors looking for higher yields will turn to buying dollar denominated assets.
- We really don’t know how long the “short run” might be. It’s clear that Japan isn’t about to reverse its weak yen policy any time soon and the European Central Bank has revised its historic tendency to privilege low inflation above economic growth to the extent of keeping interest rates at historic lows for a long period of time as the EuroZone struggles to escape recession or near recession. But a sufficiently chaotic U.S. political season—one that saw a budget impasse and a credible threat of default resulting from a failure to raise the debt ceiling–could make the dollar seem decidedly less attractive as early as October.
- A strong dollar is a negative for commodities priced in dollars—such as oil—and for precious metals. Extreme fear and turmoil, such as that set off by the threat of U.S.-led military intervention in Syria can overwhelm the effects of a strong dollar in the short run. Gold was up 19% from its June low as of August 29 to $1409.80, but I think gold along with other physical commodities will have a hard time building a sustained rally as long as the U.S. dollar keeps moving up and as long as global growth remains slow enough to remove all fears of inflation. The pressure that a strong dollar puts on commodity prices plus weak commodity prices due to slow demand from China and other developing economies has hit commodity currencies hard. For example, the Australia dollar traded near 89 cents on August 28. That’s down from $1.05 in April.
- A strong dollar isn’t good for emerging market financial assets. In 2012 as the U.S. Federal Reserve expanded its balance sheet, $1.2 billion flowed into emerging financial markets. In 2013 that cash flow has reversed.
- The countries, currencies and financial markets hardest hit by the strong dollar are those running the biggest current accounts deficits. Economies such as India, Indonesia, and Turkey need to attract overseas cash in order to balance those deficits. Turkey, for example, needs to attract $5 billion a month.
- A falling currency can set off a vicious cycle in a current account deficit country. A falling currency makes it harder to attract the cash needed to balance a current account deficit. And worries over a country’s inability to cover its deficit can lead to a further retreat in the currency as investors and traders pull money out of assets that are worth less in dollar terms day by day.
- A stronger dollar and weaker local currencies works to make trade deficits higher in developing economies. For example, India imports about 80% of its fuel. A climb in the dollar price of benchmark Brent crude makes it more expensive to pay India’s fuel bill in rupee. India’s oil imports averaged $14.2 billion a month in the first seven months of 2013, up from $13.9 billion a month in the same period a year earlier. The same dynamic savages companies in emerging economies that collect revenues in local currencies but that have to pay costs in dollars. About 56% of the costs at Brazil’s airlines, for example, are denominated in dollars, mostly for jet fuel. If, as in the case of India, a relatively weak manufacturing sector makes it hard to take advantage of a cheaper currency to increase exports, a falling currency is a lose/lose proposition
- The potential responses by central banks to falling currencies all have nasty side effects. Central banks can intervene by spending down foreign exchange reserves to buy local currencies. That can actually weaken a local currency if the markets believe that the central bank doesn’t have the foreign exchange reserves or the policy will to spend enough to reverse the market trend. That’s the market’s take to date on interventions by India, Indonesia, and Turkey. Another potential response is to defend a currency by raising domestic benchmark interest rates. That has a potential toxic side effect: Higher interest rates slow rates of economic growth. That seems to be happening now in Brazil
- All this has made emerging market stocks and bonds cheaper, but also has led investors and traders to question if these markets are cheap enough yet. For example, the Indian rupee is down 20.1% n 2013 on its way to its worst loss since the 1991 balance of payments crisis forced the government to sell gold to pay for imports. But even at 68.845 rupees to the U.S. dollar on August 28, that may not be a bottom. Speculation now is that the currency will have to sink to at least 70 rupees to the dollar before this crisis is over. No one, right now though, is willing to bet very heavily that 70 rupees to the dollar will make a bottom
- Putting in a bottom in emerging markets in general will probably start with putting in a bottom in individual economies with larger foreign exchange reserves and that look closer to seeing economic growth move from slowing to expanding. Brazil is a strong candidate for an early turn on sufficient foreign exchange reserves, and a central bank that has been early to raise interest rates. But growth in Brazil is still anemic. Mexico is another early recovery candidate, especially if the government’s efforts to increase foreign investment in the country’s oil industry look like they will result in a significant increase in production at Pemex, the national oil company. An overall recovery in emerging markets, however, is probably a 2014 event and will depend on data showing a believable recovery in China’s rate of economic growth. Or at least confidence that growth in China isn’t about to fall much further. From that perspective improved manufacturing data in the August Purchasing Managers Index for China is a very positive step.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a complete list of the fund’s holdings as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/