The Fed, emerging markets and bank shares
With inflation well below the Fed's two per cent target, the monetary rationale for no rate hike was decisive.
It did not surprise me that the Federal Reserve did not raise interest rates at last week's Federal Open Market Committee conclave. Global financial turbulence offset the fall in the US jobless rate to 5.1 per cent and accelerating growth momentum in the US economy. The reluctance of Dr Yellen to risk a global market meltdown amid a China/emerging market growth scare became obvious after the IMF, World Bank and BIS all pleaded with her not to raise interest rates, pleas I believe were orchestrated to give her political cover on the eve of a US presidential election.
With inflation well below the Fed's two per cent target, the monetary rationale for no rate hike was decisive. The US central bank now forecasts a 1.5 per cent Fed fund target range by end 2016 and a three per cent long-term equilibrium rate by end 2018. Yet Janet Yellen muddled her message and Wall Street tanked. If the Fed is scared, why buy risk?
The fall in the two-year US Treasury note yield from 0.80 per cent to 0.60 per cent reflected the new kinder, gentler Fed since the two year Uncle Sam IOU is the coupon note most sensitive to Fed policy expectations. The US Dollar Index also fell below 95 and Dr Yellen even citied King Dollar as a key culprit in de facto financial tightening, primarily due to its impact on energy, China, commodities and emerging markets.
Macro trade ideas from the Fed's new policy tilt? I think a December rate hike is certain as the Fed struggles to keep its political independence intact from Congressional critics in an election year. This means I want to short currencies where central banks need to cut rates this autumn, like the Thai baht, Brazil real, South Korean won and the Malaysian ringgit, now the $11 billion 1MDB scandal has morphed into a public Najib Mahathir feud. The MSCI Malaysia Fund surged 8.7 per cent on short covering. This country fund is a screaming short.
It is no coincidence that the Brazil Fund fell when the Fed did not raise interest rates. Brazil's sovereign downgrade to junk (S&P rating is BB+) means life insurers and pension funds will be forced to sell its debt even as the economy slips into the most vicious cycle of stagflation since President Collor's ill-fated tenure in the early 1990s. Brazil remains a strategic short, as it has been since early 2013. I also see little value in the JPMorgan iShare Emerging Markets Debt ETF at 109 (5.1 per cent yield) as the new sovereign credit downgrade cycle will trash Turkish, Russian, Indonesian and South African debt below investment grade.
The Cinderella of emerging market debt? Pakistan, the only country in the world that can raise $3 billion in Eurobonds/sukuk with a single-B rating. It obviously helps to be "too big to fail" for the diplomatic chancelleries of Washington, Riyadh and Beijing when it comes time to negotiate a $6.7 billion IMF loan. Leverage fundamentals could also force default and debt rescheduling in a major trading nation I will not name since I love to visit its palaces, beaches and ancient Aegean ruins.
The stock market went ballistic after the FOMC decision and ended 350 Dow points lower. When the dust settles, I expect the S&P 500 index to continue to fall to 1,860. Both a Fed fund rate hike and stock market volatility are my twin base scenario for December. So I sell puts on US money center banks with low delta and January expirations.
Bank shares fell sharply after the Fed announcement since the fall in US Treasury note yields hits net interest rate margins, loan spreads and profits. A weak global growth milieu that alarms the Fed, IMF, BIS and World Bank is not exactly positive for the $1.6 trillion Western bank exposure to emerging markets. Think HSBC and Stan Chart in Asia, BBVA and Santander in Brazil, Deutsche Bank in Russia, GCC banks in Turkey and Malaysia, Erste Bank and Raiffeisen in Central Europe. Dark storm clouds in international finance are not exactly bullish for the "animal spirits" of bank stock investors after seven post-Lehman years and $8 trillion in central banking easy money. So I take the highway to the danger zone in the NYSE and nibble money-centre bank value zone.
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