Turning Points: Will the Fed Upset the Apple Cart?

The US Federal Reserve’s next meeting of the Federal Open Market Committee will be on 15–16 December. Many expect Fed chair Janet Yellen to begin the process of reversing the extraordinary monetary measures adopted after the crisis by raising interest rates. If so, this should further strengthen the dollar and weaken other major currencies which are either standing pat (e.g., the Japanese yen) or escalating monetary accommodation (e.g., the euro). The prospect of tightening is already showing some fissures in the market. Junk bond spreads are soaring, and the US 10-year swap spread has recently turned negative, suggesting, among other things, that companies might be looking to ramp up debt before rates rise. Despite these marked changes, the US equity market has yawned through it.

Emerging market demand continues to weaken, and a stronger US dollar will exacerbate that. China continues showing weakness in demand for iron ore, copper, and oil. Moreover, China’s housing worries suggest that no quick fix is possible. At a broader level, the prospect of rising rates could bring so-called bubbles into focus. Clearly the Fed has been cautious not to upset the precarious balance of markets and policy. Let’s see if they can achieve their policy aims without upsetting the apple cart.

Here’s a wrap-up of key issues affecting global markets for fundamental investors.

Currencies

• The IMF is warning the Fed that economies are too soft to raise rates. (Mises Institute)
• Chinese yuan becomes a reserve currency of the IMF’s Special Drawing Rights basket. Will China let market forces determine yuan’s exchange rate? (The Economist)
• A strong dollar will give the Fed a weak feeling. The stronger USD will lead to lower inflation and weaker overseas currencies. (Wall Street Journal)

Commodities

• Chinese copper imports are down 5.5% year over year. “Grim Outlook for Copper Pricing.” (Barron’s)
• In “Goldman: Only China Can Save Metals,” CNBC reports that supply continues to grow while Chinese demand does not. (CNBC)
• Iron ore is on the cusp of $30s as BHP and RIO shares slump. (Bloomberg Business)

China’s Direction

• Housing prices in Hong Kong and Singapore are forecasted to decline 10% as the slowdown spreads. (Financial Times)
• Indicators suggest that the Chinese economy is not growing anywhere near 7%. (Business Insider)
• China’s housing slump will weigh more heavily on GDP. (Financial Times)

Credit Markets

• “The Credit Markets are Softening and Funding is Tightening” (Enterprising Investor)
• Junk spreads (of bonds rated CCC and below) reach 15%. (St. Louis Fed)
• How bad is the conflict of underwriting bonds and selling credit default swaps at large banks? (Zero Hedge)

Derivatives

• The 10-year US swap spread is now in negative territory. Maybe companies are looking to cash in on issuing low rate bonds before a rate rise in the United States. (Financial Times)
• OTC derivatives market down to a “mere” $552 trillion. (Bank for International Settlements)

Energy

• The OPEC meeting ends with no production cuts. (Wall Street Journal)
• Global oil demand growth to slow in 2016, the IEA says. (Wall Street Journal)
• Saudi Naimi says the global oil demand can absorb the Iran output jump. (Reuters)
• Brillouin Energy may have just figured out Cold Fusion. (PR Web)

Euro Crisis

• Why negative interest rates are becoming the new normal. (New York Times)
• Bad loans at European Banks double that of the United States. (Financial Times)
• “The Wrong Euro Reforms Will Deepen the Next Crisis” (Wall Street Journal)

Hedge Fund Money

• Icahn gives thumbs up to Lyft funding. (Fortune)
• Billionaire Ken Griffin warns art prices are cause for concern. (CNBC)
• World’s largest hedge fund dumps 31% of its US equity exposure. (Zero Hedge)

Interest Rates and Central Banks

• “Why December Is Looking Likelier for a Fed Rate Increase” (New York Times)
• “Draghi: ‘No Particular Limit’ to ECB Policy Tools” (CNBC)
• Japan’s central bank wants the country’s unions to ask for bigger raises. (Quartz)
• “China to Free Up Interest Rates within Two Years” (China.org)

Japanese Debt and Inflation

• Japan is locked in a struggle to spark inflation. (Chicago Tribune)
• Japan’s debt trap won’t fix itself. (Bloomberg View)
• Japan to unleash inflation by fabricating data. (Zero Hedge)

Stock Market

• Are high yield bonds sending a warning message to the stock market? (Forbes)
• Why Wall Street expects 7-11% upside in 2016. (Forbes)
• US market cap to GDP is more than 120%. (Investor Place)

Follow the Bubble

• What junk bond spreads (which are starting to widen) reveal. (Financial Times)
• London mansion prices fall 11.5% as home bubble may have burst. (Bloomberg Business)
• Will the Fed finally put an end to Hong Kong’s property bubble? (Market Watch)
• China’s debt bubble may be ready to explode. (Zero Hedge)

Time Capsule

In light of the prospect that the Fed may raises rates, I thought it might be instructive to go back and reconsider the 1937–1938 period when the United States slipped back into recession without having fully recovered from the Great Depression. Of course, our interpretations are always colored by our beliefs and perceptions, so I will present two papers that interpret that recession quite differently. In the first, Christina Romer describes a narrative that tight monetary policy, including a sharp increase in the reserve requirement ratio at banks, forced the United States back into recession. In the second, Jonathan Finegold describes how an influx of gold from Europe, escalating inflation, waning productivity, and heavy government regulation led to recession.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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