So, I talked a bit on Thursday about how, in the post-crisis world driven as it is by the relentless hunt for yield catalyzed by DM central banks, everything has converged on one trade.
That discussion was part of a piece about Italy I digitally penned for Dealbreaker and as I’m prone to doing, I turned a post ostensibly written to make a point about a specific market into a comment on cross-asset strategy in a QE-driven world. That tendency of mine (to try and reinvent wheels with every post) is probably annoying for some readers, but the bright side is that it helps me (if maybe not you) keep track of the overarching market narrative. Here are some excerpts:
In one way or another, all the bids are price insensitive these days, whether by definition (e.g., central banks), by choice (e.g., Norway’s SWF) or else by accident (e.g., retail investors not understanding that ETFs don’t generally contribute to price discovery). Everyone else is effectively forced to adopt a similarly “long hair don’t care”-ish strategy because what else are you going to?
When everything is indiscriminately bid to infinity and that dynamic traces its roots to policymakers with printing presses, well then you either harvest yourself some carry alongside everyone else or you go the fuck out of business. It converges on one trade. It’s a binary option: you either short vol. (explicitly or implicitly) or else you take it upon yourself to shriek “the emperor has no clothes!” and risk nobody being willing/brave enough to go along with you.
That serves as a nice segue into a couple of passages from the latest missive by former trader and current Bloomberg columnist Richard Breslow, who suggests that as we try and transition back to a world that’s less binary, there’s nothing inherently “wrong with cutting emerging markets loose.”
“During the financial crisis and the quantitative easing era, it was well-observed that how just about any ‘risk-on’ asset went so did everything else,” Breslow writes, adding that “as the global economy solidifies its recovery and rates rise, we might find out that this old saw is also getting a bit rusty.”
It’s easy to see where he’s going with that. The idea is that even if the dollar’s ascent and rising U.S. yields do end up catalyzing an EM rout (i.e., causing broader-based problems that go beyond exacerbating the idiosyncratic stories in Turkey and Argentina, for instance), it’s not necessarily the end of the world. Here are a couple of quick excerpts from Breslow:
These positions can be put to the test without necessarily having negative implications for the broader asset classes. In fact, it may represent a very positive development. A big chunk of these trades weren’t originally done because people were feeling chuffed. They were just desperately searching for yield and following the bidding of the central banks. Guess what? If you can get acceptable returns with less duration by rotating back into plain vanilla instruments, resident in countries whose capitals you can name, it’s a great way to “diversify”. I can just imagine overhearing debates in trading rooms across the globe about the pluses and minuses of lightening up on the safe tuna-bond holding and jumping into the scary waters of the Russell 2000.
That’s some classic Richard Breslow there (the bit about the tuna-bond-to-U.S.-small-cap rotation trade), and it’s an important point worth considering.
When “selections” become “choices” again, we have to decide whether that’s ultimately a “bad” turn of events or whether it’s just an inevitable (and ultimately desirable) consequence of a return to two-way markets.
In the meantime though, there’s trouble. EM FX was under pressure again on Friday and it’s getting to the point where folks are worried. Reinhart probably didn’t help and neither did this, from El-Erian, on Wednesday afternoon:
History reminds us that
higher oil prices+rising interest rates+appreciating dollar,
the trifecta that continues in #markets today (albeit not in an extreme fashion),tends to test the "self insurance" of several #EMergingMarkets ,together with their economic policy responsiveness pic.twitter.com/Jb1tTtgaU4
— Mohamed A. El-Erian (@elerianm) May 16, 2018
And so here we are on Friday and things seem to be getting materially worse. For instance, the MSCI EM FX Index is down for a sixth week in seven, going back to March:
Here’s the week chart:
Meanwhile, EM equities are on pace for their fourth monthly loss – the longest stretch since February 2016:
The pain is widespread. The lira, the rand and obviously the Argentine peso are the week’s worst performers:
Meanwhile, the rupiah continues to get hit (remember that story?). It fell to its lowest level since October 2015 on Friday as a rate hike failed to assuage concerns:
As Bloomberg notes, benchmark yields for Indonesia are up some 65bps this quarter, on pace for the largest quarterly jump since December 2016 and “global funds have dumped a net $2.3 billion of sovereign bonds since the end of March, set for the biggest quarterly withdrawal based on data compiled from 2009.”
And then there’s Brazil. As a reminder, BCB decided to eschew another rate cut on Thursday in the interest of helping stabilize the real. In short, that hasn’t worked. It was down sharply on Friday. Take a look at this shit:
Of course not cutting rates again hurt Brazilian equities. The ETF and its absurd 3X levered counterpart had their worst days since the May 18, 2017 collapse yesterday:
And things aren’t looking much better on Friday. EWZ is now on track for a truly egregious 2-day slump:
So I don’t, folks. If the dollar rally doesn’t stall and U.S. yields continue to rise, this could get increasingly precarious.
But as the above-mentioned Richard Breslow notes, cutting some of these trades may not be the worst thing in the world; but it will certainly be painful. Fingers crossed on no spillover.
This is probably a good time to remind you what Jerome Powell said last Tuesday in Zurich at an IMF/SNB event:
Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.
There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.