Global financial markets have been extremely volatile and hard to understand over the last year.Many market ‘experts’ have been flummoxed by the frequent changes in market ‘mood’ and have flung up their hands in frustration at the supposed ‘concerns’ of the market, whether it be economic data, the price of oil, the Fed’s view, etc., All the while, many who considered themselves ‘the smart money’ have been losing lots of money along the way. However, if you take a step back and look at this scenario from the 30,000 foot level, the one thing that has been consistent with the market’s dramatic moves over the last several months has been the Federal Reserve Bank of the United States threat of removal of monetary accommodation, or said in another way, the removal of quantitative easing and artificial interest rates. This is what has spooked the equity markets and pushed up the value of the dollar.
The Fed had been an active participant in the bond market for years. The moves by the Fed to buy up mortgage and treasury bonds has created fake demand for these instruments and pushed up bond prices. This has created an artificial interest rate environment where the United States is basically paying next to nothing for the privilege of borrowing almost twenty trillion dollars. These low rates have allowed companies to access capital at below market rates, therefore driving up equity prices. Although the Fed has stopped buying, this accommodation has not yet been relaxed as the Fed still owns the bonds it purchased.
The problem is this game of musical chairs could be about to stop. The Fed is itching to raise short term rates (when it has the supportive inflation and employment to do so).
The markets are a forward looking indicator. They can see that at some point in the near future, the punch bowl will be taken away. It’s not rocket science. Equity markets have forecast that profits will drop, corporate valuations will sink, and therefore, stock prices have corrected. They probably have a lot further to fall.
In the currency market, the U.S. Dollar has been king, to the detriment of dollar-pegged currency regimes globally, as traders forecast that rates will eventually move higher in the United States. In addition, the price of oil has collapsed and put further upward pressure on the greenback due to the inverse relationship between oil and USD.
In spite of all the market’s moving parts and short-term issues and focus, I believe the markets will be in this phase until the QE bubble unwinds. We could have a long ways to go as yet. Only when the markets realize that the removal of the punch bowl has been digested and the sky has not fallen, or if it has fallen, only then will the market’s forward looking indicator start to forecast a return to growth and create the positive upswings that participants are hoping for. October of this year could be a very bad month, as we are a long way from this scenario.
The other point that many have not taken into account is the influence of the 2016 election in the United States. This will be a very consequential election, literally deciding the political and societal path of America for decades to come. Visibility into the outcome of this race will heavily impact market action I think. I’m not going to forecast what I think will happen but I do believe investors should pay special attention to the political machinations in the U.S. during the coming year. It could very well impact your pocket book. Just sayin…
L. Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is also an author of historical fiction thriller novels. His first of several books, Currency, deals with the consequences of overwhelming sovereign debt. He is a contributor to many media outlets and is a foreign correspondent for Newsmax TV. LToddWood.com