Bobby’s New Clothes Part 2

Price action in global markets remains wobbly (technical term). Like trying to keep 6 huskies under control as they threaten to break out in different directions, we appear to be holding on tightly while our sled careers off into the sunset. The question is, are we about to abruptly reverse course, or will the huskies tire and keep going in their original direction?

Never has so much thought been spent on what the markets are telling us. Blondemoney has seen traders explain that “all the bad news is priced in” (can that ever be so without some kind of soothsaying black-swan knowledge??). We see these kinds of charts appear that tell us these are excellent buying opportunities for stocks:

Buying after crashes 1 Buying after crashes 2

[links here and here]

There is certainly plenty of analysis that suggests markets rebound and usually fill gaps. Blondemoney does not dispute this possibility in the short term. But something much more profound is going on with the market’s psychology that marks a shift from the 2008-2014 period.

1. Ever since volatility bottomed last summer we have seen it pop back with a vengeance, but really only in the form of flash crashes. The market has now learnt this. Sell-offs have looked disastrous and have been outsized, but they have also been brief.
2. Investors have also learnt from the past 20+ years about the Greenspan put.

Add those together and it means: fade any equity sell off.

However. Central banks have changed. They knew they had to rush in and save the world from disaster in 2008, but they have also become responsible for monitoring financial stability (in some cases that is now explicitly part of their mandate). Note Yellen’s speech in May of thisi year:

“I would highlight that equity-market valuations at this point generally are quite high. Now, they’re not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low, but there are potential dangers there”

This means they actually want a bit of volatility now. That would mean the markets were normalising which would in turn allow them to normalise.

Note these comments from everyone’s favourite central banker Raghuram Rajan, now Governor of the central bank of India:

“I have been a little concerned about the immense burden for action that is falling on central banks and I think it is quite legitimate for central banks to say at some point we can’t carry the burden ourselves in fact we may not have the tools to do everything that is asked of us.”
“Don’t keep asking us to do more because at some point we get into territory where the consequences may be more bad than good if we actually act.”

Of course they don’t want too much volatility, but thus far they don’t seem to think it’s systemic and they actually think economies are recovering well enough to withstand it.

Remember 2 years ago when everyone expected a September taper from the Fed, it didn’t come but then it did in Dec and no-one cared? The world thinks Yellen is a perma dove but not so. She knows she was hired to manage the exit. As does Carney, hence his continued nudges towards volatility.

Meanwhile markets have changed. Liquidity is not what it was. Recent price action is considered ‘risk off’, but really it’s just been ‘position off’. Why should any central banker worry about that?

Let’s consider 2 scenarios:

1. Let’s say the Fed delay a bit. But it looks unlikely they reactivate QE, despite the comments from self-promotist Larry Summers and Ray Dalio. They may not even push back into 2016. The Fed are still the next major central bank to be hiking, and most likely they are going this year.

– Equities will rally a bit but then worry. No Fed cavalry there.
– Meanwhile bonds sell off a bit as there is no need for a flight to quality bid; plus EM remains under pressure and their CBs need to liquidate FX reserves to smooth their ccys, hence they will have bonds to sell.

2. Or, the Fed stick to their guns.

– Equities puke again until bargain hunters come in and realise the reason for the hike is underlying economy is OK.
– Bonds sell off due to the EMFX angle as well as the final death of the lower-for-longer mantra.

So, bonds and equities down for both, just quicker in the 2nd scenario.

But in FX we will find the ultimate irony. Monetary divergence will be confirmed between Fed/UK and Europe/some EM. But the Euro will rally and USD will sell off on ‘position off’ as positions are liquidated across the board in rising volatility.

Any rally back from this week’s price action just means we have only postponed the final puke, not capitulated forever. And it will actually signify the return to a much better economy.

So those who think that everything is alright fundamentally will be right; and those who think there will be a big unwind are also right. So although it will look ‘risk off’, it will just be ‘position off’. As many traders will have experienced we will be left with this conclusion: the market had the view right at the start of the year (the Fed normalising) but the wrong position.

And that’s how Bobby’s Dream will lead to the Emperor’s New Clothes… Flash crash, becomes crash, becomes truth.

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