I’m taking a two-week hiatus as it is time to contemplate the massive volatility we have experienced during the past three months. The rise in vol was no surprise as the world financial and political landscape has been rife with uncertainty for several years. Central bank actions have lulled financial markets into complacency, though turbulence underlies the surface of calm. In the past three weeks we have experienced the Swiss National Bank removing its EUR/CHF PEG and sending currency markets into a whirl of uncertainty. (Plus, the generation of huge losses on long-held short Swiss franc positions.) More importantly, the SNB decision wreaked havoc on European banks that had financed loans in Swiss francs because of the ultra-low interest rates.
Following the SNB, President Draghi announced that the ECB was embarking on a QE program of monthly purchases of 60 billion euros in European assets, from sovereign bonds to asset-backed securities. Then, the Greek elections provided a new sense of uncertainty as a leftist government is threatening to challenge the austerity budgets imposed on Greece by the TROIKA (IMF, ECB and EC). If the Syriza Party elected by disaffected Greek populace continues to honor its threat and renege on the previous government’s commitments, the entire EURO and EU project stands to become undone. Prime Minister Tsipras is threatening to default on Greek debt, challenging the Germans who have been the purveyors of fiscal austerity. How it plays out is far from certain but it seems that the Greeks believe that the Eurocrats in Brussels will not allow the dream of a United States of Europe to be undone by the small amount of Greek debt. But as the clock winds down the outcome is far from certain.
Adding to the political drama in Europe or Eurasia is the ongoing civil war in Ukraine. The Russians have armed the “rebels” in the Eastern Ukraine and have brought the Ukrainian army to a precarious position. The Ukraine government in Kiev is asking for advanced military hardware from the U.S. and Nato countries to offset the military might of the Russian-supported “rebels.” The tension is growing and the Nato alliance is going to have to decide how far it wants to go in combating and confronting Vladimir Putin. If the Ukranian army has the wherewithal to battle the Russian-supported fighters then it may make sense to send advanced weapons. But if the Ukrainian army is not capable then improved hardware will only act to force Putin to increase supplies to the “rebels” and the Ukraine will become a killing ground and a meat grinder of death. The West has to remember that the Russians have very short supply lines into their allied fighters so how deep do Obama and Merkel want to be involved?
If the landscape wasn’t difficult enough to navigate, the U.S. unemployment data on Friday was strong enough to revive the forecast of a June interest rate rise by the Fed. The 257,000 nonfarm payrolls was better than expected, but the large upward revisions to the two previous months made the data more robust. Coupled with an increase in jobs was the strong AVERAGE HOURLY EARNINGS, up 0.5%, the strongest gain in several years. It is Chair Yellen’s focus on wage gains that made this data release strong enough to send bond Yields higher and even eurodollar implied yields gained 20 basis points. The rise in U.S. yields sent the U.S. dollar up more than 1 percent against the YEN and EURO, and GOLD and SILVER prices dropped dramatically.
It is now on again for the mid-year rate rise … at least until we see the next unemployment data, which will provide a more comprehensive look at the impact of lost jobs in the energy sector of the economy. The investment landscape will be hazardous and volatile in the near ahead. The complacency of 2014 has been laid to rest.
***In the Barron’s Round Table with Felix Zulauf, he mentions why the U.S. dollar will rally at some point this year. He alludes to a BIS research piece (PAPER NO. 483 by McCauley, McGuire and Sushko), which says that the large of amount of borrowing by offshore U.S. entities is going to cause many borrowers to buy back their dollars as they are sustaining losses as the currency appreciates. Zulauf notes that $9 Trillion “… of dollar-denominated debt in the private sector around the world. That is the short position. Whatever the reasons for the recent firming of the dollar, the true firming will occur when all issuers of dollar-denominated debt see their liabilities rise.” This is a big problem for the FED going forward.
The concept of QE and zero interest rates allowed massive amounts of CHEAP money be attained by global borrowers. As U.S. rates were considerably lower than rates in borrowers home countries it made perfect sense to borrow dollars. Much of this private borrowing was done through the issuance of BONDS DENOMINATED IN DOLLARS AND SOLD TO CREDITORS SEARCHING FOR SOME EXTRA YIELD. The extra yield is not enough to compensate for the increased costs of paying back the appreciating dollars.
The rising dollar is not just a domestic consideration for the FED but because of the huge role of the dollar in global funding for developing nations the FED has to be concerned about “international developments.” If off-shore dollar borrowers experience large losses because of the rising DOLLAR then global credit may come to a grinding halt. The FED‘s QE policy has not stopped at the U.S. border. This is just something else to be aware of.