Many Fed speakers deliberating over the past week suggested that low yields were a sign of a healthy economy, a sign of confidence by investors. They clearly need to go back to school or retake their Economics 101 examinations, as they do not deserve to be in that post to begin with. In less-public circles, we all know that the Fed knows exactly what they are doing and why, they can't help it and they just can't admit it, at least not to the public that do not question their words. Over the past decade, they have pumped the U.S. financial system with ample liquidity and kept rates low, such that neither the U.S. nor the world can handle even the slightest increase in interest rates, lest the entire system collapses.
This asset price bubble needs more and more money to fuel it higher. That is where we stand today. One little crack in the system, as we saw in the repo markets last September, and what did the Fed do? Throw even more money at the problem and raise their balance sheet in four months what they took 1.5 years to normalize prior to it. Such is the dependence of the Fed's liquidity gravy train on the markets and asset classes. Fed Powell can claim all he wants that T-bill buying and repo are not QE, but we all know the markets have been defying any cracks in the system because there is money being pumped in by the U.S. Fed and various central banks. In some metrics, fundamentals were ignored over the past few months because of this very liquidity, even if some indicators showed wide divergences. But as they say, don't fight the Fed.
But then the Fed minutes released something the market did not quite focus on, initially at least. We all knew that the Fed was on auto-drive pumping money into the repo market via daily repo operations to keep overnight lending rates subdued, without questioning which bank/s were short of liquidity and investigate further. This was pledged to be in place until April, or Q2 2020 this year. However, in the release of the minutes last week, the Fed intimated that they could consider gradually slowing down the repo auctions before April, so it is phased out after April. And that was the carpet that got slightly pulled from underneath the market. As always, it is the rate of change, or the marginal new news, that dictates price action. Monetary policy is accommodative, but the Fed is thinking about taking away the punchbowl a little bit earlier, when everyone else thought it was a green light until April.
Towards the end of last week, something else sinister was taking place. Despite the equity rally off of the lows as China showed a lower rate of change of new confirmed cases, and pumping money into the system, bonds commodities and FX markets were not playing ball. Yields on U.S. bond markets kept collapsing, with the 10-year having fallen below 1.5% for the first time since last September, which was itself a three-year low.
Together with the equity markets rallying last few weeks, even gold was rallying, which was at odds given gold is a harbinger of a recession or fear trade. Things were not adding up and as the yuan trickled back above 7 to the dollar, implying devaluation -- that's when it all broke. Equities were getting ahead of themselves, ignoring everything, purely because of this liquidity rush.
What made matters worse on Friday was that South Korea is turning out to be another Hubei province -- as the rate of new cases reached 600 and six people died. It has raised its emergency level to the highest level amid the outbreak. South Korea is a big hub for Technology and Semiconductor industry, so any brake here is bound to have consequences for the Technology sector and supply chain disruptions. The Technology stocks were down about 3%-6%, which is a big move for a sector that just grinds up day on day usually. Italy this morning confirmed about 100 cases in northern Italy, with the Carnival being cut short as cities in the hotspot around Milan and Venice have been put on lockdown for now. Before it was just China shutdown and officials showed the rate of change to be lower and lower, pointing to optimism. Now as this news breaks out, that optimism is fizzling out as the market is worried about a serious global slowdown.
The other side of the argument is that the Fed and central banks will (or could) be there to support any major sell offs as they have stated. But the world is a lot more leveraged and in a far more precarious state today, given the huge debt amassed across the board. Back in 2007/08 Financial Crisis, they started with a balance sheet of $1.5 trillion, today they are already at $4.18 trillion and rates are hovering around 1.75%. Sure they can print more and cut more, feed the beast, but their hands are certainly tied as the beast needs a lot more to keep going.
The S&P 500 is now down 4% from its highs of 3395, trading close to the first level of key support, 3250. Volatility has spiked up to a massive high of 20 as it is up another 15% today. Gold is trading close to $1700/oz. But the S&P 500 is up 17% from October lows. Whether it will hold the first level of support remains to be seen. What level will/can the Fed announce QE4 (officially, that is) also remains to be seen. There will be a reaction from across the world to come in, but at what level and how soon, that is debatable.
Oil is back down towards $55/bbl Brent, down 7% after rallying to $60/bbl. Copper back down towards $5600/tonne. The lows have not been breached, but bears are worth watching. We can all make a fundamental case for Oil and Copper here, IF this does not turn into a full-blown recession like 2000 or 2008. All asset classes are linked and interest rates and dollar are the keys that hold this thing together.
This is a reality check, an unwind of the excess. The virus did not cause the slowdown or collapse, it was just a spanner in the works that proves how weak the system really is. What the Fed giveth, the coronavirus taketh away.