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Which Door Will Yellen Choose?

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    January 28, 2014

    Two theories to explain the year-to-date global dumpathon. The first is that it’s all local issues – no single macro story explains the depth of the sell off. Some examples (and why they are individually no big deal):

    + Turkey is facing big domestic political/economic problems – it’s no surprise that some of the ‘air’ is coming out of the currency, bonds and equities that were so recently loved. All in, Turkey is now cheap – one should buy this dip.

    + South Africa is facing labor issues. This explains the drop in the Rand. This is not a ‘contagion’ story. It’s an isolated case.

    + Brazil is temporarily suffering from some weakness in other EM markets. But Brazil is a ‘special’ case – this is the land of the future.

    + Argentina’s deval is a good thing. Every time that Argentina has hit a wall over the past 30 years they have gone through this, and came out strong. Buying this dip will be a moneymaker.

    + Japan is going to ‘Whip Deflation’ in 2014. The coming 40% increase in the national sales tax is not going to be a speed bump at all. The (still) cheap currency that has been engineered is about to trigger an export boom. Japan has the ‘Platinum Coin’ option, and it will use it to eliminate the debt problem.

    + Europe is really in ‘recovery mode’ this time.  All the evidence you need to confirm this is that Spanish ten-year bonds were sold the other day (in size – E13b) at a dirt cheap 3.75%. The offering was 3Xs oversubscribed.

    + The ‘worst case’ in Puerto Rico will never be seen. Treasury Secretary Jack Lew will ape Mario Draghi and pledge that PR will not default. There’s big money to be made in PR bonds.

    + China’s latest ‘blip’ in funding costs is going to go away as of Feb. 1 (New Year). The fact that there will be a default of a Wealth Management product in a few days is well known – it’s already in Friday’s market print. China Inc. will not allow defaults to spread. And what’s all the complaining about? GDP of 7.5% is in the cards.

    + The US is going to have the best year of GDP growth in years. The higher corporate top line/earnings that will follow this economic spurt will keep multiples expanding. Janet Yellen has confirmed that she’s going to keep the short end at zero for years to come, so the Fed’s put is alive and well. Buy this dip!

    + The US picture is bright because of all those new holes that are being pounded into the ground from Colorado to Pennsylvania. For the first time in decades crude is a short. $75 WTI is in our future. As this evolves, there will be no meaningful consequence to Saudi Arabia, Iran, Iraq, Indonesia and it will not hurt Mexico a bit.


    The “spin” on the foregoing issues have the same theme. They are isolated issues that are (for the most part) not really interconnected. Yes, those issues are causing some markets to adjust, but there is no case to be made for a single source of the global puke-out. And anyway, there is a positive side to all of this.


    But there is another take on this story. All of the issues that are emerging have one common thread – It’s the Fed’s Taper that is behind all the uproar.

    Is this possible? Can a relatively small adjustment in the supply and demand equation for the US bond market be responsible for the rout? I think the answer is “Yes”.

    The real question is what does Janet Yellen think is behind the global sell off.  I’m as certain that I can be that Ms. Yellen is itching for an excuse to extend (expand) QE. QE is, after all, her ‘baby’.

    Next weeks’ Fed meeting is supposed to bring us another notch down in the QE monthly purchases – at least that is what the WSJ’s Jon Hilsenrath told us a few days ago (link). Given what has happened since then, the possibility of a Fed ‘surprise’ is now a distinct possibility. Yellen could fall back on the ‘data dependent’ theme, and opt for a pause in the Taper. This translates to a continuation of QE at the rate of $75B a month for a bit longer.

    What might be the consequences if Yellen does a U-turn on the Taper?  The hoped for result would be a rapid turnaround for the EM markets, and with that, the US market would quickly revert to green. Happy days would be here again. There are enough people who believe in the magic of QE that a suspension of the Taper might be sufficient to turn the global capital markets back to stability (Yellen is on top of the list). But that outcome is by no means assured – a delay in the Taper could backfire. The difference between QE of $75B a month versus $65B is meaningless. The markets are not that dumb – it will just take a few days for markets to reach this conclusion.

    We have only two scenarios:

    1) Yellen opts for a continuation of the Taper and we have an immediate blowout in the EM economies/markets or,

    2) She delays the Taper and holds QE at $75B for “a few more months”. The next leg down in markets would start in less than a week as reality/disappointment set in.


    Both of these outcomes have a bad ending. Either way, the concept of the “Fed Put” is about to be tested. Seat belts should definitely be worn (tightly) next week.


    Images: Flickr (licence attribution)

    About The Author – Bruce Krasting

    I worked on Wall Street for twenty five years. This blog is my take on the financial issues of the day. I was an FX trader during the early days of the ‘snake’ and the EMS. Derivatives on currencies were new then. I was part of that. That was with Citi. Later I worked for Drexel and got to understand a bit about balance sheet structure and corporate bonds from Mike Milken. I was involved with a Macro hedge fund later. That worked out all right, but it is not an easy road. There was one tough week and I thought, “Maybe I should do something else for a year or two.” That was fifteen years ago. I love the markets. How they weave together. For twenty five years I woke up thinking, “What am I going to do today to make some money in the market”. I don’t do that any longer. But I miss it.


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