Macro: The Bottom Line (4/14/2014)

 

After a couple of weeks of relative calm, markets were back in turbulent waters this past week as a number of factors conspired to re-inject volatility:

 

Nasdaq - who spoiled the party? For all the attention that investors have been paying to the Eurozone, Fed policy, emerging market imbalances etc., the equity markets have shown striking resilience to macro events. Aside from temporary hiccups - like the EM scare in January - stocks have continued to march higher year-to-date in 2014. But in the first half of April, the euphoria suddenly seemed to grind to a halt. The party spoiler was the technology sector: home to some of the market's hottest stocks - including the likes of Netflix and Tesla - and to some of the most outsized rallies. But suddenly, on the eve of the latest round of earnings releases, the 20+ price-to-earnings ratio on the Nasdaq didn't seem so harmless after all. This is especially considering the widening gulf between the Nasdaq and the Dow, where the trailing P/E ratio remains at a respectable 15. The resulting mayhem was relentless, sending the Nasdaq down close to 5% on the month so far.

We on Red Bull will have ongoing coverage of the equity market developments, including how you can make the most out of this latest round of turbulence. But suffice to say on a macro blog: mind your valuations. If there's anything potentially more dangerous to the equity markets these days than Greek profligacy, Senate filibusters, Chinese wealth-management-products-of-mass-destruction, or Vladimir Putin, it's stretched valuations.  

 Yellen & Co. try to make amends - but what does this mean for the FOMC's credibility? In a previous post, we noted how new Fed Chair Yellen had made possibly the most reckless mistake a central banker could make: providing a numerical timetable for a rate hike. Recall how, when pressed on how long the Fed would keep rates at near-zero levels after the end of quantitative easing, Yellen responded with a not-so-ambiguous "about six months". Well, after seeing the resulting maelstrom on the Treasury markets (with especially 0-5Y yields shooting higher), Yellen and team have been in full damage-control mode. This included a decidedly dovish speech by ... you guessed it, Yellen herself ... the week after her "six months" comment. Even more interestingly, the Fed minutes this past week explicitly branded the FOMC's own (more aggressive) rate-hike projections as "overstated." The reverse-jawboning has had the desired effect for now, with Treasury yields falling and the 30Y rate falling to a one-year low.

What does this whole episode tell us? Besides being an incredibly useless piece of market noise - adding absolutely nothing new to our understanding of Fed policy going forward - it leaves an enormous dent in the FOMC's credibility. Who's to believe the Fed's communications - whether it's rate or inflation projections, or its much vaunted "forward guidance" - if they were released only for the FOMC to publicly repudiate them a few weeks later? Far from managing market expectations, these mixed signals only serve to confound them even further. If Yellen truly wants to keep interest rates anchored at low levels so as not to jeopardize the economic recovery, her first rule of thumb ought to be: avoid making unequivocal statements, only to issue equally unequivocal retractions of those statements.   

 

Biggest casualties of the month: equities and the dollar. Biggest benefactor of the month ... Greece!

 

No surprise in terms of the biggest casualties of the month. We just discussed the carnage on the equity markets. And with the Fed's aggressive jawboning, the dollar has had no place to hide. Over the month, the greenback is down versus most of its developed market peers, including the euro, pound, yen, Australian dollar, and Canadian dollar.  

 

But what about the biggest benefactor? As surprising as it sounds, this is no typo. In fact, amid all this mayhem, Greece managed to issue a 5-year bond at a meager yield of 4.95%! Keep in mind, this isn't any borrower coming to market. This is the Greece, a country whose total debt exceeds its annual economic output by 70%, whose shaky government is still struggling to bring tax evaders to heel, and whose growth model is poorly defined at best. Would you really lend to such an issuer?

 

The issue is that in the perverse logic of the financial markets, turbulence in one sector or asset class often turns another sector into a sort of haven. In the context of today, the fault lines of yore - such as Greece - suddenly appear to be a stable source of higher yield, in the face of the abrupt about-face on the equity markets. So the next time you come across an article claiming that Greece has come out of the woods, take it with a grain of salt ...