Older readers who are fans of British comedy may remember The Hitchhikers Guide to the Galaxy. The front cover of the guide itself contained some helpful advice. It had, to quote author Douglas Adams, “the words ‘Don’t Panic’ in large, friendly letters” inscribed on it. If the world’s currency markets are to be believed, this would seem to be good advice for investors in US equities right now.
My background is in Foreign Exchange, so it is only natural that I look to that market for clues when things get hairy. “Hairy” aptly describes the last couple of days in the stock market as all major indices have dropped precipitously. The reaction to the FOMC minutes and Ben Bernanke’s discussion has been swift and vicious, and, as is the pattern in these days of algorithms and high frequency traders, losses have triggered more selling. The snowball has started to roll and talk of a correction has, for many, turned to fear of a collapse. A look at the FX market, however, in the context of global finance, cautions us against panic.
The confirmation that, at some point in the future, the effective printing of money, which dilutes the value of the dollar, will slow down had the expected effect. The Dollar gained ground (See the 1 Month chart for the Dollar index below).
In the past, the “flight to safety” response of global capital was normal in the markets when trouble was coming; holding “risk free” assets (US Treasuries) was the logical thing to do. Demand for Dollars increased and the Treasury market was a safe parking ground. The recent move has been interpreted by many that way. This is, however, not what we are seeing here.
Treasury yields, as represented by the chart of the 10 year above, have risen in the last few days rather than fallen, meaning prices are lower. This is hardly surprising. The biggest buyer of Treasuries over the last few years has just announced that they are going to slow down purchases; nothing else could have happened.
So, we have the expected reaction in both cases, but they are not compatible in the normal way. If demand for Dollars were high due to a flight to safety, demand for Treasuries would also be high. This breaking down of the old relationships between asset classes has been happening over some time as a consequence of Central Bank action. Equities and bonds rising and falling together has been a common site over the last few years. The Fed, by using bond purchases to inject cash into the system, has created that situation. Their presence in the bond market has pushed up prices (and therefore depressed yields), while the cash has been used by the recipients to buy stocks, pushing their prices up at the same time. As the end of QE is signaled, so stock and bond prices have fallen together over the last two days. The Dollar has also gained strength, but this hasn’t translated into growing demand for Government paper.
We have a situation, then, where the world’s big players, the sovereign, pension and hedge funds for example, are holding a lot of Dollars without a home. Global cash, like nature, abhors a vacuum. The US stock market is likely to be the beneficiary. Looking around, US stocks still look to be the best of a bad bunch. Europe’s troubles, though out of the limelight, continue. The Nikkei bubble seems to have burst, at least for now. Chinese growth is slowing and, as we said, Treasuries are losing value. Stock P/E multiples look reasonable and US companies have shown a remarkable ability to grow profits in a slow, grinding recovery. In a global context, buying US equities doesn’t seem like a bad idea, whatever the Fed does.
The Foreign Exchange market, like all markets, can be deceptive at times. The positioning of participants and internal market dynamics can sometimes lead to moves that can easily be misinterpreted. In this case, however, I believe that the desire to be long Dollars is genuine. Those Dollars have to go somewhere and if even some of them move into the US stock market they will act as a stabilizing factor.
The logic here is a little convoluted, so let’s simplify it.
End of QE = less supply of Dollars in future = more demand now.
End of QE = less demand for Treasuries = lower Treasury prices
Lots of Dollars looking for a home = support for stocks
This is why, even though I can’t find the “large, friendly” font, I would repeat the “Hitchhiker’s Guide’s” advice: Don’t Panic!