Market observers continue to give short shrift to the fact that the Federal Reserve is the perpetrator of the “Red Wedding” in the markets. The Federal Reserve doesn’t trust the markets. It thinks it knows better than the markets how to set the price of capital and create the conditions for economic growth.
Every once in a while, we get an errant number like the revised second quarter GDP number of +3.7% to tease us into thinking that they know what they are doing. But once we look below the headline number, we find the same weakness that has plagued the economy since the financial crisis. Years of ZIRP and QE have suffocated the economy in too much debt that will continue to smother growth for years to come.
The Fed continues to speak out of both sides of its mouth, when its best course of action would be to say nothing. On Wednesday, New York Fed President Bill Dudley sought to calm markets by saying that the case for a September rate increase was “less compelling.” On Friday, Fed Vice Chair Stanley Fischer said that a September hike was still a possibility.
Market Manipulation is Not Leadership
Leaving aside the bathos of the market’s pathological concern regarding a miniscule 25 basis interest rate hike, the Fed’s contrasting messages are unsettling the market when they are ostensibly intended to do the opposite. The Fed governors aren’t idiots, so why are they acting like ones?
A week ago, stocks plunged by 6% after China – acountry even more debt-engorged than the United States – began to devalue its currency. Last Monday, investors panicked and sent the Dow Jones Industrial Average down 1,100 points at the open. This move, which ended with the biggest one-day loss in history, was exacerbated by changes in market structure that increase volatility and reduce liquidity.
The Dow lost 1,300 points between Friday, August 21 and Tuesday, August 25 before recovering 1000 of them on Wednesday and Thursday, August 26 and 27. The volatility was historic, with the Chicago Board Options Exchange Volatility Index (VIX) spiking to levels that we haven’t seen in years. After hitting 44 on Monday, the VIX settled down to close the week at 26.05, much higher than the average levels in the mid-teens that have prevailed over the last two years. After four years without a 10% correction, investors were given a much-needed reality check.
The big question that is now being asked is “is it over”? Nobody knows the answer to that question. What we do know is that China’s policymakers eased interest rates and bank reserve requirements in order to try to stabilize the country’s plunging markets.More notably, it appears that China began dumping some of its $1.5 trillion hoard of Treasuries, which contributed to an unexpected rise in long-term Treasury rates as stocks were gyrating wildly.
Normally, one would have expected Treasuries to keep rallying throughout the week as they did on Monday when the 10-year yield dipped below 2%. Investors tend to seek safety in a storm – butnot this time.By all accounts, selling by China appears to have prevented that from happening. Of more significance is what could happen if China becomes a consistent seller of Treasuries.
Bond Returns Signal More Distress
Investors of all sorts were battered by last week’s action. While a number of large hedge funds sunk into the red for the year, large bond investors – who normally thrive when the stock market plunges – weren’t spared. Most notable was an almost unheard-of one day 3% loss suffered on Monday by Bill Gross’s Janus Unconstrained Bond Fund (MUTF:JUCAX), most likely as a result of Mr. Gross’s strategy of selling volatility.
In addition to extending Mr. Gross’s performance slump, which goes back to his final years managing the PIMCO Total Return Fund (MUTF: PTTRX), this points to the fact that many large bonds funds (including PTTRX and JUCAX) invest in derivatives and other instruments that are far afield from what investors are led to expect by the people marketing those funds.
It also points to the fact that Mr. Gross feels he is unable to generate decent returns in traditional bonds and has therefore chosen to look elsewhere to make money for his investors, something that was apparent in his final years managing PTTRX. JUCAX is now down -2.4% year-to-date. The best performer among large bond funds continues to be Jeff Gundlach at Doubleline, although even his returns are barely above zero. This is what happens when the Fed destroys markets.
After the smoke cleared, however, the headline damage was muted. Remarkably, the Dow ended the week 1.1% higher, gaining 183 points to 16,643.01. The S&P 500 also gained 0.9% to close at 1988.87. Both indices are solidly down for the year, however. The Nasdaq Composite Index was the biggest gainer, adding 2.6% to close at 4828.32 and remaining positive for the year. Below the surface, however, many stocks are nursing double-digit losses.
And despite these gains, investors entered the weekend with big questions about what is coming next. The answer is likely more volatility with a downward bias until there is more clarity on the Fed’s intentions.
Regardless of the fact that any initial 25 basis point rate hike is far less important than what happens to rates afterwards, markets remain freaked out at the mere mention of a rate hike. If the Fed had wanted to calm markets (which is not its job though that has never stopped it before), it should have given a clear signal last week. Instead, it left investors hanging, which means that the wild ride may not be over for several weeks.