Why the Fed Doesn’t Want Emerging Markets to Run

Yesterday, the ASX 200 closed beneath 5,000 points for the first time since late September. This tried to bounce higher several times, but couldn’t. The index actually closed less than a stage away from its low. It is really an indication of heavy selling and suggests further falls are ahead.

Thanks to a late bounce in stocks within US trading overnight, there is a bit of respite in store for Aussie stocks today. But the ASX 200 is still well beneath support at 5,000 points.

I’ve written for several weeks now that 5,000 is a crucial level for the Aussie marketplace. A sustained break below here suggests this keep market is entering a new and nastier phase.

But there is nuance to this analysis. It’s not as simple because just saying a fall below 5,000 points indicates the bear market can get worse. You’ve got to look just a little deeper.

Looking deeper is something I’ll be doing for subscribers of Crisis & Opportunity this week, so out of regard for them, I won’t go into too much detail here. But I will say that the break below 5,000 this week might not be as bad as it seems. A few other things have to go wrong before you get seriously worried about where the forex market is headed.

Mind you, there is plenty of scope for items to go wrong. Firstly, the mid year budget update, due out today, should provide a wake-up call to anyone who thinks situations are travelling along nicely.

That is, it should make it clear just how broken the Federal budget is. With metal ore, coal, gas and other commodity prices tanking, and with wages growth at multi-year lows, the government just won’t get the growth in tax receipts it needs to fund its promises.

Without spending reform, the budget will just keep getting worse. But there won’t be any spending reform if the government does not first outline the problem. Underneath the ‘leadership’ of Abbott and Hockey, there wasn’t any intention to raise awareness of the problem because there was no intention in order to enact structural reforms.

It appears as though Turnbull and Morrison are interested in doing some thing. But to do that, they need to tell us how bad things are. That isn’t going to be good for confidence within the lead up to Christmas. Santa Claus is certainly not coming to town. He isn’t even coming to the country.

What otherwise could go wrong?

Keep your eye around the banks. It’s all about their ability to maintain dividends. If this dividend support goes, the trapdoor will open and the market will plunge.

More immediately, there’s the looming US rate decision. The market is panicking, selling off just like it did mid 12 months, when it assumed rates would rise in September.

As Bloomberg reports:

Once once again, the Federal Reserve is about to create a historic interest-rate decision against the backdrop of rising equity volatility, tumbling commodity prices and jitters in credit markets. This time, investors expect policy makers to pull the trigger.

In the lead-up to the Dec. 16 decision, investors are contending with crude beneath $36 a barrel, stress within the U.S. junk-debt market and the longest streak of losses in global equities because August. While the financial turmoil spurred by China’s yuan devaluation that month stayed the Fed’s hand in September, policy makers possess since signaled increasing determination to go ahead with the first rate increase since 2006.

The Fed really has not one other choice. They will have to raise rates this week. Otherwise the ‘market’ may have them in a corner and it will end up being obvious who the boss is really.

This time the problems are in the high yield, or ‘junk bond’ markets. The collapse in commodity prices (particularly oil) is lastly working its way right through to the balance sheets of the companies that produce these goods.

This is when it’s meant to work. Affordable prices eventually bring about a supply response. To cut supply, you need to cut financing. With a huge amount of financing occurring with the junk bond market in recent years, the current turmoil should not be surprising.

This is just how the commodity period works. Although easy credit made this cycle much worse by giving marginal producers access to funds they normally would not have received.

So problems in the rubbish bond market should not be an excuse for the Fed to hold away raising rates. But the issue is one of contagion. That is, will deficits in the junk bond marketplace spark selling elsewhere…that will lead to a general credit crunch?

A similar threat is playing out in emerging markets. This is really only a continuation of what’s been occurring for the past six months. That is, numerous emerging market economies lent heavily in US dollars. And lots of rely on commodities to generate income in their local currency.

The combination of falling local currency income and rising debt within US dollars is a toxic one. The market’s response is to sell assets in these countries, that sends their currency lower and interest rates higher. Which only makes things worse.

According to the Wall Street Journal:

‘Corporate debt in emerging markets had more than quadrupled in the decade to 2014, based on International Monetary Fund numbers. But investors have been tugging money out of the market this season, spooked by signs that borrowing was ballooning unsustainably ahead of an imminent rate increase by the Government Reserve.’

So far it’s only a quick stroll to the exits. The Given will be hoping that their very first interest rate rise in a decade does not turn it into a run.

If it does, you can expect to see the return of QE at the start of 2016. And plenty of market turmoil.

Regards,

Greg Canavan