The Blame Game

Rest assured when investors wake up on a Monday morning to the proverbial “Sea of Red,” they are going to be looking for someone to blame.

Our most recent Black Monday saw the S&P 500 fall 3.9%, pushing its 2-day decline to 7%, which is the largest 2-day sell-off since the height of the Financial Crisis.

Globally, Chinese equities fell the most since 2007 and stocks in Germany also fell into an official bear market. Commodities continued to slide with crude oil hitting a 16-year low, falling below $45 a barrel for the first time since 2009. The US Dollar fell 1.6% and 10-year Treasury yields slid to an April low.

There were rumors that a number of large hedge funds were forced to sell as margin calls came in.

A number of blue-chip names saw unprecedented swings in a matter of minutes: Apple: 16%, JPMorgan: 22%, GE: 22%.

However, this type of unprecedented price action was only the beginning and not nearly the most important development that occurred last week. In the wake of a 2-day, 16% decline in Chinese equities, the PBOC came out with its fourth rate cut since February. The rate cut caught everyone by surprise because investors had been clamoring for a rate cut over the weekend. So the fact that the PBOC chose to wait until after the US markets closed on Tuesday to announce the cut, caught people off guard.

People were surprised by the timing of the cut because they expected the cut to come as a result of the continued slide in the Chinese stock market. But this latest rate cut has everything to do with trying to stabilize the Yuan and absolutely nothing to do with the economy or the falling stock market.

China has cut rates 5 times since November. None of the previous cuts did anything to alter the trajectory of the Chinese economy, which just recently reported its worst manufacturing data since the Lehman bankruptcy. And while the stock market did in fact benefit briefly from the cuts, it has gone from being up 60% in mid June to being down 4.5% for the year as of last Friday’s close.

The rate cut was about unlocking $100B in much needed funding so that China could continue to intervene in the FX market by dumping a comparable amount of US Treasuries since its August 11 devaluation. The Yuan devaluation, which has received the blame for recent global market volatility, has had a significant tightening effect on domestic liquidity. So in essence, every devaluation requires an offsetting rate cut and around and around we go.

The rate cut is also trying to offset some of FX outflows that China has experienced in both July and August. The PBOC needs to keep a steady level of liquidity and rate cuts can help with that.

That said, the dramatic intervention in the FX market and the resulting 6% bump in Chinese equities on Wednesday makes it clear that the PBOC stands ready to do whatever is necessary to prevent market declines.

In the end, all people care about currently is how any of this global market volatility and Chinese policy action impact the probability of a Fed rate hike this month. While the world has been pointing the finger at the Chinese for the last 3 weeks, China officially pointed the finger back at the Fed last week saying that it should delay a rate hike because it risks pushing emerging markets into crisis.

 

Will The Fed Tighten In September?

Here’s my call, the rate hike is on for September.

My reasoning is based on Fed independence, the Fed being data dependent and what markets are saying.

There is plenty of time to get a new reading on the labor market, and for the markets to stabilize before the Fed needs to make a decision. Even though it should be pointed out that the most recent global turmoil will not be reflected in this next batch of data.

In my mind the real question on the table is will the Fed show its independence from the rest of the world? Often when people talk about the independence of central banks they mean independent of meddling by the elected representatives of the people. However, in the current context, the Fed needs to show that US monetary policy is independent of other central banks' choices.

The Fed should be independent of whether China allows its currency to be influenced by outsiders. It should act independently whether or not Saudia Arabia is producing record amounts of oil to purposely suppress oil prices to hurt the competition. And most importantly, the Fed needs to show that monetary policy is independent of normal performance and volatility in financial markets.

 

Fed Needs Independence More Than Interdependence

Even if the Fed hikes rates, it will remain data dependent. The most recent data will likely show that the US economy is in a position to absorb a short-term shock. Last week’s durable goods orders suggest that business investment is off to a good start in Q3, and was also consistent with the upward revision for Q2 GDP. 

In addition, US consumer data showed marked improvement from June to July. Wages and salaries grew for the fourth consecutive month and expenditures also improved month over month.

Keep in mind that even if the Fed raises rates 25 basis points, it doesn’t mean that we will never see another round of QE. If the economy begins to deteriorate after the hike, the Fed will cut, initiate QE4, or both. Even with a September rate hike, there is still a good possibility that we see QE4 before we see 1.0% on the Fed Funds futures.

But the right move for now is to hike in September.

If the Fed doesn’t hike, it sends too many wrong signals to markets. A rate hike allows the world to stop fixating on being zero bound and when the first hike will happen.

A rate hike allows markets to begin thinking about the path to true policy normalization.

 

What The Markets Are Saying

Despite the carnage to begin the week, most markets stabilized quite nicely by Friday’s close. The US domestic markets showed no signs of damage at the end of the week.

The US Dollar rallied the remainder of the week and finish over 1% higher than the prior week. US 10-year yields showed strength and closed the week back above a critical line at 2.15%. The S&P 500 finished the week up 80 basis points and back above a critical line of support at 1972.00. Last week’s strong finish also means that the S&P 500 is only 7% below its all-time high, which doesn’t even qualify as a correction.

And the blue chip stocks that were taking it on the chin to start the week, all finished higher from the prior week’s close. Globally, most markets rallied back from Monday and finished the week much stronger.

I don’t buy the rationale that the Fed should delay the rate hike because of what's going with China, commodities, the emerging markets or all 3. If these concerns were going to impact how the Fed shifts policy in the US, then Yellen would have never broached the subject of a rate hike during 2015.

China’s economy has been slumping for the better part of 3 years. Look at a chart of the Big 3, industrial production, retail sales and fixed asset investment, and you’ll see what I’m talking about. The Shanghai Composite declined from the beginning of 2009 all the way until the start of 2014.

I seriously doubt that the pricking of the Shanghai stock bubble over the last 2 months is going to push the Fed off course. My rationale is the same for commodities and emerging markets. Look at a chart of any commodity - crude oil, corn, cotton, soybeans. Commodity markets had been weak and declining for months and in some cases years before the Fed announced the possibility of a 2015 rate hike. The same goes for emerging market equities, currencies and bonds.

All of these asset classes have been declining for years, with few exceptions. So while the decline may have picked up in recent weeks, the trajectory of these asset classes were known at the time the Fed began discussing rate hike. The rate hike is coming in September, plan and allocate accordingly.