August 2015 – Monthly Commentary
As written in last month’s update, we feared the Chinese monetary authorities risked losing investor confidence due to their manipulation of the capital markets. That fear came to pass in August and it wasn’t limited solely to the Chinese market. With investors grappling with whether the Federal Reserve would raise overnight rates in September, price volatility in the capital markets continued to soar.
Spooked by the continued weakness in commodity prices, especially the price of crude oil, nervous investors were pressuring stocks lower. That nervousness spiked on August 11th when the Peoples Bank of China did the unthinkable and devalued their currency. It was done under the guise of moving to a market driven exchange rate. The bank said that they would reference the closing rate of the major commercial banks in setting the closing price. On the first day, after losing 1.9% versus the dollar, the PBOC “intervened” to sop-up the selling, allowing the currency to close above the low of the day. The following day, the currency fell another 2% before the central bank intervened, bringing the Yuan back to down only 0.90%. As the Peoples Bank of China described it, after months of stability, the Yuan had succumbed to commercial bank selling. Despite what has been characterized as a Soros-like attack on their currency, the PBOC was able to step in and absorb what no one wanted, especially the United States; namely a sharp devaluation in the Yuan. However, it’s all a contrivance. The Commercial banks are state owned and operate at the behest of the government. In essence, the government directed the commercial banks to “hit the bid” only to have the central bank step in and absorb most of the selling. In this way China can claim to allow a free floating currency and simultaneously devalue their currency versus the dollar. Brilliant! The problem with their solution is that other emerging markets followed their lead and devalued their currencies, echoing the behavior observed in the emerging markets in 1998. Recall that multiple currency devaluation destabilized the global capital markets at that time and ultimately led to the demise of the hedge fund Long Term Capital Management. Investors quickly digested the similarities and dumped stocks around the globe, leaving the S&P 500 down more than 6% for the month. Stock markets around the globe suffered similar loses.
In early September trading, the stock market continues to gyrate wildly and we’re just days away from what may or may not be the first rate hike in 10 years. Consensus is that there are two potential outcomes. The first is that the FOMC raises rates 25 basis points and “promises” not to hike again for the foreseeable future. The second is that they leave the rate unchanged and communicate that they will continue to be data dependant. However, we think there is a chance that they do a less than expected rate hike of 12.5 basis points and deliver a neutral assessment at the press conference. In doing so, the FOMC would be able to maintain a modicum of credibility, begin a move toward interest rate normalcy, and give the open market desk time to figure out if they actually have the technical tools needed to raise interest rates. As we’ve explained on several occasions, raising the overnight interest rate is a highly technical operation. Given that the Fed has flooded the markets with liquidity, they will need to drain some of that liquidity to bring supply and demand into balance at their newly targeted rate. How much will need to be drained is anyone’s guess. One thing that’s for sure is that the Fed’s policy paralysis has added to market volatility. It’s been nearly a year since Yellen stated that it would be appropriate to raise rates in a few meetings. That inaction has confused markets and distorted risk appetites.