Still Waiting For That Oversold Rally

Longer term, however, the poor relative performance of HY and EM credits remains a concern as they are signals of rising risk aversion from the fixed income markets.

Here is what I learned from the PBoC devaluation affair. First, there is no need to panic over minor currency fluctuations. Here is a chart of how much other currencies have depreciated against the USD in the last year (via CNN ):

1 year currency depreciation against US Dollar

tanked 9% against the dollar last month? What about the news that the Turkish lira hit all time lows? OK, Brazil and Turkey aren't major economies. What about Japan? How did the market react when one of the stated aims of Abenomics was to weaken the Japanese yen? What about the euro? The euro peaked in 2009 and it has been steadily weakening against the USD. Did the markets tank? Um, not really. Instead, American investors poured money into currency-hedged European stock funds and ETFs.

Longer term, however, I am concerned that the scenario of Chinese weakness outlined by Ray Dalio of Bridgewater Associates is in play (see Is China getting hit with THE BIG ONE?). Remember the quaint old days when we were just concerned about the bubble in Chinese real estate? Now we have added the Chinese stock market and their currency to the list of worries. This latest move by the PBoC to weaken its currency is therefore confirmation that Chinese economic growth is weakening. Indeed, a research report from Citi indicated that five Chinese provinces are in recession. Economies growing at 7% do not behave this way.

A research note from Citi published earlier this week forecast further stimulus measures from Chinese authorities, with five provinces believed to have shrinking economies.

"There is a widespread acknowledgement of the economy's weakness, and three resource-oriented provinces in north-east China - Liaoning, Jilin and Helongjiang – are thought to be in recession already, along with north China's Hebei and Shanxi provinces," the analysts wrote.

I had postulated one fallout of the Ray Dalio scenario of a China slowdown would be a "soft boiled egg" landing for China and Asia. The landing would be soft on the inside (China), but hard on the outside (for anyone doing business with China). An article in the Sydney Morning Herald quoted analysts from Lombard Street Research and ANZ expressing precisely these concerns, Shweta Singh of LSR brought up the spectre of another Asian Crisis:

Lombard Street Research senior economist Shweta Singh said the sharp yuan devaluation in 1994 was now recognised as leading to the emerging financial market crisis in 1997 and described the current situation as the "perfect storm".

"The start of the Fed's rate rise cycle during the same year was the straw that broke the camel's back. No wonder that the repercussions for emerging markets of a similar change in the direction of Fed policy have been an issue of lively debate among investors," Mr Singh said.

While emerging markets could benefit from greater US private consumption and greater competitiveness, Mr Singh said the worst-hit economics would be those that are fairly uncompetitive with similar export programs and structures to China, such as South Korea, Malaysia, Vietnam, Thailand and Taiwan.

The concerns expressed by ANZ were less alarmist, but nevertheless worrisome for regional trade:

ANZ chief economist of Asia Glenn Maguire has revised Asian forecasts down until 2018 due to a "trade recession" that is likely to endure.

"The surprise renminbi devaluation announced by China yesterday and the Vietnamese dong band widening announced by Vietnam this morning speaks of the economic stresses that are arising from this unusually depressed period of global trade and a global economic backdrop that remains tepid and uneven rather than synchronised and ascending," Mr Maguire said.

Describing the "de-correlated and weak" Asian market response to a strengthening US economy as a "relay baton drop", Mr Maguire said it was a remarkable every Asian nation is experiencing negative year-on-year export growth given the regions trade history.

"It is suggestive of further 'breaks' in the traditional determinants of the Asian trade multiplier. Structurally lower potential growth rates among major economies, unfavourable demographic trends and under-investment in capacity are not sufficient explanations for this breakdown."

The ratio of Asian trade export growth to global GDP growth prior to the global financial crisis averaged around 2.9 per cent but has dropped to 1.5 per cent since then. Mr Maguire said it may have actually fallen even lower towards 1:1 since the commodity prices crunch in June.

Now add into the mix the expectation that the Federal Reserve will raise interest rates sometime this year, probably at its September meeting, and you have the makings of a financial Molotov cocktail. Will fragile EM economies be able to withstand the shock of rising US rates when there are USD 9 trillion in offshore loans (see The key tail-risk that the FOMC missed (and you should pay attention to))?

Independent of those risks, Tim Duy penned a Bloomberg View article stating that he believed that the Fed may be tightening prematurely. The disagreement between market expectations, which believes that the US economy remains anemic, and the FOMC`s expectations, which are more hawkish, is leading to trouble (emphasis added):

The Fed...doesn't believe it has engineered the soft landing just yet. It expects that interest rates will need to rise farther to tame inflationary pressures. In fact, the Fed believes that the economy will evolve in such a way that it can raise short-term rates back to levels comparable to the old normal.

Financial markets participants, however, are not on the same page. They see the Fed staying persistently lower than Federal Open Market Committee meeting participants anticipate.

I would argue that financial markets are signaling that a soft landing has already been achieved and that much additional tightening will risk tipping the economy back into recession. The Fed staff is stuck in between; at least that is the story told by the accidental release of staff forecasts . The staff envisions a near-term policy path that better resembles what is expected by financial markets, although the staff, like FOMC participants, can't shake its faith that eventually rates will return to something more like the historical norm.

He thinks that the Fed is on thin ice because the economy remains too fragile for a rate hike:

My concern now is that the FOMC is on thinner ice than members realize because they don't believe they have already tightened policy. The soft landing may already be upon us. They just don't know it, or won't admit it.

That's a recipe for recession.

You don`t necessarily have to buy Duy`s argument that Fed tightening will lead to a recession. The combination of the fragility of China-dependent EM economies, the possibility raised by a respected Fed watcher like Tim Duy of a US recession and a somewhat "unexpected" September rate hike (which is only priced at roughly 50% right now) could be the catalyst that spooks the markets.

Despite these concerns, I am not overly worried about a nasty sell-off in stocks right now. That's because bearish sentiment is still overdone. The Fear and Greed Index remains in fear territory. In order for the market to meaningfully decline, we need the bears to capitulate and get washed out. In order for a meaningful correction to begin, the Fear and Greed Index needs get to at least neutral and preferably into the greed zone. That implies a market rally to test and make new highs.