- Explaining in logical terms why Russia has moved to occupy Crimea - think, the US dollar.
- Understanding the China/Russia-led contingent to usher in a new system of global trade.
- Understanding China and Russia's role in the multi-year battle to get the US on board with their plan.
- Explaining why the US will ultimately lose this battle, as China and Russia have all the bargaining chips in this game.
- Explaining what happens to risk assets if the US loses the battle.
We listen to CNN, Bloomberg, CNBC or Fox and hear various views on the situation with Russia's aggressive move into Crimea. Some of the views are offered by military experts; other views by diplomats; more views from politicians; and some views are offered by journalists. In my opinion, those views are slanted and biased based on the commenter's own field of expertise - or in some instances, lack of expertise - and none of these views fully or accurately states the motives or the consequences of the actions currently being taken or those actions being contemplated.
To date, no one seems to be taking the matter very seriously - at least, as it pertains to investor risk. After all, as of this writing, no one has been killed by Russian troops, and US stocks remain within a stone's throw of all-time highs. In fact, the matter is viewed at this point in terms of peaceful measures that can be taken to dissuade the Russians from continuing along their chosen path. That said, those peaceful actions could result in retaliatory actions by Russia that cause the very fragile global economy to come completely unhinged.
I have written extensively on the matter of the BRICS - led by China and Russia - to usher in a new system of global trade that displaces the US dollar as the world's reserve currency. Most seem inclined to take my comments on this subject as melodramatic and alarmist and not worthy of consideration in the short term. That said, the evidence is mounting that these views are indeed alarmist, but certainly not melodramatic. The most recent example of the Russia/China effort to advance their agenda is the measured steps Russia has taken in Crimea.
You can view Russia's moves as calculated measures that are certain to backfire, if you want, but if you more thoroughly understand Russia's motives, you end up with a different view. What are those motives? As I stated, Russia and China, along with the emerging market economies, want a new system of global trade that displaces the US dollar. I will offer evidence of the truth of that matter, but first a look at the dilemma that so troubles them in the first place.
Defining what is at stake
The following excerpt from a paper entitled Reforming the Global Reserve System sets forth the inherent flaws in our current system. The paper was written in 2009:
The global reserve system exhibits three fundamental flaws. All of them are associated with the essential fact that the system lacks mechanisms to guarantee that balance of payments surpluses and deficits (i.e. global imbalances) compensate each other without having adverse effects on world economic activity. Most of the deficiencies generate global deflationary biases but some can also generate inflationary risks.
The first problem, which was highlighted by John M. Keynes during the debates that preceded the creation of the Bretton Woods arrangements, is that the current global monetary system-as all international monetary systems that preceded it-is tilted against deficit countries. This tends to generate a global deflationary bias: the adjustments that deficit countries have to adopt to balance their external accounts, when financing is not available in sufficient amounts (or if those deficits and associated financing are not deemed desirable), will not be matched by expansionary policies in surplus countries, which do not face a similar pressure to adjust. This bias becomes profound particularly during periods of generalized balance of payments crises, such as the one we are experiencing today. The Bretton Woods arrangements were born with this intrinsic imperfection since the International Clearing Union, the proposal by Keynes (1942-43) to create a more symmetric system, was not accepted. Its very imperfect substitute, the "scarce currency clause," has never been used. We will refer to this problem as the anti-Keynesian bias.
The second deficiency, which is generally referred to in the literature as the Triffin dilemma after the pioneering work of Robert Triffin (1961, 1968), is associated with the fact that an international reserve system based on a national currency (the U.S. dollar)-and, more generally, on a limited number of national or regional currencies (the euro today)-has a built-in instability. The only way for the rest of the world to accumulate net dollar assets is for the U.S. to run a current account deficit. However, U.S. deficits and associated deteriorating in its net external balance sheet tend to erode confidence in the dollar as a reserve currency. This loss may then force adjustments to restore credibility-or, more generally, reverse dollar depreciation-, but this could make the deflationary bias of the system felt.
It must be underscored that, aside from this "exorbitant privilege" (to borrow de Gaulle's characterization of the role of the dollar in the global reserve system) of receiving transfers from the rest of the world (appropriating seignorage powers), its position at the center of the global reserve system gives the U.S. the additional privilege of running a truly independent monetary policy. The basic reason for this is the perception (and consequent use) of U.S. Treasury bills as the "safest assets" in the world economy, which implies that the determinants of U.S. interest rates are relatively independent of the exchange rate of the U.S. dollar against other currencies. This is contrary to what is usually assumed in open macroeconomic models, in which runs on currencies tend to be associated with upward pressures on domestic interest rates, a result that is consistent with the experience of most countries facing balance of payments crises.
The third deficiency of the current reserve system is that it is inequitable, as the demand for foreign exchange reserves forces developing countries to transfer resources to the countries issuing those reserve currencies-a case of "reverse aid" (see the Zedillo report published as United Nations, 2001). We will refer to this problem as the inequity bias. It has been magnified in recent decades of financial and capital market liberalization by the pressures generated by strongly pro-cyclical flows that developing countries face in world financial markets, which in turn reduce their room to undertake counter-cyclical macroeconomic policies. These facts have led to a massive accumulation of foreign exchange reserves by developing countries as "self-insurance" or, better, "self-protection" against reversals in capital inflows. This adds up to the more traditional "precautionary" demand for reserves in commodity exporting countries against commodity price volatility and, more generally in today's export-led economies, against international trade volatility.
That, in a nutshell, sets forth the problem and forms the battle lines, with the US consortium being on one side and the China/Russia consortium being on the other side. The following excerpt - again from the paper referenced above - explains in part why the US might be averse to a system that moves away from the US dollar and toward the IMF's Special Drawing Rights:
The current environment could actually be a good time to introduce these reforms. First, the inflationary risks associated with SDR issues are minimal. Secondly, the United States has embarked on a large fiscal deficit and an aggressive monetary strategy. This has potential implications for the stability of the current reserve system, as some countries (particularly China) have already indicated. Under the current circumstances, the U.S. might actually find its role at the center of the global monetary system quite uncomfortable, as it could eventually constrain its policy freedom. Also, as indicated above, by giving up its dominant reserve currency status, the U.S. would also free itself from the need to generate current account deficits to provide world liquidity, which have adverse aggregate demand effect on its economy.
Just as a point of reference on the bad stewardship of the world's reserve currency, let's consider the 1985 Plaza Accord - an arrangement between the US, France, West Germany, Japan and the UK to devalue the US dollar. This excerpt from Wikipedia explains the Plaza Accord effects, and the dollar index chart that follows shows the impact of this accord on the US dollar:
Devaluing the dollar made U.S. exports cheaper to purchase for its trading partners, which in turn allegedly meant that other countries would buy more American-made goods and services.
The exchange rate value of the dollar versus the yen declined by 51% from 1985 to 1987. Most of this devaluation was due to the $10 billion spent by the participating central banks. Currency speculation caused the dollar to continue its fall after the end of coordinated interventions. Unlike some similar financial crises, such as the Mexican and the Argentine financial crises of 1994 and 2001 respectively, this devaluation was planned, done in an orderly, pre-announced manner and did not lead to financial panic in the world markets. The Plaza Accord was successful in reducing the U.S. trade deficit with Western European nations but largely failed to fulfill its primary objective of alleviating the trade deficit with Japan. This deficit was due to structural conditions that were insensitive to monetary policy, specifically trade conditions.
The manufactured goods of the United States became more competitive in the exports market but were still largely unable to succeed in the Japanese domestic market due to Japan's structural restrictions on imports.
The recessionary effects of the strengthened yen in Japan's export-dependent economy created an incentive for the expansionary monetary policies that led to the Japanese asset price bubble of the late 1980s. The Louvre Accord was signed in 1987 to halt the continuing decline of the U.S. dollar.
The signing of the Plaza Accord was significant in that it reflected Japan's emergence as a real player in managing the international monetary system. Yet it is postulated that it contributed to the Japanese asset price bubble, which ended up in a serious recession, the so-called Lost Decade.
(click to enlarge)
A look at the chart above suggests the US hasn't been a great steward of the world's reserve currency in that, above all else, the instability of the currency is at the heart of the matter, and that instability is by design - for example, the Plaza Accord. The problem is simple - in a free-floating system, if the dollar is strong, the implications for countries who run trade surpluses is positive, and for those who run trade deficits, it is negative. If the dollar is weak, the inverse is true.
The truth is the BRICS are justified in their complaints - at least from their perspective. On the other hand, the US - from their own perspective - has a very legitimate reason to oppose those who would dethrone the dollar. After all, the US is the beneficiary of the "exorbitant privilege" that comes with the country who provides the world with reserve currency.
In any event, that is what the whole matter is about, and since early 2013, China, Russia and the rest of the BRICS haven't been content to simply talk of change. To the contrary, they have taken measured steps to demonstrate that they are not to be trifled with and that they are indeed serious about effecting a change that displaces the US dollar and ushers in a new system.
How the battle has been played out to date
The decision to move toward a non-sovereign reserve currency and a central bank's central bank - the IMF - was made by the China/Russia contingent in 2008-09. Until 2013, the matter was substantially academic. My own thought is that they had hopes the US would sign on and participate in defining the new system. After all, there was a reason to believe that was a possibility, as Obama himself has expressed his own support for the idea.
However, as it became more and more apparent that Congress would not concede on this point, the China/Russia-led contingent finally moved from talk to action in early 2013. More on that in a moment, but let's fast-forward to the present. Here is an excerpt from a recent Reuters article entitled, Russia wants IMF to move ahead on reforms without U.S.:
(Reuters) - Russian officials are pushing for the International Monetary Fund to move ahead with planned reforms without the United States, which could mean the loss of the U.S. veto over major decisions at the global lender, sources said.
Russian Finance Minister Anton Siluanov brought up the idea at a meeting of top finance officials from the Group of 20 nations in Sydney late last month, two G20 sources told Reuters this week.
The failure of the U.S. Congress to approve IMF funding has held up reforms agreed in 2010 that would double the Fund's resources and give more say to emerging markets like China.
If you don't connect the dots, the comments above seem relatively inconsequential. After all, the US still has the veto on any change. One could surmise that Russia has no chance of really effecting change, and so, why does it matter. This excerpt - again from the Reuters article referenced above - establishes the point I made that Obama is on board with the idea of expanding the IMF's role:
For a year, the Obama administration has been trying to get Congress to approve a shift of some $63 billion from an IMF crisis fund to its general accounts in order to make good on its 2010 commitment.
The U.S. Treasury is now seeking to attach the funding to a financial aid package for Ukraine that is under consideration in Congress. It argues the reforms would allow crisis-hit countries like Ukraine to borrow more money from the IMF.
"It is imperative that we secure passage of IMF legislation now so we can show support for the IMF in this critical moment and preserve our leading influential voice in the institution," Treasury Secretary Jack Lew told lawmakers on Thursday during a hearing in the U.S. House of Representatives.
The Ukraine bill may be the administration's best chance of passing the IMF funding shift this year, analysts say.
And this, from another Reuters article - U.S. uses Ukraine to push for IMF voting reforms - that in all likelihood wasn't read or even considered as relevant by most:
(Reuters) - The United States on Tuesday sought to use the crisis in Ukraine as leverage in its effort to convince Congress to approve a long-sought measure to increase the International Monetary Fund's financial power.
Treasury Secretary Jack Lew said Ukraine would be able to borrow more money and avert a potential default if U.S. lawmakers signed off on the measure, which would double the IMF's resources and give countries in crisis access to a bigger pool of potential aid.
The Obama administration on Tuesday tucked a request for a shift in IMF funding into the president's proposed budget for the 2015 fiscal year, which begins October 1.
For about a year, the administration has been pushing Congress to approve a shift of some $63 billion from an IMF crisis fund to its general accounts in order to maintain Washington's influence at the global lender, and to make good on an international commitment made in 2010.
For what it's worth, Congress summarily rejected the attempt by the Obama administration to move forward and honor our commitment on this matter. Here is another excerpt from a Reuters article -U.S. aid bill for Ukraine will not include IMF funding - that explains that Congress once again refused to fund the 2010 commitment:
(Reuters) - A financial aid package for Ukraine that the U.S. House of Representatives plans to vote on soon will not include funding for the International Monetary Fund, a senior House Republican aide said on Wednesday.
For a year now, the Obama administration has been pushing Congress to approve a shift of some $63 billion from an IMF crisis fund to its general accounts to make good on an international commitment made in 2010.
U.S. failure to approve the funding has held up reforms to the global lender that would double its resources and give more say to emerging markets.
China/Russia taking measured steps to apply pressure
Understand that China and Russia - from their perspective - are fully justified in their displeasure with the United States' refusal to even honor a very modest commitment made almost 4 years ago regarding a $63-billion contribution. They are also justified in their displeasure with the Fed's QE policy that did almost nothing to produce real economic growth, and in fact, has produced yet another equity bubble.
Now the US feigns outrage at Russia's move into Crimea, calling it an egregious breach of international law. Keep in mind, this is the same United States that has demonstrated much more aggressive moves to overthrow regimes in the Middle East to protect their own interests, and has in fact, demonstrated much more aggressive behavior for decades.
The point seems clear enough. Russia's move into Crimea - purportedly to protect their own interests in the region - are certainly no more egregious than numerous similar moves made by the United States. As a US citizen, one can take a blind loyalty stance if he chooses and assume that the US is without fault and Russia is demonstrating a complete lack of regard for international law, but to do so would seem to demonstrate a level of unprecedented hypocrisy, and anyone with the capacity for objective reasoning would have to arrive at a similar conclusion.
That said, I still think the matter is just another measured step to persuade the US to sign on with the rest of the world on a new system of global trade that will address a number of very valid deficiencies that exist in the current system. Keep in mind, the China/Russia contingent is in a position to fully destabilize the dollar and produce another market crash of major proportion if they desire.
The problem, of course, is that their own economies will suffer if they make the decision to do more than take measured steps to demonstrate that they, in fact, do have the capability to force the issue. Notwithstanding the risk to their own economies, they seem resolved to move forward in a measured way to effect the changes they desire, and make no mistake - it is producing a destabilizing effect for them on the domestic front.
What steps have been taken to date? Well, back in early 2013, China moved to enter into bilateral trade agreements that bypassed the US dollar. To date, 23 countries have signed on with China, and those countries - by some estimates - represent roughly 60% of global GDP. What is important in this context is that China is no longer holding US dollars or US Treasuries to the same degree they have in the past.
The sale of US Treasuries started in early 2013, as Reuters reported in August of 2013 - China, Japan lead record outflow from Treasuries in June:
(Reuters) - China and Japan led an exodus from U.S. Treasuries in June after the first signals the U.S. central bank was preparing to wind back its stimulus, with data showing they accounted for almost all of a record $40.8 billion of net foreign selling of Treasuries.
The sales were part of $66.9 billion of net sales by foreigners of long-term U.S. securities in June, a fifth straight month of outflows and the largest since August 2007, U.S. Treasury Department data showed on Thursday.
And more recently - as reported by Bloomberg here:
China, the largest foreign creditor, reduced its Treasury holdings to $1.2758 trillion, and Japan trimmed its holdings for a third straight month to $1.0834 trillion. Combined, they accounted for about $40 billion in net Treasury outflows.
China, the largest foreign U.S. creditor, reduced holdings of U.S. Treasury debt in December by the most in two years as the Federal Reserve announced plans to slow asset purchases.
The nation pared its position in U.S. government bonds by $47.8 billion, or 3.6 percent, to $1.27 trillion, the largest decline since December 2011, according to U.S. Treasury Department data released yesterday.
Is the US playing into their hands?
To date, Russia hasn't fired a shot. In fact, they have defended their move with at least some degree of logic. Their response has been measured and tempered for the most part, and at least marginally conciliatory, while at the same time articulating what they could do if they wanted. Consider these comments from The Voice of Russia article - Russia vows to switch to other currencies over US sanctions threat - Glazyev:
Russia can dodge any proposed US sanctions by switching to other currencies and creating its own payment system, Putin's economic advisor Sergei Glazyev said Tuesday. A senior Kremlin official has denounced Glazyev's remark on US-Russia economic ties, calling them "a personal opinion" inconsistent with the Kremlin stance.
For those who don't understand - The Voice of Russia is the Russian government's international radio broadcasting service. I find the senior Kremlin official's denouncement of Glazyev's comments just a little disingenuous. After all, the remarks were made public through the Kremlin-controlled media outlet.
A more logical conclusion is that the Kremlin engaged in the good cop/bad cop game, where Glazyev explains what they might do - the bad cop version - and the Kremlin explains that they really have no such intentions - the good cop version. What matters is that we are made aware of what could happen at the extreme, while the Kremlin pretends to remain conciliatory.
As a point of interest, the title to The Voice of Russia article seems apt and consistent with the arguments set forth herein regarding the China/Russia position of moving away from the US dollar. For one who is willing to listen and connect the dots, it tends to reinforce my view that this is about one thing and one thing only - moving to a new world reserve currency system.
Back to the point - is US playing right into the hands of Russia and China? Consider that Obama seems to have set the stage for retaliatory actions by both Russia and China, as reported by Reuters here - UPDATE 4-Obama warns on Crimea, orders sanctions over Russian moves in Ukraine:
(Reuters) - President Barack Obama on Thursday ordered sanctions on people responsible for Moscow's military intervention in Ukraine's Crimea Peninsula, including travel bans and freezing of their U.S. assets, and said a referendum by the region to join Russia would violate international law.
Consider these comments in a CNN article - Why Western sanctions against Russia could inflame Ukraine crisis:
First, even if economic sanctions were an effective form of leverage, Russia can squeeze us almost effectively as we can squeeze them. Sergei Glazyev, a Kremlin economist, simply threatened to not repay debt to U.S. bankers in response to American-imposed sanctions. Between great powers, leverage is a two-way street.
How can Russia squeeze the US? Consider these comments by Robert Gates - Obama must carefully calibrate Russia response, rhetoric: Gates:
Russia is the EU's most important trading partner after the United States and China, with 123 billion euros ($170 billion) of goods exported there in 2012. It is also the EU's most important single supplier of energy products, accounting for more than a quarter of all EU consumption of oil and gas.
And for what it's worth, don't forget China - Russia's key ally in the efforts to promote their joint agenda. China, for their part, is already doing what they can to cause pain to the US, and they seem more than willing to suffer short-term pain on the home front for long-term gain. For instance, China's massive trade deficit print in February, as reported by Zero Hedge here:
Plenty of excuses out there for this evening's colossal miss in Chinese exports (-18.1% YoY vs an expectation of a 7.5% rise) mainly based on timing issues over the Lunar New Year (but didn't the 45 economists who forecast this data know the dates before they forecast?) This is a 6-sigma miss and plunges China's trade balance to its biggest miss on record and 2nd largest deficit on record. Combining Jan and Feb data (i.e. smoothing over the holiday), exports are still down 1.6% YoY - not good for the much-heralded global recovery. Exports to the rest of the BRICs were all down over 20% but no there is no contagion from an emerging market crisis.
It seems entirely reasonable to assume that Obama has, in fact, set the stage for retaliation by Russia. The executive order has been signed, so the next question - will Obama actually act on it and impose sanctions? It seems hard to think Obama would make the mistake of drawing another line in the sand and then backing away from it, as he did with Syria.
If he does move forward, make no mistake on this point - Russia will take measured steps to do just as they indicated they would do. Here is how Michael Snyder sees it, and I agree:
The U.S. government and the Russian government have both been forced into positions where neither one of them can afford to back down. If Barack Obama backs down, he will be greatly criticized for being "weak" and for having been beaten by Vladimir Putin once again. If Putin backs down, he will be greatly criticized for being "weak" and for abandoning the Russians that live in Crimea. In essence, Obama and Putin find themselves trapped in a macho game of "chicken" and critics on both sides stand ready to pounce on the one who backs down. But this is not just an innocent game of "chicken" from a fifties movie. This is the real deal, and if nobody backs down the entire world will pay the price.
Assuming you buy my argument that the real war has to do with moving to a new global system of trade and displacing the US dollar, the next question is - who wins the war? If the winner is the China/Russia contingent, then make no mistake on this point - gold moves dramatically higher. First, a look at the following table, courtesy of the World Bank reflecting total foreign exchange reserves, including gold holdings expressed in US dollars. The table below is a partial listing and reflects selected countries, but the full table can be found here:
Total reserves (includes gold, current US$)
Total reserves comprise holdings of monetary gold, special drawing rights, reserves of IMF members held by the IMF, and holdings of foreign exchange under the control of monetary authorities. The gold component of these reserves is valued at year-end (December 31) London prices. Data are in current U.S. dollars.
The sheer magnitude of total foreign exchange reserves China holds relative to other countries suggests China is in a position to dictate terms, should they choose to do so. To be honest, I double-checked the China numbers, as I was astonished that their reserve holdings were greater than all the others on the list above combined. More important to the point is the portion of those reserves held in gold. As RJ Wilcox notes in a November, 2013 article, China has been a major accumulator of gold, but they remain very opaque in terms of revealing their true position:
The last time that the PBOC announced the amount of its official gold reserves was in April 2009. At that time it stated that their holdings had increased from 600 tonnes (announced in 2003) to 1,054 tonnes. Essentially, China had doubled its official gold reserves in 6 years without letting on.
One straightforward reason as to why they do not report their gold buying activities is because they do not want to tip their hat and cause the price to rise dramatically. The PBOC also has to be careful about creating too much volatility in currency markets.
However, China has a pattern in recent times of announcing their gold holdings every 5 to 6 years and thus the date for the anticipated next announcement is fast approaching.
According to James Rickards, author of the superb book Currency Wars, in April of 2014 China will shock the world and announce that they have accumulated 5,000 tonnes of gold. This would give them the 2nd largest official gold reserve in the world, second only to the U.S. with a reported 8,133 tonnes.
They are accumulating gold as a foreign exchange asset as one aspect of a broader plan to elevate their currency in international stature commensurate with the size and importance of their economy, the 2nd largest in the world, again second only to the U.S.
Just looking at the foreign exchange reserves number in the World Bank table above, one notes that if the total reserves held by China are roughly $3.4 trillion and the US Treasuries portion is roughly $1.7 trillion, a substantial portion of the remaining reserves would be gold holdings.
As I have stated, China and Russia seem content to suffer short-term pain for long-term gain, and indeed, they have suffered some short-term pain recently. For example, the Russian ruble's collapse and the recent print on China's trade balance numbers. That said, if the goal is to dethrone the dollar, it is hard to conclude that over the longer term, they won't both see their positions substantially improved. The RJ Wilcox article referenced above makes the following points regarding Russia's situation relative to gold:
In our recent article "From Russia with Gold", we detailed that Russia has the 2nd largest unmined gold reserves in the world. Its gold production since 2008 has risen dramatically and remains on the rise. And the Russian central bank has been steadily increasing its official gold reserves since the 1st quarter of 2007, in the lead-up to the Global Financial Crisis (GFC).
In addition, last week our esteemed managing editor and chief analyst penned an excellent essay entitled "Hiding in the Gold Demand Shadows", which demonstrated the fact that central bankers worldwide (i.e. in emerging and developed countries) fully recognize the importance of gold.
Certain emerging market central banks, in particular the BRIC nations, have been net buyers of gold since the GFC. In addition to the BRIC's, Turkey is also on track for a record year of gold imports at an estimated 270 tonnes.
The bottom line here is that gold has dramatic upside potential, and in particular, if measured steps to undermine the dollar continue. I think it is reasonable to conclude that the US fiscal and monetary policy missteps will - at some point - be revealed as major blunders.
As I have written on numerous occasions, the current trajectory of debt to GDP ratios, driven ever higher by the flawed policy of massive fiscal stimulus will - at some point - require a massive revaluation and monetization of sovereign debts globally. There is simply no precedent to where we are today on a global scale, and the truth is apparent for those who are willing to look at the matter with objectivity, and that truth is that we are on an unsustainable path.
At the present the US stock market is being held aloft for no other reason than the fact that it refuses to sell off. That makes some sense, I suppose, in that markets can ignore real economic data for a long time. My own view of what has kept the bull market alive has more to do with the carry trade than anything else. The carry trade is a highly leveraged play using cheap money - borrowed money - to buy risk assets that yield more than the cost of the borrowed money.
It is reasonable to assume that stocks won't sell off dramatically as long as the metrics of the carry trade remain positive. One of the greatest risks to the carry trade is the USD/YEN relationship. There are 3 ways the carry trade can come unhinged. The first, those lending short term begin to see the dangers and adjust short-term rates higher or - in the worst case - simply refuse to lend. If the latter situation were to occur, those holding carry trades have no choice but to sell assets.
The second way the trade can come unhinged is if the assets themselves begin to fall in value. That scenario seems the less likely of the three in that the upside momentum has been a function of readily available cheap money, and as long as that short-term money remains available and remains cheap, those playing the carry trade will continue to do so and effectively keep a floor under the markets.
The 3rd way that the stock market can come unhinged is a sudden recognition that there is very little economic support for higher stock prices, and those who engage in the carry trade make the decision to exit the trade based on ever-increasing perceived risk. This scenario could start as a pragmatic decision and would be a voluntary move to reduce risk, but it would quickly move to an involuntary action that would be dictated by lack of cheap money or falling asset prices.
What is most disconcerting about the whole structure of the market today is that it is built on the back of highly leveraged trades, meaning that when markets do begin to sell off for any of the 3 reasons cited above, the selling will be involuntary and produce a virtual vacuum under the market. In other words, it won't be a slow descent and, the magnitude of the sell-off will be much more dramatic than most envision.
Why the Fed is tapering
Perhaps one of the most inexplicable reactions to the Fed's decision to begin tapering back on asset purchases is the idea that this decision means the Fed is confident the markets and the economy can survive without life support. I find almost no metric that suggests this is the real reason for why the Fed has elected to end QE.
What I do know is that the US dollar is under immense pressure, largely as a result of the decision by China and others to bypass the dollar. What that means is that dollars are not being held as foreign exchange reserves to the degree they were prior to the decision to bypass the US dollar in foreign exchange transactions.
For the Fed to continue to flood the system with dollars at the same time dollars are being dumped into the market by China and others creates significant supply/demand imbalances, resulting in downward pressure on the US dollar. The truth is the Fed must withdraw QE, and I would not be at all surprised if the Fed isn't engaging in reverse repos right now to sterilize the QE purchases and withdraw as much liquidity through the reverse repos as they are injecting through QE.
Lest you doubt the impact of these actions by China on the dollar, a look at the US dollar index should convince you:
The chart above is one of the most relevant charts investors can monitor at the moment. Why - because that is where the battle is being fought by the Fed and its contingent on the one side, and the China/Russia contingent on the other.
Equally important is this chart of the USD/YEN:
(click to enlarge)
The red lines show the levels of the dollar index and the yen that seem to be levels that move central banks to step in and aggressively defend the dollar. So far, so good in that they have managed to keep a floor under the dollar, and in so doing, keep the yen from climbing and therefore protecting the carry trade.
What happens, though, if Obama actually imposes sanctions on Russia, and Russia retaliates, as has been suggested they might. One wonders just how much pain the global economy can stand. Consider what Russia's options are:
- Fully abandon the US dollar in foreign trade
- Sell US Treasuries
- Default on obligations to US banks
- Freeze natural gas movements to Europe
Keep in mind, we don't exist in isolation in that economic upheaval in any economy will impact all economies. At the moment, the Fed is literally between a rock and a hard place in that withdrawing liquidity from the system in an effort to defend the dollar has detrimental effects on economies such as the Fragile 5. Consider these comments from a January 30 article - Worst is yet to come for Fragile Five:
Last year was painful for emerging markets and 2014 is shaping up to be even worse.
Among the hardest hit are Brazil, India, Indonesia, Turkey, and South Africa -- dubbed the 'Fragile Five' by Morgan Stanley last August.
Those countries have seen their currencies tumble 15% to 20% over the past year. And that plunge has continued this month, despite a series of aggressive and, in some cases, unexpected interest rate rises aimed at stopping the rot. So after years of rapid expansion, and relative calm, what's going wrong?
For one, economic growth has slowed. As a group, emerging and developing economies grew on average by 6.4% over the past decade. Last year, that number was 4.5% and it's forecast to rise only modestly in 2014.
And signs of instability in China's huge shadow banking system have raised fears of a credit crunch that would make it hard for Beijing to deliver its 7.5% growth target. The first decline in factory activity in six months has only made matters worse.
Cheap money is also drying up. The Federal Reserve said Wednesday that it would continue pulling back on its stimulus, to the tune of $10 billion.
Summing it up
I am not sure it matters a lot what Russia does going forward, as the fragility of the global economy is such that I am not sure any Russian actions in response to Obama's executive order to impose sanctions really matters. That said, if the US does act and Russia responds as it has been suggested they will, then it could be all the catalyst needed to induce carry trade investors to move to risk-off.
I have consistently sounded warnings on the high risk of equity markets over the course of the last 12 months, and even gone so far as to call a high twice. As we all know, attempting to call a high is a dangerous pursuit in that to do so with any degree of timing accuracy is indeed one of the most difficult things for a market analyst to do.
That said, I guess I am going to go out on a limb one more time and state that I think we have seen the highs in equities (NYSEARCA:SPY) for 2014 and the lows in gold (NYSEARCA:GLD). Furthermore, I think we will see significant upside in gold in 2014 and a very significant sell-off in equities.
The bond market (NYSEARCA:TLT) is a little more tricky. In one sense, it seems a little counter-intuitive to think that US Treasuries would move significantly higher when the Fed is moving out of the buy side of the market and China and others are beginning to be net sellers of US Treasuries. Notwithstanding that fact, it seems a real possibility that US Treasuries could get a safe haven bid in a sharp sell-off in equities.
My own view is that wouldn't make a lot of sense in the long term, but it does make the bond market a little tricky to call in the short term. My guess is that we do see a safe haven bid on bonds if we break below the 79.00 level on the dollar index or the 101.00 level on the USD/YEN, as I think those are key support levels that are keeping the carry trade in play.
In conclusion, I think the Fed, the BOJ and the ECB are in a pickle, and no matter what they do going forward, it will be wrong. I do think they will do all they can to protect the dollar against downside risk and to keep a lid on the yen. As long as they succeed in this strategy, it is reasonable to assume that equities will hover in a narrow range close to the tops. Make no mistake, though - the China/Russia-led contingent is on the other side of the battle lines, and they are indeed a formidable adversary.
Additional disclosure: I am also long puts in PCLN, FB, NFLX and AMZN.