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Deciphering Macro: Another Novice's View

The Catalyst:

Just earlier today, the now ex-chairman of the Federal Reserve Ben Bernanke bid his farewell to the United States markets, announcing (mostly expected) continued tapering of Fed's bond buying program by another $10 billion. With that, markets retreated 100 basis points (on average) along with the continued decline in bond yields and strengthening of the U.S. Dollar against emerging market currencies...

Major U.S. indices are down over 3% year to date, while the 10-year treasury yield declined almost 12% or 35 BPS to 2.69% in January alone. Wait... wasn't the actual tapering supposed to send the interest rates skyrocketing?! Well, I have been trying to connect the dots, and maybe (just maybe) I have finally come to an explanation. At least - it makes sense to me.

Now, I'm not claiming to have "the answer" and I certainly don't hold a Ph.D in economics. But I have had my share of Finance 101 and if I didn't lost track in reasoning, the logic should be sound (... in other words - this is an invitation for the more enlightened out there to provide insight into things and assumptions in my article that do not hold ground).

The Efficient Frontier:

Remember that nice looking curve? If not here is a sample of what it looks like (taken from

efficient frontier

Ah, the wonderful risk-reward relationship... things to the left of the curve are "mythical" - situations where rewards are above the level of risk they bare, "Free Money" in a sense... To the right - conditions where reward is not worth the amount of risk, situations that no investor wants to be in. The curve itself is the ultimate allocation of funds, where amount of reward is exactly matching ones perception of justified risk.

Efficient frontier is unique for each individual investor as everyone has their own perception of risk and reward balance. Yet, once the efficient frontier is determined, the investor is "free" to move along the curve, potentially rebalancing as circumstances demand.


"So how all of that applies today?", you ask. Simple. Consider money managers that are sitting along their unique efficient frontier curve with a combination of mixed assets ranging from highly safe U.S. treasuries to highly risky emerging market equities. And here comes the Fed and says they will reduce tapering, read as "increase interest rates".

Woah... what just happened? Not much, except that suddenly one of the assets that makes up the portfolio has moved up north in the above graph - e.g. the return on that investment just increased while the risk remained the same. What do we do?! Re-balance!

So the money managers dump their emerging market investments, sell their Brazilian reals and Argentinean pesos, buy US dollars and invest them in US economy. After all, why would one want to bare higher risk for the now identical amount of return?!

The impact? As far as the currencies are concerned, USD strengthens (increased demand) while emerging market currencies weaken (oversupply of sellers). Emerging market economies begin to tumble as money is being taken out of their infrastructures. What about the interest rates? Well... those same dollars are likely invested in "soon to be" higher-yielding bonds. In other words - inflow from emerging markets replaced the reduction in Fed buying stimulus.

Why Now?

"Nope, not buying this", say you "After all, tapering has been announced mid-2013 and back then rates spiked while emerging markets boom continued. Thesis does not hold". Sure there is a lot of speculation in this assessment, but I may still be able to justify it.

Think about it as a chess game:

First move is completely U.S. internal. The efficient frontier has not yet budged - the money managers are not rebalancing. There is no certainty the yield will rise: Federal Reserve is just "considering" depending on "economic conditions" bla bla bla... But the local folks who are most sensitive - bond funds and mREITs - certainly took notice. If Fed is to reduce purchasing, demand for bonds will drop and so will the bond prices (now we are shifting the supply-demand curve and sliding to the new equilibrium). Bond fund managers start selling bonds while the prices are still high. mREITs in turn start rebalancing from longer-term to shorter-term treasuries adjusting duration of their assets and liabilities to protect their balance sheet. Of course at the expense of lower profits in the short term until the dust settles. All that creates abundance of bond sellers, prices drop and yields rise.

Then comes the second step - the actual taper. At this point the "locals" are hedged and rebalanced and they are not panic selling anymore. Yet the inflow of new funds creates demand for the already oversold bond market, reversing the bond price movement.

Net effect - the taper that was supposed to send rates higher actually taken them lower when implemented.

What About the Equity Market?

"How do you explain the decline in U.S. Equity market? Is it related?". Maybe, but maybe not. For one, investors could in fact be locking in profits. They didn't sell in December to not put the profits on the 2013 tax forms, thus "earning" another year of yield on these taxable gains. On the other hand, consider what the falling emerging currencies are implying in the earnings reports of companies that operate internationally? How many are likely to miss analyst estimates because of "unfavorable FX impact"? How many are likely to miss on guidance in the environment where they are facing revenue headwinds due to lower returns in markets they sell to? Hmmm...

The Double Whammy:

A quick step back to the efficient frontier hypothesis. While I have earlier stated the move "up north" on the graph, I actually believe that US securities have moved "north-west". The fact behind the taper which is to raise interest rates (higher reward) actually implies improving US economic conditions (lower risk). Thus the net impact is twofold - "higher reward at lower risk". More reason to sell those emerging markets and invest in the United States!

To summarize, what I believe we are seeing is just an outflow of money from emerging markets into the United States, allocated across various security classes.

The Action Plan:

"So what do you do?". Me? No idea. Quoting Keanu Reeves from the movie Speed: "You're the expert, I just work here". I shared my thoughts. I'll be glad to hear feedback and dismantling of this thesis of mine. After all, I'd prefer to not make trades on phony conclusions :)

But if true, I think this trend may continue for sometime as portfolios are rebalanced. Just keep in mind that overall real economic situation most likely has not changed. Brazil or Argentina have not gone into recession just because their currencies trade lower. And when the dust clears I think markets will rejuvenate, recognizing the overreaction. In the end, the money "migration" will stop, causing either increased interest rates in the international markets, or continued suppression of rates in the United States. If you want to be on the safe side - buy growth oriented stocks that derive majority of their revenues from within the U.S. I would think of recommending value companies as well, but there is a share of inherent risk - after all if the treasury yields return to growth, risk-premium baked into dividend stocks will send their shares lower to balance out the risk-reward. And lastly, I would reduce holdings of internationally exposed stocks as there is never certainty of how much "FX driven guidance mix" is already factored into share price.

Just remember: it is a game and it is worth playing. Increased risk drives increased reward: think of Greek bond payoffs after resolution of the first Euro Crisis iteration. But increased risk does not always pay: it certainly did not for Lehman Brothers bond holders...

At the end of the day - don't panic. If yesterday's thesis still makes sense today, ignore the panic, wait for consolidation and... double down!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.