Who Spiked the Market?

From Greg Canavan in Albert Park:

--The Aussie market is set to follow up Friday’s massive rally with further gains today, although the action will be much more subdued. And with Christmas just a few days away, volumes will be much lower.

--Anyway, all the fireworks occurred last week. Markets were on the cusp of a meltdown, then experienced a melt-up. The ASX 200 finished up last week with a 124 point gain on Friday… the biggest rally in over 18 months.

--So what exactly is behind the melt-up on global markets? Is it the Fed, as is widely believed, or is there something else at play?

--I’ll look into that in a moment. But first keep in mind that rallies like this are usually the product of ‘short-covering’. That’s when traders who previously made bets on falling markets have to suddenly reverse those bets due to a change in circumstances. 

--Reversing bets means they have to buy back whatever asset or security they previously borrowed and sold. This adds buying power to the market and results in huge and sharp moves to the upside.

--The obvious change in circumstance last week was an appearance from the all seeing and omnipotent Fed. They shuffled some words around on a piece of paper and the market — apparently — loved it.

--While no doubt the Fed had some effect on market sentiment, it’s worth asking what else is going on. After reading Doug Nolan’s Credit Bubble Bulletin on the weekend (a bloke whose work I often quote from here at the Daily Reckoning) it seems there’s another angle to this vicious rally. Here’s how Doug saw it…

‘If forced to venture a guess, I’d say the Chinese were actively supporting the ruble and Russian debt on Wednesday and Thursday. Early Thursday from Reuters: “China is closely monitoring the slide in the Russian rouble, the foreign exchange regulator said on Thursday, as the currency of one of its major energy importers struggles to avoid a free-fall… Chinese Foreign Ministry spokesman Qin Gang, speaking at a later news conference, added that he believed Russia would overcome its problems. ‘Russia has rich resources, quite a good industrial base. We believe that Russia has the ability to overcome its temporary difficulties,’ Qin said.”

‘And early Thursday from the South China Morning Post: “Russia May Seek China Help to Deal with Crisis: Russia could fall back on its 150 billion yuam currency swap agreement with China if the rouble continues to plunge… The deal was signed by the two central banks in October, when Premier Li Keqiang visited Russia. ‘Russia badly needs liquidity support and the swap line could be an ideal too,’ said Ban of Communications chief economist Lian Ping.”

‘The South China Morning Post came later with additional articles, including “Beijing May Spend Bigger in Russia,” and “Russia’s Currency Crisis Poses Risks to Other Emerging Markets.”’

--It’s certainly been all about Russia this past week or so. The oil price collapse threatens to take down its economy…the ramifications of which are completely unknown.

--Which is probably why the market turned so nasty last week. The fall in oil prices makes many projects uneconomic, and many companies, who have issued lots of debt, vulnerable. In addition, you have sharply falling emerging market currencies (across the board, including Australia) putting a massive strain on the global financial system.

--And this is where the Fed comes into it. Ambrose Evans-Pritchard at the UK Telegraph had a different take on the Fed’s actions (or lack thereof) last week…

‘The US Federal Reserve has pulled the trigger. Emerging markets must now brace for their ordeal by fire.

‘They have collectively borrowed $5.7 trillion in US dollars, a currency they cannot print and do not control. This hard-currency debt has tripled in a decade, split between $3.1 trillion in bank loans and $2.6 trillion in bonds. It is comparable in scale and ratio-terms to any of the biggest cross-border lending sprees of the past two centuries.

‘Much of the debt was taken out at real interest rates of 1pc on the implicit assumption that the Fed would continue to flood the world with liquidity for years to come. The borrowers are "short dollars", in trading parlance. They now face the margin call from Hell as the global monetary hegemon pivots.’

--So last week, with Russia on the brink and emerging markets in general under pressure, traders tried to protect against downside risk by buying market ‘insurance’. As Doug explained, this insurance comes in the form of a derivative contract. 

--Not just one derivative contract. There are many different types of insurance you can take out. But who is the insurer… and do they have the capital reserves to pay out if you need to claim?

--Of course not. Derivatives are a largely unregulated market…unlike the actual insurance industry, which must hold reserves against the risks it insures.

--Doug explains how it works…

‘Who is on the other side of the explosion of Credit and market insurance? Computers and models. If a customer buys an option on a CDS contract – a computerized trading system will dictate how much of the underlying instrument that must be either bought or sold to “hedge” the contract written. And as market prices change, “dynamic trading” strategies will adjust trading positions accordingly. If prices move little, there will be little to do on the trading/hedging side. If prices move a lot, there will be a major trading effort involved. Big price changes ensure a trend-following bias.’

--Which is why you’re seeing big swings in both directions lately. First, concerns over Russia send the market (and the machines) into a panic. Then, when it looked like China might help Russia out, the panic reverses as bearish trades are unwound.

--In 1998, the Russian bond default sent markets into a tailspin. It brought down the highly leveraged bond fund Long Term Capital Management (LTCM). The Fed had to step in and bail them out, a liquidity injection which pretty much led to the tech bubble peaking in early 2000.

--This time around, the system is way more leveraged and susceptible to problems. That doesn’t mean Russia will default again. But it does mean there are many different areas where problems could emerge.

--As 2014 draws to a close, it’s a good reminder that the global economy and the financial system are not getting healthier. They’re getting sicker. And while policymakers continue to treat the symptoms, and not the cause, they will keep on getting worse.

Greg Canavan,
for The Daily Reckoning Australia