“Too many tectonic plates are shifting at once and markets can’t cope.”
That’s the sobering introduction to a new research note from Gavin Friend, senior market strategist at the NAB in London.
“There was never any doubt that the end of the China-led commodity super cycle would be problematic for the global economy,” he adds.
But he puts the blame for the destabilising market ructions squarely at the fed of the US Federal Reserve and its move to raise rates last December.
Friend says because of that tightening, “the world will never know however just how unsettling (or not) China’s rebalancing would be on its own because its impact has been magnified many times over”.
The Fed’s decision has “indirectly set off a stream of damaging side-effects”.
In the first instance markets are grappling with a rebalancing China (a nation responsible for 30% of 2015 global GDP), the collapse of global growth drivers after 15-years of EM dominance and the first Fed hike in 9-years at a time when just about every other nation is still easing. This is before considering the collapse of inflation, the most significant shift in capital flows out of EM in 30-years and a possible Brexit. Too many tectonic plates are shifting at the same time and markets can’t cope.
He highlights that the current policy divergence between the Fed and “everyone else” has not been witnessed “for decades.”
This policy divergence, and the signalling 18 months ago that the Fed would eventually raise rates has underwritten the 25% rally in the US dollar. This, Friend says, has “been ruinous for higher inflation aspirations” of central bankers and been a large contributor to the fall in commodity prices, especially oil.
“It was the start of the Fed-inspired USD rise that tipped oil over the edge and in so doing wreaked havoc on oil producing nations, while also presiding over the collapse of capex in that sector that has caused so much damage for the energy-related sectors of global industrial production,” he argues.
Friend highlights that the breakdown in the emerging market (EM) growth model and China’s overproduction is also a key driver of the current market ructions and uncertainty about global growth.
This EM slowdown and a stronger US dollar has caused the capital flight China and other EMs are currently experiencing. Again the Fed gets a guernsey as a cuplrit.
“That significant turnaround (in capital flows) is a direct result of the aforementioned EM slowdown and the spectre of higher US yields and lower local currencies, which will punish EM corporates who have gorged themselves on $6 trillion of cheap US (and EZ) debt since 2009. EM –based investors, fearing devaluation and hungry for yield are looking abroad, exacerbating the outflows,” Friend says.
But it’s not all one-way traffic. It takes two to tango Friend says and that means the “ECB , BoJ, SNB and Riksbank’s negative yields are doing their part to fuel the global currency war and race to the bottom against the USD’.
Clearly these central bankers should have been careful what they wished for because they have created a negative feedback loop where the US dollar’s rise pressures oil prices lower which in turn forced “other central banks such as the ECB to recalibrate and extend their monetary easing”.
“That process both feeds the global currency war and poses potential problems for bond markets and investors as more bonds yield go negative,” Friend said.
Which means that the next move by the Fed, and the signalling around what they are currently thinking and perhaps how they think they might act, are crucial to the market’s outlook.
This week’s semi-annual testimony by Fed chair Janet Yellen is now a key risk point for markets.
Friend said that Yellen has a chance to calm markets, “but it’s not clear that will be sufficient given she will not want to give the impression the December hike was a policy mistake and she’ll want to argue that elements of the US economy such as the labour market remain strong.”
That sounds very much like Yellen will be walking either a tightrope or the plank.
If Yellen can’t calm nervous traders then Friend believes it will up to global policy makers at the G20 meeting of central bank governors and finance ministers, in Shanghai, February 26-27, who may have to launch a co-ordinated response.
The big question is what can they all agree on, what might they say, and will it even work.