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As the market tumble continues in 2016, pundits point to various causes for the sell-off. Foremost among these are China and oil.
But I’m of the belief that these aren’t the main drivers behind the weakness. For example, China’s economy has been slowing from its torrid economic pace since 2010-2011. Why should money managers suddenly take notice now?
The real reason behind the recent global market meltdown is the Federal Reserve’s inept policies. Its policies have led to a U.S. dollar that is far too strong for the good of the global economy.
The Fed’s Liquidity Drain
Many think the Fed raising interest rates by a mere quarter point was meaningless. But they’re wrong.
To raise the rate and keep it there, the Fed uses reverse repos to drain liquidity from the financial system. U.S. liquidity is the lifeblood of global financial markets. The Fed drained a record $475 billion on Dec. 31. On Jan. 5, it drained another $170 billion. And it will keep doing so just to keep the federal funds rate at its target range.
That’s bad enough. But the perception of the Fed raising rates even more is worse. That is leading to the overly strong U.S. dollar. On a trade-weighted basis, the dollar soared 22% since July 2014 alone. That’s just about when the Fed began dropping hints about raising rates in 2015.
Source: Financial Times
The dollar is absolutely crushing the U.S. industrial economy and exports. The industrial sector is quickly heading into recession. Just look at what Michael Ward, the CEO of railroad company CSX Corp. (NASDAQ: CSX), said last week. Pointing to very slow rail traffic at his company, he called it a “freight recession.”
It’s not surprising then that the Dow Jones Transportation Average is already down double digits in 2016. And don’t forget that ISM manufacturing data showed a contraction for the second consecutive month. That’s the first time that happened since 2009.
Dollar Is Clobbering Emerging Markets
But it gets even worse: The Fed and the U.S. dollar are just hammering emerging economies.
The currencies of the emerging economies are being laid to waste by the U.S. dollar. Most currencies are at lower levels than prior financial crises that centered on emerging markets.
Even Mexico, a country doing well and becoming a manufacturing powerhouse, is being affected. The peso is sitting at a record low versus the dollar, at about 18.12 pesos to the dollar.
Many smaller countries not doing as well economically are being forced to devalue their currencies. Devaluation hurts domestic consumers in those countries, since it lowers their buying power.
Countries like Kazakhstan and Azerbaijan have had to devalue their currencies sharply. Others like Nigeria, Oman and Bahrain may be next to fall.
Even strong currency pegs to the U.S. dollar like the Saudi Arabian riyal and Hong Kong dollar may not hold. Both are trading at multi-year lows.
All of which is caused by capital outflows stemming from the too strong dollar. The dollar has had a double whammy effect on the emerging countries that rely on commodities. It has exacerbated the decline in commodity prices, most of which are denominated in U.S. dollars.
Finally, we have China. It is trying to pull away from having its currency pegged solely to the dollar.
Why? In order to maintain the previous peg to the very strong dollar, China was forced to pump too much liquidity into its financial system. That led to a stock market bubble. Then the bubble burst and the whole world has felt the reverberations since.
The Fed Blew It
Even though Wall Street worships at the temple of the Fed, I do not. Its inept policies have led to the current turmoil.
The Fed should have raised rates long ago, when former Chairman Ben Bernanke – who stepped down in 2014 – was still in charge. The global economy was strong then and could have absorbed a number of interest rate hikes.
But the Fed didn’t want to stop the bubbly party on Wall Street and chickened out. Now, Janet Yellen’s Fed raised rates and is draining liquidity at just the wrong time.
What will the Fed do next?
Despite Wall Street saying more rate rises are in the cards, I do not, unless the market stages a miraculous rebound.
If Wall Street enters bear market territory (a drop of 20% or more), the Fed will likely announce that it will step back from more rate rises. If that doesn’t stop the carnage, I think the Fed will do a volte-face and lower rates back to zero.
And if that doesn’t work, more quantitative easing and even negative interest rates are possible. The Fed’s actions will then solve the global financial markets’ No. 1 problem – the U.S. dollar.
If I’m right, exchange-traded funds such as the PowerShares DB US Dollar Index Bearish Fund (NYSEArca: UDN) and the WisdomTree Emerging Currency Fund (NYSEArca: CEW) will benefit.
How to Sleep Easy at Night
Is the economy keeping you up at night? Do you worry there’s another crash just around the corner? If so, you can stop worrying right now. All it takes is a few minutes.