Tags: Fed | Scotland | UK | investors

The Dance Will Go On Until the Music Finally Stops

By    |   Tuesday, 16 September 2014 08:40 AM

The next seven days have the potential of becoming one of the most interesting periods of the year for a wide range of markets.

On Wednesday, the Federal Open Market Committee (FOMC) concludes its two-day monetary policy-setting meeting and will release its statement together with its economic assessments. That will be followed by a press conference given by the Fed Chair Janet Yellen.

It will be interesting to see if the Fed changes its wording of the last sentence of its minutes, which has remained unchanged for several months: "The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

I really don't know if we will see on Wednesday the beginning of the end of the Fed's era of doing all that was legally in its power to facilitate "inflationary finance," which is of course not a risk-free tool.

The day the Fed changes its wording and indicates in "clear" language its intention to normalize the target fed funds rates, it will have deep and relatively quick impacts on most of the important markets in the world.

Please keep in mind when the Fed finally will start its long way to "normalization," the U.S. monetary environment will gradually and fundamentally change from expansionary to contractionary.

Nevertheless, I still expect another Fed economic assessment that dangles the tantalizing promise of a defined policy schedule before the market without actually delivering. Besides that, I also see uncertainty in just how the rising dollar now will fit into the Fed's policy equation. It could become interesting if Yellen would be willing give her view on that during the press conference.

For long-term investors it would be good to keep in mind that once the so-called normalization process by the Fed starts, it will irrevocably dampen current optimistic market predictions.

In this context, it's interesting also to take notice of the results of the Investors Intelligence Advisors Sentiment survey, which shows the percentage of bears among advisory services stands now at 13.3 percent, which is its lowest level since 1987 and well below the 18 percent we saw in 2007. Both of the previous extremely low bearish numbers occurred in periods that were at the dawn of two very deep and substantial market setbacks.

Investors who think that the environment of low interest rates, low volatility and depressed risk spread premia signal low risk are seriously mistaken. The latter two signal higher risk taking, which occurs when investors start searching for yield while negating the fact that when you buy something that always implies it will be sold one day, and there is no such a thing like permanent liquidity in markets

For example, when we consider options on volatility and there comes that moment, and you can be sure that moment will come, when broad-based markets have to face a considerable and sustained spike in volatility, where will all those market participants who have issued options find the liquidity to fulfill the "tsunami" of their obligations.

Many investors are at risk of wholly underestimating the scale of the very recent emerging trends in the markets in what may yet prove to be a completely different backdrop to the first six months of this year.

In this context, no one should ever forget, "permanent liquidity" is in this new developing environment nothing but an illusion. Of course, the dance will go on until the music finally stops, but when it stops you'd be better off if you don't have investment instruments issued in one of the "Fragile Five" currencies — the Brazilian real, the Turkish lira, Indonesian rupiah, Indian rupee and the South African rand. Don't worry, one day some of these investment vehicles will become really interesting to invest in, but we aren't there yet. No, not by a long shot.

That said, on Thursday we'll also have the referendum on Scottish independence, which is too close to call right now. Whatever the outcome, the vote for independence from the United Kingdom will leave the United Kingdom, as well as Scotland, with serious headaches and many puzzles to resolve for quite some time to come. One thing is for sure, the many uncertainties the Scottish referendum has aroused will by no means conclude with the count on Thursday evening.

Please don't misunderstand me, I'm not saying the British pound is bound for extreme high volatility, but I think the potential risks and the British pound's history of large scale moves could surely be of value to long-term investors if the final vote is a "yes" to independence.

Since 1971 we have had three important crises in the British pound. These occurred in 1975/76, in 1992/1993 and in 2007, when the pound lost, respectively, 36 percent in 19 months, 29 percent in six months and 32 percent in four months against the dollar.

This means you shouldn't be surprised, as volatility could easily come back with a vengeance.

Yes, these days it would be a good idea to be prepared for the unexpected.

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The next seven days have the potential of becoming one of the most interesting periods of the year for a wide range of markets.
Fed, Scotland, UK, investors
Tuesday, 16 September 2014 08:40 AM
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