Exuberant markets see strong rebound
Sticking to market related news, global equities saw one of their best rallies in a long time on Thursday and Friday. European markets up over 3%, Dubai's stock exchange up a massive 13%, US stocks were up over 2% (the biggest two day rally since December 2011). North Sea Brent oil rallied from $58.16 on 16 December to $63.32 on 18 December, an 8.8% low to high swing in 2 days. Pretty impressive. The VIX index (or fear index) on American equities fell from over 25 on Thursday to today's lows of 15.47, a 41.4% decline on implied volatility as US stocks staged their largest 2 day gain in more than 2 years, even surpassing the up thrust from the lows of September which itself was bonkers.
The chart below will give readers an idea on the extent of the sell off we have seen, and the rebound since the latest and last FOMC meeting of 2014. For why it was a crucial meeting, please read my post following up to last Wednesday's meeting. The chart below depicts how global markets have performed over the last half of 2014. Pretty stellar moves.
Collectively, global markets have seen their inflection points at or slightly after 16 December when the CBR introduced FX controls and its 7 drastic measures to reign in on the wildly careening ruble and collapsing asset prices. Immediately after the CBR's draconian measures, it was time for the proverbial FOMC to write another set of put options underneath risk assets, and sure enough markets were catapulted much higher following the 17 December FOMC event.
Market participants understand that there was nothing materially different in the last week's statement other than a slight alteration in language. However, whatever prompted the take off in risk still leaves many scratching their heads. Whatever prompted the rotation out of safety and into risk must have been pretty significant that it occurred in a global level. One thing I've learned after more than half a decade in the markets, is that one should never every doubt the ability the convening powers of the world hold. The extreme measures taken by the CBR, and the favorable jawboning by the Fed was a very current example of convening power.
For us to understand the reasons for the abruptness and strength of this rally, we first need to know what caused the sell of in the first place. A lot of forces get intertwined in the maelstrom of a crisis that it becomes blurry. Everyone rushes to the exits, and the market turns hard leaving many half naked in the dust.
What broke the markets?
Without going down this rabbit hole, I think the following linkage might be able to explain the rout we saw:
- Declining oil prices were initially seen as a side effect of weakening global growth, no one really thought much about it until the decline became more protracted and significant than normal;
- When the OPEC summit failed to yield any supply cut from the Middle East, traders and money managers started to panic - the market had then priced in a slight production cut by OPEC;
- As oil continued to decline, now accelerating in velocity, concerns started spreading - concerns about lower oil prices and more importantly the shift in OPEC's strategy to counter the rise of small and medium shale oil producers in America;
- At this moment, markets are already crashing in the Middle East - markets there are more tied up to oil prices and hence national revenues from energy exports than anything else, hence Middle-Eastern markets were very highly geared to oil prices;
- As oil continued to tank, an increasing number of smaller scale producers that leveraged on the shale revolution started to loose money for every marginal barrel of oil they produced. However, if they stopped production, this would mean the Arabs had won via their new strategy to crowd out smaller US producers using low prices - on the basis of them having a much lower per barrel breakeven price than their American competitors;
- When Brent and Texas Intermediate oil fell below $70, Russian assets and the ruble started collapsing in earnest as the new oil paradigm coupled with financial sanctions took too much of a toll;
- At the same instance, spreads of HY credit in the oil and gas sector started to explode wider as concerns of bankruptcies due to weakening top lines and consensus that oil prices would remain low for a considerable time into 2015 weighed on confidence. Energy HY credit formed more than 20% of the entire HY credit market in America, and this fact alone meant that the entire HY market started selling off hard way before equities started to even flinch;
- Russia's CBR hiked its main interest rate by 150bp to 10.5%. This has little to no positive effect on the ruble's performance. USDRUB and the Russian stock market continued on their accelerated trends;
- By now, Middle-Eastern markets were in their free fall on an entirely different league. Anything that had a sizable exposure to those markets were also brought down;
- Besides the Arabs, Russia was also on fire by the time Brent printed $67 when the next week opened for trading. Several large European banks had sizable exposures to Russian credit and equity names of large state-owned energy firms and banks (Rosneft, Gazprombank, SMP Bank et al), even a few of PIMCO's funds had roughly 21% exposure to Russia, and in the first week of November (long after Gross had departed), PIMCO saw more than $200mn in withdrawals from funds that had significant exposure to Russia. This gives a good impression of how mass liquidations occurred as things when off in a flurry;
- European corporate credit, especially financials were one of the first to be hit through the Russian transmission, this sparked selling in the broader equity markets;
- By now, when Brent was just over $65, US HY spreads had already diverged so far under where US equites were still trading. A few disappointing macro data prints later and equites started selling off, and placed catch up to where HY credit had been traversing all along;
- Up till now, more insulated markets such as those in the US, Singapore, and UK were still taking their cues from oil. Fast forward less than 36 hours and they were behaving as if they had minds of their own. By then, markets were truly a rout;
- As Brent touched $60 and Texas $55, the CBR raised rates by 650bp to 17% in an unprecedented move. For about 15 minutes this had an positive impact on the ruble (USDRUB slipped lower a couple of hundred pips), only to erase all its gains moments later. When Europe opened for trading a few hours later, there was mass selling across the board and USDRUB proceeded to test 80, all time lows against the dollar;
- Trading session after trading session only saw a sea of red as risk was either hedged or unwound entirely. By now, the rotation from risk into safety was more apparent than daylight;
- The day after the worst day in Russian markets since the 1998 LTCM-Russian default, the CBR announced that it was suspending the trading of the ruble on international FX markets. The CBR also announced 7 measures in response to the mass flight of capital. Multiple FX brokerages stopped offering their retail clients USDRUB for trading the day before;
- It was at the end of this trading day, the 16 December that global markets bottomed and found their respective inflection points. The FOMC concluded their 2-day meeting on this day and the ensuing statement seemed to propel markets magically higher;
- The rest, as they say, is history