Oil stable Tuesday, but PBOC credit action clobbers stocks
WASHINGTON, December 9, 2014 – Just when many of us were expecting at least a benign Tuesday trade, the Chicom central bank—(the People’s Bank of China, or PBOC)—which was thought to be loosening its grip on credit somewhat, actually went and tightened it last night without warning. To oversimplify, they largely accomplished this this by imposing stricter rules on certain kinds of derivatives transactions.
The action caught traders and many institutions off-guard. The resulting headlines immediately set in motion mass dumping by dumber-than-stone HFTs in international markets last night and early this morning. The negative action carried over to American exchanges, which got clobbered right at Tuesday’s opening bell.
Carnage report: The Dow was off well over 200 points in the 10:00 a.m. hour this morning. As we write this, circa 11:00 a.m. EST, that average is still down roughly 190 points. Things don’t look a lot better on the S&P 500 (down 20.39) or the tech-heavy NASDAQ (down 42.53) either.
The financial media is still blaming today’s continuing negative action on the huge decline in oil prices, but they’re missing the point. The Chinese move has had a gigantic ripple effect across a broad investment area, while the price of U.S. benchmark West Texas Intermediate (WTI) crude is actually up a bit this morning.
What’s likely making things worse, however, is that this move is throwing off that favorite international game of institutions, hedge funds, and big kahuna traders known as the “carry trade.” That’s something neither you nor the Maven can indulge in because we’re not rich enough to play in scale. But it’s a fun game if you can afford it.
Again, to oversimplify a bit, here’s how you do it: You simply pull a substantial amount of cash from wherever you’ve parked it, like a money market fund, trade it for borrowed cash in a different currency which boasts low current interest rate returns (like the Japanese yen), and then use this leveraged batch of cash to buy, say, bonds in another country with higher real interest rates.
Confused? Try this slightly edited example from Investopedia:
Here’s an example of a “yen carry trade”: a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let’s assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then he can stand to make a profit of 45%.
Well, when a big state-owned or state-controlled central bank like PBOC suddenly changes international currency trading by making a big move, this throws everyone’s numbers and exchange rates out of kilter and spoils the carry trade fun, usually resulting in mass dumping of…whatever. Again, we’re seriously oversimplifying here, but suffice it to say, events like this that essentially come out of the blue can be incredibly disruptive to the normal flow of things whether you approve of the action or not.
As if this weren’t bad enough, rumors are now starting to emanate from the Fed that they’re about to change their language Re;\: interest rates perhaps as soon as this Wednesday’s meeting. As we’ve mentioned before, we’re specifically talking about that soothing phrase “for a considerable period of time,” which refers to how long the Fed will keep interest rates low.
Added to the PBOC fun and the ongoing, huge downward spike in international oil prices—something that may signal the end of OPEC was we know it when the Venezuelans and Iranians are forced to get out of the Revolution Financing business, You can see why the machine hit the sell button today early and often.
What we could be facing here, perhaps just in time to torpedo this year’s nonexistent Santa Claus Rally, is the long-feared, realistic re-pricing of all asset classes should the Fed finally determine we can once again face real-world financial conditions, i.e., normal interest rates.
Who knows? At this point, much of this is pure speculation. But Wall Street has apparently decided that “all of the above” is what’s happening this morning, and down she goes. It’s treacherous, that’s for sure.
Today’s trading tips
Stay cautious, and judiciously trim anything in your portfolio that’s getting badly killed. We’re likely to encounter a short-term oversold condition after a day or two of action like this, and may experience a nice, if brief bounce. But then, it’s really hard to say where things will go after that.
We’re slowly peeling off more shares of oil stocks, regretting the losses. But it’s just too treacherous to hold very much in this sector for now. We briefly tried to hedge with the double short (inverse) S&P ETF (SDS), but that didn’t work very well for some reason. It hardly moved as the market crashed, and then actually started receding. Must be something in the way it’s constructed. But it didn’t help us and we quickly dumped it again.
REITs are holding up reasonably well, but they, too, could get clobbered if the Fed says some bad new words after their meeting.
MLPs are iffy as well, for you yield fans. We’re currently in two ETFs that contain many of them—AMLP and YMLP—and both have been getting hit, with YMLP taking far the worse beating.
We’re a little mystified at this as most MLPs are actually holding “midstream” oil and gas assets. By that term, we’re referring to MLPs whose primary business is building fuel transport pipelines a then charging rent to “upstream” players (i.e., drillers like the big oil companies) who use their pipelines to transport natgas and black gold to where the refiners are.
In other words, many if not most MLPs in the midstream sector are not actually much affected by the price of whatever fuel they’re transporting, since they charge basically the same rent. We suppose that if the price drops lead to a bit less drilling for a while that there might be a bit less raw fuel going through the pipelines. But that’s not likely to drop aggregate rents very much.
And besides, if less fuel flow inspires these midstream MLPs to slow down on “capex,” i.e., capital expenditures on new pipelines, they could keep the cash flow relatively the same anyway.
At any rate, MLPs are getting beaten anyway. We’re currently in an MLP refiner of specialty products, Calumet (CLMT), which is very volatile right now. And are also suffering with AMLP and YMLP.
However, we recently climbed into the newly consolidated Kinder Morgan (KMI)—pieces of which used to be MLPs until earlier this month when the mother ship digested them all into its Corp C entity. As a well-respected, virtually pure pipeline play, KMI seems to be holding up well in spite of occasional (and, we suspect, largely unfounded) attacks that appear in Barron’s each and every time this stock starts to take off.
We think we’ll hold onto KMI under most circumstances, as its price and yield are bound to improve (we think) once the current nonsense settles down.
Otherwise, as long as the market stays the way it is, with increasing risk and volatility, most moves, however carefully considered, are going to look and feel like shooting craps. If that’s not the way you like to invest, it’s time to stay on the sidelines.
BTW, we haven’t been printing disclaimers lately because our reports have been lacking specifics. But now, we’re getting more specific again, so remember: the Maven lets you in on what he’s doing or thinks he’s about to do. It’s up to you whether you agree or think observations here are just a pile of BS, which occasionally, they just might be, as Mr. Market is the world’s greatest ego-humbling mechanism.
What we mean is this: travel at your own risk. We’re not recommending buys or sells. We’re just thinking out loud. And right now, we’re very confused.
Have a good one. The sun will come out tomorrow. Except maybe on the East Coast.