Will FOMC's "considerable period" bite the dirt?

Outlook:

We have two events this weekend that could be market-moving Events, although right now that is not expected. First is Japan’s election, which Abe should win easily since the opposition doesn’t have any ideas (sound familiar?). But Abenomics is not exactly a roaring success, either.

Next is the European Court decision on Outright Monetary Transactions or OMT (QE), but the ruling is non-binding and Mr. Draghi may declare the ECB able to proceed with QE anyway. The next ECB meeting when we could hear about real QE is not until Jan 22, and by then we will have had over a month of other new information. This is not to say QE will take a back seat. It will always be of paramount importance. But by then the expected Greek election will be looming and yields are not likely to stay calmly down under 10%. Another Grexit crisis is not really expected but not ruled out, either. If the opposition party Syriza wins the election, it will seek a renegotiation of the troika-imposed budget limits. In the NYT, Krugman says it could “lead to a confrontation with Germany and exit from the euro.” Well, probably not, but a mess all the same. The election will likely be in Feb. And Italy could be in the same soup. Any election that throws Renzi out with the baby’s bathwater is a bad thing.

The bigger issue is whether the falling oil price (and the IEA forecast of falling demand) really does mean the whole world in falling into recession. Or, if it doesn’t mean that, whether falling oil prices will crush equity markets via the effect on earnings in some big index components, setting off a panic. You’d think more companies would benefit for falling energy prices than are adversely affected, but we have yet to see analysis of this point. Meanwhile, for US consumer product companies, foreign sales will be sluggish due to recessionary conditions, and all US companies are at risk of lower foreign earnings because of the stronger dollar and failure to hedge properly. Whatever the line of thinking, risk aversion is on the rise and demand for fixed income securities is following along. The 10-year yield hit a low of 2.11% overnight. It’s cold comfort that the Bund hit 0.64%, too.

The rise of risk aversion is seen in some predictable places—for example, the WSJ reports that money is fleeing junk-bond funds by the bucket-load. “Investors pulled nearly $1.9 billion from funds dedicated to low-rated corporate bonds in the past week, extending a retreat from risky debt amid a free fall in the price of crude oil. The outflow is the largest weekly decline since the $2.3 billion withdrawal registered in the week ended Oct. 1, and follows $859 million that flowed out the week ended Dec. 3, according to fund tracker Lipper.

“Tremors from the slide in oil prices that initially hit energy bonds are now being felt across the broader $1.3 trillion junk-bond market, investors and analysts said, causing hesitation among would-be buyers and a hurried reshuffling of bond portfolios as funds look to raise cash to meet redemptions.” The key—most of the new energy producers in the US are the issuers of high-yield paper. “The oil rout has put a dent in issuance volumes, causing a handful of energy companies to delay or cancel their borrowing plans. The issuance boom had helped a host of energy companies fund their business plans by borrowing heavily on the back of investor demand for higher yielding debt. Energy companies used the reach for yield among debt investors to line their pockets for new projects, equipment and acquisitions.” And in the end, “The drawdowns signal a growing wariness about owning risky debt, following a slide in oil prices that has left investors worried about energy’s trickle-down effect on the economy. Energy bonds constitute 14% of the U.S. high-yield bond market.”

Golly, maybe Saudi Arabia will get its wish to drive US producers out of business--through the back door.

While the dollar should benefit from the two big weekend events and ahead of next week’s FOMC, where “considerable period” is likely to bite the dirt, it’s not happening so far. Today’s data is PPI and the University of Michigan consumer sentiment index. PPI is expected down 0.1% after a 0.2% rise in Oct and core PPI up a measly 0.1% after 0.4% in Oct. And yet we mustn’t forget that the Fed is some-what hawkish against a backdrop of everyone else cutting rates or offering stimulus. At what point does the bond market relent and start pricing in that First Rate Hike? Don’t hold your breath.

So far we are wrong about the dollar rally resuming after a relatively mild, if scary, correction. It would be a travesty of good economics if the euro surpasses the last high (Dec 10) at 1.2495. In fact, we would judge the environment unstable and disorderly if that were to occur. With the market becoming thinner as year-end approaches and the big players paring extreme positions, such an outcome is not impossible. But that doesn’t mean it would make sense in any sane and reasonable interpretation of the factors.