Some markets see no hope of climbing out from Fed shadow

Ahead of the opening bell, European equities are lower by about 1% while S&P index futures are recovering from double-digit losses (down 0.5%). Investors are now starting to get a sense of why some option traders have been targeting significantly higher strike prices. Earlier in the week one trader bought 90,000 call options on the May expiration VIX future at the 23.0 strike with the underlying index reading about 12.9 at the time. By Thursday the index closed at 13.77.

Thursday’s losses were assumed to be related to fears of a slowdown in Chinese manufacturing activity while encouraging pressure to build in U.S. markets. However, fears escalated in the afternoon as emerging market currencies proved the escape vent amongst sellers.

For those of you with poor memories, while 2013 turned out to be a stellar year for U.S. equities, the climate proved unsavory for emerging markets. You can find reference back in February last year to Bernanke’s discussion over the inevitable onset of a Fed exit from bond buying, although the real heat didn’t hit until May. That made for a long summer for bond and currency traders in emerging markets. The selling across equities resulted in contagion until early September as U.S. 10-year yields shifted from a low of 1.67% to as high as 3.00% between May and September.  

While the perceived threat of rising U.S. yields resulting from a prospective tapering at the Fed sent shockwaves through emerging markets, it ultimately caused the Fed to deny the market what it had promised in September. Those markets recovered, prompted by a massive rally across leading markets and was in part fuelled by a reversal of upward pressure on bond yields in the U.S.

Now that tapering has been announced and the Fed has ratcheted down its monthly pace of purchases, emerging markets appear even more vulnerable to signs of cracks in the surface. In the meantime, U.S. yields have fallen to as low as 2.72% on Friday in response to contagion fears. As a reminder, on Dec. 18 when the FOMC took U.S. investors by surprise by announcing it would indeed slow the pace of purchases, the yield stood at 2.68%.

While we can’t argue with real selling of hard emerging market currencies and bonds as investors pull in their horns, the pressure on U.S. stocks in the midst of decent corporate earnings seems somewhat misplaced. For now though, emerging markets can’t seem to escape the shadow of the Federal Reserve.

About the Author
Andrew Wilkinson

Andrew is a seasoned trader and commentator of global financial markets. He worked for several London-based banks trading cash and derivatives before moving to the U.S. to attend graduate school. Andrew re-joins Interactive Brokers following a two-year stretch at a major Wall Street broker-dealer as their Chief Economic Strategist. His coverage of stocks, options, futures, forex and bonds regularly surfaces in global media, and over the last several years Andrew has made many TV appearances on Bloomberg, BBC, CNBC and BNN and Yahoo Finance.

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