‘Tis the season’ for a year end rally. A time for good cheer and merriment!   Watch out, the spiked Egg-nog can make you delusional. I suggest you stay sober, so you won’t have a hangover after the traditional Santa Clause rally is over. In the last four days stocks shot up 950 POINTS on news from the Fed that they would be ‘patient’ in raising interest rates. Analysts  took this to mean, that rates would not go up for a ‘considerable time’, some say 6 months or more. This eased investor anxieties that the Fed would raise rates in January( for the first time since the 2008 financial crisis). The Fed is committed to an inflationary stimulation policy, which is crucially tied to not allowing a deflationary scenario to gain momentum, as they have no way to offset a deflationary effect on the economy. As we pointed out in our page above ‘SURPRISE! DEFLATION’. THEY APPEAR TO BE FIGHTING A LOOSING BATTLE. Oil was down again today at 55,49! However, there are other things besides deflation, that investors should be concerned about.


Washington and the Fed have tried to strengthen the financial and banking system ever since it almost broke down five years ago. With the current turmoil in the emerging nations bonds and currency markets, the vulnerability of these efforts are currently being tested. With oil prices declining and with oil priced in dollars, there is a full-blown currency crisis in such countries as Russia, Brazil, Mexico and Venezuela.1) Will big banks be sturdy enough to bear the shocks? and 2) How dangerous are derivatives that banks now hold in record levels? If the stock markets worldwide starts to decline and short-term money suddenly dries up, there could be unforeseen difficulties dealing with a bond/currency crisis that has the potential to cause panic selling.

With lower oil prices, a disruption in oil producing countries economies could cause global instability and undermine the efforts of Europe and Japan to stimulate their economies. Petrobras in Brazil, Pemex in Mexico and Gazptom in Russia, sold billions of dollars of bonds to investors looking to receive high interest rates. Trouble with these State run companies, could cause worldwide investment growth to slow, leading to other corporate bond defaults. The bonds of non oil producing countries like Turkey, India and South Africa, have already suffered, as anxieties have caused selling in other emerging markets.
The problem is further multiplied by the holding of emerging market mutual bond funds and exchange traded funds, that cannot liquefy their bond portfolios as quickly as the shareholders can sell. The investors who hold these high-yielding funds have immediate liquidity. However, the managers that hold these funds in high-yielding bonds, have far less liquidity. PIMCO owns close to 50% of many foreign bonds and controls over 40% of the debt issued by the bank of China, 40% of the state bank of India and close to 30% of some Spanish banks. In some exchange traded funds like widely held BlackRock, they have 9% of its funds in government owned oil companies. These bonds cannot be sold quickly. Already this month Petrobras, 10 year bond has gone from 6% to 8% and Pemex bonds  have gone from 3.8% to 4.8%. The sell off in these bonds could quickly turn into a panic and a domino effect could occur, as managers sell more liquid bonds to meet redemption demands. This could spread to other markets including the stock market or visa versa..Anxieties are rising as Jefferies Company has reported a 73% decline in fourth-quarter revenue from its bond trading unit.

BlackRock, PIMCO and Franklin Temelton funds, among others, hold large amounts of high-yielding bonds. Since 2009, $1.7 trillion of emerging market bonds have been sold. Petrobras has $170 billion in debt, making it the most indebted company in the world. Russian companies sold some $244 billion of bonds since 2009. PIMCO’s Emerging Market Corporate Bond Fund assets soared to $1.5 billion in 2013, but now reportedly stands at only $496 million. The Russian stock market is down 50% this year and the rubble has crumbled. To some extent the panic has already started. However, its international economic implications have yet to be recognized. ‘Junk Bonds’ can very quickly become the new name for for these high-yielding bonds. Remember, markets hate the lack of liquidity!

Source: Barrons Magazine and The New York Times


Carl M. Birkelbach 12 /22/14