ROB Insight is a premium commentary product offering rapid analysis of business and economic news, corporate strategy and policy, published throughout the business day. Visit the ROB Insight homepage for analysis available only to subscribers.
The ongoing global market mayhem began with positive economic news from the United States – a fact that is largely forgotten amidst the portfolio carnage. Tracing the sell-off from its starting point provides insight into the future path of asset prices – positive for the U.S. dollar but likely not good news for the Canadian stocks.
On May 22, Federal Reserve Chairman Bernanke's hinted that QE3 may be drawing to a close because the U.S. economy was showing signs that it could stand on its own without monetary help. Positive or not, the chairman's comments formed the starting gun for sellers. The U.S. bond market, concerned that the Fed would stop buying, fell sharply and the yield on the 10 year U.S. Treasury bond spiked 25 basis points in the week following Mr. Bernanke's comments.
The quick jump in yields caused a whole host of problems for equity markets. Hedge fund managers – the quick money – immediately started unwinding the yen carry trade , selling U.S. bonds and equities to repay yen-denominated margin loans.
The higher Treasury yields also dragged the price of high-yield debt – corporate and emerging markets sovereign issues – lower. High yield debt, and yield-sensitive equities, had been the favourite sector in 2012 and investors began taking profits . This intensified the downward price pressure on all yield investments, with Canadian REITs among the sectors taking a hellacious beating.
The decidedly risk off environment has catalyzed a massive repatriation of investment funds out of emerging markets (and emerging markets-sensitive investments like commodities), back to developing world assets. The flows are huge – the Brazilian central bank has had to intervene twice to prevent a collapse in the value of the real. There are also disturbing signs of an interbank liquidity shortage in China .
Where global markets – including the TSX – go from here will be determined by U.S. economic data. Remember, it was good news that kicked off all this misery.
U.S Industrial Production will be reported Friday. A stronger than expected results will likely put more upward pressure on U.S interest rates, increase the probability of a Fed "tapering" and cause more equity market volatility. The U.S. dollar will climb at the expense of emerging market currencies.
A weaker than expected industrial production result might allow global bond and currency markets to stabilize – it would imply the Fed is more likely to continue QE3. But, it's hard to see why the U.S. dollar would decline.
Stable Treasury rates are likely to see a resumption of the yen carry trade, which would boost U.S. bond and equity assets at the expense of emerging markets and commodity prices. Either way, the U.S. dollar looks like a better bet than the loonie or commodity-related stocks.
There are too many long term investment trends – China's expansion, steadily declining interest rates, Fed intervention, debt refinancing as a source of corporate profits (and share buybacks) just to name four – standing on a knife edge for investors to be increasing portfolio risk at the moment. Take some profits and wait this one out.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
The Globe is launching a Streetwise and ROB Insight newsletter, with content available exclusively to Globe Unlimited subscribers. Get the best of our exclusive insight and analysis delivered straight to your inbox in a daily e-mail curated by our editors. Sign up for it and other newsletters on our newsletters and alerts page .