Emerging Markets (EMs) are highly fragile. This is due to the fact that usually when there’s a recession, capital flees, the currency melts, inflation increases and interest rates explode, choking businesses, and making the situation far worse than it would otherwise be (View Highlight)
To fight this, the local Central Bank often aggressively raises rates, which defends the currency and reduces inflation, but often makes the economic situation even worse. (View Highlight)
You may ask why it is that interest rates climb during an EM crisis. It comes down to the fact that during a recession, the government’s fiscal situation worsens, deficits expand and frequently the government will resort to money printing to fill the gap, leading to accelerating inflation and a weakening currency. (View Highlight)
On the other hand, Developed Markets (DMs) have this unique privilege where during a recession, capital returns home and seeks out the perceived safety of government bonds. (View Highlight)
Sure, DMs have widening deficits and excessive money printing, but the flow of inbound capital tends to overwhelm that, and the bond market rallies anyway (View Highlight)
During a market crash, many traders not only offset the decline in equity markets, but frequently make stupendous sums by leveraging their long positions in bonds. This Pavlovian response is now so well engrained, that in my opinion, duration is currently the most over-owned asset class amongst aggressive funds. (View Highlight)
What if investors wonder about rule of law after we nationalized Russian yachts, cut off SWIFT and froze various assets of private citizens?? I don’t care if you hate Trump or not, the US had a long tradition of leaving past Presidents alone. Arresting your political opponents on dubious charges is almost emblematic of becoming an EM (View Highlight)
Finally, what if investors now have other options, liquid options that can absorb capital and provide safety?? What if during the next time down, the US bond market rolls over, and acts more like Turkey’s bond market, instead of the US of old?? What is the financial outcome that would destroy the most speculators??? Probably this outcome. (View Highlight)
Sure, the Fed will probably try yield curve control—they’ll utilize “Operation Twist.” However, I think this just accentuates the money printing and accelerates the inflation that’s leaning down on the bond market. Markets can be manipulated, but they yearn to be free. Zimbabwe couldn’t hold their bond market inline forever. Neither can we—markets are bigger than governments. (View Highlight)