Why The Plunge In the South African Rand Matters to You

Away from the yen, the other focus in the currency markets was on the implosion we’re seeing in emerging market currencies.  The Indian rupee hit another all-time low vs. the dollar. The Brazilian real and South African rand hit four-year lows vs. the dollar, and even strong currencies like the Mexican peso got hit yesterday.

The reason for the weakness is this:  Since the Fed went to 0% interest rates and round after round of QE, investors have moved into higher-yielding emerging-market currencies over the past few years.  Well, now with the Fed potentially “tapering” and interest rates in the U.S. rising, investors are reversing the trade, as they no longer need to take the risk of being in emerging markets, as rates are rising here at home.

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Emerging market debt has collapsed since May, and the decline is unnerving
equity investors.  This ETF needs to stabilize before we can sound an “all clear” in stocks.

Well, that’s causing the currencies of those emerging-market countries to drop as investors sell their bonds and reconvert those investments back into dollars.  Basically, “doomsayers” are saying the world’s major central banks, led by the Fed, have created a bubble in emerging-market credit, and now it’s popping.

The question I’m sure you’re asking right now is “Why the hell do I care about emerging-market credit?”  Well, you care because as these currencies and bonds plunge, it’s causing losses in the leveraged hedge funds that have put the trade on. That’s causing them to liquidate other holdings to cover the losses (like stocks and gold, for instance).

Point being, you should care for the same reason everyone should have cared when the mortgage-backed security markets started blowing up in ‘07, ‘08 and eventually led to the takedown of Bear, Lehman, etc.  I’m not saying it’s the same thing here at all—but it’s the leverage and the huge declines that are making people nervous.

So, while it’s not a disaster yet, this unwind out of emerging-market debt and currencies is having an effect on all asset classes.  It’s not anywhere near 1998-style proportions yet (the emerging market debt crisis), but it is unnerving investors, and weighing on other risk assets.  Bottom line is watch the PowerShares Emerging Markets Sovereign Debt ETF (PCY) and the iShares JPMorgan USD Emerging Bond Fund (EMB), the two emerging-market bond ETFs. Emerging-market bonds need to stabilize in order for equity markets to calm down a bit.

Bottom Line

Since the Fed “tapering” narrative began 3+ weeks ago, equity markets have basically been at the mercy of other markets (namely currencies and bonds), and that continued Tuesday.

The volatility in those markets is starting to unnerve investors, as watching major currencies and bonds gyrate around like penny stocks is a bit unsettling.

But so far, this is just part of an adjustment process that is to be expected as the market comes to terms with the prospects of higher interest rates going forward. Unless 1,600 is violated on the S&P 500, I don’t think that there’s any reason to materially reduce equity exposure at this point.

Continuing to focus on the clear trend of higher rates remains, in my opinion, a good place to slowly and methodically add exposure.  To that end, I do want to point out one ETF that rallied more than 1% yesterday and seems to be positioned to capitalize off this bond-market turmoil. The ProShares Short High Yield Bond Fund (SJB), the short junk-bond ETF, doesn’t trade with a lot of volume (90K shares yesterday) but it’s about the only way I know of for non-bond investors to get short exposure to the high-yield market, which is seeing a nasty sell-off as emerging-market debt and other high-yielding bonds get hit.

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Shorting the high yield market has served as a good hedge against equity volatility,
and should continue to do so as long as currency and emerging market bond volatility weigh on stocks.

SJB is a volatile position and not for everyone. But if you’ve got some risk capital to put somewhere, it’s worth a look, as it should continue to benefit during this “adjustment period” and might serve as a good hedge. (It basically is acting like a short position on the market.)