It was only a week ago traders were complaining the stock market was too correlated with the oil market. For a while there it seemed the only input you needed to trade S&Ps was the price of crude oil.
My guess is most traders are now regretting their complaints. For the past couple of days stocks have not been following crude oil, but instead traders have been glued to their screens watching the price of Deutsche Bank and the other European banks drag the whole stock market lower. Fears of financial contagion have quickly spread. Every time it seems like the selling might abate, it quickly resumes.
Take this morning for example. Deutsche Bank CEO John Cryan tried to reassure the markets Deutsche Bank had adequate liquidity. From CNBC:
Deutsche Bank co-CEO John Cryan said on Tuesday that the bank remained “absolutely rock-solid”, given its strong capital and risk position, adding he did not share the market’s concern over the adequacy of the bank’s legal provisions.
This provided a puff of wind in the sails of the bulls, and the Deutsche Bank “CoCo” bonds quickly rallied 3 handles:
But the rally was met with selling, and the price of both the Deutsche Bank “CoCo” bonds and the common equity have now sunk to new lows.
The German DAX was down 3.5% yesterday and this morning it is already down another 1.5%. This rout is quickly taking on a worrisome self fulfilling nature.
Deutsche Bank is often referred to as Germany Inc. To say it is integral to the Germany economy is an understatement.
I suspect we are close to a coordinated Central Bank response. It is one thing when Greek or Italian banks slip under the water surface as they try to tread water, but Deutsche Bank is a financial institution with global systematic risk.
Yellen and Draghi are not going to stand by and watch Deutsche Bank go under
I firmly believe the problems of the past couple of months are the direct result of Yellen’s decision to tighten. She has robbed the financial system of desperately needed US dollar liquidity. It has created a vicious feedback loop where US dollar strength causes deflationary price adjustments, which only encourages more foreign Central Banking easing, which causes even more US dollar strength, and so on. What the world needs now is US dollar liquidity, but so far, the Federal Reserve has refused to provide it.
I have watched in wonder as the FOMC members have all held the line like William Wallace, refusing to deviate from their message of even more tightening. Their steadfastness has only made the problem worse.
I had thought the Federal Reserve would only reverse course when the last of the lagging economic indicators (like employment) had rolled over. But given the market’s reaction, I don’t think the Fed can wait that long.
Although I think Yellen was prepared to sit through massive carnage in non-financial industries (note her imperviousness to the disaster in the North Dakotan and Texas economies due the collapse in oil), she will not be as patient with financial contagion. If there was one lesson Central Bankers learned from the 2008 credit crisis, it was bank runs are extremely difficult to stop once started.
This morning Germany’s Finance minister said:
“No, I have no concerns about Deutsche Bank,” Schaeuble says
As a government official, once you have to defend a financial institution in the press to maintain confidence, it is already too late. Governments (and not just Germany or the ECB) need to nip this bank run in the bud.
I suspect there is already a plan, and it will be a coordinated affair with even the Fed doing their part. The Central Bankers will strike back - the one thing they are desperately afraid of is a repeat of 2008. They will do everything in their power to prevent that outcome.
If I am wrong, and Yellen stays on her path of normalizing rates, then another financial credit crisis is almost guaranteed. The longer she refuses to acknowledge this reality, the greater the risk it reaches a point where Central Bankers are powerless to stop it.
Thanks for reading,