From Russia With Fear


What a week this was! The most important trading commodity in the world crashed and so did the currency & financial markets of the second most powerful nuclear military power in the world. Capital rushed out of Russia as if it was chased by a mad bear and its sisterly capital ran out of all emerging markets. It didn’t stop there. The contagion spread fast & furious to corporate credit & stocks of US energy companies and created a sharp sell-off in the US stock market. Then came soothing words from a wonderfully dignified silver-haired lady on Wednesday afternoon and calm was restored to Russia & Oil. Stock markets shot up as if they had struck a new gusher of money. We pity the poor souls who get their entertainment from movies and books. Is there a better game in the world to play or watch? 

1. Never ask why – Ask how

The most expensive question in the world is why? It is expensive because it is utterly useless and because of the old wisdom that when you think you have it figured out you get a bullet in the head. The real question is how this happened. How did a country that can destroy the entire world with its strategic nuclear missiles, a country with a strong determined leader, get so utterly humiliated & totter on the verge of financial ruin?

This week in the Ruble, the Russian currency, was captured in the tweet below:

  • Kirit Radia ‏@KiritRadia – Here’s how the ruble fared for the entire week. It largely recovered from the crash, but tough times expected ahead . Embedded image permalink

Now compare the graph above to the unbelievable action seen in US Treasury market on Wednesday, October 15: 

  • Toby Nangle ‏@toby_n – 10yr UST intraday yield is one for the photo collection. As whacky as those JGB yield shifts in April 2013 (?)

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The photos look similar as they should. If we had a graph of the crash of the Indian Rupee in August 2013, it would look similar. The question isn’t why the Ruble collapsed this week, why the Rupee collapsed in August 2013 or why interest rates collapsed on October 15, 2014. The question is how these very different entities collapse with similar speeds in a similar fashion.

The answer is simple. It is just like how the largest army in the world collapsed in a week at the start of World War II. The collapse and the surrender of France in just one week tells the story of how that large, powerful army was caught in a horribly wrong position, massed at its maginot line while the Germans blitzkrieged from the Ardennes and caught the French army facing the wrong way. 

In each of the three financial cases above, huge forces were positioned the wrong way and they were blitzkreiged from behind. They collapsed and ran as a poorly positioned army does. In the financial markets, there is only one way to run – find a buyer/seller at any price for what you must sell/buy. We bet that is what happened on October 15, 2014 when machines ran amuck in search of treasuries they needed to buy to cover their shorts. Traders with decades of experience said that they had never ever seen anything like that. Somebody big got wiped out that Wednesday morning.

So what happened this month to Oil? Smug self-glorifying publications like Economist wrote “the trigger for this acceleration of the crisis is mysterious“. That’s because people at the Economist are talkers not doers. The answer is obvious as David Rosenberg of Gluskin Sheff said to CNBC’s Kelly Evans this week:

  • “nobody talks about the financial demand for oil;we had the first 25% decline & before the OPEC mtg oil was sitting at $75; a lot of speculators were expecting the Saudis to do something; they didn’t; those net specs long on the NYMEX who were at 500,000 are down at 280K; there has been a large demand destruction happening on the financial side; that is the principal cause for this latest swoon in the price of oil”

Translation – Large Speculators were caught massively long in Oil; as others began selling after the OPEC meeting on November 30, losses began building for those who had not sold. So, finally, some big guys decided to cut their losses & run. When the big guys run, you get a price collapse. And a collapse looks the same whether the battleground is US Treasuries, the Indian Rupee, Oil, the Russian Ruble, or the French army on the maginot line.

Frankly, the sell-off was worse because of the impending year-end. People get paid based on their investing performance or profit-loss. No one can afford to lose their realized gains by sticking to losing positions. So the natural propensity to sell in fear got amplified this month because of fear of losing their year-end bonus. Ergo meltdown!

2. Fall in Emerging Markets 

In every collapse, the worst hit is the entity that is the most exposed. This week it was Russia. Yes, the middle eastern markets like Dubai, Abu Dhabi also collapsed. But they are not systemic and frankly few care about how hard they fall. Russia is different. It is a developed European country and global investors are large players in Russian markets. The Russian economy is essentially a one-factor model – Oil. But unlike Saudi Arabia or UAE, Russia has been a large borrower of credit from global investors in foreign currency:

  •  Alejandra Grindal ‏@AleGrindal  Dec – #Russia’s problem… foreign currency external debt @NDR_Research NDREurope   

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The epi-center of this crisis is not Russia’s government debt but debt of huge Russian energy companies like Rosneft. And a crisis in the private debt market of a country always becomes a crisis of that country’s banks. And when the health of the banking sector comes in doubt, the currency craters. This is manageable as long as domestic savings are perceived to be large enough to support the debt markets – read Japan, UAE, Saudi Arabia. But when the financial markets of a country are largely supported by global investors, you get a currency crisis – read Russia, India, Brazil, EM in general.

3. EM-Fed – the more they change, the more they stay the same 

Russia has drawn all the attention but this crisis is much broader and much more global.

  • Tracy Alloway ‏@tracyalloway – The emerging markets sell-off, in context. From Barclays:

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Isn’t this a revealing chart? Now think QE – the Quantitative Easing launched by the Bernanke-led U.S. Federal Reserve to stimulate the U.S. Economy:
  1. When did the second QE end? June 2011. What happened during the Summer of 2011 – the largest EM debt crisis as the above chart shows. 
  2. The Fed then launched its Operation Twist program with $400 billion in September 2011. They extended it in June 2012 by a smaller amount after the Spring 2012 crisis. 
  3. Then came September 2012 and the launch of QE3 or QEternity with $85 billion of injections every month for ever.
  4. In May 2013, Bernanke’s announced his intention to “taper” their monthly stimulus. The chart shows you the next EM debt crisis in July-August 2013.
  5. Come October 2014 – the taper is complete. The markets now have been weaned of monthly stimulus of $85 billion and have to look forward to the Fed raising interest rates in 2015. Presto –  another big EM Debt crisis.
Each crisis threw up a different epi-center – Greece, Peripheral Europe, India and now Russia. That should not obscure the underlying central problem. The growth in the world is dependent on the financial stimulus from the U.S. Federal Reserve – the world’s single source of risk capital. The high growth you see in growth darlings is funded by borrowed money, not domestic borrowed money but money that essentially springs from the policy orientation of the U.S. Federal Reserve. 


The Fed is not interested in helping out EM economies. That is not their mandate. Their mission is to get the U.S. economy growing at a faster pace. That is why they keep throwing financial stimulus at the problem. Money being fungible flows to the economies that are most leveraged to growth – Emerging markets. 


When U.S. growth becomes stronger relative to the world, the U.S. Dollar rises and capital flows out of leveraged emerging markets leading to a crisis in the most exposed economy at that juncture – India in August 2013 and Russia in December 2014.  


This is why the world needs to be tremble when the U.S. Dollar spikes higher. This is why we warned of the impending financial contagion on October 11, 2014.


When did this week’s crisis reach its nadir – Tuesday, October 16, the day before the Fed Chair Janet Yellen made her decision & speech. She said they were going to be “patient” and the financial markets exploded in sheer joy. How big was the move?
  • Lawrence Altman @traderxaspen Aspen, CO – I have been trading for 30 years this is the first crash up I have ever seen  amazing!!
Why the crash-up? Once again investors were caught in a wrong position. They had sold during the panic and were now sitting in cash. When the market turned, they were caught facing the wrong way. That is deadly when the end of the year is so near. People get paid based on the value of their profit-loss on December 31, 2014. So no one can afford to under-perform in December. Ergo baboom!


4. The Big Problem


This points to the real problem in today’s world – the ginormous amount of money running from market to market, from asset class to asset class, looking desperately for returns – money that has been injected by the U.S. Fed in a frantic hope to take the U.S. economy to a higher plateau.


Until the Fed succeeds, the cycle of booms & busts will become remain frequent with real damage to the economies of the world. If the Fed doesn’t succeed, then the global economy might enter an “Ice” period or a global cooling period of slower & slowing growth.


If you think that is bad, imagine what might happen if the Fed succeeds. If the U.S. economic growth gets stronger, then the Fed will raise rates, remove liquidity from financial markets leading to capital flying back into America from the rest of the world. What might happen to emerging markets then? This fear is why Governor Rajan (pronounced “Raajan”) of the Reserve Bank of India has been asking for a co-operative approach from the world’s central banks. Good thought, but that’s not how the game is played.


5. Getting back to how – Complexity Theory


What precipitates any one collapse is always a mystery and, frankly, unimportant. The straw that finally breaks a camel’s back, the snowflake that finally causes an avalanche, the final reaction that causes a nuclear meltdown – these are utterly unimportant. The key is not the size of the trigger but the state of the complex system at that time. Once a complex system reaches a critical state, any small trigger becomes enough to cause a meltdown or collapse. 


The key is to watch a complex system begin to change its state and to take preventive steps at that time. As we pointed out in October 2014, a spike in the U.S. Dollar is a major warning. The Fed saw it and expressed their concern about the rise in the Dollar. This was a 180-degree turn by the Fed and we brought it to the attention of our readers.


Those who are interested in Complexity Theory should read Chapter 10 of the book “Currency Wars” by Jim Rickards or begin with our summary of it in Avalanches, Nuclear Reactors & Financial Markets – A Complexity Theory View by James Rickards.


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