By Alan Gula, Chief Income Analyst
The fickleness of financial markets is truly amazing at times.
Back in May, I suggested that investors were downright sanguine. I even cautioned that the markets may be too calm.
But today, things are distinctly different…
The price of crude oil has crashed. The Russian ruble is experiencing a proper currency crisis. Emerging markets are getting routed.
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The situation is reminiscent of the events leading up to the Asian currency crisis in 1997 and Russian default in 1998.
Some are even saying that a major blowup, like the one Long-Term Capital Management (LTCM) experienced in 1998, is lurking. The collapse of LTCM, a massive hedge fund, prompted a bailout organized by the Federal Reserve.
A similar blowup is certainly possible, but only because crucial warning signs that have been apparent for months were ignored…
In September, I showed the following chart:
I warned that currency market volatility was a “harbinger of doom.”
Since sharing that chart, the iShares MSCI Emerging Markets Index ETF (EEM) has declined around 15%, and the CBOE Volatility Index (VIX) has also spiked above 20 twice in the past three months.
Now, emerging market corporate bonds are really taking it on the chin. As you can see below, EM corporate credit spreads have blown out to the widest levels in over two years:
Globally, we’re starting to witness the unintended consequences of monetary policy.
Stability Breeds Instability
Quantitative easing – the Federal Reserve’s bond-buying program – did a great job suppressing volatility, boosting stock prices, and narrowing credit spreads.
For instance, it aided energy firms in issuing $550 billion in new bonds and loans since 2010.
So in actuality, the stability bred instability, a process that economist Hyman Minsky examined in his work.
The currency markets were the first to portend a phase shift in volatility and the potential for improbable or unforeseen events.
The “black swan,” a metaphor developed by Nassim Taleb, is an event that comes as a surprise, but that has massive consequences.
In Russia’s currency crisis, we’re witnessing what will be the first of many black swans.
Things may calm down a bit over the next two weeks as we celebrate the holidays. However, prepare yourself for the VIX to hit 40 in 2015, just like it did in 2010 and 2011.
Safe (and high-yield) investing,
Alan Gula, CFA
The post Echoes of Financial Crises From the Late ‘90s appeared first on Wall Street Daily.
