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'Fear gauge' hits multi-week high

Fed's upcoming rate hike tops diverse fears spooking market
Monday, September 29, 2014 - 00:00

SOMETHING returned to the stock market last week that had been missing for months: fear.

While the broad Standard & Poor's 500 was more or less flat on the week, the Chicago Board Options Exchange volatility index - known as the "fear gauge" - hit its highest levels in weeks.

The source of the fear is manifold: there's fear of slowdowns in China and the eurozone, there's fear of warfare in the Middle East and Ukraine, and there's fear of a "Death Cross" on stock charts. But the biggest bogeyman of all is the looming interest-rate hike from the Federal Reserve.

This week will feature the most critical ingredient for Fed policy - jobs data. Friday's September employment report will have to be just right, or the volatility that's gripped currency and stock markets since the Fed's policy statement 10 days ago is likely to intensify.

The main impact of Fed chairman Janet Yellen's promise to raise rates was to jolt higher the US dollar against the euro and other currencies. The Fed likely expected that reaction because the European Central Bank and Bank of Japan are ramping up their printing presses with quantitative easing programmes just as the Fed is cutting down the supply of dollars.

What few anticipated were the shockwaves that the dollar's appreciation has sent through global markets. For years, the Fed's low-rate policy had encouraged investors all over the world to borrow in dollars and invest in higher-yielding emerging markets or corporate bonds to profit on the "spread". Last week, hedge funds scrambled to close those trades, selling emerging-markets and junk bonds and anything else they could to lower exposure to foreign-exchange markets, according to one observer.

"The dollar has been the main funding currency for every risky trade," said Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund. The "big and quick and disorderly rally" of the dollar has caused a "liquidity crunch" in the risky assets favoured by hedge funds and other speculators, he said. The divergence of the Fed and other central banks' policies were supposed to "minimise the effect of tightening, but (in fact) they are exacerbating it", said Mr Di Mattia.

Another side-effect of the stronger dollar is that the exports that provide a majority of US multinationals' revenue may be undercut by competition priced in weaker currencies, said Quincy Krosby, investment strategist at Prudential Financial.

Mr Di Mattia says the dollar rally has created a lose-lose situation for stock investors. Either the Fed will continue on its current policy, and the dollar rally will continue to hurt the stock market, or the Fed will switch back to a rate-cutting stance yet again. The Fed has said it would only reverse course if economic data turned sour, and that would be just as bad for stocks, said Mr Di Mattia.

This week, economists expect September services, factory and employment surveys to hold strong, at least on the surface. Traders may drill below the surface on the jobs report in their attempts to pre-empt Fed policy.

"The consensus estimates right now actually are running at about 210,000 jobs," said Ms Krosby, of Prudential Financial. "What's crucial at this stage given the Fed's comments the tug of war between hawks and doves at the Fed is whether or not the jobs that are being created are in the category of higher wages, well-paying jobs versus … hospitality jobs" or temporary jobs.

One fear that's unfounded, says a technical analyst, is talk of an ominous shape on the chart of the Russell 2000 small-cap index. To be sure, the Russell cannot seem to maintain a rally this year. In contrast to the S&P 500, which is up more than 7.0 per cent year to date, the Russell is down almost 3.0 per cent. Nevertheless, the recent "Death Cross" on the Russell charts was likely a false alarm. "The Russell 2000 has completed a Death Cross where the faster moving 50-day moving average crosses the slower moving 200-day moving average," said Ryan Detrick, technical analyst for research firm See It Markets.

This week, strong economic data could stoke the rally in banks and the broad market. Unless the dollar spoils the party.

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