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posted on 12 February 2016

Why Negative Rates Won't Rescue U.S. Markets And More Reader Questions

by Shah Gilani, Money Morning

Special Report from Wall Street Insights and Indictments

Over the last few weeks, we've talked a lot about where the markets have been, how they've broken down on news of China's slowing growth, struggling U.S. equity markets, central bank madness in Europe and Japan, and crashing commodity prices...

Which begs the question: "Where do we go from here?" Everyone wants to know what happens next - will the markets continue to struggle under the weight of these problems, or will they shake it off and rally back near all-time highs?

Fortunately, you all have been paying attention, and have hit me with some excellent, well-informed questions that speak to this very issue.

Let's get down to business.

Q: Will the Federal Reserve ever take interest rates negative? If they do will that be a "risk-on" opportunity like it has been every time they did QE? ~ Patrick

A: The Fed could push short-term interest rates (Fed Funds) into negative territory, but it wouldn't be a "risk-on" opportunity for investors to buy stocks.

Here's why...

First of all, if the Fed thought it was necessary to drive rates negative, either they believe the economy is surely heading towards recession, would have fallen into a recession, or the stock market had crashed, which could happen on its own, or result from a steep contraction of GDP. There's no way the Fed taking rates negative under those circumstances is a risk-on opportunity.

Investors are watching other central bankers drive rates negative in Europe and Japan and it's not working. The ECB drove rates negative a while ago and, most importantly, European bank stocks have been absolutely smashed.

Lest we forget, central banks don't exist for the benefit of economies, they exist to further the interests and profitability of the big banks they serve.

So, the banks getting hit on the heels of negative rates is a real problem for the ECB. The real truth is the ECB is doing what it's doing to help "liquify" struggling banks. That's really scary. A big bank failure in Europe could be one of the Black Swans that foreshadows a global panic, a la 2008. Negative rates have done nothing to spur any meaningful or even demonstrable economic growth in Europe.

Adding insult to injury, stock markets across Europe are slipping as investors see all this and don't believe a negative rate strategy is working or going to work. Sure, the ECB could go for broke and accelerate its failed policies in a mad, last ditch, throw-the-kitchen-sink-at-the-fire approach. But that would be out of pure desperation.

Japan presents another lesson. They just pushed rates negative and, lo and behold, instead of knocking the yen down (to spur exports), the yen has risen. It's crazy out there, and investors are quickly coming to the conclusion that what central bankers are doing isn't working.

As far as the Fed, they're sitting on a $4 trillion balance sheet. They don't have any capital to leverage, they're actually leveraged against thin air. The Fed pushing rates into negative territory could add another trillion dollars or more to their balance sheet. That's not going to go down unnoticed. There's an election coming up, and if any of the candidates turns on the Fed, and tells the truth, that they've failed the economy, crushed savers and the middle class, bailed out Wall Street when it sank America, then aided and abetted the wealthy asset-owning class by pumping up markets... well, there might be a "Kill the Fed" movement. That would be scary at first, and hardly a "risk-on" opportunity.

But if we got rid of the Fed, "after the flood" the economy would adjust, start growing again and we'd get a "risk-on" light so bright the streets would once again look like they were paved with gold.

Q: So where do we go from here? Do you feel the dollar is going to continue to get stronger and if so which currency put options are ripe to purchase? ~ Warren

A: Where we go from here may not be up to us. If the rest of the world were muddling along, I'd say we're going to muddle along too, and do better than everybody else.

But we're not alone - we're all tied together now.

China faltering will hurt global economic growth. China imploding will cause a global panic and possibly a worldwide depression. If China muddles along, we're all okay, for now. Europe could sink and take everyone down with it. Their banks are flashing a warning signal, and it's not yellow, it's red. Japan is going into another lost decade. It's been something of an island whose flu hasn't affected the world yet. But that too could change. Emerging markets are teetering and that's weighing on all of us.

And of course the fall in oil - with its implications for bankruptcies and producing nation-state turbulence - is a huge problem we all face. All of these problems are being addressed the same way, everyone is trying to sell (export) more to generate more revenue. And that spells currency wars.

The U.S. dollar has slipped lately, but that's temporary. The dollar may not rise on its own, but other falling currencies will, by default, strengthen the dollar relatively. The euro has been rising. That's not going over well with Europeans, who aren't so flush they like the idea of traveling and buying more with their currency. They'd rather amp up their exports with a cheaper currency to get growth, create jobs and increase wages.

So, though it's been a tough trade that hasn't worked yet, I'm shorting the euro against the dollar. I'm shorting the yuan big time, because China will either have to devalue the yuan (for the sake of its exports, jobs, and civil stability), or the market will do it for them. Either way, the yuan is due for a minimum 10% drop against the dollar, but it could easily fall 20%.

All emerging markets currencies are vulnerable - I'd short all of them. And while I'm at it, the ruble has more room to go on the downside and so does the Aussie dollar. Of course, the U.S. will be the port in the storm in any global panic. The flight to safety here will cause money to exit other countries, which means they will have to sell their currencies to buy dollars to invest in the U.S.

There are lots of ETFs (like EUO) you can get into to make these plays, but many of the currency ETFs have thin volume and even thinner options volume. Just make sure you can get out of the options you buy, or sell calls, or for safety call spreads, to collect premium.

Q: Which sectors have a chance to hold or excel in these markets? ~ Juan

A: As long as the markets are wobbly, I'm mostly on the sidelines as far as my "investments." As a trader, I'm short a lot of stuff in markets like these.

As far as what to hold, there aren't going to be any sectors that shine if we're wobbly or head further south. What I do is nibble on beaten-up stocks of companies that aren't going anywhere and pay nice, fat dividends - stocks that I want to own because of their yield and their dominance in their "space" or industry. If I'm trying to bottom-fish in hopes that the next bounce will turn into a good rally, I like to use tight stops. Or if I'm in love with a stock's yield and don't mind buying more at lower levels, I'll play that way. But as far as any sectors excelling, I'm not seeing any group that makes sense to pile into.

Q: How much lower do you believe it will go? ~ Gerald

A: We're getting oversold again, so we're probably going to try and rally. But we could still go lower, maybe a lot lower. 16,500 is the upside number on the Dow. We could get there. What happens if we get there will be about when we get there as well as how we get there (really good news or short-covering and bottom-fishing?).

On the downside, we probably will re-test the lows around 15,400. That could happen any day. From there, the next support is 15,000. If we can't hold there, we're going to 13,000 and maybe quickly.

Let's hope not.

Q: So what do you suggest [for] defensive positional advice? ~ Malcolm

A: Stay light on your long positions.

I'm not worried about missing a rally. So what if we rally? Even if we rally 13% or so back to the highs, and I miss that 13% move, I don't care. Trying to pick up 13% is not worth that risk.

If conditions change and we can rally (by "we" I mean global markets), great. I'll start getting long big dividend payers and former high-fliers that have been beaten up the most, but are still great companies.

Otherwise, I'm so defensive here I'm offensively buying puts, shorting stocks, very comfortable and making great calls and money.

If you're going to play the downside, play big themes. China faltering is a big theme. Currencies coming under pressure is a big theme. Commodity exporters and commodity-exporting countries who have to lower their currencies to sell more into a weak global market are big themes. I generally prefer big theme trades to individual "I hate that stock" kind of plays.

But when I have good reasons to single out a company I think is going down, I will hit it. Take a look at European banks, they're in trouble and have been hit hard already. But there may be more to go there. Just use tight stops on your bank plays, on commodity plays, and the like, because so many of these plays are getting crowded that any ray of optimism, or a group of "players" trying to force shorts to cover could cause some quick, big pops.

Be careful out there.

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