Pro Perspectives 6/14/22

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June 14, 2022

The Fed meets tomorrow on policy.  
 
Following Friday's hot inflation report, the market has now priced in a more aggressive 75 basis point rate hike for tomorrow.
 
That would take the effective Fed Funds rate to 1.5%.
 
The problem is, as we discussed last month, there are three supply issues that are driving inflation, that the Fed's interest rate ammunition can do nothing about.
 
1) The reset of wages at the low end of the scale.  Thanks to pandemic unemployment subsidies, the government established a new (higher) living wage.  That's being passed on to consumers through higher prices.
 
2) The global supply chain disruptions from the lockdown period have been exacerbated by war in eastern Europe and zero covid policies in China.
 
3) High energy prices, sustained by a self-inflicted supply shortage, by the design of global anti-fossil fuel policies.
 
These factors will keep a fire under prices, regardless of whether the Fed sets interest rates 50, 75 or even 100 basis points higher.
 
From this point, a more aggressive rate path will ensure a lower quality of life, more so than it will ensure lower prices. 
 
And that is being projected in this chart …
This is the spread between the 10-year and 2-year Treasury yields (the yield curve).  The yield curve is near a second inversion in three months.
 
Why does this matter?  Each of the six recessions, dating back to 1955, were preceded by a yield curve inversion.  Recession followed between 6 and 24 months.
 
Now, what we should be watching closely tomorrow is what the Fed says about quantitative tightening.  It officially started on June 1.
 
As we've discussed here in my daily notes, there's one thing we know about historical central bank exits of QE.  They don't last long, before QE is back.  
 
Why?  Things tend to break. 
 
Already, the bubble has been pricked in the latest iteration of the internet boom, including the end of the mania in crypto currencies.
 
But the real trouble, when central banks start extracting liquidity from the economy, tends to come from the interest rate market.
 
Back in the depths of the lockdown-induced financial market crisis, the Fed wasn't able to get markets under control until it tamed the corporate bond market. 
 
It did so by crossing the line — and outright buying corporate bonds (individual bonds and ETFs).   You can see how that Fed intervention/rescue looked in the biggest corporate bond ETF.  And you can see where it's trading now (back to the depths of the crisis).  

Pro Perspectives 6/13/22

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June 13, 2022

We had two key events last week that triggered a Monday market meltdown today.
 
First, the European Central Bank announced the end of QE (and the liftoff of interest rates next month).   Second, the May U.S. inflation report showed no sign of slowing in the rate-of-change of prices.
 
The latter underscores the monetary policy regime change that’s underway in the U.S. (from easing/pumping liquidity to tightening/extracting liquidity). 
 
In short, the liquidity spigot that has come from the two biggest economies in the world (the U.S. and the euro area), for the better part of the past 14 years, has been closed.
 
That said, this coming regime change has been well telegraphed.  And already, some of the bubbles from the excesses of the era have been pricked.
 
What is now being contemplated, is maybe the biggest bubble of them all.  The government bond market. 
 
As we discussed last week, with the end of QE in Europe, the sovereign debt buyer of last resort, particularly debt of the fiscally fragile countries in the euro zone, will soon be out of the market. 
 
In the U.S., the Fed is no longer buying Treasuries.  Conversely, as of June 1st, they are selling Treasuries.
 
With the exit of this life-line-like bond market demand, this all seems like a formula for a sharp fall in bond prices, which would translate into a shock in market interest rates (i.e. spike).
 
That’s precisely what it looked like today.
 
The U.S. 10-year yield spiked 29 basis points today – a huge one-day move, the biggest since March 2020. 
 
And we talked quite a bit last week about two very vulnerable sovereign debt markets in Europe. 
 
Both Italian and Spanish yields spiked today too (up 20 and 25 basis points, respectively).   As we discussed last week, when yields for both Italy and Spain were around 7%, back in 2012, they were on default watch. By the pace these bond yields are moving, just in the past three days, we could revisit that danger zone by this summer.
 
And the debt load for each is greater now than it was back in 2012 –therefore, the unsustainability of the debt service burden would trigger at even lower yield levels now.
 
Now, with all of this said, what was the most troubling market observation of the day?  It wasn’t bitcoin.  It wasn’t the U.S. stock market.  
 
It was the Japanese government bond market.
 
The 10-year JGB did this today …
     
 
Remember, the Bank of Japan is still in full quantitative easing mode.  In fact, not only are they buying JGB’s, under their “yield curve control” program, they are managing the yield curve, and doing so by manipulating the 10-year yield. 
 
They are targeting 0%, allowing 25 basis points on either side.  As you can see in the chart above, that top limit breached today.  This created some speculation that the BOJ might be fighting off speculators (and losing), or perhaps considering an increase in the band (to plus/minus 50 bps). 
 
In the end, the yield came quickly back into line (within the limit).
 
What does this all mean? 
 
It’s a reminder that, not only is the Bank of Japan (BOJ) still in the QE business, but they are in the unlimited QE business.  To defend the top limit of their yield target, they become buyers of unlimited Japanese Government Bonds.  They have a stated policy to buy as much as they see fit.  And in Japan, that also means buying stocks, real estate, corporate bonds, foreign assets – it’s all fair game.
 
With that in mind, we shouldn’t underestimate the appetite of global central banks to coordinate, to keep key global interest rates in check.  That includes U.S. Treasuries, and European sovereign debt. 
 
As I said in my April 28th note: 
 
How do you prevent a global economic shock that may (likely) come from reversing the mass liquidity deluge of the past two years (if not 14 years, post Global Financial Crisis)? 

 

You keep the liquidity pumping from a part of the world that has a long-term structural deflation problem, and that has the biggest government debt load in the world (exception, only Venezuela). Japan.

 

The Bank of Japan, in this position, can be buyers of foreign government debt (namely the U.S.) to keep our market rates in check (keeps the world relatively stable), which gives the Fed breathing room on the rate hiking path.  

 

And Japan‘s benefit?  The world gives Japan the greenlight to devalue the yen, inflate away debt and increase export competitiveness (through a weaker currency).  They hit the reset button on an unsustainable, debt-laden economy.

 

So, what’s going on with the yen? It has been devaluing, rapidly (24-year low today) …  

Pro Perspectives 6/10/22

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June 10, 2022

The May inflation report came in hot this morning. 
 
Despite what the Fed, the politicians, the media and Wall Street wanted us to believe, inflation has not peaked.
 
In fact, not only was the year-over-year 8.6% rise in prices a new forty-year high, the really big number was the monthly change.  
 
In a month where prices were expected to cool, the change in the consumer price index from April to May was 1%.  If we annualize that, we get 12.7% inflation.
 
As we've discussed here in my daily notes, in the 1973–74 and early 80s inflation spikes, the Fed had to ratchet rates above the rate of inflation to finally get it under control.
 
With this in mind, the markets are expecting some reaction to today's inflation data by the Fed.  Conveniently, they meet next week on rates, where the expectation is that they will raise another 50 basis points (the second 1/2 point hike in six weeks).  
 
But we shouldn't expect anything more from the Fed, than delivering on what was promised (50bps and gradual balance sheet reduction), and some more tough (but empty) talk. 
 
Remember, for the reasons we've discussed about sovereign debt vulnerabilities (domestic and global), a 70s and 80s-style inflation fight isn't in the cards.  Instead of double-digit interest rates, the Fed has opted to attack inflation by attacking demand (jobs, wages and the net worth effect from a lower stock market).
 
That has been working.  Household net worth has fallen for the first time in two years.  Confidence in May hit a record low. 
 
The problem:  The largest contributors to the inflation numbers this morning were shelter, gas and food.  These are supply related (even housing), mostly related to the policy attack on fossil fuels, and the subsequent structural supply deficit. 
 
Again, this is the stagflation, lower standard of living formula. 
 
The notable movers today:  stocks lower, sovereign bond yields higher (including another jump in European yields), and gold higher.
 
On a final note, we've talked about the vulnerabilities in Europe to another sovereign debt crisis, following this week's ECB announcement that they will be ending QE in July (QE=the lifeline to the Eurozone government bond market).  A sovereign debt crisis would threaten the existence of the euro (as it did in 2012).  
 
This chart of the euro seems to be communicating that risk.     

Pro Perspectives 6/9/22

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June 9, 2022

We get the big inflation report tomorrow. 
 
Has it peaked?  Has it not peaked?  We’ve talked about this earlier in the week.  It’s unlikely that inflation has peaked.  The reports we’ve seen globally, for the month of May, have shown hotter, not cooler prices. 
 
Let’s talk about the bigger news for markets today.
 
The European Central Bank this morning announced the end of QE, and telegraphed, not just a liftoff of interest rates, but a series of interest rate hikes to begin in July.
 
With this in mind, let’s revisit the end of my note yesterday, where we discussed the potentially explosive intersection of fragile European sovereign debt and hawkish European monetary policy.  
 
As I said, “it doesn’t take much imagination to see the danger zone for these two countries (Spain and Italy) emerging quickly, if the ECB were to telegraph a series of rate hikes, while simultaneously ending QE.“
 
They ECB has done just that. As of July 1, the ECB will be out of the European bond market (with the exception of reinvesting principal of their current bond holdings, at maturity).  
 
Remember, the only reason the euro and the EU didn’t collapse under the insolvency of Portugal, Italy, Spain and Greece, a decade ago, is because of official intervention — led by the European Central Bank’s promise to become the buyer of last resort of government bonds (and pretty much anything else that threatened the euro).
 
These countries are no more healthy today.  In fact, they are worse off (deeper deficits, higher debt).   And now the ECB has vowed to end the bond market lifeline, in the name of inflation fighting. 
 
This is a greenlight for speculators to attack the European bond markets, – sovereign and corporate bonds.  
 
So, how did those markets perform today?  Not well.

Pro Perspectives 6/8/22

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June 8, 2022

We talked yesterday about the big barrier to meaningful interest rate increases.  
 
It's sovereign debt.
 
Debt is at record levels.  And it's growing, thanks to the even deeper (than pre-pandemic levels) deficit spending that first backstopped consumers and businesses from a lockdown apocalypse, and later funded the global political agenda. 
 
With that, if we add a slowing economy, to rising debt service costs (from central bank tightening), we get a formula for a debt spiral.
 
The central banks know this.  That's why they are attacking demand, verbally, to influence confidence (down), and therefore demand (down).  They get the desired effect of slowing the economy, without having to meaningfully raise rates.    
 
On that note, tomorrow the European Central Bank meets on rates. Inflation there is running 8%.  And yet they've continued with pedal-to the-metal policy — negative deposit rates, and QE.
 
The expectation is for the ECB to announce the end of QE, and project a first (post-pandemic) rate hike in July.
 
Why should you pay attention? 
 
ECB policy, and the related outcomes in Europe, are very, very important to global economic stability (or instability). 
 
The biggest risk of a global sovereign debt default contagion comes from Europe.
 
It was only a decade ago that Mario Draghi (ECB President, at the time) averted disaster for Europe and the global economy. A contagion of global sovereign debt defaults were lining up in Europe.  And the second most widely held currency in the world, the euro, was vulnerable to a break-up.  To stop the meltdown, Draghi publicly threatened/vowed to become the backstop in the European government bond market.   

Here's what he said in a July 2012 speech: "the ECB is ready to do whatever it takes to preserve the euro.  And believe me, it will be enough."

The imminent risk was sharply rising yields in the big, dangerous weak spots in Europe:  Spain and Italy.  Speculators were hitting the bond market, yields were rising to unsustainable levels.  Spain and Italy were on the path of default — and once one went, the others would fall.  The next step would mean these countries leaving the euro, returning to national currencies and inflating away the debt through currency devaluations. 

It didn't happen because Draghi stepped in. 
 
With the statement above, he threatened to be the unlimited buyer of these troubled government bonds, which was enough to purge the speculators from the market, and reverse the capital flight.  Quickly the yields on those bonds plunged.

Here's what the chart of those bond yields looked like before and after Draghi's line in the sand …
Now, fast forward to today ...
 
Though deposit rates are at negative 50 basis points in Europe, and the ECB is still buying assets (which include government bonds in Europe), sovereign bond yields in the weak spots in Europe, Italy and Spain, have been on the move, higher.  
As you can see in the chart, when yields for both Italy and Spain were around 7%, back in 2012, they were on default watch.  Italy's debt load was 126% of GDP.  Spain's was 90%.
 
Today Italian yields have popped to 3.5%.  Italian government debt is 150% of GDP.  Spanish yields are at 2.5%, with debt at 118% of GDP.
 
It doesn't take much imagination to see the danger zone for these two countries emerging quickly, if the ECB were to telegraph a series of rate hikes, while simultaneously ending QE (which has been their explicit tool to outright control the bond yields of these fiscally fragile countries).
 

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Pro Perspectives 6/7/22

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June 7, 2022

The World Bank downgraded global growth today to under 3%. 
 
On that news, after a strong climb yesterday in U.S. yields, the 10-year yield reversed, and traded back below 3% today.
 
This was a recipe for higher stocks on the day. 
 
Why?  As we've discussed, in this environment, bad news is good news.  It takes the pressure off of the Fed to carry out a draconian campaign of aggressive rate hikes.
 
The Fed has been successful in guiding demand lower.  But they can do nothing about supply.  
 
The biggest structural supply shortage (oil) will continue to put upward pressure on prices.  And the energy price input on the cost of living, and cost of doing business, will continue to be a primary headwind for broad economic activity.
 
Higher rates won't fix this stagflation conundrum.
 
As we've discussed, the softening of demand that has taken place from the influence of markets (lower stocks, higher gas, higher mortgage rates), is the optimistic scenario.  So far, so good. 
 
The pessimistic scenario is an economic crash induced by aggressive global central bank tightening campaign (led by the Fed).
 
But as I said, the Fed doesn't have the tools to deal with the supply issue.  So, contrary to what they say they're going to do, the Fed has no reason to aggressively raise rates. 
 
But they have reasons not to. 
 
Despite seeing the hottest inflation in four decades for about a year now, the Fed still hasn't gotten the effective Fed Funds rate back above 1%. 
 
Meanwhile, in Europe, the ECB still has the deposit rate at negative 50 bps.  Yes, you have to pay the bank to keep your money on deposit. That's an incentive to spend, not save — so, that's not exactly the kind policy you would expect with the inflation rate in Europe running at 8%.
 
So, why aren't they raising rates? 
 
Here's why …
This chart above is shows the 12% U.S. fiscal deficit last year, which compounds the record U.S. debt. 
 
In short, the global sovereign debt markets can't handle it (i.e. higher rates). 
 
Even if the U.S. could handle adding to record debt and a massive fiscal deficit, Europe could not.  The zombie economies in the euro zone, which nearly defaulted 10 years ago, only to be saved by the backstop of the ECB, would surely go bust.  And the European debt, and then global sovereign debt, dominoes would fall from there. 
 
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Pro Perspectives 6/6/22

June 6, 2022

We get the May inflation report on Friday. 
 
Remember, the consensus view/hope is that inflation has peaked.  Just as the "transitory" theory was spoken into the economic psyche by the Fed, and distributed by the media and politicians, so has the "inflation has peaked" theory.   
 
To be sure, the former certainly influenced behaviors last year.  In fact, the idea that inflation was transitory gave Congress the cover to nearly push through another $3 trillion in fiscal spending ("Build Back Better")!  If not for the heroic steadfastness of Manchin, we might be looking at inflation in the mid-teens, if not 20%, by now.
 
So, what does the "inflation has peaked" messaging do to influence behaviors this go around?  When people expect the price of everything to runaway, they chase prices (higher, and higher).  "Inflation has peaked" can change that expectation, and therefore, soften inflation. 
 
Remember, as the former Fed Chair, Ben Bernanke recently said: "Monetary policy is 98% talk and 2% action."  They've tried to talk down inflation on the one hand, by saying it has peaked, and on the other hand by telling us they are going to bring down demand.
 
So, we'll see on Friday if indeed we are getting the signal that inflation has peaked (from the May report).  
 
The April report (last month) presented some hope.  The monthly change dropped from a very hot 1.2% (from Feb to March) to just 0.3% (from March to April).  Despite a, still, hot 8.3% year-over-year inflation rate from the April report, the rate-of-change from month-to-month fell sharply.  If we annualize that 0.3% number, we get inflation back in the high 3s.  
 
The Fed would be very happy to see another monthly number projecting something in the 3%-4% annualized range.
 
All of that said, the "peak" inflation theory is unlikely.  Just looking at the data coming in globally, the U.S. would be bucking the global trend with a softer May inflation report.
 
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Pro Perspectives 6/3/22

June 3, 2022

The jobs report this morning wasn’t weak, but it wasn’t strong.  
 
As we discussed yesterday, in this environment, bad news is good news.  The Fed wants to bring demand down.  Therefore, any data, to that end, is a “positive,” because it takes the pressure off of the Fed to carry out a draconian campaign of aggressive rate hikes.
 
So, it wasn’t good news today, but it wasn’t bad news (confused yet?).   
 
The Fed has targeted employment, as a tool to influence demand lower, primarily through correcting the imbalance between job openings and job seekers.  It’s this imbalance (two openings for every one job seeker) that has given job seekers the leverage to negotiate higher wages.
 
How are employers dealing with paying a higher wage?  They are passing it along to consumers through higher prices (inflation). 
 
On that note, if we look at the wage component of today’s report, it may be signaling some softness.  The month-to-month change is just 0.3%.  If we annualize that, it’s 3.7% wage growth.  That’s well below the roughly 5.5% year-over-year wage growth numbers we’ve seen over the past eight months.
 
And while it’s not showing up in the employment data yet, we know that employers are pulling back on jobs.  

We looked at this chart above last week.  With the telegraph of higher interest rates, and less liquidity in the system, the start up and early stage technology businesses had the biggest layoffs in May, since the depths of the lockdown-induced recession.  Big tech is now announcing hiring freezes and head count reduction too. 
 
So, again, the market is doing the Fed’s job for them. 
 
Layoffs and softer wages sound like bad news.  But it’s good news within the context of the probable outcomes that are on the table.  A looser labor market, softer wage growth, lower stock valuations and higher gas prices are a formula for lower demand.  That should keep the path of interest rates shallow and, therefore, lower the probability of an economic crash scenario.
 
That said, the Fed’s attack on demand will do little to contain the prices driven by structural supply deficits, namely oil.  With that, a lower standard of living seems to be a common denominator in both the soft and hard landing scenarios for the economy.             
 

Pro Perspectives 6/2/22

June 2, 2022

Last Wednesday, we talked about the setup for a break of the big trendline in this chart below (the yellow line).  Moreover, we were looking for a close above the 4,000 level in the S&P 500, as a bullish signal for stocks. 
 
We got it, and we've since had about a 5% rally in stocks. 

This, as we head into a big government jobs report tomorrow. 
 
What should we expect?
 
We had some clues from the private jobs report this morning, published by ADP.  The jobs added in May came in at 128k, versus the market consensus of 300k.  It was a miss.
 
For tomorrow's report on non-farm payrolls, the expectation is for the weakest report in over a year, at 325k jobs added.
 
To be sure, this will be one of the more important jobs reports we've seen in a while.  
 
Why? Because the Fed has explicitly targeted jobs, in the effort to bring down inflation.  The Fed Chair, Jay Powell, told us explicitly that they intend to bring the ratio of job openings/job seekers down from two-to-one, to one-to-one.
 
Yes, we have a Fed that is trying to manipulate to the goal of higher unemployment.
 
In my 26-year career in markets, I've never witnessed a Fed that is explicitly attempting to destroy demand and jobs.  But here we are.
 
With that, we are in a bad news is good news stock market.
 
As we've discussed here in my daily notes, the more verbal influence that the Fed can have on markets, and consumer and business psychology, the less work that the Fed has to do with interest rates. 
 
The shallower the path of interest rate hikes, the higher the probability of a soft landing for the economy.  That's a slowing growth scenario (the best case scenario in the this environment). 
 
On that front, so far so good.  The markets are doing the Fed's job for it.  Lower equity valuations, higher gas prices and higher mortgage rates have quickly changed consumer and business psychology.  Demand is coming down, which should translate into some loosening in the job market.  We will see tomorrow.   
 

Pro Perspectives 6/1/22

June 1, 2022

Today was the official start of the Fed’s quantitative tightening (QT) program.  This is taking liquidity out of the system.
 
The Fed plans to allow the securities they bought at the depths of the pandemic (which injected liquidity into the financial system), to mature from this point forward, without reinvesting the proceeds.  With this plan, they think they will extract $1 trillion from the financial system over the next year.  And they estimate that a trillion dollars worth of QT will be the equivalent of about a half of a percentage point rate hike.
 
Remember, the Fed first disclosed that they had discussed plans for QT back on January 5th, when they published the minutes from their December meeting. 
 
Here’s an update of what stocks have done since the minutes hit the wire (back in early January).  

So, the anticipation of reversing QE has already contributed to a steep decline in stocks.  Now actual QT is officially upon us.  
 
With that in mind, let’s take a look at how stocks behaved during the Fed’s first experiment in shrinking the balance sheet, following the Great Financial Crisis period (GFC). 
Stocks went up!
 
Over 535 days, stocks gains 22%.  This measures the period of time from when the Fed signaled balance sheet normalization (June 2017), up until the day they ended it (July 2019).
 
On that note, as we’ve discussed over the past couple of months, the historical track record of QE exits is not good. 
 
We know that in each case (globally and domestically), the “quantitative tightening” experiments ended with more QE.
 
From the chart above, clearly the Fed’s return to QE wasn’t because of a crashing stock market.  
 
Why did they restart QE back in 2019?
 
Things started breaking in the financial system.  
 
Remember, we discussed this back in my April 6 note. We had this 300 basis point spike in the overnight lending market.  
Here’s how the Fed explained what happened (my emphasis) …

 
“Strains in money market in September occurred against a backdrop of a declining level of reserves, due to the Fed’s balance sheet normalization and heavy issuance of Treasury securities.”
 
So, the Fed was forced to rescue the overnight lending market (between the biggest banks in the country) because of an unforeseen consequence of balance sheet normalization.
 
It’s important to understand that reversing the Fed balance sheet is an experiment, with outcomes unknown.