Pro Perspectives 5/12/22

May 12, 2022

We talked yesterday about the crypto currency bubble.  Bitcoin has more than halved, which is not unusual for its history.  But the bigger issue is the stablecoin universe.  
 
Again, this is a couple of hundred billion dollars that were traded for private digital currencies, with the promise of remaining pegged to a currency (like the dollar) or asset (like gold). 
 
These pegs have broken.
 
A once $15 billion stablecoin called Terra now trades for 42 cents on the dollar.  The biggest stablecoin is Tether ("tethered" to the U.S. dollar).  It too, has broken the peg, trading as low as 95 cents on the dollar.
 
Interestingly, on Monday (May 9) the Fed released its annual report on Financial Stability.  That same day, Terra broke the peg.  And on Tuesday, Janet Yellen (the Treasury Secretary) testified before the Senate Banking 
Committee.  Tether broke the peg on Tuesday.
 
In the Fed report, among the vulnerability to the financial system that were cited:  "the vunerability to runs" in the "rapidly growing stablecoin sector." 
 
Guess what that triggered?  Runs on stablecoins (i.e. mass simultaneous investor withdrawals/redemptions).
 
So, is this a threat to the financial system?  Will there be contagion?  
 
In the case of Tether, it doesn't hold its $80+ billion of liabilities in U.S. dollars in a bank.  In fact, below is the breakdown of how the Tether liabilities ("reserves") are invested, based on their end of year 2021 independent accounting report. 

They have about $40 billion of investments (including commercial paper, money market funds, secured loans and other digital currencies).
 
This is like a shadow bank. 
 
It seems very likely, that the company will have a difficult time recovering principal from these investments to return to Tether holders – if they see mass Tether redemptions.  But the bigger problem is what a mass exodus of Tether's investments (all of that commercial paper, money market funds, etc.) might mean to the financial system.  
 
Remember, it was a run on a money market fund back in 2008 that set off more similar runs across the money market universe, requiring the Fed to step in.  They halted redemptions, and guaranteed the principal of money market funds.
 
This risk seems to be what is adding significant weight on markets.
 
With all of the above in mind:  
 
>The Japanese yen tends to behave like a safe haven in times of global uncertainty and economic/financial stress.  Today it was up 1%. 
 
>Treasuries have bounced sharply the past three days (THE place for global capital flight when risk is elevated). 
 
>And the dollar made new 20-year highs today (the other hiding place for global capital in "risk-off" environments).
 
As we've discussed, when the Fed announced it's quantitative tightening plans, history tells us that unforeseen consequences will follow (something will break in the financial system).  This may be it, in the making.  
 
The good news:  History also tells us that the Fed will respond (in such a case).  With backstops, guarantees, more QE.  Whatever it takes.  
 
The easiest, first step for the Fed to take, to curtail any flare up in the financial system, might be to signal to markets that they will hold off on QT — take a wait and see approach.     
 
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Pro Perspectives 5/11/22

May 11, 2022

The inflation report came in hotter than expected this morning.  Yet, both the monthly and twelve-month change came in lower than the March report's blow out numbers.
 
So, has inflation indeed peaked, as the media, the administration and the Fed have suggested throughout the past month?  
 
Unlikely.  The 8.3% twelve-month change in prices for April (in this morning's report), was indeed cooler (slightly) than the 8.5% inflation in the March report.  But oil had a lot to do with the cooler number. 
 
If we look at the change in price of crude from Feb to March, it was 18%.  From March to April, crude prices were down 6%.  Not so coincidently, Biden announced a record release of oil from the U.S. Strategic Petroleum Reserve (SPR), on March 31.  Oil prices were manipulated lower.  But now, prices have returned to pre-SPR announcement levels.
 
Bottom line:  This oil price driver of inflation isn't going anywhere.  And with the strong ex-food-and-energy inflation number this morning, we should expect higher inflation prints from here (i.e. we haven't seen "peak").
 
With all of this, yesterday we talked about the dynamic between bitcoin and gold.  With the bursting of the tech bubble, bitcoin has technically broken down, and we suspected that a hot inflation number today might reveal a return of the real inflation hedge (i.e. gold).
 
We might be seeing it.  As I write, bitcoin is down 10% on the day.  Gold is up better than half a percent.  
 
These are the two charts we looked at yesterday.  One is bouncing (gold), technically, the other has broken down (bitcoin)…   

As Warren Buffett has said, "only when the tide goes out, do you discover who's been swimming naked."  The "tide" in this case, is the easy money, low inflation era. 
 
The tide has gone out, and the mal-investment is being exposed.  That includes high valuation, no earnings tech companies … SPACs … and crypto currencies. 
 
Those "no eps" tech companies, that have relied on endless streams of capital to burn have been exposed as uninvestable (without easy money terms).  
 
The stablecoin universe is beginning to break.  This is a couple of hundred billion dollars that were traded for private digital currencies, with the promise of remaining pegged to a currency (like the dollar) or asset (like gold).  These pegs started to break over the weekend (i.e. those initial dollars invested will not be returned).  
 
This may be (likely is) the beginning of the end of private crypto currencies.  At the very least, it's a major shakeout.  We should expect this reckoning in crypto to create continued selling in the tech sector (tech stocks).  And a bursting of the crypto bubble will likely create some waves in the financial system.  We will see.   
 
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Pro Perspectives 5/10/22

May 10, 2022

The big April inflation report comes in tomorrow morning.
 
Let's talk about what to expect …
 
First, it was the inflation report from last month that finally got the market stirring.  The 8.5% headline change in prices, from the year prior, was the hottest since 1981. 
 
But it was the monthly change that was even more stunning, at 1.2%.  That number, compounded monthly, would give us around 16% annual inflation.  And that would actually sound more like the reality of prices consumers are seeing in every day life.
 
Still, following that report last month, the media, the administration and the Fed immediately responded by promoting the idea that (somehow) inflation had peaked. 
 
We will see tomorrow. 
 
The market is expecting a 0.2% change from April to March.  That would be a dramatic softening from the March report.   And the year-over-year expectation is for 8.1%.
 
If we focus on the monthly number, this sets up for a negative surprise (i.e. a hotter than expected number).  
 
This comes as the historic inflation hedge, gold, sits on this big technical trendline/ support.  

Meanwhile, what has been considered the "modern day gold," and new inflation hedge, Bitcoin, has already technically broken down — in sympathy with the bursting of the tech bubble.   
If we get a hot inflation number tomorrow, and moreover, if inflation has yet to peak, I suspect we will get to see if gold recovers its role as the favored inflation hedge. 
 
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Pro Perspectives 5/9/22

May 9, 2022

We've talked a lot about the historical track record of QE exits. 
 
The record is not good.  We know that in each case (globally and domestically), the "quantitative tightening" experiments ended with … more QE. 
 
With that, in my note last month, I posed the question of whether the Fed will even get the opportunity, this time, to start the process of "normalizing" the Fed balance sheet (i.e. quantitative tightening)?
 
We know the Fed formally announced their intentions in its meeting last week.  But with the start date set for June 1, and the air quickly coming out of the QE sponsored tech-stock and crypto bubbles, they may be back to damage control by June 1.
 
But it won't be because of stocks.  It will likely be because of the side-effects of QT (the unwind of the tech bubble, related).    
 
Without question, all along the path of the post-financial crisis, the Fed has wanted and needed stocks higher (and they behaved accordingly).  Higher stocks drove the wealth effect, and confidence, and that underpinned demand, in a world of weak demand (following the very long, slow recovery from the debt-induced financial crisis). 
 
This time, the Fed is explicitly trying to slow demand, to align with supply disruption (though much of it is by the design of bad government policy-making).
 
With that motivation (slowing demand), they are probably quite satisfied with the quick haircut in the stock market — particularly, the high flying, high valuation, high speculation tech sector.  It will slow the animal spirits, and therefore the 'rate of change' in prices (inflation).
 
But, as we've discussed, putting the QE genie back in the bottle doesn't have a good record.    
 
Unforeseen consequences tend to arise.      
 
Remember, after spending eighteen months shrinking the balance sheet (2017-2019), the Fed quietly started reversing course in late 2019.  By the time Jay Powell acknowledged it, in a prepared speech (in October of '19), they had already bought $200 billion worth of assets.  
 
This was a response to what they called "strains in the money market."  Things started breaking.  And interestingly, the Fed refused to call the resumption of balance sheet expansion "QE."
 
Nevertheless, here's how stocks responded to the stealth QE of late 2019 … up 15% in a near perfect 45 degree angle (… then covid lockdowns, and the response:  more QE). 

 

As we discussed last month, as much as the Fed might like to move on from QE, from what we know of it, QE is "Hotel California." 
 
"You can check out, but you can never leave."
 
Again, it highlights the eventuality of a reset of global debt, and a new monetary system. 
 
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Pro Perspectives 5/6/22

May 6, 2022

As we end the week, let’s take a look at a few charts.
 
First, here’s a look at the performance of global asset prices over the past week.

You’ll notice, despite all of the financial media hand wringing over stocks, related to the Fed meeting, the S&P 500 (the proxy for global stability and risk appetite) was only down less than 1/2 percent on the week. 
 
Other notables:  The VIX (also known as the market’s ‘fear gauge’) was down on the week, not up. 
 
And crude oil was up more than 5% on the week — not exactly a signal of economic slowdown, but then again, crude is now trading on a supply shortage, brought to us by the design of global (and domestic) policymakers. 
 
On that front, it’s important to remember how we started the week.  On Monday morning, it was reported that the European Union was ready to propose a Russian oil embargo, and Germany was now on board. 
 
That triggered a 3% decline in the S&P 500 over just a few hours (on Monday).
 
And crude finished up nearly 10% from the Monday morning levels.
 
Here’s how crude looks heading into the weekend — a bullish technical breakout.  
 

Finally, let’s take a look at money supply.  Remember, the policies surrounding the pandemic response, ballooned the money supply by over $6 trillion.  
Now that the Fed has started quantitative tightening (i.e. reversing QE), some are expecting the money supply to shrink. 
 
While money may be extracted from bank reserves (by changing a digital number to a smaller number with a keystroke), it didn't show the desired effect on actual money supply during the Fed's 2017-2019 QT program.  As you can see in the chart above, money supply grew during the period (by a trillion dollars). 
 
What's the point?  The rate of change in prices should subside.  But the level of prices, caused by this tidal wave of new money, isn't going anywhere. 
 
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Pro Perspectives 5/5/22

May 4, 2022

The Fed raised rates yesterday, and announced its quantitative tightening plan to begin on June 1.
 
As we discussed yesterday, markets responded well. 
 
Today, that was not the case.
 
What’s going on? 
 
My view:  Mostly this …

This is the chart of the yield on the 10-year Treasury.  This is the benchmark market-determined interest rate, which is the basis for setting many consumer rates. 
 
It spiked today, 16 basis points (a big move), and above 3%.  Mortgage rates went to 5.27%, the highest level since 2009.  
 
So, is 3% a dangerous level for rates, given that the Fed has just taken the Fed Funds rate up to 75 basis points?  No.
 
The fear is, that this move (in rates) today is just the beginning of a fast repricing of the interest rate market. 
 
After all, the Fed told us yesterday that they intend to "expeditiously" take the Fed Funds rate to what they deem to be the "neutral" level (maybe this year).  As we discussed yesterday, that's believed to be somewhere between 2 and 3%. 
 
If we consider a 2% spread between mortgages and the 10–year … and a spread of about 2% between the 10–year and the Fed Funds rate … then the right yield for the 10–year should be in the mid-4% area.  That would take mortgage rates to be over 6%.
 
This begs the question:  Why hasn't the bond market already priced this "neutral" Fed rate in?  Why isn't the 10-year yield at 4.5% right now? 
 
Moreover, if the bond market really is the "smart money," why hasn't the 10-year yield adjusted according to an 8.5% inflation economy (i.e. much, much higher yields)?
 
Why?  Because the government bond markets have been highly manipulated by central banks, globally.  
 
The Fed has been explicitly manipulating the bond market, to suppress interest rates, for the better part of the past fourteen years.  But now, they are out of that business (allegedly).
 
So, it's logical to think, now that the Fed is out, that the interest rate market could quickly reset to the reality of the inflation environment.  
 
That would put the economy at risk of a runaway interest rate market.  And that would make the Fed's job of price stability and full employment exponentially more difficult.
 
I suspect that is what created fear in markets today.   
 
But as we discussed over the past few weeks, don't underestimate the appetite of global central banks to coordinate (with the Fed), to keep market U.S. interest rates in check (making the Fed's job to manage inflation expectations and the monetary policy "normalization" easier – and, therefore, the global economic and interest rate environment more stable).  
 
Remember, not only is the Bank of Japan (BOJ) still in the QE business, but they are in the unlimited QE business (buyers of unlimited Japanese Government Bonds as part of their yield curve control program).  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 – it's all fair game.
 
From my April 28 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.  We will see.

 
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Pro Perspectives 5/4/22

May 4, 2022

Let's talk about the Fed meeting today …
 
First, there were no surprises.  The Fed had telegraphed a 50 basis point rate hike.  The market had it priced in.  That's what they delivered. 
 
The Fed had also telegraphed the start of quantitative tightening.  As we discussed yesterday, given the recent history of their 2017-2019 failed effort to trim the balance sheet (they were forced to return to QE), we expected them to tread lightly on the balance sheet issue.  They did.
 
They are starting small, and watching.
 
As we discussed yesterday, a careful and conservative Fed messaging should be positive for stocks.  
 
Markets liked it. 
 
Then, when Powell said they are not considering something as aggressive as 75 basis point hikes, stocks took off. 
 
Add to that, the Fed has projected to return the Fed Funds rate to what they deem to be the neutral level (neither accommodative, nor restrictive to economic activity).  That's around historically normal levels of 3% (maybe between 2% and 3%).
 
And, importantly, he said that they will not consider whether or not they need to get restrictive until they get to the neutral level. 
 
As it stands, that will be in early next year.  And in case you think they might surprise us with something in the interim, he said, flatly, that the world is uncertain, and that the Fed would do nothing to add to the uncertainty.
 
So, the Fed has just told us that they will not raise rates in a way that will become "restrictive" to the economy, until at earliest next year.  Moreover, for much of the rest of the year, they will continue to be accommodative.  
 
So much for slamming the brakes on the economy. 
 
With this in mind, we came into the year expect a major "regime shift" for markets — to adjust for a high inflation, rising interest rate world. 
 
The adjustment hasn't been pretty.  When we heard the December minutes from the Fed, on January 5th, as they discussed strategy for rate liftoff and balance sheet reduction, markets began to price in the worst case scenario.  
 
That was anticipation of Fed action. 
 
Today, we got the actual Fed action (which included QT).  As you can see in the chart below, this looks like the classic, sell the rumor (assume the worst), buy the fact (on a rational action).

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Pro Perspectives 5/3/22

May 3, 2022

As we head into tomorrow's Fed meeting, we've talked about three supply issues that are driving inflation, which the Fed can do nothing about.
 
1) The reset of wages at the low end of the scale.  Not only did the government establish a new living wage through pandemic subsidies, but employers are in a position of weakness to negotiate pay, as they compete in a labor market that now has one job seeker for every two open jobs.    
 
2) The global supply chain disruptions, from the lockdown period has now been exacerbated by war in eastern Europe, and new lockdowns in China.  
 
3) High energy prices, sustained by a self-inflicted supply shortage, by the design of global anti-fossil fuel policies. 
 
These are reasons the Fed will likely not even attempt to raise rates, over the course of this tightening campaign, beyond what are historically normal levels (around 3%).
 
And I suspect they will be very, very careful and conservative in reducing the balance sheet.
 
If we get this message from the Fed tomorrow, it should be positive for stocks.  
 
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Pro Perspectives 5/2/22

May 2, 2022

On Wednesday, we will get the second move from the Fed in this early stage tightening cycle.

We go into this meeting with the last inflation reading at 8.5% (year-over-year). If we extrapolate out the monthly change in prices from February to March (which was 0.9%), we are looking at double-digit annualized inflation.

Now, as we know, the Fed has done an about face on the inflation threat.

They spent much of last year telling us that inflation was due to supply-chain disruptions (bottlenecks), and “base effects” (i.e. the inflation data was misleadingly high, as measured against depressed prices of the lockdown period). And Jay Powell told us, flatly, that the Fed didn’t have the tools to solve the supply chain disruption (not their job).

Never did they talk about demand. Never did they talk about the government handouts, which inflated demand: the overly generous and prolonged government subsidized unemployment checks, the PPP loans, debt moratoriums, the “child tax credit” handouts (that neither required a child, nor a taxable income … nor was it even a credit — it was a direct payment).

It was clear to see, on the ground, as consumers, that these easy money fiscal policies had distorted prices. But it wasn’t politically palatable to admit it. Why?

All along the path last year, the administration was trying to push through even more excessive spending (the most profligate of them all = “Build Back Better”). Acknowledging the demand distortions would have been a disqualifier for a new spending bill. Ultimately it was, thanks to a couple of democrat hold outs in the Senate.

Suddenly, the switch flipped.

This year, the talking points from the Fed, the Treasury and the President have been about “bringing down demand.”

But the economy is slowing — contracted in the first quarter. The savings rate has gone from ballooning in 2020, back to pre-pandemic levels, if not below.

The velocity of money is at record lows. This is the rate at which money circulates through the economy. It’s supposed to represent the demand for money.

What’s the takeaway?

The Fed, may indeed have no tools to deal with the rise in the level of prices. Demand destruction is already happening.

There is nothing they can do to reverse bad energy policy-making, which has choked off investment in new oil exploration and production, and regulated away incentives to produce — which has led to structural supply problem – guaranteeing high prices.

And there is nothing they can do to influence food supply disruptions, driven by the Russia/Ukraine conflict (which has resulted in elevated grains prices).

Short of inducing a deflationary collapse, the solution will be higher wages, to close the gap with higher prices.

That has started, but there is a long way to go. It will take a while, and will be painful.

And I suspect the pain will create a political opportunity to push through “Build Back Better.”

Pro Perspectives 4/29/22

April 29, 2022

We close the week, and month, with stocks near the lows of the year.
 
Let’s take a look at what earnings are telling us.  
 
We’ve seen the formerly loved streaming stock, Netflix, nearly halved after a bad earnings report.  We’ve heard a lot about “higher costs” on earnings calls.  And yesterday we got a negative GDP number for Q1.  
 
Still, Q1 corporate earnings have come in broadly better than Wall Street expectations.  
 
Half of the S&P 500 has now reported for Q1.  Eighty-percent have beat estimates.  Earnings growth is running about two-and-a-half percentage points better than was expected coming into earnings season.  And with rising costs, this is the most important point: profit margins are still strong, at 12.2% (the fifth highest since 2008, only topped by the prior four quarters). 
 
So, higher costs continue to be successfully passed through to the consumer. 
 
Is it sustainable?
 
On that note, this is important to know:  The level of prices isn’t going lower (anytime soon), despite what the Fed might have in store for us. 
 
The $6 trillion of new money floating around the economy, since the initial pandemic response, isn’t going anywhere. In fact, it continues to grow.  
 
It’s the rate-of-change in the increase of prices that will slow, we hope.
 
With that, as we’ve discussed, the only offset to the reset of prices that the government knowingly unleashed in March of 2020 (through direct payments to businesses and consumers, subsidies and debt moratoriums), is a wage reset (i.e. a broad-based shift in the wage scale, up).
 
You can see the wage issue clearly in this chart …

Despite some wage gains at the low end (driven by federal unemployment subsidies and “hazard” pay), after adjusting for inflation, wages are well below pre-pandemic trend.
 
That said, the wage reset is happening, but slowly.  There are roughly five million more job openings than job seekers.  And the number quitting jobs is the highest on record.  Job switching is the driver of the highest future wage growth. 
 
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