The Archegos Domino

In a recent post I rang the alarm bell for Contracts For Difference (CFDs), a so-called derivative product that allows for enormously leveraged bets on anything from stocks, FX and commodities to whatever moves.  Such “products” are very old, they were the staple of all bucket shops in the US back in the late 19th and early 20th centuries.  You can read all about it in Reminiscences Of A Stock Operator, my all time favorite book on markets.

Guess what? A private hedge fund (an animal also known as a Family Office), called Archegos (Greek for Chief) just blew up, as such bucket shop CFDs turned sour.  Its prime brokers (Goldman, Nomura, Credit Suisse) had to liquidate $20 billion in shares (real ones, not the bucket shop kind) to cover massive margin calls. They, too, are expected to incur losses north of $1 billion. (Update: losses now estimated at $6 billion)

The impact of such large forced real sales (ie not the algo nonsense volume) was large, indeed: Stocks such as Viacom CBS, Baidu, etc were down as much as 30%+ in one day.  

One time event? Maybe, after all a hedge fund blowing up is not the real news here, it happens all the time.  The important news is in the tape: Archego’s brokers had to dig all the way down to -30% to -40% to unload a rather middling amount of shares; $20 billion may sound like a lot, but with market capitalizations in the trillions it should have been a drop in the bucket.  But, it obviously wasn’t.

What this means is this:  THERE ARE NO REAL MONEY BUYERS OUT THERE.  The market is very, very, very thin. 

Archegos is, I’m afraid, but the first domino to fall.

Money Supply And GDP

 Looking at the chart of M2 as a percent of GDP below, the spontaneous questions is..

• How can this NOT lead to inflation? 

Furthermore, this chart does not include the latest $1.9 trillion that just started going out.  When included, the ratio jumps to 98%, though because of accounting and time delay factors the number is more likely closer to 95% (I have already factored in a higher GDP for 2021).

Why isn't this keeping Fed and Treasury officials up at night? Well... I think it actually does, never mind what they say in public, because there are only three possible outcomes:

1. The economy explodes upwards in unprecedented fashion and brings the ratio back to around 70%.  But for this to happen nominal GDP would need to climb to $31 trillion, 40% higher from today's $22 trillion level. Mind you, that's to bring the ratio back just to 70%, which was already high by historical standards.
   
2. There is an asset/debt collapse leading to mass bankruptcies, slashing debt and money supply (money=debt). 
3. Inflation jumps to levels unseen in decades. 

 Outcomes (1) and (3) are related since a spike in inflation would lead to higher interest rates, further expanding M2.  Unless, of course,  the Fed keeps interest rates artificially low - which is exactly where we are right now...

Pick your poison...

 

Global Debt And Black Swans

Global debt climbed new highs in 2020 as developed countries borrowed at a record pace to, basically, send out free money to their citizens - Chart 1.  The ratio was up an eye-popping 50% from 294% to 343% - a new all time record, of course.  Total debt stood at $281 trillion at the end of 2020. Given the continued fiscal and monetary largesse from the Biden administration ($1.9 trillion already done and another $3 trillion announced) and the  economic trouble in the EU, debt/GDP will almost certainly go even higher this year.

Chart 1

Combine massive debt, zero/negative interest rates, a financial bubble, loony toon spending on crazy stuff (eg NFTs and cryptos) and looming inflation and... what do we get?  

Honestly, no one really knows - this situation is unprecedented in history.  We can't really find anything to "rhyme" with what is happening today.

So, when in doubt, get the hell (!) out.  Given the unknown-unknowns, this is my best prediction:

• There's a Black Swan coming.  No - not even that, because we know that black swans actually exist. I'm not going to put it down in pixels, just let your imagination run rampant to come up with an appropriate simile. Matrix, anyone? Blue pill or red pill? (Big Smile).
  

C'mon, this could be fun: imagine the wildest, most out-of-the-box outcome over the next few years and let it rip in the Comments section. 

Volatility: Buy It Or Sell It?

Here's a question for market people (and not only): do you buy volatility here or sell it? For those less market inclined, do you expect more or fewer pronounced swings in markets? Are financial markets going to go up and down significantly, or are they just going to trend? 

Note: Many people think that VIX, the CBOE volatility index, is a measure of volatility; in fact, it isn't.  It is best described as a "fear" index, since it is based on the balance of prices between out of the money put and call options. The higher the price of puts, the higher the index. Interestingly, VIX just made a new 13 month low a couple of days ago (and, conveniently for us tea leaf readers, closed a chart gap - see below).

 VIX Index

While interesting in itself (hmmm... puts are cheap, you say?), it's not what I'm talking about. My question is about volatility per se. For example, let's take 10-year Treasury bonds.  They are currently a hot topic, with yields trending up sharply due to fears of inflation.  

Say you are the Treasury and have to fund the massive $1.9 trillion Biden program.  You need to auction a whole lot of bonds into a rather shaky market, hoping there won't be a repeat of the last, disastrous 7-year bond auction.  What do you do?  Leave it up to the good will of the Bond Vigilantes? None other than Bill Gross has been making ugly noises recently, after all. (Short Treasurys, inflation will go to 4%).

So, you need to put a stop to yields trending up - somehow. You need to create volatility, to break the "trend (up) is your friend" meme in bond yields and strike fear into the icy cold hearts of them bond-shorting Vigilantes. How do you do it?

There are two ways:

• Short term, make absolutely sure that the next couple of auctions go well.  Line up your bidding ducks, call in all your favors with banks, foreign and domestic funds, cajole speculators and investors alike.  Shouldn't be too difficult, Pax Americana still wields a heavy sword, after all. (Tragically, quite literally - see Boulder, CO).
  
• After that, surprise the market with a concrete policy change signal.  For example, have the Fed announce that it is now confident the economy is out of the woods and will soon re-examine its bond buying and/or zero interest rate policies.  The stock market won't like it, but there are much bigger fish to fry here, like the cost of servicing the ballooning debt - can't screw around with that.
  

So, to answer my own question, I would be a buyer of volatility right now (Not VIX, necessarily).  

Then again, I'm an idealist, always thinking that the American political elite is smart, capable and at least one step ahead of the crowd.  (I know, I know... Trump..).

PS Mr. Biden just announced another $3 trillion spending program for infrastructure, climate change, etc.  Eh, a trillion here, a trillion there, pretty soon you're talking about serious money...

 

Is The US Headed For A Turkey Moment?

Let me say right off the bat that the title of today's post is intentionally inflammatory and outrageous. How can the US possibly have anything in common with Turkey?  Well... let's for a moment forget the cozy relationship that Presidents Erdogan and Trump enjoyed, and look at monetary policy, instead.

For some time now Turkey has been under severe inflationary pressure and the lira has devalued.  Mr. Erdogan hated high interest rates (very unpopular with homeowners who saw their mortgages soar and with businesses that borrowed in hard currencies), so he kept pressuring the Turkish central bank to keep them low.  

That changed a few months ago when a new governor was appointed and raised rates.  The pressure came off the lira - but it was not to last.  He was summarily fired two days ago when he raised interest rates again - so, the lira plunged again. It is currently flirting with its old lows against the dollar.

What does that have to do with the US? Connect the dots: a fiscal/monetary policy that is seriously - very seriously - loose and a Fed chairman who insists inflation is not a problem, notably a gentleman carried over from the Trump administration which absolutely hated high interest rates.

Obviously, the US is no Turkey.  But I can't help drawing the parallel as a warning of what could ultimately happen.

 

Let's Look At Unemployment

The Fed claims that the US economy is not out of the COVID woods yet, therefore monetary policy has to remain uber-loose until at least 2023.  The most frequent statistic quoted is "high unemployment" and its attendant output gap.

OK then, let's look at unemployment.  From the Bureau of Labor Statistics (BLS) we get the following chart:

 

In February, total non-farm payrolls were down by 9.5 million versus last year. That's certainly lots of jobs - but what kind of jobs are we talking about? Are they professional, highly paid positions? No: 3.5 million are in leisure and hospitality (i.e. restaurants, hotels, theaters, etc) where wages are the lowest, 1.4 million are in government (lots of shutdowns) and another 1.3 million in education and healthcare (schools and colleges were closed).  Those three sectors alone account for 6.2 million of the total jobs lost between Feb. 2020 and Feb. 2021 - that's 65%.

As the COVID emergency subsides, these are the kinds of jobs that are coming back fastest.  Leisure and hospitality is already leading the comeback.  Last month the sector added 355.000 jobs out of a total of 379.000 (94%) in employment gains.  And as soon as education goes back to in-person classes (already happening), those jobs will be restored, too.  Government may be a bit slower in restoring some services, but it won't be very far behind.  So, I have to ask... what output gap???

It is, therefore, highly questionable as to why the government thought it necessary to send $1.400 to just about every American. I can certainly understand helping those who are unemployed, but... everyone? 

I'm not the only one who thinks this is irresponsible, dangerous even.  Larry Summers just spoke out again - Bloomberg notes in an article (my bold):

In his latest attack on the recent rush of stimulus, Summers told David Westin on Bloomberg Television’s “Wall Street Week” that “what was kindling, is now igniting” given the recovery from Covid will stoke demand pressure at the same time as fiscal policy has been aggressively eased and the Federal Reserve has “stuck to its guns” in committing to loose monetary policy.

“These are the least responsible fiscal macroeconomic policy we’ve have had for the last 40 years,” Summers said. “It’s fundamentally driven by intransigence on the Democratic left and intransigence and the completely irresponsible behavior in the whole of the Republican Party.”

I'm with Larry, who now sees a one in three chance of the US falling into stagflation, a condition we haven't experienced in 40 years.  I may remember it, but today's "investors" (aka kiddies running algos) have not a clue, they could care less about such outmoded, Buffet-era fundamentals.  Today, it's all about momentum and pie-in-the-sky "tech".  Their hero being Elon Musk, all I have to counter with is.. PT Barnum.

 

Funny Money

 I’m getting tired of “experts” saying that the torrent of money being created by the unholy alliance between the Treasury and the Fed is not really worrisome, won’t lead to inflation, won’t affect the status of the US dollar as global reserve currency, and so on.

Ok, just one chart: 

Annual Percent Change in M3

C’mon, no effect? Seriously???  The madness with cryptos, NFTs, massive speculation and volatility in clinically dead company stocks, SPACs, 12 year old stock traders... no effect??? 

Inflation IMHO is not going to come so much from a “hot” economy driving up demand.  Instead, it will be goods producers and service providers realizing that with all this funny money sloshing around the nominal price of their wares MUST be marked up in order to maintain their intrinsic value. 

Bottom line: funny money = monkey business.

The End Of Cheap Money

The end of an era, any era, is signaled by a loud "bang", some sort of obvious event that makes clear to one and all that times have changed - assuming they are listening.  In financial markets they say "no one rings a bell" to signal the end of a bull (or bear} market - but that's absolutely wrong.  If you pay attention and do not get distracted by the surrounding cacophony, you always hear the "bell". 

 US Treasury bonds have enjoyed a stellar ride for a full 40 years.  After reaching a stratospheric 15% in early 1981, yields for the 10-year bond have been on a steady and constant downward slope - until 2020 (Chart 1).  That's when the bell "rang": a combination of panic and central bank interventions caused yields to fall off a cliff to 0.5% - and then rebound sharply.  The chart is in log scale, making it easier to see the massive departure from "normal".

 

 Chart 1

The interesting thing about "bells" is that they are always denied, disputed and very often ridiculed by "experts".  The reason is simple: too many people have been lulled into complacency and too many vested interests have accumulated over too many preceding years, when "the trend was your friend".  (As an example from history, the seemingly sudden collapse of the USSR was signaled years earlier by its ruinous campaign, defeat and ignominious withdrawal from Afghanistan.)

The good thing about markets, when allowed to perform freely, is that they distill every bit of available information and turn it into action, plain for all to see. So, what is the above chart telling us?

• A reversal to the existing downtrend should bring yields back to at least 3%, almost double today's 1.66%.
• The departure from trend was so sudden and extreme and the rebound so equally abrupt, that it is highly unlikely that we will experience lower rates any time soon.
• The V-shape in rates is now accompanied by the largest ever increase in money supply and government debt, plus a sharp spike in commodity prices.

 Furthermore:

• The Fed and Treasury are in rare concurrence, both trying to convince the market that monetary and fiscal profligacy are inconsequential - but, it's not working. Talk is cheap - worthless, actually.
  
• Bond yields are still well below current and projected inflation, i.e. negative real interest rates.  It makes zero sense for any real money investor (eg pension fund) to assume the market risk of owning long bonds.

 IMHO, therefore, the confluence of events is a clear and loud "bell" that interest rates have bottomed out and are very probably going to be going up for a protracted period.  The Era Of Cheap Money is over.

Central Bank Raises Rates

 Denmark is a member of the EU but not of the Eurozone and has its own currency, and runs its own monetary policy, of course.

Guess what? Its central bank just raised interest rates!  Yes, that’s right, it raised them from -0.75% to -0.60%  Why? Because there was some downward pressure on the krona and, much more importantly, the government faced problems in selling bonds.

As the Reuters story reports, 

“Nordea’s chief economist Helge Pedersen said the rate hike was partly due to a recent substantial widening of Danish mortgage bond spreads and the massive sell-off of these by investors. He also noted the Danish central bank had difficulty selling government bonds at its most recent auction.” (my bold)

Are you paying attention Fed and ECB? I’m sure you are...

Note that Danish government bonds are rated AAA while US are at AA+. Most of us have forgotten that the US lost its AAA rating from S&P back in 2013.  More recently, in July 2020, Fitch placed its AAA rating on negative outlook, meaning that a downgrade is coming.  Yup, let's keep piling on debt America and see what happens.... May I also remind that back in 2007-08 CMO tranches went from AAA to D in one step... Assumptions are bad business, eh?

Sure, Throw More Oil To The Fire

 The ECB's Mrs. Lagarde is concerned and determined.  Concerned about the ongoing increase in bond interest rates and determined to stop it.  How? By buying even more bonds, of course!  

Right... let's follow the logic here: interest rates are going up because sane and rational bond investors see the flood of new money being printed by the Fed and ECB creating significant monetary-driven inflation.  Commodity prices are already spiking alarmingly, there are massive shortages of memory chips and sea transport rates are climbing very fast.  In our highly interconnected, just-in-time manufacturing and delivery economic system it is only a matter of time - a very short time - until consumer prices start spiking, too.  For example, crude oil prices are now the highest in three years - you can't really expect the Saudis to sit idly by and sell their oil for depreciating dollars.  

Back to Mrs. Lagarde: buying even more  government bonds, even if only pre-existing ones from the secondary market, is not going to make Bond Vigilantes any happier.  Oh sure, they will be very happy to hit ECB's bids and unload as much of their portfolios as the ECB will buy - but they're not going to buy any more new ones at auction. At least nothing longer than 3-5 years MAXIMUM.  

So, two things: 

• Mrs. Lagarde is losing her cool.  Talk is cheap: if you want to bring bond rates down ADJUST YOUR MONETARY POLICY, or be prepared to buy trillions in long bonds. And then, watch them depreciate fast.
• ECB buying more new bonds at auction will just add to the money stock, ie create even more monetary inflation - exactly what the bond market is currently worried about.

In short, Mrs. Lagarde is NOT calming the market and, in fact, she's making things worse.  

That's the problem with political wonks... never having worked in a real life dealing room they think their title and words alone will make markets do their bidding.  Well, it just ain't so...

Popular Delusions And The Madness Of Crowds

 The following piece of digital, blockchain “art” was recently sold for $7.6 million.  Are we in the loony bubble phase of money?  You be the judge - and you don’t even have to be an art critic.

This Is Not A Pipe 

The above, plus the $69.000.000 paid yesterday at an auction that started at $100 for another piece of such “art” is all made possible by the following picture.  IMHO it even has more artistic merit than the one above.  Hey, it even has letters and numbers... 

Change In M2 From Last Year

Delusion and madness are gripping the planet.  What could possibly go wrong...??

Commodity Prices In Other Currencies

Yes, commodity prices are zooming, the Dow Jones Commodity Index is near a  10 year high - in US dollar terms (Chart 1).  But, what if you are paying in Euro, Yen or Aussie Dollars?

Chart 1 - Commodity Price Index in US Dollars

In euro, commodity prices are already past their 10 year high - Chart 2.

Chart 2 - Commodity Price Index in EUR

If you are paying Yen, commodities are even more expensive - Chart 3.

Chart 3 - Commodity Price Index in JPY

And what if you are a producer of commodities, say Australia?  You are very pleased, indeed - Chart 4.

Chart 4 - Commodity Price Index in AUD

Finally, here is a  comparison chart of the Commodity Index in USD (blue mountain) with the 10-year Treasury bond yield (red line) - Chart 5.

Chart 5 - Commodity Price Index in USD and 10-Year Treasury Yield

It looks to me that interest rates have a long way to go higher before they catch up to commodities.  That, or commodity prices will come crashing down because the current hyper-optimistic global economic growth expectations are proven false.