...And What About The ECB?

 I have been harping about the Fed's atrocious monetary policy for very long - so, how about the ECB? Are they any better?  Most definitely, not.  If anything, they are even further behind in normalizing monetary conditions for the Eurozone.

To begin with, the ECB expanded its balance sheet (QE = "printing money") by buying euro area government bonds just as much and just as fast as the Fed - see chart below.  

Central Bank Assets For Euro Area

Unlike the Fed, the ECB hasn't even started raising interest rates;  they are "guiding" towards a couple of quarter point increases, starting - maybe - sometime in July.  Meanwhile, inflation is soaring to historic highs, producing negative real interest rates only seen back in Weimar days.  Right now, eurozone inflation is 8.1% while ECB's  main refi rate stands at 0.05% - see chart below.

Eurozone Inflation And ECB Refi Rate

That's certainly not a rational monetary policy, at least not in the face of it.  Does the ECB know something the rest of us do not? Do they fear something even worse than massive inflation?  Or, are they just hoping and praying that inflation will just go away all by itself?

I believe that the ECB is hemmed in by a trio of concurrent problems: 

1. Several euro nations have still not truly recovered from the 2008 Debt Crisis. Italy, Greece - even France - carry enormous Debt/GDP burdens and will simply go belly up if their borrowing costs were to rise to "normal" levels.
2. The pandemic wreaked havoc to the European economy, particularly the tourism sector that is so vital to the same countries as #1.
3. The war in Ukraine sent energy an food prices soaring, crimping real household income available for discretionary spending, vital for the EU economy.

The ECB is, thus, paralyzed.  While some of its stronger nation-members could weather higher interest rates, its weak links would break under the strain. And a chain is only as strong as its weakest link(s).

The Fed viz Lehman

In June 2008 Lehman Brothers announced a loss of $2.8 billion and went bankrupt shortly thereafter. The vast majority of its losses came from its mortgage securities portfolio which it had to write down by $5.8 billion, ie mark the securities to market and take a charge to earnings.

In late May 2022 the Fed released its financial statement for 1Q22 from which we infer that it is carrying at least $330 billion in unrealized losses in its portfolio, mostly from its mortgage securities. That is to say, it has not (yet) marked them to market. Even worse, interest rates have gone higher since and bond prices fallen further.  Some analysts calculate that unrealized losses have now reached $400 billion or more.

Does the Fed have to mark to market? Not really…. Unless, that is, it starts selling bonds from its portfolio to the open market. And guess what?  That’s exactly what it has to do, in order to carry out Quantitative Tightening - which it has to, in order to combat soaring inflation. 

Let’s think about it…. The Fed currently has losses 100 times bigger than Lehman. And that’s the lender of last resort? The issuer of currency? Really? 

Hello, anyone read The Emperor’s New Clothes recently?

The Train Is Off The Rails

Take a look at the price of crude oil in the last 20 years: boom and bust, wild vertical swings up and down, even to (gasp) minus $40 per barrel. Why is that? Why does the price of arguably the most important commodity exhibit such radical volatility? Is it wild swings in supply and demand, or is it something else entirely?

Wild Price Swings In Crude Oil

First, let's examine supply and demand.  The chart below from the International Energy Agency shows that supply and demand have been rising in lockstep;  indeed, supply (light blue line) has increasingly been outpacing demand (dark blue line) for years (supply gap in green bars).

Crude Oil Supply And Demand 

So, if the wild price swings cannot be explained by fundamentals, they must be caused by something else. What? IMHO, it's the financialization of the entire global economy.  Everything now has a "market", it trades on an exchange, it begets futures, options, CFDs, ETFs.  Investors, speculators, hedge funds, private equity and pension funds have become the prime movers of prices of everything, instead of producers and end users.

Like I have said many times, financial markets were formed to help the economy allocate scarce resources in an organized and rational manner. Instead, they have now become the economy itself - the global economy is financialized.  Prices are no longer set by the nexus of supply and demand, but by the flow of speculative money in and out of "markets".

Think of the economy as a train.  Mr. Fundamental, the old engineer, sped up or slowed down according to the grade and the curves ahead. But now a new engineer has taken over: Ms. Market does not give a fig about the safety of the train and its passengers;  all she cares about is to go as fast as possible.  For her, there is only one setting: full speed.  Derailments are much more frequent, and the train safety authorities are forced to come to the rescue more and more often.

To wit, markets swing wildly, the economy suffers and the central banks have to rescue it by printing ever more money.  It is an untenable situation, obviously, and cannot last much longer.  We have to replace the engineer...

It’s Just The Beginning

Equity markets are in full correction mode, politesse for dropping like a stone.  They are discounting the Fed’s recent and future monetary tightening measures - most of which haven’t even started yet.  Specifically, the Fed will commence Quantitative Tightening, ie the reduction of money supply by shrinking its balance sheet. Starting in a few days, the Fed will begin selling bonds from its portfolio in the open market to the tune of an estimated $90 billion per month. The result? What went up, will go down: pump and jump turns into stop and drop, see chart below.

The question in everyone’s mind is, has this drop fully discounted the Fed’s upcoming actions?  In my opinion, not by a long shot - as the title says, it’s just the beginning. 

Why?

Because the Fed is - finally! - committed to combatting soaring inflation, the very inflation it created all by itself by vastly expanding its balance sheet (ie creating new money) from $4 trillion to $9 trillion.  And the ONLY way to lower inflation this time is to give it a one-two punch: raise interest rates and decrease money supply.  Make money more expensive and make it scarce.

Unlike inflation in the 1970s and 1980s which was brought about mainly by exogenous oil price shocks, today’s inflation  is purely a domestic monetary phenomenon.  It cannot be dealt with by raising energy efficiency, turning down the thermostat or wearing a sweater indoors (who remembers Jimmy Carter’s cardigan?).  This time, it must be dealt with in monetary fashion.

My guess is that the Fed and its goofy cousin the ECB will draw this out unnecessarily, instead of  going for a knockout punch - they are just not decisive or brave enough, and they are much too beholden to the financial-investment community.  So, this will go on for a long while and inflation will persist. 

My working model is for years, not months, of restrictive monetary policy  and a long-lasting bear market in equities instead of a big “crash” followed by a sharp rebound.  This is going to be with us for much, much longer than Wall Street expects.

Elon Musk And Twitter

 Why is Musk sowing doubt on his Twitter deal?  Is it because of "fake" or auto/bot  accounts?  Or, is it something else?  For the answer look no further than the chart below.

Tesla Stock Down 37% From One Announcement To The Next

Musk was (is?) going to finance his Twitter purchase via a loan backed by his holdings of Tesla stock - in other words, he was going to margin his shares. 

Margin loans are tricky business; when share prices go down the lender calls for extra cash and/or more collateral to keep the loan to collateral ratio topped up.  That's where the term "margin call" comes from, and if the "call" is not met immediately, the lender sells out the collateral position to cover the "call" amount.  And that's how crashes happen... 

Lunar Landing

The best example of a top Head and Shoulders pattern I have seen in my 40 years in markets - see chart below.

Luna Crypto Crash Lands Back To Earth

There are plenty of similar patterns around these days. 

Here's a random pick.. well, not so random :)

S&P 500

Introducing HARIX: The Hellasious Appetite for Risk Index

Just for fun, today I'm introducing HARIX the Hellasious Appetite for Risk Index.  (It's pronounced  hairy-x, for obvious reasons.. har, har, har:)

In a totally unscientific and arbitrary (-ish) way, it is calculated as the sum of the capitalizations of  Bitcoin, Tesla and GameStop.  Below is a chart tracking it from 1/1/20 to today.

The Hairy Ride Of HARIX Up... And Maybe All The Way Down?

HARIX rose almost tenfold within just a year from 1/1/20, and has now corrected 40% from the top. 

 BUT!! It is still up 550% from when its wild ride started in  2020.  My opinion? Don't go bargain hunting, don't attempt to catch a falling knife.

Also... here's a recent ad from one of the world's premier yacht brokers:

Spend your Crypto on Superyachts! 

You can now secure charter bookings and purchase vessels in our fleet using Crypto currency.

To which I counter with....

Inflation: Hit Them Hard

When it comes to money (aka debt) and inflation, I sound like a broken record, I know... but, I can't help it.  In that, I'm just like central banks: they can't help thinking that the only way to solve problems is by printing money.  After all, if the only tool you have is a hammer pretty much everything starts to look like a nail :) 

So, rinse-repeat: The inflation we are going through right now HAS NOTHING TO DO WITH THE WAR. It is all about the monstrous amount of money printed and thrown out of helicopters by the Fed and ECB - two years before the war started.

Proof: 

Bank Demand Deposits (aka cash) Soared As Much As 120% And Are Still Rising 30% Annualized

Inflation Jumped At Exactly The Same Time And Reached 7.5% Before The War Started

The ONLY way to kill this inflation is to shrink the amount of money in circulation by engaging in a determined round of Quantitative Tightening (the Fed shrinks its balance sheet by selling bonds in the open market).  

While the Fed has pretty much pre-announced that it will start doing so in June, I stress that it still hasn't sold anything.  Its balance sheet is as bloated as ever.

Federal Reserve Assets Remain At Record High

The longer the Fed delays QT (it should have started months ago) the more difficult it will become to tame inflation. Inflationary expectations are already feeding through to the labor market, which is itself experiencing unprecedented tightness with near record low unemployment.

I am and have always been a proponent of drastic action: if you must do something, do it fast and do it all out.  Markets are like packs of wild animals, the only thing they understand is fear and greed.  So, a "little" fear is just not going to do the trick.  Hit them with the stick and hit them hard - and then watch as they do the rest of the work for you.

Update:  US Inflation data were just announced today.  Core inflation ex-food and energy came in much higher than expected, ie inflation is rising fast even outside the volatile items.    The chart below shows how average core CPI was tame for decades (green line), but is now soaring.

Core Inflation Soaring Far Above Average For The First Time In 20 Years

It all makes decisive action by the Fed all the more urgent....

The Fed, Plus Risk On/Off Mode

 First, about the Fed.

I believe it is very, very early in its interest rate battle against inflation. The chart below shows that it has taken only baby steps in tightening: look at how drastically the blue and red lines diverge, mostly because the FedFunds rate I still so very low versus inflation, current and expected. So, there is much more upside to come.

Second, on risk appetite.

Spreads between junk bonds and Treasurys are still very near historical lows - unrealistically low, in my opinion. I believe investors  are still expecting (hoping) that there won’t be a full blown-out recession in the near future, so they’re still pretty blasé about bankruptcy risk.

Putting the two together:

The Fed still has a long way to go in raising rates, meaning things will get much more challenging for the economy in the near/medium term. Investors don’t seem to appreciate this risk, so they’re still pretty much on Risk On mode - dangerously so.

(Both charts come from Yardeni Research. Their interpretation is mine alone.)

Labor Costs Soar, Productivity Turns Negative, Fed In A Bind

 Data for labor costs and productivity were released yesterday.  Predictably, costs rose at the fastest rate in 40 years and productivity turned negative.

Unit Labor Costs (blue line) and Labor Productivity (red line)

As we know, inflation becomes "baked in" to the system as labor costs rise, with workers expecting larger pay increases to combat inflation. Essentially, it creates a self-reinforcing inflationary loop feeding on itself; it is the Fed's greatest fear - and rightly so.

To make matters worse - or better, depending on which side of the fence you are sitting - unemployment is just about the lowest in history: continued claims for unemployment insurance at 1.38 million are the lowest since 1970. 

Continued Claims Lowest Since 1970

Massive government handouts and two years of pandemic restrictions resulted in a vertical rise in bank deposits, creating the fuel for very strong consumer spending - thus, even more inflation.

Demand Deposits In Banks Soared

Conclusion: The Fed has no choice but to step hard on the brakes to combat inflation.  In my opinion, whoever believes in a "soft landing" may as well believe in the Tooth Fairy.

Fed To Tighten - How Will It Impact Stocks?

Yesterday the Fed announced at 50 bp interest rate increase and the start of a monthly reduction of its balance sheet - ie quantitative tightening (QT).  I strongly believe that QT is far more important and impactful for markets than raising rates.  It will drain liquidity, the very oxygen of markets that today are highly dependent on plentiful and cheap liquidity to "carry" financial assets on borrowed money.

The following chart makes things clear: notice how in 2020 the stock market (red line) soared at exactly the same time as the Fed pumped its balance sheet to record highs (blue line).   Pandemic fears made no difference: the torrent of money raised equity prices, regardless.

Is it now time for a reversal? I think so, depending on how committed the Fed is on killing the inflation itself has brought upon us all by the self same money torrent.  Again, I don't think the Ukraine-Russia war has any real significance in all of this.. it's all about money.  Predictably, share prices have eased off their highs well in advance, discounting the Fed's actions.

The only remaining question, therefore, is how tight will the Fed get?  Again, in my opinion, it won't ease off any time soon;  the process will drag on, possibly for years instead of months.

Inflation, Pie To The Sky

Looking at the weighted components of US CPI is revealing, to say the least (see chart below).

Housing (includes fuel, electricity, etc) accounts for a massive 42% of all consumer spending; food and transport is another 33%. Therefore, a huge 75% of all spending goes to cover the absolute necessities of shelter, food and transport. And it’s exactly those sectors that are impacted the most by price spikes in energy, food and basic materials. 

Since incomes are not rising rapidly, spending on all other, more discretionary, items is going to get curtailed to a very great extent. We are already seeing hints of this: Netflix is losing subscribers and Amazon sales are softening. 

Ergo: Recession watch is ON and risk appetite is OFF.