Be Careful What You Wish For

 Seems like everyone in markets is hoping for a recession so that the Fed will stop raising rates.  They point to the yield spread between 10 year and 2 year Treasuries as an accurate predictor of recessions.  The spread is now at its most negative in 40 years, and a quick glance at the chart below confirms that a yield inversion accurately predicts recessions (grey areas in the chart).

From a fundamental perspective, it makes sense to expect a recession.  Sharply higher prices for consumer essentials like energy, housing, food and transportation means that disposable income is curtailed for other expenses such as clothing, electronics, vacations, dining out, etc.  So, yes, a recession is more likely than not.

But, "markets" had better be very, very careful what they wish.  For one, squeezing available incomes and raising unemployment in today's America is downright dangerous.  The middle class has evaporated, replaced - mostly - by the working poor;  and they cannot afford to see their incomes eaten away by inflation, because they simply cannot make ends meet living paycheck-to-paycheck.  Labor actions are already in the works where unions still have a toehold, but if this negative income/expense balance continues for much longer there will be serious social trouble.  At the very least, expect higher wage demands even where there is no unionization.

The government/Fed's record breaking largesse during COVID via QE helicopter money is now long gone, spent away on the likes of FAANG-type services and punting on scams like meme stocks, cryptos and NFTs.  Moreover, the Fed has - finally - started to drain the excess liquidity at the rate of $95 billion/month.  Not fast enough to kill inflation quickly IMHO, but this is money that will be increasingly "missed" from the economy.

Americans' Savings: Easy Come, Easy Go

Bottom line: I don't think this will be a recession like all others.  It won't be the quickie down-and-up of old but a shallower and more prolonged affair, possibly marked by social unrest and political upheaval. Markets: Beware what you wish for!

Fed Update:  Mr. Powell confirmed that rate increases will moderate from 75 to 50 bp and sent markets into a strong relief rally.  He also, however, pointed out that structural changes in the economy, demographics and employment patterns mean that inflation is now more difficult to bring down quickly, requiring restrictive policies for a longer time. He thinks that a “softish” landing is possible, rather than a deep recession. Another name for it? Mild stagflation…

Is The US A "Safe Haven" Or A "Powder Keg"?

Every time there is some sort of global upheaval in markets or geopolitics the US benefits from a stronger dollar and a rally in Treasury bond prices.  It has been thus for decades, as the US is viewed as a safe haven for capital from all over the world. 

Is this view still valid?

In my opinion, no it is not.  The US should no longer be taken for granted as a safe haven;  instead, it should be viewed more as a risk factor than anything else, a powder keg that could potentially blow up spectacularly. This is not a recent development, it has been a long time in the making.

• For one, it was the US itself that caused the Great Credit Crisis in 2007-10.  Yes, there were other economies that followed the same unsound path: loose money, substandard lending practices, real estate excesses and unbridled securitization of loans and derivatives.  But, it was the US that was the main culprit and it was the US that subsequently "printed" trillions to save its banks, brokers, funds and insurance companies from default - well, most of them anyway. The deleterious effects of that massive QE are still with us, even if the even more massive COVID era QE has far outdistanced it.

• The US is now amongst the most highly indebted nations in the world, with public debt to GDP at 121%, an enormous increase from just 30% in 1980.  The debt ratio has accelerated the most during the Great Debt Crisis (see chart below), precisely because the government "saved" the private sector banks, investment banks, etc. by assuming their debt - foolishly, in my opinion.

• Going back further, the US economy has become emasculated, wasting away its manufacturing muscle by shifting it abroad, mostly to China.  As I said before, manufacturing is the fountainhead of all technology, of all high value-added economic processes. According to the Bureau of Economic Analysis, US manufacturing now accounts for 11.5% of GDP, down from 27% in 1960.  Crucially, manufacturing employment is now a mere 7% of total, down from 30% in 1960.  US manufacturing leadership is now limited to aircraft (Boeing) and military equipment.  Not good.

• The loss of manufacturing jobs has all but eliminated the solid American middle class, creating a socio-economic chasm between the working poor and the ultra rich.  The political consequence of this divide are becoming apparent (Trump/MAGA) and dangerous (storming of the Capitol, rise of the far right).  Unthinkable previously, the US can no longer be considered a politically stable nation.

• As is common in nations, societies and economies that are losing their leadership edge, financial speculation in the US has increasingly replaced healthy, productive economic activity.  American tycoons are now mostly owners and top executives of hedge funds, investment banks, and until recently, all manner of crypto/NFT firms.  That's not a healthy sign, it marks an economy that makes money from trading paper, instead of innovating and producing. 

• One final observation: a sure sign of an Empire in decline is that its supremacy is increasingly challenged by second or even third rate powers, who would never dare do so before. Iraq, Venezuela, Afghanistan, North Korea, Turkey and, of course, Russia are nipping at Uncle Sam’s heels with increasing frequency, if with questionable success. But the mere fact that they are doing so speaks volumes.

So, yeah, the US is no longer a safe haven in my book.  And unless American leaders wake up soon, they will end up wondering why the proud nation has become a has-been.

That’s Oil Folks

The recent slight drop in inflation caused a wave of optimism that we are out of the woods. All markets rallied and the Fed decided to slow down the pace of raising interest rates.

But, let’s take a closer look at the constituent parts of inflation, shall we? The following chart from the WSJ tells it as it truly is: the drop in inflation came 100% from lower energy prices. Core inflation remains mostly unchanged and high, and so does the food component.

To make this clear, here is another chart: energy price inflation came down from 42% yoy - the highest in 40 years - to a more manageable 17.5%.

And why did energy prices come down in the US? Because the government released an unprecedented amount of oil from the Strategic Petroleum Reserve, increasing local availability of cheaper oil to domestic refiners thus lowering gasoline prices from $5.00 to $3.60 per gallon. Gasoline is the largest component of energy CPI thus… lower overall inflation.

This unprecedented drawdown in the SPR is not sustainable, of course. If continued at October’s rate, America’s strategic reserves would empty completely in a mere 17 months. In fact, there are signs that the drawdown is slowing down in November - after the midterm elections, of course. Now, if I were of a suspicious nature I would say that lowering gas prices and inflation was a political ploy designed to shore up the Democrat’s showing in the midterms. 

One way or another, we will soon be back to normal (whatever that is), the oil drawdowns will cease and the SPR will need to be filled up again, reversing the downward pressure to an upward one.

As Porky used to say - almost - “That’s Oil Folks!”

More On The Creaking Treasury Bond Market

In a recent post I pointed out that liquidity in the secondary market for US Treasury securities is at the lowest point in years, creating serious problems for dealers, traders and the Treasury itself.  I did some more data mining in SIFMA  and came up with the chart below.

You can see that the average daily volume in all Treasury securities (bills, notes, bonds, TIPS) as a percentage of all marketable Treasuries outstanding (ie excluding those held in the Social Security accounts) is at the lowest level ever.  The big drop in activity came about after the Debt Crisis in 2008-09 and has been falling steadily since.

This drop in activity is very worrisome, particularly now when the spike in inflation has led to sharply higher interest rates and an increase in new bond issuance to cover higher budget deficits and debt service payments/refinancing.

Why did activity drop in the secondary market?  Partially, it is due to the sharply higher amount of bonds held by central banks, particularly the Fed, which now owns 6 times more Treasuries than in 2008.  Such holdings don't trade, so the percentage traded has come down - but this can't explain everything.

Amount Of Treasury Securities Held By The Fed

Something else is going on… it could be the near zero interest rate environment that held for such a long time sapped all desire to trade - there was very little price volatility for years on end. Also, investors had no reason to sell their older higher coupon bonds since they could not replace them.

No matter the reason, low liquidity and low volume is troubling and could create serious problems for the government’s finances.

Inflation and Wages - A Follow Up

Following up on yesterday's post on how inflation is eroding the buying power of the average American and European wage earner and the upcoming strikes in key sectors like rail, mail, education and health.

It has been decades since unions flexed their muscle - indeed, unions have become emasculated. In the US private sector only 6.1% of workers are unionized today, a far cry from almost 35% in 1960.  The primary reason is the de-industrialization of the US/West, particularly after China became the world's factory.  I am certain that this shift of production from West to East (it started with Japan, remember?) is one of the stupidest socioeconomic decisions made by all Western leaders, bar none. Pardon the "stupid", but as a trained engineer I understand very well how production drives R&D advances and quickly leads to technological supremacy.  Lose your technological edge and you destroy your high value-added economy and your prosperity - period.

The loss of manufacturing jobs emasculated the entire middle class, now but a shadow of its former glory.  And along with that, has come the rise of populist politics, and politicians promising to Make America Great Again.  It is happening everywhere: in the US, France, Italy, Brazil, Austria, Poland, Hungary... it is no accident that Germany, the only Western economy still boasting a large and solid manufacturing base, has not fallen victim to populism - at least not yet.

It was a matter of time, then, that something would give and social unrest would follow.  Soaring inflation and loss of real income is now threatening to throw the West into a vicious cycle of social unrest.  It is no accident that Russia/Putin is taking advantage of this situation, hitting Western economies in their soft underbelly: energy, food and transport.  And it is still early in the game.

What should the West do? Here's a list, from immediate actions to longer term:

1. Substantially raise minimum wages - at least to cover inflation.
2. Do everything necessary to kill inflation immediately: raise interest rates at least at or near inflation levels AND get rid of excess liquidity ASAP.
3. Promote saving instead of spending. Pressure banks to raise deposit interest rates.
4. Raise corporate taxes, enforce minimum tax policies and invest the proceeds in alternative energy technologies, public transport, technical education and R&D.
5. Provide serious incentives to bring factories back. Perhaps impose trade/import restrictions.
6. Promote "buy local" policies, with tax incentives.
7. Seriously evaluate the consequences of getting rid of WTO, replacing it with bilateral/multilateral trade agreements. 

If the West - and by West I mean 70% USA, 20% EU, 10% Japan - does not act immediately, it will fail spectacularly and suddenly.  There is no time left for navel gazing.

 

Real Wages Eroding Fast, Strikes On The Horizon

With inflation running hot in the US and Europe, labor unions are preparing massive strikes not seen in decades.  

US railroad employees are set to strike next month, though the federal government will likely step in and impose labor terms, as it has the right to do in order to prevent the economy from grinding to a halt (40% of all goods move by rail and many commuter trains use private railroad tracks). In the UK rail workers are also set to strike in December, joined by university professors, teachers nurses and mail workers.

Can you blame them? In the US consumer inflation is rising much faster than pay raises, resulting in negative real wage growth (see chart below).  

Real Average Hourly Earnings - Annual Percent Change

Lower/middle income workers feel the pinch much more, since a greater portion of their earnings go to buy essentials like food and transport where prices are rising faster than overall inflation: Food and beverages are up 10.6% and transport up 11.6%, while overall CPI inflation is up "only" 7.8%.  For them, wage erosion is closer to minus 5% - 6% instead of 3%.

Service workers in Amazon or Twitter may be laid off in droves without immediately causing an economic upheaval, but essential workers are a different matter altogether.  Expect more labor actions to surface in the immediate future.

It's Deja Vu (All Over Again)

 Very short post today.

The gut feeling I get from all markets these days is that I've seen it all before, specifically during 2007-08.

Back then the Debt Crisis started slowly at the very edge of the risk/credit/real estate spectrum, ie subprime loans for speculative type properties.  Some mortgage brokers started going under, then specialist mortgage lenders (remember Countrywide?) and - finally - the doodoo hit the fan all at once: venerable investment banks who had bought and securitized loans and derivatives went bankrupt or were bought/bailed out for peanuts, seemingly overnight. The Fed saved the day by providing massive liquidity in amounts that looked immense - back then.

Today, the "edge" of the credit/risk spectrum is in cryptos and their associated exchanges and lenders.  They are now going under leaving behind losses in the billions.  Since the financial system is highly interconnected, however, I'm waiting for the next domino to fall, and it won't necessarily involve cryptos.

Once the Risk switch is turned to the OFF position all manner of critters are going to be rushing for the exit doors.

COP27 Ends In Failure

The COP27 conference just ended in abject failure, as leaders failed to agree on the mitigation of emissions from fossil fuels and arresting global warming. Not surprising. God help us and our children, because global leaders won’t.

Below, relevant charts. 

Fossil Fuels Are 80% Of Our Global Energy Consumption

CO2 Emissions Have Risen 800% In 70 Years

Global Land-Ocean Temperatures Up 1C In 40 Years

Heat Map In 1950

Heat Map In 2022

All charts are alarming, of course, but the last one is particularly so.  It shows that Arctic temperatures are rising the fastest,  4C+ over average.  This means:

• Polar caps are melting fast, raising sea levels
• The Siberian Arctic tundra holds immense amounts of trapped methane near its permafrost surface. Methane is up to 80 times more damaging as a greenhouse gas and its release will act as the most powerful accelerant of global warming/climate change, much more than CO2.  It means that we may see climate and habitat disasters happen within years, not decades.  

The Most Important Market In The World Is Creaking

The stock market gets the glory (incessant publicity), but the most important market in the world is the bond market, particularly US Treasurys. Everything, and I do mean everything, is ultimately based on it. It hasn’t always been so, but ever since the abolition of the gold standard in 1970’s, and more recently the emergence of shadow banking and the effective abolition of bank reserve requirements has led to an explosion of debt. 

Yes… Sudden Debt…

Obviously, the proper functioning of the US Treasury market is of paramount importance: liquidity, breadth, depth, transparency and regulatory oversight are the cornerstones of any market and are taken for granted for Treasurys.  Lately, however, something is seriously wrong as the chart from a very important FT article shows.

Liquidity, measured as the amount of a single trade that can be executed without seriously moving the market up or down,  has deteriorated to dangerous levels at the very time that the size of the market has quintupled. In 2010 liquidity stood at almost $800 million and today at just $100 million.  As a ratio of the total market, liquidity has collapsed 97.50% from its 2010 levels. Another way to look at it: for a bond trader it is now 42 TIMES more difficult to execute trades in US Treasuries - in equivalent market size. 

In practical every day terms it's not as bad as that because a chunk of Treasuries sit at the Fed's balance sheet, around $5.5 trillion worth. Still, it's bad enough.  Furthermore, the Federal Reserve Bank is ultimately... a bank!  At the end, it too has to take into account how heavily exposed it is to its borrowers and how liquid is its portfolio.

As a bond market professional, this liquidity plunge is really scary.  It could create enormous price volatility in the market, a possible repeat of what we saw in UK gilts recently, but magnified many times over.  If it happens, it would necessitate the massive intervention of the Fed in the form of another QE, at a time when we need the exact opposite (QT).to tame inflation. 

Fed Funds Projections

Markets seem to be monothematic these days: it's all about the Fed.  How fast will it raise rates and, even more crucially, how high will it raise them from today's 3.75-4.00% band.  With this in mind, here's a chart I came up with with data from the CME's Fed Funds futures market. 

The blue bars (left scale) show the Fed Funds rate and the orange line (right scale) shows the highest probability associated with this rate, as implied from the futures market.

Interpreting the chart, the market is betting that the Fed will immediately temper its hikes to 50 basis points next month, giving that scenario an 81% probability, and will subsequently raise by only 25 bp, but give this a lower probability of 50%. Further, the chart says that rates will top out at 5.00% by March and stay constant until late next year, but with ever lower certainty.  To be clear, the orange line involves the rate that shows the highest probability - others are for lower or higher rates.

We’re Sorry If You’re Starving, But…

 The iconic Harrod’s of London decided to go all out this Christmas and, in cooperation with Dior, transformed itself into a giant ultra luxury gingerbread house bedecked with thousands of lights showcasing products that are far beyond the reach of even the merely rich, never mind the middle class. 

The manager of the store said - on camera! - that he’s truly sorry for those Britons that are in trouble, but Harrod’s only caters to the 0.1% of the ultra rich. Never mind being socially incredibly deaf and blind, a supersize retail establishment like Harrod’s cannot long survive with the custom of only 68.000 Britons plus some visiting tourists. I mean, if you are one of other 99.9% do you now feel welcomed? Do you really want to set foot there, even if only to buy a trinket? Is the Harrod’s brand now one that you want to be associated with?

The fact is that a whopping 25% of all Britons, some 20 million, cannot afford to heat their homes this winter: for them, it’s heat or eat. Yet, the 0.1% store says they’re truly sorry.  Like Dickens’s Tiny Tim from A Christmas Carol, 20 million cold and underfed Britons could crowd outside and stare at the store windows in wonderment. Hopefully, they won’t decide to start throwing bricks.

The All-American Sandwich

 Final results for yesterday's mid-term elections are still being calculated, but this picture (see below, from Reuters) speaks volumes.  It's the House of Representatives map, awash in red.  Yes, its pretty misleading because the large population centers with their large numbers of House seats are actually blue, but it is troubling nevertheless.

Basically, the map says that America's affluent liberal coasts are completely at odds with everyone else who is poorer and socially conservative, or even regressive. It's a recipe for a social/national disaster: America is not a single country but a federation of States.  Why should the approx. 40 red States stay in a union with the other 10 if they hate each other? The Reds produce most of the food, energy, minerals and forestry products - what do the Blues make that is essential to survival?

America is a very fat red sandwich with two very, very thin slices of blue bread.  Perhaps the red "meat" may decide it does not need bread, after all?

For comparison, see below the same map for the 1978 mid-terms.  Why 1978? Because like today, Jimmy Carter was a deeply unpopular Democratic President faced with an energy crisis and soaring inflation. Yet the nation was much more balanced and united, even if angry.

Stage Management

 I cannot shake the feeling that for the past couple of months the US stockmarket and the price of gasoline at the pump are being manipulated, stage managed if you like, ahead of today's crucial mid-term elections. 

I strongly believe that these mid-terms are the most important since at least WWII.  The confluence of economic, financial, social and cultural issues is creating an unprecedented political tinderbox for the US, far beyond anything we have experienced in our lifetimes.  I think President Biden is right in saying that "democracy is at stake", though it doesn't necessarily follow that voters should cast their ballots for Democrats.  Indeed, America faces far more important issues than Blue-Red politics.

Back to stage management: there is no question that gasoline prices at the pump are being suppressed, mostly by massive domestic oil releases from the Strategic Petroleum Reserve, which has now fallen by 45% to 40 year lows (chart below).

What is very peculiar is that while gasoline prices are being kept low, diesel fuel (also used for heating) is soaring to new highs (chart below).

US Prices for Diesel (red) and Gasoline (blue) 

The spread between the two has reached unprecedented highs (chart below).

Spread Between US Diesel And Gasoline Prices Reaches Record High

Unlike Europeans, Americans don't drive many diesel cars, preferring gasoline ones instead.  The country consumes three times more gasoline than diesel/heating oil.  Therefore, voters are not experiencing "pump shock", just now. However, diesel is essential for moving goods in trucks and trains, as well as heating homes where natural gas is not available.  Therefore, it plays an important role in shaping consumer inflation, even if voters don't see it everyday driving to and from work.

As for stage managing the stockmarket: while tech companies are taking a massive beating, broad averages like SP500 and the ever popular Dow 30 are not.  Why? Because (a) oil companies are soaring (b) "defensive" shares like pharma are holding up and (c) Apple, the biggest biggie of them all, is also holding up, comparatively.

The election will be over today. No matter what the result, I believe stage management will also be over today.  Let's see how markets fare then.  

Irreverent Interelationships

 From our weird comparisons department: are these two charts related? And if so, what can they tell us about the future of the US stock market?

 Note: Apple has the highest market capitalization, and is by far the largest component, of S&P 500.

Percentage Of US Population Using Social Media

Price Of Apple Stock

Shipping Indexes: The Real Economy

The real economy moves lots of stuff around, most of it in ships.  Raw materials like coal, iron ore, fertilizer and grains are transported in bulk carriers and finished products in containerships.  The vessels are chartered either long-term (time charters) or on a voyage basis (spot).  Spot charter rates are, therefore, among the best current economic indicators since they reflect the actual supply/demand balance for raw materials and finished goods.

Moreover, unlike financial markets shipping rates are almost impossible to manipulate;  there are simply too many players and too many destinations, with none dominating. Thus, it's a pretty "pure" market.  Even though futures contracts for freight rates do exist, they are not very popular or active.  Therefore, shipping is one sector of the real economy that hasn't yet become "market-ised" and "financial-ised" (unlike, say, energy or pollution emission permits). 

Recently the pandemic created massive disruptions in the global supply/logistics chain and caused spot charter rates to rocket upwards (see charts below).

Baltic Dry Bulk Carrier Spot Charter Rates

Freightos Container Shipping Index

After nosebleed levels, charter rates are now rapidly coming back to the ground, albeit  still somewhat elevated vs historical averages. This price action has apparently caused the head of AP Moeller Maersk, the world's largest containership and logistics company, to comment that he expects Europe to go into recession very soon, perhaps followed by the US as well. 

Yet another global recession warning from the head of one of the largest real economy companies in the world.  Couple it with high inflation, which the Fed and ECB are clearly NOT willing to deal with decisively with strong QT, and we are left with the prospect of an anemic economy saddled with high inflation.  Not good news for financial markets, aka The Uninvestible Universe.

The Fed: Superman Or Mini-Me?

 If you read the financial and mainstream press you get the impression that the Fed has embarked on the most aggressive interest rate hikes ever.  But even a cursory look at the facts (see chart below) shows it just isn't so, even when we add the75 basis point hike expected today.  Moreover, everyone is already talking (hoping) about the Fed tapering its hikes after today.

Fed Funds (Blue line) and Inflation (Red line)

The reason for this rate anxiety, the view that rate hikes are perhaps already excessive, is simple: rates started from zero and hikes look excessive. In fact, they are small given how high inflation is right now. Real Fed Funds (Fed funds minus inflation) are at record negative territory (see below) and are thus having very little, if any, impact on fighting inflation. Instead of being a Rate Superman, the Fed is still a mere MiniMe.

 Fed Funds Minus Inflation

Once again: focusing only on interest rates is wrong, wrong, wrong.  The real cause of inflation is excessive liquidity created by the Fed itself via massive QE in a very short period of time, and which is still sitting on its balance sheet undrained (see chart below).

Fed Balance Sheet Assets

If one needs more proof that liquidity is indeed excessive, he/she need look no further than the Fed's own O/N reverse repo, now at a massive $2.2 trillion (see chart below).  That's money that banks and other major institutions have no other use for and are electing to park it overnight with the Fed.

Fed O/N Reverse Repo

The Fed is currently draining liquidity at a maximum $90 billion per month.  Judging from the size of the reverse repo alone, this pace is too slow to have any meaningful impact on inflation and should be increased immediately, perhaps to a level approaching the initial rate at which liquidity was added during QE, ie around $500-750 billion per month.  

It certainly won't reach that level, but $90 billion/month is clearly too little - a monetary policy MiniMe when it comes to inflation fighting. 

I can't help but to say it again: its all in the QT - and I really wonder why almost no one is talking about it, at least not widely. I'm becoming suspicious in my old age :)