LDI: Do They Ever Learn? - Or Is It Plain Old Greed?

 Remember my UK Plunge Extra post from just a few days ago? Told you so….

This blog was one of the very first to point out the risks inherent in CDS going back as early as 2007.  We know what happened afterwards.  Let’s be absolutely clear: there is ZERO fundamental need for CDS, or a plethora of other such financial market derivatives. In fact, instead of reducing risk such derivatives BY DEFINITION increase systemic risk because they introduce at least one (and frequently many more) extra counterparties to the equation: the issuer(s) of the derivative(s). Just Google “AIG CDS credit crisis” and my point becomes clear.

After the CDS meltdown in 2008-09 one would think that the market learned its lesson: Derivatives are dangerous, no matter if they dress in sheep’s clothes. But no, the lesson hasn’t been learned.

The newest culprit is called LDI, an innocuous enough strategy of Liability Driven Investing targeted mostly at corporate pension funds. As a pension fund manager you have a known future liability stream X to pay pensions, medical benefits, etc. , and current assets of Y.  Unless you work for Norway or Qatar, you have a definite mismatch problem, which ultimately boils down to this: you can’t possibly predict the far future.

Enter your friendly investment bank/pension consultant who offers you an investment strategy called LDI purporting to solve your mismatch problem.  It involves an array of derivative instruments, of course, but hey,…. It sounds good, right? Give them your money, toss the Bloomberg terminal password into the drawer and head down to the pub for a few. Problem solved.

Riiiiiiiiight….. until the (not so) unthinkable happens and a new PM decides to go for a massive unfunded tax cut and absolutely destroys the gilt market. The LDI derivatives go underwater and scream for additional margin money.  Which, of course, you don’t have unless you sell gilts or other such in order to raise cash, which pushes prices down, which creates more margin calls. Same old, same old… time and again.

10 Year Gilts Collapse

Why do they come up with this stuff, you ask? Why not stick with plain old long government bonds? Wanna know the truth? Because there’s no money in it for anyone. Plain bond trading commissions are almost zero, and so is managing portfolios of such plain vanilla stuff.  But OTC derivatives are opaque and carry hefty fees and spreads. In a word, it’s greed dressed up as “innovative” finance.

Why does LDI exist in the first place? 

Regulators started requiring corporations to carry unfunded future pension liabilities on their balance sheets, first in the UK and then in the US - and properly so. Obviously, companies hate this because it destroys their valuations.  And many companies, particularly older ones, have very sizable unfunded liabilities.  Enter your friendly banker who sells you a bunch of swaps that “hedge” all or part of your liability, thus reducing or even eliminating the hit to your balance sheer. Problem with hedging with derivatives is that they may hedge the future all right,  but they require margin today, so when the doodoo hits the fan you end up getting squeezed cash-wise, today. And, of course, you counterparty risk has increased as well. 

It boils down to this: you buy a swap from BubbaBank to reduce your future liability and promise to keep such swap properly collateralized. Essentially, you have swapped your future liability for:

1. An unknown stream of margin/collateral payments today

2. Increased counterparty risk from BubbaBank

3. A hefty upfront fee, included in the price of the swap

Doesn’t sound too attractive to me but, hey, PT Barnum had something to say about it.

Not surprisingly, the LDI business is now huge, growing from zero to $4 trillion in less than 10 years, globally.  Half of this amount involves UK pensions alone, ie a whopping 65% of UK GDP. Explains the gilt and sterling disaster last week, doesn’t it? It also explains why Truss & Co today backtracked on their I Love Maggie tax cuts. (Note: it’s a tiny backtrack, it involves only 2 billion out of a 45 billion program).

This episode of Greed Is Good is very far from over, I think. Stay tuned.

Credit Suisse

 Credit Suisse is a fiduciary institution. Fiduciary is a word derived from the Latin fides, ie trust. The word Credit prominent in its name also derived from Latin: credo means belief.  Like any financial institution, it bases its entire existence on the widespread belief that it can be trusted.

When the market prices its CDS (credit default swap) as in the chart below, it signals that it believes that it can’t be trusted.  Any other explanation, like using Credit Suisse CDS as a vehicle for hedging the investment banking industry in general, while partly true, doesn’t begin to negate the overwhelming conclusion: Credit Suisse is in trouble.

Another pretty obvious conclusion: when the chairman/CEO of a bank has to distribute a memo to all employees to proclaim that all is well…. All is not well.

I hear CS private bankers have been working the phones furiously, contacting customers to reassure them their money/securities are safe.  OK…. put yourself in a customer’s position: you get such a phone call from your advisor/PB. What’s your first thought? 

Unfortunately, the demise of Lehman, et al is not so long ago in the past as to be shrouded in the mists, in the Lethe of history.

German Inflation Highest In 70 Years

 I usually post about the US but today it's Germany that's on the spotlight.  And properly so, since German consumer inflation hit 10.9% in September, the highest reading since the end of WWII - see chart below.

 Germans have a deeply imbedded visceral fear of inflation.  After what happened during the Weimar Republic and its Nazi aftermath no one can blame them.  It is very likely, therefore, that German leaders will be pushing the ECB very hard to raise rates more than expected and to - finally - start shrinking its balance sheet to remove liquidity from the system.  I hasten to note that the ECB is very, very far behind the curve in fighting inflation, a situation that is 100% the fault of Mrs. Lagarde.

ECB Balance Sheet Assets Remain Sky-High

With markets already wobbling, the ECB's possible actions will likely bring fresh downward pressure.  It's definitely NOT a good time to go bottom fishing.

Crude Oil, SPR And US Elections

The US is the world's largest petroleum consumer.  It is also the largest producer, but domestic production does not cover its needs, so the US is also the second largest importer of crude oil, after China. The country, therefore, prudently maintains a Strategic Petroleum Reserve (SPR).

Given developments in Russia/Ukraine, the SPR is currently being drawn down at a very rapid pace (see chart below) and it now stands at the same level as in 1984.  

The SPR now amounts to just 21 days of consumption, down from 33 days in mid-2020 and lower than even in 1984 when it stood at 29 days. Predictably, oil prices peaked a few months ago and have been coming down as more and more oil is being released from the SPR - not a coincidence, of course.

Given political priorities - crucial US midterm elections are coming up in early November - the SPR drawdown is probably going to go on until at least then.  Anyone familiar with US politics knows that nothing, and I mean nothing, is as important for the average American voter as the price of gasoline at the pump.  After reaching and even surpassing $5/gallon in midsummer and creating howls of anger, it has now come down to around $3.75/gallon.  Still high, but better than the psychological barrier of $5.

What happens after November 8 is anyone's guess, yet the US cannot continue emptying the SPR given the present geopolitical risks, which include a significant risk of a crisis in Taiwan.  Another factor is the resumption of increased oil demand from China, which reduced consumption during lower economic activity due to strict and widespread COVID lockdowns, now being lifted.

Are Central Banks Bankrupt?

The title of today’s post is intentionally sensationalistic, chosen as a wake up call. With this proviso in mind, keep reading.

Central banks are.. banks (duh).  They have other duties and obligations as well, but their primary function is to borrow money by issuing promissory notes (currency) and to lend it when and if necessary, usually by accepting high grade bonds (Treasurys and mortgage-backed) as collateral. In some countries, like Japan and Switzerland, they even invest in equities, funds, etc. just like any other commercial or investment bank. And just like any other bank, the quality of their asset portfolio backs the solidity of their promissory notes, ie the currency they issue: dollars, euros, yen, etc.

Regular banks are prohibited from being overly exposed to one borrower, or one asset class. But central banks are mostly hemmed in: they have to lend to the State (they buy government bonds and issue currency) and, in the case of the US, to lend to the mortgage/property market.  Do normal credit parameters apply to central banks? They should, of course, but they don't - particularly during times of crisis when they step in as lenders of last resort.

But it's one thing to manage a transient crisis of liquidity in the banking system and quite another to monetize enormous amounts of government debt in order to then distribute it to one and all during the pandemic or other "emergencies" (helicopter money).  And how do you judge how much is too much?  As with any other bank, do a simple ratio: loans to turnover, or for central banks, balance sheet assets to GDP.

Here, then, is a chart of balance sheet assets to GDP for the Fed, ECB and Bank of Japan.  

• BOJ is, by far, the most overexposed to government debt but there are some mitigating factors.  Chiefly, Japanese government debt is mostly domestically owned and the yen is not a major global reserve currency.  It's bad, but not as bad as it looks.
• The ECB is definitely in trouble: it has to continue buying debt from the likes of Italy and Greece, countries that are, essentially, bankrupt if it weren't for the ECB's continued support. It's bad and, given internal friction between North-South in the EU, it's actually worse than it looks.
• The Fed seems in fine shape, comparatively, but this is an illusion.  The dollar is the sole global reserve currency and cannot afford to be "watered down" by massive debt monetization, as has happen in the last three years.  

The chart goes a long way in explaining why the euro and the yen have collapsed vs the dollar in the foreign exchange market.  But, unless the Fed starts to rapidly shrink its balance sheet this will not last. The ECB is - finally - starting to talk tough on raising rates, even if it won't touch the subject of QT, particularly after Sunday's election results in Italy.

Bottom line: if the Fed, ECB and BOJ were regular commercial banks their regulators would be all over their case, accusing them of insane credit practices.  They aren't, but... if they keep going this way they will end up like the Reichsbank in the Weimar Republic. 

UK Plunge Extra

 

Short post today.

The sudden plunge in UK bonds, FX and stocks is certain to have created some massive margin calls, particularly for positions involving the first two which trade with huge leverage, easily exceeding 30-50x.  Margins are dynamic these days, calculated using complex algorithms that take into account the credit quality of the counterparty, the underlying asset, and most relevant right now, historical price volatility.

UK gilts and pound sterling are not exactly volatile instruments, therefore margin would be lower, all other things equal.  Yet, volatility just exploded as prices plunged, for sure creating massive losses somewhere - and SUDDENLY.

I'm waiting for the shoe to drop HARD somewhere, be it banks, hedge funds, family offices... somewhere.  I think we will be hearing about it pretty soon. 

It’s Not Time For A Maggie

 The UK’s new (unelected) Prime Minister just announced a raft of new economic measures. Basically, it’s  old school Thatcherite trickle-down voodoo economics, and completely unsuited for today’s needs. But, hey, if all you got is a hammer everything looks like a nail, right?

Markets immediately voted nay, and strongly so: the pound, bonds and stocks all plunged in tandem. Honestly, I don’t think I have ever seen a major western nation’s bond market ever collapse like this. Yields on the benchmark 10-year Gilt soared by 65 basis points in days and a total  200 basis points in a month.

Yield On Ten Year Gilt

The world has moved on from the 1980’s. Government debt is heavy and central banks are stretched beyond breaking (more on that in the next post). You simply can’t make things right by cutting taxes on corporations and on the rich. Quite the opposite in fact..

How Long Will It Take The Fed To Tighten?

In my last post I said that the Fed hasn't really started tightening yet, based on its still very bloated balance sheet.  We know that ιτ has promised to increase Quantitative Tightening (QT) to a maximum of $95 billion per month, but judging from the numbers it hasn't done so yet.

But, let's say that it bites the bullet and it starts tightening for real.

How long will it take it to reduce its balance sheet to some version of normalcy?  The chart below helps  put things in context - the Fed's assets as a percentage of GDP currently stand at a record 36%, double than in 2019 and a massive 7 times (!) higher than in 2009, when the Fed stepped in to avert what could have become a second Depression during the Great Debt Crisis.

  Fed Assets As Percent Of US GDP

OK.. let's assume that the Fed wants to go back to "just" 18% and that nominal GDP will grow by 4% annually. If the Fed reduces its balance sheet at the maximum rate of $95 billion/month, it will take 3.5 YEARS of constant QT until its assets reach 18% of GDP.  

Mind you, 18% is still high by historical standards. Several analysts put the "proper" size at around 14%.  To reach that it would take a full five years. And this assumes that GDP will keep rising.

In my opinion the Fed cannot afford to be so timid in attacking monetary inflation.  For one, this drip method is akin to Chinese water torture for the economy.  For another, the Fed will lose credibility as a committed inflation fighter.

With unemployment at record low levels, wages rising and productivity dropping, the Fed must increase its QT to a level that broadcasts loud and clear its determination to immediately kill inflation.  Yes, it needs to keep money and bond markets operating smoothly, but it can do so through other means, even if it were to double its QT to around $200 billion/month.

===================================

PS Things are a lot worse in the eurozone.  Just before the pandemic the European Central Bank's balance sheet assets amounted to 34% of GDP.  Today they have reached an astonishing 60% - no wonder the euro is collapsing. Oh, and there is no indication of any QT happening there, not anytime soon anyway.

Why were things allowed to get so much out of hand?  Why is the euro scorned as a global reserve currency?  Because the ECB has been buying .. and buying and buying .. government bonds issued by essentially bankrupt countries, particularly Italy and Greece, bailing them out at the detriment of its own credibility.  

While the Fed has retained a modicum of political independence, the ECB is 100% a political construct, caught in the crosscurrents of radically different priorities from each individual eurozone member.  It's a central bank charged with producing a "one size fits all" monetary policy.  But, monetary policy is a corset, not a nylon stretchy.  The results are, sadly, apparent.

The Fed Hasn't Even Started Yet

 Everyone is looking for the Fed to raise rates again this week, most likely by 75 basis points (0.75%).  But that's not the real way to kill inflation this time around, because the real problem is the enormous amount of liquidity still out there.  On this front the Fed has done nearly nothing: its balance sheet is still very near $9 trillion, up from $4 trillion just before the pandemic.

I've been hoping to see some serious reduction week to week, but.. nothing.  My expectation is that the Fed will eventually (soon?) throw in the towel and start removing liquidity in earnest, just like it finally admitted that inflation is for real and started raising rates.

The effects on all markets will be substantial.  To put it mildly.

The Uninvestable Universe - Follow Up

In a recent post I posited that there is nowhere to invest right now that makes any financial sense.  Not in bonds, stocks, real estate, commodities and most certainly not in digital "assets" like cryptos and NFTs.  A reader asked if there is nothing at all to invest in, and I replied with an old Wall Street dictum: "When in doubt, stay out".  But, that's not very helpful, is it?  So, I've been thinking about it a bit more... 

In my considered opinion, the more relevant question to ask presently is: "How can I protect myself from what is likely coming?"  Meaning, switch focus from making money to protecting money/assets.

The easy answer would be "stay in cash"... but, right now, cash is indeed trash since it yields nothing or nearly: around 1% at best if you are an individual or 2.30% if you are a large institution with access to the Fed's O/N reverse repo. With inflation at 8.30% your cash is depreciating at a furious, historically unprecedented rate.  Sure, it's less trash than anything else, but losing 6-7% per year is no way to protect yourself.

Ah, but cash carries an opportunity premium: you can quickly invest opportunistically when things bottom out.  In other times I would agree, but since I believe we are in for a long, drawn out bear market in everything instead of a sharp drop and even sharper rebound, the opportunity premium is, in fact, a very heavy discount given the very negative real interest rates. So, cash isn't it.

Alternatively, you could keep your assets and use hedges as protection. But hedging comes at a premium, the time/interest cost of futures, options, credit derivatives, etc.  As interest rates rise, this cost goes up as well.  Also, as with any hedge, it matters most who you buy it from - as buyers of CDS quickly discovered during the 2007-09 credit meltdown (Lehman, AIG Financial...).  You hedge is only as good as the institution who underwrites it, and during times of turmoil those institutions become very vulnerable.  Yes, I even include the likes of derivatives exchanges/clearing houses in this category because they are certainly not immune to systemic risk. 

The Fed bailed everyone out last time as lender of last resort, but will it this time? Can it, this time? Its balance sheet assets have now reached an astronomic 36% of US GDP, up from 7% in 2007.  One way to look at this 36% vs. 7% is as a measure of how much the dollar has been watered down, and within a very short time.  

At which point does the world stop trusting the dollar as a global reserve currency?  Ask Putin, who is demanding payment in rubles for Russia's oil and gas exports - and the many countries who are doing so, without exactly advertising the fact.

No cash, no hedge... what is left to protect ourselves, at least longer term?  

The answer is this: forget ALL financial "assets" and focus on real, productive assets.

I shall continue with ideas fitting the bill in a follow-up post.

Inflation Surpises To The Upside - Yet Again

Markets plunged yesterday on the news that headline and core inflation in the US fell only by a tiny bit, much less than markets had hoped for and optimistically priced in.  My post yesterday (before the CPI numbers came out) went into why inflation is not going to go away any time soon, at least not without a massive, deflationary asset price correction, aka a Crash (capitalized on purpose to denote massiveness in the style of 1929 or 1987).

Historically, Crashes only happen when two conditions are met, concurrently:

1. A prior new all time high marked by extreme optimism by professionals and the madness of crowds, who come late to the party.
2. A credit crunch which makes liquid money very scarce and expensive to use for market leverage.  

The first condition has certainly been met, but not the second - at least not yet and not as much as necessary to force massive margin call liquidations, which is the prime cause of all Crashes. 

The Fed has raised rates off the bottom and seems - finally - determined to raise them even further.  But, rates are still very far from becoming a true inhibiting factor for consumer behavior. Real rates are still very, very negative and must go closer to zero before they have any serious impact on inflation - see chart below.  Right now the national average interest rate for savings accounts is a puny 0.13%. The American consumer is therefore strongly incentivized to consume even more, instead of saving. 

2 Year Treasury Minus CPI Inflation

With inflation at 8.3% market rates for the 2 year Treasury should go to around 8% from 3.8% today - or inflation has to come down to approx. 4% by other means (ie recession or Crash).

But, it is not only interest rates which determine liquidity conditions: the most important factor is the amount of money available in the system.  In this regard, the Fed is still dragging its feet;  its balance sheet is still extremely bloated and will continue to be for a long time, even as it ramps up QT to a maximum $95 billion per month starting in September - see chart below.

Fed Balance Sheet Is Still Hugely Bloated

For perspective, in 2009 Fed assets were "just" $1 trillion and in 2019 "just" $4 trillion compared to today's massive $9 trillion. This deluge of liquidity caused asset price bloat for years and, eventually, resulted in today's spike in consumer inflation.  

The Fed is, thus, faced with a stark choice: in order to seriously attack inflation it has to raise rates AND reduce liquidity very substantially.  Doing so will cause a recession and could precipitate a market Crash.  Not easy to do, particularly just before mid-term elections in November which may result in Republicans regaining firm control of Congress.

What will the Fed do? I think it will continue raising rates while keeping QT at today's levels for a few more months, erring on the side of liquidity caution.  I can't really blame them, they are politically appointed policy boffins, not independent, hard-headed business leaders.

Housing Price Inflation

 The shelter component makes up a massive 33% of the headline Consumer Price Index (CPI) in the US and 40% of the "core" CPI which excludes food and fuel.  It is one of the least volatile contributors to inflation, ie once it starts going up (or down) it doesn't reverse course quickly.

Thus, without much further ado, here is a chart that shows the rise in home prices and rents in the US. Home prices (red line) are rising at a record pace, fastest in history, and rents (following prices after a lag time) at the fastest rate in 40 years.

Today's CPI may show a slight de-escalation from lofty levels due to lower fuel prices - no surprise there, since with elections in less than 60 days the Biden administration has drawn down the Strategic Petroleum Reserve to its lowest level in 40 years by selling to the open market to push prices down (nod to AKOC for the heads up).

But core inflation is not going to go away any time soon - unless we get some sort of sudden asset crash.  Which, as I've said before, I don't think is in the cards

 Housing Costs Soaring

The Un-Investable Universe

The world has experienced 40 years of almost uninterrupted asset appreciation.  From stocks and bonds to real estate and commodities, the overall trend has been up and up in a rally that has no precedent in history.  Some asset classes fared better than others, but  in general you could have thrown a dart blindfolded and still made money. Or, have a monkey choose for you with the same result.

Sure, some asset managers did much better than others: it is hard to argue against the genius of Warren Buffett, for example.  Then again, how would he have done against a backdrop of a decades long bear market? As he likes to say, it is when the tide goes out that we see who’s swimming naked.  Another way to say it, a rising tide lifts all boat. Yet another, don’t confuse brains with a bull market.

Enough with the platitudes, on with facts. Let's look at all major investment categories:

• Inflation is at 8.50% and Treasury bills, notes and bonds yield far, far less (same is happening in the EU, to a much worse degree).  Even risky junk bonds yield less than inflation (approx. 8%). All credit markets are, thus, currently fundamentally un-investable.  This is crucial: bonds form the backbone of every major portfolio, particularly pension funds which depend on positive real yields to provide current and future pensions for hundreds of millions of people all over the world.

Inflation - Bond Yield Gap Largest Ever

• Equities benefited for decades from the collapse of the Soviet Union, China's boom, new technologies, emasculated labor unions and low inflation. Consumer spending kept rising, corporate profits soared, a host of neo-liberal/conservative governments slashed taxes and privatized everything.  All of these factors are now going in reverse, all at once.  Corporate profits, with the momentary exception of fossil fuel dinosaurs, are dropping fast, even for "new" technology companies.  Real earnings are the most negative ever. Equity markets are, on the whole, fundamentally un-investable.  

Inflation-Adjusted Earnings Plunge To Most Negative In History

• Real estate has soared, boosted by enormous liquidity and - until recently - record low interest rates.  These two factors are now also reversing, but prices have not adjusted yet.  Predictably, housing affordability has collapsed to the lowest level in over 15 years through a combination of higher prices and higher interest rates.  I get that “real assets protect from inflation", but if people can't afford to buy homes, who's going to buy them from the investors?  Housing/real estate is un-investable.

Case-Schiller House Price Index Rose At Record Pace - And Is Still Rising Very Fast

Housing Affordability Plunges The Most Since 2007

• Commodities have soared on the back of (a) huge amounts of liquidity, (b) a sudden resumption of strong demand after the pandemic and (c) the war in Ukraine. After rising 100% from pre-pandemic levels, the Dow Jones Commodity Index is now correcting somewhat, but it is still 65% higher.  Assuming that the Fed (and soon the ECB) wants to kill inflation via, most likely, a recession, demand is going to suffer and prices will correct further. Dry bulk carrier shipping rates - a gauge of current and future demand for dry raw materials like iron ore, coal, grains, etc - are now back to pre-pandemic levels.  Likewise, containership rates are coming back to Earth after shooting to the Moon (but are, interestingly, still quite high compared to 2019 - there is apparently a lag between shipping demand for raw material and finished goods).  Commodities are also un-investable.

Dow Jones Commodity Price Index Correcting But Still Very High 

Dry Bulk Shipping Rates Back To Pre-Pandemic Levels

Freightos Global Container Freight Rate Index Coming Back To Earth

• Last (and most certainly least, in my opinion) all things crypto: cryptocurrencies and all sorts of non-fungible tokens.  I must admit that I am not a crypto expert and, if anything, a committed adversary.  I strongly believe that they have no fundamental value whatsoever, are prone to fads, scams, criminal activity and immense volatility.  Maybe I'm just an old f@rt, so I will just say that cryptos are "by definition" un-investable and leave it at that.

Am I leaving an investment category out? Precious metals, perhaps? No, they are commodities.  Diamonds?  Surely, they are a girl's best friend but I can't really call them investments in the traditional sense.  Likewise for art and wine - unless you mean "investing in the finer things in life", in which case they are always investible!! 

After decades of ever higher returns for all asset classes, they have now all become un-investable when assessed against current economic reality.  And I haven’t even mentioned geopolitical risks, which are rising daily.  Our asset universe has become un-investable: no matter how carefully you throw your dart it is more likely than not that you will end up with losses and, as I projected in my previous post, those losses will persist for a long time.

This One Is Going To Last

 US economic contractions don't last long. Since 1945 recessions have lasted 10 months on average, while expansions lasted almost six times longer, 57 months.  The longest ever expansion lasted 129 months and ended with the COVID pandemic.  If we exclude the COVID recession (and we should, if we don't count exogenous factors), we are currently in an unprecedented economic expansion (again excluding the two most recent quarters of faux contraction) of 161 months.

Think about it.. over 13 years.  If reversion to mean holds any sway here, things are going to get seriously recessionary, and for a long time, too.  But, statistical means mean nothing without first examining the facts on the ground. These are today’s facts:

1. Inflation has soared to 40 year extremes, and it doesn't look likely to recede to manageable levels any time soon. Negative
2. Personal income is not rising nearly enough to cover inflation.  Tight purses mean less consumer spending until the situation is reversed. Negative 
3. The labor market is extremely strong, particularly in lower pay service industries (hotels, restaurants, bars, etc).  The Great Resignation from young GenZ-ers is mostly to blame, and it doesn't look like it will recede any time soon. Young Americans are quitting the rat race in millions - or, they are not entering it at all, preferring the gig economy, instead.  This creates counter-recessionary forces that partially offset 1 and 2 above. Positive
4. The Fed is raising rates and will step up QT starting this month.  While not nearly enough to quickly kill inflation, taken together those two will slow down the economy to some extent, particularly the important housing sector. Negative
5. The Biden administration is spending heavily on social and infrastructure programs. Positive.

Taken together, the above may result into a long, slow-burn recession that could last far longer than 10 months, precisely because its causes are fundamentally long term.  The Fed certainly isn't courageous enough to act drastically to produce a deeper but shorter V-shaped contraction. 

So, my basic model is for long, slow and persistent economic weakness that could last years, not months.  For equity markets, this is a real poison - one that no one is yet talking about.

You heard it here first, folks: This one is going to last!  (NOTE: as luck would have it, a major investment bank analyst just proposed this exact scenario).

Final thought: there is a whole generation of Americans out there that has never experienced a real recession, for who prosperity is a given and perpetually rising asset values a law of nature.  I think they are being set up for a hard lesson in reality.

One final final thought: could it be that lots of young Americans are “self-employed” in stock and crypto trading?  Anecdotal evidence points in that direction and could also explain the stubborn Great Resignation.  My sense is that lots of rather inexperienced speculators are still very much active and are trying to call bottoms. If so, the present bear market is going to get much uglier before it ends. 

Quantifying QT

 I’ve been harping on the critical importance of QT in fighting record inflation for a long while.  The issue is-finally-getting some much needed attention from the financial press.  This article just published by the Financial Times is the best, and most useful, on the subject of QT.  

It includes calculations on how much tightening is needed as a combination of higher interest rates and shrinking the Fed’s balance sheet.  The article calculates a QT of some $3.9 trillion plus a further hike in rates by 4.50%.  

I think no one is expecting anything like that, certainly not financial markets.  But if they started fearing anything near it… watch out below.

No Money, No Honey

 Sometimes, all it takes is one or two charts.  Without further ado, see below 

1. What has happened to disposable income for Americans (basically, gross income after all taxes) and the price of everything (inflation).  I'm showing only the last 4 months because COVID cash handouts muddle the picture.  Inflation is soaring, income is not.

.

Annual Change In Disposable Income (blue) And Inflation (red)

2. Surely, you may think, Americans still have plenty of money left over from the Biden/Powell shower of free cash during 2020-21.  But no, they most definitely do not.  Savings balances are the lowest in 8 years in absolute dollar terms ($945 billion as of 2Q22) and the lowest in 12 years as a percentage of current GDP (3.88%).

Personal Savings As A Percentage Of GDP

With prices soaring for essentials, incomes rising at a much slower paces and not much money in the bank, it's pretty easy to predict a consumer-driven recession in the immediate future, after the current spate of "revenge" spending post-COVID (eg travel) is over.

It isn't rocket science...

Slay The Sacred Cows

 The Gang That Couldn’t  Shoot Straight To Save Their Lives, aka the EU, has proclaimed upcoming “measures” to deal with sky-high energy prices. The announcement contained zero specifics, in keeping with TGTCSSTSTL standards. Oh, wait.. they announced a summit meeting on a specific date. Good night, and good luck.

What could they do? Here’s a list of sacred cows that they could (but won’t) slay:

1. Abolish the TARGET model for pricing.

2. Suspend and quickly abolish all energy trading on exchanges (they are OBVIOUSLY being manipulated).

3. Abolish all energy wholesalers, permit only one energy provider per country/region who must also be a sole producer and heavily regulate prices/ROEs.

4. Use a Public Utility Commission model for pricing once a quarter, or even less frequently.

5. Use eminent domain and state of emergency statutes to impose the above.

This should do for now…. 

Powell To The People

 Fed Chairman Jerome Powell did the right thing and poured cold water all over markets, affirming a tight US monetary policy until inflation goes back to around 2%.  Kudos, and good for the average working American who is seeing his/her disposable income evaporate under the highest inflation in 40 years.

Back in Europe, Mrs. Lagarde is immobile like a deer caught in the headlights of a truck.  Only, the truck (soaring inflation) has already hit her, so it’s  probably better to remove her and replace her with a real central banker of acknowledged status.

Super Mario (Draghi) is once again available 😄

American Luddites

 US Republicans are seeking to ban Environmental, Social and Governance (ESG) investment criteria. Florida governor DeSantis banned them from state pension funds (PS he wants to run for President) and Texas banned investments that are “hostile” to the fossil fuel industry.

During 1811-16 bands of English workers attacked cotton mills, destroying machinery that would, supposedly, put them out of work. They were called Luddites, after their purported original instigator. It didn’t work then and, hopefully, it won’t work now. But, one has to wonder: Luddites were uneducated, poor workers. Today’s naysayers are educated, rich political leaders who hold major positions of power.

What does this say for the American Empire’s future?

How About, It Madame Lagarde?

 Yesterday I said “don’t fight the Fed”.  How about the ECB, how is it doing in its fight against record inflation? In a word, it’s doing nothing.  

The real (inflation adjusted) main refi rate, the ECBs main policy rate, is currently at minus 9%, a record negative reading that - if anything - promotes inflation instead of fighting it.  

Yes, it’s true that the ECB faces serious troubles: Italy, Greece, Portugal, even France, are highly indebted and a jump in interest rates will pose a serious threat of bankruptcy.  And unlike Greece in 2010, this time such an event will be the end of the euro as we know it.  So, Mrs. Lagarde is choosing inflation, what she thinks is the lesser of two evils.  

She is making an enormous mistake, being completely deaf to people’s cries of despair over the enormous price increases in basic necessities: energy, food, transportation and housing.  

Social unrest is rising: Italy is almost certain to swing hard right in next month’s elections, its population totally disgusted with “politics as usual”.  Labor strikes are becoming more common after decades of inaction. Governments in the EU are providing stopgap subsidies for electricity and fuel, but they are nowhere near enough and no one is getting fooled. Germany provided near free train travel until the end of August, Greece has devised "Fuel" and "Power" passes that subsidize gasoline and electricity to the tune of 40-80 euro per user, etc.  But those amounts pale by comparison to utility, food, transport and housing bills, which are only going to get much steeper when the heating season begins in a month or two. Even the UK is facing a “heat or eat” winter.

Mrs. Lagarde has to move, and she has to do so fast.  

PS The only thing that will work in bringing down soaring prices, especially in energy, is a firm realization by "the free market (laugh!)" that ECB is willing to do "whatever it takes" to kill inflation. OK, forget raising rates by too much. How about a very sharp eurozone QT? It will certainly work.  Because things cannot continue like this... (see below).

Natural Gas Prices Have Exploded 1000% In One Year

Don’t Fight The Fed

 I just read in Bloomberg that investors don’t seem bothered about the Fed. They don’t believe that the Fed has the “spine” to keep tightening until inflation drops to its target, around 2%.  Maybe they’re right, maybe Mr. Powell will revert to last year’s stance of thinking that inflation is “temporary”.  But, having made that mistake last year it seems highly unlikely to me that he will repeat it.

One of the oldest dictums in Wall Street is “don’t fight the Fed”, ie don’t bet against its ability to set monetary policy goals and to achieve them.  I think lots, maybe most, investors have been lulled into complacency after decades of a docile, nearly somnolent Fed.

But make no mistake: the Fed is the biggest dragon of them all and once it awakes….

A Nice Article On The Fed’s QT

 While most look at interest rates to gauge the Fed’s monetary policy, this time around it’s Quantitative Tightening (QT) that’s more important, in my opinion.  This article from Vanguard Advisors provides a very nice analysis.

As it states, the Fed hasn’t done anything like this before, not in this scale, anyway.  I think markets are still blind to the negative effects of constantly draining such large amounts of liquidity from the system. According to Vanguard, the Fed is looking to drain around $4-5 trillion over the next 3 years. That’s truly unprecedented.

Should The Fed Stop Tightening? Hell No!

The "market" is already discounting a Fed that will stop tightening soon.  Is  "the market" right? And, more importantly, should the Fed stop tightening?  You be the judge - take a look at the chart below.

It shows the real Fed Funds rate, ie Fed Funds minus CPI inflation. It is at the most negative since at least 60 years ago...

Fed Funds Minus CPI Inflation

How high can/should interest rates go?  Let's do a "back of the envelope" calculation:  last time inflation was this high was in the early 1980s and Fed Funds were as high as 500-1,000 basis points over inflation.  By this measure today's rates should be 13-18% !!

But, let's not be so extreme: let's assume that inflation will ease back to "just" 5% and that Fed Funds should "only" be 250 basis points over that. This gives a reading of 7.50% for Fed Funds versus 2.50% today and expectations that it will go up to, say, 3.50%

What do you think?

What I think is this: there are very few of us dinosaurs left active in markets who remember and understand what high inflation really means for the economy and its ultimate impact in markets. Instead, we have millions of younger people who have never experienced a bear market and thus firmly believe that a bull market by rights a foregone conclusion and buy the dips, plus hundreds of thousands of meme chasers.

In sum, the social anthropology of markets is problematic: myopic, emotional,  uneducated in history. 

Unit Labor Costs Rising Fastest In 40 Years

 Unit labor costs are now rising at the fastest pace in 40 years, and are even outpacing headline inflation - see chart below.  This reading is caused by lower productivity (-4.6%) as well as higher wages (+5.7%) - a one-two punch that is really bad news for inflation prospects.

Once again: whoever thinks the Fed can afford to slow down its tightening is simply whistling past the graveyard.

The Fed’s Path Towards QT

 Warning to markets: things are about to get a lot tighter, money wise.  

The Fed has been tightening money supply very slowly for the last two months, but after August QT is set to double to $95 billion per month - see chart below.

These amounts have already been announced as official FOMC policy - I wonder how many non-professional investors have bothered to look (perhaps even some professionals?). Yes, these are caps, ie maximum QT amounts, but after yesterday’s very strong employment report I don’t see the Fed doing anything less until the economy takes a serious dive.

I believe the Fed, if anything, will err on the side of too tight, to make up for thinking inflation was “transitory”. The market, I am certain, is now expecting/hoping that the Fed will raise its foot off the brake. It is wrong.

More Recession Warnings

 America's economy is cooling fast.  The mighty American middle class consumer has apparently gone on a strike, shunning everything except going on vacation and dining out, the two activities he/she missed during pandemic closures.  Real retail sales (adjusted for inflation) are now flat or slightly negative, after whipsawing violently down/up in the pandemic - chart below.

Imports of everything from plasma TVs to t-shirts are languishing on store shelves and retailers are discounting heavily to move the merch.  Walmart, Target, Amazon, et al are issuing one sales/earnings warning after the other. 

Accordingly, container shipping rates are coming down fast, albeit from nosebleed levels - chart below.

Because the merchandise isn't selling, it has to sit in warehouses.  California's enormous Inland Empire warehouse area is now filled to the max, with vacancies at record lows - chart below.

Consumer sentiment is ambivalent - they feel that current conditions are ok, but their expectations for the future are quite grim, lowest in 10 years - chart below.

No question, consumers still have lots of money sloshing around and jobs are plentiful.  This explains the present situation reading and why the economy hasn't fallen off a cliff.  But, they also see prices for basic necessities soaring, which explains their views for the future.

And what is the Fed doing? Basically, net really very much.  Yes, they have raised short term rates to pre-pandemic levels, but they haven't  drained any money from the system, the one action that would truly make a difference in fighting inflation - see chart below.

 Fed Balance Sheet

PS I am really curious why Mr. Powell claims in Congressional testimony that the Fed has already taken steps to shrink its balance sheet.  It isn't showing in the data..

Geopolitics vs American Markets: A Fallacious Premium

Update: US Speaker Nancy Pelosi just landed in Taiwan, the first time such a high level official visited the island since 1997. China reacted strongly back then, but it was mostly hot air. I think it will be different this time.  In 1997 China’s GDP was 10% of America’s - today it approaches 80% and I think it will react accordingly. 

The US stockmarket has always been "optimistic".  It always managed to quickly discount geopolitical crises and move on to new highs.  For example, in the last 10 years S&P 500 is up 190% while Germany's DAX is up a mere 85% - see chart below.

The obvious reason has been the status of the US as the world's premier economy and undisputed geopolitical power. But, this is no longer the case as China and Russia are clearly nipping at America's heels. The fact that Pelosi's visit to Taiwan has to be kept a secret speaks volumes.

How long can US stockmarkets trade at a fallacious premium?  IMHO, until China decides to truly flex its muscle and challenge the US in a one-on-one confrontation. Pelosi's trip may very well be one such situation, there will certainly be more.  (Russia is already challenging the US/EU with impunity, sanctions are a joke).

The American general public has always been isolated from and indifferent to international affairs, taking their country's power for granted.  Sad to say, but my experience shows that the same holds with American financial professionals. 

I think a rude awakening is fast approaching and the premium will melt away.

PS There are more signs that America's pre-eminence is weakening: India is siding with Russia and China, Turkey's Erdogan is flouting US power, Saudi Arabia is going its own way.  This is not "normal", it's not business as usual.

Stop The Reverse Repo

The Fed runs an overnight reverse repo facility for institutions like banks and money market funds. It works like a one day interest bearing deposit, secured by bonds held in the Fed's portfolio. The amount on deposit has now reached the astronomical amount of $2.2 trillion, and it currently collects interest at 1.55% which will likely go to 2.30% today when the Fed raises rates again.

                                                 Fed Reverse Repo Reaches $2.2 Trillion

Reverse Repo Interest Rate Paid By The Fed

Thus, the Fed will pay a huge $50.6 billion annualized in interest to banks and money funds. Why should it?  If the Fed was a regular bank, the reverse repo would be a way to fund its existing bond portfolio, which probably earns more than 2.30% - at least for now.  But unlike regular banks and institutional investors the Fed doesn't have to worry about funding anything - it just prints the money it needs, that's the whole idea of central banking.

When amounts deposited to the Fed via reverse repo were minute (usually around $1-2 billion before the pandemic) the rate paid didn't matter.  But with $2.2 trillion now flooding the Fed the rate paid makes a very big difference, indeed.

Thus, the reverse repo is now nothing more than a direct "subsidy" to the financial sector and should be immediately stopped, or at least be modified to pay minimal interest well below market rates, say one tenth Fed funds, ie around 0.15-0.25%. Naturally, this will force financial institutions to seek other places to park their excess cash, driving short term rates lower, probably below where Fed wants them to be to fight inflation.

The problem, quite obviously, is the "excess cash" itself and this is another reason the Fed should start draining it aggressively from the system via Quantitative Tightening.

Labor And Inflation

I've been saying for quite some time that high inflation will soon cause labor demanding higher wages -  and it is already happening. Labor unions have been losing power to employers for decades, but conditions are now ripe for their resurgence.  

The close relationship between high inflation and labor actions is intuitively obvious and can be demonstrated in the two charts below.  With inflation now back to 1980s highs, will many more strikes soon follow? I believe they definitely will.

And when they do, politicians will abruptly switch allegiance from the corporate suite to the street. The Era Of Markets is clearly over.

PS In the 1970s and 1980s it was pre-Thatcher UK that led the world in strikes.  I'm not sure if we will see a repeat, since the UK is no longer an industrial nation, but after Boris the Menace the Conservative party is in disgrace and tatters.  Can Labor make a strong comeback in an economy based on financial services? If it can transform itself into New-New Labor, focusing on climate change and health services, yes it can. 

US CPI Inflation

UK Inflation

The Economy Is Weakening - Channel Your Inner Volcker

 The US economy is weakening very fast, much faster than most analysts are currently predicting.  

Witness yesterday's announcement by Walmart CEO: "The increasing levels of food and fuel inflation are affecting how customers spend", he said and went on to announce that earnings would drop by 13-14% this quarter, squeezed between lower demand for durable goods and non-essentials like clothing, and having to heavily discount to clear inventory.  This is Walmart's second negative announcement in just 10 weeks, which shows just how fast things are unravelling at the consumer front.

Walmart is the world's largest retailer, so what's going on there is an indicator for consumer spending trends everywhere.

There are those who are attempting to interpret this as good news for markets. Oh, since we are going into a recession the Fed will stop tightening aggressively, they posit. Well, maybe - if Powell and Lagarde prove to be totally spineless and whipsaw monetary policy back and forth. If so, inflation will become even more entrenched. Witness the German labor union for Lufthansa's ground-handling workers: they are demanding an immediate 9.5% pay hike and are going on a one day strike this Thursday. Can you blame them? With basic consumer good prices soaring well over 15%, workers need immediate real income relief.

Note to Powell and Lagarde: Channel your inner Volcker and stay the course, your duty is to the wider public not to financial markets. In fact, since you are still not doing much on the QT front, you should double down and announce truly substantive money supply shrinking measures.  Nothing else will work to kill inflation fast.

Less Popular Indicators

The vast majority of economists and traders follow a few very popular indicators: GDP, payrolls, weekly unemployment benefit applications, inflation, home sales and starts...  

Then there are other, less popular indicators.  Here is a smattering...

• Philly Fed Business Conditions.  Lowest in 30 years. Why?

• GDPNow estimate from Atlanta Fed 2Q22  (-1.6%) far below consensus (+2%). Why? 

• SPAC IPOs have evaporated in 2022. There are certainly serious regulatory issues, but down 94% from 2022 points to more trouble  than that. What could it be?

• NFIB Small business owners' outlook for business conditions at the lowest level in history.  Why?

• US Services PMI is at the lowest level in nearly 10 years (pandemic excepted).  Repeat: services.

Hannibal Ante Portas

On 216 BC Hannibal was just a few dozen miles from Rome, having repeatedly defeated its legions in battle. The city was about to be sacked - terror was palpable in the population: the barbarians were at the gates (ante portas). It didn't happen, and some years later it was Carthage itself that was razed to the ground. 

Fast forward: Italy's glories are today renowned all over the world. Venice, Florence, Armani, Ferrari... a slew of luxury brands and pricy tourist destinations have supported an economy that would otherwise be more like Greece than France. Based mostly on those lifestyle sectors, Italy has grown to serious size: its economy is the ninth largest in the world. But under the glitter, Italy has serious problems, making it the Sick Man of Europe.

• Government Debt to GDP at 155%.
• Aged population, third oldest median age in the world.
• Perennial government paralysis, 69 governments since 1945 (soon to be 70), one every 1.1 years. 

Just like in Greece, the adoption of the euro 20 years ago brought down borrowing costs, masking and even exacerbating the underlying problems.  But unlike Greece which accounts for a minuscule 1% of eurozone GDP, Italy comes in at 13%, behind only Germany and France.  Should Italy fall apart the eurozone would fail, and probably so would the EU itself.

How likely is an Italian collapse?  Let's start with this: it's not unthinkable. The ECB is definitely scared enough to propose some sort of mechanism to immunize its debt from market attacks.  I think the ECB has no idea how to accomplish such a task, which is precisely why it has so far abstained from providing any specifics on this mechanism.  The bond market is biding its time, with Italian 10 year bond spreads to German Bunds around 200 bp (2%) up from 90 bp last year. They briefly touched 250 bp last month, causing the ECB's "mechanism" announcement .

With eurozone inflation at 8.60% and Italian 10 years at 3.70% I cannot really imagine how the ECB can immunize Italian debt against a combination of credit and inflation related attacks (Greece is in even worse shape, by the way).  After all, the ECB has to raise rates significantly starting today, if it is to retain even a modicum of inflation fighting credibility.  

My feeling is that Rome will be sacked this time around....

PS Ex ECB head Mario Draghi just resigned as Italy's Prime Minister.  He lasted 17 months.