Friday, September 30, 2022

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.

Wednesday, September 28, 2022

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.

Tuesday, September 27, 2022

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. 

Monday, September 26, 2022

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. 

Sunday, September 25, 2022

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..

Wednesday, September 21, 2022

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.

Monday, September 19, 2022

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.

Friday, September 16, 2022

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.

Wednesday, September 14, 2022

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.

Tuesday, September 13, 2022

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

Saturday, September 3, 2022

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.

Friday, September 2, 2022

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. 

Thursday, September 1, 2022

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.