Debt To GDP For The US - We Have A Winner!

Note: Numbers on Debt/GDP below have been calculated using GDP on a Purchasing Power Parity (PPP) basis.  Also, I have removed countries such as Lebanon, Suriname, Sudan, etc. from the chart.

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When it comes to Debt/GDP Japan is the undisputed "champion" - but most all of its debt is domestic. Only 6.5% of all debt is owed to foreigners, while the vast majority (52%) is held by the Bank of Japan. This has significant global repercussions, but Japan is not my subject today.

Number two on the rogues list is Greece - no surprise there - but unlike Japan most all of its debt is owed to foreign official sector lenders. The bad news here is that this debt load exists even after the country went bankrupt a decade ago and plunged its economy into a decade long depression. But Greece is also not my subject today.

Numero tre is Italy.  A perennial problem child, the only reason Italy can still finance itself at reasonable interest rates is that its Eurozone membership is presumed to preclude a bankruptcy. Let me point out, however, that as recently as 2008 its debt/GDP(PPP) was ca. 70%.  But Italy, too, is not my subject today.

My subject today is the USA - not a shock to regular readers of this blog going back as far as 2006.  And my main question here is this: how logical, or even safe for the global economy, is it that the issuer of the world's reserve currency is so heavily in debt?  Indeed, what does this mean for the US dollar when its issuer is the world's #4 most indebted economy? 

Sure, under our current fiat currency regime, where debt is money and money is debt, it is expected that the availability of the global reserve currency can only come from a country that has a commensurately high debt.  

But at which point does the debt load finances mostly domestic consumer spending of cheap imports (eg China) and defense spending, instead of productive, high value added activities? At which point does the incessant printing/borrowing become a vicious cycle? 

Hint: the crypto boom is stoked to a large extent by those who look at such statistics and rub their hands in glee.  I do not share their glee because if we go down that route we are opening a much worse Pandora's Box - no need to enumerate all the nasty stuff that will come out from the Crypto Box.

But... something must be done to contain the US propensity to borrow and spend with abandon as if "tomorrow never comes, la, la, la".  Because, unlike in the song, tomorrow always comes.

Let me try to quantify the debt excess, even if roughly: the US accounts for approx. 16% of global GDP(PPP), but its government debt stands at ca. 35% of global government debt.  In other words, the US is twice as indebted when measured against its global economic size. 

US Inflation And The Fed

 The one certainty from Mr Powell’s Jackson Hole speech a couple days ago is this: The Fed remains firmly committed to its 2% inflation target. Corollary: all policy decisions will stem from that.

I’ve put together a chart comparing headline, core and employment cost inflation - see below. My interpretation of the data is this: headline inflation may have come down sharply due to an outsize drop  in energy prices, but core and employment cost inflation are still more than double the Fed’s target.

Those expecting a quick reversal of high interest rates and restrictive monetary conditions (QT) are going to be very disappointed - unless a severe recession hits. Either way, not ideal for debt and equity markets.

Charting Tealeaves

 In my experience, charting as a market analysis tool is as useful as reading tealeaves.  But, occasionally it actually works, so when I have nothing better to do I look at charts for those familiar patterns which, purportedly, foretell the future.

I have nothing better to do right now (dog days of summer), so here's an annotated chart of SP500. The chart pattern is called an inverted flag (a bearish "trend continuation") and, theoretically, a downward breach of the flag signals a continued downward move to at least as low as the length of the pole from the point of the breach.

How do you take your tea? I recommend large doses of grains of salt... :) .  Nevertheless, as I said in my previous posts, the bond market - which I strongly believe is a very good warning indicator - is looking decidedly ugly, so maybe this time the tea leaves are issuing a valid reading.

Maybe The Real Reason Bond Prices Are Dropping Is...

 Analysts are somewhat baffled by the drop in bond prices.  Inflation is moderating and the Fed is sending "hold" messages. So what is driving bond prices to 20 year lows?

Maybe - just maybe - it's the oldest reason in finance: creditworthiness.  After all, Fitch just downgraded the US from AAA to AA+. 

Just how creditworthy is the US? 

In just 4 years the US has raised its gross Treasury issuance from $12 trillion to a projected $21 trillion in 2023. Yes, it's not net issuance (ie after maturities/debt retirement), but bear with me for a bit.  Gross issuance has gone from 50% of GDP in 2018 to 77% of GDP in 2023P - see charts below.

Why am I choosing gross issuance instead of net? Because if the US were to become less creditworthy (and it arguably has) some lenders could balk at rolling over their existing bond investments and/or demand a higher return.

I think this is exactly what is happening right now: increased supply (more gross issuance) is starting to face demand headwinds causing prices to drop.

Gross bond issuance is also a measure of debt service stress.  Since the government is running massive budget deficits, it has to issue debt to cover that plus interest payments.  And as interest rates rise, so does the amount of new debt required to pay just interest.

Take a look at the chart below: in just a few months, the federal government's annual interest payments have soared from $500 billion to nearly $1 trillion.  

Is this sustainable? Is it compatible with even a lower AA+ rating?  From one perspective, it is: interest payments as a percentage of GDP have jumped from 2.5% to 3.6% (1Q23), but still well below the highs of the 1980s - see chart below.

Interest Expense as % of GDP

However, when we look at the budget deficit, things become scarier - see chart below.  The FY 2023 deficit is projected to reach well over $1.5 trillion, perhaps even reach $2 trillion.  In just the first 9 months from October 2022 to June 2023 the deficit stood already at $1.4 trillion, fueled in large part by the soaring interest expense discussed above.

US Federal Budget Deficit (FY 2022 Last Point On Chart)

In sum, the US government finances are, in a word, unsustainable. Unless:

(a) the budget deficit is slashed and,

(b) interest expense comes sharply down

even the AA+ rating is very generous, optimistic and likely to go lower quickly.  In my opinion, Fitch's action is a first warning - I bet they wanted to go lower but chose to be politically cautious, at first.

The Trillion Dollar Question

A one question post today:

• Given its enormous debt load and the spike in interest rates driving debt service closer to unsustainable levels, which is in the US government's interest?

a) A sharp recession to drive interest rates down.

b) Robust economic growth.

Comment freely.

More Trouble Ahead From Bonds

I don't think most people realize the massive losses that have been suffered by bond investors in the last year and a half - take a look at the chart below.

                                                30-Year Treasury Bond Prices 

The US 30-year Treasury bond was at 156 points as recently as January 2022 (and as high as 180 in mid-2020);  today it has collapsed to 118.  Ignoring the 2020 COVID-induced high, bond investors are suffering a staggering mark to market loss of 25% in just 20 months.  This is not a loss normally associated with the presumed safety of Treasury bond investments.  Even worse, it has happened fast - it is the sharpest price drop since at least 1977.

So what, you may ask?  Bonds are the preferred investment for banks, insurance companies and pension funds.  They usually make up well over 70% of their portfolios, one way or another (eg home mortgages are regularly packaged into long term pass-through securities such as Ginnie Maes).  And while such investors may choose to place long bonds into their "investment/hold to maturity" portfolios, to shield them from having to recognize mark-to-market losses in their books, that's just an accounting trick.

Reality, however, can never be avoided for long.  Rating agencies are already downgrading US banks, for example.  Given the persistence of inflation, pension funds are coming under uncreased pressure to raise pensions, particularly government entities.  And insurance companies must be worried about more natural disaster claims as global climate change is occurring much faster than anyone thought.  All of that means that traditional bond investors may have to sell positions in order to meet liquidity demands.

And I haven't even touched on the subject of much higher borrowing and refinancing costs for governments and businesses.  In brief, the entire world had become grossly and unhealthily addicted on ultra-low interest rates for the past 10+ years.  It is now discovering that money is not free, or even cheap.

The Bond Market Is Sending A Warning

 Those of us who are, or were, active in the professional/wholesale side of markets (eg interbank) know very well that bond markets lord over all other markets.  The daily trading volume of the US bond market is simply enormous: just amongst primary dealers daily volume averages around $750 billion for Treasury securities alone.  Add the rest of the participants, corporate and muni bonds, throw in repo and you're up to well over $2 trillion changing hands every day. Compare this to the US equity market at around $200 billion per day and you get the picture.

Therefore, what goes on in bonds is extremely important, not only because interest rates are paramount in our economy but also because size matters! - and it matters alot.

Bonds are now looking rather worrisome.  Take a look at the yield on 30-year Treasurys - chart below.  At 4.44%, the yield is at, or very near, 12 year highs. I don't care what equity analysts say, the real pros are sending us serious warning signals.

US Treasury 30-Year Bond Yield

The thing that is truly worrisome, from a long term perspective, is that bond prices have broken down from their very long term up channel going back 40 years - see below.  If you are a chartist - and many  pros are - this chart looks scary. VERY scary. 

Why, Oh Wise One?

 Berkshire Hathaway, Mr. Buffett's primary investment vehicle, has investments in 56 publicly traded companies.  Yet, just one (Apple) makes up a massive 51% of its holdings by market value.  Another seven make up an additional 34%, for a total of 89% (see below).

So, Berkshire is essentially a proxy for Apple, plus a very, very few more stocks.  OK, so Mr. Buffett is not bound by the usual rules for portfolio diversification... but still... WHY has he decided to turn Berkshire into such an incredibly NON-diversified investment vehicle?

Honestly, I don't understand it.  Can any reader please comment?

Thanks!

Inflation Warning

 Inflation has come down fast from its highs… but! It’s all due to sharply lower energy prices - see chart below. If it wasn’t for energy (ie oil prices tumbling) inflation today would be at 5% or higher.

And why did oil prices tumble? Almost entirely because the US drained its Strategic Petroleum Reserve down to levels last seen in 1983-84. Within just a few months the government sold a massive 300 million barrels of crude oil, causing prices to tumble - see chart below.

Sales from the SPR have now stopped and - shock! - crude oil prices are climbing once again, going from $73 to $83 per barrel in the last 30 days. Not surprisingly, gasoline futures are trading at $2.95/gallon, the highest level in 12 months. Even more ominously, 30 year Treasury bond yields are at 4.24% very near the highest level in 20 years.

It doesn’t take a degree in economics to guess where inflation is headed next…or what this means for markets.

Tech Voodoo Stuff

When I have nothing better to do, I cast a technical analysis eye upon markets.  It's voodoo stuff, mind you, but here goes...

Yesterday, S&P 500 initially cheered the "better than expected" CPI number and rose strongly, only to reverse and close flat on the day (see chart below).  Such intraday reversals, particularly on the back of positive news, indicate underlying selling pressure: investors who wish to unload long positions quickly take advantage of the fleeting buying demand and sell into strength.

And now, back to our regularly scheduled program :) 

Show Me The Money!

Sometimes all it takes is a picture or two.

Oh so much can be explained about inflation, stock prices and housing by a quick glance at the charts below: assets on the balance sheets of the Fed and ECB.  

Just in case you're not 100% percent familiar with monetary matters, within just a few months the Fed printed $5 trillion and the ECB 4.5 trillion euro. 

Enough said... but please note that they are currently attempting to drain the oceans of cash, albeit ever so slowly. 

FITCH DOWNGRADES US DEBT

 Yesterday Fitch downgraded US Federal debt to AA+.  Everyone in the administration and many economists attacked the decision as baseless, curious, etc.

But, one chart says it all (see below).  US debt as a percentage of GDP is now at wartime levels and has been climbing steadily for decades.  Not good...

Ok, Ok... one more chart.

The Fed has been printing enormous amounts of money (debt) ever since the Great Debt Crisis.  It has ballooned its balance sheet from 6% of GDP in 2008 to 36% of GDP at the height of the COVID Crisis, and slightly lower today at 32% (see chart below).

Basically, the Fed is financing the huge federal budget deficits by printing money and buying Treasurys (government debt).  The US economy is being "monetized", to coin a term.  Another term, more apt for Roman times, is that the "coin" is being debased.

Hence, the downgrade.

Persistent Inflation And Its Cause

 I just read an article about the reasons why inflationary pressures persist despite sharply higher interest rates.  Nowhere in the article did I see the one and only real reason for inflation: Money (duh!).

I mean, here it is in its simplistic form:

In the entire economy...

• You have one egg and one dollar.  The maximum price for the egg is $1.
• You have one egg and two dollars. The maximum price for the egg just went to $2.

During the pandemic, and shortly thereafter, the number of "eggs" remained more or less constant.  But the number of dollars literally exploded (see below).

Raising interest rates does not reduce the amount of dollars, it just makes them harder to borrow and, supposedly, slows down the economy, slows down demand, etc. etc.  But for as long as there are "excess" dollars out there chasing a limited amount of goods and services... inflation!

Enough said...

PS It's the same in the EU and Japan..

Debt Default Averted - Again

 So, the US has (once again) averted going into default. Good news? Sure, on the face of it... but...

Is this what should be the headline news for the world's largest economy? For the issuer of the global reserve currency? For the world's largest debtor? That it averted bankruptcy?

Hmmm... let me think about it... NOT????? 

Lemme Get This Straight...

So, the US is getting closer to defaulting, Fitch threatens to cut its AAA rating on US government debt, the politicians are arm wrestling and... the Fed signals its willingness to intervene in case the worst happens? Seriously???

The Fed previously intervened in the Great Debt Crisis of 2007-10 by bailing out banks, mortgage lenders, insurance companies and foolish speculators (yup, some investment banks were exactly that).  The Fed, basically, turned private debt into public by printing a (then) huge amount of dollars (see chart below).  In the process, it ballooned its balance sheet from $900 billion to $2.2 trillion within months.  It was the very first instance of Quantitative Easing (QE).

• Round One: The central bank funded the bailout of some speculators and a goodly number of players in the financial sector.

The Fed Bailout (QE1) During The Great Debt Crisis

The Fed intervened again during the COVID pandemic by, literally, raining money from the federal helicopter (see chart below).  Only this time the amounts involved were truly epic: its balance sheet literally exploded from $4.1 trillion to $9.0 trillion. 

• Round Two: The central bank supported a portion of household spending for a year or two.

The Fed Bailout (QE2) During COVID

So, lemme get this straight: the Fed is now saying that it is ready to intervene again to do what exactly? Bail out the entire Federal Government?  What will Round Three look like, if it comes to it? Purchase a portion of the entire federal debt (see chart below) and flood the world with worthless dollars? 

The Fed Bailout (QE3)????

Federal debt held by the public (ie excluding the Social Security Trust Fund) has exploded from $4 trillion to $25 trillion in just 15 years.  How much of it is the Fed  willing to buy? Some of ? All of it?  The Fed already has $5.2 trillion of Treasuries in its balance sheet (ie it owns them) - that's 20% of all Treasuries (excluding the SS fund). Looking at it another way, it owns Federal debt equal to 22% of US GDP.  How much more can it buy, before it turns the US into Zimbabwe?

 OK, OK... I am being an alarmist here, so let me rephrase.  

How much more can the Fed buy before it turns the US into the Weimar Republic.  Now isn't that better?

USA Default Warning

 Very quick post.

The US is inching towards default because of the debt limit situation, and markets are no longer ignoring the risk.  

Take a look at the 1 year Credit Default Swaps (CDS) for US sovereign debt (ie Treasuries).  Prices have soared to 150 bp, up  15-fold since early 2023. 

USA 1-Year Sovereign Credit Default Swaps

By comparison, 1 year CDS for Germany are at 3 bp,  Japan is at 5 bp and the UK is at 8 bp. Worried? You bet - literally!

PS President Biden declared that "the US will not default". Take a minute to think this through: if the world's largest debtor and issuer of the world's reserve currency is reduced to such statements... the game may not be over, but it is past its half-time, for sure.

Transiting From Permagrowth To Permaflat - Part Two

In the previous post I laid out the context for transiting our present socioeconomic paradigm from permanent growth (Permagrowth) to steady state, a condition I will call Permaflat.  In this post I examine the financial/monetary aspects of such a transition.  But first, a bit of history.

The last yoke on unchecked money creation was removed in 1971 when the US went completely off the gold standard (ok, going to zero bank reserves in 2020 is also significant, but in other ways). It was not an entirely bad idea, given the severe pressures created on the monetary system by OPEC's oil price shock.  Some ten years later, things got really ugly when inflation spiked to 15% and the Fed (ie Paul Volcker) had to throw the country into a deep recession in order to kill it. 

The relation between excess money creation and inflation is pretty obvious to anyone with a passing familiarity with basic monetary economics: if you create more money than is needed by the underlying economic growth you end up with inflation, created by the existence of money alone. For example, if you create 10% more money but the underlying economy only grows by 5% you could ultimately end up with inflation around 5%.  It's really a cocktail napkin calculation, but it's close enough.

If you need proof look at the chart below: M3 annual growth in blue, CPI inflation in red. The recent huge spike in money supply growth is scary, to say the least.

What is of more concern is that authorities/politicians seem to think that most all problems can be solved by running the printing presses.  Countries/banks/mortgage lenders become insolvent? Print money.  COVID strikes? Print money.  A major bank's liabilities need to be backstopped? Print money. A regional bank (or four) becomes insolvent and needs to be taken over by a behemoth? Print money.

But such money printing is also creating short term excess demand for goods and services, straining the Earth's limited resources.  It's as if  the enzyme critters are boosting their activity by using money as a catalyst.  Yet, the reactor vessel isn't getting any larger and the amount of corn/food is also ultimately limited,  no matter how much money is printed.  Money, after all, is an artificial construct based on faith alone.

Therefore, we could not limit Permagrowth until and unless we also hit the brakes on money/debt creation.  A transition from Permagrowth to Permaflat requires zero money growth.

More on that in Part Three.

End Of An Era, Transiting From Permagrowth To Permaflat - Part One

This will be a series of posts on a subject that is of great concern to me as a father: how to create a better, more sustainable world for our children.  I have long thought about starting the series but I kept putting it off.  It is now time to start, no more excuses.

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Back when I was a chemical engineer (it only lasted 2 years after college) I was involved in the design of a corn-to-ethanol plant.  Several such plants were built in the US Corn Belt as a response to the oil crisis in the early 1980s, and were heavily dependent on federal subsidies for gasohol (a blend of gasoline and alcohol).  But it wasn't the economics of the plant which created a lasting impression on me - rather, it was the chemistry/bioprocess itself.

Corn ethanol is produced by fermentation using enzymes, aka yeast, living microorganisms that convert sugars contained in the grain into alcohol. In simple terms, they eat corn and excrete alcohol as their waste.  The process takes place in chemical reactors aptly called "digesters", and it relies on constantly maintaining an optimum balance between healthy enzymes (the critters), corn (their food) and ethanol (their waste).  

And it has to be a balance because if there is too much food the critters will multiply uncontrollably, produce too much alcohol - which is actually a poison for them -and  will die from exposure to their own waste.  Conversely, if there is too little food they will turn on each other and become critter cannibals. Also, if the fermentation is allowed to run too fast and too hot (it is exothermic) the critters will die off, since they cannot tolerate high temperatures. The trick, therefore, is to introduce food (corn) and extract waste (alcohol + CO2+heat) in a carefully calculated balance to keep the critters healthy and happy.  

Does this sound familiar? 

Of course it does: we humans are the enzymes, the Earth is our reactor vessel and we consume its  resources to fill it with our waste.  But, there is a crucial difference: The Earth is a closed system with limited resources (with the important exception of incoming solar radiation) and no way to extract excess waste/heat. Also, we too are prone to cannibalism (war). 

What's our saving grace? We got critter brains - but even that is a double-edged sword, as we know from the likes of  Caligula, Attila, Hitler, Mao and many more such nasty "critters".  And no matter how smart, at some point the deleterious effects of exponential growth overcome our capacity to deal with them.

Signs of  such a Tipping Point are everywhere: Global warming, climate change, species and habitat  collapse, massive pollution and, very worryingly, a trend towards lifestyle diseases and habits, resulting in poor health and sudden life expectancy drops in wealthy countries like the US.  We even got a global deadly pandemic, a war and “critter arm wrestling” between the world’s two largest critter colonies (US vs China). The alarm bells are ringing, that's for sure.

I think the physical, scientific evidence on the ground is overwhelming.  But what about finance - what is happening there?

This will be the subject of Part Two.

Brave New Overleveraged World

 A loyal reader asked a pointed question: is this the worst market mispricing ever? (Thanks AKOC).

Perhaps it is. Why? 

Because the entire global economy is grossly overleveraged on a fundamental basis.  

When we think of markets and leverage we think of margin debt, derivatives, corporate debt, etc.  This was certainly the case in 2007-10 during the Great Debt Crisis, which was "resolved" when the US and EU central banks and governments stepped in and assumed the debt. Private sector debt became government debt, with lots of it sitting in central bank balance sheets. The problem was - literally - papered over.

Then came deflation (thank you China and you cheap manufacturing juggernaut), interest rates went to zero or lower, and for almost a decade everyone forgot that debt carries a servicing cost (interest). Even the worst serial bankrupt in Europe came back and tapped markets for fresh debt (Greece).  It had to mortgage its silverware for 99 years, but.. it did.

COVID changed everything: American, European and Japanese governments panicked and printed money like never before.  They made 2008-10 QE look like a statistical aberration by comparison (see charts below).

United States Federal Reserve  Balance Sheet Assets

European Central Bank Balance Sheet Assets

 

Bank of Japan Balance Sheet Assets

Looking at the charts we can draw only one conclusion: the West is fundamentally extremely overleveraged.  Central banks are financing the economy - take that out and what remains? Let's remember that central banks are regulators and lenders of last resort, not day to day financiers.  By trying to stay in the economic race the West is shooting itself in the foot.

Who is doing things differently?  The second largest economy in the world - China.  Its economy is growing rapidly - yes, it created a real estate lending bubble of its very own in the process - but, in general, it has kept its central bank's nose clean (see chart below).  

Back in 2006-07 I started this blog by posting just a few charts of debt going through the roof. They seemed self evident to me, but it took a couple of years until the doodoo hit the fan.  Today, the first three charts seem just as self evident, so I'll leave it at that.

Are Markets Whistling Past The Graveyard?

 It's the Monday after Easter Sunday and all markets are closed in Europe in deference to Christ's miraculous rise from the dead.  In some ways, then, it's apropos - if a bit sacrilegious - to mention graveyards.

Here's what's been nagging me for a long time now (at least a year): 

• There's a major war in Europe which keeps escalating. People are using the word "nuclear weapons" with increasing frequency.
• Tensions between US and China are high and rising.  The proximate cause is Taiwan, but the major issue here is nothing less than global supremacy.

Both of the above are clear and present dangers, and they are here and now.

• Climate change is accelerating but no one is really doing anything about it in a practical manner.

The latter is forever talked about as a "future" threat, but I'm increasingly worried that the tipping point is much closer than our society thinks.

IMHO markets are completely (and willfully?) ignoring these risks when pricing ALL securities, from bonds and stocks all the way to commodities and derivatives.  I get the feeling that no one in the mainstream is willing to develop a model to take these into account, perhaps fearing that he/she will be branded a loonie.  

How about this model, then?

Pnwu  = Probability of nuclear weapon use(decimal  0.00 - 1.00)   

Pucc    = Probability of USA/China conflict 

Ptp      = Probability of tipping point within 5 years 

Enwu   = Effect of nwu on equity markets  (+/- %)

Eucc    = Effect of ucc on equity markets 

Etp      = Effect of tp on equity markets 

Cumulative Effect = (Pnwu)x(Enwu) + (Pucc)x(Eucc) + (Ptp)x(Etp)

Plug in your own probabilities and likely effects and you'll come up with something a bit more concrete than "um, let's not worry about it right now".

I'm not doing it, they'll call me a loonie -  Well, at least I'm not doing it in public (ha, ha).

 

OPEC+ Was Not Amused

 A week ago OPEC+ (essentially, Saudi Arabia and Russia) announced a wholly unexpected cut in crude oil production and took everyone by surprise.  Prices immediately jumped from $75 to $80 per barrel.  Why did they do it?

I think it was a response to the new round of dollar "printing" by the Fed, engineered to salvage (once again) the US banking system.  How are the two connected? Simple: crude oil is priced in dollars  - when there are immediately more dollars around producers of "hard" goods are encouraged to hike their prices. 

The Fed had started reducing its balance sheet (QT) - but then sharply reversed course and "printed"  overnight as many dollars as it had withdrawn in the last 6 months (QE) - see chart below. And a week later... OPEC+ hiked prices.  I don't know about you, but I don't believe in coincidences.

It seems to me that the negative effects of unwise money creation to the real economy are becoming ever more rapid and obvious, even to the untrained eye.  From another perspective, demand for luxury goods and services by even the merely rich (not to mention the HNW and UHNW) is continuing unabated.  I can speak from personal experience, observing how American tourist bookings abroad are booming, particularly in the luxury sector.  There is just too much money sloshing about and it does not really matter how high interest rates go, until consumer deposit rates go significantly higher than inflation.

The Great Financial Crisis I & II

 Many historians view WWI and WWII as one world war separated by a brief period of peace.  The punitive terms imposed on Germany after WWI directly caused the rise of Adolf Hitler and his Nazis to power and, inevitably, WWII - all in a Europe where WWI had not truly solved the underlying power structure.

Drawing a parallel to the Great Financial Crisis of 2007-10, I believe that the way it was handled by central banks and governments in the US, EU and Japan is now - inevitably - causing the current spate of trouble. Let's call them GFC I and GFC II.

GFC I was "handled" by - literally -  papering it over: Western central banks "printed" enormous amounts of money to save the financial/banking systems in their countries and drove interest rates below zero.  This is a parallel to the punitive terms the Entente Powers imposed upon Germany at the Paris Peace Conference in 1919-20, in the sense that a "sane" financial/economic system cannot long operate under zero/negative interest rates without sowing the seeds of its own destruction.

For example, the ECB drove interest rates below zero from 2015 to 2022 (black line in chart below). It was thus only a matter of time and happenstance until inflation soared (red line) when it expanded QE massively during the COVID pandemic.

The same happened in the US, though interest rates there never went into negative territory.

And just like WWII was massively more destructive than WWI, GFC II has the potential to wipe out much more than regional banks, or even global systemic banks.  It has the potential of wiping out the public debt of countries like the US and Japan, or even the entire Western financial system.  Unless governments and central banks get really serious in averting the fast rising dangers, we may well become witness to the "Nazification" of our Western economic/financial system.  For example, look at how cryptos are reacting right now..

We really and truly need to act fast and decisively, before the "Nazis" take over:

1. We must immediately bring inflation down to as close to 2% (maximum) as possible.  There is only one way to do so in a rational manner: QT.
2. We must immediately eliminate budget deficits and eliminate the need for more public debt.
3. We must immediately start the process of re-balancing socially unjust income and wealth excesses. 

We must do everything necessary before GFC II starts.  

To draw another parallel from WWI - WWII, it was Winston Churchill, more than anyone else during the interwar period, who warned that Hitler was a dangerous megalomaniac and had to be contained before it was too late.  Instead, Hitler was appeased with disastrous consequences.  Likewise, we cannot afford to let things get out of hand, we must act NOW!

My Shortest Post Ever

 Today I'm gonna go for a record: Hellasious's shortest post ever.

Here goes:

TSIHTF

Hint: It's about global banks

Prize for the first to decipher the "Delphic" initials... free upgrade to Subscriber Status (which doesn't exist, but hey, you never know) ;)

The Oracle Of Wall Street And The Oracle Of Delphi

 Warren Buffet’s Berkshire Hathaway has 39% of its holdings in Apple shares and another 11% in Bank of America. Thus, a massive 50% is in just two stocks. In my opinion, not exactly a prudent “widows and orphans” investment stand - but who am I to question the Oracle’s judgement?

Instead, I will act like the ancient Oracle of Delphi who was famous for prophesies that could be interpreted any which way: here are charts of Apple and Bank of America. Readers are encouraged to read them as they themselves see fit.

Quantitative Tightening Ends Abruptly, Inflation To Follow

 Well...There goes QT.... In just a couple of days the Fed has pumped back in as much money as it drained in the last 4-5 months. 

Do you think inflation will follow? Unless we go into a full, blown out Crash yes, inflation is going back up ... 

Federal Reserve Balance Sheet Assets Jump Sharply

PS The Fed may flood the system with liquidity if it needs to, but the real problem here is counterparty risk exposure between financial institutions. As many of you may know, the entire global financial system (and thus the global economy) depends on the smooth functioning of the interbank market for foreign exchange, money (ie deposits) and their derivatives. It is, by far, the largest market in the world and depends on “lines” granted by banks to each other, ie how much do they trust each other to fulfill their obligations arising from trading.  Will they deliver on settlement date, will they return the money when due, etc.

When banks’ interbank credit departments get spooked they immediately slash their lines - and when that happens it’s basically all over for the bank whose lines are being cut - it can then only go to the Fed as lender of last resort.

Problem is, when one domino falls it is followed by others. As one bank gets its lines slashed it must do the same with lines it has itself extended to smaller banks, and so on and so forth.  The bigger the bank that gets in trouble the worse the result down the line. For example, Credit Suisse is amongst the 30 largest globally systemic banks in the world.  You can safely bet that it’s counterparties are taking a very serious look at their exposure to it. In fact, I’m pretty darn certain that bank officers are re-examining ALL of their credit lines to all banks right now.

Trying To Stop A Falling Knife - Memories of Crashes Past

Yesterday a team of banks announced that they will deposit $30 billion with Republic First Bank in an attempt to bolster confidence in what is quickly becoming a banking crisis.  Likewise, the Swiss National Bank threw Credit Suisse a lifeline.

My immediate reaction was to remember a parallel from 1929.  

On Thursday October 24, 1929 i.e. a few days before the infamous Crash of Black Monday, the stockmarket was getting pummeled.  A few top bankers decided to stem the bloodbath by getting themselves physically on the floor of the NYSE and making a show of buying stocks: Charles Mitchell from First National City Bank, JP Morgan Jr., Thomas Lamont and Albert Wiggin from Morgan. Indeed, their show of confidence managed to stop the drop, stabilized prices and even created a rebound. But, it was all extremely short lived, as we know.

Why? Because then as now, fundamentals ALWAYS rule the day, eventually.

A Few Days Before The Crash

And Right After

Three Banks Fail, Fed/Treasury Step In - And Save The Day?

The REAL news in the Fed/Treasury moves to shore up deposits in the banks that failed last week is not the Fed/Treasury moves.  The REAL news is that no other bank stepped in to take them over. Think about it... 

Also news is that the cost of saving them will be spread out amongst all other FDIC insured banks for all amounts over $250.000.  That's not going to be chump change, as total deposits for Silicon Valley and Signature come to approx.  $300 billion and FDIC's Insurance Fund balance in the end of 2022 came to $128 billion. Sure, the failed banks' assets will be liquidated to pay out depositors but given the state of the tech and crypto industries... don't expect anything near 100 cents on the dollar for the loans.

Update: First Republic Bank stick is plunging 60% today. With $210 billion in assets, it #14 in size in the US. The dominos refuse to stop falling despite Mr. Biden’s pledge to do whatever is needed.

Two ... Ooops... THREE Banks Fail

 

Two...errr...THREE ...US banks failed this week: Silvegate and Signature specialized in crypto financing and transactions, Silicon Valley in tech startups. Are the two ... THREE.. events connected?

Yes: they were emblematic institutions in the two market sectors that experienced the most rabid bubble speculation.  Their failure comes on the heels of their respective bursts.  

The question now is this: are there more dominos to fall? Yes, there are. Our financial system is highly interdependent and leveraged, so it is only a matter of time until losses surface elsewhere.

Normally, when things get precarious the Fed immediately steps in and provides liquidity to the banking system. Can it do so today? With inflation where it is?  No, objectively it can’t - but, it will if things get nasty. The Fed simply isn’t wired to be a truly tough taskmaster.

UPDATE: The Treasury and Fed stepped in to protect all Silicon Valley deposits, even those above $250.000 which are covered by FDIC.  Turns out 90% of all deposits were over $250.000.  And so it begins...

We're Not In Kansas Anymore - It's A Brave New World (?)

Today I'm using two well known "blurbs", one from The Wizard of Oz and the other a famous book title. I will connect the two below.

We're certainly not in Kansas anymore.  The financial world has come topsy turvy on the heels of massive monetary injections which, predictably, caused rampant speculation and massive inflation.  The days of near zero inflation and negative interest rates are gone, and the sooner we realize and assimilate this into our models, the better.  

Furthermore, because of crushing debt loads we need to have a serious political debate about the future of fiscal policy in the US, EU and Japan.  We will have to make really tough decisions, and the choices are few and very unpleasant. The reason is simple, as in this blog's name: Sudden Debt.  The West has encumbered itself with enormous debt amassed over several decades in order to achieve a standard of living that could not be otherwise sustained.  

To put it simply, we borrowed our prosperity.  With zero interest rates this could arguably be ok - to a degree -  but with rates now spiking debt is becoming an ever heavier millstone around our necks.  How long before our necks break and Sudden Debt causes Sudden Death? Judging from Mr. Powell's recent conversion to inflation fighting, it won't be too long - because he also has to take into account the rabidly anti-tax Republicans and the significant possibility of failure in debt limit negotiations. 

In other words, the Fed HAS to bring down inflation and interest rates as soon as possible, before they bring down the whole show, Pax Americana included.

Is it a Brave New World? Maybe. Maybe Mr. Powell will not flinch and could even double down on his inflation fighting. Perhaps he will even go as far as increase the amounts of QT, something he should have down a long time ago.  But, I'm not holding my breath, because he really does not want to be blamed for bringing down Wall Street, something that must be done if financial conditions are to tighten enough to kill inflation for real.

So, yes, we're not in Kansas anymore - but we're not yet in a brave new world.

China's Manufacturing Comeback And Global Inflation

 Until recently China's economy had been toiling under strict zero-COVID rules - but no more.  Manufacturing PMI jumped in February signaling a return to the factory floor, and - naturally - demand for raw material, energy and transport services (see chart below).

China PMI

Which raises this question: if global inflation soared without Chinese demand, where will it go now?  IMHO, it certainly won't go down any time son...

The Fed Was 17 Months Late In Raising Rates

 The Fed printed a gusher of money during 2020-21, and then hid its head in the sand ignoring inflationary pressures, labeling them “transitory”.  Finally, they woke up from their dream state and started raising rates all in a rush.  How much time did they lose, how far behind the curve were they?  The short answer is they were at least 17 months late - way too late in my opinion. 

Here's a chart.

  The blue line is the yield on the 2 year Treasury, which is anchored by the Fed funds rate.  The red line is the yield of the 10 year Treasury which is entirely dependent on the market.  Notice how the red line starts to creep higher starting in August 2021, even as the 2 year remains flat.  Meaning, the market was already pricing in higher inflation, way before the Fed started raising rates in October 2022; that's a whole 17 months where the market was telling the Fed to get its head out of the sand - to no avail. 

By the time the Fed acted, the 10-2 spread was already at 100 basis points (the black arrows).  The Fed has been playing catch up ever since, causing the spread to - finally - go negative.  Yet, rates are still lower than headline inflation and the ocean of liquidity created by the Fed is still almost entirely untrained.  The “easy” part of inflation moderation is now finished as fuel prices have stopped dropping, and it is highly likely that inflation will, if anything, start rising again as higher wages kick in.  And that’s when the Fed will, at last, truly wake up.

If The Fed And ECB Were "Regular" Banks They Would Be Bust

 The Fed and ECB are now running huge operating losses PLUS enormous mark to market losses. To wit:

1. There is a wide gap/mismatch between paying high short term rates (eg on the Fed's reverse repo) and low returns on their bond portfolios.  This is a classic borrow short - lend long problem, exactly the same as the Savings and Loan Crisis of the late 1980s.
2. Central banks are holding long term bonds on their balance sheets that are now priced much lower than what they bought them for.  The unrealized mark to market losses are in the trillions of dollars/euros.

This article explains things pretty clearly.  I wonder how much longer the monetary world will continue to operate as if the Emperor's clothes are real...

 

Inflation Will Not Come Down Until And Unless Money/Liquidity Is Drained Away By The Fed

 Inflation has come down from the highs registered last summer, but most recent data is showing that it's becoming "stickier" at uncomfortably high levels. For example, PPI released yesterday came in at the highest reading since last June.

This is prompting various analysts to revise upwards their terminal Fed Funds target rate, now expected to peak at 5.25-5.50% from 4.50-4.75% currently.  That's 0.25% higher than previously expected.

At the risk of my becoming repetitively boring, that's not enough.  Until and unless the Fed truly bites the bullet and starts to drain liquidity in earnest, ie to sharply reduce the size of its own balance sheet, inflation won't come down rapidly.  Why? Because inflation is a monetary phenomenon, more money = more inflation.

Looking at monthly changes in the Fed's assets, we see the pumping of huge amounts of cash into the system, as much as $590 billion per week, during the COVID era (see chart below-red circle).  By comparison, the draining of this flood is extremely timid, at around $ 20-25 billion/week (yellow highlight).

Once again, then: if the Fed really wants to fight inflation it better look at its own house first and start selling bonds from its portfolio.

Be My Valentine

 On this Valentine Day index lovers must send lots of chocolates and roses to AAPL and XOM.  The pair are a spike lover’s delight.

EXXON

APPLE

The 10-2 Treasury Yield Spread Conundrum

The 10-year minus 2-year Treasury yield spread is considered one of the best recession predictors. When it goes negative, ie when the 2-year note yields more than the 10-year bond, a recession soon follows (chart below, recessions in grey). Will the past repeat?

I think there is something different and unusual about this episode of yield curve inversion. 

• For one, it comes after a very prolonged and unprecedented period zero/negative short interest rates.  Meaning, short rates were extraordinarily low and had a ways to go higher before they normalized. By comparison, long rates had not fallen as much. Therefore, it is logical for the spread to be more negative than otherwise.
• Secondly, there is a growing feeling that the Fed will be successful in quashing inflation in the next few months, and thus long rates need not be as high as current inflation implies. Therefore, while short term rates are high, long rates are still low ---> spread more negative than otherwise.

Markets are definitely acting along those two concepts above.  Are they correct?  I have no idea, but if they are not we are going to see a major "disillusionment" drop in all markets.

Putting it another way, the near record negative spread is more an indicator of markets defying the Fed (and common sense) than anything else. It’s an indicator of excessive speculative optimism which may be proven unfounded.

Personal Saving Rate At All Time Low

Right before the Great Debt Crisis of 2006 - 10 Americans' personal saving rate had dropped to an all time low around 3.5%.  After rebounding significantly to around 7.5-9% (excluding the COVID period) it has now collapsed back down to all time lows (see chart below).

Personal Saving Rate At All Time Low

Another way to look at it is that Americans spend 96.5% of their income, the highest percentage in the world.  This statistic goes a long way in explaining the current resilience of the US economy despite soaring inflation and slow wage growth.  But this resilience is hollow: people just can't keep raiding their savings forever.  And given sharply higher interest rates they can't keep piling on more debt.

In fact, what keeps piling on are warning signs that all is not well.  But, as usual, people are ignoring them.

National Financial Conditions Index And Inflation

The Chicago Fed publishes a national financial conditions index (NFCI) which rises when conditions tighten (eg when interest rates rise and risk appetite decreases).  Obviously, as financial conditions tighten the economy faces headwinds and slows down, while inflation also eases (at least theoretically).

Here's a chart of NFCI (blue line) and CPI inflation (red line).

NFCI And Inflation

An immediate conclusion here is that financial conditions are still rather loose (blue line below zero) while inflation is still near historic highs.  And that's despite the Fed's rapid increase in interest rates.

If history is any guide, it will take much tighter financial conditions to bring down inflation to more manageable levels.