Pro Perspectives 7/7/23

 

 

 

 

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July 07, 2023

We close the week with the 10-year yield above 4%. 
 
As we've observed over the past year, this has been the danger zone for global financial stability.
 
As Warren Buffett has said, "only when the tide goes out do you discover who's been swimming naked."  The "tide" in this case is the easy money, low inflation era. 
 
And the trigger for the indecent exposure has tended to come from the level of market interest rates (not necessarily the Fed-determined interest rates).
 
So, will more bad behavior be revealed, with the 10-year here? 
 
Maybe. 
 
That said, what could relieve some of the selling pressure in the Treasury market (and rise in yields)?  
 
Maybe a very eye-appealing inflation number next week.  We get June CPI on Wednesday, and a "good" number is coming.   
 
Remember, we've been talking for several months about the "base effect" in the inflation data, and the coming "cliff dive" for the headline inflation number by June.  This June data is the month we should see the headline year-over-year number drop into the low-3s (maybe 2s). 
 
Even if the monthly change in June inflation were to match the hottest we've seen over the past year (like 0.5%), the headline year-over-year CPI change would still fall to something like 3.15%.  
 
It's the "base effect."  As you can see in the chart below, the June inflation number will be measured against a number, twelve months ago, that stepped significantly higher.
 
 
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Pro Perspectives 7/6/23

 

 

 

 

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July 06, 2023

We left off yesterday looking at this chart of the 10-year yield …
 
 
After being well contained over the past three months, under the 4% level, we headed into this morning's jobs numbers with what looked like a technical breakout, and a potential catalyst for a revisit of 4%.
 
With that, the ADP report came in much hotter than expected this morning.  
 
Yields did this …
 
 
So, we're back above this 4% area for the world's most important interest rate (the anchor for global rates).  And this is where things have tended to break in the global financial system.  
 
Most recently, it was the collapse of Silicon Valley Bank, when the 10-year traded up to 4.09%.  The crypto-exchange FTX blew up when the 10-year traded up to 4.22%.  The Bank of Japan was forced to intervene to curb the decline in the yen, when the U.S. 10-year traded up to 4.34%, back in October.   And the UK bond market nearly melted down in late September, when the U.S. 10-year traded to 4.02%.
 
As you can see in the chart below, we haven't spent a lot of time above 4% (the red line), before the fireworks start.  And we revisit this time with UK bond yields now trading above the levels that created stress in UK pension funds last September.    
 
  
 
Notably, the cure to the level of rates, in the events denoted in the chart above, has been some form of intervention (with the exception of FTX).
 
That brings us back to an image from one of my notes last year, when the Fed was just kicking off its tightening program. 
 

 

Remember, we've yet to see an example of a successful exit of QE.  So the above has been the plan all along:  plug the holes, as they open (in coordination).

 

On that note, as we've discussed in my daily notes, there is one central bank that has played a key role in suppressing the U.S. benchmark government bond yield (keeping this key global interest rate out of the danger zone):  the Bank of Japan.

 
There's probably a good reason that Ueda (the Governor of the Bank of Japan) said last week, while on stage with his global central banking counterparts, that rates would go up by a large margin in Japan, "IF they GET to normalize policy."  It doesn't look like it will be anytime soon, despite their own forecast of hitting their inflation target by next year.  The rest of the world needs them to continue buying assets. 

Pro Perspectives 7/5/23

 

 

 

 

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July 05, 2023

We're through the first half of the year.  And with history as our guide, we came into the year expecting a good year for stocks.
 
Remember, going back to 1950, there has never been a 12-month period, following a midterm election, in which stocks were down.
 
And the average 12-month return, following the eighteen midterm-elections of the past seventy years, was +16.3% (about double the long-term average return of the S&P 500).
 
The S&P 500 opened at 3,750 on November 8th, 2020 (election day).  At the highs this morning, it was trading just shy of 4,500.  That's a rise of about 20% over the past seven months.
 
That begs the question:  What was the best 12-month period following a midterm election (over the past eighteen periods observed)?
 
It was under Kennedy.  Stocks rose 31% in the 12-months following the 1962 midterm election.
 
And interestingly, the worse stocks did in the 12-months prior to the midterm elections (over the 70-year period observed), the better they did after.  In the current case, stocks were down 22% prior to this past November.
 
So, history would suggest more upside for stocks is probable over the next four months.
 
On that note, last week we discussed some reasons to believe the economy can do better than the consensus view.  Among them, we've had some key risks removed over the past couple of months (the removal of the risk of a banking crisis, the removal of the risk of a U.S. government debt default, and the removal of the Fed's constant threats to destroy jobs and suppress wages).
 
Add to this, the fiscal bazooka has been loaded but has yet to be fired — just $600 billion of the $4+ trillion approved under the Biden administration has been deployed.  A tsunami of money will be hitting this economy.  And we have the introduction of a productivity boon, in generative AI.    
 
With that, we've just had a significant revision higher to Q1 GDP (from 1.3% to 2%).  And the Atlanta Fed's GDP model is tracking an almost 2% annualized (real) growth rate for Q2.  Importantly, that's about double the consensus view of the economist community.
 
Of couse, the economist community will tell you that the yield curve is inverted.  PMI's (manufacturing and services activity) are under 50 (economic contraction territory).  The Fed is still hawkish.  And with that, they continue to look for a impending recession. 
 
But as we've discussed, on the former, the inverted yield curves (globally) can be quite reasonably attributed to bond market manipulation by central banks.  Central bank intervention in bond markets, of varying degrees over the past 15 years, has all but canceled the validity of signals bond markets have historically given to markets about the economy.   
 
On the latter (manufacturing activity, and the Fed), what matters (for markets, and the economic outlook) is incremental change.
 
 
This chart above is ISM Manufacturing PMI.  The June reading was reported on Monday. Since the Fed began telegraphing a tightening cycle (in late '21), this index is down from 60 (in healthy expansionary territory), to 46 (in contractionary territory).  
 
The widely held assumption is that this contraction in manufacturing activity is predicting an imminent contraction in economic activity.  Indeed, the plunges below the white line (in the chart above) have been accompanied by recessions.     
 
Is it different this time?  In each of these cases where the index has been at the white line or below, unemployment has been rising sharply, and, at least, at multi-year highs.  This time, we're near record lows.  Labor supply is very tight.  And as we discussed above, we have a tsunami of fiscal spending coming down the pike, which is supportive of the labor market.  
 
So, the question, when looking at this chart:  Is it more likely that we see the next 5 points on this manufacturing index higher or lower?  I suspect higher is the higher probability.  That incremental change (higher) would be positive for market and economic sentiment.
 
Finally, on the Fed outlook.  Once again the Fed has postured to do more.  And once again, the market is pricing it in.  What matters most is that the Fed is near the end, and that market rates (the benchmark 10-year yield) remain contained.
 
On that note, this chart becomes very important to watch, with the move in yields over the past four days. The 4%+ level has been Kryptonite for global financial stability …
 
 

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Pro Perspectives 6/28/23

 

 

 

 

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June 28, 2023

The four most important central bankers in the world sat on a stage in Portugal today and fielded questions spanning from the inflation outlook and rate path to geopolitical concerns (Russia and China), fiscal policy, digital currencies, and AI. 
 
They all continued to talk about doing more to get inflation to target.
 
And yet benchmark 10-year government bond yields, in each case, went lower on the day.
 
In fact, if we look at the most important global (market) interest rate (the U.S. 10-year yield), it continues to trade comfortably under 4%, despite a Fed that is setting expectations for a Fed Funds rate of 5.5% (or higher).
 
As we've discussed here in my daily notes, this 4%+ area on the U.S. 10-year yield, has been Kryptonite for global financial stability.
 
But as long as this guy on the left (picture below) continues to do what he's doing, the three on his right can do what they're doing ("normalizing" rates) without sacrificing the global financial system and economy — and it's in large part, because these market interest rates (in the U.S., EU and UK) have remained relatively subdued (relative to the inflation picture of the past two years, and the respective rate paths).   
 
The guy on the left is the Governor of the Bank of Japan, Kazuo Ueda.  He was the most important person in the room today.  He's the only one in the room trying to get inflation UP to 2%, and therefore is the only one in the room with negative interest rates (still), and printing yen each month and buying both domestic and global assets with that freshly printed yen (with no limits).
 
With that, guess who has overtaken China as the biggest foreign buyer of U.S. Treasuries. 
 
Japan.
 
So, this BOJ policy not only suppresses Japanese government bond yields, and promotes inflation and economic growth in Japan, it also suppresses the U.S. benchmark government bond yield (the 10-year yield), and has served as a liquidity offset (to a degree) to the Fed's tightening.
 
So, the question was asked of all of the central bankers today, "do you coordinate?"  They dodged the question.  But the answer is, yes.  This is well coordinated.   This "normalization of rates" in the U.S. and Europe only works with assistance of the Bank of Japan.
 
And as we discussed a couple of weeks ago, what's in it for Japan? 
 
The world gives Japan the greenlight to devalue the yen, inflate away the world's largest debt load, and increase export competitiveness (through a weaker currency).  It's all happening.  

Pro Perspectives 6/27/23

June 27, 2023

We had some strong economic data this morning. 
 
For the month of May, durable goods and housing data were all very strong.
 
And consumer confidence for this month (of June) had a big bounce back, after trending lower for much of the first half of the year. 
 
 
What could fuel a technical breakout in this confidence index (i.e. restoring confidence in the economic outlook)?
 
>The removal of the risk of a banking crisis. 
>The removal of the risk of a U.S. government debt default. 
>The removal of the Fed's constant threats to destroy jobs and suppress wages. 
 
Check, check, and check.
 
What else could underpin a surge in confidence?  
 
Maybe a tsunami of yet to be deployed fiscal stimulus.  And that would be even more powerful if it were to coincide with the beginning of a new industrial (digital) revolution, accompanied by productivity gains comparable to the invention of electricity (in the words of OpenAI's co-founder).
 
Check, and check. 
 
With this in mind, as we've discussed here in my daily notes, we need a period of boom-time growth.  We need it to inflate away the unsustainable debt load.  And we need it to return GDP to long-term trend (i.e. to close the post-GFC gap, between the blue line and the orange line).
 
I think we have the ingredients for it.    
 
 

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Pro Perspectives 6/26/23

June 26, 2023

On Friday we get May core PCE.  This is the Fed's favored inflation gauge.
 
As you can see in the chart below, the Fed Funds rate is ABOVE the inflation rate (core PCE), and it has been since March.  
 
 
 
As we've discussed here in my daily notes, this is historically where the Fed has taken rates to get inflation under control (i.e. above the rate of inflation).
 
So this dynamic of a positive real interest rate, for the past three months, should be putting downward pressure on inflation.
 
As for sentiment during the month of May, the debt ceiling drama had it plunging back toward the levels of the Global Financial Crisis, and the 2011 debt ceiling standoff …
 
 
 

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Pro Perspectives 6/23/23

June 23, 2023

As we end the week, let's talk more about generative AI.
 
We've talked in recent weeks about Nvidia, (now) the most important company in the world. 
 
Nvidia is powering the computing side of generative AI. 
 
The other, very important side is data.
 
The large language models like ChatGPT will make everyone a computer programmer.  With simple, plain-English text prompts, the models will ultimately do the work of hundreds of coders — perhaps months of work, in seconds.  But the output is only as good as the prompt it's given, and the data it is trained on.
 
With that, in the era of generative AI, companies that are data-rich are in a position of strength.  These companies will have the data to train their own models.  They will enhance their decision making, identify opportunities to create new products and improve customer experiences.  And those with rich and unique data, will have an opportunity to monetize that data – to become a new revenue source. 
 
And as we've discussed, the speed of change in this "industrial revolution" could be unlike those of the past.  It's moving fast. 
 
And it seems pretty clear that the productivity gains will be huge.  As an example (from an OpenAI case study), CarMax used ChatGPT to summarize 100,000 customer reviews to include on their website, for every make, model and year. They say it would have taken their editorial team 11 years to complete the job.
 
So, who are the kings of data? 
 
Meet the new kings, same as the old:   Google, Amazon, Facebook, Apple, Microsoft.
 
When the government turns a blind eye to antitrust law, the moat only becomes wider and wider.
 
Position yourself for the high-growth opportunities in the emerging fourth industrial revolution (the digital revolution) … 
 
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Pro Perspectives 6/22/23

June 22, 2023

The Bank of England surprised with a bigger, 50 basis point, hike this morning.   
 
The 10-year UK bond yield responded to this larger than expected hike by moving lower, not higher. 
 
This takes the benchmark short-term rate in the UK to 5%, which is (maybe not so coincidentally) about where rates for the world's most important central banks are converging (with one exception, Japan).    
 
So, the major central banks of the world have been able to successfully exit zero interest rates (and QE) with an historically fast normalization of rates, all in the face of one of the most complicated global financial, economic and political environments in history — and without losing control of the bond markets.
 
How?  It's a "managed" normalization.  As we've discussed often in my daily notes, in the post-GFC era of no-rules central banking, they are in the practice of "fixing and manipulating."  And as long as it's done in cooperation with their global central bank counterparts, there are no penalties (not to the currency, not to the bond market, not to equity markets, not to foreign investment).
 
And, in cooperation, they buffer the effects of tightening by keeping the liquidity pumping from a part of the world that has the most severe structural deflation problem, and the biggest government debt load in the world:  Japan.
 
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Pro Perspectives 6/21/23

June 21, 2023

Jerome Powell is back on Capitol Hill. 
 
It was just a week ago that the Fed ended a series of ten consecutive rate hikes. Though for good measure, to keep any exuberance in check, the Fed projected a couple more (hikes) by year end. 
 
He reiterated as much today.  But the markets don't seem to care. 
 
Why?
 
As we discussed last week, as long as the 10-year yield (the anchor market interest rate) is out of the danger zone (in the 3s), then financial and economic stability seem to be preserved.
 
It's a similar situation in Europe and the UK.
 
And as we also discussed last week, this phenomenon of "inverted yield curves" can clearly be attributed to bond market manipulation by central banks.  
 
That said, the Bank of England will hike rates again tomorrow. 
 
They are dealing with the highest inflation of G7 countries.  And they are dealing with the highest 10-year government bond yield — which is creeping dangerously toward the levels of last September.
 
Importantly, in September, the BOE had to step-in to rescue failing pension funds, which was directly unraveling the UK government bond market, which would have quickly become a financial crisis. 
 
The moral of the story: the central banks will continue to plug the holes, where needed, with the full support of their global central banking counterparts.  
 
 

Pro Perspectives 6/20/23

June 20, 2023

We had strong housing numbers this morning.

Housing starts jumped, though off of the lows of the past year.  The decline (to those lows) was driven by the Fed’s historic interest rate hikes, which (related) caused the quickest doubling of mortgage rates on record.

With that formula, following the post-covid boom in housing prices, the housing market has been a subject of “bubble talk.”

Let’s take a look.

First, here’s a look at building permits.

And here’s a look at housing starts.  In May this was running at the hottest rate in seven years  …

Now, from these two charts you can see the direct impact of rising interest rates on home building.  We can also see, on the left side of the charts, what a housing bubble (and burst) looks like.

If we look back at that 2006 period, home builders were building at about a 40% hotter pace, with about 10% less population.

That real estate bubble was primarily driven by credit agencies AAA stamping high risk/high yielding mortgage portfolios (a mix of fraud and incompetence on the part of the ratings agencies). With a AAA rating and a high yield, massive pension funds had no choice, if not an obligation to plow money into those investments.  And with that insatiable demand, mortgage brokers and bankers were incentivized to keep sourcing them and packaging them.

This post-covid housing environment was much different/ much less vulnerable to rate hikes.

You can see in the graphic below, the risk profile is very different, which aligns with the current environment of high creditworthiness (low debt service) and stringent lending standards (post-financial crisis).

We discussed these housing market comparisons by in my December 14th note in 2021, as we were a few months away from the Fed’s rate liftoff.

With that, I said … “What looks likely, in the face of a rate tightening cycle, is that real estate prices just stay persistently high, and even continue higher — driven by multi-decade high economic (nominal) growth, massive new money supply floating around, and a very tight labor market.   And at higher rates, it will just cost more to live.”

This aligns with what we’ve discussed throughout on the inflation topic:  “rate-of-change” in prices will slow, but the level of prices is here to stay.

And it’s by design: inflate asset prices and inflate away the value of debt.