Pro Perspectives 9/30/22

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September 30, 2022
 
As we end the third quarter, let's take a look at year-to-date major asset class performance. 
 
Stocks are down 24% (S&P 500).
 
Government bonds are down 14% (the 10-year U.S. Treasury note).
 
Corporate bonds are down 18% (Bloomberg Baa Index)  
 
Real Estate is up 8.5% (existing home median sales price).
 
Commodities are up 4% (S&P GSCI equal weighted index).
 
Cash is up just less than 1% (money market fund).
 
After adjusted for inflation, it's all negative (exception real estate, which is flattish).
 
The performance in asset prices has less to do with whether or not the economy can withstand a 3% interest rate, and more to do with a Fed that has explicitly and continually (over the past six months) threatened to destroy demand, and jobs.  
 
With that, the Fed has manufactured the desired slowdown in economic activity (again, with just a 3% interest rate, which is still below the long-term average). 
 
The first two quarters have already been booked as negative GDP growth.  So the recession is not questionable.  It is here.
 
And we now have the valuation on stocks at 15 times next year's earnings (less than the long-term average P/E on the S&P 500, of 16x).  That's on earnings growth expectations that have been dialed down to 3%.  That would be negative real earnings growth (after the effect of inflation).  
 
So the Fed has manufactured a recession, without taking rates above the rate of inflation (not even close).  They've killed the wealth effect of rising asset prices.  And they've cut the valuation on stocks from very overvalued to slightly undervalued (relative to long-term historical valuation).   
 
And this week, the Fed has pushed the limits to the point of destabilizing the financial system (given the events in the UK this past week). With midterm elections six weeks away, this seems like a time for the Fed to step back.     
 

Pro Perspectives 9/29/22

 

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September 29, 2022

Just in case we thought the Bank of England’s intervention yesterday in their government bond market, signaled a course correction for the Fed, we were disabused of that thought this morning.  

The Fed lined up three speakers today, all affirming the draconian rate outlook (hawkish).  And they put two on the calendar for tomorrow, which undoubtedly will have the same message.  Moreover, the European Central Bank is following the same playbook, having lined up media for numerous ECB governing council members to promote the narrative of steadfast loyalty to the inflation fight (i.e. telling us that tough rate hikes will persist).  

Meanwhile, they all support the Bank of England’s flip-flop on bond buying yesterday (a monetary “easing” tool that is a counterforce to the Bank of England’s own interest rate hikes).  And of course, as we know, the European Central Bank did a similar flip-flop over the summer.  They are outright buying government bonds of vulnerable euro zone countries, while also raising interest rates.    

How does this make sense?  

As we know, since the Great Financial Crisis, the major global central banks have done nearly everything in coordination.  They continue to coordinate.  In fact, Jerome Powell subtly said in his last press conference, that he had just returned from Basel, Switzerland, where he was meeting with other central banks.  

It seems that they are focused, in coordination, on crushing inflation expectations, and therefore demand. Meanwhile, as their policies destabilize the financial system, they unapologetically intervene to absorb the shock.  

That brings us back to an image from one of my April notes, as we were discussing the plans of the central banks to exit QE.   

The problem:  we’ve yet to see an example of a successful exit of QE.  

Here we are again.  The attempted exits have only led to more control and more intervention by central banks over markets – to plug new leaks in the global economic system. 

The question now is, have the central banks lost credibility, and will the markets, this time, test them (i.e. continue to put pressure on currency and government bond markets)?  

We seem to be at that point.   

That said, when the biggest most powerful central banks in the world are coordinating (the Fed, ECB, BOJ, BOE, SNB, BOC), they can’t be beat.  In their own words, they will “do whatever it takes” to maintain stability in the financial system. They will keep plugging holes, in coordination.  

So what’s the end game?   

As we’ve discussed often here in my daily notes, this all continues to progress toward an eventuality of a  coordinated reset of global debt, and a new monetary system. 

 

Pro Perspectives 9/28/22

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September 28, 2022
 
In my note yesterday, we talked about the pivotal moment for global markets and economies.  And it was manifested in the price of the global benchmarks for stocks and interest rates — which is the S&P 500 and the U.S. 10-year Treasury yield.
 
A revisit of June lows in U.S. stocks, and the rise to 4% in the U.S. ten-year government bond yield appeared to be the pain tolerance for the global financial system stability. 
 
That pain, in this case, is the effect of increasing debt servicing costs on bloated global government debt, and the related capital flight from around the world, and into the United States (relative safety).
 
As of yesterday afternoon, it looked like the breaking point.  
 
And with that, we suggested that we may (should) get a response from the Fed today.  We didn't.  But early this morning, the pain was relieved (for the moment) by another major central bank:  the Bank of England. 
 
After a doubling of the government bond yields in England over the past month, and a collapsing currency, the Bank of England was forced to restart QE this morning.  
 
Sound familiar?  
 
The European Central Bank did the same back in June, after watching yields in the fiscally fragile euro zone countries spike to over 4%. Just after they ended QE, they were forced to restart it. 
 
By the way, that decision by the ECB back in June, in addition to the subsequent commitment to QE by the Bank of Japan, put a bottom in for global stocks and lead to a sharp 19% rebound).     
 
So, this is central banks coming to the rescue (again), to (in this case) avert a global sovereign debt crisis.  They are going back to the well, of printing money/intervening to maintain stability in markets. 
 
This continues to support the point we've discussed all along the way: The financial system is too fragile to extract global liquidity, and sovereign debt is too bloated to endure higher interest rates (i.e. higher debt servicing costs).  
 
With that in mind, as we've also discussed along the way, QE and low rates are like Hotel California.  "You can check out, but you can never leave."  We have another confirming data point now, in the Bank of England response.
 
How did markets respond to today's intervention …
 
Yields on UK government bond yields collapsed 50 basis points!
 
Yields on Italian 10-year bonds were sniffing around 5%, before dropping back to 4.58% (still above the June highs).
 
And U.S. yields dropped back to 3.70% after trading above 4% overnight. 
 
Is 4% in the global bond benchmark the "uncle point" for markets?
 
Maybe. 
 
Lower yields (less pain) equals higher stocks.
 
With that, the S&P 500 was up big on the day, first breaching the June lows, and then reversing 3% higher. 
We now have a technical reversal signal in stocks (an outside day) – into the June lows.
 
This is a bullish technical signal.  But we will still likely need the support from the Fed, walking back on the overly aggressive rate path they've projected.

Pro Perspectives 9/27/22

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September 27, 2022
 
The S&P 500 traded just below the June lows today.  The U.S. 10-year yield traded just shy of 4%.
 
These two markets are global benchmarks for stocks and interest rates, and, importantly, proxies for global economic health, stability and risk appetite.
 
With that, I would say we are at a pivotal moment.
 
As we've discussed, bond and currency markets in Europe may already be in a currency and sovereign debt crisis.
 
Again, this is all triggered by the Fed (the defacto global interest rate setter), by:  1) ignoring the obvious (and intentional) inflationary formula in the pandemic response, and then ignoring the subsequent evidence of that inflation last year, and then 2) finally acknowledging the inflation problem, while continuing to fuel the inflationar through zero rates and QE, up to the point they flipped the switch — and only after six months of crawling rates higher, did they reach a somewhat historically normal level for interest rates, to address near record levels of inflation. 
 
With that, the Fed Chair is on the calendar again tomorrow for a prepared speech (a pre-recorded speech) for a community banking conference.  Will he try to calm markets by walking back on the aggressive rate path that is being priced into markets? 
 
We had a couple of Fed speakers today, that may have opened the door to some softening of the tone.  Both Kashkari and Evans said rates are now "tight" or "restrictive," which is where they say they want to be.  Kashkari admitted there is "risk of overdoing it."  And Evans admitted he's nervous about the pace of hikes.
 
We will see if Powell has something to add. 
 
What else can play into this pivotal moment for global markets?  Today the Nord Stream 2 pipeline, developed to carry Russian natural gas to Germany, leaked into the Baltic Sea.  This could be a global war flashpoint, as fingers are being pointed in a lot of directions (most consequentially, at the U.S.), claiming an attack.  
 
What would come with a full-blown World War?  Among many things, a lot more government spending, and an economic boom.   
 
 

Pro Perspectives 9/26/22

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September 26, 2022
 
I want to revisit an excerpt from my July 14 note (blue font), and then talk about how it's playing out. 

 
Pro Perspectives, July 14, 2022: 
 
The Fed doesn't have the appetite for big rate hikes. 
 
If they did, they would have acted bigger, and more aggressively already. High inflation environments, historically, have only been resolved when short term rates (the rates the Fed sets) are raised above the rate of inflation.  The Fed is currently almost eight percentage points behind.  We can only assume, at this point, that it's intentional.  
 
Also, when asked about the inflationary risks of QE, back in 2010, the former Fed Chair (Ben Bernanke) said dealing with inflation is no problem.  "We could raise rates in 15 minutes." 
 
They haven't [done that, i.e. a big one-off emergency rate hike]. 
 
Add to this:  The current Fed Chair has told us that they were going to aggressively attack inflation, by "expeditiously" raising interest rates, and "significantly" reducing the Fed's balance sheet.  They have done neither.
 
So they have the tools.  They understand the formula for resolving inflation.  But they aren't acting. 
 
Why? 
 
Even if the U.S. economy (including our government's ability to service its debt) could withstand the pain of nearly double-digit interest rates, the rest of the world can't.  That's it.  End of story. 
 
Capital is already flying out of all parts of the world, and into the dollar.  Is it because U.S. bonds are finally paying interest?  Partly.  Mostly, it's because the U.S. is pulling global interest rates higher, which makes sovereign debt more expensive (more likely, unsustainable), particularly in the more economically fragile emerging market countries.  Rising U.S. rates accelerate global sovereign bond markets toward default/ sovereign bankruptcy. 
 
And historically, sovereign debt crises tend to be contagious (i.e. you get a cascading effect around the world).  So far, we've seen defaults by Sri Lanka and Russia. 
 
This is why the Fed is talking a big game, but doing very little with rates.

Okay, let's fast forward to today.  The Fed has now raised the effective Fed Funds rate to 3.08%.  The balance sheet?  At this point, the Fed has scheduled to have reduced the size by $237.5 billion.  They done just $100 billion.  Inflation, of course, remains much higher than the Fed Funds rate.  So the Fed still hasn't delivered on the tough talk.  

As we've discussed, they haven't because they can't.  Still, as we discussed on Friday, they now may have even gone to far with the tough talk.

Projecting another 125 basis points of tightening in the U.S. over the next three months has destabilized global markets.  

U.S. stocks have traded to June lows.  More importantly, the vulnerabilities in Europe have become amplified.

We've talked about the vulnerabilities in Europe, specifically Italian debt. 

Yields on Italian government debt are spiking, now 40 basis points above the June levels – levels that prompted an emergency meeting by the ECB …
As we've discussed, this should trigger the ECB's new bond buying program, to curtail the rise in these yields, and protect the solvency of Italy.  But it will come at the expense of the euro. 
With that, the euro continues to trade to new 20-year lows.  Sovereign debt yields in the UK are also spiking, and the British pound is collapsing (down as much as 8% in the past two trading days, falling to 37 year lows).  And as we discussed on Friday, rapidly declining currencies tend to come with (ultimately) debt defaults (even with central banks putting up a fight). 
 
Where is the money going, that's leaving Europe?  The U.S. — into the dollar/dollar denominated assets.  It's a (global) flight to safety (somewhat positive for U.S. assets, very negative for global assets).    
 
So, this all heading in the direction that we discussed back in July (i.e. the excerpt copied in above). 
 
And to be sure, it has been triggered by the Fed.  They have miscalculated — even at the (still) relatively low levels on interest rates. 
 
Remember, back in 2019, after a shallow rate hiking campaign and attempts to "normalize" the balance sheet (from the Global Financial Crisis response), the Fed was forced to stop and reverse (to cut rates and go back to QE). 
 
The reason: Things started breaking in the financial system.  To be specific, we had this 300 basis point spike in the overnight lending market.
What's happening now?  Things are beginning to break in the financial system (this time sovereign debt markets). 

 
With that, the market will continue to look for the Fed chair to walk back on the hawkish rhetoric and projections from last week's meeting.  He had a chance on Friday, at the "Fed Listens" conference.  He said nothing. Powell is on the calendar for a prepared speech again this week — on Wednesday. 
 
 

Pro Perspectives 9/23/22

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September 23, 2022

We end the week with the warning signals of a meltdown.

Stocks retested the June lows today.  U.S. 10-year yields spiked up to 3.82%.

This comes following Wednesday's Fed meeting, which suggested, via the Fed's economic projections, that they are planning to ramp rates another 125 basis points into year end.

As we've discussed in recent days, that rate scenario would bury the economy into a deep recession.  It is also a threat to the solvency of global sovereign debt.

As we know, the rise in U.S. yields tends to pull global yields higher. 

With the spike in U.S. yields today, yields on the vulnerable Italian sovereign debt went to nine-year highs (to 4.36%).
 
Importantly, that's ABOVE the June highs — a level that triggered an emergency response from the ECB, where they designed a plan to become buyers of last resort of fragile sovereign debt in the euro zone (more QE).  This is a strategy intended to defend their vulnerable constituent countries in the euro zone from a sovereign debt default.
 
So with this move in rates, the ECB will likely be forced back into printing euros to finance debt and deficits in the euro zone.
 
That problem, comes with another problem.  When the rest of the world has exited QE and you're still printing, your currency will devalue. 
 
We've seen it with the yen. 
 
Today, we saw what may be an important day in the history of the euro (the most widely held currency in the world).  The euro traded to new 20-year lows – and now well under parity with the dollar.
A weak euro, like a weak yen, isn't unwelcome.  Weak, at a rapid pace (i.e. crash), however, tends to be accompanied by debt defaults.
 
This is all part of the fine line the Fed has been walking, in trying to tame inflation, without creating a bigger, more dangerous, and global, crisis. The markets are telling them, this recent guidance on the rate path has gone a step too far.  We may see some damage control from the Fed next week (some walking back).  
 

Pro Perspectives 9/22/22

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September 22, 2022

Remember, yesterday we looked at the Fed's recent economic and policy projections.
 
In these projections, the Fed painted a pretty gloomy picture: ultra-low growth, rising unemployment, and what would be a stifling increase in interest rates into the end of the year.
 
As we discussed yesterday, if they were to follow through on this outlook, they would bury the economy into a deep recession.
 
But keep in mind, these projections are part of the Fed's "forward guidance" strategy.    
 
And "forward guidance" is an explicit tool, at the Fed's disposal (just like interest rate setting), intended to manipulate behaviors.
 
What behavior do they want to manipulate?  Hiring. Spending. Investing. Confidence.  Mostly, they want all of this to manipulate the "expectations" of where inflation is going.  
 
Remember, the Fed is far more concerned about inflation expectations, than they are about inflation.  If they lose control of expectations, people start pulling forward purchases, in anticipation of higher prices, creating a self-fulfilling upward spiral in prices. 
 
On that note, they are winning.  This next chart is their favored gauge on measuring inflation expectations.  
 
As you can see, there was a spike in inflation expectations early this year.  That spike peaked in April.  This happened as the Fed was making the first rate hike (moving away from zero rates).
 
The Fed's fear at that time, was a continuation of that spike (both the rate of change, and the rising level of expectations).  But as you can see to the far right, inflation expectations have since been very tame.  And that's tame relative to history, despite the forty-year high in inflation.
 
Powell said as much yesterday:  "Despite elevated inflation, longer-term inflation expectations appear to remain well anchored." 
 
So the Fed is winning, in that they've successfully killed the animal spirits in the economy.  We can see it in the deteriorating economic data.  We can see it in lower trending price data.    
 
I suspect yesterday's use of "forward guidance" was intended to secure a little more demand destruction (a little more power in the punch).  
 

Pro Perspectives 9/21/22

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September 21, 2022

The Fed raised by another 75 basis points today.  No surprise there.
 
And Jay Powell opened his post-meeting press conference by saying his main message from his Jackson Hole speech (last month) hasn’t changed.
 
So, no surprises in the press conference.
 
Markets rallied. 
 
But then reversed into the end of the day. 
 
Because of this …
 
This is the Fed's quarterly economic projections.  
 
They revised down their growth projections for the economy to just 0.2% for the year.  Just three months ago, they were looking for the economy to grow 1.7% this year.  That's a big downgrade.
 
They also revised up unemployment projections, and inflation. 
 
And with that, they revised UP the projection for interest rates. 
 
And it wasn't a small upward revision.  After today's hike, the Fed is now at 3.00%-3.25% range on the Fed Funds rate.  And the projections have them getting to 4.4% by year end.  
 
That's another roughly 125 basis points of tightening.
 
If they were to follow through on this outlook, they would bury the economy into a deep recession.
 
We've already had two consecutive quarters of negative growth in the first half of the year.  And the Atlanta Fed's GDP model is barely showing growth for the third quarter (at just 0.3%). 
 
With the deterioration in the economic data it's a safe bet that Q3 will turn negative too.  If the Fed goes another 125 basis points before year end, we would probably have four consecutive quarters of economic contraction. 
 
Stocks reacted to this scenario late in the afternoon.  
 
If the slide in stocks continues tomorrow, and into Friday, we may get a response from Powell himself.  He's conveniently scheduled to speak on Friday afternoon in a virtual conference called "Fed Listens," where the Fed engages a wide range of business leaders from a variety of industries. 
 
Remember, while the Fed cares about inflation, they care more about inflation expectations.  And Powell said today that inflation expectations remain anchored (under control).  What the Fed cares most about, is maintaining stability.  If stocks test the June lows (not too far away), stability becomes questionable.   
 
They don't want to see market meltdowns.  Market meltdowns can quickly become financial system meltdowns and economic meltdowns.
 
I suspect the Fed will be "listening" to markets closely over the next day and a half.  If today's message isn't resonating well, Powell will likely soften the tone (walk things back) on Friday. 
 
 

Pro Perspectives 9/20/22

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September 20, 2022

We have four major central bank decisions over the next 48 hours.
 
The Fed will continue to move the anchor on global interest rates. 
 
The Fed is expected to raise rates by 75 basis points.  The Swiss National Bank is expected to follow with 75 basis points Thursday morning.  That would end seven years of negative interest rates in Switzerland. 
 
And the Bank of England is expected to hike 50 bps on Thursday morning.
 
With that, let's revisit the snapshot of major global central bank rates (adjusted for the expected hikes coming this week) vs. current inflation.
 
Almost every major financial publication in recent weeks has invoked the Paul Volcker analogue.
 
As we've discussed here many times, Volcker beat inflation in the early 80s by taking short term rates ABOVE the rate of inflation.  
 
As you can see in the table above, even after a series of "aggressive" hikes, we are not even close.
 
With that, as we've also discussed many times, global central banks in this post Great Financial Crisis and Post-Pandemic era don't have the firepower to take down inflation with high interest rates.
 
Among the reasons: Government debt levels (globally) are incompatible with high interest rates.
 

Pro Perspectives 9/19/22

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September 19, 2022

We've talked a lot about the buildup to this week's Fed decision. 
 
This will be the first Fed meeting since July 27th, where they raised rates by 75 basis points AND told us that they had reached the "neutral level" for rates (no longer accommodative, but also not restrictive). 
 
Jay Powell went further, in his July press conference, to say that they didn't want to telegraph mechanical tightening (my words, his words: they were no longer providing "guidance"). 
 
He said from that point (in July) they would go meeting by meeting, based on the data.
 
This was dovish.  Stocks went up.   
 
Let's talk about what has happened since the Fed's July 27th meeting…  
 
Just hours after the July Fed meeting, headlines started hitting the wires about another massive spending bill (a deal between Manchin and Schumer).  This was the Build Back Better agenda, with another name.  
 
A day later, the House approved the Chips Act (more spending). 
 
A month later, Biden followed with school loan forgiveness (more spending).
 
This was a fiscal bazooka, just after the Fed intimated that they may be done (or near done) raising rates.
 
More fiscal spending plus less restrictive monetary policy is a formula for a growth boom, but also an inflation boom (more fuel on the fire).
 
With that, the Fed spent the next three weeks in damage control, trying to dial down the expectations of a hotter economy and hotter prices. 
 
As we've discussed, the Fed is far more concerned about inflation expectations, than they are about inflation.  If they lose control of expectations, people start pulling forward purchases, in anticipation of higher prices, creating a self-fulfilling upward spiral in prices. 
 
So, the Fed went on a media blitz.  Fed officials were all over the wires, day-in and day-out, telling us just how relentless they will be in raising interest rates, "keeping at it" until the war on inflation is won, "unconditionally" focused on stabilizing prices.
 
It has worked. The market has bought the message the Fed is selling.
 
The damage (i.e. consumer and business perception of a more inflationary environment coming down the pike) has been controlled.  Stocks lost 4% in August.  The 10-year yield has gone from 2.5% to 3.5% since early August.
 
The question is:  Will the Fed deliver with actions that match the words? 
 
They haven't to this point.  And they have plenty of reasons, by sticking to the data, to under-deliver on Wednesday. 
 
Gas prices are a buck cheaper than late July.  The monthly change for both July and August CPI was roughly flat (0% and 0.1%, respectively).  And that aligns with the broad declines in the pace of price increases across the various manufacturing reports (which has been trending sharply lower for months).
 
Remember, the Fed is tasked with rate-of-change, not level.  The level of prices is here to stay.  The rate-of-change in prices has already subsided.