Last week we saw the technology laden NASDAQ market drop over 10% from its prior week high, hitting 6906 down from a high of 7728 a week earlier. We have spoken at length over the last few letters how insiders and institutions have been selling out of technology positions but retail seems to be picking up what they are putting down. This kind of action where the weak hands are buying from the strong hands is a notorious set up for a market set back and last week did not disappoint.
This last week was full of reports of wide spread over valuations across the gamut of both global equity markets as well as global bond markets, especially Europe. Now we aren’t talking about some bobble headed main stream media types, we are talking about titans, the likes of Ray Dalio, Stan Drunkenmiller, Jeff Gundlach all relaying the same theme, “well above historical norms.” We even read a great piece on the PEG ratio from Fasanara Capital, which stated that the PEG, which is a statistical measure of how expensive a stock is relative to its ability to generate earnings, is well above 1999 highs and probably rightfully so given the plethora of cheap financing from zero rates, unprecedented HY rates and of course continued tax breaks. All that said, the pressure from the rhetoric from the guys we just mentioned should begin to mount, as they most certainly have an agenda attached to such warnings.
The FOMC decided to raise rates another 25bp to a high mark range of 2.25%. We applaud the continued move; however, we feel that we could be doing more and doing it faster. Holding interest rates or real rates still negative, some 10 years after the 2008 crisis is deeply concerning. All too often people focus on the Fed Funds rate, but the real rate, the FF less inflation, is still negative. Rates are still very accommodative...although the FED left that word out of the statement today. Watching Powell is like watching your Accounting professor discuss reconciling the balance sheet on a late spring afternoon. He and the FED continue to use words like transitory, gradual and appropriate, a decade into a recovery and we are still using these words. The dot plots are all calling for continued hikes peaking around 3.25/3.65%. We view this as highly opportunistic and we do not think the global economy nor the domestic economy will be able to absorb such a short rate given the sheer size of global debt growth. For those that haven’t seen, we often use our own “dot plot” picture:
We are going to keep this week’s letter short and to the point. We are sick and tired of the political charade that is ongoing in DC with the tariffs and the SC vote. For us general Americans deserve better and we will just leave it at that. As for the markets, US Treasury yields have risen above the 3% threshold and in no doubt in further anticipation of next week’s FOMC 25bp hike. We aren't a big fan of the FEDs slow drip process, we would rather they just hike the FED FUNDs above the 10yr rate and be done with it. With the ECB and BOJ firmly entrenched in continuing QE operations, the world will certainly absorb a relatively hawkish FED. Further evidence is mounting that the FED itself has become somewhat impotent and that these 25bp hikes amount to nothing more than buying time till the next crisis. Where they will most certainly peg long rates below 2.5%. Anyway, the global corporations have done their own fair share of monetary printing.
Welcome everyone to another edition of the weekly global macro roundup. I struggled a bit this week with my thesis as it seems as if there is a plethora of narratives to choose from.
As my long-time readers know, I just don’t write to write, it has to have meaning, has to have substance and above all else engagement for you, the reader. So, I decided that I would touch briefly on various things and not go too far into any singular issue.
What I want to do first if give you the trading, investment and economic thoughts and then move onto a few other topics that I think are important for you guys to dig further into on your own.
Many studies have shown that by actively engaging in reading and research, you build a cognitive process and this process aides in the development of memory and understanding. That is why I encourage you to be inspired by what I write in hopes you end up doing a bit more reading on the very topics I bring up. Anyway, let’s get to it…
Ok, what’s been circling around the financial sphere’s lately? What seems very obvious to me is that there has been an extreme focus upon the flattening of the U.S. yield curve. As a long time, fixed income basis arb, this outcome is purely fundamental from a hawkish and tightening Federal Reserve.
Yield Curve flattening, which is nothing more than short rates moving faster than long rates for a given interest rate shift and is usually attributed to an expected higher interest rate environment. Now this doesn’t mean the yield curve can’t flatten if interest rates fall, they certainly can, but generally they are of the bear market form.
What do we mean by bear market in interest rates? It means that the prices of bonds are falling and the corresponding interest rate is rising, price and rate are inverse. I have chosen the following chart to display this visually:
The black line represents the current U.S. Treasury yield curve and it is obviously flat, which should seem strange to any investor because it doesn’t make sense to loan someone money for a longer period of time and receive the same interest rate does it?
No, it doesn’t and it shouldn’t, but many forces are in play, wait till we go inverted that will really blow your mind! The blue line represents a “normal” yield curve where the interest rate (%) rises as time (years) rises. This makes more sense, right? Then the red line is clearly an “inverted” yield curve, the alleged holy grail predictor of recessionary times.
I am not sold on that idea of its predictability, rather I believe the inverted curve to be a highly central bank driven construct that is less deterministic and more intrinsic based purely on raising the cost of funding in a highly leveraged system.
So, for me it’s more backward looking than forward. Meaning recessions form because money becomes tight and capital is withdrawn and was exacerbated by the artificial support of interest rates by central banks in the first place.
Any novice can look at the slope of the red line and say, that doesn’t make sense, why would the demand for an interest rates be greater for a shorter period of time? I could simply borrow money at the long end and sell the higher rate at the shorter end and lock in profit! Yes, you could and you would then be an expert bond arb like myself, however, it is not that easy trust me, but the fundamentals of that arbitrage are what eventually brings it back into line!
One thing that most people don’t think of is, counterparty risk, at least they don’t think of it till it’s too late. What risk does the U.S. treasury bond have…plenty and there are reasons why peripheral EU countries pay less for borrowing money then our very own “safety net” U.S. treasury bond!
Those fundamentals however are for another day, a day in the future I am sure, but this should peak your interest as to why and how the cost of money truly affects things. You have been sold the fact that lower interest rates are good for you, they lower the cost of money.
What they haven’t told you is the very fact that investments that come from borrowing are exponentially different from investments that are made with savings.
As a saver would you rather earn 8% on your 1-year T-bill or be able to borrow more money at 1%? The answer should be quite obvious if it isn’t and if it isn’t we highly suggest you continue to watch the U.S. debt pile up and then ask yourself, can the U.S. taxpayer continue to expand their debt obligations while interest rates rise?
Every investor I talk to knows equities, but they rarely follow bonds, which is a mistake. In a debt and fiat monetary system, interest rates and their flip side credit determine aggregate nominal prices.
The system is designed to always increase in price or “inflate.” This phenomenon is most unfortunate for the majority, but extremely fortuitous for a select few.
The problem with a fiat monetary system is debt must constantly expand or else the aggregate price level will collapse.
I believe the price level collapses anyway purely by the weight of the debt that is accumulated. Not only will nominal asset prices fall, but in general the purchasing power of the consumer erodes as well.
Austrian economists call this the “Minsky moment”, named after in my opinion one of the greatest American economists ever, Hyman Minsky.
Maybe I am partial to the fellow Chicagoan, or maybe it’s the fact he was highly critical of Keynes’ neoclassical interpretations, I’ll take either one as admission.
It doesn’t take a genius to figure out that debt can only be sustainable if more and more is created, this type of system is the one we unfortunately adhere to. Will this change?
I believe so and the moment everyone is so desperately trying to avoid will eventually arise, it always does. Here is a great chart from PIMCO:
Perhaps the Central Banks should consult this French poet’s quote in order to learn something:
“A person often meets his destiny on the road he took to avoid it” -Fontaine
With all this in mind, it is no wonder the equity markets have gone nowhere since January. The Federal Reserve continues to raise not because they want to, but because they have to.
They will need room to maneuver for the coming recession and they know rates were way to low causing the elites and corporations to take full leveraged advantage.
The SP500 put in a high back on January 26th at 2872.87 and we haven’t even come close since. The SP500 trades near 2725, some 5% off the highs.
The longer the market fails to even take a clean shot at new highs the greater the odds of a stronger sell off, in fact another trade below 2650 should bring in a host of new sellers.