Less Negative is Positive

"A negative times a negative equals a positive."
--Jaime Escalante (Stand and Deliver)

Negative interest rate policies (NIRP) enacted by central banks across the globe in the middle of last decade spawned a mountain of negative interest-bearing debt. It was hard to imagine who was buying it although, in reality, central banks themselves were hoovering much of it up as part of their quantitative easing (QE) programs.

The worm has turned dramatically as inflation has picked up and CBs are now raising rates. After hitting a peak of about $17 trillion in 2020, negative yielding debt has plummeted to less than $2 trillion. Most of that decline has come since the beginning of 2022.

As NIRP debt declines, it seems likely that broken conventional discounting processes get repaired.

Central banks become extra big losers as NIRP reverses. They bought $trillions of negative yielding bonds that have now been pounded as rates rise and bond prices fall. Many CBs are approaching the broke point on paper.

While these institutions can simply print more money out of thin air to rectify their upside down balance sheets, this would create quite the paradox of creating more money in an inflationary environment.

Repos and QT

Then the door was opened
And the wind appeared
The candles blew
And then disappered
--Blue Oyster Cult

Interesting WSJ article suggesting that declining reserves stemming from the Fed's 'quantitative tightening' (QT) program poses a significant threat to financial markets. 

QT is the reverse of quantitative easing (QE). In QE, the Fed printed money out of thin air to buy bonds from banks. That printed money became 'reserves' that the banks have deposited with the Fed. Unsurprisingly, reserves have rocketed higher given the $9 trillion of bonds that the Fed now holds on its balance sheet via QE. 

Bank reserves serve various purposes. They can be used to settle trades with other banks. Reserves are also kept to satisfy regulatory requirements, which have generally been ratcheted higher since 2008, to provide some margin of safety in the event of another systemic credit event.

Reserves can also be used for investment purposes. One popular avenue toward this end is the repo market. Repos are contracts where one party sells securities to another party in exchange for cash. The buyer (who is engaging in what is called a 'reverse repo) promises to sell the securities back to the original holder at some future (usually near term) date and at a set (usually higher) price.

These pseudo loans help the pseudo borrowers manage short term cash obligations while providing the reverse repo pseudo lenders with quick profits.

When reserve levels are high then the 'interest rates' governing repos are low and usually in line with the Fed Funds Rate. However, when reserves decline, repo rates are prone to rise because there is less capacity for reverse repo 'lenders' to employ. 

As the Fed embarks on QT, reserves are beginning to fall. Although there are no signs yet of stress in the repo markets, there is belief that it is only a matter of time before problems surface. 

Indeed, in 2019, the Fed had to inject emergency shots of liquidity into these markets after previous QT programs resulted in skyrocketing repo rates that threatened to seize up money markets.

Given the size and centrality of money markets to contemporary market functioning, it may once again be time to fear the repo.

Lagged Effects

Take a chance like all dreamers

Can't find another way

You don't have to dream it all

Just live a day
--Duran Duran

Another insightful interview with Stephanie Pomboy. I find the Maven's focus on credit market fallout from the Fed's tightening program intuitive. In leveraged systems, rate hikes and tight money policies increase stress and lead to failure.

But, as Pomboy observes, the effects are often lagged. She points to recent trends from credit upgrades to downgrades, as well as a lender bankruptcy or two, as evidence since they come several months after the Fed began its tightening campaign.  

Recall the 2008 credit collapse. The Fed was raising rates in 2006 but it wasn't until early 2007 that the first substantial cracks started appearing. New Century Financial, anyone?

And then it took another year until the crescendo really started to build.

If Pomboy is correct, and I think she is, then additional data points that reflect credit market stress should be pending.

Undercover Hero?

My beacon's been moved
Under moon and star
Where am I to go
Now that I've gone too far?
--Golden Earring

I enjoy reading Tom Luongo's work. Thought provoking--even when his general premise is wrongheaded. 

In this recent piece, for example, Luongo gives the Fed entirely too much credit, arguing that the central bank is essentially the 'good guy'--battling inflation wrought by irresponsible fiscal policies that sent money to people in boxes during CV19. 

He fails to mention the Fed's long history of bailing out markets (and policymakers) when markets break, or of the central bank's $9 trillion of balance sheet assets purchased with money created at the click of a mouse. Because, as Friedman observed, inflation is always a creature of monetary policy, arguing that the Fed is somehow not the Dr Frankenstein that created our present monster seems a bit naive.

However, Luongo does make an interesting point toward the end of his article. He notes (correctly) that the Davos/World Economic Forum crowd would like to put an end to commercial banking, and put all monetary power in the hands of central banks--perhaps even in a one world central bank with digital currency-producing capacity.

He then suggests that, in the United States (and perhaps elsewhere), the Fed represents the interests of those commercial banks. As such, the Fed is motivated to break the EU-centric Davos/WEF threat to US commercial banks by raising rates, pounding the euro, and perhaps even driving the EU toward dissolution.

There's lots of holes in that argument--including the Fed's 'institutional obligations' both domestic and abroad--but interesting to ponder the 'undercover hero' thesis nonetheless.

On the QT

It happened one summer
It happened one time
It happened forever
For a short time
--Motels

Bank of America (BAC) analyst and former Fed staffer who has a good track record of predicting Fed policy shifts forecasts that the central bank's current quantitative tightening (QT) will be ended much sooner than expected. He thinks QT will cease in early 2023 with about $1 trillion in asset rolled off the Fed's balance sheet.

While consistent with what these pages have been suggesting, I'll pick the under on both. Sooner than early 2023 and less than $ trillion unwound.

position in BAC

Updated Charts

You can make or break
You can win or lose
That's a chance you take
When the heat's on you
And the heat is on
--Glenn Frey

Updated version of two very important charts. The first is Fed funds rate and the SPX since 1980. What does this chart suggest about how for the Fed can raise before crying uncle?

The second is Fed balance sheet assets and the SPX since the onset of QE. What does this chart suggest about how much the Fed can unwind its balance sheet before crying uncle?

As we have asked before, when facing a choice between keeping money/credit in the system to keep markets from collapsing or removing money/credit from the system to fight inflation, the Fed will choose which option?

On the Zoom

Well she ran into this guy
Who was down at 54
Had a lot of gold and chains
And he got her in the door
And he knew so many people
Who made her lots of pretty promises
--Don Henley

FOMC announces 50 bip hike in the fed funds rate and QT to being on June 1. QT will be capped at $30B in Treasuries and $17.5B in agencies/MBS for the first three months, and then doubled after that.

Let's see, $90B monthly in runoff on a $9T balance sheet--with the stipulation that the Fed intends to "maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively."

Seems to me that the FOMC is signaling that the it will take its sweet time pulling down its balance sheet--inflation or not.

Maybe that's why stock and commodities are zooming post announcement.

Chronically Dovish

How can you leave me standing
Alone in a world so cold?
--Prince

Despite doing next to nothing thus far, the Fed is currently perceived as hawkish in manners not seen since Paul Volcker. The popular narrative posits that the Fed will be raising rates 8-10 times this year to 'fight inflation,' with some rate increases possibly in the 50-75 bip range, as well as unwinding $1T or more of its balance sheet assets accumulated during more than a decade of quantitative easing.

This is...doubtful.

Evidence indicates that the Fed's so-called hawkishness never lasts longer than the marginal monetary policy action that triggers a crisis. As the graph above suggests, the tightening threshold that triggers a crisis has been declining in each successive policy cycle.

Why the declining threshold? Cheap credit created during monetary easing causes the system to lever up more so than the previous cycle. When asset prices fall during the subsequent tightening phase, balance sheets flip upside down quicker. Consequently, the financial system approaches insolvency at lower interest rate levels than before which, in turn, causes the Fed to ease off. Monetary policy never returns to where it was in previous cycles.

While the Fed might engage in hawk talk from time to time, its actions are chronically dovish.

The chart above suggests that the Fed will resume easing operations sooner rather than later--and at fed funds rate levels far lower than currently forecast.

Falling FAANG Forecast

I see the bad moon rising
I see trouble on the way
I see earthquakes and lightning
I see bad times today
--Creedence Clearwater Rivival

Couple of interesting charts. First (Chart 3) presents a ratio of resource vs biotech ETFs alongside the yield on the German 5 yr bund since 2010. The relationship is readily apparent. Lower yields favor biotech ETFs (a proxy for speculative risk taking in 'tech') relative to price of resource ETFs (a proxy for inflation and conservative positioning in 'stuff' stocks). 

Now, as rates climb higher, the ratio is moving in favor of resource ETFs. Note that the ratio has lots of room to move higher, as suggested by the previous peak in 2010-2011.

The second chart plots central bank liquidity (presumably the aggregate assets on central bank balance sheets mostly due to asset buying programs associated with quantitative easing) alongside the market cap of the FAANG+ group which, due to their immense size can be seen as proxies for the overall market--particularly the tech side. This can be seen a slightly different take on this important chart.

The relationship could not be more obvious. The trillion$ of money printed out of thin air to fund central banks asset purchases has goosed stock prices higher.

With central banks now signaling a reversal of QE programs as they address surging prices of goods and services, the ramifications of doing so are ominous for stocks--particularly those of the speculative FAANG variety.

QT Pipe Dream

Sweet dreams are made of this
Who am I do disagree?
I've travelled the world and the seven seas
Everybody's looking for something
--Eurythmics

This article highlights problems for the federal government should the Fed engage in quantitative tightening (QT) in earnest. QT involves reducing the ~$9 trillion in assets on the Fed's balance sheet. These assets, primarily Treasury and agency securities, were accumulated during various quantitative easing (QE) campaigns waged since 2009. 

The Fed can shrink its balance sheet in two ways. It can simply sell the bonds on the market. Or it can let maturing bonds roll off the books without replacing them.

Either approach is problematic for the federal government. Every bond that the Fed sheds will need a buyer. Because the Fed was by far the biggest buyer of newly issued federal government paper over the past few years, thus artificially elevating the price, it seems unlikely that there will be buyers willing to purchase these bonds unless the price is much lower.

Consequently, Treasury prices are likely to fall, which is bad news for a federal government seeking to finance $trillions in spending this year.

Falling bond prices raise interest rates, which creates another problem for the federal government: higher debt servicing costs. Higher interest expense means more federal dollars must be spent to service the debt. It wouldn't take much to break the already burgeoning federal budget.

By monetizing debt via QE, the Fed financed the federal government's profligacy. Should the Fed engage in QT, the federal government would be forced into austerity.

Given the chickenhawks at the Fed, this seems a pipe dream. 

Stock to Flow Ratio

I don't know why
You treat me so bad
Think of all the things
We could have had
--Talking Heads

Nice point about stock to flow ratio differences between gold and other commodities. Stock to flow ratio is measured here by taking above ground inventory and dividing it by annual production.

Unlike most commodities, gold's stock to flow ratio is high. Nearly all gold mined over thousands of years still exists in its stand alone, elemental form. Because physical gold is durable and inert, it remains with us. On the other hand, annual gold production is relatively low, constituting only 1.5% or so of above ground stock. Consequently, gold's current stock to flow ratio is above 50.

Compare this to wheat. Above ground wheat stocks are rapidly consumed. Wheat put in storage is subject to decay. In order to meet demand, about 3x the amount of wheat inventory must be produced annually. Inventory turnover is high, resulting in wheat's low stock to flow ratio below 0.5.

Of course, the properties of gold that elevate its stock to flow ratio, e.g., durability, scarcity, etc, make it attractive from a monetary perspective. In fact, it seems to follow that commodities with high stock to flow ratios would constitute a nice short list of plausible monies.

The article stresses that stock to flow ratio helps explain pricing differences between gold and other commodities. Whereas the price of wheat is driven largely by supply/demand dynamics of its stock to flow ratio components, the price of gold is less subject to short term volatility. Above ground inventories are high compared to new supply and consumer demand.

Instead, gold price should be driven more by changes in institutional demand. The more institutions demand gold, the higher the price--regardless of inventory levels or annual production.

While institutions are often regarded as large financial entities such as money center or central banks, in a broader sense institutions represent societal rules and norms.

Stated another way, when it becomes more 'societally correct' to own gold, then price will go up.

Stated another way again, changes in institutional rules are likely to coincide with changes in price of high stock to flow ratio commodities such as gold.

Monetary Cease Fire

It's 2 am, the fear is gone
I'm still sitting here, the gun still warm
Maybe my connection is tired of taking chances
--Golden Earring

Last week the Fed made a final bond purchase before shutting down its fourth round of QE operations. 

During the most recent round of QE, which was instigated during the CV19 panic, the Fed has added an additional $5 trillion to its balance sheet--on top of the roughly $4 trillion from the previous QE junkets.

As shown above, QE programs by the Fed and other central banks around the world have lit a fire under asset prices. Any attempt to unwind QE balance sheet assets has led to lower prices.

This begs questions about the durability of this monetary cease fire. What will the Fed do with those $trillions on its balance sheet? And how long will it be until QE5 fires up?

Risky Hedges

Past the church and the steeple, the laundry on the hill
The billboards and the buildings, memories of it still
Keep calling and calling, but forget it all, I know I will
--Squeeze

We're seeing some eye-popping moves in commodities with chatter that many commodity producers are getting margin calls on their hedges. 

Why should producers face problems with commodity prices going thru the roof? Commodity producers sometimes short futures to lock in prices. In fact, futures markets came about mainly for this purpose years ago.

The problem is that producers' 'long' positions are usually physical ones that have yet to be sold, meaning that producers lack liquidity (cash) to cover margin calls when their short hedges move higher.

Nickel is up over 80% today as producers feel the squeeze.

Peabody Energy (BTU), a major coal producer, announced today that they had secured a facility from Goldman Sachs to cover temporary cash requirements for their hedges. After hitting a 52 week high yesterday, the stock was off more than 10% on the announcement. 

Although hedging is generally considered a risk management tool, the current situation demonstrates that this is not always the case. 

no positions

Cornered

There's a storm on the loose

Sirens in my head

Wrapped up in silend

All circuits are dead
--Golden Earring

In addition to providing more perspective on the Fed's dilemma (recently discussed on these pages here, here), this article includes some nice historical perspective on the Fed's approach to managing its monetary policy cycles. The Fed responds to crises by easing rates. Once trouble has passed, the Fed begins to raise rates. 

But because the easing phases invites more risk taking (and leverage), new troubles arise as rates go higher. Consequently, the Fed begins easing again. 

The important thing to understand is that the tightening phase generally does not return rates to their previous levels, resulting in a downward sloping long term trend as denoted by the red dotted line.

It should not be surprising that the secular downtrend in rates has been accompanied by higher asset prices. The graph below shows how the SPX has responded.

This is how the Fed has cornered itself. By failing to raise rates back to previous levels at the end of a monetary policy cycle, it has invited massive risk taking in financial assets. Nearly 40 years of this behavior has hyper financialized the system.

Now, with rates near zero, along with $trillions of balance sheet assets (also known as monetization) to keep the wheels on the wagon with rates at the 'zero bound' for the past decade+, the Fed will find it difficult to engage in any substantial tightening of monetary policy (necessary to fight inflation) without tanking financial markets.

Inflation or asset prices? The answer seems obvious.

Important Chart

There's a room where the lights won't find you
Holding hands while the walls come tumbling down
When they do, I'll be right behind you
--Tears for Fears

Have been looking for an updated version of this chart for a while. Finally found one courtesy of maven Stephanie Pomboy.

The chart continues to tell an important, if not THE, story behind the huge rise in stock prices (as well as other asset prices) since the 2008 credit crisis.

The graph plots balance sheet assets of the Federal Reserve alongside the S&P 500 Index (SPX) from 2009 thru the end of 2021. The correlation between the two series is unmistakable. Increases in the Fed's balance sheet, which has more than quadrupled in size since 2009, correspond to increases in overall stock prices.

What has caused the Fed's balance sheet to increase so dramatically? The primary driver has become known as 'quantitative easing' (QE)--a program designed to, among other things, stimulate economic activity after major calamities such as the 2008 credit collapse. 

When conducting QE operations, the Fed purchases securities (mostly Treasury and agency bonds) from financial institutions that deal in those securities. For instance, the Fed might observe $100 million in Treasuries sitting in J.P. Morgan's (JPM) inventory, and then buy them all by placing a credit of $100 million with JPM in exchange for the bonds. The $100 million in Treasuries is added to the Fed's balance sheet.

Where does the Fed get the $100 million to buy those bonds from JPM? Out of thin air, baby. It creates the money with a few clicks of a mouse. 

The freshly minted cash now in the hands of financial institutions can be used to fund everyday operations, including trading and speculation in financial securities. As implied by the above graph, a sizable fraction of this cash has gone into stocks over the past decade or so.

It should be noted that the relationship works in reverse as well. When the Fed has halted QE operations over the past decade, stocks generally move sideways along with the value of the Fed's balance sheet assets. And, although you have to squint to see it, on the rare occasion that the Fed has attempted to unwind (read: sell) assets from its balance sheet (which has the effect of removing some of that magically printed money from the financial system), stock prices have fallen.

The only time this relationship did not hold was 2018-2019. Despite Fed efforts to curtail QE and even unwind balance sheet assets during this period, stock prices continued to rise. However, as indicated by Stephanie on the graph, this period also corresponds to a time of tax cuts and deregulation that was favorable for stocks. Stated differently, the bullish backdrop essentially overpowered the bearish forces of Fed actions on stock prices.

The relationship quickly got back on track in early 2020 when the Fed embarked on a gargantuan QE program in response to the onset of COVID-19. The Fed's balance sheet has more than doubled since then to over $8 trillion. The value of the SPX has commensurately doubled as well. 

Moving forward, the relationship between QE and stock prices has important policy implications. As inflationary pressures grow, the Fed may be tempted to curtail or perhaps even reverse its bond-buying practices. Although doing so would relieve inflationary pressures that the Fed itself helped to create, stopping or reversing QE is likely to put downward pressure on stock prices. Any policy that tanks the stock market promises to be politically distasteful.

Whatever the Fed and other central banks who have engaged in QE decide to do from here to address the inflation that they themselves brought about, you can bet that they are looking at the same chart we are...

no positions

Positioning for Retirement

Doing the garden
Digging the weeds
Who could ask for more?
--The Beatles

With retirement coming up fast I've been doing a few things w.r.t. personal finance. I've been saving more and spending less in order to build cash. Have also been selling some stuff on ebay and elsewhere to collect extra 'juice.' Also helps thin things out at the house--much needed.

Preparations are being made to rollover my 401(k) from work. I'm looking forward to allocating this capital among far more choices than those available thru the current fund administrator.

In both my brokerage and IRA accounts, I've been buying dividend paying stocks. Dividends are real cash that can provide a significant, and perhaps under-appreciated, income replacement in retirement.

Inflation is particularly bad for retirees as it erodes purchasing power of savings. To hedge against the prospects of Big Inflation, I've been building stock positions in the oil complex (e.g., ENB, XOM) and miners (e.g., AEM, AGI, PAAS). 

The miners appear particularly attractive. The financial strength of many in this group has perhaps never been better. Solid balance sheets and cash flows. Many are paying significant, and increasing, dividends (which helps me kill two birds with one stone). The sector has been pounded down to attractive valuation levels--particularly given the growing inflationary environment.

I've been swapping funds out of precious metal ETFs such as PHYS and into the miners to more fully express my perception of this situation--albeit at a slightly higher risk profile. 

positions in AEM, AGI, ENB, PAAS, XOM

Inflation and Stocks

Hundred dollar car note
Two hundred rent
I get a check on Friday
But it's already spent
--Huey Lewis & the News

Some believe that if Big Inflation cometh, stocks will get creamed. Surging prices will drive folks to spend less. Simple ECON 101.

Lower demand for goods and services should be bad for stocks.

A counterargument is that Big Inflation occurs when people get nervous about the value of their dollars sitting idle, so they put them to work today assuming that they can buy more today (i.e., goods, services, AND stocks) than tomorrow. The psychology feeds on itself, creating, in its ugliest form a reinforcing cycle of higher prices and money printing that feeds it.

Although producers are hurt on the input side with higher costs, they can offset them at least partially by raising prices, thereby preserving profit margins to some degree. To the extent that producers own tangible assets, these are also likely to appreciate in value as inflationary pressures rise--giving a boost to book value at least in nominal terms.

In this scenario, stocks are likely to rise. Perhaps not to a degree that completely compensates for purchasing power decline, but at least to serve as a partial hedge that preserves wealth (note Kyle Bass estimates perhaps 85% coverage).

Historical analysis supports this thesis. Weimar Germany, Venezuela, Zimbabwe. Equities tended to rocket in the local currency--even if they didn't keep pace with exchange against more stable currencies (and gold).

One thing seems increasingly clear. In Big Inflation environments, stocks are likely to be a better place to be than cash.

It also seems that, in the current market environment where the CPI is starting to print some big numbers, stocks seem unfazed--like they want to go higher.

position in gold

Parabolic Decline

And there's some chance we could fail
But the last time someone was always there for bail
When will, when will we fall down?
--Toad the Wet Sprocket

Nice depiction of the gravity of our fiscal situation. Yes, debt is 'soaring,' but its actual effect is to pull progress downward--as in negative net worth.

btw, if you're wondering what the secret sauce was that brought about a brief reported surplus in the late 1990s, it was a combination of a capital gains tax windfall from the dot.com stock market runup and an accounting change engineered by the Clinton administration to count payroll taxes collected for Social Security as revenue (in reality they are trust payments). The key tell is that debt continued to increase during the 'surplus' period.

The days of smoke and mirrors surpluses are long gone, however, as even the boldest accounting chicanery cannot obscure the parabolic decline in financial position augured by our reckless borrowing behavior.

All You Need to Know

Rain keeps falling
Rain keeps falling
Down, down, down, down
--Simple Minds

This report provides a nice sense of where we stand w.r.t. monetization. In particular, it shows just how active central banks have been during the CV19 period. We'll focus on a couple of the charts here.

Since early 2020, the four central banks pictured above have monetized over $10 trillion in securities, meaning that they have created $10 trillion out of thin air to purchase the financial assets that have been added to their balance sheets during the period. The Fed and ECB have been the largest money printers at about $4 trillion apiece in square wave fashion with the onset of the pandemic. The BOJ and PBOC have kicked in another $3 trillion over that time, although their contribution reflects more of a continuation of longer term monetization policy.

The obvious question is why haven't we seen the effects of this in goods and service prices? The quick answer is that we might be. Surveying the WSJ headlines, I am finding increased reference to higher prices both upstream and downstream in supply chains.

The longer answer is that it may take time for large chunks of this money to make it into the hands of consumers. The first users are financial firms, as they are the direct recipients of freshly minted cash when central banks lift bonds and other securities from dealer inventories.

And there can be little doubt that these firms are using this cash to bid prices of financial assets. Indeed, if you're trying to explain why stocks are currently hitting all time highs and have been since the onset of QE a decade ago, relationship portrayed in the above graph is essentially all you need to know.

Wave of Cash

We'll all be planning that route
We're gonna take real soon
We're waxing down our surfboards
We can't wait for June
--Beach Boys

Comparison of Fed's current round of monetization (a.k.a. 'quantitative easing' or 'QE') compared to previous versions.

Within the span of a few weeks, the Fed has added more balance sheet assets than any previous QE program did in its entirety. And those programs lasted 1-2 years each.

The upshot is that 2 trillion dollars created out of thin air by the Fed have recently been released into the financial system. We've seen what this manufactured money has done to asset prices such as stocks.

What do you suppose happens when this wave of freshly minted cash splashes its way onto the shores of goods and services markets?