See the Signs

Life is demanding
Without understanding
--Ace of Base

Article lays out five signs of recession currently flashing red:

1) Declining monetary base. As quantitative tightening proceeds, money supply should drop even more.

2) Inverted yield curve. Inverted yield curves are leading indicators of economic problems, and have preceded every recession for decades.

3) Tighter lending standards. Economic slowdowns increase risk aversion. Banks tighten credit standards to avoid losses during recessions. We're approaching tightness associated with past recessions.

4) Falling housing market prices. Mortgage rates have more than doubled over the past year. As prices and borrowing costs go up, demand for houses has gone down. Inventory is now above 10 months of supply--a threshold that has consistently been associated with past recessions.

5) Declining manufacturing and trade sales. Sales are down over one percent YOY. Declines below zero have coincided with every recession since the 1970s.

These indicators suggest that a recession is not imminent. Rather, it is likely already here.

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.

CCC Spreads

Papa don't preach
I'm in trouble deep
Papa don't preach
I've been losing sleep
--Madonna

As we remain on the lookout for cracks in the system, particularly credit, this chart is noteworthy.

Low quality CCC debt spreads have once again breached 1000 bips.

Trouble usually starts at the risky end of the credit stack...

Leveraged Loans

"The mother of all evils is speculation--leveraged debt."
--Gordon Gekko (Wall Street 2: Money Never Sleeps)

Leveraged loans are loans extended to entities that already have high levels of debt and/or poor credit history. Loans are usually arranged by at least one investment or commercial bank, and are often syndicated to other banks or institutions.

This article estimates the current value of leveraged loans outstanding at $1.4 trillion--nearly double the 2015 market size. I have read elsewhere that leveraged loans have become popular among college endowments and other institutional investors as high yielding alternative investments.

With that high yield, of course, comes higher risk. Leveraged loan borrowers are more prone to default. Indeed, the article also suggests that leveraged loans may be a useful 'canary in the coal mine' this time around as credit market stress builds.

We know that tight monetary policy moves are often lagged in their effects. The leveraged loan market may be a good place to look for manifestations of the Fed's previous actions.

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.

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?

More Extremes

Dr Melissa Reeves: Why do you call Billy 'The Extreme?'
Dustin 'Dusty' Davis: Because Bill IS 'The Extreme!'
--Twister

More data points suggest that we're approaching noteworthy market extremes. Bank of America's (BAC) fund manager survey is touching crisis-level sentiment in both expectations for economic growth...

...and for profit growth.

On a separate front, credit default swaps on investment grade (IG) debt widening--approaching levels that have historically caused the Fed to pivot away from program intended to tighten monetary conditions.

I continue to sense that, although the Fed is talking tough, it will act far more dovishly than currently expected.

position in BAC

Spreading Out

We

So tired of all the darkness in our lives

With no more angry words to say can come alive

Get into a car and drive

To the other side

--Joe Jackson

Spread between high yield bonds and stocks has been widening.

But classic 'credit spreads,' i.e., difference between 'risk free' Treasury rates and bond rates, are in early stages of widening.

Interpretation: spreads have a ways to go before reaching 'blow out' levels. But they bear watching.

Crisis Management

"Some of you have to depart immediately. We have a crisis situation."
--Lt Mike 'Viper' Metcalf' (Top Gun)

Nice graph showing how many past Fed rate raises have ended in financial crisis--which subsequently causes the Fed to reverse course and lower rates.

This should be expected. Lower interest rates reduce borrowing costs, thus driving more debt and leverage into the system. Raising rates stresses the leverage. 

After lowering rates, the Fed can never get rates back up to where they were before. If they did so, the additional leverage accumulated during the easing phase would rupture the system when taxed by higher rates.

This is why rates have trended lower for decades, and why the Fed is now cornered.

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

Premeditated Destruction

There's a room where the light won't find you

Holding hands while the walls come tumbling down

When they do, I'll be right behind you

--Tears for Fears

Since the beginning of the pandemic, reasoned minds worldwide have been disturbed by how events have unfolded, and by the illogical nature of policy response. Personally, I theorized about an initially random but increasingly organized movement among various factions to advance their interests as authoritarians inevitably perceive that crisis presents opportunity.

Here is an alternative theory proposed by a German analyst. I am going to list key aspects of his theory below.

The pandemic and associated events over the past 18 months were not random or accidental but planned.

The master planners consist of a complex of large IT companies (discretionary power over huge data pool), global asset managers (raw financial power), and various policymakers (state power).

This is a plan hatched out of desperation to combat threats to the complex that have been many years in the making. 

The central threat to the complex stems from increasingly futile efforts of central bankers to inflate money supplies through evermore credit creation. With interest rates now effectively at the 'zero bound' since the 2008 credit collapse, the complex have lost the primary tool for advancing (read: funding) their interests.

Because driving interest rates negative to keep the wheels on the wagon would be socially unacceptable to the people at large, the complex requires a strategy that people would accept. Their solution: create a new system using a veil of economic and social chaos.

The system involves digital currency controlled by central banking authority. No more paper money. All money would be digital. Such a system provides power over money creation, surveillance over all monetary transactions; control over what money can purchase; where and with whom money can be spent, and the times that govern purchase; power to set and collect taxes; the power to impose fines; ability to distribute funds to whomever is deemed worthy. 

Such a system is seen by the complex as necessary to keep their interests (both economic and social) alive.

Under 'normal' conditions, the disenfranchisement that such a system would create would make it subject to huge pushback by the general populace.

Therefore, under the textbook authoritarian assumption about the crisis-opportunity relationship, the complex has determined that the most likely way that their the new system can be implemented is by a premeditated series of events that create economic and social chaos.

Enter CV19. Years of prior discussion and scenario planning informed the complex that a health crisis presented the best opportunity for creating fear and submission necessary for widespread acceptance of the new digital control system. Beginning late 2019, the complex began to implement the plan.

The plan's essence has been to implement policy responses to the pandemic that disturb economic and social fabrics in a manner that gradually escalates to the point of rupture. When the system collapses, people will beg for a policy solution like the digital currency and control system.

The author is careful to note influential role of the World Economic Forum (WEF) in the complex's preparation and execution of the plan. The WEF has 'trained' nearly all leaders of the complex, and has populated the ranks with thousands more like minds set on the goal of premeditated destruction.

On an optimistic note, the author suggests that the complex's plan is destined to fail. The 'deadly virus' narrative is already collapsing, leading to increasingly illogical arguments for pandemic countermeasures that even half wits are waking up to. Protests and pushback are growing.

Put differently, the complex's plan depends on chronic ignorance among a great majority of the world's people. But in order to advance its plan, the complex must resort to increasingly absurd measures certain to alert multitudes to the crimes being committed.

Truth will win. Evil will lose.

Forms of Fiat

All the old paintings on the tomb
They do the sand dance, don't you know
If they move too quick
They're falling down like a domino
--Bangles

Modern money creation is a function of fiat. Government simply declares it into existence. Currently, there are three primary forms of monetary fiat:

1) Credit money. Central banks declare an interest rate, and then endeavor to make it so--primarily by setting the price of money at their 'discount window.' Banks borrow from the window at the fiat discount rate, and then use the borrowed funds as the basis for speculating or for making loans to others. Credit money therefore creates a pyramid effect thru the financial system as one dollar borrowed from the Fed's window might be leveraged 10x or even 100x in subsequent loans.

2) Security monetization. Also known as QE, monetization entails central banks lifting bonds out of primary dealer inventory in exchange for money created out of thin air. The Fed sees $500 million in Treasury and agency inventory on JP Morgan's (JPM) sheets, and it buys them from JPM by placing a digital credit of $500 million in JPM's account. Where did those funds come from? From a few clicks of a mouse, baby.

3) Money in the mail. Former Fed chair Ben Bernanke famously declared that central banks could always just drop money from helicopters if financial systems were in need of liquidity. Today, of course, dropping money from the sky isn't necessary because it's just as easy to send checks thru the mail. Where did the Federal government get the trillion$ of dollars to fund 3+ rounds of so called 'stimulus checks' associated with the CV19 situation? From a process that prints dollar values on checks and then mails them. That's all.

Questions to ponder: Which of the above is credit money and which is cash money? Which ones are most likely to result in higher prices of goods and services?

Gas Left in Tank

Who's gonna tell you when
It's too late?
Who's gonna tell you things
Aren't so great?
--The Cars

Surprise jobs report this am indicating that employment actually grew in May. Markets up big on the news.

Today's #jobs #s shocker spike. Growth in jobs ⬆️ 2.5mm jobs in May. Hospitality/leisure jobs ⬆️ 1.29m construction ⬆️ 464-k goods producing ⬆️ 669-k @POTUS news conference on jobs today @ 10am et @MorningsMaria @FoxBusiness join us now

— Maria Bartiromo (@MariaBartiromo) June 5, 2020

As we have discussed frequently on these pages, there are many reasons to doubt the accuracy of government statistics related to jobs. These numbers are easily manipulated.

However, I must admit that a faster-than-expected recovery from the Lockdown Depression would not completely surprise me.

Yes, the fraction of people suddenly out of work resembles Great Depression levels. And GDP has likely contracted by double digit percentages on an annualized basis over the past 2-3 months.

Unlike the Great Depression, though, the Lockdown Depression has not been driven by natural forces. Buyers and sellers did not voluntarily decide to dial back production and trade due to unmanageable leverage or collective risk aversion.

Instead, commerce was forced to the sidelines.

Even if there are structural issues likely to impair economic progress down the road, there may still be gas left in the tank to permit further travel before breakdown.

Therefore, it seems reasonable to consider the possibility that once lockdown force is removed from the system, production and trade fire back up and get back on the road for at least a while.

After all, if some gas remains, economic drivers will be prone to use it.

Borrow and Print

"I'm tapped out, Marv. American Express has got a hit man looking for me."
--Bud Fox (Wall Street)

How does a federal government pay for a sudden multi-trillion dollar stimulus package when it has no savings? Simple.

Just borrow...

...and print.

Problem solved.

position in AXP

$0 Oil

"We're going to get bloody on this one, Rog."
--Sergeant Martin Riggs (Lethal Weapon)

Crude oil is down another 40% (!) this am to under $11/barrel. Prices haven't been this low since 1999 (note that the chart below does not update price till day's end).

Collapsing in the wake of world economic lockdown, oil demand is way out of balance with supply--particularly in the US where cheap credit has funded many marginal domestic producers. These highly leveraged players had little chance of surviving prolonged crude prices below $30 much less down here close to $10.

The situation gets more desperate for marginal players by the day. Their options are these: 1) Keep on pumping oil and sell it for whatever you can while hanging on in hopes that prices recover soon, or 2) shut down and default on your loans and probably never open your doors again.

The situation has gotten so crazy that spot prices for physical barrels of crude are approaching $0 in some local markets. Why? Upstream oil supply chains are running out of storage capacity. With nowhere to put it all, buyers are less willing to take oil off the hands of producers at any price.

$0 oil. Strap yourself in for an ugly shake out coming in the oil patch.

From Thin Air

Sgt Roger Murtaugh: That's pretty thin.
Sgt Martin Riggs: Anorexic! 
--Lethal Weapon

With the Fed buying everything in sight, its balance sheet is going vertical. The Fed added nearly $600 billion in assets in the last week, and is now carrying over $5.2 trillion in assets.

Fed balance sheet moves up to $5.254 trillion, a new high. In the last week it increased $586 billion, the largest weekly increase ever (prior record was $356 billion last week, and before that $292 billion from Sep 24-Oct 1 in 2008). pic.twitter.com/KH9Z5sMVHm

— Charlie Bilello (@charliebilello) March 26, 2020

This could go much higher depending on how long the COVID-19 lock down continues and the amount of economic destruction that the lock down leaves in its wake. While the over/under in my head currently stands at $10 trillion, I certainly hope for a downside surprise.

Meanwhile, it is important to remember that the Fed is doing all of this with money created out of thin air.

Threat and Liberty Lost

Vasily Borodin: The crew know about the saboteur. They are afraid.
Captain Marko Ramius: Well, that could be useful when the time comes.
--The Hunt for Red October

Over the past few days, running near empty streets during what is usually early morning rush hour has been a strange feeling. No school buses. No traffic piled behind neighborhood intersections. No long lines of cars pushing up Observatory Ave. A deserted Hyde Park Square.

A reminder, I think, of how readily people are willing to surrender freedom for some semblance of security when they feel threatened.

Early in my study of the Great Depression, the notion that people gladly consented to heavy-handed New Deal programs seemed incredible to me. Didn't these people realize that they were giving up liberties that would be difficult to claw back?

The phenomenon is much easier to understand after having experienced situations that elevate collective fear. 9/11. The Credit Crisis. Now the COVID-19 Pandemic.

"Give me liberty or give me death" is certainly not the common mindset in these situations. Instead, it is more like, "I will give up my liberty if you can guarantee my safety."

Unfortunately, those who do so are likely to wind up with neither in the long run.

Unlimited QE

"Those are not Mulligan's mortars anymore. Those are German eighty-eights!"
--Little Joe (Kelly's Heroes)

With bonds tanking and credit spreads blowing out, the Fed has announced several new programs with alphabet soup titles reminiscent of 2008 aimed at 'supporting the economy.' These programs amount to unlimited QE with the twist that corporate bonds, including bond ETFs, are fair game this time around.

This is monetization of debt like we have never seen before.

Inquiring minds wonder when the scope of Fed buys will be extended to stocks.

Fear and Power Grabs

"What we need right now is a clear message to the people of this country. This message must be read in every newspaper, heard on every radio, seen on every television. I want everyone to remember why they need us!"
--Sutler (V for Vendetta)

It is one of the first lessons in the political playbook. Make people fearful and they will be willing to sacrifice liberty in the name of security. Under conditions of threat, people are prone to think less critically and centralize decision-making authority (Staw, Sandelands, & Dutton, 1981)--part of what Kahneman (2011) refers to as 'fast thinking'.

Because emotions dominate thought process in threatening situations, and those emotions drive us to cede power to government in hopes of quelling those threats, politicians lick their chops when 'crisis situations' arise. Knowing this, government officials might even be willing to create or prolong threatening situations in order to assimilate more power.

Rookie House member Mark Green, a doctor from Tennessee, learned a hard lesson in this regard last night as the House rushed a 110 page, multibillion dollar bill to quick vote after midnight. No analysis, no discussion.

My thoughts as I walked off the House Floor at 1AM: pic.twitter.com/H2rYT1TiwI

— Rep. Mark Green (@RepMarkGreen) March 14, 2020

Why the rush? We have a 'national emergency' related to COVID 19, you see, as declared yesterday afternoon by the president. Careful thought and consideration? We can't afford that. Those in charge have to do something right quick.

Politicians indeed acted quickly, seizing the opportunity to fill the bill with special interest agenda items, knowing full well that their largesse would not be questioned in the name of expedience.

As in crises past--Civil War, WWI, Great Depression, WWII, 9/11, Credit Collapse to name a few--we have once again surrendered freedom for the illusion of safety.