Euro Energy Bailout

Here I am in silence
It's a game I have to play
You and I in silence
With nothing else to say
--Information Society

On the back of yesterday's post, headlines this morning find euro bureaucrats committing to massive bailouts of consumers and producers as they face virtual margin calls as energy prices spiral higher.

These bailouts are forms of stimulus--subsidies that work against efforts to reign in higher prices.

Still wrapping my head around how this spills over to the US. The obvious consequence is an even strong USD vs the euro.

Cause for Pause

How can you just leave me standing
Along in a world that's so cold?
--Prince

Our working hypothesis is that the Fed will pivot from its hawkish track when 'something breaks' in the market. That's been the historical pattern and there's no reason to believe this time will be any different.

But where will the breakage occur this time around? One possibility is something in the credit markets. The greater the systemic leverage, the more susceptible the system is to higher interest rates. And systemic leverage has never been higher.

After the Fed's historic tightening over the past six months (on a relative basis), some folks are on the lookout for cracks in credit. We recently noted, for example, that low rated debt spreads are widening toward alarm levels.

Another possibility, one stressed here, is that a funding crisis arises in Washington. Higher rates mean more interest expense on ever-escalating federal debt levels. We're currently on a run rate to spend over $1 annually on Treasury bond interest. How much longer before politicians exert enough pressure on the Fed before it breaks?

Finally, one possibility that I frankly had not entertained concerns the strong dollar. The dollar index (DXY) currently stands at its highest level since 2002. The broader Bloomberg dollar index has spiked above the pandemic highs.

There is growing suspicion that this is sparking margin calls in emerging markets stemming from short dollar positions. 

If so, then systemic contagion could provide another possible cause for Fed pause.

Disconnect

Hungry to touch
I'm eager to please
Out of control
And I hand you the keys
--Rick Springfield

Nice graphic that complements our previous post.

When you bail out bad decisions, you get _____ of them.

a) more

b) less

When the Going Gets Tough

I got something to tell you
I got something to say
--Billy Ocean

The two key charts, updated again. Fed funds rate, recessions/crises, and SPX.

QE, SPX, and related events.

When the going gets tough, what does the Fed do?

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.

Don't Bet On It

They show you photographs of how your life should be
But they're just someone else's fantasy
--Styx

Policymakers seem to be betting that people would rather see inflation than recession. Current policies seek to curtail demand, lower wages, and raise unemployment--with the hope that these things will result in falling prices. 

And people are supposed to be happy with that outcome?

Don't bet on it.

I also wouldn't bet on the either/or proposition. What if it turns out that we get inflation and recession?

Zero Coherence

Maybe someday
Saved by zero
I'll be more together
--The Fixx

Earlier today the European Central Bank (ECB) raised its deposit rate 50 basis point to...zero. The ECB's deposit rate had been in negative territory since 2014, meaning that depositors essentially paid to keep their money in the central bank's vault.

This is also the first interest rate increase by the ECB since 2011.

Needless to say, monetary policy in Europe has been off the rails for quite some time.

To demonstrate that it hasn't suddenly been transformed into an institution with coherence, the ECB unleashed a blizzard of acronym-heavy programs, such as Transmissions Protection Mechanisms (TPI), designed to selectively buy bonds of struggling EU countries (e.g., Italy) to keep sovereign debt from imploding.

Thus, we have a central bank raising interest rates while continuing easy money policy using a quantitative easing (QE) transmission mechanism.

The ECB truly makes the Fed look smart.

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

Ceiling Prices

We run though the day
And stare at the night
Is your head full of noises?
For me, well, it's just like
The Fourth of July
--Roger Daltrey

Among the dumbest of economic policies pursued by politicians is the price ceiling. The thinking is typical authoritarian. Think prices are too high? Then simply declare them lower. Set a maximum price for transactions on the market. Punish those who engage in transactions at a higher-than-mandated price.

What happens when producers are forcibly restrained from selling output at higher prices? Supply leaves the market. Shortages develop. 

Not only does present supply leave the market, but future sources do as well. Entrepreneurs are less motivated to develop marginal or substitute sources of supply when the profit signal of higher prices is suppressed.

Over time, prices are likely to be much higher--particularly if it takes a long time to replace capacity once it is taken off the market by the caps.

Cogitate on that as G-7 bureaucrats mull price caps on Russian oil.

Suck It Up

"Whatever it takes is something that happens to somebody else."
--Jake Lo

As Americans increasingly question the logic of a distant war--an in particular the associated sanctions--that are jacking domestic cost of living higher, the administration is telling the citizenry to 'suck it up.'

When asked how long US drivers should be expected to pay a 'war premium' for gasoline, the president responded, "As long as it takes."

Hard to imagine replies like this will play well at the ballot box.

That Ain't Workin'

We got to install microwave ovens
Custom kitchen deliveries
We got to move these refrigerators
We got to move these color TVs
--Dire Straits

One factor that influences price pressures is the number of people in the workforce. Less workers mean less supply. Less supply at constant demand means higher prices.

The labor force participation rate has been in secular decline. The 'Great Resignation' resulting from CV19 policies added fuel to the fire as able-bodied people hit the silk.

How are markets likely to compensate for the labor shortfall? Offer higher wage rates--which also, by itself, is inflationary.

As one policy distortion begets others...

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?

Yen Destruction

One day you feel quite stable
The next you're coming off the wall
But I think that you should warn me
If you start heading for a fall
--Saga

When leverage + money printing start going way wrong, the billiard balls begin careening around the table. One never knows where the blow ups will occur.

This time around, Japan is becoming an epicenter. Faced with unrelenting Bank of Japan (BOJ) intervention, the yen has been getting pounded and sits at 20+ yr lows. 

Now, with the 10 yr Japanese government bond (JGB) yield hitting the upper band tag in the BOJ's yield curve control program, the BOJ has bought about 1.5 trillion yen's worth of JGBs. If the pace continues through end of month, the BOJ will have purchased about 10 trillion yen's worth of bonds.

To put that in perspective, that would be the equivalent of the Fed doing more than $300 billion of QE when adjusted for GDP.

It is hard not to envision outright monetary collapse if the BOJ does not take its foot off the gas soon.

What that means for financial systems worldwide, as integrated as they are, is anyone's guess.

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

Real Reds

"I would say they were WAY off course. This is very unusual."
--Mr Teasdale (Red Dawn)

Ironic that the email thread among public health officials that spawned the lockdown mess was internally labelled 'Red Dawn.' In this version of the 80s classic (and remade in the 2010s to feature North Korean/Chinese antagonists rather than the original Soviet bloc brigades), the virus was the invader and public health officials seemed to view themselves as the groundswell insurgents staving off the incursion.

The bureaucrats seemed to be engaging in a behavior that seems characteristic of their ilk: projection.

In reality, public health officials were working to impose an authoritarian program rivaling anything that socialist outsiders could conjure.

Public health officials were the real reds.

Three Peat

When my back is broken
When the mountain moves away
All the dreams and promises
That we give
We give away
--INXS

Ten yr yield touched 3% yesterday. Not terribly high by long term historical standards but noteworthy given recent context. Last time at 3% coincided with Fed chair Powell folding like a cheap suit and reversing the Fed's tightening policies in 2018.

The above chart shows the relative field position then vs now. Last time, the Fed had already raised rates several times by the time 10 yr yields touched a 3 handle. This time, we're at 3% after only one measly 25 bip increase.

More fuel for the argument that the current tightening campaign will cease far sooner than currently forecast.

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.

Ruble Round Trip

Call it morning driving through the sound of
In and out the valley
--Yes

After getting smoked on Western sanctions, the ruble has clawed all the way back to pre-invasion levels.

Lotta manipulation (both ways), so it's difficult to assess precisely what has driven recovery. That said, hard not to include these factors:

Russia's strong commodity position

Ineffectiveness of sanctions over time

Russian proclivity toward gold

One thing seems certain. Those engaging in financial system warfare vs Russia early on were not counting on a ruble round trip.

position in gold

Harding's Path

Nick Carraway: You can't repeat the past.
Jay Gatsby: Can't repeat the past? Why, of course you can!
--The Great Gatsby

The dominant narrative about President Warren G. Harding was that he was a boob who ran a corrupt administration. To be sure, the Tea Pot Dome scandal happened on his watch, and, similar to Donald Trump, Harding may have been far too trusting of those working in his administration.

However, as this article points out, Harding achieved much during his term in office--a term that was cut short by his untimely, and somewhat suspicious, death in 1923.

A likeable sort who was elected by a landslide in 1920, President Harding was determined to lead Americans weary of war and Wilsonian progressivism into a peaceful age of prosperity. After quickly overcoming a post-war depression using a 'hands off' approach completely lost on modern administrations, Harding focused on perhaps the crown jewel of his legacy: foreign policy.

Harding clearly ended WWI for America. He withdrew troops from the German Rhineland, presided over agreements on war debt, and shunned the military-industrial complex's calls for arms buildup. He convened the Washington Disarmament Conference in late 1921 to ink international agreements on weapons limitations. Harding also withdrew US troops from Latin America and signed several treaties to ease tensions in Asia.

Completing work begun as a senator prior to his presidency, Harding killed his predecessor's League of Nations proposal. "America can be a party to no permanent military alliance," he said. "It can enter into no political commitments, nor assume any economic obligations which will subject our decisions to any other than our own authority."

Wise words which were, of course, subsequently ignored by bureaucrats following WWII.

Warren G. Harding reversed the dangerous internationalism of Woodrow Wilson and put the United States back on the path of neutrality and non-interventionism. America proceeded to roar down that passageway during the Twenties.

Harding's achievements provide a roadmap for how to get back onto that path today.

Dot Matrix

"Whatever you're thinking, rethink it."
--Phil Broker (Homefront)

The Federal Reserve Open Market Committee (FOMC) announced that it will raise the fed funds rate target to the 0.25-0.50% range. It also indicated that it plans to begin reduction of the $9 trillion of balance sheet assets amassed during it various QE campaigns 'at a coming meeting.'

The lone dissenter was 'hawk' James Bullard who preferred a 50 bip increase in the fed funds rate instead of the 25 bip bump announced.

The Fed's 'dot plot,' which indicates current FOMC member forecasts of where the fed funds rate is headed suggests that Fed heads foresee higher rates in 2022-2024 than previously expected. However, longer run rates are seen as unchanged or slightly lower than previously forecast.

The dots suggest a couple of things. Several rate hikes this year--six of them if they are 25 bps each. Then a relatively benign longer run.

The FOMC also forecast price inflation of 4.1% by end of 2022.

Given the Fed's previous track record, don't be surprised if all if its guesses here are way off.