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.

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.

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.

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.

Whippy Trippy

Jared Cohen: Sam, how long under normal operations would it take your people to clear that from our book?
Sam Rogers: What?
--Margin Call

After the +900 Dow pt day post Fed on Wed, Thurs saw -1100 pts. This am the Dow opened -400 in the hole only to claw back to even.

Chatter is that there was forced liquidation yesterday--which makes one wonder about the force behind the post Fed announcement rally that serendipitously brough higher prices for the folks who needed to sell...

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.

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. 

Plugged Nickel

Well, it's midnight
Damn right
We're wound up too tight
--Nickelback

First of several posts seeking to record some of the craziness in commodity markets. This one follows up on the short squeeze in nickel.

After moving over 80% higher at one point yesterday, nickel outdid itself today.

Trading was halted after the squeeze jacked nickel prices to over $100,000/ton.

This action seems the mirror image opposite of what we saw at the depth of CV19 market craziness where crude futures dipped below zero...

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

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.

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.

Every Time

Every time I think of you
It always turns out good
Every time I've held you
I thought you understood
--The Babys

Peter Schiff is correct. Despite some hawkish rhetoric, the Fed can't raise rates significantly nor unwind its QE assets. Doing so would surely collapse the overleveraged, hyper financialized system.

This is, of course, an untenable outcome. 

After decades of recklessness, the Fed appears to have finally painted itself into the inevitable corner. Trillion$ of easy money and credit created to goose asset markets is now spilling into the mainstream economy, jacking prices of goods and services higher.

Fed heads face a decision. Tighten monetary policy to tame inflation but tank financial markets. Or let inflation ride.

When push comes to shove (and it will), the Fed will choose door number two every time.

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

Bass Fishing

The trees are drawing me near
I need to find out why
Those gentle voices I hear
Explain it all with a sigh
--Moody Blues

Always interesting to hear what Kyle Bass has to say. Some points from this recent interview.

Fed monetization of debt will result in inflation. 

The 'official' numbers grossly understate the extent to which purchasing power is declining. He provides an example of the average car 30 yrs ago which cost $13,000 then marked at less than $15,000 in the inflation basket today--even though the average price of a new car is about $40,000. How can this be? The trick of hedonic adjustments. Even though a new car buyer's bank account goes down by $40K, the CPI number account for only a fraction of the actual price.

The Fed will be unable to taper much. Short rates higher than 1% would break the system. This means more monetization (inflation) pending in attempts to keep the wheels on the wagon.

The field position of government and central banks makes it unlikely that they will be able to intervene as Paul Volcker did in the late 70s/early 80s to 'break the back' of big inflation. Radically raising interest rates (and therefore borrowing costs) to curb inflation today would bankrupt the federal government (debt payments skyrocket) in addition to rendering leveraged entities across the globe insolvent.

He's not a Bitcoin/crypto fan.

Instead, he especially likes the prospects of rural real estate, particularly as populations migrate to states such as Texas, Tennessee, and Florida that are positioning themselves as business and consumer friendly with less regulatory burden. He likes land as a 'hard asset' play better than gold due to real estate's functionality.

Lots of discussion about China. Bass has been outspoken on what he feels is China's irresponsible, aggressive agenda. He believes that the country's move toward a national digital currency bodes poorly for global trading partners. He thinks the US should outlaw trading in it. He also believes that Taiwan faces imminent threat, and that markets have not seriously discounted the possible of Taiwan asset appropriation by the Chinese (e.g., TSM). Suggests strategic supply chain risk as well.

He thinks that the Chinese real estate problem will remain largely contained to the mainland, and that the PBOC will print yuan to keep the local economy afloat. He did NOT discuss what that money printing might mean to the global system.

Bass believes that fiduciaries should be fired if they buy Chinese stocks for their clients--due to their unaudited, manipulated nature.

Although he admits that he is a 'tree hugger' and believes in global warming, Bass thinks that under-investment in hydrocarbons over the past few years (due to widespread virtue signaling behavior) may take oil and gas prices to levels that we've never seen--particularly if we have a cold winter. The transition to cleaner energy will take decades and requires a far more measured approach than climate change zealots have been pushing. 

Stock may be the best tool for average investors trying to weather inflationary periods. Bass's work suggest stocks keep up with about 85% of general price increases. Investors will still lose, but stocks mitigate the losses.

position in gold

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.

Banking Options

So true
Funny how it seems
Always in time
Bet never in line for dreams
--Spandau Ballet

Major indexes put in their worst week since last October. Among the weakest sectors has been the financials. The bank index (BKX) has broken its uptrend from last fall.

Inspired by a couple of recent Stan Druckenmiller interviews, I have been thinking about what a modest short portfolio might look like to hedge against my investment longs. I concluded that a modest group of options (some in indexes and some in individual names) might be prudent for my taxable account in this environment. 

The financial sector seemed like a good sector for an initial project. Huge run up. Vulnerable in 'risk off' environments. Interesting characteristics of price movement in sector indexes (low short term volatility, but potentially high long term volatility). So I initiated a small put option position in the financial sector SPDR (XLF). Although I have a fair amount of option experience, it's been a while. Wanted to see how it felt.

Trading options is much easier these days. Narrower bid/ask. Much lower commissions. Can see why options have become so popular. Can also see why many folks quickly get into lots of trouble. Derivatives constitute another form of leverage. Gains are magnified, but so are losses.

Used in moderation, however, options can be a tool for managing some of the risk associated with a long-term stock portfolio. So far, feels like a good tool for me to use in this environment.

position in XLF

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?

Margin of Danger

"Look at these people. Wondering around with absolutely no idea of what's about to happen."
--Peter Sullivan (Margin Call)

Margin debt now at record levels--north of $800 billion. Margin debt is increasing at its fastest rate since...2007. And before that...1999.

The unfortunate reality is that leverage works both ways. It magnifies gains on the way up, and creates elevator shafts on the way down. It also shortens time horizons, as price swings make investors jumpy.

Easy money courtesy of the Fed, as usual.

Lotta Robin Hooders think they're borrowing their ways to riches...until Sherwood Forest catches fire.