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.

TINA Turning?

All I want is a little reaction
Just enough to tip the scales
--Tina Turner

During the era of interest rate suppression, people turned to stocks, particularly dividend payers, because it seemed there was no alterative (TINA). With yields presently moving higher, the TINA attitude should dissipate as investors switch out of stock in favor of the relative safety of high yielding bonds.

Today the 2 yr Treasury yields touched 4%. This more than 2x the S&P 500 dividend yield.

The higher this spread goes, the more pressure we should see on stocks as investors flock to 'risk-free' cash yields.

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.

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.

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.

Utilities Yielding to Miners

"You know, the worst ain't so bad when it finally happens. Not half as bad as you figure it'll be before it's happened."
--Curtin (The Treasure of the Sierra Madre)

Those seeking dividend income often flock to utilities given the sector's consistently high payouts. However, the income-producing status of utes is currently being challenged by...mining stocks. The dividend yield differential has narrowed to decades+ lows.

Two things are going on. One is that utility stocks have been bid up recently, causing their yields to fall. The other is that mining stocks, despite their strong balance sheets and cash flows, have been crushed recently, causing their yields to rise.

While they have surely been disappointed that the sector has not yet responded to the present environment as expected, gold bulls are at least being paid well to wait.

position in gold

Jackson's Hole

"You're the disease, and I'm the cure."
--Marion Cobretti (Cobra)

The much-awaited Jackson Hole speech from Fed chair Powell is now in the books. Personally, I always chuckle when Fed heads wax about economic problems that always seem to be exogenous, and the Fed's heroic role in taming them.

The topic this time around is, of course, inflation. Powell suggests that the Fed must draw upon 3 lessons learned. One is that the Fed must take on responsibility for delivering low and stable inflation. The obvious question is why should the Fed be responsible for delivering any rate of inflation at all? Moreover, if the Fed is responsible for delivering low inflation, then how did we get to this state of high inflation in the first place?

The second lesson learned related to 'inflation expectations.' Powell asserts that "if the public expects that inflation will remain low and stable over time, then, absent major shocks, it likely will. I found that statement particularly rich. It suggests that a major goal of 'fighting inflation' is persuasion--persuading the public that inflation is low. 

Never mind the decades of easy money compliments of the Fed.

The third lesson is that the Fed must keep at it until the job is done. That is, keep monetary policy restrictive until "inflation is down to the low and stable levels that were the norm until the spring of last year. But monetary policy was extraordinarily 'unrestrictive' for more than a decade before the spring of last year. 

If that prolonged period of easy money didn't unduly elevate the public's inflation expectations, then how will the Fed 'keeping at it' with restrictive monetary policy do the opposite?

Powell once again markets the Fed as the cure rather than the disease it is.

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?

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.

75 Bips

Hot summer streets
The pavements are burning
I sit around
Trying to smile
But the air is so heavy and dry
--Bananarama

After signaling thru their WSJ mouthpiece that they were considering a 75 basis pt fed funds rate increase, the FOMC followed thru on Wed. The last time the Fed did 75 bips was 1994. 

This puts the fed fund rate target at 1.75-2%.

The infamous 'dot plot' showing forecasts by FOMC members of future fed fund rates find them firmly above 3% by year end.

The Fed's miserable record in forecasting anything accurately makes taking these dot plot projections seriously pretty laughable. 

As these page have noted, all previous rate hike cycles end when something breaks. This is because of the increased systemic leverage that results from the previous easing cycle--which never allows interest rates to return to previous cycle highs. A recession usually follows, along with more easy money from the Fed.

How high will rates go before triggering the next recession? A review of history suggests we may not be far from the peak. Perhaps this 75 bip move pushes things over the edge.

The 3%+ dot plot forecasts seem destined to be wrong (again).

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?

Much Higher

I have a picture
Pinned to my wall
An image of you and of me
And we're laughing
We're loving it all
--Thompson Twins

Yesterday 10 yr Treasury yields closed back above 3%. As long duration yields rise, I've been pondering just how high they would need to be before I was a serious bond buyer.

My answer is, "Much higher."

For me, fixed income competes with dividend-paying stocks. Currently I can put together a portfolio of dividend paying stocks that pays a 3% or more in cash annually. 

Plus, those dividend yields are likely to increase over time. If yields increased 5% annually (not far from historical averages for many dividend payers), then a stock that pays $5/share annually in dividends this year will be paying more than $8/share ten years from now. 

There is also the potential for share price appreciation. These features are especially attractive to hedge against inflationary pressures like we have now.

Bonds simply do not offer the same risk/reward profile--at least at current levels.

Where would 10 yr Treasury yields need to be for me to consider them? Maybe 10% or more to compensate for the risks and opportunity costs of foregoing dividend-paying stocks.

It should be noted that these levels would approximate T-notes yields in the early 80s when the last bond bull market began.

Not Wide Enough

Sam Rogers: It's gonna get worse before it gets better.
Will Emerson: Ya think?
Sam Rogers: Much.
--Margin Call

One indicator that we're not at 'defcon' market levels is credit spreads. While spreads on junk bonds on rising, they're not at the wides associated with previous crises.

Due to its centrality to modern finance, we likely need to see more stress in the credit domain before 'the' bottom is in...

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.

How Low is High?

And there's some
Chance we could fail
But the last time
Someone's always there for bail
--Toad the Wet Sprocket

What is the max that the Fed can push its Fed funds rate before it stops? Judging from the downtrend line defined by previous cycle highs in the graph below, the ceiling appears to be about 1.5%.

Much lower, as we've said, than market participants seem to be forecasting.

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.

Inverted Yield Curves

Upside down
Boy, you turn me
Inside out
And round and round
--Diana Ross

This past week the yield on two-year Treasuries exceeded the yield on ten-year Treasuries. This is unusual. Normally investors demand higher interest rates on longer dated debt. When the yield relationship flips over, or 'inverts,' it often seen as a harbinger of forthcoming economic recession.

Indeed, a review of past occurrences of inversions between 'twos and tens' suggests a good predictive track record. Even if the relationship subsequently 'un-inverts' (which it often does), recession appears imminent.

However, it should be noted that many maturities comprise the complete Treasury yield curve--beginning with 1-3 month T-bills all the way out to 30 yr Treasury bonds. Currently, only the twos and tens relationship is upside down. 

For example, the spread between 12 month and 10 year Treasuries has yet to invert. Yet, note that the 12 month/10 yr relationship has also been a good predictor of recession.

What this suggests is that the relationship between twos and tens, and subsequent recession may be a spurious one when viewed in isolation. The recessionary signal sent by the inversion phenomenon is likely stronger when more of the yield curve joins in. 

Consequently, look for shorter duration yields to continue rising relative to long duration yields before confidently concluding that the inverted yield curve/recession warning is in play.

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.

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.