Less Negative is Positive

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

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

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

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

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

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

Repos and QT

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

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

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

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

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

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

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

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

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

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

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

Student Loan Forgiveness

"Somebody's got to pay. Not gonna be me."
--Harry Lynch (Wall Street)

Ron Paul discusses the administration's plan to forgive college student loan debt. The plan is an overt attempt to buy votes, of course. Who is being bought?

Indebted college students, naturally. Plus all those who benefit from government subsidies to higher ed.

The plan can be viewed as a wealth transfer to the elite class. The working man is being forced to subsidize the 'educated.'

Moreover, the plan is inflationary. Loans that are forgiven don't just disappear. The liability must still be paid for. The money that can't be raised through taxes or borrowing will be...printed.

One more thing. Those who have actually paid for college now feel like suckers. In the future, more will borrow under the assumption that they won't have to pay.

Moral hazard writ large.

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.

Inflation Reduction Act

I bought a novel, some perfume
A fortune all for you
But it's not my conscience
That hates to be untrue
I asked of my reflection,
"Tell me what is there to do?"
--Squeeze

As we've discussed, leftists are rarely honest with their rhetoric. They label things largely contrary of their actual effects.

Cast in point: the proposed Inflation Reduction Act. 

As Ron Paul discusses, the bill does the opposite. It increases government spending by hundreds of billions of dollars. It takes resources out of the hands of private citizens and puts them into the hands of bureaucrats.

Not only does this increase the risk of capital misallocation, but it must be funded. To the extent that citizens are taxed, it reduces economic resources available to people during an era of high price inflation and slowing economic activity.

It is a universal truth that slow economic activity motivates easier central bank monetary policy (read: inflation).

To the extent that taxes won't cover the spending, then those funds must either be a) borrowed, which taxes future incomes, or b) printed (the reason why inflation is called the 'invisible tax').

There is little doubt that the Inflation Reduction Act will ultimately result in more inflation, not less.

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?

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...

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. 

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.

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.

Petrodollars to Petroyuan

When situations never change
Tomorrow looks unsure
Don't leave your destiny to chance
What are you waiting for?
--Swing Out Sister

Courtesy of the 1944 Bretton Woods Agreement, the US dollar has enjoyed reserve currency status for the better part of a century. A reserve currency is a money that circulates extensively internationally. It is deemed the standard used to price and execute financial transactions. As such, it is constantly in demand. Banks worldwide must keep piles of reserve currency on hand.

Strong international demand for the USD has been a boon for the federal government. Money can be printed and debt can be issued without having to worry about destroying the value of the currency. 

It is safe to say that the financial position of the United States would be in a much different place were it not for the USD's reserve currency status.

No market demonstrates USD reserve currency privilege more than the international oil market. For decades, Saudi Arabia has priced barrels of crude in USD. Any non-US entity seeking to buy crude from the Sauds has to pay in USD, which lights a fire under dollar demand in forex markets.

Plus, the US gets an extra kicker. Because it can print gobs of USD with little penalty, the US can do so to buy oil on the international market. Let's see...paper dollars printed out of thin air versus a barrel of crude. 

Who gets the better deal? 

The USD's use in oil trade has led to the term 'petrodollar.' The US has reaped huge gains from the petrodollar.

However, the age of the petrodollar may be coming to an end. Financial system warfare currently being waged as part of the Ukraine conflict is awakening countries to their vulnerability, and prompting them to investigate ways to reduce dependence on the USD. By doing so, these nations could sidestep crushing sanctions that might be hurled toward them in the event that they cross the US in some manner.

Seeking alternatives to petrodollars in oil markets would constitute  a significant step in that direction. 

It should not be surprising, then, to learn that countries are experimenting with pricing oil in yuan rather than in USD. In an uncertain world, it makes sense to diversify--even more so when some of that uncertainty involves a country that might decide to weaponize its currency against you.

By engaging in financial warfare the United States appears to be looking the proverbial gift horse in the mouth. The gift of reserve currency status may be rescinded as countries scramble to increase their sovereignty in a sanction-heavy world.

Movement from petrodollars toward petroyuan demonstrates.

Financial System Warfare

"Dude, we're on the grid!"
--Riley Poole (National Treasure)

Over the past month we've witnessed countries using the financial system to suppress behavior that they don't like. First it was the Canadian government freezing bank accounts and funding sources of citizen CV19 protestors and their allies. 

Then there has been the international response to the Ukraine situation. The US, EU, and other state entities have levied an array of financially-oriented sanctions on Russia to the point where it seems nearly impossible for people inside Russia to engage in external economic transactions. Even inside Russia, those sanctions have wrought chaos--sovereign debt downgrades, plunging stock markets, a cratering Ruble among them.

What should be clear is that modern financial systems, whose digital configurations are far easier to manipulate than in the past, are being used as geopolitical tools of warfare. Armed with these tools, governments can target either their own citizens (e.g., Canada) or remote citizenry (e.g., Russia).

This lesson is unlikely to be lost on at least two groups. One group involves countries with, shall we say, invasive aspirations. In anticipation of where escalating geopolitical tensions might head, Russia began decoupling its monetary and financial system from the international grid several years ago. For example, it substantially cut its US dollar reserves and increased its gold holdings. Consequently, the present barrage of financial system sanctions, while difficult to handle, has not completely incapacitated a more independent Russian financial system.

Given its aspirations to take control of neighboring Taiwan, China will undoubtedly prepare for a similar barrage before physically moving across a border (if/when). Any belligerent, for that matter, will need to decouple its financial system to the point where it will be able to survive the monetary salvos.

The second group involves citizens at large. The issue is captured in a question: Knowing that a government can, at its discretion, freeze or confiscate digital bank accounts as well as block digital financial transactions of any citizen, do you really want to have all of your financial resources on the grid?

The more people wake up to the specter of government-waged financial warfare, the more likely they will begin re-positioning for greater financial sovereignty. 

This re-positioning to combat geopolitical financial warfare seems likely to include gold.

position in gold

Debt Parabola

Well, it's a marvelous night for a moon dance
With the stars up above in your eyes
--Van Morrison

Federal debt has crossed $30 trillion. Prior to 2008, the trend was bad enough.

Since then, the trend line slope has essentially doubled.

A new segment for our debt parabola.

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.

Crack-Up Boom

"It's just money. It's made up--pieces of paper with pictures on it so we don't have to kill each other just to get something to eat."
--John Tuld (Margin Call)

Ludwig von Mises coined (!) the term 'crack up boom' to refer to people swapping out of money and into real goods out of fear that purchasing power was being destroyed by ever increasing monetary creation--either through expansion of bank credit or through monetization of debt. 

As supply of money ever increases, demand for money (i.e., desire to hold cash rather than spend it) collapses. People buy stuff even if they don't need it because anything tangible is better than holding cash which is deemed worthless.

Mises witnessed this phenomenon first-hand during the marquee hyperinflation of the 20th century in 1920s Weimar Germany. He saw children playing house with piles of worthless currency, and men pushing around infamous 'wheelbarrow wallets.'

Ron Paul wonders whether we're on the verge of another crack-up boom. Trillion$ in new money have been created with no end in sight. Inflation measures are printing multi-decade highs. Asset prices have followed suit.

He thinks that re-kindling the spirit of liberty would stop progress of a crack-up boom. Why? Because liberty-minded people do not tolerate massive government spending nor central bank intervention in financial (and social) affairs).

That's a worthy cause to pursue.

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