Fantasy

Markets are heading for the moon, apparently based on a very small downtick in CPI inflation last month. Mostly this was due to a 3.5% drop in the energy price component, as Biden cranked up the pumps draining the SPR and the price of gasoline fell 11.7%.

Meanwhile, back in the real world, “the Atlanta Fed’s Wage Growth Tracker was 6.4 percent in March, up from 6.1 percent in February. For people who changed jobs, the Tracker in March was 7.3 percent, compared to 6.7 percent in February.”

On April 2 OPEC+ announced a major cutback in production so that USO, the oil ETF, is already up 5.6% this month. Two weeks ago, commercial traders were at their lowest net short position as a group since 2016. This means that they are not willing to take those prices for their future deliveries.

And of course the federal deficit spend continues to rise. As of the end of March, the first 6 months of FY23, the cumulative deficit was $1.1 trillion, compared to $668 billion in the same period last year.

In other words, good luck with the moonshot. The fall back to earth will be a Deusy.

Edit: Added the price change of gasoline in context.

Something’s Going To Break

From past experience, we can be pretty sure that the bear market doesn’t begin until the inverted yield curve returns to a positive slope. Usually this happens because of a major disruption in the financial markets. Here are some of the opportunities for breakage.

• The average 30-year mortgage rate, as of today, is 7.13% according to Bankrate.com. Housing affordability has dropped to what Redfin deputy chief economist Taylor Marr calls the “lowest level in history.”
• Office occupancy in major city centers is ranging from 40-60% as a result of WFH practices. Pressure on bricks-and-mortar retailers from online shopping continues to build. The overall US CMBS delinquency rate jumped 18 basis points in February to 3.12%. (The all-time high on this basis was 10.34% registered in July 2012. The COVID-19 high was 10.32% in June 2020.) . Giga-investor Blackstone just defaulted on $562 million of CMBS.
• CPI/PCE inflation continues. While energy prices continue to be contained by withdrawals from the SPR, labor prices continue to increase. Fed chair Powell says that his primary measure of inflation is core PCE less housing, which implies a heavy weight on labor costs when evaluating inflation.
• The Fed continues to raise short-term interest rates to reduce business activity and therefore reduce inflation. So far with little success. Financial markets are busily fighting the Fed’s attempts to tighten financial conditions. History says this does not end well.
• There’s a war on, into which black hole the US continues to pump money and armaments. These will need to be replaced at great cost. Defense spending will be increased. The big risk is of further escalation, which could include the use of nuclear weapons.
• The primary source of inflation is deficit spending by government. Half of the government’s debt has a maturity of less than five years. The Fed’s rate increases are quickly running up the government’s interest bill, which of course will increase the deficit – that’s how the black hole works. Interest is already nearly as large a budget item as defense spending.
• China’s recovery from its draconian COVID policies is limping badly after a small initial surge. In addition, the US is actively hampering the development of technology in China and relations are a historic lows. There is a significant risk of another war, this time over Taiwan, where TSMC is the crown jewel of semiconductor manufacturing. All this means that China is unlikely to be the source of cheap manufactures goods that have helped quell inflation for the last twenty years or so.
• The US stock markets remain highly overvalued and not investable as the flood of liquidity during the COVID era has supported speculation. The options market has grown to be larger than the equity market of which it is supposedly a derivative, leading to extreme gambling activities such as 0DTE options..

Get the idea?

Honne And Tatemae

There are many financial conditions indexes, but in general terms they represent the cost and availability of credit and equity financing, interpreted as relatively “tighter” or “loose, easy”. Markets were surprised that Powell appeared unconcerned that these indexes showed that financial conditions were more or less unchanged by the Fed’s rate and QT actions. His unconcern was interpreted as conceding that the bulls were right in believing that rates would soon come down.

My interpretation was that he simply didn’t think it was a problem. One of the Fed’s primary concerns is to keep financial markets functioning normally, and the indexes show that they are. However, it is important to remember that the Fed is very well informed. The Japanese have words for this, “honne” and “tatemae”. “Tatemae” is the outward appearance of conformance to society’s norms and rituals, while “Honne” is what is really going on behind the scenes. In this case, the “Tatemae” is the traditional information bureaucracy – the BLS, BEA, and even the Fed itself – and the ritual announcements of  lagged and often politicized estimates of economic data. The “Honne” is that the Fed uses all kinds of information services and is very much in touch with the high-frequency data that is gathered by state governments, industry associations and many other private services. The recent callout of the BLS by the Philly Fed shows that the Fed has little faith in the BLS. Powell knows that the economy is either on the verge of recession or already in one regardless of the NBER’s view. He knows that deflationary collapses are underway in markets like housing and used cars. He probably also expects that taking down inflation, as happened in the GFC, will likely require a severe correction in financial markets, probably worse than the GFC. But I am of the opinion that  he is willing to be wrong about that, so if markets are right to “look through” the recession to a return to low inflation he would be perfectly OK with that. He did warn that no rate reductions should be expected in 2023, nor would he back off prematurely, but this was widely ignored.

Edit: This morning’s employment report demonstrates the useless, erratic nature of the BLS data.

What If?

The stock and bond markets are depending on the recession to “force” the Fed to “pivot” back to money printing and ZIRP. The economy is addicted to free money and is slowing rapidly now that it has been withdrawn. The bond market has already priced in disinflation and Fed easing, and the stock market has been buoyed accordingly, proceeding from short squeeze to short squeeze since June of 2022.

But what if Powell has decided that the QE policies that have yielded only $1 of GDP growth for every $10 of fresh debt are toxic and the addiction must be broken, no matter what the symptoms of withdrawal might be? That his legacy will be having returned the economy from dependence on continuous stimulus to sustainable growth? To say nothing of reducing the Fed-induced income inequality that is being exacerbated by inflation? That would certainly earn him a niche in the financial Hall of Fame, perhaps next to Paul Volcker.

Kumquat

Recession is here. The official dating will come later, much later. But the economy is slowing quickly. Commodity prices are falling due to lack of demand. Property – real estate – is slowing. China is struggling with Covid – and trying to infect the rest of the world with whatever variants they have incubated over the last couple of years. Europe is struggling with the Ukraine war and self-inflicted wounds from sanctions and immigration.

But equity markets don’t care. The S&P 500 looks to be making a bottom at a level that was the May bottom. The Dow seems to be heading for all time highs. Only the NDX seems to be close to a new low as some hypervalued “tech” stocks have been clobbered.

Confusion

Much is being made of the report from the National Ignition Facility (NIF) of a positive energy gain from their inertial confinement technology. This means that more energy was released from the hydrogen pellet than was received from the laser array, a 154% gain.. It is nowhere near break-even when the energy consumed to generate the laser pulses is included (about 100x the output) or create the hydrogen pellet. The best that can be hoped for from the laser efficiency is about 10%, which is a steep wall to climb for this approach. Remember, this is a cost-no-object government project that should have been shut down years ago, desperate for a press release so it can continue p***ing taxpayer money away. It is worth noting that the NIF first claimed to have achieved break-even in 2013, based on the energy delivered to the fuel. This time the definition has shifted slightly, to the energy in the laser pulse, but is 0.01 times any reasonable definition of breakeven. Still BS.

Panic Buying

Panic buying this morning resulted from this morning’s CPI report. Core inflation was reported at 0.2% for the month and 6.0% y-o-y, down from 6.3% in the previous report. This disinflationary update resulted almost entirely from falling energy prices, courtesy of Biden’s draining of the SPR, with some help from used car prices. Anyone who thinks that falls in energy prices are sustainable in the face of suppression of the use of fossil fuels is probably still checking to see if the Tooth Fairy has been.

What Happens Next

Well 2022 is just about over. I traded badly this year but that is behind me, I hope. Especially annoying since I have been expecting this bubble to burst for a long time. The big question is, where do we go from here. Some thoughts:

• Housing. Sales volumes are falling very rapidly because affordability is poor, but prices are holding as sellers are reluctant to drop their expectations. In the last housing bubble pop, it took a year and a half for this process to work through so that sellers finally acknowledged that prices could actually fall. This means that housing costs, which make up a disproportionate share of CPI, will be sticky.
• Employment. The pandemic significantly reduced the labor pool as many people retired or just dropped out. In China, the pandemic and measures to suppress it have badly damaged the economy and look to continue to do so. It seems likely that the offshoring that reduced labor demand in the US is over, and will be replaced by onshoring and relocation of production. Either way, labor demand is likely to remain relatively strong well after consumption growth falls. Labor looks to reclaim at least part of the loss of its share of economic output, at the expense of capital, i.e. profits.
• Energy. The idiocy of belief that minor reductions in CO2 output will have a material affect on the climate is hampering investment in energy sources. Of course this will throttle growth in energy production and keep prices high, even as a slowing economy will reduce demand for other commodities. I was amused to find that DNA recovered from northern Greenland revealed that during the region’s warm period, when average temperatures were 20 to 34 degrees Fahrenheit (11 to 19 degrees Celsius) higher than today, the area was filled with an unusual array of plant and animal life, including aurochs and mastodons. Then of course there are the (hopefully temporary) supply constraints that have been caused by the sanctions on Russian production.
• Food. The good news is that more CO2 in the atmosphere helps food production. But modern farming depends heavily on diesel fuel for big equipment and natural gas for fertilizer production. Fossil fuel prices directly affect food prices, because even though yields may be good, farmers will not plant crops on which they cannot make a profit. In addition to high prices, shortages of some crops will develop as farmers pivot to crops which require less of these costly inputs.
• Interest Rates. It seems that no-one believes that Fed Chair Powell will actually carry out the attack on inflation that he has outlined. Some argue that a recession will “force” him to abandon his current goals and resume ZIRP and QE, redefining his goals in the process to accept a higher level of inflation on an ongoing basis. Others believe that the recession will cause inflation to fall quickly and make the question moot as his goals, such as positive real rates across all maturities, will be automatically met.It is certainly true that this long-suppressed business cycle is moving fast, but there is a long way to go to normal. My personal view is that his vision for his legacy is an economy that does not depend on massive growth of debt relative to GDP as has been the case in recent years, and he will do “whatever it takes” to get there

In summary, inflation will prove sticky although not runaway, and Powell will accept a recession. But as the recession gains hold, it will accelerate as defaults reduce credit availability regardless of Powell.

Housing Collapse Redux

Take a look at this chart:

That is a collapse in process. An unprecedented collapse in modern times. Perhaps 1346-53 showed something similar. It will take 4-6 months to work its way into the hard data, but it is coming. Recall Stephanie Pomboy’s observation that in July of 2008, inflation was at 5.6%. By July of 2009, it was at -2.1%. There’s a Fed pivot of some kind. Now look at John Hussman’s pivot chart:

Which clearly shows that the real bear market will follow the pivot. Then contemplate another of Hussman’s charts which shows the potential losses from here:

Now look at the international context. China has its own housing bubble collapse going on, to say nothing of choking its economy with a stupid Covid strategy because a dictator like Xi cannot admit error. Europe is seized with political correctness, internal division over immigration from Africa and an energy catastrophe. Oh and there’s a proxy war with Russia going on and another with China waiting in the wings, to say nothing of a demented President. Just don’t choke on that turkey.

Central Heating Poverty

When I was growing up in the UK, our house had no central heating.  It was rare. In cold weather, I had a hot water bottle in my bed to take the chill off. Other than that, there was no heating in the house overnight. When I was old enough, it was my job, first thing in the morning, to light the fireplace in the living room, which burned coke. The black stuff, not the white stuff. There was a gas poker that was used for a few minutes to light off the coke. Until age 11 I went to school in shorts year round, long trousers being the exclusive privilege of the upper forms.

We had a gas cooker and water heater, electric lights and refrigerator, plus a few small electric appliances such as a vacuum cleaner. The gas supply was not natural gas, it was made from coal and, unlike natural gas, was highly toxic. It was common that people, especially those living in flats (apartments), would have a coin-operated gas meter that needed to be fed to provide gas.

I couldn’t find data earlier than 1970, at which time adoption of central heating was at 30% of households and rising steeply. By 1990, it was 79% and by 2018, it was at 95%. (Statista). Almost all of that is based on natural gas. So now there is widespread panic about fuel poverty in the UK, as there is a shortage of natural gas. The government can print money, and even generate hot air in small quantities. But not natural gas. So, folks, you are going to have to turn down the central heat. Or off. But I can testify that you will survive.  Got eiderdown?

When I was 14, the family moved to Canada. Now, there, winter is a more serious matter.