Category Archives: Fixed Income

That’ll Buff Out

Well I got that one wrong, fortunately my trading system had no dog in the hunt. Yes, Powell did hint at slowing rate increases. But the markets were shocked, shocked I say, by his acknowledgement of the 15 years of futile attempts to curb inflation before Volcker took matters in hand. That an economist should consider history rather than models and calculus is pretty much unprecedented, at least in modern times. His academic credentials may be called into question. The calculus thing was introduced because economists – it was called, correctly, “political economy” at the time – felt they were underpaid, relative to the physical sciences, and therefore needed to emulate them. It helped their prestige but not their forecasts.

Sarcasm aside, it’s a good thing. But the bad thing is there is way too much money in circulation. Consider the following mantra from Milton Friedman in 1963, years before the 1970s inflation.

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

Then please consider the following:

fredgraph

money to gdp

That’s going to take a lot of buffing. And yes, Mr Powell, it is the product of years of central bank economic idiocy and arrogance. First chart St. Louis Fed, second John Hussman.

Friday

Friday is the Jackson Hole retreat, where the US taxpayer hosts a gathering of the people who believe they are the masters of the world economies.

Our esteemed Fed Chair, Jerome Powell, is expected to speak about, inter alia, Fed policy. Much digital ink is being spent on speculation about what he will say. So I will join in and spend a little.

It is important to remember that he, and many other attendees, claim to be economists. They are a dangerous species, especially when they attempt to manipulate economies and markets, as the records of booms and busts show.

Chair Powell has stated that he intends to curb inflation by slowing growth, not by slowing the economy, as in the R-word. In my personal opinion, as they say in Japan, we are going to have a deep and dark recession regardless of what Chair Powell says or does. But back to Friday. This means that he will at least hint at slowing rate increases. Of course this is not a “pivot”, more like a “swivel”. But it will be friendly to the stock and bond markets, at least for a little while.

The Price Of Moderation

From my last blog post of 2020:

William Greider, in his book, Secrets of the Temple: How the Federal Reserve Runs The Country, reports Nixon (’69-’74) as saying: “We’ll take inflation if necessary, but we can’t take unemployment.” The nation eventually had to take both. Note that Fed Chair Powell has indicated a willingness to let inflation “run hot” to encourage economic growth. That’s what they thought in the 1960s, too.

Well, inflation is running hot. Too hot for comfort. Discretionary spending is falling rapidly as the cost of essential goods and services takes more of people’s income. Fed Chair Powell is raising interest rates in baby steps, presumably in an attempt to quell inflation without slowing the economy significantly. People seem to think that raising rates to 2 1/2 percent will achieve this result, and are competing to time the “pivot” when the Fed returns to easy money. All I can say is good luck with that. History says that once inflation starts to surge – as it has – it is not easy to stop, as all kinds of feedback loops keep driving prices higher. Weakness now will only make the pain worse.

Perfect Storm Plus

The Perfect Storm began as an extratropical system, absorbed a tropical system (i.e., Hurricane Grace), and ended somewhat uneventfully as an unnamed hurricane. In the process it caused considerable damage on the US East Coast, and sank the fishing vessel Andrea Gail, with the loss of all hands.

We are now living through the early stages of the economic Perfect Storm Plus. The “Plus” is due to the near-simultaneous collapse of four great bubbles – China, Japan, North America and Europe. All are due to central bank monetization of government deficit spending, coupled with over-expansion of consumer and property credit. As Austrian economics teaches, there are only two paths out of these bubbles – stop the credit expansion and accept the resulting recession or depression, or continue to hyperinflation and the destruction of the currency.

The collapse of China began with the cascading failures of property developers, such as Evergrande, when President Xie’s “three red lines” reined in their ability to raise new debt. Then his idiotic “zero-Covid” policy drove a dagger into the beating heart of China’s economy, Shanghai. Then failures in a handful of smaller banks were mishandled by local governments which failed to honor deposit insurance guarantees, instead hiring toughs to beat up demonstrators. This has been followed by a wave of buyers refusing to continue mortgage payments on unfinished properties, especially where cash-starved developers have stopped working on them. A loss of confidence in the CCP government has resulted. It is attempting to stop the collapse with promises of more government funding, but so far success is elusive.

Japan is, so far, following the path of currency destruction. Even though Japan’s central bank now owns virtually all government debt and a very large chunk of the stock market, it continues its path of yield curve control – at zero. This has led to a downward slide in the yen as the US Fed has reacted to inflation, well a little bit anyway. Japan is short of natural resources and must import many commodities, especially energy as the Fukushima disaster has constrained the use of nuclear power. One could easily see a return of the yen to dollar valuations like the pre-1989 mid-200s, compared to 140 today and the 2012 high in the 70s. Needless to say, this would kick off serious inflation in Japan.

North America’s asset bubble, in property and financial assets of all kinds has finally been joined by rapidly inflating prices of consumable goods and services. While Alan Greenspan started the Fed’s monetization addiction around the turn of the century, rapid growth in outsourcing to China, India and numerous other countries kept consumer prices and wages under pressure. Finally the combination of supply chains ruptured by Covid and government payments that put large sums directly in the hands of consumers started to drive up prices, and also allowed large numbers of people to withdraw from the labor force. The coup de grace was Biden’s decision to follow the urging of the climate fanatics and cut off investment in future fossil fuel supply. Anecdotally, a farmer of 1,800 acres in Canada reports that his annual diesel fuel bill has doubled from $40K to $80K, and nitrogen fertilizer (made from natural gas) has gone from $270/tonne to $900/tonne. The Fed’s reaction has been a minor increase in interest rates. A recession is either already underway or set to begin anytime now.

Europe (including the UK) is a basket case. It shares many of the same problems as North America, but in addition climate fanatics and the Russian attack on the Ukraine have conspired to leave it desperately short of energy. EU inflation is running high (8.8%) but the real problem is yet to come. Germany continues to shut down its remaining nuclear plants, while Russia has just notified Germany that it is terminating natural gas deliveries. Germany lacks the terminals needed to import LNG.

A key component of the coming confluence of these storms is the climate mania. This mania is based on bad science, but socialist politicians and activists see an opportunity to disrupt the status quo.

Alchemy

Ancient alchemists – including, amazingly enough, Sir Isaac Newton – strove to transform base metals into gold. Modern alchemy is accomplished by central banks, which transform interest-paying government debt into interest free cash. This alchemy allows governments to borrow unlimited amounts of money, unhampered by the need to pay interest.

We can consult Sir Isaac, as it turns out. “For every action, there is an equal and opposite reaction,” said he, referring to the impossibility of reactionless acceleration. Yes, we are talking about economics here, not physics, but there is a good analogy. The central bankers have attempted the reactionless acceleration of the economy and now follows the reaction.

Looking specifically at the US  Fed, there is a $7 trillion pile of debt that has been processed into cash, representing money that the government has spent beyond the means provided to it by taxes. This money has been sloshing around in the economy, driving up asset prices first of all and now the prices of consumables. Tiny increases in interest rates won’t solve this problem. The fake money has to be destroyed. The Fed can do this by reverse alchemy – selling off the pile of debt – which will drive up interest rates even further. Small problem, even current rate increases will mean that the Fed will become technically bankrupted by the loss of value of the bonds if it sells them. Capital call? Creative accounting? If it continues to hold them it does not have to mark them to market. Alternatively, debt defaults will destroy money as inflation cripples the economy. Your call, Jerome.

Debt

According to the St Louis Fed, from Q1 2000 to Q1 2022, federal debt has expanded from $5.77 trillion or 58% of GDP to $30.4 trillion or 125% of GDP. And the deficit spending continues unchecked. History says that government debt of over 80% of GDP inhibits economic growth.

The interest rate on the debt is currently about 1.5%, but 70% of the debt is due at various dates within 5 years, and will be rolled-over and re-priced at whatever rates are current at its maturity. However, the following chart shows that the highly negative real rates currently in effect do not persist for very long. The red line is the inflation rate, the black line is the Fed funds rate and the blue line is the “real” rate – the nominal Fed rate minus inflation. It seems likely that the Federal budget and interest expense will have a nasty collision in the next few years unless inflation falls rapidly.

Screenshot 2022-06-20 205338

Complacency Is Back

There’s always a bullish story. Now the story is that a recession is coming (very likely true) and that will cause the Fed to stop tightening and resume easing. That would bring back happy days to the stock market.

There are a couple of problems with this story. The first is that the Fed is willing to see inflation run away and destroy any last shred of credibility that it has in order to save the stock market bulls.

The second is that this scenario would be good for the stock market – negative growth and high inflation – even though coupled with low interest rates.

But it’s OK with me. Take it up, clean out the shorts so that when it rolls over the next time there are no buyers left.

Reality Check

Everywhere I read the pontifications of eager interpreters of yield inversions, and other signs and portents, predicting smooth sailing for the economy until a possible recession in 2023.

All I can say is you have to be kidding me. First of all, markets are still at unprecedented and artificial extremes. It seems to me to be a trifle naive to assume that scenarios from the past apply here. Markets have never been here before and hopefully will never return again. Secondly, there are major and poorly understood economic disruptions underway:

China: The world’s largest asset class, real estate in China, is in trouble. March sales of new homes are down 29% y-o-y. Lockdowns in Shanghai and other large cities in China are stalling production and shipments of many goods.

Ukraine: The Russian invasion and its corollary sanctions are negatively impacting agricultural and commodity exports. Restricted supply and high prices of fertilizer will reduce agricultural production around the world.

United States: Historically high consumer price increases have resulted from years of low interest rates and massive expansion of the money supply. Measures announced so far to deal with this issue are unlikely to have much effect. The 10-year Treasury yield has doubled since the beginning of 2022, with direct impact on mortgage rates and thence real estate prices. “Green” policies have driven up energy prices by restricting supply.

EU: “Green” policies have left the EU (and the UK) without reliable domestic sources of energy, leaving the group dependent on imports from the rest of the world, but without adequate LNG terminals to replace Russian pipelines. The EU is expected to announce an embargo on Russian oil immediately after the French election, which will drive prices higher.

Japan: The third most traded currency, JPY, the Japanese yen, is falling rapidly, now down more than 10% since the beginning of 2022 against the US dollar. The Bloomberg Commodity Spot Index rose 8.2% in JPY terms over just the past week. It’s up 29% since end of Feb., more than 48% ytd and 177% over the past two years (all in JPY terms). The possibility of intervention is being bruited about. Currency wars are the nuclear option for financial markets.

Look out below.

Fed “Hawk”

St. Louis Fed President James Bullard, considered a “hawk” on the Fed Board, believes that a 3.5% Fed Funds rate should be enough to counteract inflation. All I can say is ROFLOL. I didn’t know that a hawk was a particularly stupid kind of dove.

The Fed should have taken the punchbowl away years ago. It is too late now for anything but the strongest of measures. The punchbowl must not only be taken away, it must be destroyed so that it never appears again. Just diluting the contents a tiny bit only makes matters worse, because it keeps the party going while providing an illusion of adult supervision.

Deadly Embrace

In a computer system where multiple programs are running at the same time, updating shared data can be a serious problem. A program can lock a chunk of data while it is modifying it so that no other program can inadvertently update it at the same time, which would lead to bad data. But then the situation can arise where program A locks chunk 1 and then needs to lock chunk 2 to proceed, except that program B holds the lock on chunk 2 and needs chunk 1 to proceed. Clearly neither A nor B can proceed. This situation is called a deadly embrace.

The escalating sanctions remind me of this. Both sides are trying to hurt the other but it seems that there is no way that either side can emerge victorious. Mutually Assured Destruction (MAD) may be achievable without any nuclear missiles leaving their silos.

Typically in a computer system the supervisory software will step in and pick a winner, forcing the other program to start over. Unfortunately there doesn’t seem to be a candidate for that task in the geopolitical system.