Tag: Interest rate (page 1 of 4)

Fed Officials Push Radical Change In Monetary Policy As Powell Takes Over

Oh no…with the Federal Reserve in a state of flux as one Chairman prepares to step down and another (shock horror, who is not an economist) takes over, some of his colleagues who think they’ve found the “Holy Grail” of monetary policy are agitating for change. And, dare we say it, hoping it will raise their own prestige no doubt. We are specifically referring to John Williams, President and CEO of the San Francisco Fed, but it’s not just him. What they have in their crosshairs is the Fed’s 2% inflation target. It’s too low. According to Bloomberg.

Federal Reserve officials are pushing for a potentially radical revamp of the playbook for guiding U.S. monetary policy, hoping to seize a moment of economic calm and leadership change to prepare for the next storm. While the country is enjoying its third-longest expansion on record, inflation and interest rates are still low, meaning the central bank has little room to ease policy in a downturn before hitting zero again. With Jerome Powell nominated to take over as Fed chairman in February, influential officials including San Francisco Fed chief John Williams and the Chicago Fed’s Charles Evans have taken the lead in calling for reconsidering policy maker’s 2 percent inflation target.

It looks like they’ve got the backing of a recent Fed appointee (June 2017) as the report continues.

“It’s a good time given the shift in leadership,” Atlanta Fed President Raphael Bostic told reporters on Tuesday in Montgomery, Alabama. “The new guy comes in and they are able to really think about, how should this work, how do I think this should work, and is it compatible with where we’ve been and where we are trying to get to?”

The justification for the policy changes these Fed officials are advocating boils down to what Williams refers to as a “Low R-star World”, i.e. one where the natural rate of interest is very low.

The problem with what they have in mind is the Fed’s explicit 2% inflation target. However, it’s a relatively recent adoption, so Williams and Evans have to tread carefully, so as not to offend too many incumbents.

The Fed in 2012 officially settled on 2 percent inflation as an explicit target for the price stability half of its dual mandate from Congress. The other goal is maximum sustainable employment. The move formalized a policy they’d been following in practice for several years, and it was backed by careful logic: 2 percent is high enough to ensure that workers continue to get raises and to give the Fed some cushion against deflation. Other advanced economies aim for a similar level. Yet Fed officials, most loudly Williams, have been urging the policy-setting Federal Open Market Committee to revisit that approach. The reason? The target was settled at a time when officials thought they’d have no problem in lifting interest rates to 2 percent or higher without choking off growth. But fundamentals in the economy have changed since the crisis. Growth and productivity have been tepid. As a result, the so-called neutral level of interest rates — which neither speeds up or slows the economy – is very low by historic standards, leaving the Fed with less wiggle room.

What it boils down to is these senior Fed officials want to let the inflation genie out of the bottle just that little bit more…let the economy run “hot” for a while, without losing control, of course. Then they can cut rates more aggressively in the next downturn and “save us”.

Allowing prices to rise slightly higher would give the Fed more scope to ease in the next downturn. The federal funds rate is quoted in nominal terms, or not adjusted for inflation. So if neutral stands at 0.5 percent, in real terms, and prices are rising at a 3 percent pace, the Fed can get rates as high as 3.5 percent before policy would be restrictive. If inflation were only 2 percent, that level in nominal terms would be 2.5 percent.

Which sounds like a policy of less adherence to price stability, although we could be mistaken. Meanwhile, Williams is trying not to be too brazen and is advancing his ideas cautiously.

Williams told reporters in early November that he favors discussing a new framework now, though he doesn’t want to tie the talks to near-term strategy. “It would be optimal to have a decision around what’s the best framework that we should be using well before the next recession,” he said, because it will “take some time” for officials to hammer out such an important policy. Alternative approaches could include allowing prices to overshoot for the same amount of time they undershot — commonly called price-level targeting — or even raising the desired inflation goal to 3 percent.

There we have it, just more confirmation that central bankers are, at heart, inflation junkies. Yep…we knew it all along, of course, but it’s fascinating to watch them articulate it in an innocent manner. As Bloomberg informs us, yet another Fed Governor, Harker, is ready to overhaul policy when Powell sits in the Chairman’s chair.

“There’s a host of possible options, and I have not settled on any one of those yet,” but it merits a discussion “now,” Philadelphia Fed President Patrick Harker said in an interview with Bloomberg News earlier this month.


“This is a discussion we’re going to have to have within the Fed, and within the broad economic community."


There’s good reason to discuss the future of monetary policy now. The unemployment rate is low and growth is humming along steadily, and though inflation remains below target, officials expect it to pick up in coming months.


In this period of economic calm, economists can debate the merits of different approaches slowly and carefully. “Developing a new framework prior to the next zero-lower bound episode allows time for a shift in the nature of forward guidance — and communications more generally,” Evans said Tuesday in Frankfurt. The policies would then be better understood, better refined, and “therefore, likely be more effective,” he said.

So we need to prepare for a change in Fed policy and one that justifies a higher inflation target. Were they to achieve this target, it will obviously be bad news for the 80% of American’s whose incomes are already trailing the cost of living as we discussed.

But being stupid in an intellectual way is a defining characteristic of this generation of central bankers.



Fed Hints During Next Recession It Will Roll Out Income Targeting, NIRP

In a moment of rare insight, two weeks ago in response to a question “Why is establishment media romanticizing communism? Authoritarianism, poverty, starvation, secret police, murder, mass incarceration? WTF?”, we said that this was simply a “prelude to central bank funded universal income”, or in other words, Fed-funded and guaranteed cash for everyone.

On Thursday afternoon, in a stark warning of what’s to come, San Francisco Fed President John Williams confirmed our suspicions when he said that to fight the next recession, global central bankers will be forced to come up with a whole new toolkit of “solutions”, as simply cutting interest rates won’t well, cut it anymore, and in addition to more QE and forward guidance – both of which were used widely in the last recession – the Fed may have to use negative interest rates, as well as untried tools including so-called price-level targeting or nominal-income targeting.

The bolded is a tacit admission that as a result of the aging workforce and the dramatic slack which still remains in the labor force, the US central bank will have to take drastic steps to preserve social order and cohesion.

According to Williams’, Reuters reports, central bankers should take this moment of “relative economic calm” to rethink their approach to monetary policy. Others have echoed Williams’ implicit admission that as a result of 9 years of Fed attempts to stimulate the economy – yet merely ending up with the biggest asset bubble in history – the US finds itself in a dead economic end, such as Chicago Fed Bank President Charles Evans, who recently urged a strategy review at the Fed, but Williams’ call for a worldwide review is considerably more ambitious.

Among Williams’ other suggestions include not only negative interest rates but also raising the inflation target – to 3%, 4% or more, in an attempt to crush debt by making life unbearable for the majority of the population – as it considers new monetary policy frameworks. Still, even the most dovish Fed lunatic has to admit that such strategies would have costs, including those that diverge greatly from the Fed’s current approach. Or maybe not: “price-level targeting, he said, is advantageous because it fits “relatively easily” into the current framework.”

Considering that for the better part of a decade the Fed prescribed lower rates and ZIRP as the cure to the moribund US economy, only to flip and then propose higher rates as the solution to all problems, it is not surprising that even the most insane proposals are currently being contemplated because they fit “relatively easily” into the current framework.

Additionally, confirming that the Fed has learned nothing at all, during a Q&A in San Francisco, Williams said that “negative interest rates need to be on the list” of potential tools the Fed could use in a severe recession. He also said that QE remains more effective in terms of cost-benefit, but “would not exclude that as an option if the circumstances warranted it.”

“If all of us get stuck at the lower bound” then “policy spillovers are far more negative,” Williams said of global economic interconnectedness. “I’m not pushing for” some “United Nations of policy.”

And, touching on our post from mid-September, in which we pointed out that the BOC was preparing to revising its mandate, Williams also said that “the Fed and all central banks should have Canada-like practice of revisiting inflation target every 5 years.”

Meanwhile, the idea of Fed targeting, or funding, “income” is hardly new: back in July, Deutsche Bank was the first institution to admit that the Fed has created “universal basic income for the rich”:

The accommodation and QE have acted as a free insurance policy for the owners of risk, which, given the demographics of stock market participation, in effect has functioned as universal basic income for the rich. It is not difficult to see how disruptive unwind of stimulus could become. Clearly, in this context risk has become a binding constraint.

It is only “symmetric” that everyone else should also benefit from the Fed’s monetary generosity during the next recession. 

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Finally, for those curious what will really happen after the next “great liquidity crisis”, JPM’s Marko Kolanovic laid out a comprehensive checklist one month ago. It predicted not only price targeting (i.e., stocks), but also negative income taxes, progressive corporate taxes, new taxes on tech companies, and, of course, hyperinflation. Here is the excerpt.

What will governments and central banks do in the scenario of a great liquidity crisis? If the standard rate cutting and bond purchases don’t suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor. Other ‘out of the box’ solutions could include a negative income tax (one can call this ‘QE for labor’), progressive corporate tax, universal income and others. To address growing pressure on labor from AI, new taxes or settlements may be levied on Technology companies (for instance, they may be required to pick up the social tab for labor destruction brought by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). While we think unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.


The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968. In 1968, TV and investigative journalism provided a generation of baby boomers access to unfiltered information on social developments such as Vietnam and other proxy wars, Civil rights movements, income inequality, etc. Similar to 1968, the internet today (social media, leaked documents, etc.) provides millennials with unrestricted access to information on a surprisingly similar range of issues. In addition to information, the internet provides a platform for various social groups to become more self-aware, united and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from alt-left to alt-right movements. In fact, many recent developments such as the US presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis. How did markets evolve in the aftermath of 1968? Monetary systems were completely revamped (Bretton Woods), inflation rapidly increased, and equities produced zero returns for a decade. The decade ended with a famously wrong Businessweek article ‘the death of equities’ in 1979.

Kolanovic’s warning may have sounded whimsical one month ago. Now, in light of Williams’ words, it appears that it may serve as a blueprint for what comes next.


Goldman Reveals Its Top Trade Recommendations For 2018

It’s that time of the year again when with just a few weeks left in the year, Goldman unveils its top trade recommendations for the year ahead. And while Goldman’s Top trades for 2016 was an abysmal disaster, with the bank getting stopped out with a loss on virtually all trade recos within weeks after the infamous China crash in early 2016, its 2017 “top trade” recos did far better. Which brings us to Thursday morning, when Goldman just unveiled the first seven of its recommended Top Trades for 2018 which “represent some of the highest conviction market expressions of our economic outlook.”

Without further ado, here are the initial 7 trades (on which Goldman :

  • Top Trade #1: Position for more Fed hikes and a rebuild of term premium by shorting 10-year US Treasuries.
  • Top Trade #2: Go long EUR/JPY for continued rotation around a flat Dollar.
  • Top Trade #3: Go long the EM growth cycle via the MSCI EM stock market index.
  • Top Trade #4: Go long inflation risk premium in the Euro area via EUR 5-year 5-year forward inflation.
  • Top Trade #5: Position for ‘early vs. late’ cycle in EM vs the US by going long the EMBI Global Index against short the US High Yield iBoxx Index.
  • Top Trade #6: Own diversifed Asian growth, and the hedge interest rate risk via FX relative value (Long INR, IDR, KRW vs. short SGD and JPY).
  • Top Trade #7: Go long the global growth and non-oil commodity beta through long BRL, CLP, PEN vs. short USD.

As Goldman’s Francesco Garzarelli writes, “these trades represent some of the highest conviction market expressions of the economic outlook we laid out in the latest Global Economics Analyst, as well as in our Top 10 Market Themes for 2018. Some of the key market themes reflected in our trade recommendations include:

  • Strong and synchronous global expansion. We forecast global n GDP growth of around 4% in both 2017 and 2018, suggesting that next year’s global economy will likely surprise on the upside of consensus expectations.
  • Relatively low recession risk. Given the low inflation and well-anchored inflation expectations across DM economies, we think central banks have little reason to risk ‘murdering’ this expansion with the kind of aggressive rate hikes that would have historically been warranted to fight the risk of inflation becoming entrenched.
  • But relatively high drawdown risk. Even if growth remains strong in the coming year, markets are still susceptible to temporary drawdowns, especially given the high level of valuations. We think the two most prominent risks to markets in 2018 are (1) pressures on US corporate margins from rising wages and 2) a swing in market psychology around the withdrawal of QE, which could lead to a faster re-pricing of interest rate markets than we assume.
  • More room to grow in EM.While most developed economies are currently growing well above potential, most emerging market economies still have room for growth to accelerate in 2018.

More from Goldman:

Our Top Trade recommendations reflect our Top Ten Market Themes for the year ahead. To capture the gradual normalization of the bond term premium and position for a more hawkish path of the Fed funds rate than the market currently expects, we recommend going short 10-year US Treasuries. Given our expectations of a ‘soggy Dollar’ in 2018, we think investors should position for a rotation into Euro area assets and continued Yield Curve Control from the BoJ by going long EUR/JPY. We expect EM growth to accelerate further in the coming year and suggest going long the EM growth cycle via the MSCI EM stock market index. At the same time, the EM credit cycle appears ‘younger and friendlier’ than the ageing US credit cycle, so we recommend going long the EMBI Global against US High-Yield credit. The combination of solid global growth and supportive domestic factors should help the Indonesian Rupiah, the Indian Rupee and Korean Won rally in 2018, while we expect the low-yielding Singaporean Dollar and Japanese Yen to underperform. Since the strong global demand environment should also help the commodity complex perform well but commodities as an investment carry poorly, we recommend going long BRL, CLP and PEN to gain diversified exposure to the commodities story.

And some more details on the individual trades:

Top Trade #1: Position for more Fed hikes and a rebuild of ‘term premium’ by shorting 10-year US Treasuries

Go short 10-year US Treasuries with a target of 3.0% and a stop at 2.0%.

We forecast that the yield on 10-year US Treasury Notes will head towards 3% next year, levels last seen before the decline in oil prices in 2014. By contrast, the market discounts that 10-year yields will be at 2.5% at the end of 2018, a meagre 20bp above spot levels. Our view builds on two main assumptions. First, QE and negative rate policies conducted by central banks in Europe and Japan have amplified the fall in  the term premium on bonds globally and have contributed to flatten the US yield curve this year – a central ingredient in our macro rates strategy for 2017. As a result of this, we think that US monetary conditions are too accommodative for the Fed’s comfort in light of the little spare capacity left in the jobs market. This will likely lead the FOMC to deliver policy rate hikes in excess of those discounted by the market (Exhibit 1). On our US Economists’ baseline projections, Dec 2018 Eurodollar futures, trading at an implied yield of 2.0%, will settle at 2.5%.

Second, we expect a normalization in the US bond term premium from the current exceptionally low levels over the coming quarters (Exhibit 2). This will reflect the compounding of two forces. One is an increase  in inflation uncertainty as the economic cycle continues to mature. The other reflects the interplay of the lower amount of Treasury bonds that the Fed will roll over (quantitative tightening, QT) and higher Treasury issuance. We expect these dynamics to come to the fore particularly in the second half of the year.

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Top Trade #2: Go long EUR/JPY for continued rotation around a flat Dollar

Go long EUR/JPY with a target of 140 and a stop at 130.

Although most economies are sharing in the upturn in global activity, there remains scope for divergence in capital flows and therefore FX performance. Among the major developed markets, we think this is particularly true for the Euro and Yen. We expect both currencies to head back to one twenty—1.20 for EUR and 120 for JPY—over the coming months. We therefore recommend that investors go long the cross, with a target of 140 and stop of 130 (Exhibit 3).

We interpreted the run-up in the Euro in 2017 as a kind of ‘short-covering’ rally. Euro area growth picked up, national politics trended in a favourable direction, and the ECB began to turn its attention away from monetary easing and towards the eventual normalisation in policy by tapering bond purchases. Against this backdrop, many investors seem to have decided that Euro shorts were no longer appropriate—especially given estimates of long-run ‘fair value’ for EUR/USD of around 1.30. Direct measures of investor positioning bear this out. For instance, net speculative Euro length in futures swung from a short of $9bn at the start of the year to a long of $12bn as of last week. These portfolio shifts seem to have more room to run: bond funds remain long USD in aggregate, and FX reserve managers have not started to  cover their substantial EUR underweight. Continued inflows into Euro area assets should support the EUR currency, even as interest rates remain low.

The opposite holds true for the Japanese Yen. Because of the Bank of Japan’s Yield Curve Control (YCC) policy, USD/JPY has remained highly correlated with yields on long-maturity US Treasuries (Exhibit 4). As a result of the recent general election—in which the LDP won another supermajority—a continuation of YCC appears very likely for the time being. Although the policy is beginning to bear fruit—in terms of improving price and wage trends—we suspect that Governor Kuroda (or his possible replacement) will judge these favourable signs as well short of what is needed to consider reversing course. Therefore, with global yields pushing higher on the back of solid growth, we think USD/JPY can again approach its cyclical highs.

* * *

Top Trade #3: Go long the EM growth cycle via the MSCI EM stock market index

Go long EM equities through the MSCI EM Index with a target at 1300 (+15%) and a stop at 1040 (-8%).

As we outline in our Top Themes for 2018, we expect strong and synchronous global growth to continue into 2018. We prefer to own growth exposure in emerging economies, which we think have more room to grow. When EM growth is above-trend and rising, equities typically outperform on a volatility-adjusted basis.

From an earnings perspective, we see much more scope for EM corporates to surprise to the upside, driving equity performance in 2018 (Exhibit 6). MSCI EM EPS have rebounded quite quickly from a six-year stagnation and, in local currency terms, EM earnings per share (EPS) has repaired the ‘damage’ of the 2010-2016 period. We expect MSCI EM EPS to rise another 10% in 2018, which should drive the bulk of the upside in this trade.

From a valuation perspective, EM equities are not cheap relative to their own history (they are currently trading in the 86th percentile of the historical P/E range), but they are cheap relative to US equities (38th percentile of historical relative P/E range), which should hopefully offer some cushion in a global risk-off event. We find that the relative valuation of EM to DM equity is largely influenced by the growth  differential between the two regions; and we forecast this differential to widen another 60bp next year, which in turn should drive EM valuations to expand relative to DM by around 3%. To be sure, a long-only EM equity trade carries significant ‘pullback risk’, especially given the current entry point. Accordingly, we have set a stop on the recommended trade at -8%, which provides enough buffer to accommodate for a shock similar to the EM equity sell-off around the US election. Although EM equities have had a good run in 2017, we do not view the asset class as over-owned. Indeed, the cumulative foreign flow into major EM equity markets is still tracking below historical averages.

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Top Trade #4: Go long the inflation risk premium in the Euro area via EUR 5-year 5-year forward inflation swaps

Go long EUR 5-year 5-year forward inflation with a target of 2.0% and a stop at 1.5%.

We recommend going long Euro area 5-year inflation 5-years forward (henceforth 5y-5y) through EUR inflation swaps, for an target of 2.0% – levels last seen in mid-2014 ahead of the fall in crude oil prices. The rationale for the trade is the following.

First, the risk premium on Euro area forward inflation is currently depressed, offering an attractive entry point. A low inflation risk premium can be inferred from the flat term structure of inflation swap yields. The difference between 5-year inflation, which is priced roughly in line with the expectations of our European Economists (Exhibit 7), and 5y-5y forward is near the lowest levels observed since the 2011 crisis.

Second, the inflation options market assigns high odds to Euro area headline inflation staying at or below 1% over the next 5 years. Against this backdrop, the ECB has reiterated its determination to keep monetary policy accommodative in order to encourage a rebuild of inflationary pressures. With the expansion in activity and job creation likely to continue, we expect the inflation risk premium to increase.

* * *

Top Trade #5: Position for ‘early vs. late’ cycle in EM vs. the US by going long the EMBI Global Index against short the US High Yield iBoxx Index

Go long EM USD credit through the EMBI Global against US High-Yield credit through the iBoxx USD Liquid High Yield Index, with a 1.5×1 notional ratio, indexed at inception to 100, with a total return target at 106 and a stop at 96.

The EM credit cycle is ‘younger and friendlier’ relative to an ageing US corporate credit cycle. With the improvement in macro fundamentals across EM, namely better current account balances, dis-inflation and FX reserve accumulation, we do not see a near-term risk of Dollar funding concerns. While EM credit spreads are not cheap per se, we see relative value against the US High-Yield market. In addition to the growing exposure of the latter to secularly challenged sectors, with the US cycle maturing and profit margins potentially eroding, we see more fundamental concerns in US High-Yield than in the EMBI (of which 70% of the constituents are sovereign bonds and the remainder in ‘quasi-sovereigns’).

Unlike most EM trades, long EM credit vs. US High-Yield has yet to fully recover from the sell-off following the US election. Since the ‘taper tantrum’, EM has generally outperformed with the exception of a few sharp risk-off events that had specific negative-EM implications (such as the sharp decline in oil prices and Russian recession in late 2014/early 2015, and the 2016 US presidential election). However, other risk- off periods, such as the Euro crisis in early 2011, saw EM credit outperform US high-yield.

The relative performance of EM vs. US High-Yield consistently tracks the EM-DM growth differential (Exhibit 10). We expect the general trend of EM outperformance to continue in a pro-risk environment and see the entry point as attractive, albeit admittedly slightly less so following the recent High-Yield sell-off. Finally, this trade is positive carry and should perform well if global spreads move sideways to tighter. We have set the stop at -4%, which coincides roughly with the bottom reached after the US election.

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Top Trade #6: Own diversifed Asian growth, and the hedge the interest rate risk via FX relative value (long INR, IDR, KRW vs. short SGD and JPY)

Go long an equal-weighted basket of INR, IDR, KRW against an equal-weighted  basket of SGD and JPY, indexed at inception to 100, with a total-return target at 110 and stop at 95.

INR, IDR and KRW provide diversified exposure to the strong global growth we forecast in 2018 and specific idiosyncratic factors that should support their currencies in the year ahead. The combination of commodity exporting (IDR) and commodity importing (INR and KRW) currencies on the long leg of the recommended trade offers some protection against swings in commodity prices. By funding out of SGD and JPY, not only do we take advantage of their low yields, but JPY underperformance should also provide a hedge should the move higher in US yields lead to wobbles in the currencies where we recommend being long. The overall trade carries positively to the tune of about 4% over the year.

Country-specific factors in India, Indonesia and South Korea should boost their currencies, on top of the strong global growth environment we expect next year. Specifically:

India’s bank re-capitalization plan should impart a powerful positive impulse to investment in the coming year and should break the vicious cycle of higher non-performing loans, weaker bank balance sheets and slower credit growth. As the drags from GST implementation and de-monetization also fade, we expect growth to move from 6.2% in 2017 to 7.6% in calendar 2018. In addition to the three hikes we expect the Reserve Bank of India to deliver by Q2-2019, the high carry, FDI and equity inflows should also be supportive for the INR. We have moved our 12-month forecast for $/INR stronger to 62.

We continue to see Indonesia as a good carry market. As the drag on domestic consumption from the tax amnesty fades in 2018, we expect economic growth to move up to 5.8% in 2018 (from 5.2% in 2017), while the current account, inflation, and fiscal deficit should remain stable. We think Bank Indonesia is done easing and should move to hike rates by 50bp in H2-2018. We also expect Indonesia to be included in the Global Aggregate bond index, which could prompt one-off inflows worth US$5bn in Q1-2018 (vs. US$10bn bond inflows YTD in 2017). We have moved our 12-month forecast for $/IDR stronger to 13000. Finally, Indonesia, like India, has accumulated reserves over the past year that now stand at record high levels and should help mitigate volatility.

We expect the KRW to outperform other low-yielding Asian peers in 2018. The strong memory chip cycle should extend at least through H1-2018, while the government’s income-led growth policy provides a fiscal boost. Together with the boost from improving exports, this should allow the Bank of Korea to withdraw monetary accommodation in the face of rising financial stability concerns, with three policy rate hikes to 2.0% penciled in by the end of 2018. The thawing of China/South Korea relations and rebound in Chinese tourists should also help the travel balance. Overall, we expect the current account to remain stable at around 5% of GDP in 2018. Further deregulation in outbound capital flows could temper KRW strength over the medium term, but might not pass the National Assembly in the near future given  fragmentation in the legislative body. Our 12-month forecast for $/KRW is now stronger at 1060.

On the funding side, not only do SGD and JPY offer a low yield, we expect them to underperform in the year ahead. While we expect the Monetary Authority of Singapore to steepen its appreciation bias in October, we do not expect any significant SGD appreciation versus Asian peers given that the SGD is already trading on the strong side of the policy band. Meanwhile, we forecast USD/JPY at 120 in 12 months. With the BoJ controlling the yield curve as US rates move higher, JPY should continue to weaken, especially if US rates move higher than the forwards discount, as we expect.

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Top Trade #7: Go long the global growth and non-oil commodity ‘beta’ through BRL, CLP, PEN vs. short USD

Go long a volatility-weighted basket of BRL, CLP and PEN (weights of 0.25, 0.25 and 0.5) against USD, indexed at inception to 100, with a total return target of 108 and a stop at 96.

The ongoing strength of global growth should continue to support a rally in most industrial metal prices. Our seventh Top Trade recommendation aims to capture this dynamic by going long the ‘growth and metals beta’. All three currencies on the long side have reliably responded to upswings in global trade and external demand over the past two decades. Moreover, each has performed particularly well in the pre-crisis decade, a period that also featured strong global growth and buoyant industrial metals prices. CLP offers direct exposure to a particularly encouraging story in copper, while BRL and PEN provide more varied metals exposures. The recommended trade has a positive carry of roughly 2.5% a year, and our 12-month forecasts are stronger than the forwards in all cases: we forecast USD/BRL at 3.10 in 12 months, USD/CLP at 605 in 12 months and USD/PEN at 3.15 in 12 months.

Beyond these global factors, our recommended Top Trade allows for diversified exposure to an encouraging Latin American growth recovery. Not only should growth in Brazil pick up as it recovers from a deep recession (and a recent BRL sell-off, creating an attractive entry-point), but BRL screens as strongly undervalued on our GSFEER currency model due to a combination of contained inflation and current account rebalancing, making BRL an attractive high carry currency. Meanwhile, PEN – the low-vol ‘tortoise’ of Andean FX – offers exposure to one of the most attractive valuation stories in the EM low- to mid-yielder space. Last but not least, CLP – the ‘hare’ of Andean FX – has moved quickly in 2017, so sends a somewhat less attractive valuation signal, but provides direct exposure to our most encouraging metals view, copper, and what opinion polls suggest is likely to be a market-friendly outcome in the upcoming Chilean election.

Finally, although it is designed for our global base case of strong growth, our Top Trade #7 can perform well in other external environments, potentially including a global growth disappointment. In particular, while BRL is a high-yielding and ‘equity-like’ currency, CLP and PEN are each lower-yielding and more ‘debt-like’: they have historically shown relatively resilient performance vs. the USD during periods of both declining growth and falling core rates.


Axel Merk: Tax Reform Implications For Gold

Authored by Axel Merk via Merk Investments,

Last week, I got several calls asking me how U.S. tax reform will impact the price of gold. If you can answer this question, you might be able to answer how tax reform will impact other assets. Let me explain.

If you were to analyze the impact of any tax changes on any asset, you have two sets of dynamics to consider: those of the tax reform and those of the asset. What makes the comparison to gold unique is that gold is, if I may call it such, the purest of all assets because it doesn’t change. It is the world around it that changes.

Monetary policy affects nominal prices, whereas fiscal policy affects real prices. That is, printing money might affect the price level, but fiscal policy affects where money gets allocated, and what investments take place. I would like to caution that not everyone agrees, especially with regard to monetary policy, but even if you do not fully agree, bear with me, as a simplified model might help in understanding price dynamics.

When held in a vault (rather than leased out), gold doesn’t generate cash flow. Investors have the choice of investing in a so-called productive asset that generates cash flow; or to park it in something unproductive, such as a hundred-dollar bill in your pocket; or gold. While there’s a convenience factor to the hundred-dollar bill to use for purchases, most would agree depositing the cash in an interest-bearing deposit may be worth the risk. There’s the risk of the default of the counter-party. For bank deposits, FDIC insurance tends to mitigate the risk; and for Treasury Bills or Treasury bonds, there is the full faith of the U.S. government that the principal will be paid back. Yet Treasuries aren’t entirely risk free: the longer you commit your money for, the more interest rate risk you bear (the market value of Treasuries tends to fluctuate the further out the maturity even if the principal is not at risk); and while the US government guarantees to pay back the principal value of its debt, it doesn’t guarantee it will have the same purchasing power at maturity. The chart below shows the purchasing power of the U.S. dollar since December 1970, that is, the purchasing power of your hundred-dollar bill when sitting in your pocket:

This illustrates why the price of gold has appreciated: at the end of 1970, an ounce of gold cost less than $40; currently, it costs over $1,200 an ounce. The gold never changed, but the purchasing power of the dollar has eroded. Indeed, since 1970, the price of gold has appreciated substantially more than the purchasing power of the dollar has declined, suggesting the price of gold is influenced by more than merely the consumer price index.

In my assessment, a key driver of the price of gold is the real rate of return available on other investments. The benchmark for these “other” investments for U.S. dollar based investors is the so-called risk-free investment: Treasuries. Most people don’t walk around with hundred-dollar bills in their pocket, they make a conscious decision how to allocate their money. If they get compensated more for holding Treasuries, the price of gold may suffer (again: because gold is the constant here).

As such, if one believes tax reform increases the real rate of return on investments, the price of gold – all else equal – may suffer. When President Trump was elected, after the brief overnight spout of volatility, the price of gold fell as Treasury yields rose. I argued at the time that the market was pricing in higher real rates of return. In the subsequent months, the so-called Trump trade fizzled out as, and that’s my interpretation, the market priced in lower odds of meaningful tax reform.

In recent weeks, the price of gold has experienced some softness, as Treasuries have fallen once again. Note that the correlation between bonds and gold is currently elevated, but that this relationship is by no means stable. That’s why I earlier used the qualifier “all else equal”. In that context, is the most recent weakness in the price of gold due to more hawkish talk at the Federal Reserve, i.e. due to monetary factors, or due to the tax reform framework announced by the Administration, i.e. fiscal factors?

Let’s look at each, then broaden the discussion.

If you believe that the tax proposals will a) meaningfully alter the long-term growth prospects of the U.S. economy; and b) will be implemented, then odds are downward pressure is exerted on the price of gold.

Note there is a different between tax cuts and tax reform. Imposing a lower tax rate may be a short-term stimulus, but it may not fundamentally alter investor behavior. Take the estate tax, for example: let’s assume for a moment the estate tax will be eliminated (the odds of that passing are rather low), but that the elimination will expire after 10 years. Many tax provisions expire after 10 years as that’s how they get passed under Senate budget reconciliation rules requiring only a simple majority. If you are a wealthy foreign individual considering relocating to the U.S., and your life expectancy is greater than ten years, the change in tax code would unlikely change your behavior. Had this person relocated to the U.S., even as a retiree, he or she likely would have spent substantial money over the rest of his or her lifetime, contributing to higher U.S. growth.

The estate tax example is easy to visualize, even if the total impact of the estate tax is rather small. The same applies to other provisions in the tax code as well, though. For example, if U.S. companies have a long-term assurance that they won’t be taxed on income abroad, they can make resource allocation decisions based on where they believe money is best deployed rather than based on quirks in the tax code encouraging them to shield it from the IRS.

There’s also an argument to be made that long-term investors in the U.S. want to see the U.S. budget be on a fiscally sustainable course.

Because if the U.S. is on a fiscally irresponsible course, odds are, the government will at some point take the money from those who have it (and/or cut benefits; or be unable to keep up the infrastructure, etc.).

That said, one should not get too carried away with the politics. It’s not that each proposal by your favorite party is good; and the end of the world is about to come when ‘the other’ party wins. To pass through Congress, most tax proposals are substantially watered down. Indeed, the Administration’s proposal has lots of wiggle room, suggesting already that the final product, if any, may not hold up to the rhetoric: the blueprint proposed leaves open the possibility that the U.S. will not fully embrace a territorial tax system (i.e. no longer tax earnings abroad); it also leaves open the introduction of a higher tax rate for top earners, amongst others. Given the failure to pass healthcare reform, one shall be excused to be a cynic about the odds of tax reform passing as well.

Needless to say, my own assessment is that we might get a few tweaks in the tax code, but odds are low that it will be a structural transformation causing real growth to substantially change. I have not been able to identify attributes in the market that suggest otherwise. By all means, if you draw different conclusions, this is intended as a framework to think about the issue rather than a crystal ball.

So how come the price of gold has weakened since the announcement of the Administration’s plan for tax reform? Nothing ever happens in a vacuum: we also had the Federal Reserve meet and provide a more hawkish outlook; several economic indicators were positive, causing Treasuries to fall. There were also some global events that I won’t digress to for the simplicity of the argument here.

With regard to the Federal Reserve, I would like to make two comments: the tail-wagging-the-dog argument, as well as one on risk premia:

With regard to tail-wagging: it’s been my impression that the Fed would like to raise rates, but only as long as financial conditions don’t deteriorate. That’s a bit of an oxymoron as the whole purpose of rate hikes is to tighten financial conditions. In my view, the Fed is concerned about a sell-off in asset prices. According to what a former regional Fed President once told me, under normal circumstances, the Fed would not worry about asset prices; unless, that is, they created a bubble. Differently said, when the markets behave, expect hawkish Fed talk. But let the markets have a hiccup, and those good intentions are thrown out of the window. And since the markets have behaved, the Fed’s most recent talk has been hawkish. That puts a short-term dampener on the price of gold (but may be a buying opportunity if one believes this hawkishness won’t translate into higher real rates).


The other attribute is risk premia. The Fed has announced it will reduce the size of its balance sheet. I have seen Fed studies that suggest this will lead to lower bond prices (higher yields). I disagree. I believe it will lead to higher risk premia. Quantitative Easing (QE) cause the spreads between junk bonds and Treasuries to narrow; more broadly speaking, so-called risk assets rose in price; with regard to stocks, the lower volatility, in my opinion, is a direct result of QE. In contrast, in my view, Quantitative Tightening (QT) will expand risk premia. That is, risk assets are at risk of falling as volatility increases; such volatility is often associated with a “flight to safety”, i.e. purchases of Treasuries. But, and here we go back to the tail-wagging argument, the Fed doesn’t want asset prices to plunge. And, hence, the Fed is telling us QT is akin to watching paint dry. Sticking with abbreviations, the paint-drying argument is, in the opinion of yours truly, a bunch of BS.

Circling back to the price of gold: my framework is that the reason risk assets tend to fall as volatility rises is because the cash flow of said assets gets discounted more (the cost of capital is a function of the risk/volatility). As gold does not have cash flow, it shines in contrast when volatility rises.
And with that, I make assertions not just about the price of gold, but asset prices in general:

  • The benchmark of risk is Treasuries, the risk-free rate of return. That’s why it is so important to know what the Fed is up to (and so bad to have a tail-wagging-the-dog Fed).
  • To the extent tax reform affects expectations of real returns, it affects Treasuries.
  • The lower real rates of returns are, the more favorable for the price of gold and vice versa.
  • Risk assets trade at a discount to the risk-free asset (“discount” w.r.t. fixed income means the yields are generally higher). That discount varies based on financial conditions.
  • The lower risk premia are (high complacency/favorable financial conditions), the more favorable for risk assets.
  • Higher risk risk premia (fear) tends to be favorable for the price of gold.
  • QE compressed risk premia; QT will cause risk premia to expand.

In other words: don’t expect much from the tax reform, consider holding gold as a diversifier in your portfolio and buckle up, the unwinding of the Fed’s balance sheet may cause some sparks.


Central Banks Finally Hit Their Targets… Just In Time For Another Crisis

They finally did it.

Since 2008, Central Banks have been desperately trying to generate inflation.

They know they cannot produce growth (hence why both the Fed and the ECB abandoned this as a goal in their statements back in 2013)… so they have chosen to “target” inflation.

To that end, Central Banks have maintained Zero Interest Rate Policy (ZIRP) as well as Negative Interest Rate Policy (NIRP) for the better part of eight years. They’ve also printed over $14 TRILLION in new capital and funneled it into the financial system.

These two policies failed to create inflation for the simple reason that the money never made it into the economy. Banks simply were not lending. So all this cheap money just sat on bank balance sheets (earning interest for the banks) and the velocity of money continued to drop in a deflationary spiral.

This all changed in August 2016.

That’s when the Bank of Japan began a policy of targeting a 0% yield on the 10-Year Japanese Government Bond or JGB.

And this was a game-changer.

Instead of periodically buying bonds from banks (which would then park this cash on their balance sheets) this policy opened the door to endless money printing.

Put simply, if the yield on the 10-Year JGB rose above 0%, the Bank of Japan would simply print Yen to buy bonds, thereby driving the yield down.

And unlike QE, which is usually limited in both scope and time period, this policy is open-ended and can occur as frequently and for as long as the financial system can take it.

Put simply, the Bank of Japan began a campaign of abject intervention in the bond markets. And it has unleashed a tsunami of liquidity into the system.

Indeed, between this, and the ECB’s decision to maintain “emergency” levels of QE despite the fact that the EU’s economy is not only well out of crisis-mode but is in fact now in danger of heating up too rapidly, inflation has finally arrived in the financial system.

Why does this matter?

Because the Bond Bubble trades based on inflation.

When inflation rises, so do bond yields to compensate.

When bond yields rise, bond prices FALL..

And when bond prices fall, the Everything Bubble bursts.

With that in mind, take a look at global bond yields and you will see them breaking out to the upside across the board. Indeed, Japan’s 10-year JGBs (bottom box in the chart) are the only bonds to remain below their long-term downward trendlines and that’s because of the aforementioned ABJECT intervention!

Put simply, BIG INFLATION is THE BIG MONEY trend today. And smart investors will use it to generate literal fortunes.

Imagine if you'd prepared your portfolio for a collapse in Tech Stocks in 2000… or a collapse in banks in 2008? Imagine just how much money you could have made with the right investments.

THAT is the kind of potential we have today. And if you're not already taking steps to prepare for this, it's time to get a move on.

We just published a Special Investment Report concerning FIVE secret investments you can use to make inflation pay you as it rips through the financial system in the months ahead

The report is titled Survive the Inflationary Storm. And it explains in very simply terms how to make inflation PAY YOU via smart investment strategies.

We are making just 100 copies available to the public.

To pick up yours, swing by:


Best Regards

Graham Summers

Chief Market Strategist


Stockman Warns “Mind The Junk” – This Ain’t Your Grandfather’s Capitalism

Authored by David Stockman via Contra Corner blog,

The financial system is loaded with anomalies, deformations and mispricings – outcomes which would never occur on an honest free market. For example, the junk bond yield at just 2% in Europe is now below that of the "risk-free" US treasury bond owing solely to the depredations of the ECB.

Indeed, madman Draghi has purchased $2.6 trillion of securities since launching QE in March 2015, and during the interim has actually bought more government debt than was issued by all the socialist governments of the EU-19 combined!

Euro Area Central Bank Balance Sheet

Outrunning Europe's deficit-addicted welfare states is quite a feat in itself, but that wasn't the half of it. The ECB's printing press became so parched for government debt to buy that it has ended up owning more than $120 billion of corporate bonds. In some recent cases, the ECB has actually taking down 20% or more of new corporate issues—an action that surely leaves the fastidious founders of its Bundesbank prodecessor turning in their graves.

In turn, the ECB's Big Fat Thumb on the investment grade scale stampeded fund managers into the junk market in quest of yield, especially for BB rated paper which makes up 75% of the European high yield market. So doing, these return hungry managers have crushed the the yield on the Merrill Lynch junk bond index, driving it down from 6.4% in early 2106 to an incredible 2.002% last week.

That is to say, leveraged speculators in European junk have made 100% plus returns over the last 20 months on dodgy paper that should be yielding double or triple its current rate.

In fact, the current lunatic euro-trash yield is completely off the historical charts. Euro-junk rarely yielded under 5% in the past, and had spiked to upwards of 10% at the time of Draghi's "whatever it takes" ukase, which, in turn, was modest compared to the 25% blow-0ff high during the depths of the financial crisis.

Then again, there has rarely been a greater gift to speculators. The front-runners who took Draghi at his word back in 2012 have made 1000% returns. On bonds!

Needless to say, these utterly false price signals would never occur on the free market. Yet by attracting tens of billions of yield-seeking capital into radically mispriced securities in pursuit of the giant windfalls depicted above, the ECB has not only set-up speculators for massive losses, but also badly distorted the macro-economy in the process.

That is, after years of ZIRP Europe's business sector has become populated with debt-ridden zombies which survive only because their interest carry costs have essentially been eliminated. Consequently, the free market's essential function of pruning the deadwood and re-allocating inefficiently used resources has been stopped cold on much of the continent.

But to add insult to injury, Draghi has given these zombies the financial equivalent of mouth-to-mouth respiration. That is, the ECB has made junk bond yields so cheap that debt-encumbered businesses have been able to further extend and pretend—-that is, refinance higher cost bank lines and earlier bond issues with 2% money; it's just another example of a central bank driven refi machine at work.

Even the US debt junkies have gotten in on the act—with North American issuers estimated to place more than $125 billion in the euro-debt market during 2017—including upwards of $20 billion of high yield bonds. The pitifully low yield on these issues, in turn, has been arbed across the Atlantic, meaning further suppression of rates in the New York dollar markets.

Needless to say, any free market economist worth his salt recognizes the long-run folly of subsidizing loss making companies. But there is also a larger and more immediate repercussion for the day-traders and robo-machines which prowl the casino in search of instant riches.

To wit, the central bank fueled scramble for yield among bond managers—-and especially those running open-end bond funds—–has created a giant trading trap. Owing to the explosion of corporate, real estate and sovereign debt since the turn of the century, there are now trillions of bonds held by investment vehicles subject to daily redemptions.

At the same time, the drastic shrinkage of dealer balance sheets since the traumas of 2008 and the subsequent avalanche of Dodd-Frank regulatory harassment means that true liquidity has all but disappeared from the bond market—-and most especially the high yield sector which has nearly doubled in size since the crisis.

What that adds up to—-trillions of paper funded with what amounts to mutual fund demand deposits in a market with drastically shrunken dealer liquidity—is not hard to imagine. Namely, the punters who have been pleasured with vast riches by the ECB are now getting 2% yields for the privilege of evenutally being crushed by what will be the mother of all bank runs.

Not only has the absolute yield level on junk been badly distorted by the ECB's heavy handed buying (it now owns upward of 12% all euro-area corporate bonds), but the all important spread against the risk free rate has also been crushed. In recent months it actually broke through 150 basis points, representing half the level prevailing as recently as June 2016.

Stated differently, Draghi—-like all other Keynesian central bankers—-is pleased to believe that he is deftly guiding the great macro-variables of GDP, inflation, growth and wages. In fact, the ECB's heavy intrusion in money and capital markets have demolished the price signaling mechanisms of the financial system, turning yields, spreads and asset prices into momentum-driven noise.

And "noise" is the word for it because sustained central bank financial repression infects and deforms all financial information.

Indeed, this kind of fake financial information is what causes the talking heads of bubblevision to ignore the aforementioned mispricings and spread narrowings. They believe it's all warranted.

That is to say, credit loss rates have plunged into subterranean levels—so what's to worry? Arguably, even today miserly 5.6% yield in the US junk market (see below) more than covers inflation and realized default rates of 2-3% recorded during recent years.

Except they don't. What the graph below actually shows is the cyclically punctuated impact of the great game of kicking the financial can. Central bank financial repression engenders a scramble for yield during the expansion phase of the cycle which permits all except the most hopeless borrowers to refinance, thereby avoiding default by hitting the restart button.

This extend and pretend "refi" cycle is identical to what happened to the subprime mortgage market prior to the housing crash. Default rates were unusually low as long as the cripples could be refinanced, but when new mortgage funding dried up Warren Buffett's famous aphorism about naked swimmers exposed by a receding tide came true in spades.

Default rates suddenly soared, causing the mortgage crisis to spring to life seemingly out of nowhere. In effect, interest rate repression causes default rate suppression, thereby turning standard financial information into misleading statistical noise.

The world's $4 trillion junk debt market is the next poster boy for exactly that kind of springing default surge. If you look at maturity schedules, in fact, you see a huge bow-wave building-up from 2018-2022. Subtract seven years for the standard bond term and you get exactly the valley in default rates shown below for 2011 thru 2016. That is, the refi machine was working overtime.

Most everyone paid or PIK'd (paid in kind) because the yield starved market was desperately hungry for product. So hungry, in fact, that nearly $200 billion of junk has been issued to fund dividends to LBO sponsors.

Moreover, even the slight default rate bulge in 2016 was not due to the refi machine faltering so much as it reflected some very big and concentrated defaults in the shale patch.

Even then, it is crucially important to understand that the historical long-term default average of 4% is not nearly what it is cracked-up to be. That's because the modern age of original issue junk finance (as opposed to "fallen angels" in the secondary markets that Michael Milken pioneered before 1984) is essentially coterminous with the Greenspan era of Bubble Finance.

Accordingly, the two big spikes in the chart below represent a case of defaultus interuptus. Before the markets could be fully purged of the rotten credits which had built up earlier, the Fed flooded Wall Street with liquidity in 2001-2003 and again in 2008-09, thereby igniting a bid for deeply discounted junk as measured by yields that hit 20% or higher.

In turn, as yields were driven back toward the normal range early speculators pocketed enormous capital gains, triggering an additional surge of capital into the market. At length, ample demand for junk bonds enabled a renewed cycle of extend and pretend.

But here's the thing. The Fed is out of dry powder and stranded close to the zero-bound, as is the ECB, the BOJ, the BOE and most other central banks. Accordingly, this time there will be no massive central bank reflation and no consequent rip-your-face-off rally in busted junk.

That is to say, it will be a case of "no ticky, no washy". When the current bow wave of maturities unfolds over the next five years, the refi machine is likely to be severely disabled, if not shutdown entirely in the context of central bank balance sheet normalization and rising yields.

Yet in the absence of extend and pretend refi, defaults will rise significantly, thereby triggering capital flight from the junk market. And then there will follow a downward spiral of busted maturities and even further increases in the default rate.

In short, the go-forward default rate is like to be a lot more than the 4% historical average, and its likely to hang around the basket for years to come. At that point, noise will give way to signal. But not of a good kind for speculators.

Image result for images of junk bond default rates

Needless to say, if bond yields should equal inflation, credit losses and return, there's no room for all three in the current 5.6% yield on the US junk bond index. Indeed, the chart below exhibits a double whammy of Fed financial repression. The 10–year treasury yield at 2.33% today barely covers inflation—to say nothing of an after-tax return.

But only three points of spread on top of that is completely ludicrous. It can't begin to compensate for the drastically heightened risks of a business expansion which is already 101 months old and default rates that are fixing to spring out of their extend and pretend disguise.

In this context, we must note again that the GOP is missing what ails the American economy by a country mile. Republicans have become like the proverbial carpenter whose only tool is a hammer. So everything in the economic world looks like a nail—that is, a situation that can be remedied by a tax cut.

Not at all. The entire signaling system of American capitalism has been destroyed by the Fed. The lowest interest rates and capital cost in recorded history have not caused an explosion of capital spending and growth-enhancing productivity as intended.

In fact, real net business investment is still 35% below its turn of the century level, but that isn't due to high or rising taxes or inadequate after-tax returns.


To the contrary, capital is being artificially diverted into unprodutive speculative arenas. Central bank yield suppression has spurred massive amounts of financial engineering in the C-suites in response to the demand for never ending appreciation of secondary assets in the casino. As we indicated yesterday:

….. the growth and jobs problem in America originates in the Fed, not the IRS code; and that by focusing on the latter—-even as it punts on the former—- the GOP is truly earning its moniker as the Stupid Party.


That is, Trump and the GOP Senate potentially have five seats to fill on the Fed and could therefore end the current baleful regime of massive, fraudulent money printing and the destructive falsification of financial asset prices which inherently results therefrom.


So doing, they could bring honest price discovery, risk exposure, financial discipline and efficient two-way markets back into the Wall Street casino. Allowing free markets to clear the price of money, debt and stocks, in turn, would quickly shut down the financial engineering mania that now obsesses the corporate C-suites and which has caused trillions of corporate cash flow and balance sheet capacity to be diverted to stock buybacks, M&A deals and LBOs.

Needless to say, restoration of honest price discovery on Wall Street is not going to happen any time soon with a "low interest guy" in the Oval Office and another one soon to take the helm at the Fed. Indeed,  Jerome Powell voted for the destructive financial repression described above 44 consecutive times during his tenure on the Fed since early 2012.

Accordingly, what passes for financial markets will remain in fantasy-land for a time longer, deluded by the fake signals embedded in the in-coming economic and financial noise. As one bond manager noted in response to the hiccup in the high yield market during the past 10 days, why worry?

There’s stress in significant pieces of the markets, like health care and telecom, and I am not ignoring them,” Ken Monaghan, director of global high yield at Amundi Pioneer, said in an interview. “But we aren’t seeing some sort of cataclysmic event on the horizon, and I am not expecting many sleepless nights anytime soon.”

Well, here's why sleepless nights are exactly what will be coming down the pike right soon. Among many things that would not exist in an honest financial market are most LBO's. These are the ultimate financial engineering scheme enabled by cheap junk debt and a central bank safety net under extreme leverage.

Moreover, crashing LBOs were a material component of the crash back in 2008, but self-evidently no lessons were learned. Virtually all of the $10-$40 billion zombies from that era were eventually refinanced and "restructured" in a soaring junk bond market.

Not surprisingly, LBO volumes have been steadily building—although the number of companies left in America that have not been squeezed lean and mean by existing options chasing managements are few and far between. In fact, an increasing share of buyouts are second and third generation LBOs—–the work of private equity punters swapping their debt mules.

Image result for images of us M&A deals by dollar value

And they are doing so at the highest prices in history–without regard for the cardinal fact that the era of falling yields and relentlessly declining cap rates is over. Even if these LBOs made economic sense, which they don't, they should be exhibiting falling valuation multiples as the era of QT and monetary normalization sets in.

Stated differently, the private equity boys are pricing deals based on the artificially low cost of the junk debt in their capital structures—plus an equity multiple that assumes that current stock market bubble will never correct. Indeed, as shown below, the equity multiple of 4.7X is now 30% higher than it was back in 2007 on the eve of the last great bubble collapse.

And that gets us back to our theme. The present world of monetary central planning and relentless financial repression has produced endless deformations and anomalies that would not exist on the free market. They are therefore not sustainable in the present world, either, because at the end of the day even central banks cannot defy the laws of economics and sound finance indefinitely.

So there will be crashing LBOs, bleeding junk bonds and plunging stock market indices in the roadway just ahead.

Indeed, that something is very wrong in Denmark, in fact, was dramatized  by today's story de jure in the financial press. To wit, it seems that Warren Buffett, Jeff Bezos and Bill Gates have more net worth ($280 billion) than the bottom 50% of the US population; and that the Forbes 400 has more net worth than the bottom two-thirds of all American households.

That wouldn't happen on the free market, either.

So mind the junk. What is now unfolding is most definitely not your grandfather's kind of capitalist prosperity.


Consumer Confidence Unexpectedly Drops On Inflation, Rate-Hike Fears

UMich consumer sentiment declined from 100.7 to 97.8 in the preliminary November print, disappointing expectations of a small rise as anticipation of a pickup in inflation and higher interest rates weighed on the gauge.

Even with the decline, sentiment was the second-highest since January, reinforcing other reports that Americans remain optimistic about employment and the economy.

Other highlights include:

  • Consumers saw the inflation rate in the next year at 2.6 percent, up from 2.4 percent the prior month
  • Consumers expected an annual income gain of 2.1 percent for the second straight month, the best two-period average since 2008
  • Inflation rate over next five to 10 years held at 2.5 percent
  • Six in 10 consumers saw stock-market gains as likely in the year ahead
  • References to low mortgage rates fell to 32 percent in early November from 40 percent last month

Consumers (and policy makers) have four key concerns: prospective trends in jobs, wages, inflation, and interest rates. An improving labor market was spontaneously mentioned by a record number of consumers in early November, and anticipated wage gains recorded their highest two-month level in a decade. These favorable trends were countered by a slight rise in year-ahead inflation expectations and a growing consensus that interest rates will increase during the year ahead.

Americans are as exuberant about their wealth effect as they were at the peak ahead of the last crisis…

“While the majority judged current conditions in the economy favorably and consumers anticipated continued growth on balance, consumers judged the outlook less satisfactory, and were equally divided about whether the expansion would last another five years,” Richard Curtin, director of the University of Michigan consumer survey, said in a statement.


“This Looks More Frightening”: Global Stock, Bond Selloff Accelerates Amid Risk-Parity Rumblings

Yesterday’s Japan flash-crash inspired selling continues for a second day, with global equities – and bonds – sliding early Friday on concerns U.S. tax reform – and corporate tax cuts – will be delayed after Senate Republicans unveiled a plan that differed significantly from the House of Representatives’ version. After suffering their biggest plunge in 4 months on Thursday, European stocks failed to find a bid along with Asian stocks, while U.S. index futures pointed to a lower open (ES -0.5%, or -10), the Nikkei 225 ended 0.8% lower, Treasuries yields are up 1-4bps across the curve in steepening fashion, with the 10y at 2.370%, while the Bloomberg Dollar Spot Index declined for a third day. The VIX has jumped 6% this morning trading through 11 while WTI crude oil is little changed trading north of $57/bbl.

And here is one for the streak watchers: on Thursday the global MSCI index failed by one day to post its longest winning streak since 2003 as it fell 0.4% following 10 days straight of gains. The MSCI world index gained more than 18% so far this year and some investors believe a pullback is due. “I think there’s a feeling out there that there’s a long awaited correction, and no one wants to be caught by surprise,” said Emmanuel Cau, global equity strategist at JP Morgan.  “When the market is down a bit people tend to extrapolate. But I think it’s simply a bit of profit taking and digesting from a very strong September and October.”

Europe’s benchmark Stoxx 600 reversed an early rebound, falling 0.2% on high volume;  It is on track for its worst week in three months, if it falls on Friday , its fourth drop in row. Carmakers and retailers led the index to its biggest two-day drop since August as third-quarter earnings season continues, with aerospace-electronics maker Leonardo SpA crashing 20% after cutting sales forecasts.

In Asia it was more of the same, with stocks declining after a rally that saw them touch a record high less than 48 hours earlier, as shares in Japan extended losses following abrupt swings on Thursday. Asian stocks fell, tracking weakness in U.S. equities after the U.S. Senate released a tax plan that would delay cuts to the corporate rate until 2019, defying President Donald Trump. The MSCI Asia Pacific Index dropped 0.4 percent to 171.18, trimming its weekly advance to 0.8%; The MSCI Asia Pacific ex-Japan index fell 0.3%, while Japan’s Nikkei lost 0.8%, slipping off Thursday’s 21-year high after a 16% rally in the past two months. The decline was led by Japanese equities, which extended a loss Thursday on the heels of the largest one-day swing in a year. The Asian benchmark gauge has risen for six straight weeks, posting gains in 16 of the past 18 weeks. Thursday’s close was less than half a point from a record.

“Investors are unwinding expectations on Trump’s ambitious tax reform,” Margaret Yang, a Singapore-based strategist at CMC, said by phone. “Delay in tax cuts is the perfect excuse to book profits, but long-term fundamentals remain positive for Asian equities.” While most Asian markets fell, Hong Kong stocks traded higher, and Shanghai’s benchmark index headed for its best week since August, led by brokerages.

Meanwhile, in a move that smacks of a risk-parity deleveraging unwind, instead of dipping – as a risk-haven – 10Y TSY yields rose a third day, and core European bond yields followed suit not to mention the ongoing rout in junk bonds.

Indeed, as the Stoxx 600 dropped, Germany leads the bond market lower, sending 10-year Bund yield to a two-week high. Treasuries decline in tandem with the long-end underperforming and finally steepening the 5s30s curve from the narrowest level in a decade.

The world looks, if anything, more frightening given declines in both bonds and stocks,” Ole Hansen, head of commodity strategy at Saxo Bank A/S in Hellerup, Denmark, said by email. “Higher lows and lower highs following the U.S. presidential election a year ago shows a market in need of a proper spark. So far that spark remains illusive.”

In macro, majors FX pairs were trapped in familiar ranges, while bonds stole the spotlight yet again as yields ticked up steadily across traders’ screens; the Bloomberg Dollar Spot Index attempted a feeble recovery after short-term accounts took profit on shorts, but the gains lacked conviction; the pound flapped about, seeking a decisive direction, ahead of a key Brexit briefing; Treasury 10-year yields were inching closer toward the key 2.40% level. WTI crude was steady above $57 a barrel.

The catalyst for the move was yesterday’s tax reform fireworks, where Republican senators said they wanted to slash the corporate tax rate in 2019, later than the House’s proposed schedule of 2018, complicating a push for the biggest overhaul of U.S. tax law since the 1980s. The House was set to vote on its measure next week. But the Senate’s timetable was less clear.

“Things look fluid, including on when the tax cut deal will be reached,” said Hirokazu Kabeya, chief global strategist at Daiwa Securities.  “I would say a compromise will be reached …But if they indeed decide to delay the tax cut by a year, there is likely to be some disappointment.”

In FX, the euro declined 0.1% to 1.1641, while sterling was 0.1% higher  at 1.3162.

In rates, the 10y TSY rose to 2.3753% , while Bund yields, as noted above, climbed to their highest level in over a week as euro zone bonds sold off across the board for a second consecutive day. The yield on Germany’s 10-year bund hit 0.40% for the first time since Oct. 27.

Among commodities, oil prices steadied on expectations of supply cuts by major exporters as well as continuing concern about political developments in Saudi Arabia. A spokesman for Saudi Arabia’s energy ministry said the kingdom planned to cut crude exports by 120,000 barrels per day in December from November. Brent crude was at $64.01 per barrel, close to the 2-year high of $64.65 reached earlier this week. WTI traded at $57.17, also just shy of this week’s more than two-year high of $57.69. Concerns about the stability of Saudi Arabia, sparked after the purge of 11 princes and arrests of dozen other influential figures since last week, are intensifying. Sources told Reuters that Lebanon believes the country’s former prime minister, Saad al-Hariri, was being held in Saudi Arabia, although Saudi Arabia denied reports he was under house arrest. Saudi Arabia accused Beirut earlier this week of declaring war against the kingdom.

Bulletin Headline Summary from Ransquawk

  • Subdued Trade across European equities
  • GBP uncertainty remerges, as Brexit concerns grow
  • Looking ahead, highlights include Uni. Of Michigan and Weekly Baker Hughes Rig Count

Market Snapshot

  • S&P 500 futures down 0.4% to 2,572.70
  • STOXX Europe 600 down 0.3% to 389.09
  • MSCI Asia down 0.4% to 171.18
  • MSCI Asia ex Japan down 0.3% to 559.89
  • Nikkei down 0.8% to 22,681.42
  • Topix down 0.7% to 1,800.44
  • Hang Seng Index down 0.05% to 29,120.92
  • Shanghai Composite up 0.1% to 3,432.67
  • Sensex down 0.3% to 33,160.16
  • Australia S&P/ASX 200 down 0.3% to 6,029.37
  • Kospi down 0.3% to 2,542.95
  • German 10Y yield rose 1.1 bps to 0.386%
  • Euro up 0.04% to $1.1647
  • Italian 10Y yield rose 6.8 bps to 1.55%
  • Spanish 10Y yield fell 0.8 bps to 1.525%
  • Brent futures up 0.4% to $64.20/bbl
  • Gold spot down 0.02% to $1,284.81
  • U.S. Dollar Index up 0.04% to 94.48

Top Overnight News

  • China took a major step toward the long-awaited opening of its financial system, saying it will remove foreign ownership limits on banks while allowing overseas firms to take majority stakes in local securities ventures, fund managers and insurers
  • Senate Republicans released their vision for a tax-cut plan Thursday that would cut the corporate tax rate to 20 percent, with a one-year delay to 2019, as Congress moves quickly to fulfill one of the GOP’s biggest and most long-awaited goals
  • President Donald Trump will not meet formally with Russian President Vladimir Putin at an Asia- Pacific summit in Vietnam this week due to a scheduling conflict, the White House said Friday, amid U.S. concerns that the meeting wouldn’t create genuine progress on key issues
  • Alibaba is expected to announce a USD bond mandate next week and price the transaction before Nov. 23, Reuters’s IFR says
  • As U.S. markets swim in sea of red, trading in the largest high-yield exchange-traded funds has skyrocketed to dizzying levels
  • San Francisco Fed President John Williams expects a December hike and three more in 2018 and that U.S. interest rate will return to “a normal level” of about 2.5%, BBC reports;He expects incoming Fed chair Powell to continue “making sure that we have a strong consensus around our policy decisions and strategy”
  • Australia’s central bank used its quarterly statement on monetary policy to flesh out its consistent recent view of accelerating growth and sluggish inflation, suggesting interest rates will stay at a record-low 1.5%
  • Oil heads for best weekly run in a year as political upheaval in Saudi Arabia roils markets
  • China Big Bang Moment Opens Banks, Funds to Foreign Control
  • Pacific Nations Scramble to Save Trade Pact After Trump Exit
  • China Says Foreign Firms Won’t Be Forced to Turn Over Technology
  • StanChart Unit Offers to Buy Stake in Singapore Crane Firm
  • World’s Biggest Wealth Fund Calls for Better FX Market Practices
  • Drahi Takes Back Control of Altice as CEO Quits Amid Debt Woes
  • ECB Warns of Complacency Risks in Surging Euro-Area Economy
  • GOP’s Dueling Tax Overhauls Struggle to Pass a Key Red Ink Test

Asian equities are set to close out the week in the red with risk sentiment dented by US tax doubts. Nikkei 225 (-0.8%) notably underperforms, extending on the losses seen from yesterday’s dramatic swing which had come ahead of the closely watch options settlement price, which settled at 22,531. Toshiba shares fell as much as 8% following reports that they are looking to raise around JPY 600bln worth of capital. ASX 200 (-0.3%) slightly pressured, however the 6000 level has been holding, while the biggest weight has come from mining stocks. Chinese markets pared initial declines following reports that China are to relax the limit on foreign ownership. JGBs are a touch weaker with the curve showing a flattening bias. The long end-outperforming with the 40-yr yield lower by 1.6bps.

Top Asian News

  • Singapore’s Stocks Haven’t Lured This Much Cash in a Decade
  • Noble Group Needs More Funds as Default Risk Persists, S&P Warns
  • Kobe Steel Blames Lax Controls, Focus on Profits for Scandal
  • State Bank of India Surges as Margins, Bad-Loan Ratio Improve
  • Brewer Sabeco to Sell Stake of at Least $2.9 Billion in 2017
  • China Fintech IPO Fever Wanes as Regulators Weigh Crackdown
  • Jewelers Say Haven’t Smiled in the Year Since India Cash Ban

Once again, European equities (Eurostoxx 50 -0.1%) have seen little in the way of noteworthy price action in what has been a week void of substantial European-specific macro events. In terms of sector-wide moves, financial names were granted some modest support at the open in the wake of earnings from Allianz (+1.2%) with material names also higher given the latest trading update from steel heavy-weight ArcelorMittal. To the downside, utility names in the UK have seen some pressure in the wake of reports that Ofgem is to stop gas and electricity suppliers from charging as much as GBP 900 when they forcibly install pre-payment meters in households struggling to pay bills. Bonds have continued to retreat, initially in corrective trade, but then as more sell-stops were triggered on a break of technical support levels. However, some respite amidst dip-buying has helped Bunds and Gilts  recoup losses. 10 year benchmark yields have flirted with sensitive if not particularly key cash markers – UK through 1.25% and up to 1.30%, Germany resisting 0.4%. The overall trend remains bearish and curves are retracing broad flattening patterns in thinner trading conditions.

Top European News

  • Catalan Speaker’s Bail Set as Rajoy Seeks Release of Separatists
  • Germany Could Escape Carbon Hole at Home by Investing Abroad
  • U.K. Industrial Output Jumps, Construction Shrinks in September
  • Richemont Finalizes Management Revamp by Promoting Lambert
  • Telecom Italia Earnings Decline Amid Tough Wireless Competition

In FX, GBP has been a key focus for FX markets once again with a slew of potentially negative Brexit reports overnight, including a potential curve ball from Ireland regarding the Northern Ireland border as well as pressure from UK and European business bodies. It was also reported, that May could up her Brexit bill offer, which would be an increased cost to the UK but potentially a positive step in terms of getting the ball rolling in negotiations. Thereafter, GBP then took the lead from the main UK data releases of the week which saw manufacturing and industrial numbers exceed expectations and sent GBP/USD back into positive territory before later paring a bulk of the move. Elsewhere, AUD remains under pressure after the RBA’s SOMP (Statement On Monetary Policy) saw the central bank cut their inflation outlook, while they also saw underlying inflation not reaching their 2% target until 2019. USD remains steady after seeing a bid early doors which saw the DXY bounce off worse levels ahead of 94.40 (Last week’s low). The RBA’s Quarterly Statement On Monetary Policy (SOMP) lowered inflation forecasts, while underlying inflation is not expected to reach 2% until 2019. i) Forecasts CPI at 2% to June 2018, then 2.25% to December 2019. ii) Forecasts GDP 2.5% to December 2017 and 3.25% for December 2018/19. iii) Further rise in AUD would slow pick-up in economic growth and inflation.

In commodities, WTI and Brent crude futures continue to remain firm and are on course to log their fifth straight week of gains, on hopes of supply cuts by major exporters as well as continuing concern about political developments in Saudi Arabia. This morning has also seen comments from the UAE energy minister who stated that he is optimistic about 2018 and does not expect any big challenges against OPEC’s decision to extend the output cut deal. Dalian iron ore futures slipped up for a third session overnight amid concerns over a reduction in consumption as Chinese producers slash production over winter. Analysts also note that iron ore prices could drift even lower over the coming months as cuts to steel output and other industrial activity could last until mid-March.

Looking at the day ahead, a fairly quiet end to the week with September industrial production data in France and the flash November University of Michigan consumer sentiment print and October monthly budget statement in the US due. With it being Veterans Day in the US, bond markets will be closed however stock markets remain open. The ECB’s Mersch is slated to make comments while President Trump will take part in the APEC summit

US Event Calendar:

  • 10am: U. of Mich. Sentiment, est. 100.9, prior 100.7; Current Conditions, est. 116.3, prior 116.5; Expectations, est. 91, prior 90.5

DB’s Jim Reid concludes the overnight wrap

In a low vol world, yesterday was fascinating and a small shock to the system. Equities, bonds and spreads were all weaker which can happen when everything is expensive but perhaps markets had given up on the short-term possibility of it. Since the ECB’s dovish taper two weeks ago, the general perception was that one of the last chances to see vol in 2017 outside of the US tax plan had gone. As such we’ve seen carry trades get yet another lease of life with the assumption that they’ll be low risk into year end. However this week has seen some flies in the ointment. The US YC had hit the flattest for 10 years, there has been more widespread expectation that US tax reform may get pushed back, the Saudi anti-corruption drive has unsettled some, the oil price rise is starting to influence carry expectations, EMFX has been  weak, a couple of high profile US HY ETFs have fallen to 8-months lows with heavy volumes yesterday, Japanese equities saw a 3.6% swing yesterday (largest for a year) and European bond yields rose unexpectedly.

The Japan swing was the talk of the town yesterday with lots happening late in the session after we went to print. Some suggested it was due to profit taking after a strong run to a 25 year high, others pointed to position adjustments ahead of Friday’s special quotation of some futures and options. This morning in Asia, markets have followed the negative leads from US and are trading lower. The Nikkei is down -0.85%, led by losses from telco and utilities stocks but is trading close to where it opened so no real acceleration of selling has occurred so far. Elsewhere, the Kospi (-0.35%) and ASX 200 (-0.3%) are down slightly while Hang Seng is up 0.11% as we type. Chinese stocks are slightly higher and this morning, China’s Vice Finance minister Zhu has confirmed that foreign firms will be allowed to own controlling stakes (up to 51%) in local Chinese securities joint ventures. This is another step towards liberalisation of the economy.

Before all this late in the US session last night, the Senate has released their version of the draft tax bill which does not stray too much from prior press reports but is still quite different to the House’s bill. In the details, the plans
included: i) corporate tax cuts to 20% delayed by one year (vs. Jan. 2018 as per the House’s tax bill), ii) existing mortgage interest deduction for home purchases up to $1m will be retained (vs. a cut to $0.5m) , iii) state and local tax deductions for individuals will be entirely repealed (vs. mostly repealed), iv) seven individual tax brackets will be retained with the top tax bracket reduced 0.9ppt to 38.5% (vs. consolidate to 4 tax brackets and unchanged top tax rate of 39.6%), while v) the standard deductions for individuals ($12k and $24k couples) are the same. Elsewhere, in the mark up of the House tax bill, the House Ways Committee is reportedly considering lifting the one-time tax rate on US companies’ accumulated offshore earnings, from 12% to 14% if the income was held as cash (vs. 10% as per the Senate tax plan). Looking ahead, the two versions of the tax bill will be further debated, negotiated and then somehow reconciled before final voting, which was expected to be before Thanksgivings (23 November). The market is having a lot of doubts about this timetable.

Over in government bonds, UST 10y yields rose modestly (+0.7bp) yesterday before moving slightly higher this morning after the Senate tax plans were formally released. However, European bonds experienced a mini-sell off from nowhere yesterday with core 10y yields up 4-5bp (Bunds +5bp; OATs +5.3bp; Gilts +3.7bp) – the biggest moves in three weeks. Peripherals also rose 4-7bp, led by Italian bonds. We are scratching our heads a little on this, perhaps it was driven by a combination of the following; marginally higher inflation forecasts by the European Commission, more hawkish ECB talk and profit taking after the stronger bonds performance post the October ECB meeting.

Following on from this, the European Commission raised its GDP and inflation forecasts for the Euro area yesterday. GDP growth in 2017 is now expected to be the highest in a decade at 2.2% (+0.5ppt) and 2.1% (+0.3ppt) in  2018, with Germany and Spain expected to perform strongly, while forecasts for the UK have been lowered to 1.3% next year (vs. DB estimate of 1%). Elsewhere, the inflation forecasts for 2018 was marginally increased (+0.1ppt) to 1.4% in 2018 and 1.6% in 2019. The Bank of France Governor Villeroy noted “Euro area growth will be sustained in the next two years thanks to strong investment and thanks to increased convergence among countries”.

Moving onto central bankers’ commentaries. ECB’s Governing council member Lane sounded a bit hawkish, noting “there are some signs that inflation is snapping back” and that “inflation does not have to reach our goal before we discuss changing our policy”. Further “if we have enough signals, we can get active and move on” as “our monetary policy does not always have to follow such a gradual and incremental approach”. On QE tapering, he noted that as we approach the time when net bond purchases end, we will “develop a clearer communication strategy on what ECB means by well past” in its guidance on interest rates.

Elsewhere, commentary by others on the economy were fairly upbeat too. ECB’s executive board member Coeure noted “we’re now at a stage in the economic cycle where the recovery is strong….in terms of robustness and balance….probably (the strongest) in almost 20 years”. The ECB VP Constancio also noted ‘we’re encouraged by the way the economy continues to grow” and that “all the new indicators…mostly so far…indicate that growth could be indeed stronger”. On QE, he noted we should not expect “very dramatic change or development” on CSPP size in any case.

Moving to geopolitics, the official Saudi Press Agency has advised its nationals to leave Lebanon due to the “situation” without elaborating more. With the ongoing tensions regarding Iran and Saudi’s own internal anti-corruption drive heating up, we watch and see how this situation will evolve.

Now recapping the rest of market performance from yesterday. US bourses pared back early losses to close modestly weaker, in part following the Senate tax plan. The S&P traded down around -1% intraday before ending the day -0.38%. The Dow (-0.43%) and Nasdaq (-0.58%) also fell modestly. Within the S&P, losses were led by the industrials (-1.28%) and materials sector, with partial offset from energy and telco stocks. European market were all lower, with the Stoxx 600 (-1.11%) and DAX (-1.49%) down the most since 21st July, with losses driven by industrials and tech stocks. The FTSE was actually the relative outperformer, only down 0.61%. After five consecutive days of <10, the VIX jumped 7% to 10.50. Away from the markets the ECB’s head of banking supervision Ms Nouy signaled a willingness to adjust plans which could have led to higher provisions for existing non-performing loans. She noted “it is a consultation (process) and everything can be changed if we are convinced we have done something not as adequate as it should have been”. Her reassuring comments partly boosted some Italian banks, with BPER Banca SpA share price up c10% (vs. FTSE MIB -0.8%).

Over to Brexit, the current round of talks remain at a stalemate. However, the FT has reported that the UK side may be working on different scenarios to “considerably increase” the divorce settlement bill from the current EUR20bn offer (vs. EU’s reported demand of EUR60bn) with the possibility that a revised financial pledge will be tied to an agreement in principle on a transitional deal that may be announced in the December summit. Elsewhere, Brexit Secretary Davis will propose an amendment in Parliament next week, making “crystal clear” that Brexit will take place at 11pm GMT on 29 March 2019.

Back to Catalonia, the El Pais newspaper noted that Spain’s Supreme Court may take over the case and free the Catalan officials who face up to 30 years in jail for charges of sedition. Elsewhere, Bloomberg suggested that sources close to PM Rajoy noted the PM wants ousted Catalan President Puidgemont to be released if he returns to Spain and participate in the 21 December election, in part as he is confident that the pro-independence side will not secured enough votes for a majority win.

Finally, in the APEC summit at Vietnam, the 11 nations have yet to decide how to salvage the TPP (Trans-Pacific Partnership) trade deal after President Trump withdrew the US from it last year. The Australian trade minister Mr Ciobo is “hopeful of securing a deal” in the next two days, but the Canadian counter party noted “it’s far more important to get the right deal than a fast deal”.

Before we take a look at today’s calendar, we wrap up with other data releases from yesterday. In the US, the final reading of the September wholesale trade was unrevised at 0.3% mom. The wholesale sales rose 1.3% mom in  September, which meant the inventory-shipments ratio fell to 1.27 – the lowest level since December 2014. Elsewhere, the weekly initial jobless claims (239k vs. 232k expected) and continuing claims (1,901k vs. 1,885k expected) were broadly in line.

In Europe, Germany’s September trade surplus was above expectations at $24.1bln (vs. $22.3bln). Both exports (7.7% yoy) and imports (7.5% yoy) were well up on a year earlier. In France, the industrial sentiment for October was slightly higher at 106 (vs. 105 expected) – a fresh six year high. In the UK the RICS housing survey weakened in October, with just net 1% of surveyors reporting rising prices and a net 11% of surveyors expecting price declines over the next three months.

Looking at the day ahead, a fairly quiet end to the week with September industrial production data in France and the flash November University of Michigan consumer sentiment print and October monthly budget statement in the US due. With it being Veterans Day in the US, bond markets will be closed however stock markets remain open. The ECB’s Mersch is slated to make comments while President Trump will take part in the APEC summit.


Bond Bears & Why Rates Won’t Rise

Authored by Lance Roberts via RealInvestmentAdvice.com,

Here we go again…

Since June of 2013, I have been writing about the reasons why rates can’t rise much and why calls for the end of the “bond bull market” remain wrong.

Regardless, about every 3-months or so, there is a tick up in rates and you can almost bet that soon thereafter will be a litany of articles explaining why THIS time the “bond bull market” is really dead. For example, just from this past week:

What is the argument from low rates will rise?

It basically boils down to simply this – rates are so low they MUST go up.

The problem, however, is that interest rates are vastly different than equities. When people go to make a purchase on credit, borrow money for a house, or get a loan for a new car, they don’t ask what the level of the stock market is but rather “how much will this cost me?” The differentiator between making a purchase, or not, is based on the simple outcome of the interest rate effect on the loan payment. If interest rates rise too much, consumption stalls, and along with it economic growth, causing rates to go lower. If economic demand is robust, rates rise to meet the demand for credit.

The trend and level of interests are the singular best indicator of economic activity. As Doug Kass recently noted:

“The spread between the two- and ten-year U.S. notes has fallen to 68 basis points — that’s the lowest print in ten years and if history is a guide it is signaling a potential domestic economic slowdown.”

“The flattening in the yield curve is happening despite a likely continued Federal Reserve tightening and a rise back to December levels for overnight index swaps (OIS). It was back in 2004 — as the Fed started its tightening cycle (that concluded in Summer, 2006) — that both the curve flattened and the five year OIS rose. At the conclusion of the tightening in the middle of 2006, a deep recession followed by about fifteen to eighteen months later.”

In other words, “It’s the economy, stupid.”

Economic Growth Drives Rates

The chart below is a history of long-term interest rates going back to 1857. The dashed black line is the median interest rate during the entire period. I have compared it to the 5-year nominal GDP growth rate during the same period.

(Note: As shown, interest rates can remain low for a VERY long time.)

Interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time.There have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed. But that was just the start of it.

Beginning in the late 50’s, America embarked upon its greatest quest in history as man took his first steps into space. The space race that lasted nearly twenty years led to leaps in innovation and technology that paved the wave for the future of America. Combined with the industrial and manufacturing backdrop, America experienced high levels of economic growth and increased savings rates which fostered the required backdrop for higher interest rates.

Currently, the U.S. is no longer the manufacturing powerhouse it once was and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. Today, the number of workers between the ages of 16 and 54 is at the lowest level relative to that age group since the late 70’s. This is a structural and demographic problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance.

This structural employment problem remains the primary driver as to why “everybody” is still wrong in expecting rates to rise.

As you can see there is a very high correlation, not surprisingly, between the three major components (inflation, economic and wage growth) and the level of interest rates. Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically, the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. (Currently, we do not have the type of inflation that leads to stronger economic growth, just inflation in the costs of living that saps consumer spending – Rent, Insurance, Health Care)

The chart above is a bit busy, but I wanted you to see the trends in the individual subcomponents of the composite index. The chart below shows only the composite index and the 10-year Treasury rate. Not surprisingly, the recent decline in the composite index also coincides with a decline in interest rates.

In the current economic environment, the need for capital remains low, outside of what is needed to absorb incremental demand increases caused by population growth, as demand remains weak. While employment has increased since the recessionary lows, much of that increase has been the absorption of increased population levels.

Many of those jobs remain centered in lower wage paying and temporary jobs which do not foster higher levels of consumption. To offset weaker organic consumption, artificially suppressed interest rates, though monetary policy, gives the appearance of economic growth by dragging forward future consumption which leaves a future “void” that has to be continually refilled.

Currently, there are few economic tailwinds prevalent that could sustain a move higher in interest rates. The reason is that higher interest reduces the flow of capital within the economy. For an economy that remains dependent on the generosity of Central Bankers, rising rates are not the outcome that “stock market bulls” should NOT be rooting for.

The Implications Of A Bond Bust

If there is indeed a bond bubble, a burst would mean bonds decline rapidly in price pushing interest rates markedly higher. This is the worst thing that could possibly happen. 

1) The Federal Reserve has been buying bonds for the last 9- years in an attempt to push interest rates lower to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.

2) The Federal Reserve currently runs the world’s largest hedge fund with over $4 Trillion in assets. Long Term Capital Mgmt. which managed only $100 billion at the time nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 45x that size.

3) Rising interest rates will immediately kill the housing market, not to mention the loss of the mortgage interest deduction if the GOP tax bill passes, taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

4) An increase in interest rates means higher borrowing costs which lead to lower profit margins for corporations. This will negatively impact the stock market given that a bulk of the “share buybacks” have been completed through the issuance of debt.

5) One of the main arguments of stock bulls over the last 9-years has been the stocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.

6) The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.

7) As rates increase so does the variable rate interest payments on credit cards.  With the consumer are being impacted by stagnant wages, higher credit card payments will lead to a rapid contraction in income and rising defaults. (Which are already happening as we speak)

8) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.

9) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.

10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.

I could go on but you get the idea.

The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.

I won’t argue there is much room left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment. This idea suggests is that there is one other possibility that the majority of analysts and economists ignore which I call the “Japan Syndrome.”

Japan is has been fighting many of the same issues for the past two decades. The “Japan Syndrome” suggests that while interest rates are near lows it is more likely a reflection of the real levels of economic growth, inflation, and wages.

If that is true, then rates are most likely “fairly valued” which implies that the U.S. could remain trapped within the current trading range for years as the economy continues to “muddle” along.

The irrationality of market participants, combined with globally accommodative central bankers, continues to push asset values higher and concentrate investors into the ongoing “chase for yield.” There isn’t much guessing on how this will end, history tells us that such things rarely end well.


Global Markets Stumble, Spooked By Japanese Stock Fireworks

The overnight fireworks in Japan, which saw the Nikkei plunge by 860 intraday points and sent vol and volumes soaring (before recovering most losses), spooked traders in Asia and around the globe, and U.S. equity futures are red this morning, along with European shares and oil. As one early riser sellside desk notes, the Nikkei 225 provided the latest example of choppy markets and the 860 point intraday plunge “got us worried.  Is this a warning sign for risk assets?” President Trump’s challenge of China for “unfair trading practices” (which he blamed on his predecessors) did not help the calm mood.

“The stock market has run out of a little momentum since the blow-out on the (Japanese) topix so it feels like it’s temporarily paused,” said Societe Generale strategist Kit Juckes. “We are waiting for some news from the Republicans on the tax plans, there is a bond market that has stalled and we’ve got rather soggy looking emerging markets… We probably need to get U.S. Treasury yields higher to get things going again.”

In the aftermath of the Japanese vol spike, the MSCI Asia Pacific Index turned briefly negative having earlier climbed to all-time record.

Most of Europe’s main bourses also drifted in and out of the red after Japan’s disturbance spooked traders and after mixed earnings and as Brexit talks resumed with low expectations in Brussels. There were a series of ECB speeches and what should be buoyant new growth forecasts due later from the European Commission, though bond markets were mostly quiet following a rally this week in benchmark U.S. Treasuries and Bunds. In fact, German Bunds were sharply offered, with yields rising 9% on the day an approaching 0.36%: the move has dragged the rest of the European bonds lower, with OATs and Gilts also moving. According to some desks, this may be due to some rotation from the European equity markets, which are broadly trading into the red today and could be following in the footsteps of Nikkei.

Already shaken by events in Japan, basic-resources shares weighed on the Stoxx Europe 600 index following a decline in industrial-metals prices. An increase in growth expectations from the European Commission failed to lift stocks as disappointing results from companies including Siemens AG and Vestas Wind Systems A/S added to the malaise. Banks gained, led by Italian lenders after BPER Banca S.p.A. earnings beat estimates. Stocks in Asia earlier rose above their 2007 peak before an intraday reversal in Japanese shares on technically-driven trading pared gains in the region. Sterling edged lower as Brexit talks resumed, while oil halted a two-day drop.

Understandably, the yen was the dominant theme of the overnight session as investors rushed to buy the Japanese currency following the Nikkei plunge; the euro found support after the European Commission raised its growth outlook for the common area, while the pound reversed earlier gains as some hedge funds turned sellers;

Investor attention has been focused on Asia this week, where Trump has embarked on an 11-day tour. In Beijing Thursday, he said China is taking advantage of American workers and companies with unfair trade practices, but he blamed his predecessors in the White House rather than China for allowing the massive U.S. trade deficit to grow. A year after Trump was elected to president, investors are also reflecting on how financial markets have fared in the interim, and a rally that has outperformed all but 4 “new president” markets in US history.

As Bloomberg adds, elsewhere in the overnight session, the New Zealand dollar held onto Wednesday’s gains after the central bank flagged it may raise interest rates earlier than expected. The Kiwi was the day’s big mover, surging about 1 percent to a two-week high of before dipping to trade at $0.6956. The kiwi soared after the Reserve Bank of New Zealand (RBNZ) said the country’s fiscal stimulus and the currency’s recent fall would lead to faster inflation and likely an earlier rise in interest rates.

Treasury yields were range-bound as markets wait to see the U.S. tax proposal that will serve as the basis for further discussions. The kiwi was near two-week high after more hawkish RBNZ sends New Zealand’s 10-year yield eight basis points higher. Aussie dips briefly following surprise drop in housing finance activity and a subseqent short squeeze sent it to session highs; Australian sovereign bonds drift lower with 10-year yield up three basis points at 2.60%. JGB futures dip after mediocre 30-year auction tails 1.1bps.

The dollar index against a basket of six major currencies was 0.1 percent lower at 94.803 meanwhile, as it drifted further from the three-month high of 95.150 set in late October. A U.S. Senate tax-cut bill, differing from one already in the House of Representatives, was expected to be unveiled on Thursday, complicating a Republican tax overhaul push and increasing scepticism on Wall Street about the effort. Some also focused on fallout from Democrat wins in regional U.S. elections this week as signal for next year’s mid-term Congressional elections for U.S. President Donald Trump.

“There’s very much a risk of disappointment. The U.S. dollar could go through a weakening phase on the back of uncertainty around that tax reform,” said Steven Dooley, currency strategist for Western Union Business Solutions in Melbourne. Meanwhile, stalled Brexit talks resume on Thursday in Brussels with no indication that a breakthrough is in reach.

In commodity markets, Brent and U.S. crude oil futures were modestly lower, having hit two-year highs earlier in the week following a 40% surge since July. U.S. data showing a rise in domestic crude production had weighed on sentiment overnight but the Middle East uncertainty in Saudi Arabia limited the losses. Gold added 0.2 percent to $1,283.45 an ounce after rising to a three-week high of $1,287.13 an ounce the previous day. Palladium hovered near a 16-year high of $1,019 while nickel fell by more than 2 percent in London to its weakest since October as hype over potential electric vehicle demand that has been driving it higher eased. The nickel market had been ignoring downside risks from policy developments in supply markets Indonesia and the Philippines, and instead focusing on potential future demand from electric vehicle batteries, said Morgan Stanley in a report.

“We (have) heard little to alter our view that producing NiSO (nickel sulphate) isn’t particularly challenging/costly and we see near-term downside risk to price,” it said.

On today’s calendar, the ECB said economic growth in the U.K. is headed for a prolonged slowdown even as the euro-area economy is forecast to expand at the fastest pace in a decade this year. And in the U.S., tax reform discussions continue. The Senate is due to release a “conceptual mark” of a proposal Thursday, according to a spokeswoman. Expected economic data include jobless claims and wholesale inventories. Dish, Disney, Johnson Controls and TransCanada are among companies reporting earnings.

Bulletin Headline Summary from RanSquawk

  • European markets remain subdued, as equities trade mixed with a lack of any real direction
  • GBP weaker amid a late follow-through of concerning Brexit commentary
  • Looking ahead, highlights include US weekly jobs, ECB’s Lautenschlaeger and Constancio

Market Snapshot

  • S&P 500 futures down 0.1% to 2,588.30
  • STOXX Europe 600 down 0.2% to 393.82
  • MSCI Asia up 0.1% to 171.99
  • MSCI Asia ex Japan up 0.3% to 561.79
  • Nikkei down 0.2% to 22,868.71
  • Topix down 0.3% to 1,813.11
  • Hang Seng Index up 0.8% to 29,136.57
  • Shanghai Composite up 0.4% to 3,427.80
  • Sensex up 0.06% to 33,239.47
  • Australia S&P/ASX 200 up 0.6% to 6,049.43
  • Kospi down 0.07% to 2,550.57
  • German 10Y yield rose 0.2 bps to 0.328%
  • Euro up 0.05% to $1.1601
  • Italian 10Y yield rose 4.5 bps to 1.482%
  • Spanish 10Y yield rose 3.0 bps to 1.515%
  • Brent futures down 0.1% to $63.41/bbl
  • Gold spot up 0.2% to $1,283.82
  • U.S. Dollar Index down 0.06% to 94.81

Top Overnight News

  • President Trump said China is taking advantage of American workers and American companies with unfair trade practices, but blamed his predecessors in the White House for allowing the U.S. trade deficit to grow
  • The European Commission’s chief Brexit negotiator, Michel Barnier, and U.K. Brexit Secretary David Davis resume talks on the terms of Britain’s exit from the EU. Timing and duration in Brussels to be determined
  • ECB’s head of banking supervision, Daniele Nouy, signaled that she’s willing to compromise on controversial plans to toughen rules on bad loans after criticism from the European Parliament that sent Italian bank shares soaring
  • EU is giving U.K. an informal deadline of two to three weeks to set out how much it is prepared to pay in the Brexit divorce settlement, the Financial Times reports, citing an unidentified senior EU negotiator
  • Hearing on Powell for Fed Chair set for Nov. 28
  • Saudi Billionaires Said to Move Funds to Escape Asset Freeze
  • AT&T CEO Says He Won’t Sell CNN as Antitrust Tension Rises
  • Boeing Wins China Orders for 300 Planes Worth $37 Billion
  • London House-Price Slump Persists as Brokers See Sales Tumble
  • Vestas Plunges Most in 6 Years on Tougher Wind Competition
  • BOE’s McCafferty Says Banks May Leave Before Brexit Deal Agreed

Risk on sentiment had been in full swing in Asia as stocks continued to edge higher at the beginning of the session, before later paring initial advances, particularly in Japanese assets. Nikkei 225 had been the notable outperformer although reversed gains of 2% as US equity futures dipped, subsequently sparking safe haven flow in the JPY, while some investors also touted profit taking. Elsewhere, the ASX 200 hovered around 10yr highs with iron ore prices seeing another day of gains, consequently supporting miners. Chinese markets traded in mixed fashion with the Hang Seng keeping afloat after encouraging Chinese CPI and PPI data which tops analyst estimates, while the Shanghai Comp fluctuated between gains and losses. 10yr JGBs are a tad lower, while underperformance has been observed in the belly of the curve with the 10yr yield ticking up 0.1bps.

Top Asia News

  • Noble Group Posts $3 Billion Year-to-Date Loss as Crisis Deepens
  • Inside Noble-Vitol Deal Shows Colonial Pipeline as Top Asset
  • Malaysia Says It May Consider Review of Monetary Accommodation
  • Malaysian Bonds Face Specter of First Rate Hike Since 2014
  • Philippines Holds Benchmark Rate as Inflation Seen on Target
  • Bakrieland Says Singapore Court Approves Debt Restructuring Plan

European equities trade with little in the way of any notable price action after a directionless lead from Asia after initial gains were erased. On a sector specific basis, performance has largely been off the back of individual earnings from across the continent with notable movers including Vestas Wind Systems (-16.9%), Burberry (-10.5%), Sainsbury’s (-2.9%), Siemens (-2.6%) and Commerzbank (+2.6%). Upside in Commerzbank shares has subsequently lead to some outperformance in financial names with Italian banks also providing some support amid UniCredit’s latest trading update and a sector bounceback from yesterday’s losses. No sign of any investor angst or dampened demand whatsoever, as 2023 supply was snapped up with only a 1 tick price tail. This, despite a sharp retreat in yields following the BoE rate hike and not much in the way of concession going in to the DMO  tap. Note also, the issue does not fall into the more normal 5 year bucket until next year and the average auction yield was just a shade below yesterday’s closing level. However, 10 year benchmark Liffe futures have retreated from best levels to marginal new lows for the session (125.45), albeit largely alongside a general downturn in fixed (Bunds just off a new Eurex base of 163.23). In truth, debt markets are lacking clear direction and consolidating recent gains/yield declines/curve flattening.

Top European News

  • Denmark’s Negative Rates Are Seen Persisting Into Next Decade
  • ECB’s Nouy Bends on Bad-Loan Plan as Italian Bank Shares Soar
  • U.K. Likely to See More Utility Mergers If SSE Deal Approved
  • Euro-Area Growth Forecast Lifted Again as U.K. Outlook Dims

In FX, a broadly softer Greenback, largely due to ongoing US tax reform uncertainty, and supportive RBNZ impulses has enabled the Kiwi to recoup more lost ground after the RBNZ stood pat on rates at 1.75%. Accordingly, it brought forward rate hike projections to June 2019 from Q3 previously, while Governor Spencer also contended that the NZD is now fair value (although his deputy McDermott thinks a bit more depreciation is desirable). EUR is back to pivoting around the 1.1600 level vs the Dollar where large (1.7 bn) option expiries reside. USD/JPY has seen very choppy trade in line with the Nikkei, but ultimately firmer on safe-haven grounds, as USD/JJPY retreats from 114.00 again towards November lows. Currently around 113.50, bids are seen at 113.40 and then 113.00, while offers are said to be layered from 114.00-20. Riksbank meeting minutes see several members emphasising the importance of the exchange rate for the economic outlook and inflation prospects.

In commodities, iron ore prices continued to surge higher overnight with Dalian iron ore rising as much as 2% amid the persistent rise in steel prices. Precious metals gained a slight bid following the turnaround in risk sentiment, where Japan equities reversed its 2% rise to trade with losses of 1.5%. WTI and Brent crude futures trade relatively sideways with little in the way of notable newsflow other than Goldman Sachs sticking to their USD 58bbl year-end call for Brent whilst noting the ‘potential for high spot price volatility in the coming weeks’.

Looking at today’s calendar, data wise, September Germany trade data along with UK industrial production are due. Elsewhere, US initial jobless claims and wholesale inventories are also due. We’ll also receive the latest EC economic forecasts while the ECB’s Villeroy de Galhau, Coerue, Mersch, Lautenschlaeger and Constancio are due to speak. Brexit talks are due to resume between Barnier and Davis while President Trump holds meetings with China’s Xi and Li Keqiang.

US event calendar

  • 7:45am: Bloomberg Nov. United States Economic Survey
  • 8:30am: Initial Jobless Claims, est. 231,500, prior 229,000; Continuing Claims, est. 1.89m, prior 1.88m
  • 9:45am: Bloomberg Consumer Comfort, prior 51.7
  • 10am: Wholesale Trade Sales MoM, est. 0.9%, prior 1.7%;  Wholesale Inventories MoM, est. 0.3%, prior 0.3%

DB’s Jim Reid concludes the overnight wrap

Needless to say that the focus for markets today will be on what details emerge from the Senate’s version of the GOP tax bill. It’s unclear just how much detail we’ll get though with some conflicting reports out there. Axios reported that the release of the bill will be delayed however Politico reported separately that GOP leaders are ready to walk through the bill with the GOP conference at 11.30 EST. Thereafter it will be released to the public but the timing is a bit up in the air so we might have to wait and see. Overnight, a spokeswoman for the Senate Finance Committee, Ms Lawless, noted that today’s tax proposal will be a “conceptual mark” rather than the legislative details.

Over in markets, the one year Trump anniversary was one of the less exciting days that we’ve had so far. Initially the tone felt a bit more risk-off with European markets generally closing a bit softer. US markets did however pare early losses into the close at least with the S&P 500 ending +0.14%. That masked another difficult day for banks however, partly influenced by the Washington Post article that did the rounds suggesting that the Senate GOP tax  bill could delay the cut in the corporate tax rate by one year. Later in the day, Treasury Secretary Steven Mnuchin also refused to rule out a possible phase-in of corporate tax cuts. Meanwhile victory for the Democrats in the two Governor races in New Jersey and especially Virginia also appeared to play a factor given the midterm elections next year. It remains to be seen whether that will transpire into taking back votes across the rest of the country but nevertheless it was a statement of intent.

Meanwhile EM tensions continue to bubble under the surface with headlines never too far from the front pages. EM sovereign debt has certainty had a tough time of it in the last week or so but we’re also starting to see some signs of selling pressure in DM HY credit with Crossover and CDX HY 11bps and 7bps wider this week, respectively. All the talk in bond markets at the moment though is the flattening across the Treasury curve. Yesterday saw both the 2s10s and 5s30s curves flatten for the 9th and 10th successive day respectively. The former dropped to 68bps and has now flattened by 16bps during that run. The latter was only modestly flatter at 78bps but is still also 12bps flatter over the same time.

So as we know the Treasury curve is the flattest it’s been in 10 years and there is plenty of ongoing debate as to what is driving the recent price action. Various reasons have been suggested. Our US rates strategists have  previously noted that even with a tax plan, overseas investors and pension buying of the long-end is depressing term premium and yields. Another suggestion is that with 2y yields somewhat anchored relative to the Fed’s effective rate and therefore further rate hikes, the long-end is instead being weighed down by long-end Euro rates. Unsurprisingly there is plenty of discussion about how the recent moves are indicating late cycle tendencies. One thing we would note though is that the NY Fed recession model is only showing a 9% probability of a recession in the next 12 months. While that’s up from 3% at the end of last year the overall level is still clearly fairly low based on their model but it’s worth keeping an eye on. Also worth monitoring perhaps is the whether the flattening has had much impact on bank lending when we receive the next Fed Senior Loan Survey. In the last 3 days, US  banks have dropped -3.53%, so the sector has certainly materially underperformed.

This morning in Asia, China’s October CPI was slightly above consensus at +1.9% yoy (vs. +1.8% expected) and also up from +1.6% the month prior, while PPI was steady but well above expectations at +6.9% yoy (vs. +6.6% expected). Markets are trading higher in Asia, with the Nikkei powering ahead (+0.58%) to a fresh 25 year high following sound corporate results, while the Hang Seng (+0.52%) and ASX 200 (+0.55%) are also up, but the Kospi is down 0.33%. Last night Bloomberg ran an article suggesting that the White House plans to announce $250bn of business deals with China this week based on comments from Commerce Secretary Wilbur Ross. As we go to print President Trump and China President Xi Jingping are about to hold a joint briefing. This comes after Trump called the trade relationship between the two “very one sided” and the deficit “shockingly high”. Xi said that China is to become more open to foreign investment and that the nation is “unswervingly committed” to opening up.

Moving on. In the UK, PM May’s cabinet has now lost two ministers within one week after the International Development Secretary Priti Patel offered her resignation, shortly after she admitted to holding a series of unauthorised meetings with Israeli officials without the PM’s knowledge and suggested giving British aid money to an Israeli army project. In view of the increased instability around PM May’s government, some suggested this may have knock on impacts on the progress of Brexit talks. Nonetheless, the Irish PM Varadkar has signalled that Brexit talks could have a breakthrough by December, noting that “I’m more optimistic than I was in the weeks before the October Summit”. The current round of Brexit talks will resume today in Brussels.

Following on, BoE policy maker McCafferty has warned that clarity on Brexit will be needed by early next year to better allow businesses to forward plan. He noted businesses “cannot wait until the last minute”, adding that “there’s a point…even when it becomes clear what the final deal will be – whether it’s no deal or some sort of deal – the banks will have to act”. Elsewhere, the BoE’s banking regulator Mr Woods had earlier noted that it was “plausible” the UK could lose up to 75,000 jobs in the banking and insurance sector if it left the EU bloc without a trade deal.

Staying in the UK, according to a network of UK businesses monitored by the BoE, the latest agents’ summary suggest wage growth in 2018 should improve further, now likely to be 2.5%-3.5% yoy growth (up 0.5% from prior  readings), in part due to a slow-down in the availability of workers, which in some ways is not too surprising given UK’s unemployment is at a 42 year low. However, while the survey noted modest growth in spending is expected to continue for the coming year, expectations in the following two years were “weaker”.

Across the pond, the Fed’s Harker noted he has “not at this point” seen anything that would push him away from a rate hike in December, which is in line with the consensus view with the odds of rate hike unchanged at 92% (per Bloomberg). Looking ahead, he has “pencilled in three (rate) increases in 2018” but noted that this is somewhat evolving as he “will reassess that as the data comes in”. On potential tax cuts, he noted “we need more specificity as to what those programs would entail”, and that “we have not put any fiscal stimulus” in our forecasts at this stage.

Before we look at the day ahead, a quick recap of the minimal economic data from yesterday. In the US, the weekly MBA mortgage applications was flat (vs. -2.6% previous). Over in Europe, Spain’s September industrial production was above expectations at +0.1% mom (vs. -0.2% expected), leading to annual growth of +3.4% yoy (vs. +3.1% expected). In France, the September trade deficit was broadly in line at -$4.67bln, although there was a $0.3bn positive revision to the prior month’s reading. Elsewhere, the current account balance was lower than expected at -$3.1bn (vs. -$1.5bn expected). This morning in New Zealand, the central bank has the left cash rate on hold at 1.75% and noted that “monetary policy will remain accommodative for a considerable period. Numerous uncertainties remain and policy may need to adjust accordingly”. Elsewhere, inflation is now expected to trough at 1.5% yoy in 1Q18 but rebound to 2.1% yoy in 2Q.

Looking at the day ahead, data wise, September Germany trade data along with UK industrial production are due. Elsewhere, US initial jobless claims and wholesale inventories are also due. We’ll also receive the latest EC economic forecasts while the ECB’s Villeroy de Galhau, Coerue, Mersch, Lautenschlaeger and Constancio are due to speak. Brexit talks are due to resume between Barnier and Davis while President Trump holds meetings with China’s Xi and Li Keqiang.


“No Information Content”: Goldman Explains How The Fed Broke The Market

When looking at variations in the short and long-end of Treasury curves in Europe versus the US, Goldman’s Francesco Garzarelli has made a remarkable observation: whereas market expectations of the trajectory for monetary policy in the US and Euro area continue to diverge, manifesting in a growing delta in short-end yields, the correlation of returns on long-dated bonds on the two sides of the Atlantic remains very high. The explanation for these cross-country dynamics, according to Goldman, can be traced back to the behaviour of the term premium, which is technically defined as the excess yield compensation investors usually require for holding long-dated bonds, but in practice is the umbrella “fudge factor{” term used to “explain” central bank impacts on longer-dated bond prices and moves.

These two dynamics are shown in the charts below: while short-rate expectations continue to diverge between the US and Europe (left), the term premia in the US and the Euro area bond markets have tracked each other increasingly closely, especially since 2014 (right).

Whereas several years ago there was a broad disageement over what is the primary driver behind the depressed term premium, gradually the analyst community was forced to admit reality, and accepted that the term premium is merely another way of calling central bank intervention on bond prices. Indeed, Garzarelli admits as much, saying that “low term premia reflect both the present macroeconomic environment and central banks’ actions.”

As Goldman futhers explains, while “historically, the premium tends to decline in economic expansions, when investors are less wary of bond price fluctuations. Low consumer price inflation, particularly when associated with greater confidence that it will remain contained, also acts to depress the term premium. But there is more to the decline in term premia during this cycle than can be ascribed to the growth and inflation outlook.”

The chart below from Goldman shows a growing undershooting of the aggregate term premium on 10-year bonds in the major economies from where historical relationships with macro factors would have it. “This departure from historical norms coincides with the introduction of negative rates and sizeable purchases of long bonds by the ECB and the BoJ.” In other words, the nearly 1% delta can be attributed to the actions of one or more central banks.

The above observations suggest that fixed income investors expect policy rates in the major blocs to continue heading in different directions, at the same time thanks to central bank yield suppression, they continue to search for yield and remain on the look-out for the highest term premia across countries. Here’s what that looks like mechanistically:

When a central bank bids up long-dated bonds through a combination of negative rates and QE, the ensuing compression in the term premium on domestic bonds spills over onto other major fixed income markets where the term premium is the highest. After the start of the ECB’s QE in 2015, for example, the Euro area experienced substantial net outflows of long-dated bonds, which started to partially reverse this year as the term premium on US Treasuries picked up in relative terms.

The issue, as Goldman explains, is that such capital flows pose challenges for central banks. Confirming something we have repeatedly shown, namely that despite 3 rate hikes, financial conditions in the US have reacted as if the Fed has cut rates three times, as long as foreign QE contributes to keeping the term premium on US Treasuries low, the Fed may need to lean more than usual on short-term rates in order to tighten domestic monetary conditions. This means that if the Fed is indeed concerned about asset bubbles, it will be forced to tighten substantially more than the market expected.

By contrast, in order to preserve monetary accommodation, the ECB will be required to keep a firm grip on the front end of the EUR yield curve should long-dated Euro area bond yields be pulled up by a rebuild of global term premium resulting from the Fed’s ‘quantitative tightening’. This logic has been behind Goldman’s expectation for a flatter term structure of US rates, and a steeper one in the Euro area. Beyond fixed income strategy, we see three further implications for macro investors stemming from the unusual dynamics in global term premium.

What are the implications of this divergence for traders? There are three.

First, as Goldman explains, international bond spillover effects are worryingly large. Indeed, “the international co-movement in term premia has now reached levels that warrant attention, and in particular the uncertainty over the inflation outlook is gradually increasing (smaller output gaps, higher commodity prices). Reflecting an unusually high degree of cross-country term premium spillovers, the diversification benefit of international bond portfolios has declined considerably. Moreover, empirical evidence shows that the higher price of long-dated bonds has made them in greater demand by institutional investors such as insurance and pension funds. When both the demand and supply of bonds are an increasing function of the price level, multiple equilibria can arise and elicit unanticipated large changes in yields.

Needless to say, when (rising) price becomes the only variable behind purchasing decisions, any reversals could have dire consequences. And, just to make sure the warning is heard, Goldman cautions that “in the current market environment, these yield shocks may propagate more quickly across the advanced economies than was the case during the ‘taper tantrum’ episode in 2015.” This means that once the selling in the long-end begins, the consequence could be far more severe than the sharp selloff observed in one or more previous “taper tantrum” episodes.

The second implication is especially relevant for currency traders, because FX has become more correlated with relative term premia: As noted by ECB Executive Board member Coeure in a speech last Friday, in recent months the Euro-US Dollar FX cross has moved more closely with the differential in the Europe-US term premium than the differential in interest rate expectations.

Global fixed income investors were attracted to US bonds after a rebuild of term premium in the wake of US President Trump’s election (rate expectations rose as well, but to a lesser extent). Higher demand for US fixed income progressively eroded the US term premium, at a time when expectations of ECB tapering were starting to build. This swung the term premium differential further in the Euro area’s favour.

Then, more recently, the start of quantitative tightening in the US and the extension of quantitative easing in the Euro area rebalanced the term premium differential towards the US again, strengthening the Dollar. Deprived of (expected) yield, global investors are then forced to chase the highest premium that central banks afford them, affecting currencies in the process, in Goldman’s view.

* * *

But it is the third, and most important implication, that is of particular note as it goes to the very core of the “circular reflexive” conundrum that has been plaguing the Fed, which according to Janet Yellen has been unable to explain the “mystery” of low inflation 10 years into this so-called recovery. The reality, is that there is nothing mysterious about suppressed inflation: in fact, it is the all Fed’s own doing, and as a result of trillions in liquidity, “the information content in long bonds (and inflation) is low” in Goldman’s words. The bank explains:

By amplifying the compression in the term premium on nominal rates, QE may have also created distortions in the breakeven inflation market. To be sure, inflation expectations derived from both surveys (consumers,  professional forecasters) and market measures (forwards and options) are low, reflecting a protracted period of low realized inflation prints in spite of expansionary monetary policy. The uncertainty around inflation forecasts has also declined, all arguing for a lower inflation ‘premium’. Terminal real rates (R*) in advanced economies have been on a downward trajectory over the past decade, and have been affected by common factors, but they have been relatively stable in recent years, reflecting a lower frequency of real-side shocks. Against this backdrop, QE (and the price amplification dynamics it has set in motion by upsetting the demand-supply balance for long-dated bonds) has tightened the positive relationship between the term premium and inflation forwards.

The punchline can be taken right out of any Soros book on market reflexivity between cause and effect, to wit:

this circularity – QE contributes to depress longer-dated inflation forwards, which in turn encourages central banks to deliver more QE – has lowered the information content that can usually be found in long-dated fixed income instruments.

That is Goldman’s polite way to say the Fed’s QE has broken not only the bond market (i.e., its “information contnent” is non-existant as it is entirely at the mercy of central bank liquidity), but also forward inflation measures, which is terrifying as it is these very measures that the Fed gauges in determining whether to do more QE. The perverse circularity is the daily bizarro world market participants have become all too familiar with, and boils down to the following: the more QE the Fed does, the lower inflation breakevens slide, the lower yields drop, the more QE the Fed believes it has to do, and so on in a self-reinforcing feedback loop, one which has now continued for 9 years because the “smartest people academics in the room” have been unable to figure out just how they broke the market. 

And the final implication: since bond yields are artificially low – whether due to chasing term premium, or because of the Fed’s perverse circularity – it means that the only justification for 20x P/E multiples, i.e., low rates (as per the Fed model) can be thrown out of the window. Of course, if that happens, both the bond and stock markets would crash… which is also why nobody at the Fed will ever be willing to openly admit what Goldman just said.  


What Could Go Wrong?

Authored by James Howard Kunstler via Kunstler.com,

Everybody and his uncle, and his uncle’s mother’s uncle, believes that the stock markets will be zooming to new record highs this week…

And probably so, because it is the time of year to fatten up, just as the Thanksgiving turkeys are happily fattening up – prior to their mass slaughter.

President Trump’s new Federal Reserve chair, Jerome “Jay” Powell, “a low interest-rate kind of guy,” was obviously picked because he is Janet Yellen minus testicles, the grayest of gray go-along Fed go-fers, going about his life-long errand-boy duties in the thickets of financial lawyerdom like a bustling little rodent girdling the trunks of every living shrub on behalf of the asset-stripping business that is private equity (eight years with the Deep State-ish Carlyle Group) while subsisting on the rich insect life in the leaf litter below his busy little paws.

Powell’s contribution to the discourse of finance was his famous utterance that the lack of inflation is “kind of a mystery.” Oh, yes, indeed, a riddle wrapped in an enigma inside a mystery dropped in a doggie bag with half a pastrami sandwich. Unless you consider that all the “money” pumped out of the Fed and the world’s other central banks flows through a hose to only two destinations: the bond and stock markets, where this hot-air-like “money” inflates zeppelin-sized bubbles that have no relation to on-the-ground economies where real people have to make things and trade things.

Powell might have gone a bit further and declared contemporary finance itself “a mystery,” because it has been engineered deliberately so by the equivalent of stage magicians devising ever more astounding ruses, deceptions, and mis-directions as they enjoy sure-thing revenue streams their magic tricks generate. This is vulgarly known as “the rich getting richer.” The catch is, they’re getting richer on revenue streams of pure air, and there is a lot of perilous distance between the air they’re suspended in and the hard ground below.

Powell noted that the economy is growing robustly and unemployment is supernaturally low. Like his colleagues and auditors in the investment banking community, he’s just making this shit up. As the late Joseph Goebbels used to say describing his misinformation technique, if you’re going to lie, make sure it’s a whopper.

The economy isn’t growing and can’t grow.

The economy is a revenant of something that used to exist, an industrial economy that has rolled over and died and come back as a moldy ghoul feeding on the ghostly memories of itself. Stocks go up because the unprecedented low interest rates established by the Fed allow company CEOs to “lever-up” issuing bonds (i.e. borrow “money” from, cough cough, “investors”) and then use the borrowed “money” to buy back their own stock to raise the share value, so they can justify their companies’ boards-of-directors jacking up their salaries and bonuses – based on the ghost of the idea that higher stock prices represent the creation of more actual things of value (front-end-loaders, pepperoni sticks, oil drilling rigs).

The economy is actually contracting because we can’t afford the energy it takes to run the things we do – mostly just driving around – and unemployment is not historically low, it’s simply mis-represented by not including the tens of millions of people who have dropped out of the work force. And an epic wickedness combined with cowardice drives the old legacy news business to look the other way and concoct its good times “narrative.” If any of the reporters at The New York Times and The Wall Street Journal really understand the legerdemain at work in these “mysteries” of finance, they’re afraid to say. The companies they work for are dying, like so many other enterprises in the non-financial realm of the used-to-be economy, and they don’t want to be out of paycheck until the lights finally go out.

The “narrative” is firmest before it its falseness is proved by the turn of events, and there are an awful lot of events out there waiting to present, like debutantes dressing for a winter ball. The debt ceiling… North Korea… Mueller… Hillarygate….the state pension funds….That so many agree the USA has entered a permanent plateau of exquisite prosperity is a sure sign of its imminent implosion. What could go wrong?


The Big Reversal: Inflation And Higher Interest Rates Are Coming Our Way

Authored by Charles Hugh Smith via OfTwoMinds blog,

This interaction will spark a runaway feedback loop that will smack asset valuations back to pre-bubble, pre-pyramid scheme levels.

According to the conventional economic forecast, interest rates will stay near-zero essentially forever due to slow growth. And since growth is slow, inflation will also remain neutral.

This forecast is little more than an extension of the trends of the past 30+ years: a secular decline in interest rates and official inflation, which remains around 2% or less. (As many of us have pointed out for years, the real rate of inflation is much higher–in the neighborhood of 7% annually for those exposed to real-world costs.)

The Burrito Index: Consumer Prices Have Soared 160% Since 2001 (August 1, 2016)

Inflation Isn't Evenly Distributed: The Protected Are Fine, the Unprotected Are Impoverished Debt-Serfs (May 25, 2017)

About Those "Hedonic Adjustments" to Inflation: Ignoring the Systemic Decline in Quality, Utility, Durability and Service (October 11, 2017)

Be Careful What You Wish For: Inflation Is Much Higher Than Advertised (October 5, 2017)

Apparently unbeknownst to conventional economists, trends eventually reverse or give way to new trends. As a general rule, whatever fundamentals are pushing the trend decay or slide into diminishing returns, and new dynamics arise that power a new trend.

I've often referred to the S-Curve as one model of how trends emerge, strengthen, top out, weaken and then fade. Trends often change suddenly, as in the phase-shift model, in which the status quo appears stable until hidden instabilities cause the entire "permanent and forever" status quo to collapse in a heap.

The Bank for International Settlements (BIS) recently issued a report claiming that Demographics will reverse three multi-decade global trends. Here's a precis of the case for a globally aging populace and a shrinking workforce to reverse the downward trends in inflation and interest rates: New Study Says Aging Populations Will Drive Higher Interest Rates (Bloomberg)

Gordon Long and I discuss the demographic and financial forces that will reverse zero-bound interest rates and low inflation in our latest video program, The Big Reversal (The Results of Financialization Part III)

The demographic case is actually a study of labor, capital and savings. In essence, the authors of the paper are saying that the vast expansion of the global workforce (led by the emergence of China as the world's workshop) is a one-off that is about to reverse as the global Baby Boom generation retires en masse.

They also argue that the equally vast expansion of credit/debt that's powered the global expansion in the 21st century is also a one-off, as this monumental debt overhang has a characteristic peculiar to debt: it accrues interest, and as the debt balloons, even low rates of interest add up, weighing on weak growth and soaring entitlement spending.

Although it's not popular in today's debt-dependent zeitgeist to mention this, debt is not capital. Put another way: savings still matter, and as the older generation of workers retires, they will draw down their savings, a process that will make real capital (as opposed to lines of credit resting on fictitious/phantom collateral) more scarce and thus more costly for those wishing to borrow it.

Since it's a given that human labor is being replaced by robots and automation, the authors' call for higher wages strikes many as a false hope. If the human labor force is shrinking due to automation, why would wages for the remaining workers rise?

One little understood factor helps explain how labor can be scarce even as many jobs are automated: the easily automated work is commoditized, and low-touch, meaning that the human "touch" isn't the value proposition in the service.

But the value of high-touch services is added by the human presence. Do you really want to go to a swank bistro and place your order/retrieve your food from an automated service kiosk serving automated-prepared meals? Isn't the value proposition of the bistro that you will have a knowledgeable and experienced service and kitchen staff?

Granted, there may be people who will be delighted to be served in cubicles by robots, but since we're social creatures, this will wear thin for those who can afford more than an automated fast-food meal.

Even the most modest discounting of the hype about AI provides a more granulated understanding that not all work can be commoditized and indeed, nontradable work that cannot be commoditized will increase in value precisely because its value isn't created by the process of commoditization.

If the labor force shrinks at a rate that's faster than the the expansion of automation, wages will rise even as automation replaces human labor.

I explain this further in my book on work in the emerging economy, Get a Job, Build a Real Career and Defy a Bewildering Economy.

Gordon and I add the systemic fragility introduced by financialization to the demographic argument. The entire global asset market–stocks, bonds, real estate and commodities–is at heart a pyramid scheme in which the rapid expansion of credit drives asset prices higher, and since assets are collateral for additional debt, the higher asset valuations enable a new round of hyper-credit expansion.

This pushes asset valuations even higher, which sets the stage for an additional expansion of credit, based of course on the astounding rise in the value of the collateral supporting the new debt.

Central banks have powered this pyramid scheme by buying bonds and stocks with currency created out of thin air. This chart of the Bank of Japan's astonishing balance sheet is a bit outdated; the BoJ has purchased so many bonds and ETFs (stock funds) that it is now a major owner of Japanese stocks and bonds.

Of course debt isn't just a central bank phenomenon; corporate and household debt have soared as well. The global debt overhang is unprecedented:

My view is that once this tsunami of new debt-based currency hits the real-world economy, inflation will move a lot higher a lot faster than most pundits believe is possible. Trillions of yen, yuan, euros and dollars have flooded into the asset pyramid scheme. Once this tide washes into real-world goods and services, the inevitable result is inflation.

The tectonic forces of demographics meeting the increasingly fragile pyramid scheme of financialized debt-inflated asset bubbles will more than reverse the 30+-year trends of ever lower inflation and interest rates: this interaction will spark a runaway feedback loop that will smack asset valuations back to pre-bubble, pre-pyramid scheme levels.

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The Central Bank Bubble: How Will It Burst?

Alberto Gallo of Algebris Investments steps up to take his shot at the $64,000 (more like trillion) question in a report published this week “The Central Bank Bubble: How Will It Burst?”

Gallo manages the Algebris Macro Credit Fund described as “an unconstrained strategy investing across global bond and credit markets, and with lead responsibility for Macro Strategies” on the company’s website.

Gallo sets the scene as follows.

Most investors are still playing the game, and in the same direction. We estimate there are currently around $11tn in negative-yielding bonds and over $2tn in strategies that explicitly or implicitly depend on stable volatility and asset correlations. If low interest rates and QE have been the lever pushing up prices of dividend and coupon-paying assets, central banks are the fulcrum.

This fulcrum is slowly shifting: the ECB has just announced a reduction in its bond purchase programme, the Bank of England is likely to hike this month – even in the face of economic weakness –the Fed will likely hike rates again in December, and the PBoC has recently warned of asset overvaluation.

One of our favourite parts of the report is “The Magic Money Tree” infographic which explains how QE has benefited a plethora of investment strategies and created the current bubble to end all bubbles.

Now Gallo is obviously savvy because he doesn’t nail his colours to the mast on one factor which will prick the central bank bubble. Instead he offers four scenarios. The first threat is a rise in inflation, which he summarises as follows.

1. Inflation: after nine years of low-flation, the probability of a sudden rise in inflation is increasing, as job markets get tighter, globalisation leaves way to protectionist policies and liquidity reaches job-creating small and medium businesses as banks re-start lending.

Wage inflation aside, Gallo believes China could continue to export inflation based on a more resilient than expected Chinese economy. Gallo believes that China may have sufficient policy options to smoothly deflate its credit bubble. While we might disagree, it is a possibility.

The second threat to the central bank bubble is…central bankers.

2. Central bankers themselves: central banks appear to have shifted their tone to worry increasingly about financial stability. There are good reasons to do so. We are many years into a global synchronous expansion, and there will be little monetary policy ammunition to fight a new slowdown, with interest rates near record lows and $20tn in global central bank balance sheets. In some countries, like Japan and Switzerland, central banks have grown their balance sheets to sizes similar to their respective economies. The good news is some central banks are trying to curb stimulus before their mandate ends. The Federal Reserve is poised to raise rates again in December, the Bank of England will likely hike, the ECB has announced a reduction in purchases and the Bank of Canada has hiked too. The bad news is that markets have so far largely ignored this reduction in stimulus.

It makes sense…central banks created the bubble via QE and ZIRP/NIRP, so reversing that strategy might prick their own bubble.

The third threat is another merry band of miscreants.

3. Politicians: central bank QE has not only lowered yields and boosted asset prices. It has also artificially suppressed volatility. Yet volatility may come back as the consequences of rising inequality in the distribution of wealth, opportunity and natural resources across the world. The last decade has been great for billionaires, not so good for Main Street. Inequality of wealth and opportunity in developed economies has fuelled anti-establishment protest votes like the ones for Brexit or President Trump. Other populist parties are on the rise in Continental Europe and Scandinavia. In turn, domestic populism and nationalism in developed countries can increase commercial conflict and protectionism – see for instance the potential withdrawal from NAFTA, or the EU-UK tariff threat – as well as exacerbate militarism and geopolitical conflict. Populism has historically fuelled government spending and fiscal stimulus, higher taxes and aggressive redistribution policies, which could all re-price overvalued assets and/or target assets used as a store of value. 

We have nothing to add.

4. The market: rising growth, low inflation and low interest rates have proven a boon to global markets. There are now $20tn in central bank assets globally, and around 10% of global sovereign debt is yielding negative. Investors have been buying equities for yield and bonds for capital gains, and have been selling volatility explicitly or positioned in strategies that are implicitly short volatility. These assume a stable volatility and correlation among the price of assets. For example, risk-parity strategies assume a negative correlation between risky assets, like stocks, and "risk-free assets", like U.S. treasuries. But what happens if both decline together, and short volatility investors become forced to unwind their portfolios?

Exactly, this is what we’re waiting for, but what is the catalyst? Nobody knows.

If we were forced to guess what will prick the bubble, we would probably place more emphasis on China than the Algebris report does. However, putting aside what causes it, we share Gallo’s view on some of the key mechanics which will be “in play” when a crisis unfolds.

What will the next crisis look like?

The over $2tn in explicit and implicit short-volatility strategies could be the spark, similar to sub-prime for credit markets in 2008, which was $1.4tn. However, a future crisis would be very different from 2008. Growth in passive investing vehicles and in the mismatch between assets they buy and liabilities they issue, lack of risk-free assets and growing collateral chains, diminishing trading liquidity due to higher capital requirements for dealers point to more fragility in financial markets.

It's perfectly set up, if we only knew when.

*  *  *

Full report below…


BofA: The Liquidity Supernova Is Ending, “This Is The Biggest Risk of All”

If 2017 has had a surreal feel to it, it is because it has so far been a “perfect encapsulation of 8-year QE-led bull market” according to BofA’s chief investment strategist Michael Hartnett, a “bull market” which has turned financial logic and fundamental economic relationships on their head, and replaced everything with copious money creation as the only marginal price setter.

What are the characteristics of this “bull market”: Hartnett describes them as i) Lower-than-expected rates, ii) higher-than-expected EPS, iii) non-existent inflation = big cyclical returns for asset prices (e.g., EAFE equities & industrial metals); but thematic leadership of “scarce growth” (e.g., tech stocks) & “scarce yield” (high yield and EM debt) which remains the heart of the bull.

In order to spawn and rear this artificial bull market, central banks have unleashed an unprecedented degree of extraordinary monetary easing in recent years, revealed by lowest interest rates in 5,000 years. As BofA further calculates, we have seen 698 global interest rate cuts since Lehman bankruptcy, as well as $11.1 trillion purchases of financial assets by central banks since Lehman.

However, if it was central bankers’ intention to boost Main Street at the expense of Wall Street, they failed – as we warned would happen in 2009 – and as everyone now realizes. They did succeed, however, in created the biggest Wall Street boom in history: since the Global Financial Crisis ended in 2009, US equity market cap has risen $17.8tn…far, far outpacing the $2.6tn gain in US real personal income

However, like every other artifical, man-made thing, this “bull market” too, will come to an end. Here, the structural reasons are three, and all go contrary to what the inflation that the Fed is desperate to spawn: these are Debt, Demographics, and Disruption, and combined result in Deflation.

According to Hartnett, who first coined the equality, the 3 “Deflationary D’s” (excess Debt, aging Demographics, tech Disruption) cap inflation: “the slowdown in the growth of the working population is deflationary, as are new biotechnologies that may extend human life”

Here, BofA also points out that technological disruption is also deflationary via an increased supply of labor, energy, services, financial, consumer products. Furthermore, the number of global robots by 2020 is expected to rise to 2.5 million, up from 1 million in 2010. According to the bank, US urban workforces most at risk of automation are in the Midwest, Florida, south California; less at risk in San Francisco, Seattle, Boston, NY,

The combination of record debt, record deflation and record (old) demographics means that deflation assets have massively outperformed inflation assets at the same time as US equities have massively outperformed non-US equities.

This euphoria, in turns, leads to one bubble after another.

According to Hartnett, the structural risk is that the era of excess Liquidity & wage Disruption by AI ends with a tech & credit bubble, one which will force the Fed to pop it – this is Jay Powell’s “biggest nightmare.” But before he does, the 30-year UST would go to 2%, according to Hartnett, while HY spreads would drop to 100bps and the Nasdaq would hit 10,000.

Yet as the world careens to this final, mega bubble burst, the liquidity supernova is already ending.

Yet while the market is aware of this, what it does not believe is that the one thing that can stop the party – inflation – will appear. Indeed, according to Bank of America, inflation is the single biggest risk for asset prices in 2018.

In this context, Hartnett calls 2018 a “one-decision market” : either inflation returns (bearish) or it doesn’t (bullish):

 risks to “Goldilocks” consensus: 1. “inflationary boom” = rates up = flash crash a la 1987/94/98…best trade = long CRB, short CCMP; 2. “recession” via Quantitative Tightening + lower EPS = bear market…best trade…long T-Bills & gold, short HY & EAFE.

Hartnett concludes by looking at the fate of the “Icarus Rally” which he first defined one year ago, and says that “the only reason to be bearish is there is no reason to bearish.”

But even that, almost a decade into the most insane market period in history, is coming to an end: