It’s A Trap!

It’s A Trap!

I’m a twenty something millennial, and like a lot of those on Wall Street and or in finance, I lack the experience to tell me that this recent move in risk assets is a trap… but that doesn’t mean there is a lack of evidence I can put forth to support my hypothesis.

After all, if it looks like a trap…

If it smells like a trap…

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And if it sounds like a trap…

It’s probably a trap…

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Well if the OECD says it, it must be true. I guess anything is better than the level of governance the US and indirectly the world has suffered under these past 16 years. We finally have a business friendly president in the White House who respects state’s rights. You can practically feel the collective sigh of relief out of Wall Street. And yet, I must remind them that President Obama was terrible for business but great for stock prices, is it so hard to believe that the opposite be true under business friendly President Trump?

The “Trumpflation” narrative is a paradoxical joke that ignores history and common sense. The idea that Donald Trump can quickly end the political gridlock that has strangled our nation for so many years is akin to the same euphoria that marked the end of tech bubble. Donald Trump, is a deal maker, and a persuader but historically speaking, he’s early. Alexander Hamilton had already mapped out the future republic of the United States at the close of the revolutionary war in 1783, but it wasn’t until 1787 that the US Constitution was actually created and it would take another 2 years after that for it to finally be ratified.

Donald Trump much like Alexander Hamilton has promised drastic change in a time of hidden crisis. To these men it was clear that the final battle had not yet been fought, but the majority of the population did not share their sentiment.

In order to win the election, Donald Trump successfully united a diverse group of people and yet he didn’t win the majority vote. And although the republicans may have won congress, Donald is hardly a republican president. Donald Trump is akin to a battle commander who has charged too far ahead of his troops. He will need to wait to gather the army before he can launch an effective attack. I have little doubt that Donald will bring about much needed change in time, but rescinding some executive orders will only tickle the status quo.

The odds that the New Deal 2.0 will arrive later than current market expectations is high. Of course that $1T stimulus over 10 years would amount to a pittance regardless. The US government owes $20T of debt, what’s another $1T over 10 years, really?

One only needs to look to Brexit, to see the folly of the current “Trumpflation” euphoria. The action passed with a narrow vote and now remains in perpetual limbo. The situation is a bit different with the incompetent and poorly designed EU at the other side of the negotiations but has the US Congress shown to be much different over the past 8 years?

Remember when a democratic president with a majority in congress could barely pass the disaster that is the Affordable Care Act? Now there is reason to hope, and perhaps after I put ink to paper, the Democrats will push Pelosi out of her leader position ushering in a wave of unexpected change. But I’m not holding my breath.

As I have said before, the market has likely gotten ahead of itself. Perhaps I’m overestimating the narrative’s effect on surging inflation expectations and should more attribute such a move to China’s rising inflation (and I will do just that later in the article). But interest rates in this country have risen to the detriment of all those who owe debt.

History continues to rhyme as investors once again get sucked into yet another transient spout of “rising inflation” near the end of a credit cycle. The problem with rising inflation is that it pushes up interest rates which prick the credit bubble that Fed was brewing. Mortgage rates have spiked sharply in the wake of the election.

 

 

 

 

 

 

 

 

 

Which in turn hurts demand for mortgages.

The following from Wolfstreet,

“…for the national median home, priced at $232,200, with rates going from 3.57% to 4.5%, costs would rise by about $1,200 a year. If rates hit 5%, costs would jump by about $1,900 a year. For households on a tight budget, these additional costs would turn into an impossible squeeze.”

This unexpected belt tightening comes at a time when American households are incredibly sensitive to rising costs. According to the lovely WaPo,

“About 46 percent of Americans said they did not have enough money to cover a $400 emergency expense. Instead, they would have to put it on a credit card and pay it off over time, borrow from friends or family, or simply not cover it at all.”

One can only imagine the pretzel shaped box rising mortgage rates will force American households into.

But mortgage rates aren’t the only interest bearing debt that is rising. 3M Libor has been rising steadily for over a year now, even after the regulations were put in place in October – RIP 2a7 Regulation Narrative.

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As bank borrowing costs have steadily risen through out the year, one would think the value of those banks would fall, but not in the Utopian narrative of Trumpflation where all is great, yuuge and tremendous.

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To be able to trade this market, one is forced to employ the George Costanza method of trading. george-costaza-blog-rev

Of course I’m only joking. But for those managing money, whose ranks I’ll be joining early next year, this is no joke. Unsurprisingly, hedge funds have continued to get creamed by these paradoxical moves which has further accelerated the push to passive.

It appears they have all had enough of trying to out think the market and simply bought any and every asset as long as it was denominated in dollars, including US treasuries.

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But is now the best time to go long US treasuries? I hate to break it to them, but they aren’t the only ones trying to catch this falling knife.

On a rate of change basis the move in treasuries has some room to run.

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Of course the slow moving risk parity funds that have piled more and more into US treasuries have also been slow in unwinding their levered positions.

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And of course, I always enjoy a good anecdote from a trusted source, in this case Julian Brigden.

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Now I may not share Julian’s views that the “cyclical low” in yields is officially behind us, nor do I buy that this is in fact a structural change in the bond market. As I have said previously, I’m on the side of transitory spike of inflation that catches the markets and investors off guard and pushes the world into a deflationary crisis. Given the record low bond yields and investor positioning we saw over the summer, I’d say this hypothesis is still on track. That’s not to say that this head fake cannot be very large, but I must stress given the fragility of the global economy, it’s hard to imagine this inflation push not leading to some kind of global financial crisis.

The rising US interest rates have driven the dollar higher, creating a dollar short squeeze around the globe. Entities that borrowed cheap dollars will get clobbered as the dollar continues its rise. Despite investors closing their eyes, pinching their noses, and screaming La-La-La-La at the top of their lungs, currency and credit risk have continued to exist. They say an image is worth 1,000 words, this one I like to think is worth 1000x.

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Plunging cross-currency basis swaps indicate this dollar shortage has begun to accelerate.

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This dollar shortage is like a virus that turns the body’s cells against it. The longer it persists the larger it grows. And ever since the virus entered China, the global economy has been running on borrowed time.

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All durations of SHIBOR have risen steadily the past 13 days, further tightening liquidity in the country.

It was only a matter of time before these conditions prompted a response from investors…

Quoted by Bloomberg, Wu Sijie, bond trader at China Merchants Bank said “tightening interbank liquidity and the expectation of even higher short-term borrowing costs are driving up swap costs and affecting sentiment on the cash bond market.”

And those expectations are are likely justified given China’s rising inflation. Inflation that is rising because the government tried to engineer a bottom in a credit cycle through a massive stimulus push. China has added over 45% of GDP in debt this year alone, but due to the declining availability of productive investments, the lion’s share of this stimulus found its way into speculative investments such as housing and commodities. Commodities have done particularly well in China this year which has helped fuel the rising inflation and push interest rates higher. And higher interest rates have tightened liquidity, threatening to pop the speculative commodity bubbles.

This correction could be temporary but it would be foolish to assume that these parabolic moves in commodity prices were not only sustainable but entirely devoid of consequence. 2016 was a lost year for the Chinese economy and yet the leaders in Beijing continue to believe that they control their own destiny. But as they continue to close down other channels of capital outflows, it risks trapping this inflation in China and further destabilizing the country. As Julian Brigden’s model shows, China in less than a year has gone from deep deflation to surging inflation.

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This inflation will be exported to the rest of the world pushing yields higher and hurting all those who owe debt. The rising dollar should dampen the inflation China exports to the US, but still, on margin that inflation is rising and will likely continue to push bond yields higher for the short term.

Let’s not forget the impact rising oil prices will have on inflation around the globe. This time last year oil was trading in the 30’s, but as of writing this article, it appears OPEC has agreed to a production cut in concert with some non-OPEC members. The blood bath in fixed credit appears to have only just begun.

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Perhaps no place on earth is less prepared for rising inflation than Japan. Where the BOJ has pegged rates to the floor. It will be interesting to see how they respond to these pressures with the Yen in free-fall. Like all pegs, I expect this one to be broken.

Europe is not to far off Japan’s predicament either, with negative rates and a central bank expanding its balance sheet like a mad man, they too are incredibly susceptible to surging inflation. Of course I’m ignoring and glossing over the myriad of problems baked into the continent’s politics…

…as well as it’s banking system.

If we go back to the prior crises, of the last few decades we’ll note that they all started with a spurt of inflation followed by severe deflation. In this case I’d like to use the 1998-2000 example. In response to foreign shocks of the Asian financial crisis and Russian Ruble crisis, the Fed eased. Once the shocks subsided, the Fed began to tighten, which pulled capital into the US and pushed the dot com bubble to historic highs. I think we are witnessing a similar event but with important differences.

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In response to a foreign shock (the Yuan devaluation), the Fed eased (stopped its rate hike cycle). That pause, allowed for inflationary pressures to build up, while simultaneously pushing interest rates lower. Now, with those inflationary pressures too high to ignore, the Fed is forced to hike. But the foreign shocks that put the Fed on pause never went away and have only grown larger.

Although we are likely in the blow off top phase of US equities, the duration and magnitude of this phase will be dampened due to the abnormally high amount of foreign land mines just waiting for the Fed to step on. If the typical blow off top phase is 18 months, we maybe have 9-12 months which started in early November. I remain open to other possibilities but until new information comes to light, I leave the last word to Admiral Ackbar.

 

Correction: the Revolutionary war ended in 1783 not 1983. The constitution was written in 1787 not 1987. 

Weekly Review: Would You Like To Know More?

The world increasingly finds itself off-balance. The reach for yield phenomenon has left the global system exposed to any increase in interest rates. Rates were steadily rising from the relative peak in “reach for yield” over the summer, but it wasn’t until Donald Trump won the election that investors had a narrative they could latch on to, “Trumpflation”.

Trump is expected to run large deficits that will stimulate inflation. Except Trump’s stimulus package which is only $1T over 10 years will be executed mostly through tax credits. Hardly inflationary, but investors have latched onto the narrative all the same ignoring the bigger risk for rising inflation, China. According to @CrossBorderCap, the world’s factory, China, is the true driver of inflation.

Recall during a 4 week period in Q1 of this year, China pumped out $1T in stimulus. And that stimulus along with the very slow cutting of excess capacity has broken the deflationary spell that had gripped China for the past 4 years.

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Investors have been caught off-side by higher inflation leading to record losses in the sovereign bond markets.

The amount of debt in the global financial system has never been higher which will magnify the impact of any move higher in interest rates. To make matters worse, US yields have led the charge higher which has lifted the dollar with it.

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Although the trade weighted dollar index has yet to break out to 13 years highs like its DXY counter part, a rising dollar spells trouble for those who borrowed cheap Fed QE dollars post crisis. According to Paul Mylchreest of ADM,

“Chinese companies and entities probably hold $2 trillion of “short dollar” positions once contracts through Hong Kong, Singapore and Japan are included.”

With the Yuan at a post crisis low against the dollar, I’m very worried that this unwind could accelerate beyond the control of central planners.

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The BIS paper had some very interesting conclusions. Perhaps most significant is the rising dollar’s effect on interbank liquidity.

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Unsurprisingly interbank lending rates rose every day this week with the longer durations starting to make substantial moves higher.

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And yet despite this relatively large tightening, the Yuan continued to weaken against the dollar. The steep depreciation will most likely be met with increased capital flight further straining liquidity in the Chinese economy.

However, it is important to note that the Yuan still managed to hold its own against the rest of the major currencies, proving that this is a dollar strength story more so than a Yuan weakening story… for now.

But the dollar is the most important fiat currency in the world, for its rise poses problems for all countries who borrowed too many dollars, not just China.

Going back to the BIS paper,

” Our results therefore show that the dollar index has explanatory power over and above the bilateral dollar exchange rate for cross-border bank lending. This finding strongly supports our previous hypothesis that the dollar is a global risk factor, which affects the risk-taking capacity of banks, and, ultimately, the supply of cross-border bank lending.

In short, the rising dollar is a sign of rising systemic risk. To make matters worse, there are participants who are actively throwing fuel onto this rising fire.

Ignoring the fact that every peg in financial history has been broken the BOJ plunged headfirst into the breach and pegged Japanese Government Bond yields to the floor. Their goal is obvious, force investors out of zero yielding JGBs and into other higher yielding assets such as the dollar. By artificially inflating demand for the dollar this policy creates a serious dollar shortage in Japan which is evident in the deeply negative basis swaps.

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I bring this up, because the Yen normally appreciates in risk-off environments. Japanese investors hold the largest amount of assets as percentage of GDP abroad. When markets sell off, Japanese investors repatriate their capital which strengthens the Yen. And yet by strengthening the Dollar vis a vis its yield curve control policy, the BOJ is increasing the likelihood of igniting a risk-off environment that would undo all its Yen weakening efforts.

Bringing this all back to the US economy, where the stronger dollar will most certainly act as a headwind for growth and earnings. In my last post I wrote,

“Let’s not forget the US consumer who is by no means healthy with debt levels hovering at record highs. The double hit from higher mortgage rates and Obamacare premiums is likely to be too much for them too handle.”

Their rising wages will eat away at any corporate earnings growth while simultaneously being insufficient to cover the rising costs of housing and healthcare. All in all, this is not a healthy economy whose recession will likely provide a dollar head fake that could rapidly appreciate the Yen beyond the BOJ’s control and wreak havoc in the financial markets. Needless to say, the Klendathu Capitalist is as bearish as he’s ever been.

Reports Of The Bond Bull Market’s Demise…

…were greatly exaggerated.

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Rates are not likely to go much higher from here. I got ahead of myself in my latest posts, when I projected the rate rise a little too far. Although that scenario is still in play, I no longer think it is the most likely outcome. It’s likely that the narrative surrounding our newly elected and wild card president Trump will not stand the test of time… Nor will this massive jump in inflation expectations.

Consensus has simply turned bullish way too way too fast.

At the same time, a world not long ago on the cusp of deflation now finds itself worried about things going in the other direction. Higher inflation is now expected by a net 85 percent of the fund managers surveyed by BofAML, a 12-year high.

The narrative around Trump and other presidential candidates of the past has been proven wrong time and time again. After 8 years of gridlocked government it’s easy to see why investors are so hopeful for a return to efficiency in our bureaucracy. But hope isn’t a strategy and consensus is too bullish on the US government efficiency. Trump has already encountered trouble with his transition team and congressmen on both sides of the aisle are preparing to fight him on a number of issues. The US is a long way away from any stimulus plan. And the stimulus plans being discussed will likely be marginal and ineffective at best. The real growth from Trump’s plans will likely come in deregulation and tax code simplification, but those effects are still years away.

Let’s not forget the US consumer who is by no means healthy with debt levels hovering at record highs. The double hit from higher mortgage rates and Obamacare premiums is likely to be too much for them too handle. And yet investors are now piling into risky bank stocks at a record pace. Consensus is now bullish US equities and bearish bonds, ignorant of the fact that the stock bubble is supported by the bond bubble. Such a paradoxical narrative will likely be proven incorrect.

The push higher in both equities and interest rates seems to be one big head fake. The stronger dollar will hurt US international company earnings. The Fed is tightening interest rates in response to inflation expectations that are unlikely to be met. Important to remember, the rate hike has already been priced into the US dollar. US treasuries are exceptionally cheap to their foreign counterparts as well.

This bullish illusion we find ourselves in should quickly fade as the US economy slows, and inflation expectations fall, effectively dragging interest rates down with them which will temporarily weaken the dollar.

 

The Sword Of Damocles: The Rising Dollar Dooms Us All

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If it wasn’t clear from my latest post, or my September post titled: Just Around The River Bend: USD Bull Market Resumes, I believe we are in the early stages of the next leg higher in the US dollar bull market that will result in the breaking out of its central bank created trading range and in the end have devastating consequences for the global economy.As of this morning Yuan has fallen to a post crisis low against the dollar. That means all those QE dollars that the Fed pumped into China are going to come back with a vengeance.

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The stronger dollar combined with rising inflation should continue to push rates higher in China. Rising rates translates into less liquidity, thereby forcing a response from Beijing to keep the economy “humming”. Overnight shorter term SHIBOR continued to push the longer duration rates higher.

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Beijing may be able to flood the system with liquidity but that will only increase financial speculation and inflation as the amount of available investments and projects is limited. Look to keep a watchful eye on key commodities such as copper and coal.

Back in February, if you asked an investor what she would do if the Yuan was at a 2009 low against the dollar she’d probably tell you to sell everything, but time and narratives have changed. For now, investors do not care one bit about the Yuan. The Russel 2000 hit a new all time high this morning and major bank stocks are up over 3%. Meanwhile US bonds continue to sell off pushing rates and the dollar higher.

The spill over effects from higher rates are already starting to show in the real economy. US mortgage rates are on the rise.

Someone better step into the bond market soon, because the longer this bond sell off continues, the worse it will get.

But that doesn’t mean this is the end to the +35 year bond bull market. Rates cannot rise forever simply because the high levels of debt in the system will simply not permit it. For the global economy runs on debt, and if no one wants that debt anymore the system will collapse.

Which once again brings into sharp focus the irony of all these risk-on moves in equities and the selling of gold. These recent moves are most likely head fakes to be taken advantage of. I’m even looking at buying long term bonds here soon. But we’ll see, one has to be very very cautious around a sharp move like this. Sometimes instead of catching a fallen knife, it is better to let it hit the floor first. In the end, I look to fade the a majority of these head fakes and take advantage of the rising dollar story.

 

The Case For Higher Interest Rates: Setting The Stage For The Next Global Crisis

The law of unintended consequences once again has made a fool out of the Fed. Not like it’s difficult to do these days. Simply picking a random number between 1 and 2 has proven to be a better GDP forecast system than the thousands of PhD’s working for the Federal Reserve.

If it wasn’t obvious to the Fed already, it will be soon. Inflation has been rising steadily throughout the year. The FOMC made mention of it many times in their minutes, and yet still they held tight, refusing to budge, only talking up the dollar when it was about to fall from its “mystical trading range”.

In the summer months, it was clear momentum chasing and BREXIT fears had pushed government bond yields way too low. At this time inflation had already been rising for many months and was set to go much higher, and yet the Fed stayed put, unwilling to risk any volatility that might put Donald Trump in the White House. Perhaps if they listened to Jeff Gundlach, and perhaps if Jeff Gundlach listened to Jeff Gundlach they’d all be a lot happier right now.

Although I’m sure Jeff’s doing just fine. After all, he’s not the one who is behind the curve, and that’s even before Trump was elected. So now the Fed has to hike. Or as Stanley Fischer tries to explain to the world in his version of the it’s our currency but it’s your problem speech,

“I am reasonably optimistic that the spillovers from ongoing U.S. normalization will be manageable for the foreign economies… I am cautiously optimistic that the drag on the U.S. economy and inflation from past dollar appreciation may have mostly worked itself out, and that foreign economies are on a somewhat more secure footing that poses smaller downside risks to the U.S. economy.”

The Fed has been cornered for years, never able to unwind its policies without inviting disaster. The problem with being behind the curve is that the Fed will have to admit through policy that they made yet another mistake.  If the Fed doesn’t react fast enough, inflation could rip higher pushing bond yields to intolerably high levels.

Meanwhile, wages are rising at the fastest rate since the crisis.

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Trump has promised to run a highly stimulative government which will push up inflation and increase the available supply of US treasuries. Higher interest rates will also increase the US government’s cost of borrowing which will further increase the supply of US treasuries. Even before rising US interest rates had pushed the dollar higher, foreign central banks, suffering from a serious lack of dollar liquidity, have been forced to sell US treasuries en masse.

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Let’s not forget the people who piled into US treasury bonds at the all time highs in the face of this bond doomsday scenario.

The unwinding of the TINA phenomenon will not be pleasant. Bond market liquidity is incredibly low, and with everyone selling, it will likely be non-existent. Trump’s victory has opened a can of worms the world is not prepared for.

Speaking of unintended consequences, imagine you are a yield starved Japanese investor whose interest rates have been pinned to floor. Your own central bank has practically outlawed interest rates. Your currency has already started to fall against the US dollar which now offers a much higher rate of return. Would you hold that worthless government paper if US 10-year interest rate rose to 3%? The BOJ seems to be on the verge of monetizing a lot more bonds than it originally signed up for.

It’s a cocky statement, but given the scenario I’ve just outlined it’s incredibly difficult to argue against. Unlike in Japan, in Europe rates although negative can and have indeed moved higher. The tighter spread between interest rates should pare some of the losses the Euro will have against the dollar. But Europe’s economy is much more fragile than the US, and therefore will be much more sensitive to any move higher in interest rates. Said differently, rising interest rates will increase the spread between the economic health of the two Unions. That widening spread will likely be reflected in further dollar strength versus the Euro.

Of course any rising dollar story would be lost without China, perhaps the largest land mine and dollar bull catalyst of them all. Through the Yuan’s peg to the Dollar, China imports the US’s monetary policy much more directly than the rest of the world. It’s important to remember that TINA also applies to China. Although Chinese investors receive a higher yield than other nations, they arguably took on much greater risk to do so. Over the last few years, to sustain this investor appetite and generate those relatively high rates of return, Wealth Management Products (WMPs) have increasingly invested each other, creating an interconnected web of systemic risk that mirrors the subprime bubble in the United States. The rising dollar and rising interest rates will threaten to reduce the precious liquidity that this ponzi finance scheme so desperately needs to sustain itself.

But aren’t I missing something? Doesn’t the rising dollar crush commodity prices? And shouldn’t falling commodity prices keep inflation in check? Unfortunately, it’s not that simple. In reality, the rising dollar squeezes the commodity complex forcing some commodities artificially lower and others artificially higher. If you hadn’t noticed, the major commodities tied to China have all done incredibly well this year, while oil and gold more recently have been crushed. As Jeffery Snider explains,

Reconciling copper to gold, however, isn’t that difficult. As noted prior, there is much more Chinese influence in the former than the latter. And though conditions in China itself are being driven by the “dollar”, it has responded only recently with what I am sure is a wash of RMB. In that way, perverse as it might seem, surging copper would indirectly agree with a gold slam by the very difference of likely PBOC action – gold suggests an increase in “dollar” pressure, causing a more forceful PBOC internal response, having great positive effect on copper prices.

The rising dollar prompts a liquidity response from the PBOC which increases financial speculation and in turn creates these face-ripping rallies in China related commodities.

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As I noted back on November 1st, in a post titled The Mirage: China’s Speculative Fueled Rally,

“Unsurprisingly, these speculative driven commodity rallies have started to impact the real economy. In September, China reported its first YoY PPI gain since 2012.”

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The PBOC like the Fed is now faced with its own conundrum. Maintain the peg, and allow the tightening liquidity to crash the economy, OR pump more liquidity, let the currency fall and be eaten alive by rising inflation. The latter is evident in rising short term lending rates despite significant Yuan weakness. And recently, the move higher in short term rates has finally started to push longer term rates higher. Further weakness in the Yuan, instead of easing the economy, may actually push rates higher as inflation in China accelerates.

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I understand that this is an incredibly bearish post, especially given the bullish optimism and positive developments in the US economy. The long but shallow profit recession appears to finally be receding, but it is important to remember that inflation always feels “good” in the beginning. The energy sector in particular appears to be stabilizing, but at what cost. These companies piled on trillions of debt to stay alive and maintain their dividends in our TINA environment. TINA is on life support, and the cost of borrowing for these companies is set to rise.

Following up with the bullish price action in the banking sector, given my perspective, it would be a mistake to consider said action as anything more than a head fake. These stocks are simply following a snap judgement response to the steepening of the yield curve, rather than an in-depth analysis of the complex and poorly understood system that is the global debt bubble.

Perhaps the greatest example of this supposed head fake was seen in amazing out-performance of small cap stocks this week.

I truly hate to be so binary, but you have to see the irony. Central banks have been “dying” to generate inflation for years, and now that it’s here, it could destabilize this whole low volatility system they’ve been so desperate to protect. Of course, Trump still has to pass his infrastructure bill through a gridlocked Congress. He does have a republican congress, but it’s not clear how willing they are to work with him. But if the list of foreign leaders lining up to make a deal with Trump is any indication, I’d say the odds of a Trump stimulus package are quite high.

I will also add that the current blow out in US bond yields looks more likely than not to be taking a breather for now. But given the dynamics I discussed here, I think it is a matter of months before the US bond selloff re-accelerates and applies significant pressure to the weakest links in the global economy.

 

 

 

Paradigm Shift: The Return of Volatility

Holy Moses, hold on to your hats folks! We are in for a wild ride!

Interest rates led by US treasuries around the globe are sky rocketing higher. The implications attached to this meteoric move will be incredibly difficult to grasp.

The sheer amount of debt attached to these rising yields has never been higher. The same goes for the momentum that chased these ultra low yields and other bond proxies such as REITs and Utilities.

Of course there’s one place on earth where interest rates can’t lift off. Because the BOJ in all of its wisdom decided to put an artificial ceiling on their yield curve. Well there is a cost to this yield curve control and that is the monetization of every bond that gets sold to them, which is why it is so important to watch the Japanese government bond yield curve. Once rates start pressing up against the BOJ’s targets, it will be forced to intervene.

While US and other developed nations bond yields are rising, Japan’s will be pinned to the floor and the BOJ will prints trillions and trillions of Yen to maintain said peg. If this continues the Yen will weaken considerably as the Japanese seek a better rate of return outside the country.

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The weakening of the Yen is not without its consequences of course. The BOJ has given up control of its balance sheet to the markets in return for the control over the price of its bond market. Helicopter money has never ended well through out history, and yet if the Japanese are sending billions of dollars out in the world, asset prices could be supported.

With that said, there is an underbelly to rising US interest rates, which is a much stronger dollar. China’s struggles with the currency peg have been well documented. Rising rates in the US will tighten liquidity in China’s fragile economy increasing the risk of a crisis. China’s crisis has remained elusive to the bears for over a decade, and perhaps it is further out than I or most bears seem to think, BUT…

Just like emerging market bulls were blind sided by the US subprime crisis in 2008, I fear equity bulls are making a similar mistake ignoring the rising China risk.

The Sun Also Rises… Eventually

This is incredible stock market action right now. The S&P 500 has rallied over 130 points off the election night lows. It appears that American will be much better run these next few years. A republican congress combined with a business friendly President is something the world hasn’t seen in decades. The probability that the political gridlock may finally be loosening up is another boon to the economy. After a barren investment climate these past 4 years, companies and investors finally have pro-business government policy to look forward to.

But guys, there’s this thing called the credit cycle, and the American consumer is maxed out. Inflation is rising. US treasury bonds are beginning to price in said inflation and selling off. The 10 year just broke 2.0%.

If Trump can pass a stimulus bill in the face of rising inflation, the US economy will run very hot. Rates in the US could sell off incredibly sharply. The Fed will be forced to tighten, most likely far beyond China’s tolerance. Most likely, barring a significant foreign shock (Italian Referendum anyone?) the Fed will hike rates in December.

The dollar has rallied sharply since Trump got elected most likely due to expectations of higher interest rates. This has made matters much worse for China as the offshore Yuan plunged to a new record low of 6.82 on the dollar. Once again, I would like to remind those that were investing in EM unaware of a housing bubble in the US got clobbered in 2008. Those who ignore China’s problems do so at their own peril. Higher US interest rates and tighter monetary policy will only exacerbate China’s ballooning problems.

Although I remain incredibly upbeat on Donald Trump’s victory, the magnitude and time horizon of said event will be not be felt as strongly as quickly as the market currently anticipates.  The effects of his policies will likely harm our fragile trade partners and risk throwing the globe into another recession. I admit I could be wrong on the strength of China’s economy. But given the strength of capital flight at the slightest sign of weakness in the Yuan, I doubt that the market is closer to the truth than I.