Turning Japanese

Photo by Nicki Eliza Schinow on Unsplash

The Fed’s response to COVID will zombify corporate America for a generation

Written June 21, 2020

In “The L-Shaped Recovery“, we predicted that a combination of demand destruction, job market uncertainty, rising debt, and a shift in consumer behavior would hinder the economy from achieving a rapid recovery from the COVID pandemic.

Since that writing, the Fed has taken the unprecedented step of intervening directly in support of the credit markets, producing a spectacular V-shaped rebound in the financial markets. But as we all know, the market is not the economy.

The economic template that the current public health crisis is most often compared to is the Great Depression of the 1930s, but a more instructive precedent for what the future holds might be that of Japan, which is still trying to shake off the effects of the financial market bubble that popped in 1989.

To put the excesses of 1980s Japan in context, it was said that the 280 acres of land within the walls of the Imperial Palace in central Tokyo was worth more than the entire state of California. At the time, this became the benchmark against which all other insane real estate and lending valuations were linked. When it inevitably crashed, Japan, Inc. tried borrowing their way out of trouble. More than 30 years later, and after racking up an eye-watering debt-to-GDP ratio of 279%, they’re still trying to find a way out.

In Japan, bankruptcy is not seen as a financial tool deployed to clear the decks of bad debt but rather as a cultural stain, one of humiliation and loss of face. So corporate Japan, and the country itself, stumbles onward like a zombie, burdened by mountains of legacy debt, unable to reap the benefits of innovation that leaner balance sheets would enable. This interminable trap is so ubiquitous that it even has its own name: Japanification.

Unfortunately, the Fed is headed down a similar path. Not only by backstopping the credit markets but by actively pushing prices higher, the Fed has allowed almost every corporation access to cheap money. It may be necessary, but just like the never-ending policy of quantitative easing destroyed the price discovery function in the equity markets, the unintended consequence of credit intervention is doing the same to the bond market. Normally where good corporate governance is rewarded and bad decisions are punished, everybody now gets a trophy.

In my day job as an editor for a financial news service, I spend a large portion of my time reading press releases from companies tapping into an almost unlimited supply of liquidity in the credit markets, with most of it going to refinance revolving bank debt incurred during the pandemic. Borrowing is literally exploding.

While this widespread refi effort is tactically beneficial in the near term to bridge the gap in cash flow created by the virus lockdown, the long term risk is that it will allow bad capacity to remain on the books, keeping unproductive companies alive and leaving little room for innovation and for fresh entities to thrive.

Corporate America was already running record levels of debt and leverage before the pandemic hit. Half of the investment-grade bond market is precariously rated BBB, just one notch above junk. Wide-scale bankruptcies and credit downgrades are indeed a systemic threat in a weakened economy, and it is forcing the Fed’s hand to prevent the entire system from snowballing downhill and out of control. But, like Japan, the unintended consequence of today’s policies will be a debt burden that will take years, if not decades, to climb out from under.

In a note to clients last week, Bridgewater Associates’ Ray Dalio warned of a “lost decade” for the equity markets as profit margins get squeezed by debt servicing costs. See here https://bloom.bg/3hMBVtC.

We tend to agree and would use this recent rebound in financial markets to reduce risk exposure while sticking with core long positions in the US dollar, short-term treasuries, and gold.

Debt explosion (courtesy Federal reserve bank of St. Louis)
Sharp rise in unproductive debt (courtesy Deutsche Bank)

Going Negative

Photo by Ussama Azam on Unsplash

Debt deflation starts the U.S. on a path to negative interest rates

Written May 10, 2020

Last week, for the first time in the country’s history, the financial markets began discounting the possibility of negative interest rate policy.  

On Thursday, the December Fed Funds futures contract settled above par (100.00), implying that traders have moved beyond talking in the abstract about negative interest rates and started betting with real money that the Federal Reserve will be forced by events into crossing a line they’ve long insisted they would not step over. 

Japan, Europe, Switzerland, Sweden, and Denmark currently have negative interest rates, policy legacies left over from fighting the last recession in 2008. The theory was that people would be so repulsed by having to pay a bank to hold their money that they would gladly spend it instead, stimulating the economy in the process. It hasn’t exactly worked out that way.

Rather than driving consumer demand, negative interest rates have resulted in a minefield of unintended consequences. Besides the lack of confidence it conveys to the public on behalf of impotent policymakers, it has clogged the banking system and perverted the lending process.

Count us among those who previously thought there was little chance that the Fed would follow the rate policies of its Japanese and European counterparts. But as we recently wrote in “The L-Shaped Recovery“, the pandemic has exposed and accelerated the threat of debt deflation that could end up triggering waves of bankruptcies.

The deflationary scenario was brought into stark relief after we recently came across a chart overlaying the Economic Cycle Research Institute’s Weekly Leading Index (WLI) with the US consumer price index (see below). As the name suggests, the WLI anticipates economic activity 2 to 3 quarters in the future. If the correlation with the CPI holds, it means prices could begin dropping later this summer.

Just as the value of debt falls in real terms in an inflationary environment, it rises in deflationary times. The problem is compounded by declining cash flows as a result of weak economic activity, making it harder to service that debt and potentially creating a serious problem for highly leveraged economies like ours.

The other moving part in the relationship between debt and deflation is the U.S. dollar. If the Fed’s policy rate is anchored at zero and market yields can’t keep pace with falling prices for goods and services, real yields (the nominal yield minus the rate of inflation) will rise, driving the dollar higher and depressing the price of imports domestically and commodities globally. As we said in “The Biggest Trade in the World“, “the risk to the broader economy is that a stronger dollar triggers a doom loop of debt deflation, where slower global growth causes the dollar to rise and a stronger dollar, in turn, depresses prices and causes growth to slow.”

As has been the case with every rate cut in this cycle, the market will lead the way for the Fed’s next move. And given the risk that rising real yields could pose to the prospects for a recovery, investors are concluding that the Fed may have no choice but to take rates negative.

Besides being long-time proponents of the U.S. dollar and front-end treasuries as core investment themes, we recently recommended adding a position in physical gold. Gold may be subject to bouts of selling if the dollar continues to rise, as many traders still reflexively see the two as inversely correlated. But because there doesn’t seem to be any limit on central bank money printing, gold will shine as the ultimate store of value in a world of increasingly negative interest rates.

Economic Cycle Research Institute Weekly Leading Index vs US Consumer Price Index. Chart courtesy of Real Vision.
December 2020 Fed funds Futures, trading above 100 for the first time ever and implying negative policy rates in the U.S.

The L-shaped recovery

Photo by BRUNO CERVERA on Unsplash

Investors blindsided by the virus shouldn’t compound their problems by thinking that things will immediately return to normal once it passes.

It’s hard to predict the outcome of unprecedented events because, by definition, they’ve never happened before and handicapping them is nearly impossible. The models used by scientists to justify a complete shutdown of the global economy to mitigate the spread of the coronavirus may turn out to be off by a factor of ten, or more. It’s not meant as an indictment of them but an acknowledgment that like most investors trying to navigate the markets, they haven’t done this before either. At least not on this scale.

For that same reason, we should be skeptical of forecasts of a swift rebound once the virus passes. Just like how faulty data skews computer models, those calls seem to grossly underestimate the potential long-term damage to consumer confidence, supply chains, and the rejection of globalism in general. Garbage in, garbage out.

We were warning all of last year that markets were in an increasingly precarious position. See “Stall Speed“, “Tipping Point” and “Powell Plays for Time“. A decade of excessive monetary stimulus provided by the major central banks since the last recession in 2009 had all but destroyed the price discovery function of markets and dulled investors to signs of trouble. Record equity prices as a result of the Fed’s guiding hand and abundant liquidity obscured unsustainable debt burdens, slowing economic growth, declining corporate earnings and deteriorating credit quality. Many believed, and likely still do, in the Fed’s ability to extend the business cycle forever and revive the 11-year old bull market. To us the contradiction is nuts but as the old saying goes, the markets can stay irrational longer than you can stay solvent.

The virus exposed some serious vulnerabilities of the global economy, most notably the level of debt. As a result, we think that the economic adjustment to new societal norms and changes in consumption behaviors will take longer to play out than most of us can conceive.

Government officials and other commentators who are pushing a narrative of a V-shaped economic recovery are wrong on two basic assumptions.

1) It ignores the global debt dynamic, and the possibility that this event represented a tipping point long in the making. An unintended consequence of quantitative easing programs was companies taking advantage of cheap money to buy back their own stock and pay dividends rather than investing in their businesses. That’s now over, especially for any entity accepting federal assistance. And it should be.

Despite low rates and lots of government cash on offer, corporations will be forced to de-leverage their balance sheets to align with a new economic reality, which will come at the expense of capital spending, investment, and employment. Borrowing and refinancing costs could also rise as many companies suffer rating downgrades or find access to funds restricted by wary lenders. Businesses operating on thin margins, even large corporations, may not survive. If they do they are likely to run mean and lean for years to come rather than re-staff their employee ranks.

2) The claim of pent-up demand is ludicrous. Consumers are in shock. If you weren’t worried about your job before, you sure as hell are now. Just because your job might have survived the initial wave of layoffs it doesn’t mean it won’t get eliminated as the fallout ripples through the economy. Free government handouts will keep the lights on but don’t fool yourself into thinking that it is stimulative.

Rent payments that got waived in April are going to have to be paid in full in May or June, in addition to the current amount due. Credit card interest will continue to accrue. Most mortgages have been securitized, making it impossible to extend the terms and simply add missed payments onto the back end of the loan. Sure, you can defer several months’ payments but the bank is going to want all that back in a lump sum sometime this summer. And if you skipped eating out ten times or missed three haircuts while on lockdown, you’re not going to then go order ten meals when the curfew is lifted.

To steal a term from former Secretary of Defense Donald Rumsfeld, there are still too many unknown unknowns right now. To conclude that things will return to pre-virus normal is fantasy.

Many of us grew up hearing stories about the Great Depression of the 1930s. Unemployment then peaked at around 25%, and it affected spending habits for two generations. People hoarded, they saved. Like my parents and their parents before them, they never let go of that mindset.

Governments and central banks are literally throwing money at both the markets and at citizens alike in an effort to stop the bleeding, but for the reasons stated above it may not be enough. Don’t confuse liquidity with solvency. The Fed might be able to address the former, but for many, the latter is still very much a risk.

One big positive for the economy is the resilience of the American consumer. The labor force is more flexible, means of communication and transportation more efficient and capital markets more dynamic than it was last century. Technology helps society to adapt to changing conditions almost instantaneously. In large measures, people can now work and shop from home. The shutdown may actually open our eyes to better and more efficient ways of conducting our day-to-day lives.

While nobody could have forecast the COVID-19 virus, at this time last year we recommended being long of the U.S. dollar and front-end treasuries as a play on slowing global growth. We still like those positions but would urge readers to consider adding physical gold to their portfolios and use this rebound in stocks to reduce risk exposure. In the months and years ahead, many countries will be making moves to weaken their currencies (i.e. printing money) to stimulate their economies and regain an advantage in international trade. Gold is the flip-side of the depreciating fiat money coin.

So when William Devane appears on your TV urging you to buy precious metals as a hedge against “unstable governments printing paper money”, know that he may be on to something.

Gold
US Dollar Index (DXY)
US 2yr Treasury Yield

Jaws 2

Diverging paths of the economy and the market continues to be a study in contradictions

Photo by Viktor Talashuk on Unsplash

In the weeks since our last comment the major central banks, led by the Fed, have ridden in hard to try and extend the life of what is already the oldest economic expansion in history. A confluence of declining corporate earnings forecasts, weakening industrial and retail activity, and persistent funding shortfalls in dollar-based securities markets has forced the Fed to administer CPR on the financial system. Despite the outwardly calm appearance, the Fed is very nervous, literally throwing money at both the economy and the markets in an effort to prevent a downturn in global growth from metastasizing into another financial crisis. Massive levels of debt and leverage encouraged by profligate central bank policies over the past decade now mean that the normal cycles of the economy…and the inevitable periods of weakness…cannot be allowed to play out naturally without risking a complete meltdown in the financial markets. (See BBBe Careful).

In October alone the Fed restarted their balance sheet expansion, ramped the daily overnight repo financing allocation and cut rates for the third time in four months. It’s a veritable fire hose of liquidity that pumps between $60 and $100 billion per month into the marketplace. It’s also a dead giveaway that everything is not fine. Former Dallas Fed advisor Danielle DiMartino-Booth aptly described the state of play as the Fed trying to “suppress the unknown, that at its best is credit volatility and at its worst systemic risk.”

So far the deluge of liquidity, at least initially, seems to be having the desired effect. Like every other time in the last eleven years that the Fed has fired up another round of quantitative easing, regardless of prevailing economic trends, record highs in the S&P were all but certain to follow. This time is no different. And almost as if the third consecutive quarterly decline in year-on-year corporate earnings don’t matter. The title of our recent piece ‘Liquidity Trumps Fundamentals‘ speaks for itself.

Don’t be fooled by Jay Powell’s attempt at downplaying the need for future rate cuts and reassuring investors that the expansion still has legs. See https://on.wsj.com/2pTHtfE Having to hit the panic button after nearly a decade of policy stimulus is definitely not a position in which anyone on the board of governors thought they would find themselves. It’s becoming abundantly clear that without a major reset in asset prices and a restructuring of the role of the central banks in the markets, rates will never be normalized. The Fed is headed into a policy cul-de-sac from which there is no exit. Like an addict, they’ve hooked the markets on easy money. Make no mistake, the minute stocks stumble, rate cuts will be back on the table. As much as they’d like everyone to believe it, this is no simple mid-cycle policy adjustment. It’s a one way street toward zero interest rates. If there’s a lesson from the past year, it’s that the economy remains vulnerable and that the bull market in equities and credit is not self-sustaining without the Fed’s foot firmly on the gas.

Presumably, corporate CEOs get this. These are the guys making decisions on hiring and capital investment. The latest survey of CEO confidence is shockingly bad and contrasts starkly with optimism among consumers (see charts below). Visually, the surveys are very similar to the chart that became popular several months ago comparing opposing trends in equities and bond yields. Coined with the name “Jaws” it illustrated two major financial benchmarks projecting distinctly different economic outcomes. (See “Jaws” Could Take a Bite Out of Markets). Which indicator is ultimately proven right (bonds or stocks) remains an open question. The two charts below from The Conference Board on confidence reveals a similar contradiction. History shows two things: 1) CEO confidence leads consumer confidence and 2) a sharp deterioration in CEO confidence has immediately preceded each of the last five recessions (the gray shaded areas). But as with the original Jaws chart, which side is ultimately right and how these normally correlated, but currently divergent, trends snap back into line is yet unknown.

Our preference is to bet on the side of history. The heavy dose of hopium from coordinated central bank intervention driving stocks and bond yields higher in the past few weeks will fade in time. It’s another sugar high. We have been long the front end U.S. rate complex for all of 2019 and still see this sector as the most effective play on slowing global growth. The Fed has a trigger finger with respect to cutting rates. Be patient, but the widespread position flush underway in the bond market this week is an excellent opportunity to reload those long positions between now and year-end.

Jaws 2. CEO and Consumer Confidence telling different stories. Shaded areas are recessions. Courtesy Quill Intelligence

Or, expressed another way:

Record discrepancy between corporate and consumer confidence. Shaded areas are recessions. Courtesy Deutsche Bank Global Research
Dec 2021 Eurodollar future. Approaching support.

Enjoy the Party but Dance Near the Door

Reason to be skeptical of the latest central bank reflation trade

Photo by Filios Sazeides on Unsplash

The title of this piece refers to an old cautionary Wall Street cliche that describes a trader’s dilemma where the price action says one thing but his gut warns him that something is not quite right, and to not get too complacent. This is an apt description of the current state of play over the past few days. Markets are reacting optimistically to a potential trade deal with China and the prospect of supportive policy intervention by the major central banks, most of which involves creating more debt. Besides possible rate cuts by the Fed, BOJ, and ECB, China unleashed another huge credit impulse, see https://bit.ly/2kAGnTz, South Korea has enacted a massive fiscal spending program, see https://on.ft.com/2ZBihGx and the Germans are exploring ways to circumvent current limits on debt issuance, see https://reut.rs/2kDcsKl. That’s a lot of stimuli. No wonder the markets like it.

However, this collective panic among the policy crowd in the face of slowing economic growth doesn’t offer any new ideas other than to throw more money at a situation that previous waves of cash have failed to fix. Most investors now realize that after a decade of extreme monetary policies, excessive debt is becoming the problem, not the answer. It’s the reason why large parts of the world are trapped in a deflationary malaise. Not only will piling on more debt not work, but it will also make the eventual reckoning even more painful.

Since early this year we have focused on several trends: slowing global growth, falling rates, and a stronger dollar. A continuation of these generally-bearish themes, along with the pressure that it exerts on the vulnerable corporate credit and emerging market sectors, is still our base scenario.

Nevertheless stocks, yields, credit, and commodities have all caught a bid in recent days. The dollar is offered. With good reason, investors still strongly believe that the central banks can affect outcomes and that a safety net is firmly in place under the markets. One of our favorite risk sentiment canaries, the Canadian dollar, impressively held support at USDCAD 1.3400 (see chart below.) This is a sign that a broader recovery in the marketplace in the near-term is not only possible but likely.

Longer-term, the prospect of a global economy that is weakened by over-indebtedness and unable to maintain sustainable growth without the repeated intervention of central banks is a frightening prospect, and remains our primary concern. The big danger in our future will come at that point when investors lose faith in central bankers’ ability to keep the markets propped up. We’re not there yet but that re-set in valuations will be the trade of a lifetime…and not in a good way. Will it be next month, or next year, or five years from now? Nobody knows. So in the meantime enjoy this latest bull party but remember to dance near the door.

USD/CAD. The Canadian dollar (CAD) is a reliable indicator of global risk sentiment. Stronger CAD is bullish for asset prices.
US dollar index (DXY). Fails to break out higher, also bullish for asset prices, especially emerging markets.
Benchmark US 10yr Yield. Bottom in for now as broad risk sentiment recovers.

Powell Plays for Time

The Fed’s unspoken hope is that lower rates will keep the credit market from crumbling.

Photo by Adi Goldstein on Unsplash

July 15, 2019

Something doesn’t add up. Last week the Fed chairman Jerome Powell went before Congress to say that while the economy remains on “solid footing” it might need some assistance in the form of lower interest rates. It was barely six months ago when he was using similar language to advocate for higher rates. It makes no sense to pitch for easier monetary policy amid a hot labor market and record highs stock prices, but that’s exactly what Powell did.

The Fed chairman referred to economic headwinds blowing toward the US from abroad due to weakening global growth and disruptions in international trade. These pressures are real but hardly justifies the abrupt U-turn in Fed policy this year. It has to be something more than that.

Although Powell didn’t address it directly, the simplest explanation is growing concern over the state of the credit markets. As we wrote in “BBBe careful” one of the unintended consequences of easy money policies has been the explosion in debt, especially among weaker credits (lower-rated companies.) Despite a decade of massive monetary stimulus, the aggregate corporate credit profile has fallen well short of growth trends in the economy. In fact, half of the $5 trillion investment-grade bond universe is now rated just BBB, one notch above junk status.

It’s an understatement to say that this is an accident waiting to happen. It is quite literally a cliff edge, where even a handful of ratings downgrades could quickly create a feedback loop of forced liquidation by funds that are prohibited from owning junk, spreading outward and turning a simple economic slowdown to into a financial crisis.

The only option the Fed has is to play for time, massaging investor sentiment with the prospect of lower rates, maintaining ample liquidity and hoping (!) that growth will recover enough to feed through to corporate balance sheets. But considering that the current expansionary cycle is now already the oldest on record the odds are against it. Second-quarter corporate reporting season begins this week and will give us a look at whether the Fed-inspired exuberance in equities is matched by actual earnings.

Don’t underestimate the downside potential for interest rates. The Fed knows the credit market is the monster in the closet and is preemptively setting the stage for rate cuts despite the lack of any significant stress on the system. They are teed up to ease quickly and aggressively at the first outward sign of trouble. Whether the Fed has enough ammunition to alter the outcome under that scenario remains to be seen but given that the starting point on this next rate-cutting cycle begins with a policy rate at just 2.4%, we have our doubts. There is not much room between here and zero.

In April, we recommended owning short (2-3 year) treasuries. See “The dollar and deflation“. It’s still the best trade on the board and has much more to go.

HYG, the high-yield bond ETF. Despite a lot of heavy lifting from the Fed the bounces are getting smaller.

‘Jaws’ Could Take a Bite Out of Markets

Stocks and bonds both can’t be right on the economy

Photo by Clint Patterson on Unsplash

June 24, 2019

Wall Street has coined a term for the opposing economic messages being sent by the bond and stock markets: Jaws. Look at a simple chart (below) with the S&P overlayed on the benchmark 10 year Treasury note and you’ll see what I mean.

It refers to the yawning gap that began to widen early this year as a function of sharply higher equity prices and collapsing bond yields. One side suggests a boom and the other signals recession. Describing it is the easy part, guessing how it turns out is not. Both can’t be right.

The image of “jaws” also infers a danger to investors from a trap created by conflicting narratives that will inevitably snap shut, in this case as the macroeconomic state of play becomes clearer. But from which direction will the jaws close and who is most at risk? Will the economy take off or hit a wall? Will bond yields rise or will stocks succumb? We don’t know yet. Presently, both markets trade well and with the confidence that they represent the winning side.

Jaws is a reaction to 1) slower growth and 2) the Fed’s anticipated response. There’s no doubt that the global economy has been knocked off it’s footing by disruptions in international trade. In the US, it also suffers from old age. Next month the current expansion, that began in June 2009, will officially become the longest on record. Bond yields have fallen sharply as the possibility of a recession appears on the horizon, accelerated by these and other headwinds created by sub-par economic activity worldwide.

On the other hand, equity markets have enjoyed an impressive recovery since the Fed called off plans for tighter monetary policy back in January. The S&P spiked to fresh record highs last week after Fed chairman Powell went a step further and all but promised to begin cutting rates again. See https://bloom.bg/2WLgykO .

As I see it, the risk inherent in the jaws trade is that the prosperity projected by the equity markets is becoming more illusory, when in reality the economy and the markets are only viable when the Fed is backstopping them. All-time highs in stocks seem strangely disconnected from the expectation that more than half of the sectors in the S&P 500 are set to report negative growth in this current quarter.

In the last 50 years, only a quarter of all recessions were averted by easier monetary policy. Investors feeling confident that Chairman Powell has their backs may be overestimating the capabilities of the Fed to sustain a business cycle that is already past its sell-by-date.

JAWS. Competing outlooks from stocks and bonds.

Fed Set to Join Race to The Bottom on Rates

Increasingly negative yields in Europe and Japan weigh heavily on Fed policy

June 19, 2019

Photo by Braden Collum on Unsplash

Five years ago this month the European Central Bank made the desperate move of imposing negative interest rates in an attempt to spur growth and generate price inflation. It didn’t work. Economic activity on the continent now is barely noticeable, the banks are teetering and market-based inflation expectations are the weakest on record.

European bond yields are literally collapsing in a panic after European Central Bank president Mario Draghi revealed his latest prescription for growth: do more of the same. Because current policy obviously isn’t extreme enough the ECB thinks even deeper negative rates will certainly do the trick. Genius. Yesterday the benchmark 10yr German bund traded at -0.32 bps and similar yields in Poland, Sweden and France hit zero for the first time in history. Negative yielding bonds worldwide, mostly in Europe, now total about $12 trillion. What’s the goal here? How are banks ever supposed to profitably lend money with such a distorted yield structure? It has long been suspected, but today’s events confirmed that Draghi and the ECB are officially out of ideas. Europe is toast.

A similar experiment in Japan also failed miserably. The widely touted “shock and awe” scheme by the Bank of Japan in January 2016 also included a move to negative rates, which in theory was supposed to boost the economy by discouraging saving and encouraging spending. It didn’t turn out that way and the country remains trapped in a decades-long deflationary decline. A recent Reuters report claims that BOJ insiders knew immediately that the move to negative rates was a mistake. Despite the fact that they have nothing to show for it after three and a half years, the policy is still in place. See https://reut.rs/2Il0Sww .

This should be a lesson to all investors as the Fed stands poised to begin another rate cutting program of its own, possibly as soon as next month. While it’s becoming apparent that what ails the economy is moving beyond the reach of traditional policy remedies, central bankers like Mr. Draghi and Mr. Kuroda (of the Bank of Japan) are still fighting the last war. We assume that the Fed would never follow their lead and take US rates negative but who knows? The Japanese and the Europeans probably never thought they’d end up in their current predicaments either.

The last Fed easing cycle started in 2006 with an overnight rate of 5.25% before falling to 0% by 2008. This time around, if rates are eased again, the starting point will be less than half that, at only 2.4%. If the Fed feels compelled to ease policy every time the equity market gets in trouble, we’ll be at that zero threshold soon enough. In fact, some astute Fed observers think that chairman Powell’s recent reference to the downside limit on policy as being defined by the “effective lower bound” rather than a “zero lower bound” cracks the door for rates below zero. We’ll see.

Predictably, stocks are loving the possibility of lower rates but are we somehow supposed to feel good about all of this? It ignores the reason why an easier policy is back on the table in the first place. How long can we play the “bad news is good news” game before bad news actually becomes bad news?

As I wrote last week in Aussie-Yen: Currency Canary Keels Over, either growth needs to accelerate or there has to be a reset lower in the financial markets. The contrasting messages coming from the bond and equity sectors are as stretched as at any time in recent memory (see chart below.) One side will ultimately win out, but the waning influence of the central banks definitely poses a risk for growth.

Massive divergence: The S&P and the benchmark US 10yr Yield

Bonds and Commodities are the Unwanted Guests at the Equity Party

Bond yields and commodity prices see a much different outcome than stocks.

June 10, 2019

Have you noticed that issues the Fed cares about are conditional and dependent on whether the stock market is going up or down? When the market is rising things like trade wars and weak price trends, while worthy of mention, are still considered “transitory” events. More annoying than scary. On the other hand, when the market is falling these same factors are considered full-blown threats to the economy.

Market action in the month of May and the Fed’s response is a good example of the latter. Even though the S&P had dropped nearly 8% from all-time highs, it was still up 9% on the year when Fed chairman Powell hit the panic button on June 4 saying the Fed was ready to act “as appropriate” to counter growing protectionist threats to the economy. See https://cnb.cx/2WaWNi5. Wink, wink. That’s all the markets needed to hear to launch six straight days of vertical ascent. Forget about why the Fed might be considering rate cuts: collapsing inflation expectations, potentially impaired corporate earnings or deteriorating credit, the fact that they are is all that matters. The playbook for equities remains the same as it has for the past decade: the bad news is (still) good news. As renown economist John Maynard Keynes once said, “the market can stay irrational longer than you can stay solvent”. So true.

But several reliable macroeconomic benchmarks don’t seem to be playing along. While stocks rip higher, bond yields and prices for copper and oil have barely budged off their lows. It appears that the economic outlook projected by the fixed income and commodity sectors is quite a bit less optimistic than what is expected in the equity space. The conflicting message between these two worlds might be temporary and meaningless or it could be something worth paying attention to.

At some point, the marginal utility of repeated deployments of the Fed put will begin to decline. I have no idea if that time is near but subtle market divergences like these will be the first sign that the game may be over. Therefore I will be paying attention.

Two diverging outcomes: the S&P and 10yr Yields

FX Set to Tighten Screws on Dollar Debtors

May 31,2019

The US dollar yesterday closed at new highs for 2019, and at its best level in two years. It remains a safe haven destination in times of declining global growth and a weak investment climate made worse by seemingly unending trade disputes. The most recent move to impose tariffs on Mexican imports is proof that President Trump is not shy about using this tactic to advance policy. See https://reut.rs/2HLiYYc . Who would be surprised if Europe wasn’t the next target? If this is to be the new normal, traders are quickly coming to realize that many markets are not priced for it.

Two questions here are, can the dollar go higher and what is the impact? The answers are 1) yes and 2) not good.

FX, by nature, is all relative. Outside of the Swiss franc and the Japanese yen which also provide safe havens, there aren’t many currencies that you’d rather own than the dollar right now. Fundamentally, a 2% yield, deep liquidity, and a growing economy look pretty good compared to the mess in most other regions of the world. And export-dependent blocs like Asia-Pacific, Europe, and Latin America really have no choice but to weaken their own currencies to compensate for the hit to their economies from reduced trade.

Technically, the price action in the dollar is extremely bullish. In the short-term, the dollar index (DXY) continues to advance in a positive pattern of higher highs and higher lows. The long-term setup could see the DXY back at the 2002 highs, more than 20% higher from here.

The downside of dollar strength is that it’s likely to accompany, and even thrive on stress in the financial markets. The big dump in commodities benchmarks like copper and oil this week are signs that investors see this coming and are hunkering down. As we’ve written here before, the Achilles heel of the broader marketplace is the credit sector. See “Time to BBBe Careful .” A higher USD would squeeze leveraged dollar debtors, including many banking systems abroad, who are massively and negatively exposed. With half of the investment grade bond market rated BBB and hovering just one notch above junk status, a move up in the dollar could be the trigger that sets those dominoes falling and makes a credit meltdown our next black swan event.

Us Dollar Index