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.

China’s Slowdown Could Mean Big Trouble For Base Metals

Industrial commodities stand on a deflationary cliff edge

Photo by Екатерина Александрова from Pexels

Written September 19, 2019

China’s quasi-capitalist system, where the communist party still retains a degree of control over the economy, leaves the true state of affairs subject to a certain amount of suspicion.  Is the economic data accurate or is it just what they want us to see?

Which is why many investors rely heavily on proxies for Chinese activity to more accurately determine the state of play in their economy.  Base metals widely used in construction and manufacturing, such as copper, steel and iron ore have well-deserved reputations as gauges of economic trends.  They are also all freely traded on financial exchanges, where price discovery and transparency allow them to be used as a check against official statistics put out by the state.

With the exception of oil and gas, China is the world’s largest consumer of most commodities.  According to data compiled by The Visual Capitalist’s Jeff Desjardins, China imports half or more of the world’s production of nickel, copper, and steel (as well as cement and coal), so any changes in behavior in China will have a meaningful impact on prices of those commodities. See https://bit.ly/2KPz9nZ.

Chinese growth has been steadily declining for the past year and a half.  The latest GDP reading for the second quarter of 2019 at 6.2% was the weakest result in twenty-seven years.  For experienced China watchers, 6% has long been considered something of a line in the sand as a minimum level of growth required to keep a sufficient number of people employed and to avoid any dissent against the government from taking root.  Two events this past week suggest that point may soon be at hand.

Underscoring the urgency of the situation, Chinese premier Li Keqiang admitted that it is becoming “very difficult” for China to maintain that crucial 6% growth rate. See https://reut.rs/2lTmjvV.  He must have been tipped off because just 24 hours later it was revealed that in August China’s industrial output fell to a rate of only 4.4%, its weakest showing in 17 years.  And that was before the latest round of trade tariffs were imposed. See https://bit.ly/2lVzL2g.

Not surprisingly, this slowing in growth is weighing on prices in the base metals sector as well as across the commodities complex in general.  One look at a chart of either copper or the broader CRB index shows that like the Chinese economy, commodities are approaching cliff edges of their own (see below).

Legendary trader Raoul Pal calls the current price pattern of the CRB index the most dangerous chart in the world, worrying that a break lower would be a sign of complete deflationary breakdown. China might be the center of this storm but it will have global implications for consumers and policymakers alike. A dire prediction for sure. As forward-looking indicators of this possibility, investors ignore the action in the base metal sector at their peril.

Copper
CRB Core Commodities Index

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.

Fed Rate Cut: Too Little, Too Late

Strong dollar poses risks for reluctant policymakers

Photo by Colin Watts on Unsplash

August 4th, 2019

The Fed cut rates by 25 basis points (one-quarter of a point) last week, as expected, amid signs of slowing global growth. Chairman Jerome Powell tried to reassure investors that the economy was still on solid ground and that the move was merely a “mid-cycle adjustment”, not the beginning of a prolonged easing cycle. Don’t bet on it. Persistent strength in the US dollar is both a sign and a reason why a recession is closer than they think.   

As we’ve noted repeatedly here before, the US dollar is the Achilles heel of the international financial system. Through their easy-money policies in the wake of the 2008 recession, the Fed encouraged a massive buildup in leverage by both sovereign and corporate entities. Unfortunately, to service that debt borrowers are negatively exposed to any decrease in the supply or increase in the price of those dollars.

In the past year, slower global growth, declining international trade volumes, tighter US monetary policy and a reduction in the Fed’s balance sheet have all contributed to a reduction of dollar liquidity in funding markets. This fundamental shortage of dollars has driven its price higher on FX exchanges. In 2018 a strong dollar roiled the markets (especially emerging markets) before the Fed was forced to pull the plug on its monetary policy normalization plans in the hopes of capping the currency’s rise. It worked, barely. After pausing for a couple of quarters the dollar is on the move again as the global shortage intensifies. See https://bloom.bg/2YnU5fh. The path of least resistance is clearly higher, perhaps significantly, and it’s going to take a lot more than one rate cut to turn it around.

Compounding the dollar squeeze is the current budget bill crafted by congress, which eliminates the debt ceiling for the next two years and allows US government spending to increase virtually unchecked. To meet these new financing needs it is expected that over the next several months the treasury will need to raise $250 billion in fresh cash, further draining the supply of dollars in the system. See https://on.wsj.com/2SXVJOE.

Despite the shift toward easier monetary policy, the broad dollar index (DXY) climbed to its best level in two years. The FX market’s message to the Fed is unmistakable: the cut in rates was too little, too late. The risk for policymakers from here is that a stronger dollar will create deflationary headwinds, possibly tipping weak economies into recession, and force the Fed to cut rates deeper than they’re willing to admit.

The US dollar, breaking out.
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