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.

Tipping Point

Declining economic growth may become too much for equity markets to ignore

Photo by Michał Parzuchowski on Unsplash

Written October 2, 2019

Yesterday’s sharp deterioration in risk sentiment is a sign that the equity market and its patrons at the Fed may have a couple of serious problems: 1) The latest numbers from the Institute for Supply Management (ISM) suggests the US economy may be close to, or already in recession and 2) the Fed has been too slow to recognize it. Neither of these issues is exactly new news but the stock market’s seemingly oblivious reaction to the growing danger has been nothing short of remarkable. Until now.

The continued erosion of benchmark ISM survey data on U.S. manufacturing, its worst reading since 2009, was punctuated by a complete collapse in the forward-looking new export orders component. See https://bloom.bg/2oWfXgK. The disruption in commerce and global supply chains from trade wars is real and intensifying. Similarly, contractionary readings on factory production from China and Europe this week only added to the recessionary drumbeat.

It is undeniable that the Fed underestimated the deceleration in the economy. Their hesitancy to ease when signs of economic weakness first appeared earlier this year probably means that a recession is now inevitable. They missed the boat. Even if the Fed cut rates aggressively now it may not matter. And that possibility is starting to occur to investors who had come to rely on the Fed as a consistent backstop for asset prices.

It feels like the markets are at a tipping point. The major central banks have spent a decade throwing trillions at the economy and have little to show for it except for unprecedented levels of income inequality. But it hasn’t stopped them from pressing forward with more of the same policies. The renewed race to the bottom on interest rates is becoming less effective while at the same time increasingly desperate.

The failed WeWork IPO might have rung the proverbial bell in this era of easy money and stretched valuations. Fundamentals matter. Earnings, which they clearly don’t have, matter. Like Pets.com, the poster child of absurdity from an earlier bubble, WeWork will go down as an example of “what were they thinking?” for years to come. See https://bit.ly/2nE1y8N.

As I noted in my two previous pieces (see VIX Cheap as Impeachment Threat Grows and Liquidity Trumps Fundamentals), the most obvious trades in this shifting paradigm are to be long volatility and long the front-end rate market. Historically, October is more volatile than most other months. And the lurch lower in key economic data points could be the catalyst that makes volatility in equities, bonds, and FX all suddenly appear to be ridiculously underpriced.

Furthermore, anyone who doubts that the Fed could take rates back to zero, and quickly, has not looked at the U.S. dollar. The growing global dollar shortage, which we’ve written about extensively, is pushing the buck up through multi-decade resistance (see Fed Rate Cut: Too Little, Too Late). The long term dollar index (DXY) chart is very bullish, and if the USD gets legs it will make the 2018 emerging market selloff look tame by comparison. The Fed can’t afford for that to happen and will be forced to keep cutting rates to try to prevent it.

US dollar index (DXY). Breaking out higher.
Emerging market ETF (EEM). Look out below. A stronger USD leaves this sector very vulnerable.
CBOE volatility index (VIX). Cheap and bullish.

Dollar Coming Back to Life

Global USD funding shortfall pressures becoming more acute

Photo by Jp Valery on Unsplash

July 8, 2019

Even before Friday’s better than expected jobs data, dollar bears had reason to be nervous. Despite the massive decline in interest rate expectations, doubts over the Fed’s independence, the implementation of a functional alternative global payments system (circumventing the USD) and rising twin deficits the dollar remains surprisingly well bid and within 2% of the highs of the year. Even President Trump’s threat to engage the US in the same currency manipulation that he accuses other countries had virtually no adverse impact on the price of the dollar. Occasionally, what doesn’t happen in the markets is as telling as what does happen. This is one of those times and a sure sign that the setup for the dollar is now skewed asymmetrically to the upside.

We’ve written previously about the growing dollar shortage as a result of a smaller Fed balance sheet and declining international trade volumes, making it more difficult (and expensive) for leveraged corporate and sovereign entities to access adequate funding. The potential impact on financial markets worldwide continues to be largely both misunderstood and underappreciated. A strong dollar, driven by increasing scarcity, risks creating its own negative feedback loop, tightening financial conditions and slamming the brakes on a global economy that is already decelerating. It’s the ultimate pain trade, and the odds of it playing out that way are rising.

Look no further than the news out of Europe last week for evidence that the liquidity problem is becoming more acute. Negative interest rates have already impaired lending and crippled the banking system, but the new head of the European Central Bank somehow thinks that policy has been a success. See https://on.wsj.com/2KWOg12. What? With inflation expectations literally collapsing, under LaGarde’s leadership, the ECB will likely cut rates even further, driving the banks into the ground as access to funding becomes ever more problematic. Deutsche Bank is the first to be forced into a massive restructuring but it won’t be the last. See https://reut.rs/2YEjI7N. As the old expression says, there’s never just one cockroach.

The resilience of the USD on the FX markets is a sign that investors are in the process of discovering that the central banks may not be able to easily solve the problems resulting from the dollar funding shortfall. The upside trade is clearly the path of least resistance. Last month’s pullback in the dollar index (DXY) held at 96.00, roughly the same level it finished 2018. This becomes major support and a point for long positions to now lean against.

We’ve been bullish on the dollar and bonds for months. (See The Dollar and Deflation, April 29) Bonds have worked out, and have much more to go. While the FX component of that trade has been dead money so far, it feels like the dollar is getting ready to spring back to life.

US Dollar Index (DXY). Longs can lean against 96.00.

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

The Dollar and Deflation

Written by Bruce J. Clark

April 29, 2019

Friday’s better than expected number for first quarter GDP may be dominating the headlines but it’s the report on Personal Consumption Expenditures that is driving the market reaction. Prices paid by consumers for goods and services, excluding volatile food and energy components, fell sharply in the first three months of the year, extending a decline that began at this time last year (see chart below.) The big drop in US bond yields on the week despite otherwise good news for new home sales, durable goods orders and growth, in general, is a sign that global deflationary forces are gaining an upper hand.

It wasn’t supposed to be this way. In theory, robust growth, rising wages, and full employment create greater aggregate demand that leads to higher prices and higher inflation. Ever since the Fed began raising rates in 2015, tighter monetary policy has been predicated on this basic economic assumption.

The disconnect isn’t limited to the US. Some foreign central banks are beginning to panic as inflation fails to respond to years of stimulative policy. This past week Japan and Sweden joined a growing list of countries putting off any chance of rate hikes in 2019. See here: https://reut.rs/2GI0gjI and https://reut.rs/2IUj6pv . The problem is that like Europe and Switzerland, they too have already imposed negative interest rates and are running out of options to kickstart growth.

Credit to the Fed for pursuing a course of policy normalization over the past few years. They planned ahead. Part of the rationale for raising rates was to make room for rate cuts in the event of a slowdown. While this gives the US a distinct economic advantage on the world stage it doesn’t necessarily mean it will produce a happy ending.

As I mentioned in (See “Good news, bad news) the downside in this scenario of divergent global growth is that it will drive the dollar higher against the world’s other currencies. In fact, it has already begun. While the equity markets are still celebrating a good Q1 earnings season, the risk going forward now shifts to the negative impact a stronger dollar will have on the bottom line as it makes American exports less competitive. It also starts to turn the screws on entities that leveraged cheap dollars at low rates during a decade of Fed largess. In my opinion, the aggregate short exposure to the USD is grossly underestimated.

The most efficient way to express the view of intensifying deflationary pressure is to own both the dollar and treasuries. The 2-year sector is especially attractive as a play on possible rate cuts and as the flattening trend in the yield curve of the last couple of years begins to reverse (see chart below).