Notes From Underground: The Sound Of Complacency Shattering

First, for all those in the Notes From Underground community who celebrate Rosh Hashanah, have a happy and healthy New Year. For those who don’t I also wish you a happy and healthy New Year. Thanks for your continued support and if I angered you with my thoughts I have to say it was not done to be hurtful but rather to provoke a high-quality discussion around issues in the realm of global-macro finance. When I listened to the Ray Dalio interview on CNBC today it was comforting to know that the mission of this BLOG is similar to what Dalio tries to accomplish with his employees. NOTES FROM UNDERGROUND is not about PERSONAL VALIDATION but about discourse in the crucible of financial ideas, striving to refine the GOLD from the DROSS. Let’s hope the SHOFAR BLAST shatters the complacency of our static thoughts in all matters of our lives.

***Wednesday is FED day and the only  surprise will be if the central bank doesn’t begin its previously revealed balance sheet unwind. The FED FUNDS RATE will not be raised at this meeting and the DOT PLOT is worthless. If my theory about Governor Brainard being Chair Yellen’s confidant proves to be correct, then the post-FOMC press conference will have a dovish tone. Pay attention to the U.S. 2/10 yield curve as it recently tested the 77 basis point area and steepened to around 84 basis points. In my opinion, if the FOMC only announces a start to QT the curve OUGHT to steepen, especially if the press conference is dovish. It’s less reinvestment from the New York Fed’s System Open Market Account (SOMA). Yes, $10 billion per month ($6 billion Treasuries, $4 billion MBS) is a small amount, but it begins the process.

The ECB and BOJ will still be active but the FED will have set a direction for U.S. assets. Also, it will be interesting to hear if the FOMC voices any concern about extended equity values as it uses the phrase “LOOSE FINANCIAL CONDITIONS.” The FED seems to be concerned that risk premiums have shrunk to cautionary levels. Coupled with this will be any mention about the recent weakness in the U.S. dollar creating export growth. If the DOLLAR does not raise any inflation concerns this should indicate the FED will be in no HURRY to raise the FED funds rate.
Rising long-term rates resulting in a BULL STEEPENER will take the markets time to digest. The FED will have to do all it can to prevent the U.S. dollar rallying to too strong a level, especially as the FED will be the only bank in shrinkage mode.

As long-time readers are aware, one of my favorite financial journalists is Ambrose Evans-Pritchard of the London Telegraph. In a piece published Monday, “BIS Discovers $14 Trillion of Dollar Debt Offshore, Hidden In ‘Footnotes.'” In the opening paragraphs, Pritchard lays out his concerns about the previously unaccounted debt in the global financial system. According to BIS chief economist Claudio Borio, “Contracts worth tens of trillions of dollars stand open and trillions change hands daily. Yet one cannot find these amounts on balance sheets.” The types of liabilities uncovered by the BIS forensic team is FX swaps and forward contracts and while they are classified as a notional derivative “it is in effect a secured loan with principal to be repaid in full at maturity.” Most of these dollar swap agreements are short-term in orientation but much of the money has piled into longer -term investments. It is known that Chinese borrowers have been active in the dollar swap markets.

As Pritchard reminds us, “the Achilles Heel is global dollar debt. It was a seizure of the offshore dollar capital markets in late 2008 that turned the Lehman and AIG bankruptcies into a global event, and came close to bringing down the European banking system.” Currently, there is no DOLLAR SHORTAGE in the world as the recent move in the U.S. currency proves, but as Evans-Pritchard suggests, a President Trump tax reform of a big fiscal expansion and “repatriation of trillions of US corporate cash held overseas” poses a threat to dollar funding conditions. An eye only on domestic markets can cause a massive misstep in the global funding markets.

It was exactly for this reason that Rick Santelli and I argued on a CNBC segment that the BORDER ADJUSTMENT TAX would be a colossal disaster for it would create a massive DOLLAR shortage. The global fallout from Bernanke’s QE1, QE2 and QE3 is causing underlying stress according to the BIS analysis. The FED has a dual mandate but a global responsibility. Does it hear the warning blast from the trumpet call of the BIS. Interesting to see if any of the invited journalists to the press conference ask Chair Yellen about the concerns raised by the BIS forensic investigation team.


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17 Responses to “Notes From Underground: The Sound Of Complacency Shattering”

  1. Asherz Says:

    There is so much money sloshing around that no one pays any attention to the BIS 14 Trillion dollar just “discovered.” As Everett Dirkson said long ago, “A billion here, a billion there, soon you’ll be talking about real money”. We just added three zeros. All these off balance sheets derivatives will offer little concern until you have a counter-party problem and then the card house crumbles.
    The Fed has to do something just for appearances and as I’ve maintained for a long time interest rates will remain low as far as the eye can see for fear of destroying the Fed third mandate of keeping the markets on an upward trajectory. In any case you have QE continuing in Japan and Europe. So they announce a QT program for effect that will be accomplished so smoothly, as Janet said, like “watching paint dry”. It like rates will be meaningless on their affecting the markets as they will proceed at the pace of a snail who takes frequent naps.

  2. Michael Huang Says:

    From the last FOMC meeting in July, the short end and the long end of the curve has weakened, while the belly hasn’t experienced any changes. To me, this looks like the market is not buying what the Fed has to offer, aka rate hike (causing short term rates to rise) and QT (causing long term rates to rise).

    In my opinion, the biggest problem for the Fed is the 2s10s spread. The spread is so narrow that if the Fed really sees hyperflation in the future, it can’t raise the Fed Fund Rate quickly enough without inverting the 2s10s. Thus, the only way to prevent this from happening is to smack down the price of the long end by QT, bringing long term rates higher. With Harvey and Irma, I think we ought to see inflation pickup in the near future largely due to rebuilds and demands for replacements.

    So, I am really confused why the market isn’t buying the QT narrative until couple days ago the yield curve started to steepen.

    • Yra Says:

      Michael Huang—agree totally and this conundrum may reside in the bowels of the ECB and the BOJ –and we haven’t even gotten to the Swiss National Banks actions and the effect on global asset prices

  3. realitythought Says:

    I think I understand most of everybody’s comments, but one probably simply comment. Even though the wages have not increased very much, won’t inflation eventually start to heat up due to the weaker dollar? If that is correct, is there any average lag before inflation picks up in previous similar situations?

    • Yra Says:

      Reality–that is a difficult time period to measure as it is one of several possible variables–More importantly is that the DOLLAR is really been in a 20% range for a long time period so the recent moves are more mean reverting and position squaring.As David Richards points out this has not been a good year for the Dollar Bulls that fulled the airwaves in the first quarter—When Mark Fields of Ford stated in February that currency manipulation is the mother of all trade barriers he revealed the thoughts of the Trump inner -sanctum–that 1.2390 area in the Euro is interesting resistance as we look back to that week in July,2012 when Draghi made the famous whatever it takes speech.

      • David Richards (@djwrichards) Says:

        Indeed early in the year the “pain trade” was clearly to the upside for the Euro as most were long the buck as the “sure thing” for 2017. The Economist put super-dollar on its cover, which of course was a bad omen (contrarian). Now, the situation is different. Hedge funds have bets on dollar weakness and the “pain trade” will be for the dollar to rise. I don’t know when the dollar reversal begins, but expecting so this autumn or 1Q18, and the extent will signal whether or not EURUSD has already completed a long-term top.

        Lets see whether this DXY breakdown to 91 (and possibly below) sets a bear trap. We won’t want to see dollar languish down here for long and too much lower. But we will want to see an Economist cover with super-Euro on it, haha.

        Based on Yra’s blog, I have a hunch that after the German election, super-Mario might disappoint all these nouveau Euro bulls. But for now I’m agnostic and sure not chasing Euro here above 1.20 already.

  4. David Richards (@djwrichards) Says:

    The dollar is sitting just below a major long-term technical support level just under 92 on dxy. Recently the dollar re-tested that level from the underside and failed to penetrate. Classic support turned resistance. If this continues, it portends a major multi-year bear market ahead for the dollar, rather than a major multi-month correction approaching its end.

    IMHO the dollar shortage narrative is as misleading as the goldbugs’ quantity of money narrative during QE while gold plunged from 1900 to 1200. The “dollar shortage” dollar bulls have had their heads handed to them this year. Rightly so, as fundamental interpretations usually get trounced by technical observations.

    Indeed, some believe that technicals lead fundamentals, not vice-versa. If true, then we already know that any perceived divergence in monetary policy between the Fed and other CB’s will continue to close. As the charts say so.

  5. Larry Arnowitz Says:


    Happy healthy New Year to you and your family.

    Lshana tovah.



  6. Arthur Says:

    Ray Dalio: 1937

    Barry Sternlicht (Starwood Capital): “It feels like the ocean is full of money, but it could evaporate.”

  7. David Richards (@djwrichards) Says:

    If my arithmetic is correct, drawing down 10B a month against 4.5T would take almost 4 decades to unwind…lol. Paint dries at rocket pace compared to that. Oh well, at least the draw down needn’t ever be discontinued, because there won’t be another crisis in our lifetime (Janet says so).

  8. Chicken Says:

    Yellen did mutter something about lack of inflation which she attributed to that old standby term, “transitional”.

    It’s felt like watching from the bleachers of a Roman Coliseum, all that easy money sloshing around irresponsibly propping up every manor of asset under the Sun.

    • David Richards (@djwrichards) Says:

      Yeah that easy money sloshed mostly into the accounts of some banks and rich folks who had no need or desire to spend it. Thus money velocity plunged and CPI rose less than expected even as money supply soared. And asset prices soared with mediocre transmission to the real economy. The wealth gap gapped. IMHO policymakers get an F for all that.

  9. GreenAB Says:

    Allow me some final thoughts from Germany before the elecetion.

    Talking about complacency… Is anybody bothered by the German election? No?

    Well, here´s something to think about. The latest polls indicate another grand coalition of CDU+SPD. So nothing to worry about, everything stays the same? Maybe not. The SPD is tired of being Merkels junior partner. They are looking for their worst results in history. The party´s leadership made clear that the members will have the final say if the SPD will enter another coalition. And boy, listening to members it doesn´t look good.

    So there´s a real chance that Merkel will have to look for other options. There are two of them. Either the FDP gains another 2-3% and CDU+FDP get a majority. Or – and that´s more likely – for the first time we´ll see a “Jamaica” coalition. CDU + FDP + Green Party.

    Whatever the outcome – the FDP would be one of the partners. The Liberals are pro business, less taxes, less regulation… So why could there be risk? Well, EUROPE will be one of issues that doesn´t go away. There have to be reforms, if the European Union doesn´t want to fall apart. Macron has given the direction (more integration) and Merkel is willing to go along to a certain extent.

    Enter the FDP. Sure, they are pro Europe. But they are also very nationalist, when it comes to money. No transfers, no Eurobonds, no European Treasury Secretary and NO banking union! They have been very critical of Merkel´s handling of Greece. In fact, they wanted Greece out of the Euro.

    After being kicked out of the Bundestag after their last coalition with Merkel (2009-2013) they already made clear, that they will be a tough negotiating partner. And: they want the Ministry of Finance, which is currently held by Schäuble.

    All of that could bring uncertainty into the market. So maybe it isn´t a shock of a Trump election or Brexit, but a boring German election that causes volatility to rise.

    • Yra Says:

      Green AB–an excellent post and I believe we are going to experience some surprises tomorrow as the FDP and AfD are goin to receive larger votes then the present polling predicts.Macron put forward some issues that will garner increased support for the FDP

    • Yra Says:

      Green AB–talk to us about what you know

      • GreenAB Says:

        So as expected, the Grand Coalition of CDU+SPD is finished. The SPD leadership didn´t even bother to ask the party members. Right after the first polls came in they declared to exit.

        This leaves Germany with a coalition of CDU + FDP + Green Party as the only option. The scenario has been discussed over the last weeks. And there are a few examples of these parties governing together in states. But this will be Merkels toughest task yet.

        Let me give you some examples. First of all – the CDU had their worst results since 1949. Their sister party CSU has elections coming up in Bavaria next year. So the first thing the chairman of the party (Seehofer) said tonight is that they have to “cover the right flank”, which means they´re going to be tougher on refugees/migration. In fact, they´ve lobbied for an upper limit for two years now. But thats not possible unless you change the constitution. And Merkel opposes it too. Enter the Green party – they are much more refugee friendly. So the first issue will be to get CSU and Greens together.

        Second – Green Party and FDP are on opposite ends on several issues, like Energy policy, Taxes and Social Security. And: the Green party has a strong left base. They will have to give their OK too.

        Last but not least – as i mentioned, the FDP will be tough to negotiate with. They were Merkel´s junior partner from 2009-2013 and they went under (out of the parliament). The reenergized FDP will make sure to realize more of their agenda. In the first big talk show this evening their boss Christian Lindner stated that a seperate budget for a European Treasury Secretary is a “red line”. “No Germany money for French consumers or the leftovers from Berlusconi.”

        So forming a stable government will be a difficult task.

        And then there´s the AfD. I cannot state how embarrased I am as a German with their huge results. It´s not that i couldn´t live with a right wing populist party. But these people are dangerous and i hope this isn´t a start for more…

        So, that´s for now. I´ll keep you updated on the progress of negotiations.

        Let´s see how the markets handle this.

      • Yra Says:

        Green AB–going to use your two posts to start tongight’s blog

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