Tonight, I’d like to expound on the recent musings from Chris Whalen, titled, “Bank Earnings &Volatility.” Whalen stresses that the FED will not be selling assets but merely ending “its reinvestment of cash when securities are REDEEMED,” (emphasis mine). In what I consider a key point raised, Whalen said, “Yet as we and a growing number of investors seems to appreciate, the FED cannot force up long-term rates so long as it is sitting on $4 trillion worth of securities THAT IT DOES NOT HEDGE. More given that the Treasury intends to concentrate future debt issuance on short-term maturities, downward pressure on long-term bonds yields is likely to intensify.” Whalen also said, “What the FOMC has done to the markets via QE is essentially reduce potential volatility by holding securities and not hedging these securities.” The key point is enhanced by the fact that both the ECB and BOJ do not hedge their security exposure either so volatility has been diminished by the reduced hedging.
Dynamic hedging by market participants is an important piece of the signaling mechanism to the debt markets. It is a dimension of the market that has been suppressed by the will of the FOMC to control prices through the massive accumulation of debt. Its importance will only grow as the bond vigilantes return. Those involved in risk parity trades are being put on notice. Whalen concludes with the following: “More important for Chairman Powell, a flat yield curve will demonstrate to the markets and Congress that the majority on the FOMC has not the slightest idea how their policy moves impact the real world of money and credit.”
It has been a mantra of NOTES FROM UNDERGROUND that no matter how sophisticated the math of the FED‘s models IT ‘S NOT ROCKET SCIENCE. Unlike NASA, the FED has no clue how to return the space vehicle to a specified landing site. But if Whalen is correct then the YIELD curves will play a very significant role in our trading/investing strategies this year.
As an aside to this analysis, I want to point out a recent paper by the St. Louis Fed titled, “FOMC Dissents: Why Some Members Break From Consensus.” The traditional bastion of monetary analysis tries to establish some pattern to dissenting votes at FOMC meetings but fails to establish anything that FED watchers don’t intuitively anticipate (i.e. Esther George and now Minneapolis President Kashkari). What the paper revealed is that since 2005 NO FOMC GOVERNOR HAS DISSENTED. In the most tumultuous period of monetary policy in the history of the Federal Reserve not one sitting GOVERNOR has disagreed. It suggests that the central bank is an insiders’ club tolerating zero dissonance, which is what Bernanke means about zero as the lower bound. Where have you gone Larry Lindsey? Our nation turns its lonely eyes to you.
***There were recently two important stories out of Europe. The Financial Times ran a story in Tuesday titled, “German Metal Workers Strike Over Pay and Conditions.” It has been more than a decade since German industrial workers have had the temerity to even ask for a significant wage increase, let alone pursue the picket lines. German unions were always much stronger than everywhere else until the Hartz IV initiative invoked by SPD Chancellor Gerhard Schroeder forced labor to accept wage freezes and tighter work conditions in order to keep jobs from moving to the newly liberated workers of Eastern Europe (NAFTA on the Rhine). The labor market is tight and the unions are pressing for their share of the German boom. “Uwe Houck, the chairman of the Porsche workers’ council, told a rally outside the carmaker’s Stuttgart plant: ‘Our demand for 6 per cent more money is more than fair. Earnings are soaring, the coffers of employers are full. To offer us only 2 per cent is not just quixotic–it is a disgrace.'”
The French, Italians, Spanish and others will be cheering on the German unions as they want wages to rise far above the rest of Europe in an effort to make their products more competitive. The German corporations and Bundesbank will try to thwart the will of the unions because the Bundesbank cannot counter higher wages with increased interest rates in an effort to slow the economy. Germany is booming, inflation and wages are rising at the expense of German savers. Remember to ask: Whose currency is it: The Germans’ or the Italians’?
Second, as the Italian election campaign begins, Silvio Berlusconi has decided to pull a page from Donald Trump and put forth the idea of a tax cut/flat tax as a platform for his center/right party. The problem is that with the Italian debt-to-GDP ratio at an elevated 132% it is difficult for the Italians to cut taxes since it will increase the Italian debt (yes, Kudlow I know, Arthur Laffer), causing angst in Brussels and Berlin. It seems that Berlusconi wants to cut taxes because it is the only avenue to stimulate growth. Since the end of World War II the Italian response to a slow economy was increase spending and depreciate the currency (then the lira). The Italians no longer have control of their currency so the only path is increasing the debt.
Berlusconi knows he can violate all the rules of the Maastricht accord because if the Europeans were terrified of having the Greeks default and leave the euro there is nothing that the EU can do to harm the Italians. A debt default or exit from the EURO by the Italians would send tremors through the global financial system causing a major financial collapse. The ECB is loaded with Italian debt, public and private, while the Bundesbank is laden with Target2 assets from Italy of nearly 400 billion euros. The Germans are the creditors to massive amounts of Italian liabilities and through the efforts of President Mario Draghi. Silvio Berlusconi knows he is too big to fail. This is the state of Europe as we head into the political season. (Read the Rotten Heart of Europe in order to know the European actors and political economic landscape.)
***Two rumors from SOURCES: First, China is said to not buy a full load of U.S. Treasuries (this was unnamed Chinese sources). I believe it was planted by somebody short bonds who wanted an opportunity to cover short positions (sarcasm intended). The second rumor was reported by unnamed sources to Reuters was that U.S. will probably leave NAFTA. I used this opportunity to buy Canadian dollars as it dropped 1% on the chatter. I also bought some more Kansas Southern Railroad stock (KSU), a company I recommended at $91 as a play on Mexico. These are trades within my risk tolerance as I believe that Trump will not leave NAFTA, especially since he has just received feedback from the U.S. agricultural sector, which has greatly benefited from trade with Mexico. Trump’s base consists of RED STATES that are weighted toward the agrarian economy.
The Republicans are already worried about losing the Senate and possibly the HOUSE so Trump would not be a “stable genius” if he harms the pocketbooks of the red states. Low risk at today’s levels but I was patient and found an opportunity in the rubble caused by unsubstantiated rumors. Also, KSU is interesting because all the auto manufacturers yesterday announced December’s results and the constant was the enormous increase in exports out of Mexico to many different countries. Those autos are carried on KSU freight trains. In addition, KSU is the missing piece to Berkshire Hathaway’s complete dominance of the North American railroad puzzle.
***Warning to all traders about central banks: They are not to be believed. A few days before the Swiss ended the EUR/CHF PEG, SNB Chairman Thomas Jordan stressed that the 1.20 PEG remained the cornerstone of Swiss monetary policy. The SNB removed the peg three days later. In its release on January 29, 2016 meeting the Bank of Japan adopted a negative interest rate policy for the first time.
When the Guardian reported the results of the meeting, the paper cited the close vote of 5-4 to enact the shock decision. It also noted that, “The surprise decision came just days after the bank’s governor, Haruhiko Kuroda, suggested he had dismissed any drastic easing measures to boost business confidence.” The YEN dropped 3 percent on the “surprise.” The bottom line is do your analysis and don’t believe what your ears hear when your work reflects otherwise. There is always some narrative being promoted by those who desire access to the rich and great. Not at Notes From Underground, where 2+2=5.
Tags: Canadian Dollar, China, Chris Whalen, Euro, Fed, FOMC, Germany, Italy, Jerome Powell, NAFTA, Silvio Berlusconi, yield curves
January 10, 2018 at 7:51 pm |
Yra
Wonderful analysis.
Whalen’s point that the lack of dynamic hedging by the Fed and other CBs of their trillions of bonds (especially those pesky negatively convex MBS holdings) does offer an intriguing answer as to the dramatic flattening of the US yield curve.
But, if the price mechanism of the long bond is being compromised/nullified, it does not mean that the underlying impulses are not there. We simply need to look elsewhere to see where they pop up.
Candidates are
1. Lower USD
2. Heating up of pricing in “things”. Evidence abounds as leading commodity stocks are busting out all over, as well as the reversal in the CRB/SPX ratio to the upside.
I continue to believe that gold is as underextended as bonds and stocks are overextended.
As for CB wariness. You are so right. If markets break as badly as we all seem to believe, the CHF could/should act like the yen and gain a big bid as “risk off” spreads across global markets.
Could we see a one-day shock similar to Jan 2014? Perhaps not.
But a one year correction could still be quite a doozy.
Great analysis, as always
January 10, 2018 at 10:25 pm |
No central bank with open FX trading in its currency can hedge its portfolio of domestic bonds. The entire purpose of QE is to have the CBs be the buyer of first resort for their government’s overdraft. What the central bank can do is shift its perpetual buying to the maturities that are near-money as far as the FX markets are concerned. Central bankers have, by necessity, joined the diplomatic corps. Their first duty is to lie for and to their countries and those abroad.
January 11, 2018 at 5:54 am |
Actually CBs have put themselves in a position where they are accountable to national security. Not smart.
January 10, 2018 at 10:29 pm |
Stefan—one of my favorite quotes from my graduate work–” a diplomat is an honest man sent abroad to lie for his country” I have actually used it in the blog in years past—-who are you and where did you come from.But I enjoy having your wisdom add to the dialectic of Notes—-I have to inquire if you have read Braudel and Arrighi as well and if we go to Gunder Frank and Johann Galtung—I dislike being pedantic but you are pushing all my buttons
January 10, 2018 at 10:59 pm |
The first 3 – yes; Galtung – not yet. My interest is in the paradox of money and credit. People live with each other using credit but the state needs to have a monopoly legal tender money for the collection of taxes. (The German school historical notion so beloved by Libertarians – i.e. people invented money out of their ptivate dealings with one another – is ass backwards.) What specie redemption rights and now FX have shared throughout history is their being the best means by which people as individuals can literally take the money and run to freedom.
January 10, 2018 at 11:12 pm |
P.S. As a once upon a time California tax lawyer, I find myself grinding my molars every time someone says tax cuts pay for themselves. Tax RATE reductions can produce enough additional revenue to offset the immediate declines in collections IF the taxpayers believe that the rewards from legal and illegal cheating are being permanently reduced, but the important gains are in private wealth, not public income.
January 10, 2018 at 11:26 pm |
Stefan–so you accept the relevance of Ricardian equivalency?
January 11, 2018 at 12:06 am
I accept Ricardo’s judgment that people do not, in fact, discount present spending in anticipation of future taxation. None of my clients ever did.
Tax rate cuts “work” because they change people’s incentives to cheat. Laffer’s napkin calculations are roughly accurate IF the highest marginal rates are reduced enough to lower people’s overall taxation to no more than 20 per cent of their incomes. That seems to be the psychological threshhold. I know that in the age of non-recourse loan tax shelters it was a useful yardstick. A 5-to-1 write-off was sufficient to persuade even the most aggressive client that they had gotten a deal worth having from Uncle Sam.
January 11, 2018 at 7:54 am
Interesting thoughts. I’d expect that the tax rate tolerance threshold might differ depending on what people “get” for it. For example universal healthcare, quality public education, exceptional public recreational facilities, etc could raise the tax level tolerance. I’ve also observed cultural differences. Frugal societies with high savings rates are generally intolerant of higher taxes. I’d also add that the offshore tax haven industry serves the essential purpose of a creating a check and balance against excessive government taxation because, as you describe, there exists a tax level above which people will somehow change their affairs to circumvent (legally or not) what they perceive to be confiscatory taxation.
January 11, 2018 at 8:27 am
Alas, on an individual level, things are as the used car dealer Dad in Breaking Away says to his son: Everybody cheats.
http://www.imdb.com/title/tt0078902
People will be all in favor of progressive everything but still want to claim their husband’s used underwear as an itemized charitable deduction. This is why Ricardo dismissed the idea of a sinking fund even though the numbers said and still say there will be an equivalence. Legal employment in California adds a 30% surcharge to the employer above the employees’ take-home pay, not including income tax withholding. FICA, FUTA et. al. create the spread. And yet people persist in explaining illegal employment as a matter of choice by the employee – i.e. Americans don’t want to take those jobs.
January 11, 2018 at 4:00 am |
Fundamentally, the Swiss might be in a tight spot. Their biggest business historically, private banking, is under siege as it has lost its competitive advantage (bank secrecy and circumventing taxes) and this month marks the start of CRS reporting globally (CRS began a year ago on a very limited basis; Switzerland was not part of that) pursuant to the OECD AEOI agreements.
Reports on the ground at Swiss banks say it’s depressing working amongst the exodus from Swiss private banking. Capital flows analysis shows Switzerland has been bleeding capital. Further, IMO Switzerland is not a safe harbour anymore because the Swiss have surrendered much of their sovereignty, have repeatedly acquiesced in recent years to demands of foreign governments, have a landlocked nation in a continent of potential future unrest and are militarily vulnerable today unlike years ago when the surrounding mountains offered a protective barrier. And Switzerland is a bail-in regime now, with some banks of dubious solvency that place account holders at risk.
But technically, it’s another story another time.
January 11, 2018 at 2:50 pm |
David–I certainly understand your point but I always wind up with this question—who is buying all these Swiss Francs that the SNB has spent the last several years printing ?And yet UBS is performing very well.And I agree with you about the Swiss safe haven status being questioned
January 11, 2018 at 6:29 pm
Regarding bank performance, in a new interview, Mervyn King told Jim Grant that there’s two types of banks to fear. The banks with terrible financials. And worse, the banks making the most money, because they’re the ones engaged in the riskiest activities with the most leverage and they can fail massively, taking down the financial system. Worth a listen.
To perhaps answer your question, I understand that a lot of CHF has been lent in the EU because of lower CHF interest rates and rising EURCHF (falling CHF). It’s been like financial alchemy for CHF borrowers in the EU. Well, for now. But this implies there’s a bunch of CHF borrowers who are synthetically short CHF, unwittingly. Perhaps like the foreigners (many located in EM) who overindulged in cheap depreciating-dollar loans in 2010-12 and then regretted it in 2014-16 when the dollar rose.
January 12, 2018 at 7:00 am
David –first of all Larry H. says kudos on a great Euro call and I hat tip to you also–very great call and trade.Your point about the Swiss borrowers—if correct we will have another redo as in January ,2015 when eastern European got caught short Swiss through their borrowings.It also holds the SNB captive to borrowers as they fear being repaid so I guess bottom line the Swiss have created a perpetual money machine out of thin air.Why borrow Swiss when you can have all the Euros you wish.
January 13, 2018 at 4:19 am
Thank you for the kind words Mr Harris. I’m better lucky than good as markets often humble me, so key is risk mgmt and watching for levels that tell me when I’m wrong. I don’t track Swiss so I shouldn’t comment on it more. But I find Japan compelling like I wrote several days ago. EUR rose from excessive pessimism and then anti-dollar sentiment which has yet to finish. John Templeton would recognize Japan is closer than EU to maximum pessimism so perhaps it’s a better trade now, plus it broke a key level with follow-thru. Has it finally carved a key swing low? And japan offers something increasingly hard to find: a stable, stoic society that maybe better suited to cope with the global turbulence that lies ahead eventually. It’s also the only major “western” country whose debt is owed to itself and it has wonderful industries including the world’s best robotics. Long japan and yen for the long run?
January 11, 2018 at 5:34 pm |
Rocket Science indeed,
“the greatest scholars are not usually the wisest people” (Chaucer)
Piled higher and Deeper
January 12, 2018 at 7:10 am |
Update from Germany: CDU+SPD have come to a preliminary agreement. They still need a special SPD convention on Jan. 21 to give their o.k. for the SPD to enter final coalition talks. And then there´s still the whole SPD base who has to vote on the final agreement (probably by March).
But so far we´re on track for another Grand Coalition.
January 12, 2018 at 10:03 am |
GreenAB–thanks for the update and I believe Merkel has sold out Germany for her desire for power and I believe this is going to not play well.Also,it seems that she sold out the Greens with her compromise on backing off from closing coal fired power plants as the SPD wishes to keep miners employed—-this reflects that Merkel is weak,very weak—Germany is in a terrible position
January 14, 2018 at 9:05 pm |
Green Ab–Munchau’s piece in tomorrow’s FT–much to discuss along with what happens if Merkel fails to bring the coalition to fruition as some of the younger and more leftist SPD memebers vote NO
January 15, 2018 at 6:02 am
Indeed we have a revolt going on, which is getting a lot of media coverage. The Jusos and the SPD´s left wing are working hard against another coalition. They would vote No, no matter what the outcome of negotiations would be.
I still think that cooler (smarter) heads will prevail. The SPD dominated the latest negotiations. But you cannot get everything when you have to co-govern with a political opponent.
January 12, 2018 at 11:33 pm |
Kodak wooden nickles have been zooming.
Wonder if the SEC has checked into recent insider stock grant funny business or have they been paid to look the other way in our brave new world of Central Banker sanctioned lawlessness and fauxmocracy?