The concentration of the media on round numbers is going to drive me to drink that bottle of Pappy Van Winkle. In true philosophical inquiry, round numbers never fit in the square pegs of the unbalanced thinking at Notes From Underground. In Tuesday’s post I am going to run through several points that I’ve mentioned over the past several months. All of these issues will have some relation to the developing narrative that we are experiencing in the markets:
1. High-yield debt is weakening as reflected by the ETF HYG as Treasury rates rise. The problem for investors is that when the HYG ETF was making lows it was due to the decline in OIL and GAS prices as energy companies issued a great deal of junk bonds. Now the drop in HYG and LQD [a high-grade ETF] is related to the increased yields and the impact on balance sheets.
As Jim Bianco and others have discussed, it is not the 10-YEAR yield rising that is the problem, but the TWO-YEAR YIELD and shorter duration paper that has risen to 2%-2.5%. There is a great deal of borrowing priced to Libor, so the rapid increase in rates is projected to have a negative impact on profits. If the FED is right and WAGES are set to rise in response to potential inflation the feedback loop will cause forward earnings to be less than projected. This week we are seeing PROFIT REPORTS exceed already high projections but the EQUITIES are struggling. In my opinion, this suggests that interest rates are going to be an investor concern as the profit story recedes.
Again, global central banks’ QE policies have provided an opportunity for businesses and consumers to gorge themselves on cheap debt. If you don’t believe that CREDIT MARKETS are significantly mispriced, then please explain to me how the Italian government can borrow two-year debt at -31 BASIS POINTS. As Kenny Chesney would say: NO MONEY; NO GOVERNMENT; NO PROBLEM. Debt will become a HEADWIND for the equity markets as the year progresses. Even the IMF had to raise concerns about the $164 trillion global debt overhang. Rising interest rates will impact profits. As for when, we don’t know. But the failure of equities to sustain rallies for the last seven days OUGHT to concern investors. Let me add one more caveat about the recent rise in yields and the flattening 2/10 curve in the U.S.
The largest OWNER of U.S. Treasuries is the Federal Reserve, which still holds more than $3 trillion. The FED DOES NOT HEDGE ITS PORTFOLIO. So, where raising rates would historically induce portfolio managers to sell futures or buy PUTS to insure against rising rates the FED does not participate .Ben Hunt has raised this issue years ago and for those wondering why the curve is so flat it MAY BE BECAUSE THE FED IS PUTTING UPWARD PRESSURE ON THE SHORT END but curtailing supply on the long end. Difficult to prove but certainly worth contemplating as we struggle to understand the action in the bond market.
2. Will the issue of Fed independence become a topic of concern for the markets? This is a question that must be discussed in the light of the feedback loop that exists between FED rate hikes and the rising cost of financing the massive amount of debt. The higher interest rate costs move the more the government budget has to cover interest payments, which results in a cut to all types of budget items. Discretionary items will be the first casualty while the debate about entitlement programs will certainly affect the November elections. At what point will the FED become captive to political demands to forestall independent monetary policy for the sake of fiscal problems? This issue is not without precedent as the Treasury curtailed the Fed’s independence in the 1940s.
Because of the huge build-up of debt the Treasury kept pressure on the FED to keep interest rates below ONE PERCENT, even as inflation levels hit double digits in 1947. This ended in 1951 with the ACCORD, an agreement between Treasury and the FED held under the auspices of President Truman. The more things change the more they stay the same.
Last week I raised the issue over Trump’s tweet about the Chinese and Russian currency depreciation. The tweet ended with a note about rising interest rates. Trump’s analysis was totally wrong about the Russians and Chinese, especially in reference to the FED‘s recent action. Was Chairman Powell the target of Trump ire?
3. French President Macron has been in Washington for an official state visit. It seems that Macron/Trump are having a love affair as President Trump insists on calling him Emmanuel. The photo-ops show Macron shaking hands and trying to embrace Trump with the reticent U.S. president. The Donald’s standoffish posture seemed strange because the language was warm. Then I remembered that Trump is a germophobe. The issues over Iran, Syria and Russia will remain fluid as each side tries to position itself to serve its needs.
There was very little friction over trade as Macron and trump both noted that French/U.S. trade was fairly balanced although Trump raised concerns over French agricultural policy. The lack of friction over trade appears to set the stage for President targeting Friday’s visit by German Chancellor Merkel as fraught with possible deep differences as the Trump administration has noted the $114 billion deficit with the EU. The greatest part of the EU surplus falls into German coffers. The French enjoyed a love fest. Merkel, however, will not be as fortunate.
Tags: 10-year yield, ETFs, EU, Fed, President Macron, trade, U.S. yield curves
April 24, 2018 at 8:40 pm |
Hi Yra-
3.0% is indeed meaningless in spite of being a mantra on CNBC. I’ve tweeted and emailed our friend Santelli on this, and hopefully he can convince their research folks and producers to cop to the fact that the real next important 10-year cash treasury yield level is the 3.04% reaction high at the very end of 2013… not the 3.0% from January 2014 they keep citing. Much more on that in “WEEKEND: Bond Blowup?” http://www.rohr-blog.com post.
And thoroughly enjoyed the rest of this even if you criticized our ‘very stable genius’ President Trump for being wrong on the international currency front… can that really happen??? Excellent assessment of the yield impact as well, and how Trump might not Like it if higher rates driven by his economic stimulus also pressures the budget.
That especially applies to Powell being a target at some point. After years of griping about Yellen leaving rates low to assist Obama (even as the crappy economy was more so the driver), how can the new Fed head NOT end up a target of Trump’s ire when he will surely take the rate hikes as a personal affront and attack on his expansive agenda.
It’s going to be interesting.
Looking forward to more-
AR
April 24, 2018 at 9:39 pm |
Of course round numbers like 3% are meaningless. But inflationary pressures and rising yields are not. The Fed gave their portfolio profits to the Treasury with the profits from its bloated balance sheet. But losses will ensue if rates continue to rise and Treasury will have to reverse the flow to the Fed.
The equity declines will greatly affect another bank the SNB, loaded with equities. Watch the Swissie.
With debt service becoming a larger part of the national budget, Watch the politicians at some future point being forced to deal with Entitlements, which have been out of bounds for serious debate.
Debt, debt, debt, the three most important issues for the markets for all the markets will deal with.
April 25, 2018 at 7:02 am |
Asherz you are a day or two ahead of me.And yes the SNB and thus the Swissie are going to get interesting as they have pulled the greatest act of alchemy in modern history going back to Nero—I like the Chinese have a long time horizon
April 25, 2018 at 1:53 am |
Of course the 3% level is meaningless. It’s really 3.05% 😀
April 25, 2018 at 1:57 am |
France is guilty of perpetuating European protectionism for agriculture, a key industry for an important part of Trump’s base. So why Trump’s love fest with “Emmanuel”? Is it because Emmanuel supported the neocons’ quick strikes on Syria? The implication is that Trump mightn’t be calling the shots.
In contrast, neocons are undoubtedly displeased with Germany’s productive relationship with Russia and resistance to Russian sanctions.
As the Eurozone tears apart in future years, watch Germany move into the China-Asia-Russia sphere, as China is already Germany’s largest market, even larger than the Eurozone and growing much faster. A reason why Xi has prioritized the OBOR Eurasian Land Bridge corridor to Germany.
April 25, 2018 at 6:18 am |
David—yes these are very important points and of course ,like the children’s books ,Where’s Waldo,I continue to wonder where is Gerhard Schroeder?Maybe Trump will ask Merkel why a former German Chancellor is so involved with Gazprom after having abdicated office after signing a gas deal with the Russians?I am indeed a capitalist and pursuer of dreams but a German chancellor being so involved with Putin after tying its energy future to Russia has bothered me.In 2005 ,Bush Commerce Secretary,Don Evans, was offered the pipeline job with Gazprom/Rosneft and turned it down because of all the criticism—a German Chancellor,simply mind boggling.
April 25, 2018 at 7:06 am |
David–also I think that Macron understands how to seduce the narcissistic tendencies of the Donald.Also,Macron understands that Merkel is very weak politically and is looking to fill the vacuum as the German Chancellor has followed Mario Draghi down the rabbit hole and found she is not the Queen of Hearts but is getting a pen knife in the back–sorry mixing metaphors but will wait for Robert Zimmerman
April 25, 2018 at 7:22 am
Very right not only on Macron understanding flattery as a weapon, but also being much smarter than Trump. For anyone who missed it, the Macron interview on Chris Wallace’s Fox News Sunday show last week was very impressive. He has what Trump lacks: the ability to understand all of the moving parts of a broad global view.
It will serve Merkel right to be relegated to lower stature after her misdeeds of on uber-Liberal stances that have empowered the alt-right and radical Islam at the same time in Germany…
Has everyone seen today’s FT on Jewish leaders telling their flock to not wear yarmulkes for fear of Muslim attacks? https://www.ft.com/content/a4a276ba-4797-11e8-8ee8-cae73aab7ccb
April 25, 2018 at 4:43 pm
1891 Carl Elsener created the Soldiers Knife and sold it to the Swiss Army. Swiss Army Knife.
Alice’s Adventure in Wonderland “Down The Rabbit Hole” was a metaphor from the 1865 novel by Lewis Carroll. Queen Of Hearts was the Monarch who said ” Off With Their Heads”
Yra, Thank you for letting me in the joint.
April 25, 2018 at 9:27 am |
Now for a shot from the cheap seats.. Playing the Devil’s advocate I argue that 3% is meaningful if that is the number that the algos put into their sell programs. From the last 2 days of trading it appears that it was. Now the question is what number did they put into their buy programs? From the several months it appears to be the S&P 500 200 day MA. Perhaps there is less to all this than meets the eye.
April 25, 2018 at 11:57 am |
Bigman–I don’t disagree with one thing you write.I was merely taking the time to explain it from the why I look at it with the underlying fundamentals .You are correct on the importance to the algos but I think there is more and as Art Cashin suggested this morning the 200 day in the spoos will again come under assault.It is not where the breaks hold in my mind but where the rallies now fail as INTEREST RATE concerns rise to be the key metric
April 25, 2018 at 12:05 pm |
Yield curves do matter. Equity markets, built on hopes and dreams, ALWAYS disregard the initial warnings that emanate from credit/interest rate markets.
If the force of rising short term rates begins to weaken balance sheets and creates backdrop for equity sell off, I wholeheartedly agree with that sentiment that says to expect Trump to tweetstorm at Jay Powell to “fix things”.
Trump cares little about breaking conventions and norms. Fed independence? Not under his watch? Powell may not react to a drop of S&P below its 200 day Moving average. But, if we see a 20% sell off from these levels, for whatever reason, I think Powell will not only come under attack from POTUS, but even Wall St will be looking for some love, especially if VOL. explodes and we see roller coaster markets
April 25, 2018 at 2:54 pm |
Mike–yes a 20% drop will get Kudlow to call my friend jim Cramer in a hysterical–they don’t know what they are doing phone call but more importantly the threat to discretionary spending will get a joint attack on Fed independence thus the reason I cite the Accord of 1951—the cost of capital has been a derided fundamental since the Bernanke 2010 Jackson Hole speech on portfolio balance channels—even steve liesman woke up to the corporate cost of money today
April 25, 2018 at 4:52 pm
First the POLITICAL cable-personality /POTUS feedback loop that got him elected by disinforming the base. Now FINANCIAL loop??? Will Trump’s televangelist cheerleaders preside over 🇺🇸 FUNERAL on TV?
April 27, 2018 at 11:29 am |
“explain to me how the Italian government can borrow two-year debt at -31 BASIS POINTS”
Obviously dishonest pricing.
Pappy never has given me a hangover!
April 27, 2018 at 11:41 am |
And I agree the FED has not solved any problems, on the contrary.