Now that the first six months of the year have come and gone, the markets have a cacophony of events to look forward to as algos react to price, and fundamental macro analysts are trapped between WHAT OUGHT TO BE. The current concerns over tariffs, trade wars, strife between friends/allies, political uncertainty in Europe, Middle East conflagrations, the Russia/Saudi alliance on energy, Chinese growth concerns, RISING U.S. INTEREST RATES AND INCREASED QUANTITATIVE TIGHTENING (along with elevated TREASURY FUNDING NEEDS), decrease in capital inflows into emerging market economies leading to potential dollar funding concerns and U.S. Congressional elections. Yet, the markets remain are not pricing in the relevance of such concerns. Wise traders and investors do not fight markets but profit from the opportunities presented. To do otherwise is mere commentary. So to paraphrase John Maynard Keynes: When the facts change so do I, what do you do madam?
The one constant in the global macro sphere has been the flattening of the U.S. yield curves. This has been a key theme of NOTES FROM UNDERGROUND for several years (steepening as well as flattening). How long can the U.S. equity markets FEIGN INDIFFERENCE to the shape of the curve? More importantly, will the FOMC continue on its path of raising short-term interest rates even as its steps up reduction of its balance sheet? The QE experiment has brought the FED to new ground with no prior experience in measuring the impact from withdrawing liquidity while raising the price of credit. Two weeks ago, Reserve Bank of India’s Urjit Patel warned that the Fed’s recent actions coupled with increased U.S. Treasury demands for funding were leading to a global funding crisis. The 2/10 curve closed out the first half of the year making new lows (actually hitting 30 BASIS points).
Last week, I ran a chart with the 2/10 curve overlayed with GOLD. The correlation was very consistent. The recent gold selloff proceeded in lock step with the curve action. There is great concern that the U.S. curve is indicating a coming recession as the FOMC is erring by curtailing liquidity while raising rates. The concern is based on the huge growth in global debt as central bank efforts to keep interest rates low has brought borrowers to the liquidity trough.
And now the looming issues of trade wars with increased tariffs are starting to become a factor. In speeches at an ECB conference in Sintra, Portugal all of the heads of the world’s key central banks raised the negative impact from trade friction as a cause of anxiety.
A June 20 Bloomberg article from summarizes the sentiments of Mario Draghi, Harukhiko Kuroda and Philip Lowe of the RBA: “A trade war would be a headache for central banks given it would likely deal stagflationary blows to their economies by forcing consumer prices up and demand down. The policy makers would then be forced to decide whether to act to support growth or cap the inflationary pressures,for example by hiking interest rates.” This is the conundrum as we head into the second half of the year. My opinion is that central banks will always err on battling against DEFLATION fears. The Trump White House has staked out its position that economic growth is the key component of all its policies.
If the FED‘s actions are deemed to be disruptive to the Trump tax cuts as interest costs wipe out the benefits of lower tax rates and the uncertainty of trade friction curtail capital expenditures, look for President Trump to begin tweeting about the FED and Chairman Powell. A main element of sustaining the Trump narrative machine is demonizing some supposed adversary. Wait for markets to deal with increased volatility of attacks upon FED independence. Setting the table for coming attacks upon the FED was an interview on Friday that Larry Kudlow did with FOX Business News: “My hope is that the Fed under its new management understands that more people working and faster economic growth do not cause inflation.” The table is set for a volatile second half of the year.
Tags: China, emerging markets, Europe, Fed, Gold, Middle East, oil, QE, tariffs, trade wars, U.S. yield curves
July 2, 2018 at 9:25 am |
Some very astute observations. But something has to break and fall. Probably the dollar as its current rally soon ends and reverses.
July 2, 2018 at 9:39 am |
How much of the rise in short rates is from the demand for credit (perhaps based on both the irr vs borrowing cost differential AND the confidence of success) , versus from pure Fed hiking ?
What would have happened if the Fed had NOT hiked their Fed Funds target rate ?
What would have happend if the Fed had hiked to date, but credit demand had stayed at 2011 levels ?
Thank you for your great commentary .
July 2, 2018 at 11:23 am |
Trader—I don’t believe U.S. short rates would have moved as long as the ECB,SNB,BOJ and others maintained their negative rates–search for yield is a big part of the global flows story–much more on the short end as investors seek some type of return.The demand for U.S. short dated is because the U.S. dollar investors can receive an actual zero real yield versus the real yield on short term German deposits.Hiking by the FED is necessitated by its mandate otherwise the dollar would be weak and GOLD would be substantially higher–also the yield curve would be much,much steeper
July 2, 2018 at 2:06 pm |
Yra, your list of present concerns reminds me of Hoover’s memoirs:
The great center of the storm was Europe. That storm moved slowly until the spring of 1931, when it burst into a financial hurricane. At that moment the enormous war destruction, the economic consequences of the Treaty of Versailles, revolutions, unbalanced budgets, hugely increased armaments, inflation, the gigantic overproduction of rubber, coffee, and other commodities, through overstimulation from artificial controls, and a score of other aftermaths of the war which I give in detail later, finally broke through all efforts to fend off their explosive forces. The wounds of Europe were so deep that the total collapse of most European economies in mid-1931 plunged us into depths not witnessed since our depressions of 1820, 1837, and 1872.
There are many other eery similarities between now and then too. For example:
Control of interest rates could not stop them. When the public becomes mad with greed and is rubbing the Aladdin’s lamp of sudden fortune, no little matter of interest rates is effective.
It makes for required reading as we try to navigate these interesting times.
July 2, 2018 at 2:16 pm |
Dan–thanks very much for the post and you should be reading Clashing Over Commerce and American Default—will complete you.
July 2, 2018 at 4:00 pm |
“Hiking by the FED is necessitated by its mandate otherwise the dollar would be weak and GOLD would be substantially higher–also the yield curve would be much,much steeper”
It seems to me that in the end “the Fed” will save the dollar above all else, for the simple reason that they ARE the dollar. Without the dollar there is no Fed. Am I missing something?
July 2, 2018 at 5:07 pm |
Pierre–deflation or a strong dollar?Are you sure of your answer?
July 2, 2018 at 7:23 pm
Ok bear with me ☺. A deflationary environment would mean cash is king, but it would also mean the Fed lowering rates, printing more making the dollar weaker, gold stronger. Strong dollar is what we are seeing now with the Fed hiking. I guess in the end saving the dollar would have to be into a deflationary environment that the Fed does not step in to save. That would mean the great depression, people out of work, general chaos for years.. something none of us wants to see. I guess I answered my own question sensei. Much respect Yea.
July 2, 2018 at 7:28 pm
That’s much respect YRA, darn spellchecker
July 3, 2018 at 5:47 am
Pierre–that is what I take from years of reading,analysis and trading—thanks for the great response
July 4, 2018 at 4:04 am |
Are Donald Trump and Wilbur Ross prone to push for inflation? Donald Trump is a real estate developer and has gained most of his wealth in times of inflation.
https://yragharris.com/2016/12/18/inflateaway/
July 4, 2018 at 8:55 am |
Yra
Happy 4th of July to you and your readers.
Yield curve flattening…..As you have said, getting a grip on this phenomenon and its future implications is a BIG DEAL.
Your observation that gold has floundered while the curve has pancaked is solid.
Yet, at the risk of “playing trader”, I think the gold bear/sideways market is now in the 9th inning of the ballgame.
First, I look to Mr Market. Leaving aside “conspiracy” theories of cabal-like paper bomb throwing at the markets, I am struck at how UNLOVED the PMs are. Of course, anything can stay LOVED/UNLOVED far longer than expected.
But, some of the leading mining stocks are beginning to MOVE higher. Two that I particularly follow are RGLD and AG. Both now at 52-week highs despite gold/silver at $1250 and $16. And the popular ETFs such as GDX/GDXJ are NOT making new lows as PMs have crashed.
Makes me say “Hmm”
Looking now at markets, I agree that 2/10 looks like it may invert sometime in 2018…So, perhaps gold stays restrained….Or not.
Higher interest rates will ultimately “do the trick” and begin to sap the vitality of many corporate and municipal balance sheets. The ABSOLUTE rise in short-rates with SO MUCH MORE debt these days (you and David Rosenberg recently discussed how total US debt has nearly doubled since the 2008 Lehman Moment to $30ish TRILLION) is going to have as much of an impact (imo) as an actual curve inversion.
As Trump continues to welcome “trade wars”, we are already witnessing anecdotes of slowdown/layoffs as the Harley Davidsons of the world have to deal with “lost” markets overseas, while domestic users of steel/aluminum etc have seen their costs soar relative to their foreign competitors.
My point? Economic slowdown may increase if Trump continues to try to muscle the world. Somehow, I think it is a “poor” bet to believe that the EU/Trudeau/and now AMLO are going to back down to this POTUS.
Any such slowdown will force Powell (and markets) to begin to ponder if a halt in Fed hiking will soon be in order.
Add to that your very keen observation that Kudlow/Trump has already begun to tweet DIRECTLY at Powell to go “easy”. Let’s face it….If equity markets should go into a tizzy or if economy dramatically slows due to actual trade war flare ups, do we really expect Trump NOT to jump onto his electronic bully pulpit and TWEETSTORM Powell to “Make America Great Again” by dropping interest rates/lowering the USD.
As I said, anything can happen in the short-term….But, I think the yield curve inversion will not be long-lasting and will usher in its own counter action as the next round of QE will accompany the Recession of 2019 or 2020. As markets are discounting mechanisms, a 2019 recession could evidence itself in the markets later this year. If it is a 2020 phenomenon, well, then 2019 should see it show up in the markets.
Either way, I ask myself what the crazy shareholders of RGLD/AG/FNV are thinking as they bid up the share prices to new 52-week highs?
Have a happy 4th
Mike
July 8, 2018 at 6:40 am |
Mike–a usual fine post filled with much to think about.I am thinking that the CURVE WILL NOT INVERT as the POTUS will begin to question the FED thru tweets as Kudlow began last week in open-air comments about inflation and wages.Something I am beginning to think is that Trump may name Larry Summers to the FED—I am shaking in disbelief as i write that—but Summers has been very poignant in recent articles discussing why the FED ought not be raising funds rates.The only way that Summers makes it to the FED is by a Republican president because the Lizzie Warren faction of the Dems will not let it happen.The FED will come under increasing pressure and it will be bi-partisan .The markets will watch to see if Powell has the strength to stand firm in the face of rising criticism coming from both parties
July 8, 2018 at 8:13 am |
Yra
If you are right that the curve does not invert, then look for USD strength to peter out as expectations of interest rate differentials will narrow. We shall see.
Best
Mike
July 9, 2018 at 5:37 am |
Now that the Fed and other central banks aren’t buying US T-bonds, the US Treasury needs bond buyers from the private sector to fund the rising US fiscal deficit. But the private sector will no longer buy US bonds where there is any concern about dollar weakness, as we saw early this year, culminating in the bond rout, which persisted even during the global equity correction in February, causing risk parity strategies to breakdown.
This dynamic has taken a reprieve lately with the dollar bounce, but it still lurks under the cover. A re-weakening dollar will weigh heavily on US bonds, force bond interest rates higher, and threaten Fed control over the bond market.
Therefore, it seems to me that the Trump Admin and Fed are at odds over the dollar. The Fed needs a stable or rising dollar to not lose control of the bond market, while the Trump Admin wants a falling dollar to help improve the US trade deficit.
July 9, 2018 at 8:24 am |
David–I agree that the White House and Fed are at odds over the dollar .It is one of the reasons that after nato Trump will turn his tweeting powers on the FED–
July 9, 2018 at 5:39 am |
Hello Yra… I hope you get this? My few posts on Notes are no longer publishing (such as one moments ago and last Monday). They show as “awaiting moderation”. (I suspect I’m not alone). Would you please be able to help with that or approve my post(s)?
Thank you -David.
July 9, 2018 at 8:23 am |
David–will take care of it –thanks for your posts as you have been a welcome participant for many moons–look forward for you sharing your thoughts
July 9, 2018 at 9:29 am
@Yra… It’s all good now, thank you! (Blame me for changing my twitter email or something).
July 9, 2018 at 8:37 am |
The majority and near unanimous opinion is that a flattening and possible inversion is a sign/cause/warning of credit distress. When U.S. trade deficits provided bank reserves to the world that was a sensible assumption; foreign capital markets could take as a guarantee that domestic currencies could be swapped for dollars at a better exchange rate in the future. No one lost money for long being short the dollar.
Those were not the rules of the game before Keynes became the Moses of modern economic theory. Short rates were always higher than long-term rates; panics were identifiable by how much higher the inversion went. Call money could command overnight rates that were 10 times those still being accepted by buyers of long bonds.
That made sense when the question for traders was whether or not even governments would pay off – in specie. Clearing risk was far, far greater than long-term credit risk in a world where the prices of energy and the machinery that could use it could be expected to go down from one business cycle to the next.
July 9, 2018 at 10:10 am |
Stefan—so is it now the barbarous curve versus the barbarous relic??
July 9, 2018 at 11:33 am
It may be both, Yra. Before Keynes arrived with his tablets, the questions of money and revenue and foreign exchange had always been examined together. Money as specie had to become a barbarous relic because direct taxation had replaced indirect levies as the source of the government’s own income. No government had risked outright rebellion over “foreign” tax collections from tariffs; but, if voters, instead of foreigners, were going to be the main taxpayers, there had to be a way to avoid asking them to pay up in gold (or silver, for that matter – Keynes’ first foray into grand policy was to write about how India’s finances might be shifted from a silver to a nominal gold standard). Leaving the domestic gold standard solved that problem; but countries still had to keep the fiction of an international one if they were to be able to swap each other’s legal tender without the bothersome private intermediaries whose dealings who had controlled FX before 1914. Somehow, even as the world moved forward towards Keynes’ moneyless global economy, FX came back yet again as a problem – and with it the question of who will pay the taxes that the voters no longer want added, even if it does increase the GDP. During the election campaign Trump’s promise to Make Mexico Pay for the Wall seemed to be about immigration; in retrospect its greater appeal seems to have been the promise that foreigners would start paying indirect taxes so Americans could pay fewer direct ones.
July 10, 2018 at 5:17 am |
Meanwhile, back in the world where $1.5 Trillion in trades clear daily, there is a disclosure that the game has changed.
https://preview.tinyurl.com/y76oe5k7