Notes From Underground: In Light of Declining Volume and Volatility … A Repost

The markets remain locked into the latest tweet from either politicians or CEOs. Whether it’s about tariffs or taking a company private, the Twittersphere has the ability to move markets for a nanosecond. Regardless of the algos and the continued march of passive investing NOTES FROM UNDERGROUND believes that Hyman Minsky has entered the room. A Minsky moment occurs when complacency leads to increased risk-taking while using increasing leverage. It is not market valuations that disrupts markets but rather the amount of debt that needs to be serviced. Can future cash flows ensure that the vast amount of debt can be managed? Leverage is a great aphrodisiac but if priapism results the exit strategy can elicit great pain. The markets are built on record debt.

As the FED raises interest rates stress is building in the global financial system. Several emerging countries need to meet dollar-denominated debt costs with weaker domestic currencies, which makes is more expensive to purchase DOLLARS.

The Chinese YUAN‘s recent decline is a serious concern for global finance for two significant reasons:1. The drop in the yuan’s value raises costs for Chinese companies who have DOLLAR payments to make; and 2. If the YUAN decline is orchestrated by the Xi regime to combat the Trump tariffs then the global economy may be subject to SYSTEMIC DISINFLATION as China uses a weak currency to dump its excess capacity onto to non-tariff-burdened markets. The YUAN has weakened against many currencies so Chinese goods in search of alternative markets from the U.S. will squeeze prices and profits on a global basis resulting in a diminished capacity for many emerging market corporations to service debt.

The QE programs from the Fed, the BOE, the ECB and the BOJ have created an environment in which the world has gorged on cheap debt. PBOC warned about this in October 2017 when he told the Chinese government: “If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky Moment.'” This is not a clarion call to exit the market but just putting perspective to the current global financial environment.

At the end of September 2017, I alerted readers to one of my favorite indicators providing a bullish equity market signal. The S&P/bond cross was finally ending the quarter above the record high made in December 1999. The quarter-end signal has resulted in a 18% move in nine months as the Trump fiscal stimulus programs provided a major boost to STOCKS while boosting Treasury borrowing. Followers of Minsky are always concerned about the role of DEBT. Is this time different?

Enjoy the post from May 2016 for it still resonates. Be especially attentive to the quote from one of the great pieces of literature from the progenitor of NOTES FROM UNDERGROUND,Fyodor Dostoyevsky. The world is far more complex then the previous quarter’s earnings. My endeavor to is measure the imbalances stalking the world so that we can find potential profits. Waiting for professor Minsky without losing perspective on today.

As I begin my further analysis of the unfolding political/economic factors facing the global markets I seek your indulgence and set the table by quoting from what I believe is one of the most significant chapters in western literature. Notes From Underground takes its title from the essay of the same name of by Fyodor Dostoyevsky. The tagline, 2+2=5, is a summation by Dostoyevsky to poke at the Rationalists of his day. But the chapter of note is from the novel The Brothers Karamazov titled, “The Grand Inquisitor.” The scene is set as the Grand Inquisitor has arrested the Christ figure for daring to upset the social order that the Church has created. The entire chapter is so moving but allow me to quote a small part:

“Receiving bread from us, they will see clearly that we take the bread made by their hands from them, to give it to them, without any miracle. They will see that we do not change the stones to bread, but in truth they will be more thankful for taking it from our hands than for the bread itself! For they will remember only too well that in old days,without our help, even the bread they made turned to stones in their hands, while since they have come back to us, the very stones have turned to bread in their hands. Too, too well will they know the value of complete submission! We shall show them that they are weak, that they are only pitiful children, but that childlike happiness is the sweetest of all. They will become timid and will look to us in fear, as chicks to the hen. They will marvel at us and will be awe-stricken before us, and will be proud at our being so powerful and clever that we have been able to subdue such a turbulent flock of thousands of millions.”

Yes, the Great Fyodor portrays well the concept of the Davos crowd as it leaves in awe of the miracles, mystery and authority promoted by the world’s self-anointed elites.

And now, the issues from the G-7 meeting, which will play out in the communique:

1. Expect a bow to the 500 articles of Larry Summers, who has spent the last two years pushing his plan for a fiscal stimulus package based on global wide infrastructure projects. In a hat tip to Kevin McCarthy, who called me to note that a massive fiscal stimulus program financed by central bank sovereign bond purchases is the consummate “helicopter money drop.” It’s free money not spent on flat screen TVs but massive projects controlled by policy makers so no fear of any type of Ricardian Equivalence effect where the possibility of the “dropped money” going into savings accounts. The Summers effort is based on seizing the opportunity of ultra-low interest to spend, spend, spend. It is widely held that monetary policy is a spent force and therefore fiscal stimulus is the key to preventing the onset of SECULAR STAGNATION. This is certainly a desired outcome for five members of the G-7 and I would expect that Germany gets singled out for their failure to correct their massive stockpile of foreign reserves from a robust current account and trade surplus.

2. There was a Bloomberg article today titled, “Draghi In QE Quandary After Draining Bond Market By $800 Billion.” The gist of the article is that the ECB will need to change the rules on bond purchases because as the balance sheet grows there is less product that meets the criteria established by Draghi and Company. As  Richard McGuire of Rabobank said: “Everything is on the table. Whenever they meet resistance, they get around it by adjusting the rules, adjusting the limits or targeting new asset classes.” This supports the case that monetary policy has broken all global markets turning everything into a relative value trade in which the value base is established by central bank fiat.

3. The Ghost of China present will be felt at the G-7  as Bloomberg News reported today, “China Said to Plan asking U.S. on Timing of Fed Rate Hike.” I never knew CHUTZPAH was a Chinese word but this is the finest example of it. The scheduled Strategic and Economic Dialogue (SED) is to take place in Beijing on June 6-7. The Chinese have been worried that a FED rate hike would push the dollar higher and thus affect the YUAN, and also have a negative impact on some of China’s largest customers. The Chinese maintain that “consulting on policy decisions would be in keeping with a pledge that both China and the U.S. made as members of the Group of 20. After a Shanghai meeting in February, G-20 finance chiefs pledged to consult closely and clearly communicate our macroeconomic and structural policy actions to reduce policy uncertainty’ and minimize spillovers.”

It seems that the U.S. Treasury has signed onto a commitment that violates U.S. law if it is met. A move to fiscal stimulus prior to any change in monetary policy would placate Chinese concerns about  the possibility of an over strong DOLLAR. The Fed and Treasury better get their communications in sync for the Chinese have a problem about promises made.

4. In a Financial Times article from Monday, the headline says much about the inconsistency in the British Brexit discussion: “Cameron to Face Pressure Over China Relations At G7 Summit.” It appears the Cameron will be challenged over his stance to make Britain China’s “best partner in the west.” The Japanese are miffed that Britain fails to deal with the aggressive China actions in the South China Sea. As the article noted, “Britain’s courtship of Beijing has caused irritation in Washington–last year the Obama administration warned of a ‘constant accommodation’ of China by London.”

Remember, it was the British who broke ranks with the U.S. and signed up to support Chinese efforts in the Asian Infrastructure Investment Bank (AIIB), which really upset plans for the U.S. efforts to contain Chinese economic influence. Further, George Osborne said in an FT interview during his visit to Xinjiang “… he wanted to take a bit of risk with the China relationship, pushing it so it really brings jobs and growth to our country.” This of course begs the ultimate question for Cameron/Osborne: Why are you so desirous of wrapping Britain in the rules and regulations that define Brussels and the EU. Full EU membership will limit the U.K.’S choices to act in its own interests. (For explanation, see Dostoyevsky above.)

***Chutzpah, ECB edition: In today’s FT, there was a headline that caused me to shake,rattle and roll my eyes: “ECB Warns of Populist Threat to Stability.” The article pulls from the semi-annual ECB report, Financial Stability Review, and gets deep into EU politics. “These rising political risks, at both the national and supranational levels, as well as the increasing support for political forces, which seem to be less reform orientated, may potentially lead to the delay of much-needed fiscal and structural reforms.” This is a tremendous act of arrogance by an non-elected entity which has vast power and influence. If a Fed Chair would have issued such a statement Congress would have demanded he/she to appear before the legislative body. As the balance sheet of the ECB expands, its influence seems to have no self-imposed restrictions on its demands. The voices from the German Constitutional Court on June 23 will be hearing from those in opposition to ECB policies as Draghi has now stepped on political toes. The AfD will be certain to respond. Back to Dostoyevsky.

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20 Responses to “Notes From Underground: In Light of Declining Volume and Volatility … A Repost”

  1. Mike Temple Says:

    Yra
    So, if we experience a Hyman Moment in the next year (and from even higher levels), will such a “panic” be large enough to tip the real economy into recession, due to all the debt/credit mayhem?

    If so, do you believe the Fed would then turn face and re-embrace QE in the face of such a crash?

    Thanks

    Mike

    • yraharris Says:

      Mike–that is what I have believed for a long time which is why I have not been an equity bear as real yields have remained Negative but the fueling of the rally by cheap debt keeps me cautious and the coming panic by central banks when the debt burden begins to bite is what makes GOLD versus all fiat currencies the most important dynamic to watch.The present efforts by the FED to go to neutral or actual positive real yields on short term money is what keeps a lid on most commodities,especially GOLD

      • David Richards Says:

        “The present efforts by the FED to go to neutral or actual positive real yields on short term money is what keeps a lid on most commodities,especially GOLD”
        … Apparently so does the refusal by world’s largest buyer of GOLD to pay more than a specific price in terms of CNY. They’re pricing gold in CNY and bid size in CNY, which is why we see that strong correlation up & down in Gold/CNY?

    • yraharris Says:

      David–that is certainly a high quality conjecture and I one I believe is accurate.The second one being that the securitization of gold and copper by Chinese borrowers has led to a feedback loop of hedgers elling to protect collateral but I hold to your premise

  2. Chicken Says:

    “Chinese concerns about the possibility of an over strong DOLLAR.”

    I recall at the time wondering why China would be unhappy about a strong $US….

    • David Richards Says:

      Chicken, I think it’s a common concern among those who borrow in dollars but then earn revenue in something else. Not unlike how a strong dollar is a drag on multinational NYSE-listed stocks. OTOH, a weak dollar is a boon to those stocks and dollar borrowers, like we recently saw between 2017.01 thru 2018.01 inclusive.

  3. Rob Syp Says:

    Over the years have tried mimicking how Ron Baron invests and even he has to be wondering about Elon’s tweeting yesterday.

    https://www.cnbc.com/2018/08/07/elon-musk-tweet-shows-the-hazards-of-being-an-interesting-ceo.html

  4. Michael A Temple Says:

    Yra
    Thank you for your response.

    Tell me if I have correctly summarized your view.

    A. The Fed will continue to tighten until such time as the Minsky Moment arrives. Until then, it is “risk on” for credit and stocks (take a look at TSLA to see how the “animal spirits” live on)

    B. Once Minsky arrives, Fed may be forced to halt both rate hike cycle and QT if the ensuing panic is bad and spills over into the real economy due to the “wealth effect” running in reverse.

    C. After a possible/probable “margin call” move lower, gold finds its footings and may finally resume a real substantial move higher.

    D. Almost simultaneously, the Fed begins to re-embrace ZIRP and QE to Infinity.

    E. Stocks finally “catch a bid” due to the extraordinary liquidity, but USD tanks while the better action is in gold which finally takes flight.

    Is that a fair summary of your ultimate outlook?

    Thanks

    Mike

  5. Stefan Jovanovich Says:

    I dragged out The Financial Instability Hypothesis to see if I could decode what you all meant by a “Minsky moment”. If you do a simple word search of the paper using the terms “currency”, “foreign exchange”, “dollar” and “gold”, the net result is zero. The world “debt”, on the other hand, returns 15 uses in a 7 page double-spaced paper.

    http://www.levyinstitute.org/pubs/wp74.pdf

    I don’t mind giving up on the free bourbon from our bet, Yra; but I do think it is unfair of you to keep pretending that the current levels of U.S. Treasury debt present a Minsky problem for a currency is going to be on the receiving end of capital flight for the foreseeable future. Whatever the Feds’ current sins, its determination to reduce its holdings of Treasury bonds and notes stands in marked contrast to the endless QE that is now the established policy of the BOJ, BOC, and ECB.

    • yraharris Says:

      Stefan—I don’t disagree with that scenario and it certainly appears that is what is taking place in the world and of course the FED is in a far different place then the idiots at the ECB and BOJ and others that have followed Bernanke down the rabbit hole.Draghi failed the poker test–if you don’t know who is the sucker at the table it is you but Mario doesn’t care as his whatever it takes means exactly that to save the Euro and thus the EU—the creation of a eurobond by stealth is the major sword at the necks of the global financial system–when I don’t know but it is a certain as day follows night.The financial repression plaguing Europe is a catalyst to the politics that all lovers of freedom disdain—the central bankers have used their mandates to create massive political disaffection

      • Stefan Jovanovich Says:

        Thx, Yra, for tolerating my chronic misbehavior in the back of the classroom. I keep referring to Chicago financial history and your own and your friends’ experience as traders because what the pits demonstrated in the last third of a century (since the Plaza Accord) is that “credit” is now about clearing between currencies, not about bank reserves and “money”. Futures move the exchange rates; central banks can do whatever they choose in their attempted adjustments of interest rates and the “curve” does not affect what the dollar and Euro’s prices are against each other.

        For better and for worse, domestic economies in Japan, China and Europe are now clerical systems with the state as the medieval Papacy. People’s incomes are more a function of their status than their enterprise; and alms and contracts are both supplied by the state. In the world now departed Japan, China and Europe’s takeovers of their sovereign debt markets by the central banks might still be considered “financial repressions”; but they can hardly be so when sovereign defaults and outright liquidations of both public and private debtors have both been removed as a possiblity? There is still a credit market in the sense of actual interest being charged but those rates are now effectively global and all are based on adhesion contracts with consumers. The actual interest rates charged – the fees for carrying credit card balances and for small business loans – are indistinguishable from those in the U.S. For example, on loans of less than ¥1 million Mizuho charges 14 percent interest, Sony’s web bank 13.8.

        Where the uncertainty lies, as you and your other contributors have pointed out, is in capital flows between currencies. Trump’s seeming folly – in creating “trade wars” – is his effective means of assuring that the United States wins the war for capital flows – without paying the usual price of punishing increases in interest rates and/or declines in domestic wages. Or, to put it another way, he plans to capture whatever any gains China and others may realize in trade from lower exchange rates by using tariffs as a kind of FX sterilization. My bet – and Martin Armstrong’s – is that capital, which does not have to pay any tariffs, will come to the U.S. and be invested in both the stock and bond markets, much as it did under Coolidge and in the 1870s after the U.S. recovered from the Panic caused by the Great Boston Fire’s devastation of the insurance companies.

  6. Arthur Says:

    Success is “only a disaster away,” and potentisl disasters are always looming on the horizon.

    Andrew Grove “Only the paranoid survive”

  7. Richard H Papp Says:

    For the Curious read L. Randall Wray “Why Minsky Matters: An introduction to the Work of a Maverick Economist”
    Or go to the Prophet himself and read Hyman Minsky’s “Stabilizing an Unstable Economy”
    A lot to read but it’s all there!

  8. Pierre Chapuis Says:

    I’m starting to believe the Martin Armstrong’s theory. The USD and US equities will continue to rise just for the mere fact there is nothing else safer right now. Bond yields will continue to rise with equities. Gold having it’s day in the sun once trust in government is questioned, ie the Euro crashing…
    I do have my small observation to make. While everyone talks about the yield curve steepening or inverting. Could there be a chance of the yield curve expanding? Maybe all at once?

    • yraharris Says:

      Pierre—what do you mean by yield curve expanding.The scenario that you apply from Armstrong is certainly in play and will continue until something upsets the beautiful fascism of stability that is perceived to exist in the U.S. versus others ports of call for global capital.The equity market is bullet proof as investors search for predictable returns in a fairly stable environment.

      • Pierre Chapuis Says:

        Thank you for your response Yra, this gives me conviction on my long dollar trade.
        What I mean about the yield curve expanding (I probably made up my own term) that both short term yields and long term yields rise in tandem. From my vantage point it seems like the 30 yr yield is the anchor that is holding down everything. Lets say the 30 yr rises above 3.3% and keeps rising, shorter term rates continue to rise with it. To me that would look like the whole curve getting larger at once. What name do you give a curve that rises at both ends and in the middle at once?
        Is this possible? Just my small observation.

  9. Chicken Says:

    Hmm, Brazil suffering from Chinese tariffs?

  10. Arthur Says:

    Yra, your view on climate change? Thanks!

  11. Stefan Jovanovich Says:

    A repeat, with an addendum:

    Thx, Yra, for tolerating my chronic misbehavior in the back of the classroom. I keep referring to Chicago financial history and your own and your friends’ experience as traders because what the pits demonstrated in the last third of a century (since the Plaza Accord) is that “credit” is now about clearing between currencies, not about bank reserves and “money”. Futures move the exchange rates; central banks can do whatever they choose in their attempted adjustments of interest rates and the “curve” does not affect what the dollar and Euro’s prices are against each other.

    For better and for worse, domestic economies in Japan, China and Europe are now clerical systems with the state as the medieval Papacy. People’s incomes are more a function of their status than their enterprise; and alms and contracts are both supplied by the state. In the world now departed Japan, China and Europe’s takeovers of their sovereign debt markets by the central banks might still be considered “financial repressions”; but they can hardly be so when sovereign defaults and outright liquidations of both public and private debtors have both been removed as a possiblity? There is still a credit market in the sense of actual interest being charged but those rates are now effectively global and all are based on adhesion contracts with consumers. The actual interest rates charged – the fees for carrying credit card balances and for small business loans – are indistinguishable from those in the U.S. For example, on loans of less than ¥1 million Mizuho charges 14 percent interest, Sony’s web bank 13.8.

    Where the uncertainty lies, as you and your other contributors have pointed out, is in capital flows between currencies. Trump’s seeming folly – in creating “trade wars” – is his effective means of assuring that the United States wins the war for capital flows – without paying the usual price of punishing increases in interest rates and/or declines in domestic wages. Or, to put it another way, he plans to capture whatever any gains China and others may realize in trade from lower exchange rates by using tariffs as a kind of FX sterilization. My bet – and Martin Armstrong’s – is that capital, which does not have to pay any tariffs, will come to the U.S. and be invested in both the stock and bond markets, much as it did under Coolidge and in the 1870s after the U.S. recovered from the Panic caused by the Great Boston Fire’s devastation of the insurance companies.

    Where I seem to be off all by myself is in the belief that “interest rates” do not matter for sovereign debts that can be exchanged in actual volume (NOT the Turkish Lira). The Fed with its excess reserves and the ECB, and, in the second tier, the BOJ and BOE, are all “managing” rates in the same way the Morgan Bank managed the reorganizations of the overbuilt railroad companies. The investors were committed to allowing their capital to be restructured indefinitely because the alternative – asking to cash out – was not worth the cost of having future access cut off. Morgan & Co. would let you out, but they would not let you in again. Until a major bank decides that they really don’t want to be in the game any longer, sovereign debts in Europe, the U.S., Japan and Britain will be priced by marginal speculations in the futures; but the levels of interest rates will remain static. There will not be any moves of consequence and the fluctuations in the curve will be no more than splashes in the central bank/national Treasury bathtubs. FWVLIW, I agree with Mr. Armstrong and (I presume) Yra that there is a major credit crisis on the horizon; but it is, in the U.S., in the state and municipal bond market, not corporates or Treasuries. But, Trump’s likely ability to promote increased capital flows to the U.S. is going to defer that day of reckoning until after he leaves office. If one wants to find a parallel with Coolidge, look to 2025 or the date of Trump’s death in office.

    • Pierre Chapuis Says:

      Wow, thanks Stefan for taking the time to post your thoughts! And of course thanks to Yra for maintaining this blog. 👍

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