Notes From Underground: Going Where Others Fear to Tread

In a surprise visit with Rick Santelli on Wednesday, we picked up where we left off in our discussion about rising interest rates. This time we had live ammunition as the data releases revealed suggested robustness in the U.S. economy. Now that the “accommodative” language was removed from the FOMC statement, Chairman Powell will have the luxury of FLEXIBILITY in reacting to economic signals. The markets responded to Powell’s new policy by sending interest rates higher, taking out long-time technical resistance on the U.S. 10- and 30-year Treasuries. Is the rise in yields sustainable? Friday’s unemployment report will provide a powerful test for the markets because if wages increase more than anticipated there will be renewed selling all along the curve.

Click on the image to watch me and Rick discuss the rise in Treasury yields.

The U.S. 2/10 curve rose 5 BASIS POINTS today closing above 30 basis points for the first time in many moons. It is not just the improved data driving rates higher on the long end but the impact of two significant changes in the demand/supply equation for BONDS. First, the TAX advantage accruing to pension funds and insurance companies expired on September 15. This means that the taxable write-off rate for pension contributions dropped to 21 percent from 35 percent. Second, beginning this month the FED‘s caps for its balance sheet unwind rise to the maximum $30 billion for Treasuries and $20 billion for agency mortgage-backed securities. Given that there are months where the Fed will have no reinvestments (at least on the Treasury side), which will push more Treasury supply into the market. THIS IS IMPORTANT: With more supply entering the markets, there will be a need for bond portfolio hedging INCREASED HEDGING. Institutional accounts hedge duration exposure while the FED balance sheet is UNHEDGED. Ah, the exorbitant privilege of  a printing press.

***LET ME REITERATE: There is plenty of news stating that Italy will capitulate to the demands of Brussels to cut its deficit to the 2 percent level because it fears the wrath of the bond markets and the Eurocrats. FALSE NARRATIVE! The Italians have the upper-hand in these negotiations for the European banks are loaded with Italian debt as are the Italian domestic banks. The problem for Europe, the ECB (and really the world) is that the amount of debt is very large, especially relative to Greece. Global financial regulations established by the Bank for International Settlements (the BIS) have said sovereign debt has a zero risk weighting, therefore no bank reserves are required to own the debt.

The recent volatility in Italian debt markets should make all regulators challenge this ridiculous notion. However, if the rules were to be changed many of Europe’s large banks would need to raise massive amounts of capital in order to maintain their current assets and balance sheets. The Italian government, led by the Five Star/League coalition under the leadership of Luigi Di Maio [5*] and Matteo Salvini [League] are very cognizant of their strong hand. The threats from President Juncker and his minions have little credibility but there is increased volatility in response as the media readily accepts the Juncker narrative. The only way out of this destructive feedback loop is the creation of a EUROBOND, which will demand the capitulation by Germany to be the full credit guarantor of the European union for all debt, past, present and probably the future.

There are critical elections in 10 days in Bavaria. The Merkel coalition is projected to lose a lot of popular support in a long-time bastion of conservative German policy influence. If Merkel’s losses are inherited by the populist AfD, life for Merkel will become more difficult and the Italians will be emboldened to make increased demands from Brussels over budget relief. French President Macron seems to be of the opinion that Germany’s decline in stature increases French authority.We shall see.

Italian leaders will shout that the French budget is in greater DEFICIT THAN THE ITALIAN, further undermining the moral authority of Macron. What could Macron offer to the Italians to co-opt the bellicose Italians. I surmise that Brussels is contemplating some type of EUROPEAN INFRASTRUCTURE PROGRAM financed by a massive EUROBOND float. This would allow Rome to achieve some type of fiscal stimulus program while moving it off its national balance sheet. A special purpose vehicle reminiscent of the large banks prior to the Global Financial Crisis. I always fear where everyone treads. More earnings, please.


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7 Responses to “Notes From Underground: Going Where Others Fear to Tread”

  1. Asherz Says:

    Yra- Remember the old joke? If you owe the bank $100,000, the bank owns you. If you owe the bank $100,000,000, you own the bank.
    Five Star understands this. It’s called “To big to fail”. We saw that 10 years ago here. The music stopped, everyone stopped dancing, but the Central Bankers brought in their own band to restart the dance-a- thon. This time the Charleston replaced the Waltz. Daily new highs in the Dow leaves us breathless.
    The answer to the underlying cause of the problem, too much debt, is solved by more debt. Issue a Eurobond. Have a one year deficit of $1.27 trillion. Issue regular $100 billion treasury bond auctions.
    The end is predictable. The way to protect your savings is apparent.
    Not if but when.

  2. David Richards Says:

    Indeed Italian budget deficit spending will ramp up (its proposed rate of deficit spending to GDP is only about half as bad as the US). Such “fiscal stimulus” will become the new flavor in Italy, elsewhere in Europe and everywhere, replacing monetary stimulus. As they say, out with the old and in with the new.

    Why? Because they see the “success” of Trump’s massive fiscal stimulus in the form of this sugar-high, pumped-up US economy (with the hangover collapse not yet visible, but coming, absent an even higher dose of fiscal steroids to the sickly economic patient). Other nations are going to copy US fiscal stimulus, just as they copied US monetary stimulus that “worked”. Ugh.

    To the near term trade. The Euro currently trading down near 1.146 offers an opportunity as Euro has been driven down irrationally on Italy fears, a FALSE narrative as Yra discussed. I went long EURUSD from the 1.146-1.147 range with stops just below 1.14, with target 1.20-1.21 (but I might or mightn’t take partial profits at 1.18). This is a juicy 10:1 risk-reward short-term trade (after which, Euro should reverse lower). As Italy & Europe swing over to fiscal stimulus, and throttle back on monetary stimulus, the EURUSD could surge again – perhaps also helped higher by a Dem sweep in November, creating prospects for more US socialism and a presidential impeachment.

    • yraharris Says:

      David–as usual a very well constructed response and I think the recent strength of copper bears you out

      • David Richards Says:

        Yra, excellent connecting-the-dots to Dr Copper! Interesting price strength given a slowdown in China.

        In addition to the potential fiscal stimulus abroad, perhaps the Dems will work with Trump on a Fiscal Stimulus 2 plan focused on infrastructure instead of taxcut funded stock buybacks. The US economy and stocks might then power on for an encore? Maybe with materials & metals finally outperforming FANGs? (for example Jesse Felder’s BANGs, haha)

    • David Richards Says:

      A strong NFP on Friday could see a reaction rally in USD, but after Thursday’s EURUSD close higher, we want EURUSD to close Friday no lower than Thursday’s 1.1457 low to stay bullish EURUSD. Above 1.159 next week would be near-term bullish targeting 1.181 eventually, and I’d move my stop loss from 1.1394 up to 1.1466 (from the .786 to the .618 fib retracement pt of the last EUR rally, and my break-even trade entry pt).

      Global fiscal stimulus and some better global growth if any (however achieved) will help currencies against the safe haven dollar, until the fiscal adrenaline wears off and its price must be paid. Is that when gold finally loses its shackles?

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