Notes From Underground

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.