I think veteran subscribers will recognise a number of the themes I have been discussing in recent big picture long-term audios in this podcast. 

For Sun Jianbo, president of China Vision Capital Management Co. in Beijing, valuations among large-cap shares are too expensive for state-backed funds to intervene.

The CSI 300 traded at its highest level relative to the broader Shanghai Composite Index in at least 12 years at the start of this week as investors flocked to large caps such as Moutai and Ping An Insurance (Group) Co.

"There’s no need to prop up the market yet," Sun said. "A lot of big caps are still expensive and it would do more harm than good to state-backed funds if they buy now."

The divergence between large-cap shares and the rest of the market may be one reason why the government took aim at Moutai. Before Xinhua warned last week that gains in the liquor maker were excessive, the stock had more than doubled this year.

Following the botched introduction of options trading in 2015 the Chinese administration introduced new rules on disclosures and selling by company principles. It also banned short selling for a time. Through steady purchases by various state-owned vehicles, they manufactured the slow and steady pace of the stock market’s advance since the low in early 2016. 

Dear Eoin, could you comment on Niall Ferguson's market prediction in the Sunday Times: 

Thank you for this article which may be of interest to subscribers. It is always a useful exercise to contemplate the end of the financial world but in the full knowledge it doesn’t happen all that often. Niall Ferguson does a good job of articulating the potential causes of future problems in this article which is sure to garner attention for his new book. 

The U.S. jobless rate, which was 4.1 percent in October, may reach 3.5 percent in late 2019, Goldman predicted. That would be the lowest level since the late-1960s.

“Our projections would imply an evolution over the current cycle from the weakest labor market in postwar U.S. history to one of the tightest,” the economists said in a summary of their report. “We expect that a tight labor market and a more normal inflation picture will lead the Fed to deliver four hikes next year.”

That’s one more rate increase than the median forecast of Fed officials, and more than financial markets are currently pricing in. One of the reasons why Goldman Sachs economists said they disagree with market expectations is “we see little evidence that soft inflation is structural in nature.”

The USA’s economic expansion might be modest by historical standards but it is still one of the longest in history. The prospect of adding a fiscal stimulus when growth is already mature and unemployment low is the epitome of procyclical policy and increases the likelihood that inflation will increase. 

Though there is an overall tendency for velocity of money to fall over time, Napier noted, the accelerated decline we’ve seen in recent years is due to the nature of the money that is being created. This money primarily takes the form of bank reserves, which are not inherently fungible and are now stuck in the banking system.

Banks have chosen not to increase the size of their balance sheets and create deposits, which is the money that circulates in the actual economy, as opposed to the asset economy. This is why Napier thinks the velocity of money has fallen.
“There’s a form of money there that is stuck in the ‘asset ghetto,’ if you like, and not yet spreading out to normal GDP,” he said.

This plays in part into the assumption most people make that the world is awash in money. While there is a lot of money in the asset markets, the reality is that M2 growth in the United States is 5 percent, which is one of the lowest levels recorded in the past 30 years, Napier noted. Apart from the 2008 to 2009 crisis, we’re back to very low levels of total money creation.
This is true of other countries, as well. China is close to a new record low in the growth of its money supply. India is also showing levels of growth in its money supply not seen since 1963.

 

The Velocity of M2 is at a record low based on the last update of September 30th. If Russell Napier’s contention the Index has plumbed new depths since 2010 because of stranded reserves at banks then the reduction of the Fed’s balance sheet could have a positive effect by pushing responsibility for credit creation onto the banking sector.  

Until this year, struggling retailers have largely been able to avoid bankruptcy by refinancing to buy more time. But the market has shifted, with the negative view on retail pushing investors to reconsider lending to them. Toys “R” Us Inc. served as an early sign of what might lie ahead. It surprised investors in September by filing for bankruptcy—the third-largest retail bankruptcy in U.S. history—after struggling to refinance just $400 million of its $5 billion in debt. And its results were mostly stable, with profitability increasing amid a small drop in sales.

Making matters more difficult is the explosive amount of risky debt owed by retail coming due over the next five years. Several companies are like teen-jewelry chain Claire’s Stores Inc., a 2007 leveraged buyout owned by private-equity firm Apollo Global Management LLC, which has $2 billion in borrowings starting to mature in 2019 and still has 1,600 stores in North America.

Just $100 million of high-yield retail borrowings were set to mature this year, but that will increase to $1.9 billion in 2018, according to Fitch Ratings Inc. And from 2019 to 2025, it will balloon to an annual average of almost $5 billion. The amount of retail debt considered risky is also rising. Over the past year, high-yield bonds outstanding gained 20 percent, to $35 billion, and the industry’s leveraged loans are up 15 percent, to $152 billion, according to Bloomberg data.

Even worse, this will hit as a record $1 trillion in high-yield debt for all industries comes due over the next five years, according to Moody’s. The surge in demand for refinancing is also likely to come just as credit markets tighten and become much less accommodating to distressed borrowers.

 

One of Warren Buffett’s most colourful adages is “you don’t know who has been swimming naked till the tide goes out” A great many companies have survived with high debt loads because liquidity was abundant, interest rates were at rock bottom levels and access to credit was easy. Until recently, refinancing has been easy which allowed companies to pile on additional debt. An obvious point is that highly leveraged companies are heavily exposed to refinancing issues as interest rates rise. 

Prices on PDVSA’s $3 billion of bonds maturing in 2027 were quoted at 20 cents on the dollar at 9:23 a.m. in London, according to pricing source CBBT. Venezuelan government bonds maturing in 2018 slid 16 cents on the dollar to 63 cents, while longer-maturity debt was little changed.

Even after the oil producer known as PDVSA made an $842 million principal payment Oct. 27, the nation is behind on about $800 million of interest payments. All told, there’s $143 billion in foreign debt owed by the government and state entities, with about $52 billion in bonds, according to Torino Capital.

Sanctions imposed in August by the U.S. have made it difficult to raise money from international investors, and effectively prohibit refinancing or restructuring existing debt, because they block U.S.-regulated institutions from buying new bonds. It’s an unprecedented situation for bondholders, who have limited recourse as long as sanctions are in effect.

“I decree a refinancing and restructuring of external debt and all Venezuelan payments,” Maduro said. “We’re going to a complete reformatting. To find an equilibrium, and to cover the necessities of the country, the investments of the country.”

 

$60 is a big level for many higher cost private sector oil producers. It’s a number many companies have quoted as they struggled with cutting costs while prices traded below economic levels. Their fortunes are improving now that prices are at two-year highs. Venezuela’s breakeven is well above current levels so the recent rally is less of a salve, while bond payments are a constant drain on revenues. 

I was listening to a podcast at Epsilon Theory and they were discussing their observation of S&P EBITDA growth being significantly lower than Net Income growth. This would signify that the artificially low interest rates being the prime driver of earnings which poses a scary scenario. I can't seem to find an updated chart. Can you add to the Chart Library? Thank you!

Thank you for this question but I’m afraid the universe of fundamental statistics we have available to post in the Chart Library is rather limited so creating the spread between EBITDA and Net Income is not possible. 

The Bank of England may increase interest rates this week for the first time in more than a decade, but that won’t be enough to buoy the pound, according to strategists.

Markets almost fully price in a 25-basis-point increase in the BOE’s key rate on Thursday, meaning investors are ill- prepared for a disappointment. Should Governor Mark Carney and fellow policy makers keep policy on hold, or deliver a one-time hike that merely reverses the emergency cut after the Brexit vote, sterling could add to the last two weeks’ declines, according to Ross Walker, an economist at NatWest Markets.

The U.K. currency has declined 1.8 percent against the dollar during October as concerns about the lack of progress in Brexit negotiations weighed on investor sentiment. It snapped a two-day decline on Monday, gaining 0.3 percent to $1.3161 as of 9:11 a.m. The yield on 10-year U.K. government bonds fell 1 basis point to 1.34 percent.

“Sterling needs a hawkish hike in order to rally,” said Walker. “The pound could come under pressure” otherwise, he said.

While money-market pricing suggests an 89 percent probability that the Monetary Police Committee will tighten on Thursday, banks including Credit Suisse Group AG and Barclays Plc expect a “one-and-done” move. Investors will look to the language of the MPC minutes, vote split and the quarterly Inflation Report to gauge the policy outlook further ahead.

“I’d prefer to go into the meeting” with a short position on sterling, said Steven Barrow, head of currency strategy in London at Standard Bank. “There is a reasonable enough chance they don’t raise rates. We’ll have to see what comes out from the statement the bank puts out.”

The bond market has pretty much priced in the potential for the Bank of England to raise rates this week, with 3-month yields rising from a low in July of 0.12% to 0.41% today. Perhaps the biggest question is not so much whether they will raise rates but rather will they manage to sustain the hike and whether they will raise again? 

Venezuela could still also make the payments on time. While $10 billion in foreign reserves isn’t much for a country that now owes some $140 billion to foreign creditors, it’s still enough to pay the bills for a while.

And the Maduro government has surprised the bond market before, making payments the past couple years that many traders had anticipated would be missed. Some of those now betting that these next two payments will also be made actually point to the $350 million currently overdue on the other notes as an encouraging sign. Those arrears indicate, they contend, that officials are prioritizing the payment of bonds with no grace period at the expense of those they can put off without penalty.

Even if Venezuela can make the payments due this year, investors say that, unless oil prices stage some sort of miraculous comeback, they still see default as an inevitable outcome. Credit-default swaps show they’re pricing in a 75 percent chance of a PDVSA default in the next 12 months and 99 percent in the next five years.

 

Venezuela represents a problem for bond investors because it could either be a one-off default or be the thin end of the wedge for distressed energy producers. The fact PDVSA sinkable bonds are now trading at a spread of 526 basis points, versus 200 last week, suggests investors are increasingly skeptical the government is going to be able to make principal payments when they mature on November 2nd. 

We all know that nominal interest rates are a function of real interest rates and inflation expectations. The nub of our argument is that the consumer price index (CPI) as measured by the Bureau of Labor Statistics (BLS) sharply understates what bond investors should incorporate into their inflation expectations. 

The first component of our three-part argument is that CPI measures inflation where the people are, not where the money is. That is an appropriate stance for BLS since CPI is used to set government benefit levels, but consider that the top 20%, who effectively own all the bonds, generate as much consumer spending as the lower 62%. The basket of goods that 20% buys likely differs significantly from the basket of the average person. 

Second, we look at the healthcare anomaly. Healthcare accounts for 17.7% of GDP and 14.5% of the S&P 500 but only 8.5% of CPI. Most private sources estimate healthcare costs have been increasing by ~6%+ in recent years, but BLS puts the number at 2.8%. A recent study found that the average health insurance plan now costs ~$19K (with ~$6K from the employee), but healthcare insurance is just 1.004% of CPI.

Third, in looking at how CPI is calculated, we suspect there is a "streetlight effect," where one searches where the light is good rather than where the sought object is likely to be. In the case of CPI, we suspect they measure what is easily quantified. There is incredible granularity on the cost of apples, bananas and peanut butter but only big sweeping categories for healthcare and housing. 

The bottom line is that we think CPI substantially understates the inflation expectations that investors should incorporate into the pricing of bonds and that long-term rates should increase. One does not have to believe this to own bank stocks as they remain cheap in any case at a 66% relative P/E, but if we are correct about CPI, the upside should be even better.

 

A link to the full report is posted in the Subscriber's Area.

Anyone who lives in the real world and pays their own bills, mortgage and taxes knows inflation is understated. Additionally, since government spending is integrally tied to official statistics, politicians have an interest in the understatement persisting not least because fiscal deficits are already wide. However, it is reasonable to conclude that we have had such an uptick in reactionism against the status quo is because consumers have direct experience of inflation which the statistics refuse to acknowledge. 

* the excess liquidity provided by the world’s central bankers,
* serving up a virtuous cycle of fund inflows into ever more popular ETFs (passive investors) that buy not when stocks are cheap but when inflows are readily flowing,
* the dominance of risk parity and volatility trending, who worship at the altar of price momentum brought on by those ETFs (and are also agnostic to “value,” balance sheets,” income statements),
* the reduced role of active investors like hedge funds – the slack is picked up by ETFs and Quant strategies,
* creating an almost systemic “buy on the dip” mentality and conditioning.  
when coupled with precarious positioning by speculators and market participants:
* who have profited from shorting volatility and have gotten so one-sided (by shorting VIX and VXX futures) that any quick market sell off will likely be exacerbated, much like portfolio insurance’s role in a previous large drawdown,
* which in turn will force leveraged risk parity portfolios to de-risk (and reducing the chance of fast turn back up in the markets),
* and could lead to an end of the virtuous cycle – if ETFs start to sell, who is left to buy?

 

It’s 30-years since the 1987 crash which has likely been a contributing factor in why so many bearish reports have been hitting my desk in the last week. 

Rajoy would need someone reliable to enforce the ruling. With the loyalty of the Catalan police force in doubt, that probably means the estimated 10,000 national police and Civil Guard officers who’ve been sent to Catalonia as reinforcements.

They have the numbers to remove Puigdemont, but it would trigger a rejection in the streets. More than 800 people were injured when those officers tried to shut down Sunday’s vote, so there’s a clear risk that the situation could spin out of control.

The Catalan police force adds another element of uncertainty. Sunday also saw a minor scuffle between Spanish and Catalan police, one Catalan officer was arrested for attacking a national police vehicle and tensions between the different forces are running high. If Spain took control of Catalonia, Rajoy would probably need support from the Catalan police to impose and maintain order.

 

The Catalan independence vote can be seen in the wider context of a condemnation of the severe fiscal austerity handed down by the European Commission and ECB, to countries on the Eurozone’s periphery, in response to the credit crisis. Forcing governments to absorb the bad debts of private institutions, without recourse to a sharply devalued currency, has put great pressure on the populations of the respective countries and Spain’s current political impasse is a real-time example of what that can lead to.

Catalonia, which includes Barcelona and accounts for a fifth of Spain’s economy, is attempting to become the first of 17 autonomous regions that already enjoy a measure of self-government to hold a binding plebiscite on independence. It staged a nonbinding ballot three years ago that was backed by about 80 percent of voters, though barely 30 percent of those eligible turned out.

The rebel administration is pressing ahead with the referendum even after Rajoy’s government seized 10 million ballots, deployed thousands of police and arrested more than a dozen Catalan officials.

“This is the most serious constitutional crisis Spain has faced,” said Alejandro Quiroga, professor of Spanish history at the University of Newcastle in the U.K. “The Catalan question could trigger a competition among the other regions to test how far they can go. It’s a very complex matter.”

 

How much did the discovery of America, and the riches that flowed into Spain as a result, cement the binding together of Castille and Aragon when Isabella and Ferdinand were wed? There is no doubt economic abundance reduces nationalistic tendencies but the opposite is also true. 

There is good news for Trump and the Republican Congress: A short-term economic jolt might help make congressional elections next year smoother for them.

In effect, making the deduction temporary would “pull forward” companies’ future purchases and “juice economic activity in the front, during this term leading into re-election,” said Michael Drury, the chief economist of McVean Trading & Investments in Memphis.

Grover Norquist, the president and founder of the conservative group Americans for Tax Reform, says he thinks the tax plan would produce sustained growth. But he acknowledged the issue’s political importance.

“This tax bill, and its growth, is going to be the central piece of legislation that voters will vote on in October and November of 2018,” Norquist said earlier this week.

 

The Trump administration is going to need to deliver on at least one major success if it is to succeed in sustaining the Republican Party’s electoral success. That will be a central motivation for politicians as they assess the merits of this plan which is still notably skimpy on details. That also suggests a willingness to negotiate on the details so long as the central thesis of lower corporate tax rates and higher tax-free bands remain. 

A clear signal that something is afoot would be the abolition of the Saudi riyal's peg to the US dollar. As recently as April of this year economist Nasser Saeedi advised Middle Eastern countries to prepare for a “new normal” — and specifically to review the dollar pegs of their currencies: “By 2025 it is clear that the center of global economic geography is very much in Asia. What we’ve been living in over the past two decades is a very big shift in the political, economic, and financial geography.”

While the role of oil-producing countries (and particularly Saudi Arabia) shouldn't be underestimated, at present the driving forces with regard to de-dollarization are primarily Moscow and Beijing. We want to take a closer look at this process.

There exist numerous political statements in this context which leave no room for doubt. The Russians and Chinese are quite open about their views regarding the role of gold in the current phase of the transition. Thus, Russian prime minister Dimitri Medvedev, at the time president of Russia, held a gold coin up to a camera on occasion of the 2008 G8 meeting in Aquila in Italy. Medvedev said that debates over the reserve currency question had become a permanent fixture of the meetings of government leaders.

Almost ten years later, the topic of currencies and gold is on the Sino-Russian agenda again. In March, Russia's central bank opened its first office in Beijing. Russia is preparing to place its first renminbi-denominated government bond. Both sides have intensified efforts in recent years to settle bilateral trade not in US dollars, but in rubles and yuan. Gold is considered important by both countries.

 

Oil and its derivative products are used in every country in the world so it is logical that the acquiescence of major suppliers to a Dollar standard is a necessary condition of the USA’s international currency hegemony. However, it is not the only consideration. 

A link to the full report is posted in the Subscriber's Area.

There were a number of interesting points raised but I believe the most relevant for subscribers’ centre on what he said about shrinking the Fed’s balance sheet, the outlook for the Dollar, commodity markets, the relative attractiveness of emerging markets and his best guess for when to expect the next recession.

Similarly, a new strategy to deal with the surplus capital, not within our grasp.  In the meantime, officials are trying to come up with other ways to absorb the surplus, including changes in the regulatory environment.   In some ways, it might be helpful to think about QE itself as an attempt to deal with the surplus capital.

When farmers have a bountiful crop, and the price threatens to fall below the cost of production, governments often invent schemes to buy the crop and warehouse it and let it agricultural produce come to market when at a better (i.e., lucrative) time.  In some ways, QE can be understood as a similar strategy:  Warehouse the surplus capital.  This is not a permanent solution.  There is a political push back on the grounds that it blurs monetary and fiscal policy.  There is an ideological resistance to the “interference” with market forces.  There are economic arguments against the distortion of prices and the mutation of printing signals.

Interest rates are low, not simply because central banks are buying bonds and maintaining large balance sheets by recycling maturing issues.  Interest rates are low because there is too much capital.  It is a recurring source of the crisis in market economies.  We should anticipate that returns to capital will remain low until a new strategy to deal with the surplus is devised and accepted, and the risk is that we are still in denial.

 

This is an interesting take on the condition we see today in the financial markets and is a topic worthy of consideration because it will influence how high interest rates can rise in the current environment. 

Why does the US not shift its bonds to 20 and 30-year duration, increase inflation to, say, 2% and pay back the money in 20 or 30 years’ effectively free of interest? This would really kick the can down the road and give them many years to sort out the mess.  When I asked this of Americans five years ago, they thought it would cause interest rates to spike if the Fed tried to drastically increase the duration.  I think the last few years have proved that the duration could be increased without causing panic in the markets. 

Thank you for this email and since no one has ever successfully taken trillions of Dollars out circulation before I suspect everyone is asking how this can be done effectively. The Fed went through a maturity extension program between 2011 and 2012 which swapped about 667 billion from short-dated to longer dated securities. Here is a section from the Fed’s 2012 press release on the subject: 

Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative. 

“The labor market has continued to strengthen” and economic activity “has been rising moderately so far this year,” the Fed statement said. The FOMC repeated language saying “near- term risks to the economic outlook appear roughly balanced.”

The decision to leave the target range for the federal funds rate unchanged and begin the balance-sheet runoff in October was unanimous. The Fed reiterated that interest rates are likely to rise at a “gradual” pace, though updated forecasts indicated that officials see the path as less steep than before.

In their new set of projections, Fed officials estimated three quarter-point rate hikes would be appropriate next year -- the same number they saw in June -- based on the median in the so- called dot plot of interest-rate forecasts.

Crisis Action
The Fed's decision to exit from balance-sheet policies comes a decade after the global financial crisis began to tip the economy into a recession at the end of 2007. The reduction in assets will be slow -- just $10 billion a month to start. 

 

The Fed’s balance sheet has been steady at close to $4.5 trillion since early 2015 when the process of tapering quantitative easing ended. The issue facing the Fed is that they want to continue to raise interest rates, but that is going to have a deleterious effect on the Treasury’s finances as bonds mature and are refinanced at higher rates. The answer they are experimenting with is reducing the size of the balance sheet so there are fewer bonds which need to be refinanced. 

Money managers are grappling with an uptick in operational and balance-sheet challenges late in the business cycle, with debt-laden Toys ‘R’ Us Inc. the latest retailer to file for bankruptcy this week, catching bond markets off guard. Just two weeks ago, credit-default swaps, which allow traders to hedge against losses, were pricing in a low probability of near-term default at about 10 percent based on contracts expiring in June.

"Companies with the weakest fundamentals often show problems first late in a cycle, and the retail sector has many such examples," said Adam Richmond, Morgan Stanley’s chief credit strategist.

"Investors initially treat those issues as idiosyncratic, and then the problems spread, when credit conditions begin to tighten,” he said. “That is how the late cycle can transition to end of cycle."

These risks are hard to see at the index level, with the Bloomberg Barclays U.S. high-yield benchmark up almost 7 percent this year, led by CCC-rated names. Still, the latter has underperformed the broader market over the past two months, suggesting investors are increasingly compelled to price-in deteriorating fundamentals -- reminiscent of a market in its late winter, according to the U.S. lender.

 

“You don’t know who’s been swimming naked until the tide goes out” is one of Warren Buffett’s most memorable sayings. There is no doubt that abundant cheap liquidity has aided a considerable number of what might otherwise have been considered marginal businesses to remain solvent. The big question now is how they are going to refinance debt at equally attractive levels when it comes due over the coming years?

Precious metals: Gold has dropped to a 2½-week low of $1,315 per troy ounce this morning amid increased risk appetite among market participants. Gold in euro terms is trading at only around €1,100 per troy ounce. The Dow Jones Industrial Average and S&P 500 indices in the US had both climbed to new record highs on Friday. The rise in stock markets is continuing in the Asian region today. What is more, bond yields in the US have increased significantly of late, which makes gold less attractive as an alternative investment.

Presumably this is also why Friday saw the second consecutive daily outflow from gold ETFs. Portugal’s credit rating was upgraded on Friday evening by the ratings agency S&P, achieving an investment grade rating again for the first time since January 2012. Ireland was also upgraded, this time by the ratings agency Moody’s. Wednesday could see further volatility on the gold market, as this is when the US Federal Reserve meeting will take place.

If the market’s currently low rate hike expectations increase as a result of the meeting, this is likely to weigh on the gold price. According to the CFTC’s statistics, speculative financial investors further expanded their net long positions in gold in the week to 12 September, putting them at 253,500 contracts now. This was already the ninth weekly increase in a row.
The price rise to a 13-month high of just shy of $1,360 was thus driven largely by speculation. Given that the gold price is now trading considerably lower, positions have presumably been squared in the meantime

 

A link to the full report is posted in the Subscriber's Area.

We are in a period of synchronised global economic expansion where central banks are only just beginning to turn the corner towards tightening; with the USA’s Federal Reserve in the lead. Commodities no longer share the trending commonality evident at the dawn of the commodity boom in the early 2000s. Industrial resources including palladium are recovering while energy and agricultural prices have been subject to a great deal of volatility. 

Currency traders haven’t been this upbeat on the pound in more than three years. 

The cost of owning one-month call options on sterling relative to puts reached six basis points, the steepest since February 2014, as the Bank of England said the market is underpricing the prospect of rate increases.

The premium on calls shows the market’s conviction that the currency’s more than 3 percent rally against the dollar this month has legs.

The key question on investors’ minds at the moment is: where does the pound go from here? To some extent, the currency’s fortunes against the dollar will be influenced by what the Federal Reserve does, and in this context next week’s FOMC meeting will take on added significance. Witness also that stronger-than-estimated consumer-price inflation data out of the U.S. on Thursday failed to damp bullish sentiment for the pound.

 

The Pound has the clearest signs of base formation completion against the Dollar not least because the Dollar has been so weak since early January. It is now breaking up out of a first step above the type-2 base and a clear downward dynamic would be required to question medium-term scope for some additional upside. 

I have noticed from your recent postings that while you recognize all the great outcomes technology will bring, you also recognize the downside consequences of all the displaced labor. Another effect on labor has been the financialization of our economy. Check out this article (open domain) Thank you for your continued great work!

Thanks for this link may also of interest to subscribers. I found the chart of wages and salaries as a percentage of GDP to be particularly interesting. 

Technology is inherently deflationary which means we can do more with less and each of us can easily come up with examples of how innovations have improved different aspects of our lives. However, the rapid pace of innovation in artificial intelligence, robotics and healthcare while representing truly exciting developments for corporations also mean that millions of jobs are going to be under pressure. 

Here is a link to a video for the ECB’s press conference today which includes the question time that followed.

There was general agreement that both inflation and productivity were understated. Housing is a big part of the inflation calculation and, for most of the country, housing costs have been rising modestly. The prices of services like healthcare and lifestyle-supporting needs used by everyone, such as haircare and cleaning services, have risen sharply but don’t show up in the numbers. As for productivity, the measurement techniques were developed in the 1950s when the U.S. was more of a manufacturing economy. Now with services and knowledge-based industries so important, the historical measurement approaches, which underestimate the impact of computer software developments, understate productivity improvements. Time spent posting and reading posts on Facebook during working hours, however, detracts from productivity. One technology person pointed out, though, that the video games of today are intensely interactive and represent a learning experience for the kids playing them. This is in sharp contrast to the passive watching of television by previous generations.

We talked a bit about inequality and agreed the problem was likely to become worse because of globalization and technology. One investor was optimistic, however, because of the positive impact machine learning was making in improving the outlook of disadvantaged Americans and educational opportunities in the emerging markets. Another pointed out that 60% of the jobs held in 1980 don’t exist today and still unemployment is down to 4.3%. On-demand services, such as Uber, are creating jobs, but technology displacing workers is a problem throughout the world.

Even though there was an apprehensive mood at the lunches few were buying gold as a safeguard. In spite of the strong performance of the Japanese economy this year and the rise in its stock market, the group remained wary of Japan. There was no clear consensus on why the dollar was weak, but a lack of confidence in the new administration in Washington was clearly a factor in spite of strong U.S. growth and a rising stock market. One of the lunches was decidedly bearish. Overall, a vote on market performance between now and year-end showed that 60% believed it would be higher in spite of the caution expressed in the discussion.

A link to the full article is posted in the Subscriber's Area.

What I spend money on every month is going up in price yet official inflation measures tell me there is little inflation. I took a look at my family’s expenditures on a year over year basis at the weekend. My health insurance went up 30% last year, my children’s tuition increased 10%, my car insurance went up 8%, food was relatively unchanged and gasoline was volatile. Meanwhile my mobile phone service got cheaper.

“As investors go ‘kookoo’ for risk assets, they have pushed (with the help of ECB) the yield of European junk bonds towards that of the U.S. Treasury yield. Honestly… I’m speechless,” Brkan adds.

Another one worried about low yields for European junk bonds is Wolf Street blogger Wolf Richter, who notes they offer around 2.42%, while the U.S. 10-year pays out about 2.24%. And Bank of America Merrill Lynch’s credit strategists are concerned, highlighting the “eye-watering levels that European high-yield has now reached.”

I initially saw a similar article on Monday, assessed the argument and set it aside. However, a number of subscribers have emailed me variations on the story so I thought it might be instructive to highlight why I set it aside in the first place.  

“By any measure, real long-term interest rates are much too low and therefore unsustainable,” the former Federal Reserve chairman, 91, said in an interview. “When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.”

While the consensus of Wall Street forecasters is still for low rates to persist, Greenspan isn’t alone in warning they will break higher quickly as the era of global central-bank monetary accommodation ends. Deutsche Bank AG’s Binky Chadha says real Treasury yields sit far below where actual growth levels suggest they should be. Tom Porcelli, chief U.S. economist at RBC Capital Markets, says it’s only a matter of time before inflationary pressures hit the bond market.

“The real problem is that when the bond-market bubble collapses, long-term interest rates will rise,” Greenspan said. “We are moving into a different phase of the economy -- to a stagflation not seen since the 1970s. That is not good for asset prices.”

 

Central bank balance sheets are at levels that were previously unimaginable and nobody knows what the medium to long-term consequences of that are going to be. Generally speaking central banks either tightening too much, or too quickly, is one of the leading causes of crashes, so there is an increased risk of trouble for the simple reason that we are in unchartered monetary territory. 

George Pearce’s, a macro strategist with Bespoke Investment Group LLC, said: “Higher risk-adjusted returns for stocks should draw inflows, and we know from our work that Americans are relatively unexposed to the market.”

Companies have been the main buyer of U.S. equities since the post-crisis low, while households and institutions have divested, according to Credit Suisse. The outperformance of bonds since the financial crisis, risk aversion and regulations unfriendly to equities have helped create a preference for fixed income.

Global bond funds -- which include government and high-yield obligations -- have seen $1.3 trillion of net inflows since 2009, while stocks have taken in less than half of that at $600 billion, according to Jefferies Group LLC, citing EPFR Global data, which reflect holdings among mutual and exchange-traded funds. 

In the first half of the year, bond funds took in $204 billion while stocks saw $167 billion of inflows. A $107 billion injection into fixed-income in the second quarter was the highest on record going back to 2002, Jefferies said. This happened despite fears of higher global yields.
 

The size of the bond market is multiples the size of the equity market. Bonds are held in pension funds because they are supposed to offer stability, yield and some diversification from the perception of higher risk attached to stocks. Right now, the US 10-year Treasury yield is around 1.23% and the S&P500 yields 1.98% which is not a very wide spread. 

“We’ve never have had QE like this before, we’ve never had unwinding like this before,” Dimon said at a conference in Paris Tuesday. “Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.”

Central banks led by the U.S. Federal Reserve are preparing to reverse massive asset purchases made after the financial crisis as their economies recover and interest rates rise. The Fed alone has seen its bond portfolio swell to $4.5 trillion, an amount it wants to reduce without roiling longer-term interest rates. Minutes of the Fed’s June 13-14 meeting indicate policy makers want to begin the balance-sheet process this year.

“When that happens of size or substance, it could be a little more disruptive than people think,” Dimon said. “We act like we know exactly how it’s going to happen and we don’t.”

Cumulatively, the Fed, the European Central Bank and the Bank of Japan bulked up their balance sheets to almost $14 trillion. The unwind of such a large amount of assets has the potential to influence a slew of markets, from stocks and bonds to currencies and even real estate.

“That is a very different world you have to operate in, that’s a big change in the tide,” Dimon said. All the main buyers of sovereign debt over the last 10 years -- financial institutions, central banks, foreign exchange managers -- will become net sellers now, he said.

 

These are common sense statements from one of the most important CEOs in the industry and suggests central banks need to be very careful about how they adjust the status quo. That’s particularly true considering the effect quantitative easing has had on asset price inflation which was by design. 

The Fed seems to have rose-colored glasses on regarding this experiment ahead in terms of even gradually unwinding the balance sheet and the impact on the same financial markets that are deemed at least those around the table (presumably the one with Bloomberg terminal) to be excessively exuberant. And at the same time, the view on the economic outlook seems quite rosy, then again, the central bank has overestimated economic growth consistently for the past seven years. Old habits die hard.

But there are some at the Fed that share our views on many items. Here were a few new wrinkles:
“Contacts at some large firms indicated that they had curtailed their capital spending, in part because of uncertainty about changes in fiscal and other government policies…”

Reports regarding housing construction from District contacts were mixed.”

District contacts reported that automobile sales had slowed recently; some contacts expected sales to slow further, while others believed that sales were leveling out”

So here we have soft capex, soft housing and soft autos. But yet the consensus view is that the economy is doing just fine. A case of cognitive dissonance?

 

A link to the full report is posted in the Subscriber's Area.

You have Ray Dalio saying, keeping dancing but stay close to the door, regarding the equity market. Jeff Gundlach says the run-up in yields is only beginning. David Rosenberg says deflation is here to stay. The problem for investors is that they all make cogent arguments and it is difficult to divine just where we are and what is likely to happen next. Let’s just stick to the charts. 

Hello Eoin! Thank you for all your hard work for us! You highlighted the Japanese Banks a few Days ago! Is there a Japanese Banks ETF or a closed end Bank fund, that you know of. Best regards. (an FM since 1988).

Thank you for your long support and this question which may also be of interest to other subscribers. There are two Japanese listed ETFs focusing exclusively on Japanese banks but I’m afraid I do not know of any others listed elsewhere whether ETFs or closed-end funds. 

The two Japanese ETFs are the Daiwa Topix Bank ETF (1615 JP) and the Nomura Topix Banks ETF (1612 JP).  

“Several preferred to announce a start to the process within a couple of months,” the minutes of the June 13-14 meeting released on Wednesday in Washington showed. “Some others emphasized that deferring the decision until later in the year would permit additional time to assess the outlook for economic activity and inflation.”

U.S. central bankers in June raised the benchmark lending rate for a second time this year to a range of 1 percent to 1.25 percent, while describing monetary policy as “accommodative” in their statement. They reiterated their support for continued gradual rate increases, according to the minutes.

Fed officials updated their balance-sheet policy in the gathering, laying out a path of gradual reductions with caps. The central bank wants to start winding down the $4.5 trillion bond portfolio without roiling longer-term interest rates, while gradually raising the policy rate. The minutes indicated that the committee wants to begin the balance-sheet process this year.

 

Here is a link to the full text of the Fed’s Minutes. 

The only example we have of withdrawing liquidity following a bout of quantitative easing is from the ECB between 2012 and 2014 when they took €1 trillion out of circulation. That resulted in deflationary pressures picking up and forced a change of emphasis in Frankfurt which has subsequently seen the size of the balance sheet more than double. Against that background it is hardly surprising there is some disagreement about how to proceed within the Fed and the consensus, as Janet Yellen stated last month, would be to proceed slowly.

Thus, since 2007, indexing or passive activities have risen from approximately 7% to 9% of total managed assets to almost 40%. As you shift assets from active managers to passive managers, they buy an index. The index is capital weighed, which means more and more money is going into fewer and fewer stocks.

We’ve seen this act before. If you didn’t own the nifty 50 stocks in the early 1970s, you underperformed and, thus, money continued to go into them. If you were a growth stock manager in 1998-1999 and you were not buying “net” stocks, you underperformed and were fired. More and more money went into fewer and fewer stocks. Today you have a similar case with the FANG stocks. More and more money is being deployed into a narrower and narrower area. In each case, this trend did not end well.

When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.

We are witnessing the development of a “perfect storm.”

 

Will ETFs contribute to the next major stock market decline? How could they not? They represent a significant proportion both of daily traded volume and act as repositories for substantial inventories of stock.  In tandem with the prevalence of automated trading systems we already have evidence of dislocations in the spate of flash crashes we have largely become inured to. 

Full details of this trade are posted in the Subscriber's Area.

The pound soared by the most in two months and U.K. bonds slumped as Bank of England Governor Mark Carney said the Monetary Policy Committee may need to begin removing stimulus.
Sterling climbed against all but one of its major peers as the comments marked a shift in emphasis for the governor, who signaled last week that now was not yet the time to start the tightening process. The yield on two-year gilts touched the highest in more than a year as money markets adjusted to the change in language.

Sterling has borne the brunt of political and economic uncertainty since the Brexit vote, and has been further buffeted in recent weeks by a growing split among policy makers over the future path of rates. The bank’s Financial Policy Committee increased the countercyclical buffer Tuesday, marking the first unwinding of last year’s stimulus package put in place by the bank.

“The headlines appear to be in complete contrast to the Mansion House speech last week, when he said now is not the time for tightening,” said Jane Foley, head of foreign-exchange strategy at Rabobank in London. “There is the possibility that the Bank of England will, over the next few months, fire other shots across the bow really to reduce that downside potential for the pound.”

 

Central bank communication has a whipsaw feel to it over the last week. The Bank of England first said that it was not ready to remove stimulus and is now saying that an interest rate hike might be closer than we think. Meanwhile Mario Draghi fumbled his communication yesterday when he said the deflationary threat is gone which the market interpreted as a signal the ECB is discussing tapering and officials were back peddling today saying nothing has changed. 

And particularly be prepared to rethink very high minimum wages, like those supported by the “Fight for $15” folks. For as the authors note, the first round of hikes had relatively small impacts, while the second round had huge ones, suggesting that the effects may be nonlinear. And that makes sense. Relatively few people in this country make the minimum wage, so a small increase doesn’t make that much difference to most workers, or most employers. But a large jump affects more people, and the wage increases are much bigger for the lowest-paid staffers. If you make $9 an hour, but generate $10.50 in revenue for your boss, a law that raises the wage to $10.45 may cause her to shrug and decide it’s easier to keep you on as long as she’s making something. But a wage that forces her to pay you far more than you bring in…. Continuing to employ you would just be bad business.

It’s worth noting that Card and Krueger’s famous study involved an increase in the minimum wage from $4.25 an hour to $5.05. That was a significant increase -- about 18 percent. But Seattle’s minimum wage has already increased by 37 percent, and it still has roughly another 20 percent to go.

At some level, we all intuitively understood that this was true. If the minimum wage increases by a penny an hour, probably even most rock-ribbed conservatives would not predict mass firings. On the other hand, if the wage was arbitrarily set to $100 an hour, even ardent labor activists would presumably expect widespread unemployment to follow.  You can’t flat-out say “minimum wages don’t increase unemployment,” because the size of the increase, and the level of the resulting wage, obviously matter at some margin.

 

As this article highlights, very few people in the USA earn the minimum wage. However about a third of the population earns less than $35,000 a year. $15 an hour for a 40-hour, 52 weeks a year comes out to $30,200. Therefore by raising the minimum wage to $15 either those earning slightly more than the current minimum wage will demand more for their work or they will be equated with first time job applicants at fast food restaurants. 

HY total returns of 4.5% YTD have surpassed our YE target: In what has been a continuation of a strong 2016, total returns surpassed our Credit Strategists’ full year target of 3% by the end of the first quarter. We attribute much of the surprise to the US Treasury move lower, but also point out that current HY spreads of 390bp are ~50bp tighter YTD.

And US Treasury rates are … lower. We entered 2017 with the expectation that three rate hikes could help drive the 10yr UST 50bp higher, to 3.00% (GS Economics view). At mid-year, UST rates have instead declined 35bp, to 2.15% (see Exhibit 1) and our Economics team recently lowered their YE2017 forecast to 2.75% (from 3.00%). To be clear, the revised target still implies a 60bp move higher which could drive a headwind of 2.85% for the HY market (based on an average market duration of 4.76 years).

Spreads are tighter despite over $4.9bn of YTD HY outflows: With the rally in global risk assets, high yield market spreads have tightened ~50bp to 390bp, or inside the 20th percentile relative to the last 30 years. This spread move is even more surprising given it has unfolded in the face of $4.9bn of cumulative HY net outflows YTD. In fact, the HY market has experienced net cumulative outflows this late into the year only once in the last 10 years (see Exhibit 2).

Robust primary volumes continue: HY new issue activity surpassed $300bn in each of 2012, 2013, and 2014, and breached the $250bn mark for 2015. Despite dipping in 2016 (not surprising given the weak macro backdrop in 1Q2016) to $227bn, HY issuance appears poised to make a rebound this year with volumes trending up 6% yoy.

US policy is evolving and remains a key variable: The ramp in soft economic data (see Exhibit 3) suggests the outcome from last year’s election has positively impacted economic sentiment. However, hard economic data (like GDP), as measured by the GS Economics team has yet to inflect. For risk sentiment to remain elevated, we expect investors to be looking to the potential for the hard data to improve and growth to accelerate.

Disruption has been dangerous… what’s the next Rental/Retail/RLEC story? As the HY market has steadily marched higher, not all credits have participated. The market has been particularly unforgiving to stories where secular disruption has emerged. The rental, retail and RLEC sectors are prime examples here (see Exhibit 4) but we also have concerns over legacy software providers, the auto sector, the hospital facilities space and certain parts of media (see p. 4).

A link to the full report is posted in the Subscriber's Area.

The bond market has been the surprise outperformer this year particularly following the accelerated pullback following the election. The broader question is whether that is likely to continue if the Fed does indeed follow through on shrinking its balance sheet. 

This growing burden on future generations can be measured. Rising dependency ratios -- or the number of retirees per employed worker -- provide one useful metric. In 1970, in the U.S., there were 5.3 workers for every retired person. By 2010 this had fallen to 4.5, and it’s expected to decline to 2.6 by 2050. In Germany, the number of workers per retiree will decrease to 1.6 in 2050, down from 4.1 in 1970. In Japan, the oldest society to have ever existed, the ratio will decrease to 1.2 in 2050, from 8.5 in 1970. Even as spending commitments grow, in other words, there will be fewer and fewer productive adults around to fund them.

Budgetary analysis presents a similarly dire outlook. In a 2010 research paper, entitled “Ask Not Whether Governments Will Default, But How,” Arnaud Mares of Morgan Stanley analyzed national solvency, or the difference between actual and potential government revenue, on one hand, and existing debt levels and future commitments on the other. The study found that by this measure the net worth of the U.S. was negative 800 percent of its GDP; that is, its future tax revenue was less than committed obligations by an amount equivalent to eight times the value of all goods and services America produces in a year. The net worth of European countries ranged from about negative 250 percent (Italy) to negative 1,800 percent (Greece). For Germany, France and the U.K., the approximate figures were negative 500 percent, negative 600 percent and negative 1,000 percent of GDP. In effect, these states have mortgaged themselves beyond their capacity to easily repay.

 

Plato’s Republic, probably his best known work, lays out five stages of political development. Democracy, as Plato defines it, does not equate with our constitutional democracy but there are definitely parallels. Our constitutions seek to protect the needs of the few from the appetites of the many. More importantly elections ensure we do not end up with tyrants while separation of powers and an independent judiciary keep a lid on despotic aspirations. 

Federal Reserve said it intends to initially cap its Treasury reinvestments at $6b/month and MBS at $4b/month and increase both at three-month intervals over a 12-month period, according to statement.

Fed said it will begin balance sheet normalization this year if the economy evolves as the central bank anticipates

Cap on UST reinvestments will increase by $6b increments until reaching $30b/month; MBS cap will increase by $4b increments until it reaches $20b/month

FOMC anticipates caps will remain in place once they reach their maximums so the Fed’s holdings will “continue to decline in a gradual and predictable manner” until the committee decides that the Fed is “holding no more securities than necessary” to implement monetary policy

FOMC anticipates level of reserves will decrease to a level “appreciably below that seen in recent years but larger than before the financial crisis” 

While the fed funds rate will remain primary monetary policy tool, FOMC said it will be prepared to resume reinvestments “if a material deterioration in the economic outlook” were to warrant a sizable reduction in rates.

 

A great deal of debt needs to be refinanced between 2018 and 2021 so slow pace of balance sheet run off is positive news for the treasury market because it ensures the Fed will still be reinvesting at least some of its expiring debt in new issues. 

Fed balance sheet normalization might cause banks to shorten their asset mix, causing “enough of a portfolio adjustment this summer to turn the rally on its head,” RBC rates strategists Michael Cloherty and Ash Kamat say in note.

QE created bank deposits and balance-sheet unwind will eliminate them; while “massive 2003-style bank sales” are not predicted, the market “has become extremely sensitive to flows,” and risk of outsized price action is higher during summer months

Main issue isn’t a funding shortfall, but “how modeling of deposits changes” and when; deposits modeled on recent data show extremely long average life; shortening the expected life of a deposit puts pressure on banks to shorten their assets

Bank buying of shorter-duration assets should lead to “outperformance of 15yrs and CMOs and a steeper curve”

RBC expects Fed likely to announce balance-sheet unwind in September, begin in October, with initial caps of $15b for USTs, $10b for MBS; they expect caps to rise by $15b and $10b every quarter and eventually be eliminated

 

When the biggest buyer in a market stops investing and starts divesting of its holdings it represents a sea change in the interaction between supply and demand. If high prices are to be sustained the remaining buyers need to increase their purchases to compensate for the absence of a once stalwart buyer. 

To keep the boom going, the central bank must keep interest rates below their natural levels. It cannot raise them back to “normal.” First and foremost, higher interest rates would make the boom collapse. The credit market would collapse, stock and housing prices would tumble, and the financial system and the economy as a whole would go into a tailspin.

One may ask: Why is the Fed then raising rates then? Perhaps the Fed’s decision-makers think that the US economy has overcome the latest crisis and higher interest rates are economically justified. Others might wish to tighten policy for getting the short-term inflation adjusted interest rate out of negative territory.

Be it as it may, the disconcerting truth is this: Fed rate hikes will close the gap between the natural interest rate and the actual interest rate level. This, in turn, amounts to putting a brake on the boom, bringing it closer to bust. It is impossible to know with exactitude at what interest rate level the US economy would fall over the cliff.

One thing is fairly certain, though: The US economy, and with it the world economy, is caught between a rock and a hard place. Maybe the Fed’s current rate hiking spree will bring about the bust. Or the Fed refrains from raising rates further and keeps the boom going a little bit longer.

The big question is how can the Fed raise interest rates and shrink its balance sheet at the same time, without having an adverse effect on the economic expansion it has worked so hard to achieve. 

In Japan, which has one of the world’s most rapidly ageing populations, retirement can begin at 60. This could result in a retirement of over 45 years for those who will live to the current life expectancy of 1071 (see Figure 2). What is the impact of a population that will spend 20%-25% more time in retirement than they did in the workforce? How do we rethink our retirement systems that were designed to support a retirement of 10-15 years to prepare for this seismic shift? 

One obvious implication of living longer is that we are going to have to spend longer working. The expectation that retirement will start early- to mid-60s is likely to be a thing of the past, or a privilege of the very wealthy.  

Absent any change to retirement ages, or expected birth rates, the global dependency ratio (the ratio of those in the workforce to those in retirement) will plummet from 8:1 today to 4:1 by 2050. The global economy simply can't bear this burden. Inevitably retirement ages will rise, but by how much and how quickly demands urgent consideration from policy-makers. 

Given the rise in longevity and the declining dependency ratio, policy-makers must immediately consider how to foster a functioning labour market for older workers to extend working careers as much as possible. Employers also have a key role to play in helping workers reskill and adapt their work styles to support a longer working career. 

This paper focuses on the sustainability and affordability of our current retirement systems. To protect against poverty in old age, we believe that retirement systems should be designed to provide a level playing field and equal opportunity for all individuals. A well-designed system needs to be affordable for today’s workers and sustainable for future generations to ensure that all financial promises are met. 

Healthy pension systems contribute positively towards creating a stable and prosperous economy. Ensuring that the public has confidence in the system, and that promised benefits will be met, allows individuals to continue to consume and spend through their working and retired years. If this hard-earned confidence is lost, there is a significant risk that retirees will moderate their spending habits and consumption patterns. Such moderation would have a negative impact on the overall economy, particularly in countries where the size of the retired population continues to grow. 

Action is needed to realign our existing systems with the challenges of an ageing population. Those who take proactive steps will be better equipped in the years ahead.

Here is a link to the full report.

I’m 40 so according to this report I have a 50% chance of living to 94. The Chart Seminar is in its 48th year in 2017 so you never know I might manage to get it to the century because we are all going to be working a lot longer. It’s a good thing I’m doing something I enjoy and perhaps that is the best advice. You are going to be working for an awfully long time so be prepared to change jobs, adapt and enjoy what you do. 

Participants continued their discussion of issues related to potential changes to the Committee's policy of reinvesting principal payments from securities held in the SOMA. The staff provided a briefing that summarized a possible operational approach to reducing the System's securities holdings in a gradual and predictable manner. Under the proposed approach, the Committee would announce a set of gradually increasing caps, or limits, on the dollar amounts of Treasury and agency securities that would be allowed to run off each month, and only the amounts of securities repayments that exceeded the caps would be reinvested each month. As the caps increased, reinvestments would decline, and the monthly reductions in the Federal Reserve's securities holdings would become larger. The caps would initially be set at low levels and then be raised every three months, over a set period of time, to their fully phased-in levels. The final values of the caps would then be maintained until the size of the balance sheet was normalized.

Nearly all policymakers expressed a favorable view of this general approach. Policymakers noted that preannouncing a schedule of gradually increasing caps to limit the amounts of securities that could run off in any given month was consistent with the Committee's intention to reduce the Federal Reserve's securities holdings in a gradual and predictable manner as stated in the Committee's Policy Normalization Principles and Plans. Limiting the magnitude of the monthly reductions in the Federal Reserve's securities holdings on an ongoing basis could help mitigate the risk of adverse effects on market functioning or outsized effects on interest rates. The approach would also likely be fairly straightforward to communicate. Moreover, under this approach, the process of reducing the Federal Reserve's securities holdings, once begun, could likely proceed without a need for the Committee to make adjustments as long as there was no material deterioration in the economic outlook.

Over $4 trillion is still a lot of money, even in the bond markets and how the Fed succeeds in shrinking that number is going to have a significant effect on both the markets and the economy. The ECB embarked on a similar policy between 2012 and 2014; taking €1 billion off its balance sheet so we have a template for what effect that might have on other asset classes.  

I tried to find in the chart library the last chart you should on Friday's Video. That is the difference between the US 10 & 2 year. This Friday's long term outlook was different but I liked it; even got myself a copy of Plato to read

Thank you for a question which may be of interest to subscribers. The yield curve spread is the difference between the 10-year and 2-year Treasury yield. I created this video to discuss both how to create the chart and save it as a preset template for when you want to find it later. 

“The mindset is still quite cautious about inflation expectations, but I’m quite sure that with continuous accommodative monetary policy, supported by fiscal policy, we’d be able to eventually raise wages and prices significantly,”

CNBC cites BOJ Governor Haruhiko Kuroda in interview.

* Projected growth rate of 1.5% “not great” but it’s well above medium-term potential growth rate

* Means output gap to shrink and become positive while labor market continues to tighten

* Wages, prices would eventually rise to achieve 2% inflation target around fiscal 2018

* Yield curve control “has been functioning quite well”

* 10-yr JGB target should, for the time being, be maintained around 0%

* Acknowledges that “headline inflation has been quite slow to adjust upward” in part because of weakness in oil prices

 

Since its bubble burst in the late 1980s Japan has been attempting to combat deflation and despite its best efforts failed. The big question is whether this was because they were not aggressive enough early on in forcing the banking sector to write down large bad loan books, or was it because their bust occurred in one of the greatest disinflationary periods in modern history and no matter what they did they could not have fomented inflation? I suspect the answer lies somewhere in between. 

The widely expected decision contained no concrete commitment to the timing of the next rate increase. Even so, investors increased bets on a move in June after absorbing the Fed’s sanguine assessment of the outlook and its encouraging observations on inflation, following data showing first-quarter economic growth of 0.7 percent and monthly price declines in March.

“Nothing in the statement today, which was voted unanimously by the FOMC, leads me to believe that the Fed is even close to changing its mind on rates,” Roberto Perli, a partner at Cornerstone Macro LLC in Washington, wrote in a note to clients. “Base case is for a couple more rate hikes this year -- probably in June and September -- and for the beginning of balance sheet shrinkage in December.”

3-month Treasury bills are beginning to price in a rate hike in June but the rate is still only 86 basis points while the Fed Funds Target rate is 75 to 100 basis points. That highlights just how reluctant bonds traders have been to give credence to the Fed’s estimates of how often and by how much they are willing to raise interest rates. 

Nevertheless, this will be an interesting test of the view, which I and some others have espoused, that the Fed is in the process of shifting operating regimes -- from following markets to being more willing to lead them.

Last week’s disappointing reading of 0.7 percent gross domestic product growth for the first quarter, the lowest in three years, added to other data releases (such as retail sales, inflation and autos) suggesting that the U.S. economy -- and consumption in particular -- is going through a softer economic patch. In previous years, this would have provided the Fed with the excuse to soften its policy signals, assuring markets that monetary policies will remain ultra-stimulative and minimizing the risk of financial asset volatility. Indeed, these are the signals that the European Central Bank reiterated last week when its governing council met. And the ECB did so despite official recognition that, in the case of the euro zone, economic conditions have improved and forward downside risk is lower.

The Fed’s inclination to repeat past practices is countered by three considerations.

* An element of the recent data weakness is likely to be both temporary and reversible.

* The Trump administration has reiterated its intention to pursue a large tax cut that, if approved by Congress (a big if), would most likely lead to a considerably wider budget deficit, at least in the short-run until economic growth and budgetary receipts pick up (especially given the lack of large revenue measures).

* Though even harder to quantify, the Fed is not indifferent to the collateral damage and unintended consequences of prolonged reliance on unconventional monetary policies.

I believe the bond market is exhibiting what I term a “boy who cried wolf” mentality. After so many warnings and almost a decade where the Fed’s inflation target was wide of the mark on consecutive years there is no appetite for pricing in rate hikes until they are deemed to be imminent. I agree with El Erian, the flow of stimulative rescue funds has a conditioning effect on those benefitting from them. There is no credible belief that the Greenspan, Bernanke and now Yellen puts will be withdrawn.

Tergnier may be Macron’s toughest sell.

The town, with a population of 13,000, used to vote Communist and then Socialist. It turned to the National Front as its sprawling rail freight station — once one of France’s biggest — shed hundreds of jobs. Steelworks, a sugar-manufacturing plant and other firms closed down or moved elsewhere leaving the jobless rate at 15 percent. The national average is 10 percent. Thirty-six percent of voters backed Le Pen last month, among her highest votes in the country.

“Globalization is bad for Tergnier,” said mayor Christian Crohem, 67, who heads a mainly leftist coalition. “We’ve brought more countries into the EU and we’ve allowed businesses to move around, so we’re up against workers from abroad who don’t play by the same rules, it’s unfair competition.”

He tells the story of a 70-year-old woman who came to see him recently because she didn’t have enough money to feed herself. Sitting in his office, she cried with shame as she asked him for a handout to buy food.

“That kind of thing really gets to you,” he says. “People here feel abandoned, and so do we, the officials they elect.”

 

In a country like France, which prides itself on its social infrastructure, this kind of story is all the more troubling. Fiscal austerity over much of the last decade has laid bare the hollowing out of rural and legacy manufacturing centres right across the developed world. We are talking about France right now because the election is on Sunday but this is a broad issue which has contributed to populism in a number of countries and there is little evidence of sincere efforts to curb it. 

The arguments for higher bond yields
The global economy is experiencing a cyclical recovery regardless of the political noise, and its performance should remain the key driver of fixed-income markets over the next 12 months. U.S. data releases have been strong and the employment picture continues to improve, leading many investors to prepare their portfolios for reflation. We believe that Trump’s loosening of financial regulations should re-ignite the animal spirits that went missing after the 2008 financial crisis, creating self-sustaining economic growth. Corporate America will likely invest and hire more, pushing up the cost of capital and inflation. 

Aiding this momentum will be an administration stocked with business-minded department heads and White House advisors. Trump has appointed Steve Mnuchin, a former Goldman Sachs executive, as Treasury secretary and billionaire investor Wilbur Ross to head the Commerce Department. Gary Cohn, the recently departed Goldman Sachs president, is Trump’s top economic counsellor. These appointments help to validate the optimism towards streamlining  regulations and promoting business investment. 

A tight labour market is another source of economic optimism and will foster inflationary pressures as higher wages embolden consumers to spend more. A higher-inflation, faster-growth environment would be a departure from the slow growth mindset that has prevailed since 2012. 

Assuming that the government spending materializes as advertised and stokes economic growth, we would expect yields to be pulled higher by competition for capital between Treasury bonds and businesses and individuals seeking loans. Here’s why: capital must be financed either from abroad and/or with domestic savings, and administration proposals aimed at reducing imports would increase the importance of domestic savings as a source of capital. Domestic private savers as a group tend to demand higher compensation for loans than foreign entities, potentially leading to higher rates as growth quickens. 

 

A link to the full report is posted in the Subscriber's Area.

American Airlines offered pay rises of 5% and 8% for cabin crew and pilots last week. That’s well ahead of inflation and is further evidence of a tight labour market fuelling wage demands. 

The paralysis has no quick fix. Last night (April 4), in an effort to lift spirits, France’s presidential debate organizers decided to trot out all 11 eligible candidates for the second televised debate, rather than just the top five. The barrage of small candidates on stage left each with “no room to develop an idea,” and voters no time “to exercise their judgment,” one critic (link in French) argued. “Does this really help the undecided to form an opinion?” another asked (link in French).
All the better for France’s far-right wing. Voter turnout in France (80% in 2012) has long upstaged that of neighboring Germany (71%), the UK (66%) and Switzerland (47%). But as that number drops in France’s multi-round system, the odds of a far-right win creep up.

That’s because fervent support for Le Pen in the first round will likely carry over to votes for her in the second. But candidates with more tepid support, including centrist Emmanuel Macron, conservative François Fillon, and socialist Benoît Hamon, may suffer if non-Le Pen voters abstain (paywall) in the second round. Right now, Le Pen and Macron are neck-and-neck in French polls for the first round.

The predicament was similar in 2002, when candidate Jacques Chirac’s famous slogan (link in French) “Vote for the Crook, not the Fascist” helped him secure a landslide victory against Le Pen’s father, Jean-Marie Le Pen, in the second round. This time, voters may have had their fill of crooks and fascists both.

 

Last night my 11-year old asked me what does ennui mean? My French classes from secondary school came roaring back with Mrs. O’Donoghue joking that ennui was roughly translated into boredom but the reaction of the class provided a much better definition than any she could come up with. Here is what Google comes up with “mid 18th century: French, from Latin mihi in odio est ‘it is hateful to me.’ and “a feeling of listlessness and dissatisfaction arising from a lack of occupation or excitement.” Ennui is a problem for entrenched politicians when they face a strident minority willing to vote. 

I wonder if you could please analyse why the historic charts of Japan's main equity market are so divergent? 

As you know, the Tokyo market reached its "bubble era" peak in Jan. 1990 at 38,564 but has since recovered to around 19,063. 

The Topix bank index peaked at the same time at 1,480 but is still languishing at a fraction of that level, 182.64 today. 

The Topix 2nd Section index on the other hand is now at an all-time high from its peak of 4,500 reached in 1990 to approaching 6,000. 

Normally the banks are the lead indicator but Japan's banks underwent immense restructuring so I can understand why they have languished but the discrepancy between these charts seems huge.

 

Thank you for this email which raises important points worth covering with regard to Japan’s primary stock market indices. 

The Topix is also known as the Tokyo Stock Price Index. It is a free-float adjusted market capitalization-weighted index and comprised of all 1997 shares in the 1st Section of the Tokyo Stock Exchange. 

Here is where some of the idiosyncrasies of the system begin. The 1st Section is supposed to comprise all of the large companies and the 2nd Section holds whatever is left. However, at least 80 of the 567 companies in the 2nd Section have larger market caps than the smallest company in the Topix which highlights the fact that the weightings are not actively managed.

The premium on one-month options over the rate of actual market swings remains near a 10-week high set on Tuesday. It may increase further should Brexit-related negativity be less than feared in the near term, which would reduce realized volatility, and also as the implied rate should rise on capturing the second round of the French elections due May 7.

Realized volatility could find support as the euro-pound pair’s prospects look increasingly bearish on charts, with current market positioning significantly skewed toward sterling declines. Leveraged net short positions in the pound this month are at the highest level since November.

Not all investors have given up on the pound, with the British economy performing better than expected. BlackRock Inc., which reduced some of its exposure to sterling ahead of the triggering of Article 50, has said it is still marginally long as an expected slowdown of the U.K. hasn’t materialized.

With the latest reports suggesting that the European Central Bank isn’t anywhere close to reducing economic stimulus, a short-squeeze on the pound could materialize.

 

Now that Article 50 of the Nice Treaty has been triggered there are at least three big questions outstanding with regard to the Pound and the Euro. 

How willing is the Bank of England to run hot on inflation with the economy at full employment and economic growth continuing to surprise on the upside? 1-year notes yields pulled back today suggesting investors are less inclined to think an interest rate hike is anywhere on the horizon. 

It appears that asset markets are priced as if secular stagnation were a certainty. Certainty is a particularly dangerous assumption when it comes to investing. As Voltaire stated, “Doubt is not a pleasant condition, but certainty is absurd.”

In order to believe that asset market pricing makes sense, I think you need to hold any number of “impossible” (by which I mean at best improbable, and at worst truly impossible) things to be true. This is certainly a different sort of experience from the bubble manias that Ben mentioned in the opening quotation, which are parsimoniously captured by Jeremy’s definition of bubbles – “excellent fundamentals, irrationally extrapolated.” This isn’t a mania in that sense. We aren’t seeing the insane behaviour that we saw during episodes like the Japanese land and equity bubble of the late 1980s, or the TMT bubble of the late 90s, at least not at the micro level. However, investors shouldn’t forget that the S&P 500 currently stands at a Shiller P/E of just over 28x – the third highest in history (see Exhibit 17).

The only two times that level was surpassed occurred in 1929 and in the run-up to the TMT bubble. Strangely enough, we aren’t hearing many exhortations to buy equities because it is just like 1929 or 1999. Today’s “believers” are more “sophisticated” than the “simple-minded maniacs” who drove some of the other well-known bubbles of history. But it would be foolish to conflate sophistication with correctness. Current arguments as to why this time is different are cloaked in the economics of secular stagnation and standard finance work horses like the equity risk premium model. Whilst these may lend a veneer of respectability to those dangerous words, taking arguments at face value without considering the evidence seems to me, at least, to be a common link with previous bubbles.  

 

A link to he full report is posted in the Subscriber's Area.

I find myself agreeing with a great deal of what James Montier is arguing. I believe that it does not make sense to take a secular trend which is obviously at a highly developed stage and extrapolate it into infinity. That is just not how markets work. Yet that is exactly what we see in the bond markets. 

Citi’s equally large credit card book – in nominal terms the most profitable part of the business – has a gross spread of almost 1,100bp, but also reported over 300bp in defaults in 2016.  Still, with a 800bp net margin before SG&A, credit cards are Citi’s best business.  Indeed, Citi’s payment processing and credit card business are the crown jewels of the franchise.  If there were some way to sell the rest of the Citi operations, the payments processing and credit card business could be worth a multiple of Citi’s current equity market valuation. 

The trouble with Citi and many other US banks is that their business are dominated by consumer credit and real estate exposures, with little in the way of pure C&I loans.  When you look at most US banks, the vast majority of the exposures are related to real estate, directly or indirectly.  Thus when the Fed manipulates asset prices in a desperate effort to fuel economic growth, they create future credit problems for banks.  As our friend Alex Pollock of R Street Institute wrote in American Banker last year:

“[T]he biggest banking change during the last 60 years is… the dramatic shift to real estate finance and thus real estate risk, as the dominant factor in the balance sheet of the entire banking system. It is the evolution of the banking system from being principally business banks to being principally real estate banks.”

So whether a bank calls the exposure C&I or commercial real estate, at the end of the day most of the loans on the books of US banks have a large degree of correlation to the US real estate market.  And thanks to Janet Yellen and the folks at the FOMC, the US market is now poised for a substantial credit correction as inflated prices for commercial real estate and related C&I exposures come back into alignment with the underlying economics of the properties.  Net charge offs for the $1.9 trillion in C&I loans held by all US banks reached 0.5% at the end of 2016, the highest rate since 2012.

 

Commercial real estate has been directly influenced by the extraordinary monetary policies employed by the Fed and other central banks. I don’t think it is an exaggeration to conclude that rising rents have been a contributing factor in the migration of businesses online and the denuding of the high street and malls of active businesses. 

We may not be done with the bull market in bonds, or at least a very extended period of ranging if this article has merit. It is publicly available so ok to post. Would appreciate your comments 

Thank you for this article which may be of interest to subscribers. I too think of the declining velocity of money as a headwind to inflationary pressures getting out of control. However this image of what they consider low interest rates, as below 4.5% is an average level over the last century rather than what might be considered low. 

The euro is irrevocable. It was designed as Hotel California: “you can check out any time you like, but you can never leave!” However, we know that it would be wrong to take it for granted. Italexit could still happen as the unwilling and messy result of an unbearable deterioration in public finances and economic performance, combined with misguided political will and financial market turmoil. It would be a huge mistake. Much better, and less costly, would be to address the underlying problems, allowing Italy to survive and thrive within the euro by enhancing potential growth and economic resilience. 

It would be wrong to conclude that Italexit, or exit from the monetary union by any other Member State, is going to be an easy process that can be evaluated with a straight cost-benefit analysis and smoothly managed in an orderly way. While Roger Bootle, one of the advocates of the return to national currencies, came to somewhat different conclusions, he acknowledged that the exit merely being the reverse of the construction process does not make it easy: “it would be the equivalent of unscrambling an omelette”.

In the case of Italexit, redenomination and default would become very likely and would cause a number of side effects and negative spillovers into the economy. Exit without redenomination would lead the debt-to-GDP ratio to reach 190%, assuming 30% devaluation, making default even more likely. Hence, Italexit would not address the issues its proponents claim it would address, while producing significant financial instability. Just mentioning it as a viable solution as part of a political platform would imply risks of making it a self-fulfilling prophecy. The economic, social, and political consequences would be enormous and last for a number of years.

Links to the full reports are posted in the Subscriber's Area.

It has been my view for some time that the sustainability of the Eurozone is predicated on the assumption previously sovereign populations will accept any set of policies imposed by the European Commission. 

The Eurozone’s sovereign debt crisis arose because private sector loans made by banks in ‘creditor’ countries were at risk of being defaulted upon which would have caused a financial catastrophe for their home nations. The solution was to insist private sector debts be absorbed by the governments of the countries in which they were taken, with the result that sovereign debt-to-GDP ratios exploded. Massive fiscal austerity was imposed on the populations of peripheral countries which contributed to lower standards of living and deflation. 

In this paper, we examine the persistent and systematic failures of the CIP condition in the post crisis period. After formally establishing CIP arbitrage opportunities based on repo rates and KfW bonds, we argue that these arbitrage opportunities can be rationalized by the interaction between costly financial intermediation and international imbalances in funding supply and investment demand across currencies. Consistent with this two-factor hypothesis, we report four empirical characteristics of the CIP deviations. First, CIP deviations increase at the quarter ends post crisis, especially for contracts that appear in banks’ balance sheets. Second, proxies for the banks’ balance sheet costs account for two-thirds of the CIP deviations. Third, CIP deviations co-move with other near-risk-free fixed income spreads. Fourth, CIP deviations are highly correlated with nominal interest rates in the cross section and time series.

Looking beyond our paper, we expect a large literature to investigate further the CIP deviations. The deviations occur in one of the largest and most liquid markets in the world after the crisis in the absence of financial distress, suggesting that other arbitrage opportunities exist elsewhere. While trading in exchange rate derivatives is a zero-sum game, the CIP deviations may have large welfare implications because of the implied deadweight cost borne by firms seeking to hedge their cash flows. Furthermore, the existence of CIP deviation introduces wedges between the interest rates in the cash and swap markets, which affects the external transmission of monetary policy. The welfare cost of the CIP deviation is behind the scope of this paper; it would necessitate a general equilibrium model. Yet, even without such model, the CIP condition is a clean laboratory to test the impact of financial frictions in a very general framework. In this spirit, we present the first international evidence on the causal impact of recent banking regulation on asset prices. We expect more research in this direction in the future.

 

A link to the full report is posted in the Subscriber's Area. When aberrations appear in what is by definition a zero-sum game it is certainly a topic worthy of further study. This is a subject likely to be of particular interest to large institutional traders where a move of 10s of basis points can be multiplied by weight of money and leverage. 

Trends matter, for among other reasons, because they impact the impressions, expectations and actions of policy officials, investors, consumers and businesses. For this reason, we think investors should be aware of just how many financial market trends are on the cusp this year threatening to breach significant milestones.

Undoubtedly, not all of the trends we highlighted will actually break new ground this year and perhaps none will reach levels that draw much investor focus. However, in 2017, the following list of financial market trends are worth monitoring because they are “on the cusp”…

1. Evidence of inflation is broadening and inflation expectations embedded in the 10-year Treasury TIP bond is only about 0.5% below the highest level in at least 20 years.

2. Three major themes are on the cusp in the U.S. stock market. First, is the recent breach of a two-year old trading range in the S&P 500 Index to a new recovery high possibly suggesting a third leg in this bull market? Second, the relative total return performance of conservative investments is nearing its lowest level of the entire recovery. And finally, the relative performance of small cap stocks is within 10% of rising to a new all-time record high relative to large cap stocks.

3. Bond investors face several important trends on the cusp including the potential end of a 30-year bond bull, a flatter Treasury yield curve and investment grade yield spreads about to reach new narrows for the recovery.

4. The U.S. dollar is in a two-year old trading range which, with a break, will settle whether this is just a pause in an ongoing dollar bull market or the start of a fresh dollar bear market.

5. In the commodity markets, crude oil is on the cusp of breaking out of a two-year old trading range above $60 and industrial commodity prices are within 10% of rising to a new six-year high.

So far, this year has been dominated by political news and what it means for future economic and regulatory policies. Perhaps, however, in a year with so much on the cusp, investor mindsets will eventually become more impacted by financial market trends breaking outside old recovery trading ranges? 

 

A link to the full report is posted in the Subscriber's Area.

I find the choice of words “on the cusp” to be very interesting because it represents a point of view which is outside. It suggests an investor is out of the market and potentially on the cusp of investing again. 

Perhaps that’s not overly surprising. The main stock market indices spent almost two years ranging and endured some scary pullbacks during that time. Bonds have sold off aggressively in the last few months which would have prompted at least some investors to raise cash. Commodities prices are rallying of off very depressed levels but with since they are already a year into an advance there are logical questions being asked by those on the side lines centring on whether they are already too late.

For all the talk of a strong Dollar the only currency that is weaker than it this year is the Turkish Lira and even that is looking very oversold at present following an accelerated decline to test the TRY4 area. 

Polls suggest that National Front leader Marine Le Pen will make it to France’s run-off vote on May 7, giving her a shot at claiming the presidency on anti-euro, EU-skeptic ticket. She shared a stage last weekend with Frauke Petry of Alternative for Germany and Geert Wilders, whose anti-Islam platform has helped propel his Freedom Party to within reach of winning the March 15 Dutch election.

Europe’s anti-establishment forces are drawing inspiration from Donald Trump’s surprise elevation to the U.S. presidency and unexpected victory of Brexit supporters in last year’s referendum. Another common strand is an anti-immigration stance that has flourished during the worst refugee crisis since World War II, with more than one million people fleeing war and oppression in Syria, Afghanistan and elsewhere having sought asylum in Germany alone.

Gabriel, who is poised to become German foreign minister in a cabinet reshuffle allied to the Sept. 24 election, pointed to France’s two-round ballot as the key moment that will shape Europe’s destiny. While no recent poll has shown Le Pen coming close to winning the second round, Brexit and Trump’s victory have made political analysts and investors reluctant to rule anything out.

“If Europe’s enemies, after Brexit last year, manage once again in France or in the Netherlands to be successful, then the threat to us is the collapse of the greatest civilization project of the 20th century, the European Union,” Gabriel said in a speech to lower-house lawmakers in Berlin on Thursday.

 

No one has much faith in polls anymore because people lie about their intentions and those that respond to polls are often not representative of the swing voters that shape results. Lurches to the right in the UK and USA represent dissatisfaction with the status quo. France’s generous social programs have helped nullify populist uprisings until now, but an unemployment rate stuck at 10.2% and youth unemployment of 24% are intransigent problems that the current political apparatus does not appear to have a solution for.

Time costs money for Italy, due to collective action clauses (CACs) and thus, purely on financial grounds, it reduces Italexit risk and makes any voluntary debt re-profiling a better option to eventually sustain its borrowings, Mediobanca says in note.

Highlights no growth undermines debt sustainability; Sentix Index, which estimates the one-year probability of Italy leaving the monetary union based on the assessment of investors, signals stress

Says redenomination in any Eurozone country is a function of the freedom allowed on bonds issued under domestic law and the constraints of the recently introduced EU discipline on
CACs 

Quantifies cost of re-denomination, says four variables suggest EU280b loss, partly offset by EU191b gain from the Lex Monetae on bonds under domestic law

Compares CACs and non CACs pairs of Italian govies displaying similar features in order to test Mediobanca’s “time costs money” finding; that means as time goes by the
financial incentive for redenomination declines

Data suggest 30bps yield premium on 3.5yr non CACs bonds actually drops to 10bps on 12yrs

Says “Quanto” spread captures the “convertibility risk” implied in the premium between USD- and EUR-denominated CDSs

Data suggest that at end 2016 for the first time Italy’s “Quanto” exceeded Spain’s, confirming Italy crucial role for eurozone future given a 90% correlation the brokerage notes between Italexit probability and a euro break-up probability

I think most people would agree that if Italy quits the Euro the currency will be unable to function as a cohesive unit. Italy would use the opportunity of devaluation to flood the Eurozone with cheap goods which would encourage other countries to follow its lead. That’s not news and the EU is fully aware of the implications of a large country like Italy leaving the currency union. 

The dollar is a particular source of worry for U.S. policy makers, having appreciated 23 percent since mid-2014. The Fed expects to keep tightening while central banks in Japan and Europe hold steady or consider more accommodation. That could further strengthen the greenback and introduce a headwind for U.S. growth.

“Slowing down the economy a little bit at the long end of the market has some benefits if you think primarily that exchange rates are driven by short-term interest rates,” Rosengren said. “You might want some of the removal of accommodation to come at the long end, which would be done by the balance sheet.”

The Boston Fed released research on Jan. 19 that backs up this view of exchange rates and the yield curve. Former Fed economist Roberto Perli was more skeptical, pointing to global demand for longer-term U.S. Treasuries.

“If long U.S. rates were to increase significantly as a result of balance sheet shrinking, there would still be large inflows into U.S. assets, which would support the dollar,” said Perli, a partner at Washington consulting firm Cornerstone Macro LLC.

 

The Fed’s balance sheet at $4.46 trillion represents a potent source of supply for a bond market that shows increasing signs of topping out. As long as the balance sheet was increasing it was hard to argue with the rationale for pursuing the bullish momentum trade in Treasuries. However with interest rates now rising and the Fed no longer adding to its inventory of bonds a major source of fresh demand has been removed from the market.

A link to the full presentation is posted in the Subscriber's Area.

The pace of technological innovation is graphically illustrated in this report. What becomes very clear is how start-ups view the all-in-one businesses of companies like Starwood, Proctor & Gamble and the car manufacturers and pharmaceutical companies as ripe for disruption. They could be right and there is certainly a great deal of venture capital money willing to make that bet. However we should not expect established companies to go down without a fight.

Money velocity isn’t a bullet-proof economic indicator. Financial innovation, and the rise of shadow banking, have made it hard to measure exactly how much money is floating around in the financial system. And some would say that "money" itself is going through an identity crisis these days.

Hunt isn’t the only one seeing the record-low pace as an ominous sign. The fact that money velocity declined rapidly during years of near-zero interest rates may signal aggressive monetary easing actually led to deflation instead of inflation, economists at the St. Louis Fed wrote back in 2014.

"In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy," economists Yi Wen and Maria A. Arias wrote.

"I know I’m the minority here,” Hunt said. “I’m just trying to see the world as I think it should be seen.”

 

I have long argued that the disintermediation associated with the internet and technological innovation is a major contributor in the decline in the velocity of money. The downtrend in the data from 1997 offers a graphic representation of the deflationary influence of technology. It also helps to explain why the surge in the quantity of money associated with quantitative easing has not resulted in high inflation. 

As much as 12 trillion yuan ($1.73 trillion) in bonds—or 19% of the country’s $9 trillion bond market—could be subject to such repurchase agreements, according to an estimate by Shui Ruqing, president of bond clearing-house China Central Depository & Clearing Co., cited last month in China’s influential Caixin Magazine. Traders say the deals are so opaque that even estimates are hard to make.

Banks sometimes use the “dai chi” agreements to move risky assets temporarily off their books during earnings periods or audits, the people said. Brokers like Sealand typically use them to borrow quickly and flexibly—leveraging their investments many times over, they said.
Until last year, Chinese financial regulators had largely ignored the practice, beyond saying they opposed it during a bond-market crackdown in 2013. But the informal nature of dai chi also meant the trades could be difficult to enforce when conditions worsened.

“Because it’s not really an official business, agreements aren’t legally binding,” said the executive who had bought bonds from Sealand.

Sealand’s problems became apparent on Dec. 15, when the southern China-based company announced that two of its traders had forged dai chi agreements worth 16.5 billion yuan ($2.4 billion), a move that market participants interpreted as meaning the broker didn’t intend to honor the deals.

The amount was more than five times what Sealand had declared in its Sept. 30 financials as its financial assets under official repurchase agreements, and more than seven times its disclosed bond-holdings.

 

China has developed extraordinarily quickly from a closed backwater into a massive financially significant hub. While the pace of development has been blistering the evolution of regulatory standards of governance has been much more moderate. The single party system where cronyism, nepotism and the modern equivalent of simony combine to ensure just about anything is permissible, provided your social standing is within the correct circle, and only exacerbates the situation.  

Enjoy watching the video presentations. Thought you may be interested in the following interview of Gary Shilling; 

Thank you for you kind words and this interesting interview which may be of interest to subscribers. 

Gary Shilling’s view that technological innovation is inherently deflationary is very much in tune with our view. The increasing commercial applications of biotechnology, automation, artificial intelligence, the internet and mobile technology are all likely to enhance productivity and could very well represent a deflationary influence. On the other hand, the increasing calls for free money (universal social payments) lower taxes, more spending and deregulation have the capacity to stoke inflation.

I’ll end this section by sharing my latest epiphany on the macro.  I realized recently that in my early decades in the investment business, change came so slowly that people tended to think of the environment as a fixed context in which cycles played out regularly and dependably.  But starting about twenty years ago – keyed primarily by the acceleration in technological innovation – things began to change so rapidly that the fixed-backdrop view may no longer be applicable.

Now forces like technological developments, disruption, demographic change, political instability and media trends give rise to an ever-changing environment, as well as to cycles that no longer necessarily resemble those of the past.  That makes the job of those who dare to predict the macro more challenging than ever.

The Velocity of M2 has been declining since 1997. A housing bubble, sovereign debt crisis and bubble, commodity bull market and crash and massive monetary largesse have done nothing to stall the decline.

This argument from the St. Louis Fed in 2014 blames the refusal of consumers to spend as the primary culprit and suggests ultra-low interest rates are at least partially to blame. Here is a section:

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:

A glooming economy after the financial crisis

The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds

In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy).

The employment report added to data ranging from housing to manufacturing and auto sales in suggesting that President-elect Donald Trump is inheriting a strong economy from the Obama administration. The labor market momentum is likely to be sustained amid rising business and consumer confidence.

Trump, who takes over from President Barack Obama on Jan. 20, has pledged to increase spending on the country's aging infrastructure, cut taxes and relax regulations. These measures are expected to boost growth this year.

But the proposed expansionary fiscal policy stance could increase the budget deficit. That, together with faster economic growth and a labor market that is expected to hit full employment this year could raise concerns about the Fed falling behind the curve on interest rate increases.

 

The US Hourly Earnings chart was updated today and it broke out. If people are demanding more money for the same work, it is hard to argue inflation is not picking up. Even though rents have increase, insurance premiums are higher and education has been outpacing wage growth for years these figures do not move the needle in how the Fed measures inflation the way wages do. 

Treasuries extended gains across the curve, driving down benchmark yields by the most since the days after the June Brexit vote, as traders across financial markets backed away from crowded bets.

The benchmark 10-year U.S. yield plunged about eight basis points to 2.36 percent at 12:15 p.m. in New York, touching the lowest level since Dec. 8, according to Bloomberg Bond Trader data. It’s on pace for the biggest decline since June 27. The 10-year break-even rate, a market measure of inflation expectations, fell from close to the highest level since 2014.

Across financial markets, trends snapped Thursday as investors weighed the risk of a lackluster payrolls report Friday and the prospect that trades based on Donald Trump’s impending presidency had gone too far. Data from the ADP Research Institute on Thursday indicated companies added fewer jobs in December than forecast. The figures come a day before the Labor Department releases its monthly payrolls report. 

“A bunch of the widely predicted trades for this year are all being broken at the same time, with oil going lower, investment-grade corporates widening out, TIPS break-evens tightening, and then rates rallying as a result,” said Mike Lorizio, a Boston-based senior trader at Manulife Asset Management, which oversees about $343 billion. “Some key levels being broken just inspired further buying.”  

 

The odds are in favour of the view that the 35-year bull market in bonds is over, however it would be a mistake to think that such a lengthy expansion will end overnight. Inflationary expectations might well be justified in the medium-term but they have run ahead of the market and Treasury yields in the region of 2.5% are competitive with many equities and therefore desirable by bond investors conditioned over generations to buy the dip. 

No industry is immune to fraud, and the hotter the business, the more hucksters flock to it. But Silicon Valley has always seen itself as the virtuous outlier, a place where altruistic nerds tolerate capitalism in order to make the world a better place. Suddenly the Valley looks as crooked and greedy as the rest of the business world. And the growing roster of scandal-tainted startups share a theme. Faking it, from marketing exaggerations to outright fraud, feels more prevalent than ever—so much so that it’s time to ask whether startup culture itself is becoming a problem.

Fraud is not new in tech, of course. Longtime investors remember when MiniScribe shipped actual bricks inside its hard-disk boxes in an inventory accounting scam in the 1980s. The ’90s and early aughts brought WorldCom, Enron, and the dot-bombs. But today more money is sloshing around ($73 billion in venture capital invested in U.S. startups in 2016, compared with $45 billion at the peak of the dotcom boom, according to PitchBook), there’s less transparency as companies stay private longer (174 private companies are each worth $1 billion or more), and there’s an endless supply of legal gray areas to exploit as technology invades every sector, from fintech and med-tech to auto-tech and ed-tech.

The drama has some investors predicting more disasters. “What if Theranos is the canary in the coal mine?” says Roger McNamee, a 40-year VC veteran and managing director at Elevation Partners. “Everyone is looking at Theranos as an outlier. We may discover it’s not an outlier at all.” That would be bad news, because without trust, the tech industry’s intertwined ecosystem of money, products, and people can’t function. Investors may find the full version of the old proverb is more accurate: “One bad apple spoils the whole barrel.”

 

Fraud isn’t generally identified immediately because it takes time for such contrivances to be discovered. The impetus for investigation doesn’t generally arise until someone goes looking for the money that was invested, when the expected return does not materialise. It took the credit crisis to reveal problems with Madoff’s Ponzi scheme, yet it had functioned unperturbed by regulators for years before that event. The above article does an excellent job of identifying the frauds which have occurred in Silicon Valley as well as the culture that promotes exaggeration.

If Monte dei Paschi's capital plan fails, Prime Minister Paolo Gentiloni's new government is likely to meet this week to issue an emergency decree to inject capital into it.

But that could prove to be politically explosive given that investors are required to bear losses under EU bailout rules.

Parliamentary approval for the 20 billion euro government plan was needed to allow the state to take on new debt. Italy's debt burden, at about 133 percent of annual output, is already the second highest in the euro zone after Greece.

The measure approved by parliament on Wednesday says the state can borrow money to provide "an adequate level of liquidity into the banking system" and can reinforce a lender's capital by "underwriting new shares".

The failure of Monte dei Paschi, the world's oldest bank, would threaten the savings of thousands of Italians and could undermine confidence in the country's wider banking sector, saddled with a third of the euro zone's total bad loans.

Before the vote, Economy Minister Pier Carlo Padoan vowed to shield retail bank investors from losses.

"The impact on savers, if a (government) intervention should take place, will be absolutely minimised or non-existent," Padoan told parliament.

Italy Senate also approves government request to lift debt to help banks
Monte dei Paschi said it expected its net liquidity position, now at 10.6 billion euros, to turn negative after four months.

 

A bailout of Italy’s banking sector highlights clearly that the EU has one set of rules for small countries but is willing to set them aside in the cause of realpolitik to ensure the sustainability of the currency regime. 

A rationalisation I have heard promulgated is that the bail-in imposed on the people of Cyprus was nothing more than a refusal to bailout Russian billionaires and that Italy represents an altogether different case. That of course ignores the very real pain and suffering of savers who had their assets confiscated simply because they were unlucky enough to live in Cyprus. 

A common link between EM equities and EM local debt is the currency exposure. Based on our relative purchasing power parity (PPP) model, EM currencies tumbled from 25% above fair value in 2011 to 30% below fair value in January of this year. Even after this year’s rebound they remain about 19% cheap to the US dollar. If EM currencies’ relative valuations strengthen just halfway back to historical norms, such a move would translate into a near 1.0% tailwind to yearly returns over the next decade.

Although EM currencies, represented by the JPMorgan Emerging Local Markets Index Plus, have rebounded since January 2016, they continue to trade near the discounts associated with the 1997 “Asian Contagion” and 1998 Russian debt default. EM currencies can certainly get cheaper before they revert toward historical norms, but they might just as easily snap back quickly to fair value. Our relative PPP reversion expectations with high EM cash rates, a faster growing working-age population, and continued productivity growth as EM economies “borrow” technological advances from developed economies, all support our projected real return for EM currencies of 3.9% a year over the next decade.

 

The strength of the US Dollar represents a major shift in the status quo for many emerging markets, but most especially commodity exporters and comes at a time when budgets were already constrained by a multi-year bear market in commodity prices. US denominated debt has obvious risks for companies lacking substantial Dollar denominated income sources and that is likely to remain a headwind. The other side of the coin is that local currency debt is increasingly attractive for the same companies but the cost of that debt will likely rise. 

Australia’ economy shrunk by 0.5% in 3Q16. Typically in such a situation a cut in official interest rates can ease the pain. While the RBA may choose to lower interest rates, its impact on customers’ borrowing costs may be limited. In fact mortgage rates could rise again soon.

Why? The RBA only controls the cost of borrowing overnight. The longer the term of the bond, the more the market sets its yield. As the marginal investor in the A$ bond market is from overseas what happens in the global market place drives our longer term bond yields.

Just as Australian home loan borrowers could do with some relief interest rates are edging up. The reason is Australian banks raise insufficient deposits to fund their loan book. The balance of funds comes from the bond market. Should the cost of borrowing for our “AA” rated banks rise further customers will likely get more hikes on their mortgage rates.

A concern Spectrum has is if the U.S continues to grow at near its current 3% run rate both U.S and Australian bond yields could rise further. Borrowing while rates were falling was easy 

Since the 1980’s Australian households have piled on the debt. Much of this has gone into residential real estate. The continuous fall in interest rates and rising property prices created a re-affirming inducement to borrow more. Today, Australian households have world beating debt levels. This makes parts of the sector hyper-sensitive to rate rises. Should the cost of borrowing rise notably from here wide-spread financial stress within Australian households looks set to follow.

 

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Australian 10-year bond yields last traded above the trend mean in 2013 when rates were 2.5% or 100 basis points above today’s level. The yield is closing in on the 3% level more in sympathy with US Treasuries than any particular hike in Australian inflation expectations. 

China warned Donald Trump against using the One-China policy regarding Taiwan as a bargaining chip in trade talks, a swift response that indicates Beijing is losing patience with the U.S. president-elect as he breaks with decades of diplomatic protocol.

“Adherence to the One-China policy is the political bedrock for the development of the China-U.S. relationship,” Foreign Ministry spokesman Geng Shuang told reporters in Beijing at a regular briefing on Monday. “If it is compromised or disrupted, the sound and steady growth of the China-U.S. relationship as well as bilateral cooperation in major fields would be out of the question.”

Trump said in an interview broadcast on Sunday that his support for the policy --- which has underpinned U.S. behavior toward Taiwan since the 1970s -- will hinge on cutting a better deal on trade. He has repeated his accusations against China since election day, telling a crowd in Iowa last week that China would soon have to “play by the rules.”

Policy makers in Beijing initially had a more subdued response after Trump departed from diplomatic convention earlier this month and spoke by phone with Taiwan’s president. Now things are getting more serious: The official Xinhua News Agency warned that world peace hinges on close and friendly ties between the U.S. and China.

“For China, there is no balancing of trade and Taiwan,” said Wang Tao, head of China economic research at UBS AG in Hong Kong. “Taiwan is considered the utmost core interest of China, not for bargaining.”

 

China has been flexing its military muscle in the South China Sea for the last few years to the alarm of its neighbours but with very little push back from the rest of the world. Additionally it has been steadily increasing what it is spending on arms, with the total soaring from $123 billion in 2010 to an expected $233 in 2020. 

This article argues that information gaps—pockets of information that are pertinent and knowable but not currently known—are a byproduct of shadow banking and a meaningful source of systemic risk. It lays the foundation for this claim by juxtaposing the regulatory regime governing the shadow banking system with the incentives of the market participants who populate that system. Like banks, shadow banks rely heavily on short-term debt claims designed to obviate the need for the holder to engage in any meaningful information gathering and analysis. The securities laws that prevail in the capital markets, however, both presume and depend on providers of capital playing the lead role performing these functions. In synthesizing insights from diverse bodies of literature and situating those understandings against the regulatory architecture, this article provides one of the first comprehensive accounts of how the information related incentives of equity and money claimants explain many core features of both securities and banking regulation.

The article’s main theoretical contribution is to provide a new explanation for the inherent fragility of institutional arrangements that rely on money claims. The literature on bank runs typically focuses on either coordination problems among depositors or information asymmetries between depositors and bank managers to explain bank runs. This article provides a third explanation, one which complements the established paradigms. It shows how information gaps increase the probability of panic by increasing the range of signals that can cast doubt on whether short-term debt that market participants had been treading like money remain sufficiently information insensitive to merit such treatment. It further examines how information gaps also impede the market and regulatory responses required to dampen the effects of a shock once panic takes hold. Evidence from the 2007-2009 financial crisis is consistent both with the article’s claims regarding the ways shadow banking creates information gaps and how those gaps contribute to fragility.

The shadow banking sector has benefitted inordinately from quantitative easing because the cost of leverage has been so low and access to the sea of liquidity issued by central banks has been limited to a relatively small number of market participants. That fact alone has contributed to the rise of populist movements, but the prospect of rising interest rates in response to proposed fiscal stimulus represents a challenge for the shadow banking sector. 

Last year you expected “some increase” in the 10-year Treasury yield. On November 30 of last year it was at 2.21% and on Friday it closed at 2.34%, so your forecast was accurate. What is your forecast now for interest rates? Have we finally seen the end of the 35-year secular downtrend in rates? 

Rates took a huge jump after the Trump election. They are going to work their way higher. Again, there is a lot of uncertainty about what policies will be enacted, but I would not be surprised to see the ten year between 2.5% and 3% by the end of next year. That is a rate that should not be threatening for equities. If rates move well above 3% without a corresponding big increase in economic growth, it’s a problem. If there’s a big increase in economic growth, a move above 3% could still be all right. But if there is an inflation problem, the Fed will fight by increasing rates even more. That certainly would be a challenge to the equity market. 

President-elect Trump has criticized the Fed for being too dovish. Would he be wise to appoint a new chairperson or governors who are more hawkish? 

Janet Yellen’s term doesn’t end until January 2018. Vice Chair Stan Fischer’s term ends about six months after that. Trump has given no indication that he’ll ask either to step down now, although he has definitely said that he wants to replace Yellen when he becomes president. 

Yes, Trump has criticized the Fed for keeping interest rates down too much. After accusing the Fed of trying to help Clinton and Obama by keeping rates low, Trump might have to welcome low rates if he wants to implement the infrastructure program that he desires. In fact, I believe the Fed is going to move with the 10-year rate next year. If the 10-year Treasury continues to rise to 2.5%, 2.75% or 3% or more, you are going to see two or three Fed rate hikes. We are certainly going to see one in December. That’s a slam dunk. But there could be anywhere from two to three hikes next year depending on how high that 10-year rate goes. 

It’s one thing to finance infrastructure at a near-zero rate, which is where short-term rates are. But if short rates rise to 1.5% and the long rates approach 3%, it is going to be more of a challenge. Trump may not appoint someone who is very hawkish, such as John Taylor, and maybe we’ll find that Yellen’s dovishness will be welcome at a later date. 

I should mention that for quite a while there have been two openings on the Board of Governors of the Federal Reserve and the Board wants them filled. They want to be at full strength. There are only five governors now and there should be seven. Trump will have the opportunity to appoint two new governors very early in his term.

 

US 10-year Treasury yields surged again today and have now comfortably broken the progression of lower rally highs evident since the yield peak that accompanied the taper tantrum. This move is amicably being referred to as the Trump tantrum. There is some weight to the argument it will be temporary since many investors have been conditioned to buy-the-dip and the Presidential inauguration will not be until January 20th. 

Renzi, 41, has staked his political future by suggesting he would resign if he were to lose, and the first projections of the result are due just before midnight Rome time.

“You have to ask how much the market will react to something they are expecting,” said Andy Soper, head of Group of 10 foreign-exchange options at Nomura in London. "The difference this time is that it might be less about the result and more about how the vote is won or lost. There are a lot of unknowns.”

 

If you look back at history you don’t often see old revolutionaries. The leaders might be mature adults but the people on the streets doing the fighting tend to be young, idealistic, ready for anything, and glorying in the freedom they have suddenly been allowed to grasp. 

A big part of the reason Europe has not had more social unrest is because it simply does not have a large population of young people. We’ve all seen the headlines talking about youth unemployment but the reality is that the 18-25 year old bracket is small relative to the massive aging populations in Spain and Italy.

8. Inflation: Moving higher across DM
‘Reflation’ is the theme du jour following Donald Trump’s unexpected emphasis on infrastructure spending in his acceptance speech on election night. Since then, market participants have been hard at work trying to figure out the policy agenda that Trump the president might pursue (distinct from the rhetoric of Trump the candidate). What seems clear to us, as argued above, is that economic issues, notably tax cuts, infrastructure spending and defense spending, are high on the agenda — a recipe for reflation.

There was a strong case for rising inflation in the US even before Trump’s victory. Our call for higher rates in long bonds this past year was premised more on a repricing of inflation risk and inflation risk premia than on a rise in real rates. And, globally, we expect rising energy prices to push up headline CPI across the major advanced economies in early 2017. After years of deleveraging and highly accommodative monetary policy, we expect inflation to gain momentum in 2017 just as many countries are shifting their policy focus to fiscal instruments. For example, we are forecasting large boosts to public spending in Japan, China, the US and Europe, which should fuel inflationary pressures in those economies. Moreover, having had to work so hard for so long to get inflation even to the current low levels, the major central banks in developed markets sound increasingly willing to let inflation run above 2% targets

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As recently as early this month a significant number of investors were betting the discount rate was never going to go up. That has definitely changed with the bond markets rapidly pricing in the potential for inflation to pick up as fiscal stimulus is expected to kick in. 

That brings us to the outlook for bonds. Just as the U.S. stock market has celebrated Trump’s election, the bond markets have been discouraged. Interest rates rose very rapidly last week following Trump’s election, bringing big losses to bond holders. The FT wrote the following, citing Henry Kaufman, the Solomon Brothers chief economist who correctly called the bond bear market in the 1970s:

“It’s a tectonic shift”…the end of a three-decade bond bull market, because of the likelihood of unfunded tax cuts, infrastructure spending and a radically reshaped Federal Reserve. “I would say the secular trend is going to be upwards now” he told the FT “Secular swings are hard to forecast, but the secular sweep downwards in interest rates is over, and we are about to have a gentle swing upwards”

I always feel it takes a degree of innate optimism to be a devotee of stocks (with their reliance on conjectural returns awarded by the market) as opposed to bonds (which bring contractual returns guaranteed by their issuers). Thus U.S. equity investors have exhibited an optimism regarding the Trump administration that virtually no one foresaw a week ago. 

Equity investors like inflation because it pumps up profits. Bond investors dislike it because it raises interest rates, reducing the value of the bonds they hold. But the two can’t go in opposite directions forever. At some distant point, higher interest rates can cause bonds to offer stiffer competition against highly appreciated stocks. 

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Generally speaking the stock and property markets are reasonably good hedges against inflation because both dividends and rents can increase over time and compensate the asset holder. Fixed rates bonds on the other hand do not have this advantage and are therefore one of the most interest rate sensitive sectors. 

Expectations that Trump, along with a Republican-led Congress, would make good on pledges to spend $550 billion on infrastructure improvement to stoke economic growth sent inflation expectations to the highest since 2015. Yields on two-year notes, the coupon maturity most sensitive to monetary-policy expectations, rose to above 1 percent on Monday for the first time since January as traders added to bets the Federal Reserve will raise interest rates next month.

"The consensus has shifted for good reason," Matthew Hornbach, head of global interest-rate strategy at Morgan Stanley, said in an interview with Bloomberg Television. "There is some concern over the timing and the extent to which President-elect Trump will be able to follow through on some of his campaign promises specially with respect to infrastructure spending and the tax cuts."

 

This sell off in bonds has been both swift and aggressive with the net result that yields have surged to levels not seen in at least a year. For bond investors who have been conditioned by a 35-year bull market the natural response is to buy the dip. As with any bull market that has been a winning strategy for as long as anyone cares to remember and in order to conclusively signal this historic bull market is over it will have to stop being a profitable strategy. 

The short answer is very high. However this picture of the US Treasury yield curve highlights just how high prices are and how very very low yields are. 

It was a bruising campaign but with control of all three branches of government the Republican Party now has a relatively unfettered path to introducing a broad range of policy options. The one obstacle of course is that the entrenched bureaucracy in Washington and the various unions are totally opposed to just about any change to the status quo. 

Corporate taxation and the tax code more generally could be up for debate. Securing a budget large enough to make a dent in the deferred maintenance of the USA’s infrastructure is perhaps the clearest ambition of a Trump Presidency. Protectionism is also high on the agenda and the responses of NATO and EU spokespeople to the news was a picture of unease at this new source of uncertainty. Immigration is also likely to be a major topic of conversation for this administration. 

White Americans are traumatised to know they will become a minority within 50 years. The French extreme right believe there’s a conspiracy to replace the European population with Africans and north African Arabs. Like Trump supporters, they hark back to the “good old days” and want France to be “great again”.

Virtually all western democracies appear to be infected with the anger and disillusion that brought Trump to power. An opinion poll published by Le Monde on November 8th showed that close to three-quarters of the French electorate believe their elected officials are corrupt. They believe elections serve no purpose, and that political parties, trade unions and media block the country. Trump’s promise to “drain the swamp” has certain resonance.

During the campaign, Le Pen told the right-wing magazine Valeurs Actuelles: “What Americans like is that he’s a free man. If I were American, I’d choose Donald Trump.”

On Wednesday morning, she tweeted congratulations before final results were in.

 

This has been a year in which the “perceived wisdom” has been proved not to hold true. The UK voted to leave the EU, the Chicago Cubs won the World Series for the first time in more than a century, the Irish rugby team beat the All Blacks for the first time,(although it was only a friendly) and now a rank outsider has won the US Presidential Election. The question now is whether this trend of surprises and disruptions to the status quo will continue and most particularly in Europe?

At GMO we have put particular weight for identifying investment bubbles on the statistical measure of a 2-sigma upside move above the long-term trend line, a measure of deviation that uses only long-term prices and volatility around the trend. (A 2-sigma deviation occurs every 44 years in a normally distributed world and every 35 years in our actual fat-tailed stock market world.) Today’s (November 7) price is only 8% away from the 2-sigma level that we calculate for the S&P 500 of 2300.

13. Upside moves of 2-sigma have historically done an excellent job of differentiating between mere bull markets and the real McCoy investment bubbles that are likely to decline a lot – all the way back to trend – often around 50% in equities. And to do so in a hurry, in one to three years.

14. So we have an apparent paradox. None of the usual economic or psychological conditions for an investment bubble are being met, yet the current price is almost on the statistical boundary of a bubble. Can this be reconciled? I believe so.

15. There is a new pressure that has been brought to bear on all asset prices over the last 35 years and especially the last 20 that has observably driven the general discount rate for assets down by 2 to 2.5 percentage points. Tables 1 and 2 compare the approximate yields today of major asset classes with the average returns they had from 1945 to 1995. You can see that available returns to investors are way down. (Let me add here that many of these numbers are provisional. We will try to steadily improve them over the next several months. Any helpful inputs are welcome.) But I do believe that readers will agree with the general proposition that potential investment returns have been lowered on a wide investment front over the last 20 years and that stocks are generally in line with all other assets.

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I agree that the topic of bubbles is central of what our job as analysts is. If we can succeed in identifying the latter stages of a bubble, we can avoid the worst effects of the subsequent bear market, so that we are in the privileged position of having ample liquid capital with which to participate when a new bull market evolves. The big question now is to what extent the major stock market indices exhibit bubble characteristics. 

Wage gains picked up, with average hourly earnings rising 0.4 percent from a month earlier to $25.92. The year-over-year increase was 2.8 percent, compared with 2.7 percent in the year ended in September.

Higher wages are starting to encourage more Americans to quit their jobs with the confidence they’ll find other work that pays more. The number of job leavers as a share of unemployed rose to 12.1 percent in October, the highest since February 2007.

The average work week for all workers held at 34.4 hours in October. Among service providers, education and health services led with an increase of 52,000 jobs, followed by professional and business services at 43,000. Retailers pared payrolls by 1,100 on declines at electronics and appliance stores and clothing shops.

Factories reduced payrolls by 9,000 after an 8,000 decline the month before, in line with a report earlier this week that showed manufacturing barely expanded in October while orders moderated. Employment at construction companies rose by 11,000. Governments added 19,000 workers.

 

Wage growth broke out on these figures. Considering it is almost the one measure of inflation that cannot be hedonically moderated it carries weight in the Fed’s decision on whether to raise rates. In fact all other factors being equal the pop in wage demands is likely the figure that pushes the Fed over the line into definitely raising rates in December. The only thing that could derail such a move would be market tumult following a surprising US election result not least if it is deadlocked. 

It appears to us that everyone in the energy industry is fixated on whether the OPEC oil ministers meeting in Vienna, Austria on November 30th will produce an agreement to limit the group’s output, and how that production volume will be shared among the group’s 12 members. Also, it will be important to see who among the 12 OPEC members will be exempted from a monthly production quota and what those countries near-term output goals are. Lastly, we need to see some support from Russia for OPEC’s production cap to have much strength. While all these details are important to the outcome of the OPEC meeting and how the energy world reacts to whatever is agreed to, the lack of executive thinking about what happens to energy demand if the U.S. enters a recession could be the pothole everyone steps in. The duration and depth on any recession will determine how much oil demand might be lost due to weaker economic activity. We suggest you should pay attention to this hidden elephant in the OPEC meeting room. 

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While Allen Brooks is not predicting a recession more than a few analysts have floated the idea. It’s an important consideration that would of course have a significant impact on the energy markets but also on just about every other asset class. Perhaps it would be timely to review some of the leading indicators for recessions to see where we are in the cycle. 

A little more than five weeks before the ballot on reforms that Prime Minister Matteo Renzi says are needed to streamline the government, Italy’s main pollsters signal that voters are almost equally split, with the naysayers slightly ahead. While the surveys don’t take into the views of overseas voters, history suggests they might break in favor of Renzi. In the 2013 general election his Democratic Party was their No. 1 pick.

The most likely scenario is a victory for “No” by a small margin, JPMorgan economist Marco Protopapa wrote in a note on Friday. London-based Protopapa added that faced with a defeat, Renzi would likely offer his resignation to the president of the Republic, who would reject it and invite the premier to verify that he has the support of a majority in the parliament.

 

Renzi has already rolled back on his commitment to leave office if the referendum does not pass and little wonder considering how close the polls are. An Italian subscriber sent through this article which highlights the fact a number of politicians are beginning to float the idea of delaying the plebiscite to allow for greater focus on managing the response to last weekend’s earthquakes. 

Nordea’s chief analyst in Stockholm, Andreas Wallstrom, said he still expects more easing by the Riksbank, "including a rate cut” to minus 0.6 percent in December. “The government bond purchase program is forecast to be expanded by 30 billion kronor ($3.4 billion), equally distributed between government bonds and index-linked bonds,” Wallstrom said.

“The revised repo rate path delivers enough softness to keep the krona on the weak side,” said Knut Hallberg, an analyst at Swedbank AB in Stockholm. “It shows a bigger probability of a cut.”

Some analysts had predicted the Riksbank would announce more easing already on Thursday after inflation missed the bank’s forecasts by a wide margin last month. The annual inflation rate slowed to 1.2 percent in September after peaking at 1.6 percent at the start of the year.

The Riksbank also cut its inflation forecast for next year, from 1.8 percent to 1.4 percent, and for 2018, from 2.6 percent to 2.2 percent. It predicted that unemployment will average 6.7 percent next year, while economic growth will slow to 3.3 percent this year and 2 percent in 2017.

“I don’t really see the logic of making monetary policy more expansionary,” since the economy is doing well, Bergqvist said. Still, “it’s a good tactic that the Riksbank keeps the door open,” he said.

 

The video interview within the above article is quite illustrative of the complacency of central banks when married to a narrowly defined measure of inflation. Riksbank Governor Stefan Ingves quite clearly admits that a bubble is expanding in the Swedish property market and in the same breath says it is not within the remit of the central bank to do anything about it. In fact, like other central banks asset price inflation is viewed as a positive despite the fact household debt is at a record and the bubble is still inflating. 

The combination of low global growth, subdued inflation and ultra loose monetary policy among major central banks has been sending bond yields to unprecedented levels. Yet over the past few weeks, the narrative has appeared to shift.

Concerns have been growing over less support for the bond market from central banks in Japan and Europe as their bond buying is reaching limits. Economists and analysts have started talking about a shift toward fiscal stimulus to combat low growth. Such fiscal action typically raises supply of government debt for funding and is seen as a negative for long-term government bonds.

Demand for haven bonds has also been diminishing as data lately have pointed to some positive signs on the global economic outlook. Meanwhile, inflation expectation is rising, driven by a rally in crude oil prices this month and comments from major central banks to tolerate inflation slightly above their desired targets to tackle still low inflation.

 

Central banks are expressing some reluctance to continue with the same tired strategies that have fostered perhaps the greatest asset price inflation across multiple asset classes in history while failing to stock the kind of inflation central banks measure. Concurrently inflationary pressures are mounting with healthcare and education leading but Chinese producer prices and wages are two important additional factors. 

“Rates are rising from a very, very low base, which means there’s lots of downside and very little upside” for bond prices, said Kathleen Gaffney, a Boston-based money manager at Eaton Vance Corp., which oversees $343 billion. She runs this year’s top-performing U.S. aggregate bond fund and has reduced duration and boosted cash. “If you don’t know how to time it, and I certainly don’t, you just want to get out of the way.”

The lengthiest maturities have dominated the decades-long bull market in bonds, precisely because of their higher duration. Investing in 30-year Treasuries since the turn of the century has produced a 7.8 percent annualized return, compared with 4.3 percent for the S&P 500 index. Yet that run has faltered: U.S. long bonds are on pace for their worst month since June 2015, losing 3.2 percent as yields have climbed about 0.2 percentage point.

 

I’ve written quite a bit about the sensitivity of bond prices to interest rates but this is the first article I’ve seen that specifically talks about the duration of the market and how that represents a risk for investors as interest rates begin to rise. What I have not yet seen is a discussion of convexity which is the influence interest rates have on the relationship between price and yield. Nevertheless it is inevitable that this will become a greater consideration as interest rates rise further. 

All of that changed in September 2008, when Lehman Brothers filed for bankruptcy. The Reserve Primary Fund, a large money market fund, held Lehman bonds.

In turn, institutional investors pulled billions of dollars from the fund, knocking its share price from the supposedly steady $1 to 97 cents on Sept. 16, 2008. It had "broken the buck."

That crisis spurred new rules from the SEC, aimed at protecting smaller investors from large redemptions.

Two key reforms came about: One would require so-called prime institutional money market funds (generally used by large investors) to have a floating net asset value rather than a fixed $1 share price.

The other creates liquidity fees and "redemption gates," which are temporary halts on withdrawals to certain money market funds.

Highlighting the clear difference in risk between government and corporate commercial paper is at the root of these changes to the structure of money market funds. That is likely to be a net positive overall but it represents a change to the status quo and therefore an uncertainty.  

Summers’ relaxed view on the debt build-up, particularly visible in the corporate sector, is in sharp contrast with our own view that this looks set to wreck the US economy. Summers was particularly dismissive of comparing debt to income as the former is a stock and the latter a flow concept. He thought it entirely appropriate in a world of lower interest rates that debt had reached record levels relative to income? belying, for example, the concerns expressed by the IMF this week. Should we worry about the chart below or not?

The charts above and below have just been updated by my colleague Andrew Lapthorne (and using the S&P 1500 ex financials universe). Summers? point was we shouldn’t be too stressed about rising debt as 1) QE is driving up asset prices and higher debt does not look excessive relative to assets, and 2) rock-bottom interest rates mean the debt is easily serviceable. Now on the first point, Andrew shows that quoted company corporate debt has rocketed relative to assets to now exceed the madness last seen at the height of the 2000 TMT bubble. Indeed the problem with Summers? analysis in my view is that it is the higher debt that is being used to push up asset values (via share buybacks), just as it did during the housing bubble in 2005-7. And by pushing asset values well beyond fundamentals you build debt structures on false asset values, which only become apparent when the asset bubble bursts. And am I in any way reassured that the Fed sees no bubbles? No, I am not. These dudes will never identify an asset bubble? at least before the event!

Andrew notes that the way corporate bond pricing models work (e.g. Moody’s KMV and Merton’s “distance to default” models) it is not just a company’s ability to pay its coupon that affects its valuation. Investors are in effect always asking, can this company repay its principal TODAY, even though the repayment is not actually due for 30 years. If asset values collapse in the event of a recession, corporate bond spreads will explode irrespective of the fact that they can easily pay the interest. But hang on a second, let’s just look at interest cover for the quoted sector, for Andrew finds that despite record low interest rates, cover has declined to levels last seen in the depths of the last recession (see chart below)! In the next recession a sharp decline in both profits and the equity market will reveal this Vortex of Debility. US corporate spreads will then explode as the economy is overwhelmed by corporate defaults and bankruptcies. And with the Fed having been the midwife of yet another financial crisis, what price do you give me for it to lose its independence?

 

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A point I’ve made on a number of occasions is that the corporate finance courses taken by MBA students dictate that corporations attempt to access the cheapest cost of funding in order to reduce the weighted average cost of capital. It is advantageous, from a balance sheet perspective, to load up on debt when interest rates are low and to extend the maturity out as far as is practicable, then to use the proceeds to buy back shares, regardless of price, because that reduces funding costs overall. 

Not since the financial crisis of 2008 has Libor, to which almost $7 trillion of debt including mortgages, student loans and corporate borrowings, is pegged — experienced such a surge. The three-month U.S. dollar Libor rate has jumped from 0.61 percent at the start of the year to 0.87 percent currently — a 42 percent rise — ahead of money market reform that's due to come into effect on Oct. 14.

The new rules require prime money market funds — an important source of short-term funding for banks and companies — to build up liquidity buffers, install redemption gates, and use 'floating' net asset values instead of a fixed $1-per-share price. While the changes are aimed at reinforcing a $2.7 trillion industry that exacerbated the financial crisis, they are also causing turmoil in money markets as big banks adjust to the new reality of a shrinking pool of available funding.

Some $1 trillion worth of assets have shifted from prime money market funds into government money market funds that invest in safer assets such as short-term U.S. debt, according to Bloomberg estimates. The exodus has driven up Libor rates as banks and other corporate entities compete to replace the lost funding.

Now, analysts are debating whether the looming Oct. 14 deadline will mark a turning point for the interbank borrowing rate, as money markets acclimatize to a new reality.

 

A great deal of capital is parked in money market funds overnight because they are considered relatively secure because the NAV is steady. The transition to two types of money market fund; one investing only in government securities with a static NAV and others in commercial paper with a highly variable NAV, represents a major change and will need time for bedding in so the potential for volatility is non-trivial.

As a result of this confluence of conditions, we are now seeing most central bankers pushing interest rates down to make them extremely unattractive for savers and we are seeing them monetizing debt and buying riskier assets to make debt and other liabilities less burdensome and to stimulate their economies. Rarely do we investors get a market that we know is over-valued and that approaches such clearly defined limits as the bond market now. That is because there is a limit as to how negative bond yields can go. Their expected returns relative to their risks are especially bad. If interest rates rise just a little bit more than is discounted in the curve it will have a big negative effect on bonds and all asset prices, as they are all very sensitive to the discount rate used to calculate the present value of their future cash flows. That is because with interest rates having declined, the effective durations of all assets have lengthened, so they are more price-sensitive. For example, it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets, that would send them all much lower.

At the same time, as bonds become a very bad deal and central banks try to push more money into the market and yields go even lower and price risks increase further, savers might decide to go elsewhere. At existing rates of central bank buying—which I believe will be required for the foreseeable future—central banks are going to start to hit the limits of their existing constraints. Those limits were put into place because they originally thought that they were prudent but they are going to have to go buy other things. Right now, a number of the riskier assets look attractive in relationship to bonds and cash, but not cheap in relationship to their risks. If this continues, holding non-financial storeholds of wealth like gold could become more attractive than holding long duration fiat currency flows with negative yields (which is what bonds are), especially if currency volatility picks up.

Concerning what policies will likely be required of central bankers given the reduced effectiveness of interest rate cuts and quantitative easing, and assuming that political limitations on fiscal policies and structural reforms remain stringent, it appears to me that there will have to be greater purchases of riskier assets and more direct placements of purchasing power in the hands of spenders, especially as the previously described squeeze intensifies.

 

The number of large bond investors calling for direct provision of liquidity to consumers is growing steadily as serious doubts about the sustainability of negative yields continue to be voiced. In central bank parlance that equates to helicopter money.

Well ain’t that a thing! Now we know why the dialogue shifted just after former chair Ben Bernanke made his way out the door in January 2014. The exit from unconventional monetary policy, you may recall, was originally set to begin with the tapering of purchases, being followed by allowing the balance sheet to run off and then prompt the first rise in interest rates – in that order.

A funny thing happened on the way to the exit, though. Bill Dudley is not only the president of the Federal Reserve Bank of New York but also the vice chairman of the Federal Open Market Committee and coveted holder of a permanent vote. Back on May 14, 2014, in a question and answer session with reporters following a speech, he literally stood the preexisting exit principles on their head.

“Delaying the end of reinvestment puts the emphasis where it needs to be — getting off the zero lower bound for interest rates,” explained New York Fed president Bill Dudley. “In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.” Luckily for investors in any and every risky asset, his opinion holds a lot of sway. Dudley’s central banking peers in developed countries have followed his lead and peace on earth has held ever since.

As for those pesky financial stability concerns, we’ve been instructed to look the other way. Some have even gone so far as to suggest that the time has come to devise a new term to replace ‘bubble.’ No doubt, it’s an unseemly word given the nasty images it conjures. But what if the word ‘bubble’ is not substantial enough to capture what’s been created before our very eyes, across the full spectrum of asset classes?

 

This article offers an erudite exposition of the problems residing in the fixed income markets and the extent to which leverage now plays a role in just about all asset classes. The simultaneous asset price inflation of the stock, bond and property markets, particularly since 2011, is a testament to the fact that a potential problem is brewing.  

The Velocity of Money is on a steady downward trajectory, and in fact has been declining since 1997. That goes a long way towards explaining why monetary policy has been so easy and why central banks are reluctant to withdraw the additional liquidity from the market. The only reason a problem might arise is if the status quo changes. 

These are not just theoretical considerations. The BIS Annual Report of 2014 sounded the alarm when it noted that the level of debt in the AMEs (sum of corporate, household and governments) was then significantly higher than it had been in 2007. Moreover, it has since risen further, to over 260 percent of GDP. This increase has prompted the question “Deleveraging? What deleveraging?”18 This suggests that, by following polices that have actively discouraged deleveraging, we may instead have set ourselves up for an even more serious crisis in the future.

As for the history of economic thought, Keynes himself said in Chapter 13 of the General Theory (1936) that monetary stimulus was likely to be ineffective; “If, however, we are tempted to assert that money is the drink that stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip”. This conclusion marked a sharp change from the policy changes he had recommended in the Treatise on Money (1930). Hayek (1930, p21) went even further in suggesting that monetary easing would actually hold recovery back. “To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about”.

And 

The BIS Annual Report for 2016 also highlights a number of persistent market anomalies27. Not only do they indicate price distortions and potential misallocations but could also indicate underlying structural developments whose full implications for market liquidity are not yet obvious. Recall the plight of European banks in 2008 who had borrowed dollars from money market mutual funds in the US. When this source of funding dried up, the Federal Reserve was forced to reopen US dollar swap lines that it had closed only a few years earlier. All that can be said with certainty, is that we are in uncharted territory when it comes to market functioning.

And for the record, it should be noted that central bank policies might have had other downsides as well. First, with income distribution already a source of great concern (due mainly to changing technology and globalization) the recent stance of monetary policy has likely made it worse. The rich own most of the risky financial assets whose prices have increased the most. Conversely, the middle classes mainly hold the less risky interest-bearing assets whose yields are at record lows. While central banks seem increasingly aware of these effects29, what can be done about them is another issue

 

A link to the full report is posted in the Subscriber's Area.

I think we can all agree that the introduction of extraordinary monetary policy helped to avoid a much deeper economic contraction but has also led to distortions in how markets function and contributed to asset price inflation. There are substantial questions about what the eventual normalisation of policy might look like but equally important are considerations of what a further intensification of extraordinary policy might look like. 

"Based on the information at its disposal, (the HCFP) considers as uncertain that the nominal deficit will be brought to less than 3 percent of GDP in 2017," it said in a report issued as Hollande's government prepares to publish its 2017 budget on Wednesday.

Finance Minister Michel Sapin dismissed the watchdog's concerns, saying that it was skeptical every year and yet the deficit targets had been met.

"I therefore reaffirm the seriousness of the budget and the government's determination to bring the deficit to less than 3 percent in 2017," Sapin said in a statement.

Paris hopes to rebuild its fiscal credibility with its European partners by targeting a deficit of 2.7 percent of GDP for 2017, the lowest in a decade and under the EU's limit of 3 percent.

A serial offender of the EU's fiscal rules, France has delayed bringing its deficit below 3 percent several times under both Socialist and center-right governments in recent years.

EU Economic Affairs Commissioner Pierre Moscovici, who in effect polices government finances to ensure they are living up to their promises, said he expected France to get the deficit below the 3 percent threshold next year.

"I think it's possible," Moscovici, a former finance minister in Hollande's first government, said in an interview with L'Opinion newspaper.

France's fiscal watchdog said government forecasts for 1.5 percent GDP growth this year and next were optimistic, noting they were higher than what most private sector economists expected.
"The government's growth outlook, which is based on a number of favorable assumptions, does not display the caution necessary to best meet public finance targets and commitments," it said. 

 

More than any other country France exemplifies that within the EU there is one set of rules for large countries and quite another for smaller ones. If any smaller country had failed to adjust its fiscal deficits in the same way that France has it would have come under severe scrutiny from the EC, ECB and possibly even the IMF. Yet for France there has been no such talk despite the fact it has been a serial offender. 

It’s back to the future – again. Leverage has returned, most notably in the corporate sector where debt metrics have not just roundtripped but indeed are now in excess of the levels experienced before the Great Recession.

And while the Fed clings to the fiction that it is “data dependent,” its response function – cowering in the face of every market “tantrum” – reveals monetary policy to be what it really is: a put on financial prices. But can the Fed, Canute-like, hold back the future tides of de-leveraging? No, though we expect that they, like their comrades in arms at the ECB and BOJ, will keep trying. Indeed, negative rates can be best understood as merely the latest attempt to forestall the failures of policies past. But, is anyone helped by establishing negative “hurdle” rates to incentivize “investment?” If a commitment of capital requires a negative opportunity cost, then whatever activity that might be launched will assuredly be productivity destroying. Negative rates have all the economic “logic” of destroying the village so as to rebuild it. It is monetary madness and while it might hold back the flood for a time, it fairly well guarantees that when the flood comes, it will be worse than it would otherwise.

Face it: the central banking Emperors have no clothes. But, might the Fed come up with new artifices to prop up the towers of leverage they have built? They might, though it would be folly. Yet, underestimating folly is, I suppose, a folly of its own. The Fed could continue to use its printing press to falsify capital market signals, but to what end? When a central bank buys an asset with an electronically printed dollar, a “something for nothing” trade has taken place. Unless everything we understand about economics is plain wrong, the Fed cannot go on blithely adding printing press dollars to the system and expect no ill effects. Essentially, inflationist monetary policies cannot be the answer to the problems caused by inflationist monetary policy.

And this is precisely our point: when the supposed “solutions” to the Fed’s dilemma are merely new “problems,” you know you are approaching the cycle’s end. Our counsel remains as it has been: avoid those assets that will be broken in the coming de-leveraging while keeping a “steady as she goes” attitude towards the future purchase of those assets that will merely bend when the flood comes

 

Friends of ours are moving out of LA because they find the cost of living and the pace of life too hectic. Wishing to spend more time with their kids they are moving to Savannah Georgia. Thinking it would take time to sell their house they asked for a start time of January at their new employment. They were pleasantly surprised, to say the least, to find they received 3 offers within 24 hours of the house hitting the market. 

The Case Shiller 20 Index rallied 5% year on year but that does little to highlight just how hot the property market is in some of the USA’s major cities where prices for desirable locations are well above the 2007 peak. 

Today I heard on the BBC news that in the US the banks are giving mortgages with "0" down payments. Is this correct, and if so how serious do you think is the risk of a similiar financial crises as we had in 2008. 

As always thanks a lot for the wonderful service

 

Thank you for your kind words and this question. As you are no doubt aware NINJA loans (No Income, No Job, No Assets) were popular ahead of the credit crisis as lax lending standards made property available to people who had no chance of ever paying back the loans. 

100% mortgages do exist in the USA and are not a new feature. For example the USDA (Department of Agriculture) offers zero down mortgages for rural development and the Veterans’ Administration (VA) offers even more attractive terms to veterans. This article from themortagereports.com may also be of interest.