The policy mix of tighter monetary policy and looser fiscal policy provides a steroid-like boost to currencies.   This is what the US had under Reagan-Volcker.  It is was the policy mix in Germany after the Berlin Wall fell that led to the ERM crisis of the early 1990s and then Maastricht Treaty and the euro.  It helped fuel the dollar's gains last year.  Now that policy mix is reversing.  Fiscal policy is tightening, and monetary policy is poised to loosen.  That policy mix is associated with under-performing currencies.  

The third significant dollar rally since the end of Bretton Woods is in jeopardy.  Coordinated intervention marked the end of both the Reagan-Volcker and Clinton-Rubin dollar rallies.  Intervention in the foreign exchange market won't be necessary; the self-proclaimed "Tariff Man" has found another way the proverbial cat can be skinned.  

The last phase of a significant dollar rally has been marked by the movement of interest rate differentials against the US.  This been happening.   The two-year differential between the US and Germany peaked last November a little above 355 bp, which appears to be a modern extreme. It finished last week below 250 bp, the lowest in more than a year.   Similarly, the US two-year premium peaked against the UK around the same time a little shy of 220 bp.  It is now approaching 125 bp.   Against Japan, last November, the US two-year premium of nearly 310 bp was the largest in 11 years.  It is threatening to break below 200 bp.  

Quantitative tightening has been the single most important factor in the Dollar’s strength over the last 18 months. Reducing the size of the Fed’s balance sheet has contracted the supply of Dollars and created a supply inelasticity-based argument to support the currency.

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

The response of the stock market last week to the whiff of easing rhetoric from the Federal Reserve suggests investors are still willing to give the benefit of the doubt to the positive effect loose monetary and potentially fiscal policy can have on asset prices and by extension the economy.

Bond traders’ conviction that the Federal Reserve will cut interest rates within months in response to a weakening growth outlook and escalating trade tensions firmed after a batch of weaker-than-expected U.S. jobs data.

Fed funds futures show a quarter-point cut almost fully priced in for July, and indicate about 70 basis points of easing by the end of 2019. The two-year Treasury yield fell as much as 11 basis points to 1.77%, close to the 2019 low reached Wednesday, and it was on course for its fifth weekly decline.

The last time that happened was back in July 2016, when the U.S. central bank’s target range was 2 percentage points lower than right now.

Lead indicators for future problems are flashing orange. If the Fed were to persist in its policy of continuing to raise rates and reducing the size of the balance sheet it would contribute to recession risk. If it steps on the monetary accelerator once more it risks further inflating a bubble, not least in the nonbank lending and private equity sectors.

At the Marcus Evans conference I attended at the beginning of this week one of the speakers, R. McFall Lamm, formerly chief strategist at Deutsche Asset Management and now at Stelac Private Equity made a couple of interesting points about the yield curve.

While Draghi is using similar tactics to U.S. Federal Reserve Chair Jerome Powell in promising to react to any deterioration in the outlook, the challenge is that he’s seen as having less room for maneuver. ECB rates are still at record lows and the balance sheet hasn’t started to be wound down.

Moreover, he has less than five months left in office and there’s no clear sign who his successor will be, nor whether they’ll have the same commitment to the radical measures that hallmarked the Italian’s eight-year term.

“The market believes Draghi’s take on inflation is wishful thinking,” said Christoph Rieger, head of fixed-rate strategy at Commerzbank AG, which predicts the ECB will cut the deposit rate toward the end of this year and extend its low-rate pledge to mid-2021. “The talk about contingencies is cheap, but to reverse the decline in inflation expectations he will have to walk the walk.”

The ECB only ended their QE program in December so it is going to take some time to rebuild appetite for additional easing measures. The market is convinced of the need, particularly with German, Italian and French PMI’s in negative territory, however the ECB is unwilling to act prematurely.

 

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

The Federal Reserve aggressively tightened policy last year by both raising rates and reducing the size of its balance sheet simultaneously. That has had more of an effect on international growth than domestic growth but the underperformance of the banking and industrial sectors is a testament to slowing activity. We are at the point in the cycle where we can expect easier policy. The big question is whether the Fed will act soon enough to avoid negative economic figures.

A link to the full report and a section from it are posted in the Subscriber's Area.

The commonality in the compression of global sovereign yields is a clear sign bond investors, everywhere, have concluded we are at the top of the interest rate cycle. If interest rates are unlikely to rise, they can fall and the big question is when that is likely to happen.

According to the new parliament’s seat distribution based on preliminary results, 15 PINE parties throughout the European Union made gains in the election and 12 lost seats. In total, they gained just 25 seats – 3.3% of the total of 751. Without Italy, they would have come out even with the 2014 result. In a small number of countries there has been no change in PINE support.

The rise of Italian nationalism and what one could call an anti-establishment revolution there make the country the EU’s biggest trouble spot for the next legislative period. It’s unclear what the bloc can do about it except wait for Italians to become disappointed in Matteo Salvini’s League (and the national conservative Brothers of Italy, or FDI, party) – something that might come with painful economic side-effects.

The U.K. is the other obvious problem, but perhaps a receding one – either because Brexit will eventually happen or because it won’t. Last week’s election delivered a net loss of seats to British PINE parties. The success of Nigel Farage’s Brexit Party was as spectacular as the downfall of his former project, the U.K. Independence Party, and the ruling Conservatives faced a catastrophic loss that doesn’t augur well for them in the next general election. All this is for the British voters to sort out, though: The EU can hardly help at this point and it’s wise for it to wait out the crisis.

Other than the two obvious hot spots, eastern Europe remains somewhat problematic for the “ever closer union” project because of the strength of Hungary’s Fidesz and Poland’s Law and Justice (PiS). These aren’t exactly euroskeptical parties, but they are focused on not giving up any more national sovereignty, and they’re resolutely illiberal. The parties work to defang the independent media and build up propaganda machines that make them immune to scandals (PiS survived a whole strong of them in the run-up to the European election) and they tighten the political control of the courts.

The European election results reflect a rumbling sense of discontent but did not deliver the ground swell of support for populist or ant-EU to upend the centrist status quo. If we look under the surface there is a clear battle going on, but the opposition is split between populists and, the left leaning, Green movement which has allowed the centrist bloc to continue to hold sway.

Last October there was a full hike priced in, but now those expectations have completely collapsed to the point where there is two cuts already embedded into the Eurodollar futures curve.

Although it’s not quite this simple, to make money at the short end, the Fed will have to cut more than twice in the next year and a bit. Could that happen? For sure. No doubt about it. Maybe the economy hits a real air pocket and the Fed cuts aggressively. Or there is some geopolitical event and the Fed is forced to slash rates.

But the point to ask yourself is whether that is a good bet? I contend that with everyone leaning so heavily one way, the surprise will not be how much money they make, but instead if things don’t play out exactly as ominously as forecasted, how quickly the trade goes sour.

There is little room for error. Or put it another way, the global economy better collapse as quickly as these bears believe as even a lengthening of the process will make their trade unprofitable.

And in case you are bullish the long end of the curve and believe a slow-to-cut Fed is your best friend, don’t forget what Tariff Man has done to inflation. Next year should see a rise of 50 basis points across the board to core inflation. Sure commodities are falling hard, but that helps more with China’s inflation situation than with America’s.

The bond market is indeed pricing in rate cuts by the end of the year. The big question is how much of that is hedging of fears about the potential for a slowing global economy and resulting US Dollar outperformance and how much is about the need for an end to quantitative tightening in order to fend off fears about an impending recession?

Again, very grateful thanks for the very interesting and thoughtful comments you post each day. They are helpful to both newer investors and the more experienced who may get locked into their way of thinking. I count myself in that category! One factor that does not get mentioned perhaps as often as it should is the impact of currency movements on investment portfolios. Those of us using pound sterling as our home currency may feel particularly sensitive to this at this time. Those of us that assess gold as a possible investment often check gold in different currencies to determine whether a broad-based uptrend is evolving (eg compare gold in USD, Euro where the pattern looks quite different.) But I suspect fewer investors factor in currency movements when buying stocks in the USA, Europe, India, Japan and China. What are your thoughts on this?  

Thank you for this question which I believe will be of interest to other subscribers. From everything I have witnessed over the years large institutional investors look for three attributes when deciding to invest in markets beyond assets denominated in their domestic currency. These are potential for currency market appreciation, potential for capital market appreciation and yield differentials. I see no reason why investors of all hues shouldn’t follow the same rationale. That is the basis for thinking as a globally oriented investor and why this is a Global Strategy Service.

The dips may have, in fact, provided good buying opportunities for companies to step in and buy at lower prices, said Jim Paulsen, chief investment strategist at Leuthold Group.

“There’s something to be said about insiders showing confidence that their stock is probably going to go up. They think it’s relatively cheap or a good opportunity to buy it back,” said Paulsen. “It’s typically a good sign that has led to higher stock prices.”

Buybacks have climbed in recent years even as they’ve come under pressure from politicians who are focusing on corporate governance as an election issue. While far from being a consensus view, repurchases have been a bull case that strategists like David Kostin at Goldman Sachs have cited for the 10-year rally to keep going.

Corporate appetite has dwarfed that from all other investors as the biggest source of demand for U.S. stocks. Net purchases from corporations totaled $1.6 trillion during the past three years while investors from pensions to mutual funds to individuals were sellers, according to data from Goldman Sachs.

While it’s only one bank’s client flows, BofA’s data demonstrated a similar pattern. Over the last three weeks when stocks slipped, companies stepped up buying while hedge funds and individual investors retreated. During the stretch, buybacks totaled more than $7 billion. By contrast, selling from the other two categories reached almost $1 billion.

Regardless of how one feels about the merits of share buybacks they have been the primary transition mechanism for monetary and fiscal easing to enter the stock market. If that conclusion is correct then only a significant downtrend in corporate earnings or a need to defend the company’s credit rating is likely to change the spending priorities of big corporations.

re the EURO If the Euro currency breaks up, for example, if weak Italy or strong Germany leave, the transition to something else will have to be managed , to avoid chaos; either there is a new Euro, or regional Euros, or the countries go back to their old currencies. Something entirely digital could be invented overnight, perhaps through temporary dollarisation of prices now in Euro. If currency has to be printed, this would take weeks. The French destroyed their Franc printing presses back in 2000/ How would you see the transition ? How would this affect the Swiss Franc ? 2) REQUEST for INCLUSION of the following stock in Chart Library: Tanzanian Gold Corporation ( TNX), listed in Toronto. present price 0, 93 CAD Thank you

Thank you for this question which may be of interest to other subscribers. I believe thinking there is a difference between the Deutsche Mark and the Euro is one of the most common misconceptions of investors. The “creation” of the Euro was more about extending the umbrella of the Deutsche Mark to the whole continent, with its low borrowing costs, than forming a new currency out of nowhere.

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

Jeff Gundlach has a good record of spotting trouble early and he appears to share the view espoused by Ray Dalio that the Federal Reserve is going to need to adopt even more extraordinary measures to tackle the next downturn because of the quantity of debt outstanding.

Days after his coalition partner roiled markets by threatening to breach European Union fiscal rules, Deputy Prime Minister Luigi Di Maio of the Five Star Movement said Italy’s government wants to rein in the debt load to avoid it spiraling.

“Nobody wants to go over 140%,” Di Maio said during an event in Florence. “Otherwise, the debt-to-GDP level would be out of control.” He added that some investments could be financed by increasing the deficit level provided that it boosts economic output, limiting the debt ratio.

The country’s debt-GDP level was 132.2% at the end of last year.

"I think that 130% is already a lot," European Commissioner for Economic and Financial Affairs Pierre Moscovici told reporters in Brussels when asked about Italy’s debt.

Italy has a domestic economy that is struggling and a group of high-profile exporters heavily reliant global growth. Trade war worries are weighing on sentiment particularly as the populist government seeks to modestly breech EU fiscal deficit limits.

The rate on the January fed funds futures contract implies that the central bank’s benchmark will fall to 2.075% by the end of 2019. This is more than 25 basis points below where the effective fed funds rate stood Friday, showing traders are fully pricing in a quarter-point reduction. The implied rate on the contract ended last week at 2.15%.

This is happening as China threatens retaliatory tariffs on some American imports, an escalation in the trade war with U.S. President Donald Trump. The clash is fueling concern about economic growth, prompting a key part of the U.S. yield curve to invert again -- a sign to many that the risk of a recession has increased.

While “China/U.S. trade ripple effects certainly affect the Fed’s outlook, I think this is more of a macro move,” said Todd Colvin, senior vice president at futures and options broker Ambrosino Brothers in Chicago. “It’s not about whether or not the Fed sees policy shifts, that is, as much as it’s looking at
global growth woes, or increased market volatility.”

Jay Powell probably didn’t bargain for the environment he has been presented with since taking the helm of the Federal Reserve. Reducing the size of the balance sheet was supposed to be part of the re-arming of monetary policy to provide for the next crisis. It turned out to be the primary cause of the volatility last year and offered graphic evidence of just how addicted to liquidity the market is.

The Federal Reserve probably will be more inclined to cut interest rates now that President Donald Trump has followed through on his threat to increase tariffs on U.S. imports from China. But it won’t rush into doing so.

While the higher levies will put upward pressure on inflation by raising import prices, the central bank will likely be more attentive to the potential drag they’ll exert on the economy by depressing consumer and business spending, Fed watchers said.

“We would expect the Fed to initially focus on the growth implication and look past the inflation impact,’’ Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York, said in a May 7 note to clients.

The Federal Reserve is highly unlikely to raise rates against a background of low domestic inflation and heightening international tensions. That has been one of the primary reasons bond market investors have concluded we are at the top of the interest rate cycle.

Modern Monetary Theory is one of those infinite number of configurations that is in my opinion inevitable and shouldn’t be looked at in a precise way. For those of you who don’t know what Modern Monetary Theory is, it’s described here (link). It’s described differently by different folks so it has slightly different configurations. For example, some might change fiscal policy so that there is a wealth tax that is used to eliminate student loans, and others might change taxes and spending in other ways, and there are an infinite number of ways these changes can be configured that we shouldn’t delve into at this stage because that will drive us into the weeds and the particulars that will stand in the way of seeing the big important things. Also, people who are focusing on MMT as a package will limit their thinking to the specifics of that package rather than thinking about the wider range of MP3 policies to find the best one. 

MMT’s most important configuration is the fixing of interest rates at 0% and there is the strict controlling of inflation via the changing of fiscal policy surpluses and deficits, which will produce debt that central banks will monetize. In other words, whereas during the times we have become used to, interest rates moved around flexibly and fiscal deficits (often) and surpluses (rarely) were very sticky so interest rates were more important in producing buying power and the cycles, in the future interest rates will be very sticky at 0% and fiscal policies will be much more fluid and important and the debts produced by the deficits will be monetized. In case you didn’t notice, that is by and large what has been happening and will increasingly need to happen. In other words, interest rates are now pinned near 0% in two of the three major reserve currencies (the euro and the yen) and there is a good chance that they will be pinned there in the third and most important reserve currency (the dollar) in the next economic downturn. As a result, fiscal policy deficits that are monetized is the contemporary stimulation configuration of choice. That existed long before there was a concept called “Modern Monetary Theory,” though MMT embraces it. Putting labels aside, it is certainly the case that the configuration of having 1) an interest rate fixed at around 0%, 2) more flexible fiscal policies with debt monetization to fund the resulting deficits with 3) rigorous inflation targeting exists and is increasingly likely, necessary, and possible in reserve currency countries. An added benefit of this approach is that the money and credit created can be better targeted to fund the desired uses than the process of having the central bank buy financial assets from those who have financial assets and use the money they get from the central bank to buy the financial assets they want to buy. There are many historical cases of this happening (see the 1930s-1940s prewar and war periods which, as you know, I think are analogous), which offer worthwhile lessons about how this was and could be engineered. 

The big risk of this approach arises from the risks of putting the power to create and allocate money, credit, and spending in the hands of politically elected policy makers. In my opinion, for these MP3 policies to work well, the system would have to be engineered in a way that decision making would be in the hands of wise, not politically motivated, and highly skilled people. It’s difficult to imagine how the system will be built to achieve that. At the same time, it is inevitable that we are headed in this direction.  

The final paragraph above puts me in mind of Plato’s progression of democracy through tyranny and back again. Someone can only be considered wise after the fact and if recent events have told us anything it is that history is endless revisable.

“I think there was a simple message from yesterday’s elections to both us and the Labour Party: Just get on and deliver Brexit,” May said in a speech to Conservatives in Wales. “An arrangement has to be made, a deal has to be done and Parliament has to resolve this issue,” Corbyn said later, in comments welcomed by May. “I think that is very, very clear.”

The Conservatives and Labour risk being eviscerated at the next general election. That gives them both a clear incentive to conclude the Brexit impasse before then. That is the real deadline, rather than October, because it represents career risk for politicians and that is all they are truly interested in.

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

It really is all about money supply. The market has priced in the potential for the Fed to announce the imminent end of quantitative tightening instead of the planned September date and when that did not occur profit taking began.

I first created the total central bank assets chart in 2014. A couple of years ago I shared the formula with Ben Hunt at Epsilon Capital in a gesture of goodwill following his mention of the size of central bank balance sheets in one of his missives. He subsequently used it and since then the measure has proliferated. I have seen it in a considerable number of investment bank reports, but I have never received a favourable mention for creating it. In future I will be keeping the calculation of indicators proprietary, for the benefit of subscribers.

The committee repeated language from its previous meeting, saying it “will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate,’’ according to a statement Wednesday following a two-day gathering in Washington.

The unanimous 10-0 decision left the target range for the benchmark federal funds rate at 2.25 percent to 2.5 percent.

The Fed’s emphasis on subdued inflation prompted knee-jerk buying of government debt as traders added to positioning for a rate cut. However, that initial rally reversed on Powell’s comments on appropriate policy and transient inflation.

The Dollar has been particularly firm against a wide basket of currencies for the last six months and that is despite the announcement from the Fed last year that they are not going to raise rates. Therefore, there must be another reason for the currency’s strength.

I posted an article on April 9^th discussing how the Bureau of Labor Statistics is adjusting how apparel price data is being collected with the result that prices will be shaved and the end figure will be lower.

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

There is a consensus view among bond fund managers that the ability of Fed to ease in the next recession will be constrained by the zero bound. That is supported by the belief it has nowhere near as much room for easing as it had in other cycles. In turn that will create the much foretold “pushing on a proverbial string” where efforts to stoke inflation and asset prices will be ineffectual.

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

I feel a strong emotional identification with this argument. Surely it makes sense that continued bouts of credit creation will eventually result in the debts coming due and a massive round of defaults resulting in crashes for multiple asset classes? The increasingly vocal concerns about inequality and the rise of populism as a response to that are very real and likely to continue to be a factor that needs to be incorporated in our thinking. The biggest question is how urgent are the warnings?

The wider deficit forecast could revive tensions with the Commission after months of wrestling at the end of 2018 which resulted in a promise from Italy to stick to a deficit of 2.04 percent of GDP. With growth lower than expected, the money to keep the promise isn’t forthcoming. Nor is the government keen on measures that would dampen growth, with Finance Minister Giovanni Triastating recently that restrictive fiscal moves would be “absurd.”

Italy stocks extended losses after the report, with the FTSE Mib index down 0.4 percent at 3.00 p.m. in Milan. The spread between Italian and German 10-year bonds widened by 4 basis points.

"The deficit is the most thorny issue for Italy and could spark tensions with the European Union," said Vincenzo Longo, an analyst of IG Markets in Milan. "We are expecting negative growth in the first part of the year and the numbers the government is going to debate seem too optimistic. The government isn’t likely to push the issue however until after the European vote in May."

The fiscal austerity program the EU is abiding by is designed to harmonise government debt to GDP ratios ahead of introducing pan European institutions like a deposit insurance corporation and a federal transfer mechanism. It offers no leeway for subpar economic growth which is what Italy is dealing with at the moment. That represents a significant challenge for the system because it greatly increases the potential for rebellion.

The BLS change may add volatility in clothing prices, but the impact on the main index will be relatively small, subtracting maybe 0.1 percentage point from the annual CPI rate, according to Michelle Girard, chief U.S. economist for NatWest Markets Securities and the most accurate CPI forecaster in Bloomberg’s latest ranking.

“While, theoretically, this shift should not introduce a downward or upward bias in the data, we believe that prices captured using actual transactions data are more likely to be biased lower,” Girard wrote in a report. “Transactions data could capture lower price points from a flash sale that a data collector may not have observed.”

Goldman Sachs Group economist Spencer Hill estimates the change could reduce core inflation in March by around 0.05 ppt from the monthly change. Omair Sharif, senior U.S. economist at Societe Generale, also sees a possible drag from apparel. The BLS plans to collect more alternative data directly from companies, an avenue that could ultimately account for almost 32% the index, Konny and her colleagues outlined in a February paper. Examples include scraping fuel prices from the GasBuddy website.

The clear conclusion from the introduction new data sets is the Bureau of Labor Statistics has no interest in developing a measure that does anything other than help to depress the inflation gauge.

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

The clearest rationale for a positive view on gold is when we have evidence of negative real interest rates. That is becoming an increasingly likely scenario since global central banks are desperate to stoke inflation and are willing to allow their economies to run hot in order to achieve a self-sustaining cycle. That further supports the argument we are at the top of the interest rate cycle.

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

The discussion about Modern Monetary Theory is inconvenient because it brings into the public eye what governments and central banks have been doing all along. It is very convenient to sport a façade of adherence to the ideal of balanced budgets, spending within your means, low inflation and preservation of purchasing power. However, if we look at the history of government these ideals are rarely realised. Meanwhile, deficit spending, lavish social programs and rising debt ratios are the rule rather than the exception.

“The extraordinary abrupt end to central bank hiking cycle + Fed paranoia of credit event is uber-bullish credit & uber-bearish volatility,” strategists including Michael Hartnett wrote.

While negative yields on paper suggest that investors lose money just by holding the obligations, bond buyers could also be looking at price gains if growth stalls and inflation stays low. But along the way, risk assets may be entering the danger zone.

“We’ve never seen monetary easing so long, so broad, so big,” said Brian Singer, head of dynamic allocation strategies at William Blair, a Chicago-based fund manager that oversees $70 billion overall. “What’s happened after every significant period of accommodation is a reckoning. This time the bubble is lower-rated credit and illiquid private assets.”

There is always an argument about the efficacy of an inverted yield curve as a lead indicator. It was exactly the same back in 2005 when the yield curve first became inverted. There were calls that this occasion is different because of the bull market in commodities, the rise of China and the strength of the housing market all of which proved to be fallacious.

"When investors hear yield curve inversion, they automatically think 'recession.' That’s because every recession since 1962 has been preceded by an inversion. But, not every inversion has been followed by a recession, so keep that in mind."

Myth number two is that we are into the late part of the business cycle. If that is true why are the late cycle stocks acting so poorly? I have argued that the economic downturn was so severe, and the recovery so muted, that what we have done is elongate the mid-cycle. This implies there is much more time until the mid-cycle ends and the late cycle begins.

Myth number three has it that earnings are going to fall off a cliff. I do not believe it. Certainly earnings momentum has slowed, but earnings continue to look pretty good to me. And, if the earnings estimates for the S&P 500 are anywhere near the mark, the SPX is trading at 16.3x this year’s earnings and 15.5x the 2020 estimate. I think with 2Q19 earnings myth number three will evaporate.

As for Friday’s stock market action, readers of these missives should have found last week’s action as no surprise. I have talked about the negative “polarity flip” that was due to arrive last week for a few weeks. How deep the pullback/pause will be is unknowable, but I have stated I do not think it will be much. It was not only the economic data, and PMIs, that sacked stocks, but as I have repeatedly stated it was also the Mueller Report. The result left the senior index lower by ~460 points and the S&P 500 (SPX/2800.71) resting at the lower end of my support zone of 2800 – 2830.

As a brief aside. I am now the membership chair for the organisation, which is a member of IFTA. If anyone would like to pursue membership, has at least seven years of professional experience using technical analysis, and enjoys a collegiate environment for sharing ideas and methodolgy please reach out. 

The focus of Jeffrey’s Saut’s talk at the conference was to reiterate his view we are in a secular bull market. I felt a lot more comfortable when I went to conferences and was the only person making that call. It is not a majority opinion today but there are definitely more people espousing it.

Money-market traders have proven skeptical in recent years -- and much of the time rightly so -- about just how much the central bank might be able to push rates back up toward more historically normal levels. Officials on Wednesday scaled back from two to zero the number of rate increases they foresee in 2019.

Futures markets, which were already leaning toward a cut this year, have pushed the probability of easing to about 50 percent. For next year, a cut is fully priced in. The turnaround in Fed expectations in recent months has been accompanied by a rebound in stocks, which tumbled in December amid concern about the economy and the prospect of rate hikes.
 

“The Fed got the signal from markets last year as they were crashing and were pretty much devouring the economy,” said Robert Tipp, chief investment strategist at PGIM Fixed Income, which oversees about $716 billion. “A cut this year is possible. This is a good environment for U.S. fixed income,” and the 10-year yield has room to fall, he said.

The big question after the Fed’s about face on raising rates is, are they moving early enough to avoid an economic contraction? The logic is reasonably straight forward. The Fed would not have announced such a major shift in policy unless they were worried about the economic and market outlook. By going on pause and waiting for additional information they are signaling a willingness to listen to what the market is telling them.

“This was definitely a dovish outcome and even a bit of a surprise,” said Ben Emons, managing director of global macro strategy at Medley Global Advisors in New York. “The Fed took out the entire rate hike scenario for this year.”

Reaction in markets confirmed the dovish interpretation. Stocks pared losses, the dollar turned lower and Treasuries rallied. Traders lifted the odds of the Fed cutting rates. In a separate statement Wednesday, the Fed said it would start slowing the shrinking of its balance sheet in May -- dropping the cap on monthly redemptions of Treasury securities from the current $30 billion to $15 billion -- and halt the drawdown altogether at the end of September. After that, the Fed will likely hold the size of the portfolio “roughly constant for a time,” which will allow reserve balances to gradually decline.

Beginning in October, the Fed will roll its maturing holdings of mortgage-backed securities into Treasuries, using a cap of $20 billion per month. The initial investment in new Treasury maturities will “roughly match the maturity composition of Treasury securities outstanding,” the Fed said. The central bank is still deliberating the longer-run composition of its portfolio and said “limited sales of agency MBS might be warranted in the longer run.”

The Fed has cemented its about turn around with today's statements. That confirms a somewhat bearish tilt in their reasoning since the only way a pause can be justified is if growth figures are downgraded.

Chinese investments have become increasingly contentious in the EU. Diplomats in Brussels and influential western European capitals have long worried the 16+1 grouping of China and central and eastern European states, including 11 EU members, is a Trojan horse to divide the bloc. Beijing has denied this suggestion.  EU member states such as Germany and France have pushed for tougher screening criteria for Chinese investments. They want the bloc to develop a more unified strategy amid rising tensions over the security implications of using Chinese technology from companies such as Huawei, the telecoms group. Other countries including Greece and Portugal, where Chinese groups have invested billions of euros since the financial crisis, have adopted a more lenient approach.

I can’t help but think of the adage “a drowning man will clutch at a straw”. Italy’s populist administration has need of both funds for investing in public works and also a desire to snub the federalist ambitions of Northern European creditors. Meanwhile, China has a clear ambition to draw European countries within its sphere of influence in an effort to cement export markets and to weaken the chances of a concerted effort to blunt its expansionism.

The foregoing factors present perceptional problems especially when met with sizable gains in employment that would normally result in rapid household income growth. It is tempting to see rent and OER increases as only the result of higher levels of demand. But despite recent glimmers of meaningful wage growth (mostly in lower wage, lower hours employment sectors) and the longer term reduction in U-3 unemployment to historically low levels, median U.S. household income in 2018, adjusted for inflation, remained less than 4% higher than it was at the turn of this century, 18 years ago (see Figure 13).

So there is something else going on here. As Figure 5 illustrates, the contribution of rent and OER to core CPI inflation hit a historic high of 81% in the summer of 2017. While such contribution moderated some in 2018, it remains the lion’s share of core inflation and is again increasing in proportion.

This begs another question, what would be the level of core inflation without price growth in rent and OER? There was evidence at the end of Q4 2018 that rents declined nationwide on an annual basis for the first time in more than six years, according to the Zillow Group real estate database9.  Now this data, if the trend continues, will take some time to percolate through to the BLS and BEA data - even longer for it to migrate from rents to OER estimates – but if it persists it will clearly result in materially lower inflation data in 2019. Far lower than the FOMC was banking on to support its monetary policy actions of 2018.

I found this to be a very interesting and educative report not least for its breakdown of the composition of CPI figures. The Fed dot plot which will be released on Wednesday, along with its rate decision, is being eagerly anticipated by investors for some perspective of just how dovish the Committee has become.  

As the private equity industry gathers near record sums of assets, institutional investors aim to make big allocations to fewer firms with a wide range of products. Today’s deal creates such a one-stop-shop: it bolsters the credit business of Brookfield, which has traditionally focused on real estate, and provides Oaktree, a specialist in distressed debt, exposure to assets that thrive outside turbulent economic times.

“We had difficulty, up until now, meeting the strict terms of some of those mandates,” Brookfield Chief Executive Officer Bruce Flatt said in a phone interview. “Very few firms in the world are able to do that.”

Oaktree co-Chairman Howard Marks said in the interview that the two firms mesh “culturally and in terms of product lines without competing and overlapping.”

Warren Buffett has been preaching for years about the merits of owning a piece of a business and private equity investors have been listening. Private equity has taken private exactly the same kinds of companies Buffett favours, which are generally those with niche businesses, strong cashflows and low leverage.

The ECB recalibrated its rates guidance today, indicating no rate hike will come this year. With financial markets already pricing in no hike until mid-2020, this does not create additional stimulus. And at the margin, it could even reduce it if investors come to interpret the guidance as meaning the first rate hike will come in 1Q.

What the rates guidance does insure against is an earlier tightening of financial conditions if the economy beats forecasts this year.

The ECB also announced a third round of targeted longer-term refinancing operations (TLTRO). However, the terms are less favorable than the TLTRO II loans. The new maturity will only be two years. Previously, the funds were available for four years. In addition, the cost of borrowing will be indexed to the main refinancing rate. That now stands at 0%. Previously, it could have been as low as the deposit rate, which is currently -0.4%.

In addition, it seems the new loans won’t completely replace the funding provided by the old ones. The next lending operation won’t be launched until September. However, in order to meet regulatory requirements for their net stable funding ratios, banks need to have funding with a maturity of at least one year. That means fresh funds from the ECB won’t be available in June to replace the loans expiring in June of next year.

Even though a big dose of stimulus is absent, we think GDP growth will begin to pick up in any case and that the labor market will continue to tighten.

The ECB made a mistake in caving to political pressure and ending its quantitative easing program. Confidence is a fragile thing and the big mismatch in Target2 balances, with capital accruing in Germany while there is a paucity of capital on the periphery is a clear signal that the market has no faith in the ability of the bloc’s economic expansion to self-sustain without the support of stimulus.

Reserve Bank Governor Philip Lowe noted the withdrawal of foreign buyers in a speech Wednesday as he sought to explain the drivers of Australia’s property slump. The central bank is closely watching the decline, especially as it’s starting to impact household spending and slow the economy.

“Another demand-side factor that has influenced prices is the rise and then decline in demand by non-residents,” said Lowe. “The timing of these shifts in foreign demand has broadly coincided with –- and reinforced –- the shifts in domestic demand.”

While Chinese buyers helped inflate the property bubble, they’re unlikely to return in sufficient numbers to stabilize the market. For one thing, shifting money abroad from China is tougher these days as authorities there are strictly enforcing rules aimed at curbing capital outflows.

There are other domestic factors suggesting prices could keep declining too. Australian banks have turned gun-shy on lending following an inquiry that exposed widespread misconduct in the industry and more homes are coming to the market.

While in Melbourne last April, all anyone wanted to talk about was the impact of the Royal Commission’s inquiry and the price of property. Prices are high relative to incomes and Australia’s private sector debt to GDP is among the highest in the world. With short fixes on mortgage rates and floating rates dominating, the Australian consumer is very interest rate sensitive and has a lot of net worth locked up in property.

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

The long-run average of returns is indeed somewhere between 3.5% and 4%. However, despite the neat mathematics of the 119-year history we know from experience that manias occur and are inevitably followed by bear markets where valuations correct.

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

Is the trade war the primary reason behind lower expectations for earnings in 2019? That’s a big question for the wider market because if the USA and China can come to an accord that will improve confidence which will allow companies to begin to make plans on a sounder footing than they have today. However, there are other important factors that are worth considering.

The European Central Bank took a step closer to injecting fresh stimulus into the weakening euro-area economy as one of its top policy makers said discussions are under way on offering banks new long-term loans.

The comments by Benoit Coeure, the ECB Executive Board member in charge of markets, provided the strongest signal yet that euro-area policy makers are considering another round of funding. He also echoed ECB President Mario Draghi that there must be a monetary policy case for such action.

Central banks around the world are following the Federal Reserve in reining in plans to tighten monetary policy. The ECB itself has already changed its language to warn of downside risks to the outlook, while India’s central bank unexpectedly cut interest rates last week and easing inflation bolstered bets that more reductions could be on the cards.

With the euro-area outlook deteriorating, the ECB is expected to cut its economic growth forecasts at its next meeting in March. That gathering is also at the center of speculation about new loans, known as TLTROS.

With Mario Draghi exiting his position as head of the ECB later this year, a policy hawk is very unlikely to replace him. There is no way the ECB can return to anything approximating normal monetary policy against a background where the banking sector is hobbled by a legacy of Japan-style bad loans which will take years to come to terms with.

The delinquency figure represents a new high in the auto-loan market — more than 1 million more people are behind on auto-loan payments now than at the end of 2010. More people have auto loans now than in 2010, so while the overall rate of delinquency is down, the total number of people who have fallen at least 90 days behind their payments is higher.

The Fed has been tracking the auto-loan industry for more than five years, the economists said in the blog post, and it's not the first time the group has sounded the alarm. In 2017, a quarterly report from the Fed highlighted the near doubling of the rate of delinquencies in subprime auto loans originated by auto-finance companies since 2011, Business Insider's Matt Turner reported.

Turner also reported at the time that Wall Street was expressing concern over the subprime-auto-loan market as well. Meanwhile, Business Insider's Lauren Lyons Cole reported that Americans borrowed more money to buy cars than to attend college between 2016 and 2017.

There are a couple of points that immediately come to mind on reading this article. The first is that the delinquency rate for auto loans is definitely climbing and number of auto loans outstanding has increased substantially.

Faltering demand in Germany has preceded weak industrial data, which raised fears of a continued slowdown in Europe’s largest economy. Industrial production dropped for the fourth straight month in December, and Germany’s economy contracted in the third quarter of 2018 for the first time since 2015.

Standard Chartered analysts warn that the weakness could spread to other parts of Europe, further undermining demand for oil.

German demand makes up a minor fraction of the world’s oil consumption; the country was the 10th largest oil consumer in 2016, accounting for 2% of the global total, according to the U.S. Energy Information Administration. Since China made up 13% of oil consumption as of 2016, a drop in Chinese demand growth would likely have a comparatively larger impact.

Additionally, signs of slowing demand in other parts of Europe haven’t materialized, Mr. Horsnell noted.

Saudi Arabia continues to cut back on supply which buoyed the market today. However, the reasons for this move are not only to support prices but also in response to the slowdown in the global economy which is being led by Europe and China.

“Most people don’t know how much they pay in taxes,” said Bob Kerr, who leads the National Association of Enrolled Agents, a trade group for tax preparers. “But the refund is the wrong
metric to measure it.”

Right or wrong, the drop in expected refunds is creating fear and anger in accountants’ waiting rooms. “Every single person” who walks in is dreading how much they’re going to owe the IRS, said CPA Gail Rosen, who heads the Martinsville, New Jersey, office of WilkinGuttenplan. “They come in and they worry.”

But telling people they paid fewer taxes throughout the year doesn’t help the sticker shock felt by filers who’ve become accustomed to getting a check, not writing one. Only about 5 percent of taxpayers -- about 7.8 million people -- are expected to pay more under the new law. But about 5 million, according to the Government Accountability Office, will find their typical tax refund replaced by a tax liability. “A lot of people are going to be surprised,” Rosen said.

Every politician knows that when it comes to policy, perception is often much more important than substance. If people had been asked whether they would prefer more money every month in lieu of receiving a chunky refund cheque they might not be nursing a surprise now. The reality is many people are likely coming out better off. However, if they had been using the refund as a saving mechanism, instead of saving monthly from their paycheques, this situation is going to feel like a tax hike.

Thank you for mentioning MMT in the service

The most of us agree that applied MMT not necessarily leads to more growth (especially because in the reality part of the government spending is wasted in less than transparent submission processes, bureaucracy and corruption, hence it does not flow 100% into the economy process) but to more debt for future generations

However, it gives a useful framework for investors to better understand our modern world of FIAT currencies. A world in which classic economical doctrine and orthodoxy as I (we) learnt at university (pure monetarism, Fisher Theory and Schumpeterist “creative destruction”) fails to explain the modern world and the political influence

As you point out populism gels perfectly with MMT. And as long as populism is on the rise, we should maybe devote more time to understand MMT and try to profit as investors.

Interesting are the aspects related to the effect of interest rate hikes by the FED which MMT claims are inflationary and not disinflationary because hikes add income to the private sector that holds the government securities. In the same way they claim QT add interest bearing securities to the economy (via the banking system) and are also not disinflationary.

Also interesting is the stress on government spending as a source of Aggregate Demand and not just on the Debt with which this demand is financed. So national debt is the “private sector” asset.

I don’t know if I am a correct but from the perspective of an investor MMT is insofar useful as it opens a new perspective and try to explain markets behavior by looking at what is happening.

For example, from an MMT perspective we should continue have a strong economy as long as government spending is on the rise (i.e. the corporate sector profits and equities are a buy), the USD should weaken the more debt is added and the more the FED tries to stem inflation by hiking rates and engaging in QT (latter is counterintuitive) because it adds income to the system. Likewise, Bonds are a sell because of rising inflation while gold and hard assets are a buy.

Actually, if we look at reality and at countries that control their own currency that involve in profligate fiscal policies, they all tend to have depreciating currencies, high interest rates and a rising national debt. To me Turkey, Argentina, Venezuela come to mind first. However even the US under Trump is moving in this direction. Hence the USD bearishness (the US have still a big advantage though i.e. that they are reserve currency)

On the other end countries with a tight fiscal discipline, that apply QE and ZIRP or NIRP tend to have deflationary economies, zero or negative yields and strong currencies. Examples are Switzerland and the EU (where the leading countries impose deflationary austerity and real deflation on the weakest Union members). Indeed, notwithstanding all the problems in some members of the EU, the EUR has been extremely resilient over the years.

What do you think?

Thank you for this wide ranging and thought-provoking email. I agree with most of the points you make although I believe the reason for the Euro’s stability has to do with a lack of supply rather than inherent strength in the domestic Eurozone economy. The biggest issue right now is there is a clear trend towards profligate spending, fiscal stimulus, deficit spending or however you might wish to describe it. Modern Monetary Theory is the academic rationale for this spending which is being latched onto by politicians. In ages past this was referred to as devaluing the currency to point where it causes a rebellion from the bond market. 

The government will allocate 750 billion-rupee ($10.6 billion) a year for the cash plan for about 120 million farmers and give taxpayers 185 billion rupees of relief in the year to March 2020, Finance Minister Piyush Goyal said in his budget speech in New Delhi on Friday.

In the process, the government will widen its fiscal deficit targets for the current financial year and next to 3.4 percent of gross domestic product and borrow more. Bonds and the rupee fell on news of the debt plans, while the tax cuts helped to buoy stocks.

“Ongoing slippage from the government’s budgeted fiscal deficit targets over the past two years, and our expectation that the government will face challenges meeting its target again this coming fiscal year does not bode well for medium term fiscal consolidation,” said Gene Fang, an associate managing director at Moody’s Investors Service. “We view this continued slippage as credit negative for the sovereign.”

Narendra Modi made history by getting an outright majority for the BJP at the last election and was the first person from a low caste to become Prime Minister. The big challenge heading into the election this year will how to hold onto those gains. The answer so far has been to emphasise Hindu nationalism and to boost spending. It was inevitable Modi would try to buy the election and the budget is the clearest signal how much he is willing to spend.

If I am correct, I suspect we will see many Democrat candidates (perhaps all?) adopt MMT as a tenant of their platform. And here is a crazy thought for you - what if Trump beats them to it?

I have long argued that eventually we will hit a period where governments will spend and Central Banks will facilitate their deficits. MMT provides academic justification of where we all know we are headed anyway.

In one of the interviews I watched with Professor Kelton, she said that the idea of deficits being funded with bond issuance is purely a self-imposed limitation. It’s required by law, but in reality, it doesn’t need to be done. The law can be changed. The government could simply spend $100 while only taking in $90 and directly writing cheques against the Federal Reserve to pay for the $10.

Think about how inflationary this will be! But isn’t that the whole goal?

I have always chuckled at the idea that governments were powerless to create inflation. If they want to create inflation - they can. There just needs to be the political will. And it looks like that will has finally arrived.

Left-wing politicians in the USA are jockeying for who can announce the largest tax on the “super-rich”. Last week the media were discussing an upper band of 70%, today Bernie Sanders is suggesting a 77% tax and the re-imposition of a heavy estate tax on fortunes over $3.5million. Meanwhile more and more politicians are adopting President Trump’s mantra that deficits don’t matter.

Your copy on global pay-out ride is coming back to earth is timely. The well-regarded fund manager Neil Woodford has given Imperial Brands a significant 8% asset allocation in his flagship income fund. Imperial pays a hefty dividend, growing at 10% rate. It generates good cash, but has huge BBB+ debt outstanding. It has come down quite a bit from its peak, but it’s valued at 17 times earning which may roll back to the 10 times earnings it had around 2000. Is there a case for holding Imperial Brands as primary source for dividends for the long run? I wonder if you could review some good dividend paying companies, net cash global companies with strong balance sheets, that will not get caught in the pending investment grade bond crunch. Thanks!

Thank you for this question which I’m sure is something a number of subscribers are pondering. More than half of all investment grade bonds are rated BBB and approximately $600 billion are up for refinancing this year. Against a background of tightening liquidity conditions that represents a risk some companies are going to have issues sourcing funding at the highly attractive rates which have been on offer for the last decade.
 

With the economy threatened by trade tensions, European politics and temporary factors such as a slump in German car production, “we’ll probably have to wait until the June meeting before the dust has settled,” said Carsten Brzeski, an economist at ING. “However, it will require a very benign outcome on all these risk factors to see Draghi hiking rates before he leaves office.”

UBS Group AG President Axel Weber, a former ECB policy maker and Bundesbank president, said at the World Economic Forum in Davos this week that the ECB has already missed its chance to normalize policy in this cycle.

Mario Draghi is unlikely to raise rates during his tenure at the ECB and his successors are going to have equally grim prospects of returning to normal monetary policy

London home asking prices fell to their weakest level in 3 1/2-years in January as sellers spooked by
Brexit held off putting their properties up for sale.

Asking prices in the capital slipped 1.5 percent from December to 593,972 pounds ($765,000), the lowest level since August 2015, according to Rightmove. New listings in the first two weeks of the year were 10 percent lower than in 2018 as owners were deterred by the cost of moving and concern about the political backdrop, the property website said.

After years of outsize gains in home values, London and its surrounding areas have so far borne the brunt of Brexit, with a lack of clarity over the future relationship with Europe causing both households and firms to hold off on investment decisions.

Listing prices in the capital have declined from a peak of almost 650,000 pounds in May 2016, the month before Britons voted to leave the European Union.

Nationally, values rose 0.4 percent to 298,734 pounds, with the biggest gains in the north of England. Rightmove’s data is compiled from 70,068 properties put on sale by agents across the country from Dec. 9 to Jan. 12.

A separate report by Acadata, which incorporates all house transactions, showed national home prices rose 0.6 percent in the year to December. Excluding London and the south east, values climbed 1.4 percent.

There was another news story today on how Citadel Investment Management’s CEO Ken Griffin paid, a discounted £95 million, for 3 Carlton Gardens which is about half a mile of open park land from Buckingham Palace.

I’ve been discussing the rise of populism, for two years, as a revolt against the status quo which is leading to a lurch to the fringes of political opinion. The clarion call for people everywhere demanding change is “What about me?” The only way governments know how to placate disaffected people is to give them more money. That is why we have seen so many countries pursuing fiscal stimulus/deficit spending measures.

China has offered to go on a six-year buying spree to ramp up imports from the U.S., in a move that would reconfigure the relationship between the world’s two largest economies, according to officials familiar with the negotiations.

By increasing annual goods imports from the U.S. by a combined value of more than $1 trillion, China would seek to reduce its trade surplus -- which last year stood at $323 billion -- to zero by 2024, one of the people said. The officials asked not to be named as the discussions aren’t public.

The offer, made during talks in Beijing earlier this month, was met with skepticism by U.S. negotiators who nonetheless asked the Chinese to do even better, demanding that the imbalance be cleared in the next two years, the people said.

Economists who’ve studied the trade relationship argue it would be hard to eliminate the gap, which they say is sustained in large part by U.S. demand for Chinese products.

On the face of it this is good news because it at least suggests the USA and China are engaging in productive discussions and some initiatives to end of the impasse are being discussed. The stock market continues to unwind the overextension relative to the trend mean as it prices in optimism that a deal with be struck.

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

The markets have quickly turned from giving credence to the Fed’s prognostication that they would raise rates as many as two times this year to pricing in none and a cut in 2020. However, it is also worth considering that for the moment, at least, the market is pricing in one cut not a succession of cuts. The extent of the decline seen to date, therefore, has been to price out any net positive from the tax cuts; netting off trade frictions now to the earlier, and possibly temporary, bump to consumer demand.

Remember back a half-dozen years ago when all the hedgies were bearish and David Tepper came out and said something to the effect of; “if the economy weakens, then the Fed will ease and stocks go up. If the economy strengthens, then stocks will go up because earnings will be rising. Therefore I am buying.”

Well, I think it’s almost the exact opposite situation today. If the economy strengthens then Powell will hike and stocks will fall from the liquidity withdrawal. If the economy weakens, then Powell has shown he is loathe to come to the market’s rescue and he will be slow to lower rates.

I don’t think you need to overthink this. The Fed has tightened into either a slowdown, or a recession. The market sniffed it out, but the Fed ignored the signals for a bit and made the sell-off worse. Now the market is in the process of correcting that overreaction by rallying.

But don’t forget that Powell has absolutely no stomach for frothy financial markets, so beware getting too excited about the Fed’s recent dovish talk. This is not Yellen or Bernanke’s Fed. Powell has a different set of beliefs, and although he has succumbed to market pressures for the moment, it won’t take much for the old tone-deaf Powell to return.

Powell reiterated his view today in expressing the Fed’s patience with interest rate hikes but committing to continued balance sheet run-off. The market has already priced in the opinion the Fed will not raise rates again and will probably be cutting rates in 2020.

Before Xmas I forwarded an article by EPB Macro Economics who assessed that the Fed had already tightened too much and that a marked slowing of the economy was inevitable.  The latest EPB report (see attached) highlights that there has already been an inversion in US Treasuries, and that the Fed interest rate cycle has now peaked, but deteriorating economic data will cause more volatility in equity markets.

A link to the full report and a section from it are posted in the Subscriber's Area.

I agree we are late in the cycle and that has been a constant theme in the Subscriber's video for the last 18 months. The inconsistency in the trends on Wall Street, with evidence of completed top formations until proven otherwise is a clear indication that this is a particularly important time to pay attention to liquidity and credit conditions. Here is a section from the report:

A link to the full report and a section from it are posted in the Subscriber's Area. 

The broad global adoption of fiscally stimulative policies is unlikely to be as coordinated as the monetary response to the credit crisis was. The big arbiters of how much liquidity is provided to the global economy and eventually the markets will be in which large countries adopt fiscal stimulus. Germany, China and Brazil are the big additional potential sources of stimulus so it is their political machinations that are most worth watching.

Federal Reserve Chairman Jerome Powell said the central bank can be patient as it assesses risks to a U.S
economy and will adjust policy quickly if needed, but made clear he would not resign if President Donald Trump asked him to step aside.

“With the muted inflation readings that we’ve seen, we will be patient as we watch to see how the economy evolves,” Powell said Friday on a panel with his predecessors Janet Yellen and Ben Bernanke at the American Economic Association’s annual meeting in Atlanta.

“We will be prepared to adjust policy quickly and flexibly and to use all of our tools to support the economy should that be appropriate to keep the expansion on track,” he said, adding “there is no pre-set path for policy.”

The financial markets have been busying pricing out the potential for additional rate hikes this year in the aftermath of the last Fed meeting. That was a clear message to policy makers that they were making a mistake in signaling a willingness to persist in raising rates and running off the balance sheet concurrently.

The above statement begins to suggests the Fed is alert to the message being sent by the markets. The stock market responded positively to this change of emphasis by Powell and rallied to countermand yesterday’s weakness; reinvigorating the reversionary rally hypothesis.  

The above statement begins to suggests the Fed is alert to the message being sent by the markets. The stock market responded positively to this change of emphasis by Powell and rallied to countermand yesterday’s weakness; reinvigorating the reversionary rally hypothesis.  

Merry Christmas to you and your family. Thank you for all the hard work you have put in 2018 to produce such a valuable service. I'm sure that the Euro's travails are the last thing on your subscribers' minds this festive season but this YouTube video may be of interest to the Collective. It is a lecture given in fluent English) by German economist Dr. Oliver Hartwich last July, entitled 'Target 2 and the Euro Crisis'. He explains this arcane subject with great clarity and humour. 

Thank you for your kind words and this enlightening video which as you say offers a very useful exposition of the internal transfer mechanism that makes up the Euro. The simply fact is that the Euro was designed to be the currency of a pan European federal super state and has the transfer mechanisms appropriate for that objective without it in fact existing.

U.S. credit spreads widened to the highest levels since the summer of 2016 as funds saw outflows even as major American equity indexes posted a second day of gains.

Investment-grade bond spreads widened 2 basis points to 152 basis points on Thursday. The index has widened every day since Dec. 14 and most trading sessions this quarter

The junk bond index also rose Thursday, although the move was less pronounced. The index widened 1 basis point to 531 basis points, the highest level since Aug. 4, 2016. It’s risen 113 basis points this month
 

Investment-grade funds saw outflows of $4.4 billion for the week ended Dec. 26, the most since December 2015, according to Lipper. Junk bond funds registered the biggest outflows since October.

The stock market is short-term oversold and we have evidence of a short covering rally that began on the 26th. However, credit markets have not been the subject of bargain hunting and spreads continue to widen.

For all of the previously described reasons, the period that we are now in looks a lot like 1937.

Tightenings never work perfectly, so downturns follow.  They are more difficult to reverse in the late stage of the long-term debt cycle because the abilities of central banks to lower interest rates and buy and push up financial assets are then limited.  When they can’t do that anymore, there is the end of the long-term debt cycle.  The proximity to the end can be measured by a) the proximity of interest rates to zero and b) the amount of remaining capacity of central banks to print money and buy assets and the capacity of these assets to rise in price.  

The limitation in the ability to print money and make purchases typically comes about when a) asset prices rise to levels that lower the expected returns of these assets relative to the expected return of cash, b) central banks have bought such a large percentage of what there was to sell that buying more is difficult, or c) political obstacles stand in the way of buying more.  We call the power of central banks to stimulate money and credit growth in these ways “the amount of fuel in the tank.” Right now, the world’s major central banks have the least fuel in their tanks since the late 1930s so are now in the later stages of the long-term debt cycle.  Because the key turning points in the long-term debt cycle come along so infrequently (once in a lifetime), they are typically not well understood and take people by surprise.  For a more complete explanation of the archetypical long-term debt cycle, see Part 1 of “Principles for Navigating Big Debt Crises” (link).

So, it appears to me that we are in the late stages of both the short-term and long-term debt cycles.  In other words, a) we are in the late-cycle phase of the short-term debt cycle when profit and earnings growth are still strong and the tightening of credit is causing asset prices to decline, and b) we are in the late-cycle phase of the long-term debt cycle when asset prices and economies are sensitive to tightenings and when central banks don’t have much power to ease credit.

Both the Dow Jones Industrials and the S&P500 posted large upside key day reversals yesterday to signal lows of at least near-term significance. Neither followed through on the upside today but they did hold the moves. Considering just how much they fell since early this month there is certainly scope for a rebound but the true test of whether more than near-term support has been found will be in the extent to which they hold their lows.

I understand the problem about reducing the FED balance sheet and raising rates at the same time.

The impact on liquidity is however less intuitive to me. While the effect of interest rate hikes is clearer, the effect of a Balance Sheet reduction is less so.

Am I wrong to assume that what technically happens when the FED reduces i.e. sell bonds is that the private sector, through the banking system, receives these bonds? In exchange banks reduce the account balance that they hold at FED.

If banks get Treasuries in their book, they also receive more interest income (coupons) that goes into the system. This money was blocked in the book of the FED until then.

Why is this necessary bad?

Thanks for this question which I’m sure others have an interest in. Since the financial crisis banks have been paid interest on the excess reserves, they hold at the Fed. Against an uncertain environment in the real world they therefore had an incentive to park vast sums at the Fed. In return they received interest income on that money in line with the Fed’s Funds rate. 

Here are the Key Takeaways from today's FOMC events:

The FOMC hiked rates a fourth time this year to a decade high, ignoring President Trump’s criticism, and lowered its outlook to two hikes from three next year.

Powell specifically endorsed the dots, citing them in his press conference as a guideline for the committee and a useful tool.

The committee tweaked its guidance to ``some further gradual increases’’ -- a more hawkish development compared with the alternative of dropping the guidance.

Powell said all meetings are live for possible moves next year, but gave no strong hints as to when the Fed would raise next.

There was unanimous support for the hike.

Powell said that Trump's comments had no impact on policy and that the Fed is committed to doing what it thinks is best.

Powell said financial conditions caused a slight downgrade in 2019 forecasts but no real change in the outlook.

Markets took FOMC and Powell as hawkish, with the yield curve flattening and stocks falling.

The dot plots suggest two interest rate hikes next year but Jay Powell basically said they are going to be data dependent next year. The one thing that stood out to me from the press conference was that no one asked questions about the pace of balance sheet run off. That says a lot.

It’s also important to note that the natural tendency in a growing economy, absent any tax changes, is for revenue to rise. Real revenue dropped in 2016, but that was because of the mini- recession that had started the year before. Revenue has risen during every other year of the current recovery. This year the economy is growing at what may turn out to be the fastest pace since the 2000s, around 3 percent, yet revenue is down. Some of that economic growth is surely due to the tax cuts and to this year’s spending increases, but it’s clear that the Tax Cuts and Jobs Act has so far displayed none of the magical revenue-increasing properties that some of its supporters claimed for it last year. If we take last year’s revenue growth of 1.1 percent as the — very conservative — baseline, it would seem instead to have so far resulted in a revenue decline of 3.5 percent, or $109 billion.

Federal spending, meanwhile, is up an inflation-adjusted 2.9 percent so far this year. That’s bigger than the revenue decrease but smaller than last year’s 3.5 percent increase. Overall, my read of the two charts above is that the overall shift since 2015 from shrinking deficits to rising ones has been mainly about rising spending, but the increase in the deficit this year has been mainly about the tax cuts.

It is generally accepted that counter cyclical policies are the most appropriate for any economy. You loosen when the going is tough and tighten when the going is good and that is expected to keep growth relatively steady with less aggressive peak to trough swings.

Still, the central bank said 1.5 percent growth was a level that would help the country close a gap with euro-area peers. It expects consumers to drive growth next year thanks to a rise in spending power, supported by tax cuts.

“French growth should remain above its average of recent years: That is still a rather favorable economic situation,” Villeroy said.

The central bank’s forecasts do not take into account Macron’s planned tax cuts. But it said the measures could also support consumer spending next year.

In the Les Echos interview, Villeroy also commented on the European Central Bank’s decision to end its net asset purchases. He said a “gradual normalization” of policy is justified by euro-area figures, but the central bank remains flexible in uncertain times and has powerful instruments available.

Countries on the periphery of the EU got the message loud and clear that the EU has one set of rules for large countries and quite another for small countries when depositors were bailed-in during Cyprus’s troubles but were rescued when Banca di Monte Paschi di Siena was going under.

The yield curve spread has been in the news lately and with good reason considering how much of a move we have seen in the last week and because it has such an impressive record as a lead indicator for future recessions. With volatility on stock market increasing and perhaps more importantly some stress becoming evident in the credit markets I think it is timely to spend some time to do a thorough review of lead indicators for future recessions.

Few months ago, Jerome Powell, the Fed Chairman expressed the desire to smooth out past wild swings in the economy by fine-tuning its monetary policy.  Those are not mere words, but the Fed is already putting it into practice.  Note the statements made by the various Fed members. 

In the past, after the election, the Fed would slam the brakes to clean out the excesses.  After the Mid-term election, it would start to stimulate the economy.  Hence, the “Four-Year Cycle”.  The Fed has been tapping on the brakes instead of slamming them.  Hence, the slowing in the economy.  Many, however, are jumping to the conclusion that a recession will take place next year.

The Fed’s new goal is not easy to achieve, but if successful, the U.S. will experience a period of unparallel prosperity and the stock market will continue to climb to heights no one ever believe possible.

Despite its importance, few paid attention to Powell’s announcement.

One of David’s clearest lessons is monetary policy beats most other factors most of the time. Last year I was writing about the fact that the Fed was asking for trouble by planning to reduce the size of the balance sheet and raise interest rates concurrently. They have delivered a medium-term correction in stocks the big question now is what’s next?

As you have repeatedly mentioned in recent audios, we are at a very interesting time in markets. The coming weeks may potentially offer us a guide as to whether markets are pricing in a recession in late 2019/2020 or whether this maybe further delayed by the Fed and the US administration setting a looser policy tone sooner rather than later.

As David has always urged “don’t fight the Fed”.

Being away from my desk enjoying the delights of the Caribbean, I have taken the time to re-read your most illuminating book Crowd Money which you published back in 2013 and I read back in 2014 (again in the Sunny Caribbean).

I have to mention that a good many of your observations have come to pass and my holdings in a number of Autonomies who are also Dividend Aristocrats have been a core holding of my balanced personal portfolio. I have noted with interest the recent late cycle outperformance of these holdings compared to previously sexy growth stocks.

I would recommend to the collective to take the opportunity to read or re-read Crowd Money at a time when market strategy is in flux.

You have also made reference to the possibility of GE corporate debt being downgraded to junk. I attach a link to the UK Investment Manager M&G ‘Bond Vigilantes’ website and their comments relating to the US corporate debt market and with specific reference to GE’s strategy to deleverage and preserve their IG status.

Hope this is of interest.

Thanks for the link your kind words and I agree there is nothing quite like a good dose of sun in December. It is enormously gratifying that you are enjoying Crowd Money. I’m working on another book to try and put the emerging state of flux in context but it’s a hard slog. I’m reviewing late cycle phenomena in the following piece so I would like to focus on the credit market.

Here is a section from the article:

The Fallen Angel figure, of course, could balloon if one of these Angels happens to be a company with a large capital structure. One of the businesses that has lost its public single-A rating lately is US industrial giant General Electric – the 87th biggest company within the S&P 500 index, holding c. $50bn of notional debt – the majority of which could enter the HY market if multiple notches of downgrades occur. How immediate is this risk for investors?

GE downgrade fears are still speculative. The company is trying to shore up its cashflow and balance sheet, and may well retain its IG badge after all. Since liquidity, usually investors’ No. 1 concern, seems ample, the company is now focusing on improving its free cash flow and balance sheet structure. Companies at the lower end of the IG spectrum are indeed strongly incentivized to retain their credit ratings as a cut in long-term ratings from BBB- to BB+ materially lifts borrowing costs as some investors are prevented from holding Non-Investment Grade companies.

GE, however, still holds a BBB+ rating with stable outlooks from all three major credit rating agencies, leaving this flagship industrial group still a long way from junk. What will matter over the coming quarters is GE’s new CEO delivering on a promise of accelerated deleveraging, alongside turning around the structurally challenged power division. All of this amidst a backdrop of ongoing Department of Justice and SEC investigations, as well as some shareholder litigation.

“What is the most striking aspect of this move is the extent of it in just two days and how the acceleration came out of nowhere right after a supposed amicable meeting between the U.S. and China,” Peter Boockvar, chief investment officer of Bleakley Financial Group, said in a note. “It’s almost as if the bond market screamed out, ‘It’s too late, the growth slowdown underway can’t be reversed.”’

The curve is flattening because even though cuts have moved on to traders’ radar screen the year after next, the Fed is still expected to lift rates this month and tighten further next year. Inversion has preceded every U.S. recession for the past 60 years.

The spread between the 10-year and the 2-year contracted by another 3 basis points today to take the measure down to 11 basis points. This compression is being delivered by a substantial move in the 10-year and the relative inert trading in the 2-year.

You have mentioned that the graph showing central bank assets is one of the most important. Consequently, I wondered how the fact that they are reducing this tied in with your moderately optimistic views on the stock market. Do you think the US Fed Reserve will continue to reduce its balance sheet given recent market turmoil?

Thank you for this question which I believe is of general interest and is something I have also been pondering. There are two reasons the chart has been contracting since March. The first is because the Federal Reserve is reducing the size of its balance sheet and other central banks are reducing infusions. The second is the strength of the Dollar has flattered the contraction by reducing the relative value of other currencies held on global central bank balance sheets.

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

By this stage subscribers much be wondering why I am posting so many reports that express a bearish view. The simple fact of the matter is I am reposting these reports in an effort to highlight the fact that the last time my inbox was so filled with bearish reports was in the immediate aftermath of the credit crisis.

It seems that the one thing every analyst has learned from the credit crisis is to be hyper alert to any sign of trouble lest they miss out on calling the next big decline. It occurs to me that the investment community is falling into the trap of fighting the last war all over again, even though we are now in uncharted territory in terms of both monetary policy and the quantity of debt outstanding.

FullerTreacyMoney has a very varied group of people as subscribers. Some of you like to receive our views in written form, while others prefer the first-person experience of listening to the audio or watching daily videos.

The Big Picture Long-Term video, posted every Friday, is aimed squarely at anyone who does not have the time to read the daily commentary but wishes to gain some perspective on what we think the long-term outlook holds. However, I think it is also important to have a clear written record for where we lie in terms of the long-term themes we have identified, particularly as short-term market machinations influence perceptions.

Let me first set up the background; I believe we are in a secular bull market that will not peak for at least another decade and potentially twice that. However, it also worth considering that secular bull markets are occasionally punctuated by recessions and medium-term corrections which generally represent buying opportunities.

2018 has represented a loss of uptrend consistency for the S&P500 following a particularly impressive and persistent advance in 2016 and 2017. Many people are therefore asking whether this is a medium-term correction or a top. There is perhaps no more important question so let’s just focus on that for the moment.

Federal Reserve Chairman Jerome Powell said interest rates are “just below” the so-called neutral range, softening previous comments that seemed to suggest a greater distance and spurring speculation central bankers are increasingly open to pausing their series of hikes next year.

Treasuries and stocks rose, as Powell’s “just below” comment tempered remarks he made last month that markets had interpreted to mean that a larger amount of tightening was likely. Speaking at an event on Oct. 3, Powell said that “we may go past neutral. But we’re a long way from neutral at this point, probably.”

In his speech Wednesday to the Economic Club of New York, Powell said the Fed’s benchmark interest rate was “just below the broad range of estimates of the level that would be neutral for the economy -- that is, neither speeding up nor slowing down growth.”

If rates are closer to what policy makers ultimately judge is the neutral level, that could signal the Fed will tighten monetary policy less than previously projected. Eurodollar futures pricing reacted to Powell’s comments, reflecting even firmer expectations that the Fed will hike only once next year.

Investors are on tenterhooks at the prospect of central bank balance sheet unwinding persisting indefinitely. Therefore, they are highly alert to any sign the Fed’s appetite for additional tightening is waning.

Glad you had a good meeting in London the week before last. Would have been there, but still recovering from breaking a femur in June.

Two things that might interest you.

First, from a John Mauldin letter:

Quick anecdote from my time in Frankfurt. I spoke for fund manager Lupus Alpha to approximately 250 pension fund managers, representing most of Germany’s retirement monies. I asked for a show of hands on whether they liked being part of the European Union. Almost everyone raised their hands. I then asked if they thought participating in the euro was a good thing. Probably 80% raised their hands. When asked who doesn’t like the euro, maybe 10% of the hands went up.

Then the money question. I asked if they would be willing to take Italy’s debt and all the debt of every eurozone member and put it on the European Central Bank balance sheet, with caveats about controlling national budgets. Fewer than 20% of the hands went up.

I then engaged the audience further, saying, the last two questions were essentially the same. If you want to keep the euro, you’ll have to do something about the imbalances between the countries and debts. No monetary union in history has ever survived without becoming a fiscal union as well. Even reminding them that failure to do this might cause the euro to break up and bring back the Deutschmark didn’t seem to change many opinions. I reminded them that a Deutschmark would mean a serious recession/depression in Germany as it would raise the price of all German exports by at least 50%. Mercedes and BMWs are expensive enough for Germany’s customers, let alone at a 50% price hike.

This audience should have easily accepted the argument for putting all European debt on the ECB balance sheet. Imagine if I asked the typical German voter, especially those in rural areas. That tells me Europe could have a bumpier future than I thought.

Second, a piece from the FT (as an attachment) about whether property is still a long-term bet for retirement. Conclusion: it's not.

Thanks for all great recent pieces. I really liked the Ray Dalio discussion.

Have a great Christmas.

Thank you for this informative email and I am delighted you are enjoying the Service. The simplest way to summarise the contradiction at the heart of the Eurozone question is “you can’t be half pregnant” The EU is heading towards federalism or it will break up. The status quo is already being challenged and it will continue to be challenged as a long as millions of people endure lower standards of living.

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

US Corporate Profits spent about four years ranging between 2012 and the end of 2016 and then broke out on the upside. The measure is reported in arrears with a one quarter lag so we will not have another reading until the end of this year and that will reflect the third quarter.

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

At The Chart Seminar we talk about how the majority of people predict markets. The simple answer is we tend to predict what we see. Over the course of the last eight weeks a very notable rotation into higher quality companies has been underway. Interest rate sensitive businesses have been the big decliners while those angled towards the consumer, with long records of dividend increases have been the clearest outperformers. Since that is what has been working it is the easiest prognostication to think it will persist.

On the Morgan Stanley research document, you posted on Monday, there was "the most important chart in the world" as you describe it (QE globally). The "6-month rate of change" scale on LHS caught my attention. Recently, this QE tightening "rate of change" has moved upwards. Is this an early sign that CBs are starting to shy away from their QE tightening? If so, this is bullish for an equity market discounting future tightening. Maybe the tea leaves are not clear, but they must be monitored.

Thanks for this email which as you highlight raises the very important question of whether central banks have had enough of tightening after taking $1.5 trillion out of circulation since March.

Veteran subscribers who have been listening to the Long-Term audios/video over the last 18 months will be familiar with my refrain that the rise of populism is not an isolated incident but a symptom of a much wider global change where the centre is breaking.
 
That challenge to the status quo is resulting in demand for an alternative which is leading to an exploring of legitimacy by what once would have been considered fringe elements. The very fact people still consider this a battle between the left and right is a testimonial to how engrained centrism has become in the public discourse and how useless it is today as a narrative for evolving socio-economic conditions.
 
Three points Dalio makes are that he believes the closest parallel to today is 1937, the long-term debt cycle is in its 7th (of 8) innings and that expectations for future returns should be very low going forward. That begs the question what did the market do in 1937 and in the decade subsequently.
 
Incidentally, his Principles for Navigating Big Debt Cycles is available for free download here: https://www.principles.com/big-debt-crises/

China’s debt, both distressed and otherwise, account for a quarter of all securities included in the gauge, which tracks about 660 dollar notes with a par value of at least $500 million. The Asian nation is home to the developing world’s biggest bond market.

The jump in China’s distressed bonds helped fuel an increase in borrowing costs for emerging-market companies to the highest level in more than two years. The impact of the trade war on the Asian nation has compounded pressure on developing assets, already reeling under the strain of higher U.S. interest rates and Treasury yields.

 

In markets with well-developed corporate bond markets we can come to some estimation of what to expect from the default rate. It’s going to be based on history and may or may not be accurate but at least there is some historical context. China is a country with no history of defaults because everyone always got bailed out.

As the high yield market has continued to strengthen, credit spreads have tightened to 381 basis points, which is near a 10-year low (credit spreads measure the extra amount of income required to compensate investors for default risk and are a common gauge for the overall health of the economy).

There are two ways to look at the current level of credit spreads. The first is an optimistic view which would suggests the bond market is not signaling any stress in the economy. Historically, tight credit spreads (smaller premium for default risk) have reflected economy strength and a reassurance that a recession in the near-term was unlikely. In previous recessions, credit spreads have widened prior to equities falling and have therefore been an informative leading indicator for the economy.

On the other hand, it’s easy to see why some investors have a more pessimistic view regarding tight credit spreads. Without lower coupon payments, there is a smaller margin of safety for default risk. In other words, investors aren’t protected as much in the event of a recession. Furthermore, with credit spreads near a 10-year low, it might seem like there is only one way for them to go, which is higher!

US high yields spreads have been inert for 18 months but in that time Treasury yields have risen quite considerably. What that tells us is the yield on junk bonds is also rising and the coupon demanded to attract investor interest is also higher.

The decision to publish the cases, which involved millions of dollars in fines, is seen as a warning that the government is less willing to tolerate what is considered a grey area in the country's capital control rules. Liu Xuezhi, an economist at China's Bank of Communications, said this showed Beijing's crackdown on offshore commercial deals was being extended to individual investors.

"The government regulation on foreign currency is becoming more thorough. They are extending supervision from corporates to individuals," he told The Australian Financial Review.

"The tight control on foreign capital will be maintained for the next one or two years. This would bring an impact to the Chinese investors who are planning to buy properties overseas, including Australia."

Zong Liang, a senior researcher with the Bank of China, said he expected the move to more closely monitor transactions would stay in place for the next five years and weaken the appetite for Chinese investors in Australian property.

China needs to control capital flight if it is to have any hope of navigating a future of lower leverage, higher defaults and modest growth. Chinese people have been most active in getting money out of the country by buying property which is a significant outlay and is coming under increasing scrutiny with potentially worrying repercussions for international property markets.

Regarding your piece yesterday on balancing one's portfolio and finding safety, I would add a somewhat personal view. As I am in the finance industry myself, the restrictions on investing in listed securities is quite a burden and I'm finding traditional buy-to-let investing more and more compelling. It should work reasonably well also as an inflation hedge, since the rent can be adjusted with inflation and the real value of the principal generally moves with inflation. Of course this equation depends on things like whether your area has population growth and the yield curve of your respective currency, but at least in EUR the FIXED financing costs are so ridiculously low that it is hard to see how one can lose money on a say 60-70 percent financing over a 15-20 year horizon. A practical issue is that there is a (modest) amount of work when finding a new tenant, for example. For me, this also provides a nice additional retirement income, since the tenants have paid off the bank loans roughly at the same time as I'm about to leave the workforce, so that the rents become cash flow to me. Just a personal thought here, it may not be the best choice for everyone.

Thank you for this informative email and I agree that the potential for raising rents is an attractive inflation hedge, not least because property prices, as fixed assets, tend to rise with the inflation rate. However, it is also worth considering that property prices have been boosted by quantitative easing and the ridiculously low funding levels that you speak of have been available to everyone for a decade already. The key, as you mention, fixing financing costs, low leverage and attractive capitation rates.

Only once in the past century, in the 1930s, have we had deflation, serious deflation. In 2008–2009 there was cause for concern. The common characteristic of those two incidents was collapse of the financial system.

We can’t expect to prevent all financial excesses and recessions in the future. That is the pattern of history with free markets, financial innovation, and our innate “animal
spirits.”

The lesson, to me, is crystal clear. Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk.

The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the “easy money,” striving for a “little inflation” as a means of forestalling deflation, could, in the end, be what brings it about.

That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.

It has been a very long time since Paul Volcker was the head of the Fed and there has been a distinct change of culture since then. The Fed is now a serial bubble blower and the decision to adopt quantitative easing has created massive excesses in the global economy, which the market is now exploring.

FullerTreacyMoney has a very varied group of people as subscribers. Some of you like to receive our views in written form, while others prefer the first-person experience of listening to the audio or watching daily videos.

The Big Picture Long-Term video, posted every Friday, is aimed squarely at anyone who does not have the time to read the daily commentary but wishes to gain some perspective on what we think the long-term outlook holds. However, I think it is also important to have a clear written record for where we lie in terms of the long-term themes we have identified, particularly as short-term market machinations influence perceptions.

“The main reason is simply that the more a relationship moves to an extreme end of its range, the more likely it becomes that it will begin to move back toward its longer-term average.”

A historically high level of assets in money market funds, which are a home for risk-averse investors, would generally indicate that investors are feeling cautious. But Becker argued that relative to equity fund assets, money markets are actually low.  

Becker said that for asset level data he used the full history offered by Morningstar, which goes back to February 1993, covering 25 years of data. “This suggests that over the last 25 years investors have never felt more confident,” he says. 

In this case, such a move could happen quickly or slowly. It could happen more slowly through changes in allocations of new money (e.g. investors decide to stop putting new 401[k] money into equity mutual funds and start putting it into MMFs). Or it could happen quickly through a sharp decline in the stock market, causing equity funds to and money-market fund assets to get larger relative to equity fund assets.

There is certainly a concern that we are late in the cycle but there is another reason why there is so little cash in money market funds compared with historical totals. They have not been paying any interest so why would anyone invest in them. That’s changing now with more than a few institutions and family offices I talk to moving cash into money market funds.

Yet this is where the bad news comes in. As our special report this week sets out, the rich world in particular is ill-prepared to deal with even a mild recession. That is partly because the policy arsenal is still depleted from fighting the last downturn. In the past half-century, the Fed has typically cut interest rates by five or so percentage points in a downturn. Today it has less than half that room before it reaches zero; the euro zone and Japan have no room at all.

Policymakers have other options, of course. Central banks could use the now-familiar policy of quantitative easing (QE), the purchase of securities with newly created central-bank reserves. The efficacy of QE is debated, but if that does not work, they could try more radical, untested approaches, such as giving money directly to individuals. Governments can boost spending, too. Even countries with large debt burdens can benefit from fiscal stimulus during recessions.

The question is whether using these weapons is politically acceptable. Central banks will enter the next recession with balance-sheets that are already swollen by historical standards—the Fed’s is worth 20% of GDP. Opponents of QE say that it distorts markets and inflates asset bubbles, among other things. No matter that these views are largely misguided; fresh bouts of QE would attract even closer scrutiny than last time. The constraints are particularly tight in the euro zone, where the ECB is limited to buying 33% of any country’s public debt.

We are living today in a world that was previously unimaginable. Negative interest rates have been with us for a decade and about $7 trillion has negative yields. Investors would literally rather pay to own bonds. Meanwhile some of the largest privately held companies continue to attract tens of billions in capital with little prospect of near-term or even medium-term profits. Therefore, I find it hard to fathom why people are so reticent about embracing the possibility that even more drastic action will not be embraced if the current suite of policy tools is exhausted.  

Treasury said in its April report that it is considering expanding the number of countries it examines from 13, with analysts speculating that the number could go as high as 20. Such a move would be a sign of the Trump administration ramping up its use of the currency channel to negotiate better trade deals for the U.S.

Mnuchin has said since July that Treasury is concerned about the yuan’s recent drop. The currency has slid more than 9 percent against the dollar in the last six months, raising speculation that China has been deliberately weakening its currency as tensions with the U.S. escalate.

The Trump administration has pivoted to a more aggressive stance toward China since the president said last month the country is interfering in U.S. elections. Vice President Mike Pence delivered a speech last week in Washington signaling a firmer U.S. push-back against Beijing as trade anxiety weighs on the looming midterm congressional elections.

The US administration imposed 10% tariffs on Chinese imports and the Renminbi dropped by about the same amount. If we are to conclude this is the market being particularly efficient then so be it, but Ockham’s Razor suggests the Chinese administration is managing the currency lower. That might be justified based on the slowing growth trajectory of the economy but the bigger issue is the Renminbi is weakening and that is putting downward pressure on just about all regional currencies.

Thanks to a subscriber for Russell Napier’s latest missive which may be of interest. Here is a section:

The yield on 10-year Treasuries, a benchmark for global borrowing, rose to the highest level since 2011 amid growing optimism about the U.S. economy. The rate on 30-year securities reached a four-year high and the dollar gained.

Improved investor appetite for riskier assets drove the leap in yields, with stocks rising toward records on upbeat news about American jobs and ebbing concern about the fiscal situation in Italy. The jump in yields Wednesday, which pushed them above previous 2018 highs set in May, followed stronger-than-anticipated reports on U.S. services and private payrolls and came after the Federal Reserve lifted interest rates last week.

The government reports payroll figures for September on Friday, and economists forecast a decline in the jobless rate to 3.8 percent. It hasn’t been lower since 1969.

Treasuries are extending a September swoon that was triggered in part by quicker-than-forecast wage growth in employment data released early last month.

“This started overnight with the Italian risk-on trade and the U.S. data today was definitely stronger” than forecast, said Justin Lederer, an interest-rate strategist at Cantor Fitzgerald in New York. “After last month’s payroll, the market started to catch up to the Fed and it’s a continuation of that. There is reason to be believe we can continue to trickle to higher yields.”

The yield on the 10-year borrowing benchmark climbed as much as 7 basis points Wednesday to 3.1343 percent, surpassing the May intraday high of 3.1261 percent. The yield on the 30-year increased as much as 7 basis points to 3.29 percent.

Money-market traders are now pricing in more than two Fed hikes in 2019, seeing about 0.54 percentage point of tightening, approaching policy makers’ projections for three rate increases next year. About two months ago, the market saw just slightly
more than one increase.

The yield curve, which has been on a flattening trend for much of this year, steepened sharply amid Wednesday’s break-out in long-term yields.

The gap between 2- and 10-year yields surged more than 3 basis points to about 28 basis points, reaching its steepest since August.

The yield curve spread popped on the upside today with the yield on the 10-year breaking out. The last 10 basis point rally was between April and May so right now this is an equal sized rally within the downtrend but it will likely be enough to allay fears on an imminent inversion.

FullerTreacyMoney has a very varied group of people as subscribers. Some of you like to receive our views in written form, while others prefer the first-person experience of listening to the audio or watching daily videos.

The Big Picture Long-Term video, posted every Friday, is aimed squarely at anyone who does not have the time to read the daily commentary but wishes to gain some perspective on what we think the long-term outlook holds. However, I think it is also important to have a clear written record for where we lie in terms of the long-term themes we have identified, particularly as short-term market machinations influence perceptions.

Let me first set up the background; I believe we are in a secular bull market that will not peak for at least another decade and potentially twice that. However, it also worth considering that secular bull markets are occasionally punctuated by recessions and medium-term corrections which generally represent buying opportunities. 

For others, Italy’s euroskeptic government is just the embodiment of the populist sentiment taking root across Europe, which could threaten the bloc’s future and weigh on the euro for the months or even years to come.

Borghi, head of Italy’s lower house budget committee and a well-known euroskeptic, said in an interview on Radio Anch’io that “Italy, with its own currency, would be able to resolve its problems.”

“The comments about Italy having its own currency have touched a sore point,” said Jane Foley, head of foreign-exchange strategy at Rabobank International. “While the return of the lira would be almost impossible and hugely inflationary even if it could happen, the fact that the remarks can be read as anti-EMU sentiment are worrisome.”

The response of the market to the Italian government’s decision to splurge on its budget has been predictable and yields broke out to new recovery highs today. Populist rhetoric has been very vocal in saying they are not afraid of the spread but they have not yet had a taste of what higher borrowing costs will mean for the economy.

Mr Di Maio hailed the agreement as a “historic day”. “We made it!,” he said as he emerged from a balcony at Rome’s Palazzo Chigi, where the meeting took place.

“Today we have changed Italy! . . . For the first time the state is on the side of the citizens,” he said as ministers and members of parliament from his party hugged each other on the square outside.

Matteo Salvini, leader of the hard right League, part of the coalition and deputy prime minister alongside Mr Di Maio, also welcomed the agreement on spending, saying he was “fully satisfied with the objectives achieved”, which would include his party’s pledges for tax cuts and a reversal of unpopular pension reforms dating back to 2011.

Mr Tria, who is not affiliated with either party and was installed only after Italian president Sergio Mattarella rejected the coalition’s first choice for finance minister, had been pressing for a deficit number as low as 1.6 per cent of GDP going into the meeting.

A 2019 deficit of 2.4 per cent of GDP would represent a significant fiscal expansion from the 1.6 per cent target for this year agreed by the last centre-left government, and would be three times the 0.8 per cent number previously planned for next year.

Italy’s debt is BBB, which is still investment grade, but the yield trades like it is rated BB which is not investment grade. The populist administration has stated they are not afraid of the spread but one wonders if they have any conception what a downgrade to junk would do to demand for Italian debt. Large pension funds which have been gobbling up Italian debt to capture the higher yield would be forced to sell in the event of a downgrade. Meanwhile the ECB is winding down its purchase program so there will be a hole in demand for the bonds.

Given the lagged and variable impact of monetary policy on economic conditions -- further complicated in the current cycle by the Fed’s balance-sheet unwind -- policy makers will need to navigate with caution when in the proximity of neutral. Fed Chairman Jerome Powell, in his Jackson Hole speech, sounded dual warnings about this: First, he stressed economists’ inability to estimate the neutral level of interest rates in real-time and cautioned against the “mistake of overemphasizing imprecise estimates of the stars”; second, he invoked the Brainard principle, which advocates moving conservatively on policy when the effects of action are unknown.

If growth is moderating toward trend and inflation appears to be centering around policy makers’ objective as the fed funds rate probes neutral territory, a significant portion of the FOMC should be willing to slow -- if not pause -- the pace of interest-rate increases in order to assess economic conditions. Policy makers may not be able to precisely identify the neutral policy rate in real time, but a continual decline in the terminal fed funds rate over the past several tightening cycles (shown below) serves as a cautionary reminder that, as Powell quipped at Jackson Hole, a “smaller dose” of normalization may prove adequate.

The PCE Core inflation gauge, which is the Fed’s preferred measure currently stands at 2%. Chained PCE inflation is at 2.3%. The Fed’s Funds rate is now 2.25% so it is becoming increasingly clear that after 8 rate hikes policy is moving from accommodative to neutral.

Mario Draghi said he sees a “relatively vigorous” pickup in underlying euro-area inflation, signaling
that the European Central Bank is well on track to raise interest rates late next year.

In testimony to the European Parliament, the ECB president said while headline consumer-price growth will only average around 1.7 percent a year through 2020, still below the goal of just under 2 percent, that stable outlook “conceals a slowing contribution from the non-core components” such as energy and food prices.

“Underlying inflation is expected to increase further over the coming months as the tightening labor market is pushing up wage growth,” he said in Brussels on Monday. “Domestic price pressures are strengthening and broadening.”

The euro jumped half a cent on the remark, reaching the highest level since June. It traded at $1.1800 at 3:16 p.m. Frankfurt time. Bunds extended losses and the Stoxx 600 index fell to a session low.

The ECB will end its bond-buying program in December and expects to keep interest rates at record lows at least through the summer of 2019. Policy makers have acknowledged market expectations for a hike around the final quarter of next year.

The ECB has taken on a lot of additional responsibilities since the credit crisis but its one core mandate is to target an inflation rate close to 2%. With inflation rising and the ECB’s quantitative easing program ending the big question is whether the European economy will be able to grow quick enough to absorb inflationary pressures or whether stagflation is more likely?

The market views a 25 basis point Fed rate hike next week as a near certainty, based on fed fund futures. Contracts on Thursday showed more than 45 basis points of total tightening by the end of 2018. Focus is increasingly shifting to the outlook for next year, with investors moving closer to the central bank’s projected path of three rate hikes for 2019.

That won’t be enough to prop up the greenback, according to Noelle Corum, an Atlanta-based portfolio manager in Invesco Ltd.’s fixed-income group. As global growth improves and market participants start to speculate about policy changes from the European Central Bank and Bank of Japan, the dollar’s support from Fed hikes and trade tensions will wear off, she said.

“Going into year-end, we would expect fundamentals will begin to drive markets again, and this will drive the dollar weaker,’’ said Corum, whose group manages $235 billion. She forecasts the greenback will depreciate to $1.20 per euro and weaken to 104 yen per dollar by year-end.

US Treasury yields popping above 3%, not least because of the dearth of demand following the front loading of pension contributions that ended on September 15th, has been a catalyst for both bond and Dollar weakness this week.

According to Bloomberg’s Brian Chappatta, Friday was the last day U.S. corporations could deduct pension contributions at the 2017 corporate tax rate of 35 percent and will now only be eligible for the new 21 percent rate.

There has been considerable debate amongst the fixed-income community regarding the amount of curve flattening that has been the direct result of corporations accelerating their pension contributions. In fact, Brian’s article is named, “The Yield Curve’s Day of Reckoning is Overblown”and is mostly a rebuke of the idea that this factor has been the driving force to the recent flattening.

I don’t agree with all of Brian’s conclusions - but hey - that’s what makes a market!

The U.S. has been flattening at a vicious pace, while most other major bond market curves have been treading water.

The yield curve spread has widened from 20 basis points to 26 over the last week. That is not enough to break the downtrend but it does suggest a moderation in the trend of curve flattening. The transition from being able to write down 35% of pension contributions to 21% is a significant evolution for corporations and it makes sense that they would accelerated contributions to plans ahead of the move. The biggest question is how many people were buying treasuries in sympathy with the view that pension contributions were supporting the market?

There is an increasing number of commentators in Italy that have drawn to the conclusion that the current government (still supported by a vast majority of Italians, ~60% according to latest polls) is determined to leave the Euro area and the EU. I am now convinced about this too.

Since there is no legally viable way of achieving this, the path to be followed will be that of an "accident" on the financial markets: the delivery of the promises of universal income and lower taxation, will push the fiscal deficit to "breaking point", while the ECB (unelected enemy of the people #1) will start withdrawing the bond buying program. 

With the spread uncontrollably high and seized credit (banks are also notorious enemies of the people), the only solution left (so the people will be told) will be the reintroduction of the Lira, overnight. The country will default and withdraw from international markets. Most activities nationalised. 

The motivation for doing this for those currently in power is clear: seizing unrestrained power (forget ideology, or patriotic instincts... those are facades). A country with universal income (assuming that functions) ceases to be a democracy anyway. The sponsor for all this comes from the East.

Interesting (Venezuelan) times ahead. 

The conclusion: don't touch Italian domestic names, not even with a barge pole from far away. 

Thank you for your interpretation of a potential outcome to the introduction of a populist coalition in Italy which I think we can both agree is a doomsday prediction for Italy, the ECB and the nations responsible for funding the central bank. Let’s take the argument back to first principles.

Despite HNA Group Co. having sold more than $17 billion in assets this year, one of its units still missed payments on a $44 million loan this week, illustrating how the once-acquisitive Chinese conglomerate will need to unload more properties and shares to overcome its liquidity challenges.

Signs abound that the selloff will continue: It’s planning to get out of Deutsche Bank AG, seeking a buyer for its container-leasing Seaco business, surrendering eight floors of office space in Hong Kong and selling stakes in various Chinese units, people familiar with the matter have said since last week. What’s more, HNA is said to be dangling billions of dollars in real estate in the U.S., London and China to prospective buyers.

All in all, the company that was once at the forefront of China’s massive global buying binge has more than $17 billion in further asset sales planned, according to a tally by Bloomberg, as HNA tries to shrink back to its aviation roots. But as the missed payments show, there’s plenty of turbulence lying ahead for the conglomerate, which is saddled with one of the biggest piles debt in corporate China.

Chinese investment in US commercial property turned negative for the first time in a decade last month not least because HNA Group is a panicky seller. The fate of the group is tied up with the program for international expansion that characterised the first portion of Xi Jinping’s rule and which has now been reversed in response to a debt load which was getting out of control. 

Although the Balance Sheet factors do not forecast the acute phase of the economic downturn in my setup, that does not mean they were irrelevant. Of course, the bursting of the housing bubble was the spark that ignited the panic in the first place. Moreover, much other evidence (by Mian and Sufi and others) is consistent with the view that household deleveraging contributed both to the initial downturn in spending and to the slowness of the recovery. It may well be that household balance sheets evolve too slowly and smoothly for their effects to be fully accounted for in the type of analysis used in my paper, which tends to emphasize shorter-term fluctuations. But my results do suggest that, in the absence of the panic, the declines in employment, consumption and output in the early stages of the Great Recession would have been significantly less severe.

The panic of 2008 differed from the Great Depression of the 1930s in that the runs on the financial system during the recent episode were on wholesale funding, and occurred electronically, while in the 1930s retail depositors lined up in the streets.  But the overall effect was the same:  A loss of confidence in credit providers caused the supply of credit to plummet, the external finance premium to spike, and the real economy to contract rapidly.  Macroeconomic analysis and forecasting needs to take into account how disruptions to credit markets, in ordinary recessions as well as in financial panics, can damage the real economy.

The lesson policy makers are likely to have learned from the Lehman bankruptcy and the ensuing panic in credit markets is liquidity has to be made available at whatever cost early in order to avoid a worse outcome later.

“We have to sell a lot of Treasury bonds, and we as Americans won’t be able to buy all those Treasury bonds,” Dalio said. That means foreign investors will have to step up. And they probably would, as long as the dollar remains strong.

Otherwise, Treasury’s dollar-denominated interest payments to buyers in China, Europe and Japan will be worth less and less.

But, to Dalio, that’s not going to happen. “The Federal Reserve at that point will have to print more money to make up for the deficit, have to monetize more and that’ll cause a depreciation in the value of the dollar,” he said. Pressed by interviewer Erik Schatzker, he said “you easily could have a 30 percent depreciation in the dollar through that period of time.” For context, the Bloomberg Dollar Spot Index fell 8.5 percent in 2017, and that was considered massive.

It all leads up to this critique of how the U.S. has gone on a borrowing binge in recent years. Remember, the $15.3 trillion Treasury market was the $4.9 trillion Treasury market a decade ago.

“We have the privileged position of being able to borrow in our own currency because we have the world's leading reserve currency. We are risking that by our finances — in other words, borrowing too much.”

Unfunded liabilities are not only a US problem but are something that governments right across the OECD will need to eventually address. Ray Dalio’s view that the rise in populism we are seeing today is a symptom of a wider problem gels with my own. Considering we are seeing this disaffection with the status quo during an economic expansion where unemployment is low, it is likely that the jump to the fringes of the political spectrum will only intensify during a recession.  

The Credit Cycle diagram from Moody's that you had in the long-term video presentation on Friday was very interesting. Is it possible to post it?

Thank you for this request and please find the graphic posted below.

Wage growth in the USA has been volatile to say the least over the last couple of years but broke out to new highs in August. At almost 3% that is likely to contribute to inflationary pressures sooner or later and will form part of the Fed’s decision to continue raising rates.

Apple had completed $200 billion in share buy-backs since 2012. Apple’s cash hoard is so monstrous that six out of the 10 biggest share buy-backs in U.S. history were done by Apple. The $200 billion they’ve bought since 2012 is enough cash to buy all of Verizon, Coca-Cola, or Boeing. Chew on that for a minute.

Now, contemplate this: U.S. companies announced $201.3 billion in stock buybacks and cash takeovers in May 2018 alone. That’s a record monthly amount. Apple represents nearly half of that! Apple recently said it would buy back $100 billion more of its own stock. They didn’t specify when or how long that would take, but that’s about 10% of the market cap, currently at $1 trillion, the first trillion-dollar stock.

The buy-back announcements keep coming:
Broadcom (AVGO) pledged a $12 billion buy-back.
Micron (MU) pledged a $10 billion buy-back.
Facebook (FB) pledged a $9 billion buy-back.
T-Mobile (TMUS) pledged a $7.5 billion buy-back.
Qualcomm (QCOM) just upped the ante on their previous announcement to buy back $8.8 billion. On July 25th, 2018 QCOM said they would buy back $30 billion, more than 30% of the float!

Social media companies led an early pullback on the Nasdaq today as Facebook, Twitter and Alphabet were grilled in Washington. The questions being asked of these companies with regard to how they police their forums and the nature of the advertising being served to consumers/voters is understandably weighing on their performance. It is also leading to headlines along the lines of “technology stocks collapse” which if we look at the Nasdaq is clearly a case of hyperbole.