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DK Analytics, Post #42: If QT keeps ramping up to $600bn, look for an accelerated “reset”

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DK Analytics, Post #42: If QT keeps ramping up to $600bn, look for an accelerated “reset”  7/14/2018

Trade weighted US$: 89.58;  US 10-yr: 2.83%;  S&P 500: 2,801;  Oil: $70.58;  Gold: $1,242;  Silver: $15.84

YOY (year-over-year) change in monetary base as per 7/5/2018: –$84bn

Source: https://fred.stlouisfed.org/series/BASE?utm_source=series_page&utm_medium=related_content&utm_term=related_resources&utm_campaign=categories

 

Growing financing needs juxtaposed against a shrinking Fed balance sheet (“QT”) spell trouble:

 

Sources: https://fred.stlouisfed.org/series/W006RC1Q027SBEA  & https://fred.stlouisfed.org/series/FGEXPND

  • In fact, if the last recession is any guide, and given today’s even more pressing economic and financial concerns, the current federal deficit could easily bloat by $1.25trn.  Washington having to potentially fund a $2.6trn plus annual deficit via new debt (Treasury) offerings would constitute unprecedented supply hitting the bond market.
  • The “Treasury’s” current outstanding debt of $21.2trn has an average weighted maturity of 5.9 years.  Upshot: on top of a rapidly expanding US government deficit, on average about $3.6trn needs to be refinanced annually.
  • An ever-more indebted economy can ill-afford higher interest rates, much less a recession. With total US debt  already expanding at a $2.6trn annual rate and closing in on $69trn, which amounts to 3.4x GDP, a one percentage point (100 BPs) rise in the 10-year Treasury (“benchmark”) yield would reverberate throughout the “debt structure landscape,” starting with the public sector. This is because a substantial portion of outstanding debt in both consumer and corporate loan realms is tied to the benchmark yield plus a risk premium.  As investors seek greater “solvency protection (max time frame),” private sector interest rates will surge thanks to widening risk premiums or “spreads.”  Let us take a “back of the envelope” stab at the implications of a rising benchmark yield:
    • Let’s assume, for the sake of argument, a 5.9-year average maturity for “all US debt” (it may be longer or shorter, given outstanding “Treasury Yield Plus” household loans of shorter durations, shorter and longer corporate liabilities, and 7% homeownership turnover rates superimposed on 15 and 30-year mortgage refis).
    • In such a world, some $11.6trn of refinancing ($68.6trn/5.9 years) would coalesce with an assumed $2.6trn plus in new debt issuance at a higher interest rate.
    • With about 69% of all American debt consisting of non-US government debt (US debt service is supported by a printing press thus is less risky, in nominal terms), a 100 BPs higher Treasury yield could easily result in the cost of much of the other debt (including state, corporate, and household liabilities) rising, in aggregate, at 1.5x – 2.0x the benchmark yield increase, for a “blended rate” increase of some 1.5 percentage points, or 150 BPs.  (Swelling debt growth and a $16trn higher debt load than a decade ago may result in a higher “blended rate,” much as elevated monetary debasement risks may push the Treasury yield higher.)
    • Thus, $11.6trn of refinancing per 100 BP rise in the benchmark rate could easily result in $174bn higher refinancing cost (for outstanding debt) per annum for America.
    • Toss in an additional $111bn in interest expense for $2.6trn in new annual debt issuance, and America could loosely be looking at a $285bn ($111bn + $174bn) annual “step-up” in financing costs that would roll out for some six years assuming solely a 100 BP increase in the benchmark rate combined with annual debt growth.
    • Over six years, that could spell $1.7trn in higher annual financing costs, or 8.5% of current GDP.
    • Talk about cost of funds headwind prior to any interest rate “reversion beyond the mean,” much less interest rates reaching average levels (a 4.6% benchmark yield), which could raise the annual financing cost bogey to $486bn.

A potential annual barrage of $2.6trn plus in new total US debt issuance coupled with $600bn in annual debt securities sales targeted by the Fed amidst a) rising liquidity issues in a budding recession, b) mounting private sector and state-level solvency concerns, and c) a concerted global effort to reduce reliance on the dollar in global trade collectively suggest that a surge of US debt coming to market will overwhelm demand at current yields.  Said differently, higher returns/yields will be sought by investors — likely much higher yields, especially from today’s near-historically low levels.

 

Meanwhile, weaker US economic indicators add another layer of uncertainty:

 

Plus, the 2018 US fall election suggests the Fed could suddenly put back on its political hat:

Under Obama, the Fed raised the fed funds rate only once.  Under Trump, the rate has been hiked six times.  Trump nominated the new Fed chairman, Keynesian Jerome Powell, last November.  Midterm elections are around the corner even as the economy is losing steam amidst rising, and perhaps metastasizing, geopolitical — trade war — risks.  Could this provide the Fed with the perfect rationalization, even prior to a stock market rout, to revisit its rate and QE toolkit (and surely the Fed would seek to re-inflate a key yield starvation offspring, a pricked equity bubble)?  Moreover, the Fed tends to support the party in power, especially if the chairman has been appointed by a sitting president.

 

Conclusion — it is high noon head for a restrictive Fed amidst an “ecosystem” rushing to the ER:

The Fed has effectively been tightening since it started to reduce its monthly QE as of December 2013, only to end its bond purchases completely in October 2014.   Cessation of QE has been augmented by an interest rate tightening cycle since 2016.  Now, despite a) unprecedented and growing governmental, corporate, and household debt mountains, b) huge policy-induced distortions and misallocations, c) drooping productivity, d) very poor real wage growth (most new jobs have been low-paying, non-benefit, part-time in nature), and e) a long-overdue “official” recession, the Fed is desperately trying to raise rates enough to be able to lower them!  In so doing, a government-defined recession will be hastened, and asset bubbles endangered.

That same Fed is also seeking a reduction of its unparalleled balance sheet so that it can again be expanded when necessity dictates it (protecting the balance sheets of its owners, the money center banks) and politics mandate it.  In a nutshell, the Fed appears determined to take away its “cocaine and heroin” and push an economy with the albatross of a toxic public policy stew around its neck (financial repression-enabled statism, cronyism, and redistributionism amidst sustained property rights-shredding, cronyism-abetting regulatory and litigation insanity) over the edge so the Fed “can save it again.” 

If the Fed continues its restrictive trajectory both on the interest rate (fed funds rate) and on the QT/bond sales front, it is virtually assuring that the fabricated and overstated economic recovery will implode even sooner.  That very reality, coupled with the fact that other major central banks, such as the ECB and the BOE, have just commenced shifts to more restrictive monetary policies, suggests that a forced US monetary loosening could well occur just as a (likely fleeting) monetary tightening occurs elsewhere.  An unexpected dollar rout would quickly develop.

Perhaps the yield curve, which is close to inverting, will be our single best guide as to when the Fed needs to “smell the ease ASAP coffee.”  An inverted yield curve is a well-known precursor of a recession, having predicted all nine US recessions since 1955 with a lag time of six months to two years.  Given America’s fragile economy, …

Talk about a perfect revaluation storm — the dollar down, bonds down (pages 8–9), stocks down, and precious metals up — in the making, otherwise also known as a “reset.”

Or, as a brilliant macro analyst from London so precisely retorted during a recent email exchange:

Your author’s comment to the macro analyst:

A German once nailed it about 25 years ago at a Rubbermaid road show in Zurich.  He said to me: “you Americans focus on getting the stock price up, we Germans focus on getting our products right.”

There’s more than a speck of truth to that!

 

That sage analyst’s response:

Agreed.  A good product is the real value.  The rest is just a distraction.

The takeaway: the value of a nation’s currency will ultimately reflect a nation’s competitiveness in the global marketplace.  Bonds are “currency promises.”  And stocks are linked to bonds.  Meanwhile, all price manipulations eventually end, and over the long pull precious metals (PM) protect purchasing power against both the ravages of deflation and inflation.  Call PM a current “double-dip” satellite allocation opportunity.  The likely PM price “uncorking:” a sprightly and unexpected shift from QT back to possibly unparalleled QE by the Fed.  The irony that this would be triggered by a Fed-hastened reset will be hard to miss.  The good news: “Frankenstein Finance” can be capitalized on.   

Sincerely,

Dan Kurz, CFA

www.dkanalytics.com

This commentary is not intended as investment advice or as an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion of the author at the time of writing.  Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities can fall in value.

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DK Analytics, Post #41: Trump, the “real US worker deal” and Hooverism, revisited?

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DK Analytics, Post #41: Trump, the “real US worker deal” and Hooverism, revisited?  7/4/2018

Trade weighted US$: 89.97;  US 10-yr: 2.83%;  S&P 500: 2,713;  Oil: $73.64;  Gold: $1,256;  Silver: $16.08

The good:

“Red state” Americans, yours truly included, are grateful that President Trump is calling out the fake news for what it is: fake — and out to get any powerbrokers that threaten its pervasive media dominance.  Clearly, a media with a revolving-door to bureaucrats has facilitated unprecedented industry consolidation since President Clinton signed the Telecommunications Act of 1996.  The increasingly incestuous, oligopolistic relationship between big government and big business has resulted in a crony press that rivals the Pravda (“truth”) press in the former USSR.  Thus, instead of news and a check on increasingly abusive government power, as the Framers intended, the misnamed “Main Stream Media” (MSM) has been generating propaganda supportive of an increasingly fascist regime, i.e., the US government.

Billionaire real estate and successful entertainment tycoon Donald Trump refused to become part of today’s MSM quid pro quo.  He didn’t have to, nor did he want to.  Instead, he took his “America First” (including bringing jobs back home) message to “flyover country” via the Internet/his Twitter account and as supplemented by his frequent, rousing, and well-attended speeches.  Critically, he was also backed by the one largely anti-leftist entity in the MSM, ratings dominating Fox News, which has long resonated with “red state” Americans.  Thus, the battle lines were drawn.  An all-out MSM backlash against this nonconformist ensued, and “news” morphed even more completely into statist, anti-Trump propaganda, a.k,a., fake news.  It wasn’t only fabricated stories, one-sided allegations or quotes taken out of context, but utter and complete suppression by the vast majority of the MSM of lawless behavior by those positioned at the top echelons of federal power during the prior administration as well as unconstitutional behavior being carried forward into the current administration and into the 115th US Congress.

The Trump administration, however compromised, appears to be making a largely clandestine effort (via sealed indictments) to smoke out the “deep state” (the unelected bureaucracy and its hangers-on both inside and outside the government) lawlessness that it has been a victim of.  Any success here, no matter how unlikely given the de facto “broad daylight conspiracy” — criminal decision makers keeping quiet buttressed by their staffs wanting to maintain the huge bureaucracy’s unconstitutional power, their outsized compensation, and their privileged benefits status quo — would be monumental.  Such an achievement could spark a rule of law revival, arresting our B.R. trajectory. Meanwhile, a strategic return to greater constitutional fidelity is getting a sorely needed lift by Trump’s fine judge/justice selections!

 

The bad:

Trump’s integrity.  Is it there, when it counts, beyond his stellar judge selections and beyond the fact that he isn’t an “unindicted felon,” i.e., Hillary Clinton?  This isn’t an idle concern, for integrity begets and nourishes credibility, which is critical to a president’s “bully pulpit” efficacy in “troubled times.”  Some worrisome signs include:

 

The ugly:

A potential Trump trade war is a huge risk to both the US and the global economy, but the US is especially vulnerable.  This is due to America’s largely self-inflicted manufacturing enfeeblement, its huge net dependence on foreign goods (just go to WalMart’s non-grocery aisles) and foreign financing, and its dependence on continued widespread overseas acceptance of dollar-based trade, … despite America’s $7.9trn net debtor status vis-à-vis the rest of the world, over $21trn in US debt, and the US’s decade-long $1trn plus average yearly expansion in federal debt.  Some reflections:

  • Is Trump going the Hoover route (dangerous “interventionism” and an escalating trade war)? Hoover was a leading industrialist before he became president.  Are we about to revisit this dark chapter in history?
  • A nation that has an $800bn plus annual deficit in goods trade and has lost a vital portion of its manufacturing base can ill afford to start a trade war, from consumers’ or producers’ perspectives. It needs component parts that are often made only overseas nowadays (think the “787” or US-assembled cars) to produce high-value added finished products for domestic consumption and for exports, much less give it the ability to restore a domestic supplier base and address destructive corporate governance and compensation (more below).
  • Tariffs are taxes on Americans that the feds collect – we thought Trump was about shrinking government?
  • Protectionism (tariffs) is the worst form of cronyism: domestic steel and aluminum shareholders and their “Wilbur Ross cronies” will do fine, but domestic manufacturers of Maytag washers, Ford trucks, Harley Davidson motorcycles, GE locomotives, CAT dozers, Carrier chillers, etc. (and their workforces) will be negatively impacted or worse (bankruptcy). This is thanks to the resulting uncompetitive materials costs and/or retail prices that are out of consumers’ reach both domestically and in export markets, where outfits such as Harley will face a one-two punch of higher domestic steel and aluminum prices and tit-for-tat import tariffs for US made bikes.
  • Trump should solely be talking up lowering tariffs globally — e.g., seeking Mexico’s zero tariffs to 44 nations.
  • As is widely known, our top brass corporate compensation structure (CEO compensation was some 20x the average worker in 1965 and 271x in 2016), including $7m CEO signing bonuses and relatively rapid vesting of untold millions of underpriced options, coupled with litigation and regulatory insanity have come together to yield a “slash & burn” business model. In today’s world, the C-Suite a) no longer has parallel strategic organic growth interests (p. 5) with American workers, taxpayers, and communities, b) is incentivized to cut/gut domestic cap ex instead of investing, and c) is motivated to outsource and fire domestically instead of hiring and training American workers.  Today’s senior management is rewarded for slashing costs while buying back stock with both cash flow and by issuing trillions in new debt to give EPS a “financial engineering lift.”  The C-Suite focus: drive up the stock price ASAP instead of focusing on building globally competitive products, which is an unending effort.  As such, “corporate anorexia“ has become the destructive norm.  Coupled with lacking trade schools, a failing education system, and perpetually large government deficits, these are the true flies in the ointment!

Unfortunately, such truths don’t make for great soundbites, but they remain truths.  Plus, other high-wage workforces (with generally better paid workers than in the US) operating in generally strong currency nations — e.g., Switzerland, Germany, and, for a long time, Japan — have generated sustained and substantial trade surpluses of recent vintage that sometimes extended for decades, and typically included surpluses with China.

Commensurately, those that blame high US wages or a strong buck as “America’s chief culprits” are just not getting the big picture right, much less how to best address it: with “brick-by-brick” home-grown solutions (for largely home-made problems) instead of with misleading, silly, and patronizing claims of having (virtually) instantly “made America great again!”  Moreover, reputational integrity does matter when a president is attempting to make constructive deals for his country.  Yes, Virginia, both policy and integrity (character) matter.

 

Allocation conclusion:

If, against all odds, the rule of law is restored in the US and the lawless actors infesting the governing class/controlling the instrumentalities of power are brought to justice, the profound  and breath-takingly stunning “gravity of it all” would rapidly turn greed into fear in terms of so-called “traditional asset” valuations.  In other words, sales would drive risk premiums much higher and net present values much lower, pricking today’s “bubble valuations.”

In the meantime, the US government’s reckless, deficitary fiscal policy would be even more exposed in a GDP-pummeling trade war — we are already way overdue for a recession amidst a historically weak, waning-productivity, debt-encumbered, artificial recovery.  Huge US commitments, political calculations, and a fiat currency — “The US can pay any debt …, it just can’t guarantee purchasing power” — could result in unprecedented amounts of dollar printing.  It appears to be more a question of “when” rather than “if.”  This suggests that the buck will be sacrificed in a tactical attempt to protect money center bank balance sheets (and the Fed itself) from “valuation meltdowns” and to meet “nominal dollar commitments” of a strategic nature.  Monetization of debt would become permanent and be expanded upon.  How does one spell “doubling-down on currency debasement?”  Against this backdrop, it is hard to imagine a secularly more bullish case for undervalued precious metals — and a more opportune time to reduce exposure to massively overvalued bonds and stocks.  (And please recall, markets are “reversion beyond the mean machines!”)

Finally, it is fitting indeed, on Independence Day, that we celebrate America’s historical blueprints — The Declaration of Independence, which led to the first-ever strict enumeration of governmental powers and codification of individual liberty and inalienable rights, otherwise known as the US Constitution, including the Bill of Rights.  How appropriate that Americans, and proponents of codified freedom around the globe, still have the unique opportunity to fortify their financial fortunes with the very “constitutional money” that could prove pivotal in the challenging times ahead in terms of supporting their families and in terms of helping to rebuild a return to free market capitalism and constitutionalism.  An increasing number of originalist/constitutional judges should be of strategic help.  Thank you, Mr. President.

Sincerely,

Dan Kurz, CFA

www.dkanalytics.com

This commentary is not intended as investment advice or as an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion of the author at the time of writing.  Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities can fall in value.

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