"The World Is A Safe Place... And No One Hedges Anymore"

A major geopolitical event takes place and stocks (and risky assets) surge while bonds (and safe havens) slide...

As former fund manager Richard Breslow says in his latest letter, "I see it and, unfortunately, it's all too familiar not to be believed."

Via Bloomberg,

The world is a safe place, it is being put about, as traders reassess the dangers from the Middle East and every other global hot spot. Friday night was spent watching and wondering about missiles, sanctions and retaliation. The weekend was full of verbal clashes with a strong dose of one and done messaging mixed in. And on Monday morning, European stocks were being led higher by the travel and leisure sector. So much for an abundance of caution.

This recurring pattern inevitably leads to the tedious discussion of what haven assets are or aren't doing in response. The answer is nothing. It is a noble but futile exercise to try to explain events by finding something that has moved a bit and imparting some greater meaning to it other than randomness.

Safe havens are hedges. And we all know, no one hedges anymore. It just hasn't proven to be worth the cost. Being lectured by yet another central bank, as the chorus was joined by the Reserve Bank of Australia in their latest Financial Stability Review, doesn't help. Or change anyone's behavior.

Investors realize that monetary authorities are just as deeply into these trades as they are. And the current zeitgeist built up over the entirety of the post-financial crisis world expects policy-makers to be the ones responsible for keeping the balls in the air. No pain, no gain became gain with no pain. It has been just too great a strategy to call the bluff of those advising caution.

EUR/CHF, a haven fave, has been trending the last two months, no matter the news. The problem is the direction has been up.

Yen and gold have run out of steam. The dangerous game of thinking emerging markets will be insulated from global risks has been a push but requires a lot of things to go right.

History isn't on the side of this being a sleep well at night position should rates rise or growth slow, let alone trade falter.

Just selling the dollar sounds great, but hasn't worked since the end of January. But the position continues to grow. Good luck with that.

About the only hedge, other than doing nothing, that has been consistently working is the flattening yield curve.

Famous last words, perhaps, but it feels like at this point it is risk additive, not reducing. Credit has had a nice little run of late, but February and March should have been teensy reminders that spreads don't always go in the same direction. Although, to be fair, buying the IG dip at last November's wides proved once again a great trade and technically flawless. So perhaps, I doth protest too much?

I hate to admit it, but I'm quite curious to hear all of the policy speeches on this week's docket. But the latest dot plot update is probably the last thing I want to hear about. 

Missile-Mania Sparks Stock-Buying Bonanza As Yield Curve Tumbles

As a reminder, here's what happened in 2017 when Trump shot missiles at Syria...

And here's what happened this time...

Missiles were dropped...

Correlations broke everywhere today...

 

Trannies were flying today - up 2.4%!!!! but for the major indices, it was all about the overnight action that drove the main thrust of gains...Stocks went nowhere from the European close...

 

Futures show the gap open on Sunday night and retest of Friday's highs...Futures closed the day session around the same levels as they opened on Sunday night..

 

Machines dragged The Dow up to run yesterday's high stops and the 50DMA... but then it rolled over...

 

The S&P 500 managed to clamber back into the green for the year (2673.61) and test its 50DMA...

 

VIX dropped back to a 16 handle...

 

Mixed picture for bank stocks with BofA higher on earnings but still down from Friday's pre-open banking earnings drop...

 

NFLX was lower (ahead of earnings) among the FANGMAN stocks...

 

While stocks loved the missile strikes, bonds did not...

 

Treasuries were mixed on the day...but rallied throughout the US day session

 

But the 30Y rallied from the US open to end the day unchanged...

 

Driving the yield curve back down to its flattest since Oct 2007... (and 2s10s dropped below 45bps)

 

The Dollar Index slipped back below Friday's lows...

 

The Ruble spiked after WaPo headlines claiming Trump has halted Russian sanctions...

 

Cryptos slid on the day but are marginally higher from Friday's close... (with Bitcoin holding around $8,000)

 

The apparent demise of geopolitical fear prompted selling pressure in crude but PMs rallied on a weaker dollar...

 

Another disappointing data for macro data enthusiasts...

Hedge Fund Leverage Plunges Most Since The Financial Crisis

While it may seem like a lifetime ago, it was only in late January that the market was melting up relentlessly with every trading day, as volatility crashed lower and lower to unsustainable single digit levels, sending the S&P into a buying frenzy. It was, as Morgan Stanley pointed out at the time, "euphoria."

Of course, it all ended with a bang on February 5, when the VIX exploded from 15 to around 40, crushing the inverse VIX ETF industry overnight and impoverishing countless volatility sellers.  Commenting on the dramatic shift in market mood, Morgan Stanley's Michael Wilson also said that the S&P 500 P/Es peaked in December, the same day as Bitcoin, one day before the tax bill passed...

... and adds that "this peak in valuation was followed in January by a peak in positioning as both institutional and retail investors piled into stocks at rates we haven't witnessed in years... Back in January when stocks were rising sharply, we heard numerous calls for a "meltup" being made by prognosticators and investors. Of course, that's how tops are made and we think January marked the top for sentiment, if not prices, for the year."

He also noted that with volatility now much higher, "a return to those levels of exuberance is very unlikely."

However there was one particular chart supplied from Morgan Stanley that caught our attention: the gross leverage at Long/Short hedge funds. What it shows is not only the fastest collapse in gross exposure on record, but a pattern that is oddly similar to what happened during the last euphoric surge in mid 2007, which was promptly followed by the great financial crisis.

This confirms what both JPM and BofA have pointed out recently: institutions, and hedge funds, have been tireless sellers of equities in recent weeks.

It is unclear what can prompt hedge funds to reverse their sudden gloom, and lever back up: after all the S&P is still just shy of all time highs. What is clear is that unless corporations ramp up stock buybacks in the coming weeks, no matter how strong earnings season is, the outcome will be very adverse for risk.

Does Fed Balance Sheet "Normalization" Signal The Next Asset Collapse Has Begun?

After nearly a half century of unlimited dollar creation, multiple bubbles and busts...the current asset reflation has been the most spectacular...but alas, perhaps too successful.  The Fed's answer to control or restrain this present reflation is raising interest rates to stem the flow of business activity, lending, and excessive leverage in financial markets.  But in the Fed's post QE world, a massive $2 trillion in private bank excess reserves still waits like a coil under tension, ready to release if it leaves the Federal Reserve.  Thus, the only means to control this centrally created asset bubble is to continuously pay banks higher interest rates (almost like paying the mafia for protection...from the mafia) not to return those dollars to their original owners or put them to work.  With each successive hike, banks are paid another quarter point to take no risk, make no loan, and just get paid billions for literally doing nothing.

The chart below shows the nearly $4.4 trillion Federal Reserve balance sheet, (acquired via QE, red line), nearly $2 trillion in private bank excess reserves (blue line), and the interest rate paid on those excess reserves (black line).  While the Fed's balance sheet has begun the process of "normalization", declining from peak by just over a hundred billion, bank excess reserves have fallen by over $700 billion since QE ended.  So what?

The difference between the Federal Reserve balance sheet and the excess reserves of private banks is simply pure monetization (the yellow line in the chart below).  This is the quantity of dollars that were conjured from nothing to purchase Treasury's and mortgage backed securities from the banks.  But instead of heading to the Fed to be held as excess reserves, went in search of assets, likely leveraged 2x's to 5x's (resulting anywhere from $3 trillion to $7.5+ trillion in new buying power).

From world war II until 1995, equities were closely tied to the disposable personal income of the American citizens (DPI representing total annual national income remaining after all taxation is paid, blue line).  However, since '95 lower and longer interest rate cuts have induced extreme levels of leverage and debt. 

The Fed actions have created progressively larger asset bubbles more divergent from disposable personal income at peak...but falling below DPI during market troughs.  But after the '07 bubble, the pure monetization found its way into the market with spectacular effect.  As the chart below shows, the Wilshire 5000 (representing the market value of all publicly traded US equities, red line) has deviated from the basis of US spending, US total disposable income (the total amount of money left nationally after all taxes are paid, blue line).

In the chart below, the growth in monetization has acted as a very nice leading indicator for equities.  As each successive pump of new money left the Federal Reserve and entered found its way to the market in search of assets, assets subsequently reacted.  Likewise, each drawdown in monetization saw a similar pullback in equities.

What happens next? 

The Federal Reserve plans to systematically reduce its balance sheet via raising interest rates on excess reserves.  This is to incent and richly reward the largest of banks to maintain these trillions at the Federal Reserve.  As the chart below shows, theoretically this means the monetized money is set to continue evaporating, and assuming it was highly levered, then the unwind and volatility of deleveraging should only continue to worsen.

And...if the Federal Reserve is true to its word and even halves its balance sheet while banks maintain the excess reserves at the Fed, then all the digitally conjured $1.5 trillion is set to be "un-conjured".  Again, assuming the monetized monies were at least somewhat levered, the unwind of that leverage will continue to produce a chaotic and volatile slide in markets.  As the chart below suggests, if US equities (and broader assets) follow the unwind of the monetization, then equities are likely on their way back down to and through their natural support line, disposable personal income.  Conversely, I've included the 7.5% long term anticipated market appreciation for reference (green dashed line).  Quite a spread between those differing views on future asset valuations.

Of course, the "data dependent" Fed could change its mind, but perhaps this is something worth thinking about.

Fwd: Graham Summers’ Weekly Market Forecast (The Summer Rally Starts Now)

Stocks are up this morning. The media believes this has something to do with a "relief rally" regarding the fact that conflict in Syria didn't lead to WWIII over the weekend.

It doesn't. The markets knew Syria wouldn't lead to WWIII last week. If we were heading into WWIII why would stocks finish UP over 2% on the week?

In the larger picture, as I've been telling clients for the last three weeks, we are moving into a MAJOR "risk on" move for the financial markets.

In the larger picture, as I've been telling for the last three weeks, we are moving into a MAJOR "risk on" move for the financial markets. The  S&P 500 broke above critical resistance (blue line) late last week. We are now set for a massive summer rally that will see stocks go to new all-time highs.

We often talk about Black Swans, but the markets are currently prepping for a WHITE Swan. That Swan is a massive rally into a Blow Off Top that is commencing now.

Why We May Be Headed For Another "Minsky Moment"

I recently ran across a terrific chart in Grant's Interest Rate Observer that got me thinking about Hyman Minsky and The Financial Instability Hypothesis. After remaining relatively unknown during the course of his lifetime, Minsky really came to fame in the immediate aftermath of the financial crisis as his hypothesis helped to explain what left most economists baffled: the fundamental cause of the crisis.

Clearly, though, he has been forgotten just as quickly because, considering where we stand today, it's obvious the economists with the greatest power to prevent another crisis have still not adopted his insights into their frameworks.

To begin to understand the current situation in Minsky terms we must first understand the hypothesis:

The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.

Next we need to understand what these financing units are:

Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows… Speculative finance units are units that can meet their payment commitments on "income account" on their liabilities, even as they cannot repay the principle out of income cash flows… For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations.

And this is what reminded me of Minsky when I read the recent article in Grant's with the accompanying chart below. It shows the percent of companies in the S&P 500 that would fall into Minsky's "Ponzi unit" category. Specifically, Bianco Research defines these "zombies" as companies whose interest expense is greater than their 3-year average EBIT (earnings before interest and taxes). Currently, we face the greatest percentage of "Ponzi units" in at least 20 years.

This should be worrisome to investors and even more so to those managing monetary policy because it suggests that financial instability within the economy may be greater than any other time over the past couple of decades. Minsky again:

It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system.

Those last three words are critical. "A deviation amplifying system," simply means an economy built on a virtuous cycle that risks evolving into a vicious one. So long as interest rates remain low and investor risk appetites remain strong zombies will thrive and the economy will, as well, relatively speaking of course. However, should interest rates rise and risk appetites reverse course the risk of a self-reinforcing downturn grows. Minsky explains:

In particular… if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.

Interest rates have been rising for nearly two years now and the Fed seems to have turned its attention from cultivating a wealth effect in the economy by supporting asset prices via quantitative easing to reining in inflation by unwinding those policies and raising the Fed Funds rate. In the process, by way of the Minsky Hypothesis, they may end up undoing everything they strove so hard to achieve over the better part of the past decade.

It's not hard to imagine just how vulnerable these zombies might be to rising interest rates and waning risk appetites. Should they be forced into liquidation a resulting collapse in asset values could present a major problems for the economy as there are plenty of reasons to believe the wealth effect may be even more powerful to the downside than it was to the upside. Either way, the threat to the economy posed by the greatest corporate zombie army in history is surely enough to make Minsky roll over in his grave.