martedì 13 febbraio 2018

Nomura: "This Was The Moment When Everything Changed"

THE MOMENT WHEN EVERYTHING CHANGED

For the "right" reasons, the market continues to focus on tomorrow's US CPI print, which will act as a referendum on the merit of the fixed-income repricing experienced since the start of December. As stated previously, the list of 'bearish catalysts' for fixed-income is long and illustrious:

above-trend global growth

percolating US inflation and wages (i.e. last week's AHE print)

real-time US fiscal stimulus via tax reform (with further wage implications)

US 'deficit spending' requiring massive Treasury refunding needs in 2018 (running nearly 2x's 2017)

particulars of the aforementioned tax reform, which will disincentivize US mega-corporates from 'parking' offshore cash in UST-instruments and credits, and instead likely force them to pivot to turning net sellers in coming months and years.

In hindsight, the 'tie-breaker' which drove UST 10Y yields out of their multi-month 2.35-2.50 range into this new stratosphere looks to have been the US fiscal stimulus / tax reform plan passing the initial Senate vote on December 2nd, 2017. 

By December 6th, the UST 10Y Term Premium had inflected from 1+ year lows (-62bps) and "hasn't looked back," +45bps to now just -17bps. Why? This was the point where the Fed's post-crisis playbook of "perpetually low nominal rates and flatter curves" was then deemed by the market as potentially "old news." Instead, the market appropriately determined that in light of the economic expansion, the growing likelihood of higher inflation, the coming refunding / supply wave etc that rate volatility now had to move higher, because the bond market was, going-forward, no longer going to be "controlled" entirely by the same "forward guidance" regime of the GFC period….as a new era of interest rate risk was deemed to be upon us.

As such, USD 3m10Y Swaption Vol printed all-time lows on Dec 13th, while the MOVE index (UST volatility) bottomed Dec 14th.


Also on Dec 14th, the Quant Insight "macro regime" model for UST 10Y—essentially the "explainability" of the price of the underlying asset based off the key macro factor factors--peaked at 86% before collapsing all the way down to just 5% "explainable" by January 12th. On Dec 14th, the Nomura FX Volatility Index put in a three year and a half year low ( since +65%). For US equities, the 12m forward PE Ratio peaked Dec 15th. By Dec 18th, Bitcoin also peaked at $18,674 ( since 'melted down' to the current $8465 level). Since Dec 5th (3 days after Senate passage of tax bill), UST 5Y breakevens have rallied 20bps, while Gold has rallied $87 / oz. The US Economic Surprise Index peaked Dec 22nd. I could go on and on….

Point here being that the uber-ambiguous "something has changed in the market" meme that's been going-around is based-upon the underlying change in perception with regard to a bond market that is waking from its slumber due to a new-found Central Bank willingness to normalize policy on account of actual signs of "growth" and "inflation"—ESPECIALLY after being "put over the top" by US fiscal stimulus. The above observations are simply the manifestations of this mentality-shift in the market….qualitative observation into quantitative phenomenon.


How to Manipulate Stocks: Chinese Authorities Step in to Stop the Rout


For proper effect, the directives were purposefully leaked to the media.

The Shanghai Composite Index plunged 10.2% last week, the largest 
weekly drop in two years, and was down 11.4% since January 26. But
it wasn't just last week that things became unglued. The Shenzhen 
Composite Index had plunged 14% since January 24, only about half 
of it last week.

The Spring Festival holiday is coming up this week, and there were 
fears that traders want to unload additional positions ahead of it. There
are other factors lined up against the stock market, including China's 
off-and-on-again crackdown on leverage. So it was time for authorities
to step in and set things right.

Over the weekend the China Securities Regulatory Commission (CSRC)
and other regulators have sent directives to:
Major stockholders, telling them to acquire more shares of companies
listed in mainland China in which they already own large stakes.
Mutual fund firms, telling them to curtail share sales to avoid becoming
net sellers.
Brokerages, telling them to provide to the CSRC trading summaries
from last week along with trading plans and previews for the current week.

For proper effect, so that all players in the market would know that the
Chinese authorities are going to stop the selloff and turn it around, and thus
to encourage more buying by other players, these directives were 
purposefully leaked to the media, including Bloomberg, which reported
it this morning. This served as confirmation what everyone had been
hoping for: That the authorities would not let the market fall prey to market forces.

The directives went out this weekend, but late last week there was already
some heavy lifting going on behind the scenes that wasn't properly leaked.
Bloomberg counted over 110 companies listed in Shanghai and Shenzhen
that had announced that their major shareholders had increased their stakes
in them starting on Friday.

Bloomberg also reported that the Shanghai Stock Exchange had announced
on Friday that it had issued warnings and limited intraday trading to prevent
large sales that might affect market stability.

After all this had gotten out by Monday morning, it was now time to keep
small investors from selling and to encourage them to buy more. The
Shanghai Securities News reported on Monday, according to Bloomberg,
that the China Securities Investment Services Center, which serves smaller
investors, said that major shareholders can boost investor confidence by
purchasing stocks.

Authorities are once again yanking on the levers to keep the market from
backsliding into some sort of price discovery. And it worked. The markets
in China were up on Monday, with the Shanghai Composite rising 0.8%
and the Shenzhen Composite surging 2.6%, which set the tone in Asia.
All major Asian markets showed gains, except in Japan where markets 
were closed due to the National Founding Day, one of the 16 market 
holidays of the year. So they missed out.

And it is calming the waters in the US. Well done. But then, why even
have markets? Why can't Chinese authorities just set the price of each
stock and make it go up at regular intervals, at a rate deemed to be
appropriate by authorities? It would offer true risk-free investing in stocks.
It could become a national wealth builder. The entire world would invest
in such a scheme. Think of the possibilities! And it would be a lot more
efficient than this haphazard guessing-and-manipulation game.

How can the media be so gullible?

S&P 500 Snapshot: More Declines, a Correction, and Market Sell-off

The S&P 500 continued its decline from last Friday, ending the tumultuous week with a loss of 5.16% from last Friday. This week saw a correction on Thursday, 10.16% off its high. The index is 8.82% off its record close.


The U.S. Treasury puts the closing yield on the 10-year note at 2.83%.

Here is a daily chart of the S&P 500. Today's selling puts the volume 62% above its 50-day moving average.


Here's a snapshot of the index going back to December 2008.

A Perspective on Drawdowns

Here's a snapshot of record highs and selloffs since the 2009 trough.


Here is a more conventional log-scale chart with drawdowns highlighted.


Here is a linear scale version of the same chart with the 50- and 200-day moving averages.

A Perspective on Volatility

For a sense of the correlation between the closing price and intraday volatility, the chart below overlays the S&P 500 since 2007 with the intraday price range. We've also included a 20-day moving average to help identify trends in volatility.



Four Rate Hikes in 2018 as US National Debt Will Spike

Chorus gets louder. But no one will be ready for those mortgage rates.

It didn't take long for rate-hike expectations to be jostled further by last week's "monster" two-year budget bill that Congress passed with its usual gyrations, including a government mini-shutdown, and that Trump signed into law on Friday. The bill increases spending caps by $300 billion over the next two years. It includes an additional $165 billion for the Pentagon and $131 billion for non-defense programs.

The bill comes after the tax cuts slashed expected revenues by $1.5 trillion of the next ten years. So pretty soon this is starting to add up.

Going forward, the US gross national debt will likely balloon at a rate of over $1 trillion a year, every year, even during the best of times. It's $20.5 trillion currently [update 3 hours later, after debt ceiling suspended: $20.7 trillion]. It will likely be over $21.5 trillion a year from now – and this when the US economy is expected to boom. Any downturn will cause the debt to spike.
And what will the Fed do?

Four rate hikes this year – that's what Credit Suisse's US economists said in a research note on Monday. Previously, they'd expected three rate hikes for 2018.

"The FOMC has already boosted their growth outlook for 2018 in light of the tax bill passed in December and we anticipate another upward revision to their growth forecast at the March meeting," the economists wrote in the research note, according to Reuters.

"With the economy near (or above) full employment, prudent risk management suggests the Fed ought to accelerate their tightening in response to a large positive demand shock," they said.

In this cycle, the FOMC has raised its target range for the federal funds rate only at meetings that were followed by a press conference. There are four of them this year. This would mean that the Fed would announce a rate hike during each of them.

Credit Suisse added its voice to a growing chorus. Goldman Sachs, back in November and repeated on February 1, said that the strong momentum of the economy, which is boosting wages and inflation, would push the Fed to hike rates four times in 2018. This was before the "monster" budget materialized.

On January 26, also before the budget deal was done, BNP Paribas' chief economist cited stronger growth and inflation prospects for upping their forecast to four rate hikes in 2018.

Other voices too are now talking out loud about four rate hikes. Even at the Fed, the phrase "three or four" rate hikes for 2018 is now no longer taboo.

On February 2. San Francisco Fed President John Williams, who is being considered by the White House as Vice Chair of the Fed's Board of Governors and is a voting member of FOMC this year, told reporters after a speech that the Fed could raise rates three or four times in 2018. "Both of those possibilities are reasonable to think about, at this point, as options," he said.

"The expansion is proceeding at a good pace, unemployment is low, and inflation is finally headed in the right direction again," he said. This too was before the monster budget deal.

Cleveland Fed President Loretta Mester, a voting member this year on the FOMC, said on January 18, before the budget deal was even on the horizon, that the Fed should raise interest rates "three to four" times in both 2018 and 2019. She pointed specifically at the tax cuts.
So let's crunch the numbers for a moment.

If the Fed raises its target range for the federal funds rate four times this year – so to a range of 2.25% to 2.50% in December – and if the still relatively flat yield curve remains relatively flat without steepening, the 10-year Treasury yield would reach about 3.85% by December.

But if the yield curve steepens toward a more normal-ish slope, it would push the 10-year yield somewhere near or above 4.5% by the end of this year. And this would likely cause the 30-year fixed-rate mortgage rate for top-tier borrowers, which is currently at around 4.5%, to rise above 6%, by the end of December.

And if 2019 also sees four rate hikes, those mortgage rates are likely to climb above 7% by the end of 2019. No one is prepared for this. Four rate hikes a year don't sound like much – until it starts adding up.

It was one gigantic party.

US Debt To Hit $30 Trillion In 2028 Under Trump Budget


On Friday, with the US on the verge of another government shutdown and debt ceiling breach (with the agreement reached only after the midnight hour, literally) Moody's warned Trump that he should prepare for a downgrade from the rating agency that refused to join S&P in downgrading the US back in August 2011. The reason: Trump's - and the Republicans and Democrats - aggressive fiscal policies which will sink the US even deeper into crippling debt while widening the budget deficit, resulting in "meaningful fiscal deterioration."
In short: a US downgrade due to Trumponomics appears inevitable. And incidentally, with Friday's 2-year debt ceiling extension, it means that once total US debt resets  - unburdened by the debt ceiling - it will be at or just shy of $21 trillion.
Now, following today's release of the White House budget proposal from the Office of the Management and Budget, Moody's will have even greater motivation to downgrade the US as according to the forecast, total US debt is projected to rise from $20.5 trillion today to an unprecedented $29.9 trillion in 2028.
As the next chart shows, the Trump deficit, which is surely on the optimistic side with its projections, anticipates total US debt rising by over $1 trillion for the next 5 years, until 2022, then gradually declining to only $352BN annual increase in 2028.
The good news, as noted earlier, is that Trump's proposal, which calls for higher spending on military and immigration enforcement and abandons the GOP goal of balancing the budget over decade, is expected to be ignored by Congress. What is unknown is what alternative Congress will come up with, and how much higher the 2028 debt total will end up being.
For now the 10Y does not appear especially concerned, although with a debt-busting recession guaranteed in the next 10 years, it is a virtual certainty that the total debt number in 10 years will be substantially higher than what is projected above.

If 10Y Yields Rise Above 3%, Watch Out Below

Having unveiled its bearish 2018 outlook back in November, one which correctly predicted last week's short-vol implosion, S.G. has been turning increasingly more bearish on all asset classes as time went by: and not just stocks, but also bonds.

In a note to clients from S.G.'s B. R.-Hidden, the strategist writes that "The bear market in rates has started, and with it credit, and eventually emerging markets, should both come under pressure," echoing what Goldman said on Friday: "There has been a regime shift in the market, which implies further increases in yields."

And with S.G. telling clients they can no longer bet on "dormant" inflation to allow the pursuit of yield in virtually all rates products, the bank is advising clients to take "defensive" positions in short-dated debt, inflation-linked notes and Japanese government securities. Such a risk-averse move, will be worth it in the long run, SocGen claims, even if it means sacrificing income now.

"The key for fixed income portfolio investors from here to the summer should be avoiding capital losses. A loss of running yield is an acceptable price to pay."

In terms of geographical preferences, or rather the opposite, S.G. is "most wary of" and least exposed to core European sovereign markets poised for steeper repricing, according to Bloomberg.

Meanwhile, in a separate note from S.G.'s head of global equity strategy, A.n Bokozba, the bank outlines its proprietary risk premium for 27 developed and 23 emerging markets, and concludes that "a 10Y TSY yield of 3% will send the S&P 500 sliding below 2,500."

S.G. also highlights the scenario of a UST yield at 3% and an ERP of between 2.75% and 3%, in which the S&P can remain in a 2,300 to 2,500 range.


Continuing the recent theme of skepticism, S.G. urges clients to "be ready for the end of the goldilocks scenario"

Characterised by ample liquidity, low volatility, low bond yields and low inflation, the 'goldilocks scenario' masked the rich valuations of risk assets (RPIP-Jan 2018). With bond yields rising, we analyse the ability of US equities to absorb higher bond yields. We also look at the implications for asset allocation of higher bond yields and higher volatility."

This brings us to the key question: can the US equity market absorb higher bond yields? In response, the French bank calculates that at 2.8%, the equity risk premium (ERP) is significantly below its 3.9% long-term average. Over the last few months, an improving earnings growth outlook has helped equities absorb bond yields.

S.G. also looks at relative valuations, and notes that US equity has rarely been this expensive on an absolute basis as well as relative to USTs.


Cost of equity (a measure of absolute return from equity, currently at 5.6%) is significantly below its long-term average (8.6%). The US equity risk premium (excess return offered by equities over the risk-free rate, currently at 2.8%) is now below one standard deviation below the long-term average. Historically, investing at such low ERPs has delivered low single-digit annualised return in the subsequent five-year period.

As a result, with the equity risk premium approaching levels last seen during the dotcom era, any further rise in the 10y government bond yield to 3% would put pressure on the equity market to adjust lower. Historically, periods with such low levels of ERP have been led to low returns in subsequent years.

Ultimately, it's all about the equity risk premium:

If the equity risk premium is high (above average), a higher bond yield can be absorbed by the equity market. However, when the equity risk premium is already very low, the equity market's ability to absorb a higher yield is limited. Over the last few months, we have seen higher bond yields, but US equities remained well supported due to an improving earnings profile.


The problem is that even with last week's equity swoon, equities remain very rich; this rich valuation means US equity cannot absorb higher bond yields.

Our risk premium tools allow us to calculate an equilibrium index level for various scenarios of equity risk premiums and bond yields. A higher bond yield means the equity risk premium will decline and the relative valuation of equities becomes richer. dGiven an extremely rich relative equity valuation, a further rise in the bond yield would require equity markets to adjust lower to maintain the same ERP.

S.G.'s bottom line:

with ERP remaining the same, a UST yield of 3% could trigger an equity market correction. Under our base-case scenario, where UST yields rise to 3% (with ERP remaining the same), the S&P 500 falls to ~2500, which is our 2018 year-end target for the S&P 500.

Fasanara Capital: The Vol Feedback Loop Has Reversed; What Comes Next?

What's next? How QE's Positive Feedback Loops Act In Reverse (full pdf)


While the crisis may be over for the time being, a dominoes of cause-effect relationships has been triggered, which leads to a possibly tough Q2/Q3 if volatility persists. The autolytic reaction is now jumpstarted, but will take time to spread across. If this scenario proves right, what may we see from here?
  • ​Volatility (implied and later realized) further spreading to nearby asset classes.
  • Volatility staying sustained, finding a floor well above the previously held line of 9-10 VIX. No return to status quo.​
  • ​Critical slowing down. This is a general property of a system approaching critical transitioning into an alternative stable state, according to professor Marten Scheffer (as described in edge of chaos). The speed with which markets return to new highs, assuming they do, is slower than previous recoveries (Nov16 Trump election, Jun16 Brexit, Jan16 commodity slide, Aug15 Renminbi deval, Oct14 slide, among others).
  • ​Correlation increasing across asset classes. The sneaky Beta to the downside risk which surfaces during times of stress.
  • ​At some point along the way, CTAs and trend-chasing algos will delever portfolios due to the persistence of higher volatility, but not intra-day or daily volatility, as they often rebalance with lower frequency than daily and referencing longer-dated measures of volatility (which has not reacted fully yet, as shown above)
  • Somewhere along the fine line, a second failed Buy-The-Dip (possibly around the 200 days moving average on the S&P) may convince momentum strategies to follow through, beyond pre-defined strikes, and pre-identified weak points / fault lines on order books . After that, CTAs again, and those behavioral Risk Premia funds linked to momentum factor style or volatility factor, or both (multi-factor portfolios), directly or indirectly. Trend-driven investors more generally, including retail, are likely to follow. Those machine learning quant funds that learned to buy-all-dips over recent years may also learn to sell.
  • Finally, Risk Parity funds and other Target Vol vehicles at large, may sell assets, if realized volatility and correlation persist and gets recorded in monthly rebalancings. If we are to believe what we are told these days by RP largest promoters, they will all sell later (Jeff Gundlach may say, ''at a lower price''). Cliff Asness of AQR: ''we have done pretty much no trading in risk parity [these days]''. Bob Prince of Bridgewater described the fund as ''the most boring thing really, it is definitively not driving global asset prices. It just sits there like a turtle''. Technically, if volatility persists, the longer they wait the higher the chance that the rebalancing may reflect redemptions, instead of higher realized volatility.
  • Naturally, ETFs and passive index funds are programmed to follow through, whatever the circumstances, mechanically and unemotionally. Sentiment may further exacerbate the move, as 'noise traders' with incorrect beliefs – in the definition of Richard Thaler – create additional pressure at turning points (page 23 here).
  • Value investors, who in previous occasions came to the rescue and picked up good names, will buy at the margin as  the market falls, providing some counterbalancing flows, with any dry powder left and the little AUM that has not transitioned yet to passive strategies or long bias.
Eventually, it becomes a game of musical chairs. The motto goes: if you need to panic, panic early. Especially true for institutional investors, as the imposition to sell can come for one of two reasons: model-driven, due to an increase in realized volatility, a broken trend,  a flipping correlation... or client-driven, due to redemptions. The earlier of the two.
* * *
The Structure Of The Market Is Combustible
The structure of the market is the key driver of market dynamics in a QE world, above all over-fitting economic narratives: the interaction of Trend/Momentum, Volatility, Correlation. Factors such as Trend and Volatility, disseminated across the industry in the last several years, under the push of QE and NIRP, and created Correlation across 90% of the investment strategies (here), leading to an unstable equilibrium vulnerable to small perturbations. They can now all act in tandem again, but in reverse.
The autolytic reaction needs to be jumpstarted, which is what tiny short vol ETPs may have just done. 

Why Continuing Down This Path Leaves America In A No Win Scenario


According to conventional economic wisdom, economic growth is the increase in an economy to produce goods and services, compared from one period to another.  This view deems that the greater the growth in capacity and utilization of that capacity, the greater the economic growth.  Strangely, what this school of thought fails to account for is the basis of the US consumer economy...the quantity of growth among the US population (aka, consumers)?  Or how a population growing ever more slowly can consume a capacity that (thanks primarily to innovation, technology, and ever cheaper and greater debt) is allowing for ever greater production?
The chart below shows three variables from 1790 to present;
  1. Columns are US debt to GDP
  2. Black line is annual total US population growth (%)
  3. Yellow line is annual under 65yr/old US population growth (%)
Given the US is a 'nation of immigrants', the US has had a naturally high rate of population growth due to this net inflow of immigrants.  However, annual population growth has consistently decelerated from an annual growth rate of 3.1% in 1790 to just 0.6% in 2017(an 80% deceleration, with all growth now dependent on immigration).  The substitution of more and cheaper debt (likewise corporately and personally) to maintain an unnaturally high rate of economic growth while population growth decelerated is plain.  Also noteworthy is the abandonment of the Bretton Woods agreement in 1971 and the simultaneous shift from net exporter to net importer at progressively higher levels.  ***BTW, the sharp waterfall in population growth in 1918 was tied to the global H1N1 influenza pandemic.
However, gauging potential growth by the under 65yr/old population (yellow line in above chart), the organic basis of growth has nearly ceased (a 95% deceleration).  Why is the lack of under 65yr/old growth important?  Only this population is capable of child birth, this population makes up 90%+ of the work force, and this population (at its peak in earnings from 45 to 55yrs/old) earns and spends double the average 75+yr/old.  It is the under 65 population that utilizes credit while 65+yr/olds are credit averse (for good reason). This is the segment that traditionally drives the economy but is now absent...and ever more and cheaper debt is the sad substitute.

The decelerating population and real wage growth coupled with accelerating trade deficits correlate nicely with the Federal Reserve interest rate cycles since 1981 (chart below tracks the duration in years and % rate from initiation of rate cuts to rate hike completion).  Each cycle has taken the cost of credit lower for longer and the subsequent rate hikes have been slower and shallower.  The implementation of ZIRP, the duration of ZIRP, and the most timid of rate hikes in the most recent cycle speaks to the ongoing deceleration of the growth among consumers alongside the truly dubious state of the American economy.
Concurrent to the implementation of the longer, lower, and slower workout from ZIRP...the Fed essentially sold $0.7 trillion in short duration debt and took on $4.4 trillion in mid and long term Treasury and MBS debt, the federal government drove deficit spending as a % of GDP to unprecedented post-war levels, resulting in a massive increase in federal debt outstanding and debt to GDP.  While the federal deficit (as a % of GDP) has presently been significantly reduced...the Fed's selling of its assets simultaneous to hiking rates with minimal deficit spending is far more than the tenuous post GFC cobbled system can handle.
The US economy (70% driven by consumption) is facing the least population growth and smallest resultant growth in household formation in the nations history (chart below).  An economy so dependent on housing creation to drive its economic activity is now reliant on the migration of rural young adults (and the resultant rural depopulation) into urban centers (in search of opportunity) to maintain the urban growth.
A consumer driven economy with record low savings rates and sporting near record trade deficits will have the least potential organic growth in US history among the consuming population (and I explain HERE why population growth will only continue down).  The red line in the chart below shows the savings rate is back to record lows (what consumers have left to save or invest after expenses) versus record high household net worth (value of all assets; RE, stocks, bonds, etc.) as a percentage of disposable income (all sources of income remaining after taxation).
Now the White House is communicating that over the next decade that GDP will grow at 3% annually versus the sub 2% estimate from the CBO.  The WH assumes (in large part thanks to the recent tax cuts) America will grow at the same rate as the US did in the 1990's when total population growth (growth in consumers) was more than double what it currently is (and will be over the next decade)...but again, nearly all the existing current population growth is among the elderly as the under 65yr/old segment has decelerated to essentially zero.  The chart below shows real GDP versus total population growth and under 65yr/old population growth with White House and CBO future GDP estimates (luckily America has sworn off recessions indefinitely).  As for that "repatriation of overseas cash", Mish does a nice job summarizing why this is likely little more than myth (HERE) and why little to no investment boom is likely.
Lastly, the chart below shows the annual change in gross domestic product after subtracting the annual federal deficit spending essentially included as part of that GDP figure.  The US hit peak growth in 2000, adding a half trillion in economic activity above and beyond the deficit spending incurred that year.  Since then, the wheels have fallen off and economic activity (subtracting the annual deficit incurred) has been spectacularly negative.  Said otherwise, there is no growth but the growth of debt.  And this takes no account of the far larger and more pernicious unfunded liabilities.
The above chart also shows estimates through 2025.  This is based on 2.5% annual GDP growth through 2025 (splitting the difference between WH versus the CBO's sub 2% GDP growth estimates) minus CBO annual deficit estimates.  However, the annual deficit estimates through 2025 show the CBO's baseline from June 2017...prior to the tax cuts and spiking interest payments.  The resultant updated deficits (and declining economic activity absent deficit spending) are likely to be double what is shown in the chart above.  And this assumes no recessions from 2009 through 2025...a period of "growth" unlike the nation has ever seen while the nations populace (consumptive force) grows at the lowest levels.  Even in the happiest of scenarios, America will continue moving backward...while more realistically, America is almost sure to face economic, financial, and social calamity in the near term.  But this is not simply an American problem...it is truly global in its scope (detailed HERE).
Many noted when Trump was elected that his greatest asset may be his knowledge of bankruptcy and reorganization...and the time is coming soon (whether America recognizes this or not quite yet) where this skill set will be put to the test.

This May Be The Beginning Of The Great Financial Reckoning

Less than two weeks ago, the United States Department of Treasury very quietly released its own internal projections for the federal government's budget deficits over the next several years. And the numbers are pretty gruesome.

In order to plug the gaps from its soaring deficits, the Treasury Department expects to borrow nearly $1 trillion this fiscal year.

Then nearly $1.1 trillion next fiscal year.

And up to $1.3 trillion the year after that.

This means that the national debt will exceed $25 trillion by September 30, 2020.

Remember, this isn't some wild conspiracy theory. These are official government projections published by the United States Department of Treasury.

This story alone is monumental– not only does the US owe, by far, the greatest amount of debt ever accumulated by a single nation in human history, but $25 trillion is larger than the debts of every other nation in the world combined.

But there are other themes at work here that are even more important.

For example– how is it remotely possible that the federal government can burn through $1 trillion?

Everything is supposedly totally awesome in the United States. The economy is strong, unemployment is low, tax revenue is at record levels.

It's not like they had to fight a major two front war, save the financial system from an epic crisis, or battle a severe economic depression.

It's just been business as usual. Nothing really out of the ordinary.

And yet they're still losing trillions of dollars.

This is pretty scary when you think about it. What's going to happen to the US federal deficit when there actually IS a financial crisis or major recession?

And none of those possibilities are factored into their projections.

The largest problem of all, though, is that the federal government is going to have a much more difficult time borrowing the money.

For the past several years, the government has always been able to rely on the usual suspects to loan them money and buy up all the debt, namely– the Federal Reserve, the Chinese, and the Japanese.

Those three alone have loaned trillions of dollars to the US government since the end of the financial crisis.

The Federal Reserve in particular, through its "Quantitative Easing" programs, was on an all-out binge, buying up every long-dated Treasury Bond it could find, like some sort of junkie debt addict.

And both Chinese and Japanese holdings of US government debt now exceed $1 trillion each, more than double what they were before the 2008 crisis.

But now each of those three lenders is out of the game.

The Federal Reserve has formally ended its Quantitative Easing program. In other words, the Fed has said it will no longer conjure money out of thin air to buy US government debt.

The Chinese government said point blank last month that they were 'rethinking' their position on US government debt.

And the Japanese have their own problems at home to deal with; they need to scrap together every penny they can find to dump into their own economy.

Official data from the US Treasury Department illustrates this point– both China and Japan have slightly reduced their holdings of US government debt since last summer.

Bottom line, all three of the US government's biggest lenders are no longer buyers of US debt.

There's a pretty obvious conclusion here: interest rates have to rise.

It's a simple issue of supply and demand. The supply of debt is rising. Demand is falling.

This means that the 'price' of debt will decrease, ergo interest rates will rise.

(Think about it like this– with so much supply and lower demand for its debt, the US government will have to pay higher interest rates in order to attract new lenders.)

Make no mistake: higher interest rates will have an enormous impact on just about EVERYTHING.


Many major asset prices tend to fall when interest rates rise.

Rising rates mean that it costs more money for companies to borrow, reducing their leverage and overall profitability. So stock prices typically fall.

It's also important to note that, over the last several years when interest rates were basically ZERO, companies borrowed vast sums of money at almost no cost to buy back their own stock.

They were essentially using record low interest rates to artificially inflate their share prices.

Those days are rapidly coming to an end.

Property prices also tend to do poorly when interest rates rise.

Here's a simplistic example: if you can afford the monthly mortgage payment to buy a $500,000 house when interest rates are 3%, that same monthly payment will only buy a $250,000 house when rates rise to 6%.

Rising rates mean that people won't be able to borrow as much money to buy a home, and this typically causes property prices to fall.

Of course, higher interest rates also mean that the US government will take a major hit.

Remember that the federal government already has to borrow money just to pay interest on the money they've already borrowed.

So as interest rates go up, they'll be paying even more each year in interest payments… which means they'll have to borrow even more money to make those payments, which means they'll be paying even more in interest payments, which means they'll have to borrow even more, etc. etc.

It's a pretty nasty cycle.

Finally, the broader US economy will likely take a hit with rising interest rates.

As discussed many times before, the US economy is based on consumption, not production, and it depends heavily on cheap money (i.e. lower interest rates), and cheap oil, in order to keep growing.

We're already seeing the end of both of those, at least for now.

Both oil prices and interest rates have more than doubled from their lows, and it stands to reason that, at a minimum, interest rates will keep climbing.

So this may very well be the start of the great financial reckoning.

"Crazy Ivan" Fundamentals

During the Cold War, US and Soviet submarines tracked each other across the world's oceans, often following their adversary very closely to avoid detection. The Soviets developed a tactic to determine if they were being followed: a sudden and sharp turn meant to give their sensors a chance to pick up any trailing US subs. It worked well, unless the two boats collided. Which happened more than once.

The Americans had a term for this maneuver: "Crazy Ivan". If you've seen/read "The Hunt for Red October", you heard it before. Here is the history from the Russian side, if you are a fan of military history.


Global equity markets are in the middle of their own Crazy Ivan at the moment, swerving to see if inflation is hiding in their wake. After years of peaceful sailing they now fear, well, everything. More aggressive central banks, rising wage inflation, higher organic volatility, valuations… Everything.

What has struck us most starkly are the dramatically different narratives used to explain – or explain away - the Crazy Ivans of the past week, all using the same term: "Fundamentals". Here are three:
#1. Equity Analyst "Fundamentals"

Anyone who follows corporate earnings in isolation is scratching their head at the recent selloff. From FactSet's most recent Earnings Insight:
Corporate earnings for Q4 2017 looks like they will show 14% growth versus prior year once reporting season is over. This is higher than at the start of the year, when expectations called for 11% growth.
Revenue growth is strong, with 79% of companies reporting top lines that beat estimates. If this holds through the end of the reporting season, it will be a record back to 2008.
Wall Street analysts are increasing their earnings expectations for the remainder of 2018 and looking for very strong earnings growth overall: Q1 (+16.9% comps), Q2 (+18.7%), Q3 (+20.3%), and Q4 (+17.3%). Yes, much of this is due to lower corporate tax rates, but analysts still looking for 10% earnings growth in 2019 after we anniversary that change.
Earnings estimates for 2018 for the S&P 500 have been rising all the way through the market selloff, up from 12.2% on December 31st to 18.5% last Friday.
The bottom up price target for the S&P 500 based on analysts' price targets is now 20% higher than current trading levels. On January 25th, the S&P 500 was trading at just a 6% discount to these targets.

Conclusion: "Equity Analyst Fundamentals" do nothing to explain the selloff, and in fact make it much more worrisome. A falling stock market in the face of good/great earnings news is a sign of a top in both earnings and profit margins. Or, at least, a robust fear of that outcome…
#2. Cross-Asset "Fundamentals"

During equity market dislocations the first thing we do is look at every other capital market to see where else volatility is rising/falling. The next item on the to do list: assess which markets are moving in line with historical patterns, and which have taken on a life of their own.

This approach gets us closer to the truth about how markets are repricing risk. It isn't just the rise in Treasury yields that are flashing yellow. For example:
Options markets. The price of hedging an S&P 500 portfolio, as measured by the CBOE VIX Index, has not fully recovered from its melt-up on Mondayand sits at 29 (one standard deviation from its long run average).
Fed Funds Futures. We have been closing tracking Fed Fund Futures, particularly the odds that the Federal Reserve increases rates 4 times or more this year, rather than most investors' expectations of 3 moves. Futures gave 4 increases (or more) a 28% chance on February 2nd, up from 24% the prior day and 11% at the start of the year. Not a coincidence in our minds: that US stocks began their decline on February 2nd, just as Fed Funds Futures topped a 1:4 chance the Fed would raise rates more than consensus expectations.
Oil markets. Crude markets are complicated, but the price action in the current equity market decline is dead simple: it is awful. Over the long term, oil prices correlate positively to both equity prices and economic growth. The fact that WTI closed below $60/barrel even as stocks rallied isn't a good sign.

Conclusion: flashing warning signs everywhere (not just bonds) that equities aren't out of the woods yet. Volatility remains elevated, Fed Funds Futures still give 4 or more bumps a 17% chance in 2018, and oil prices remain under pressure.
#3. Portfolio Manager Fundamentals

Many portfolio managers see the world through this lens: their job isn't to find assets they like right now – rather, it is to find assets that other PMs will like in the future.

Here is the problem they face using that paradigm in the current environment:
There is a new pattern for both equity and fixed income volatility that is a sharp break from the norms of the past several years. Stock volatility is at multi-year highs; bond volatility is close to one-year highs. Challenge: PMs must decide if last week's price action is the "New normal" or an overreaction after a long run of extreme calm. If it is a blip, they will make their year by buying this week and waiting for others to realize things are fine. If it isn't a blip, they need to sell more of their holdings and wait for a bottom.
If inflation is really staging a comeback, interest rates have to rise further. Challenge: what will other money managers decide is the "Right" level of US equity valuations? We know earnings are rising, but will multiples contract further to offset the risk that long-term interest rates are heading much higher? Many portfolio managers may well choose to sell and wait for the price action to tell them valuations have bottomed.
How will very large asset managers – pension and sovereign wealth funds, for example – choose to reallocate their very large portfolios in the face of rising interest rates and incremental equity volatility? Challenge: this question is the source of much of the capital market's turmoil, and it will not have an answer for a while. In the meantime, portfolio managers will do their best to guess what the really "Big Money" is thinking.

In the end, it is "Portfolio Manager Fundamentals" that set asset prices just now. And since their game is to forecast future sentiment among other asset managers, we don't expect volatility to come down materially until they feel they have a grip on these three questions.

But we will end this section with our own Crazy Ivan thought: "PM Fundamentals" have a short half-life since they are based on sentiment rather than the fact/market based approaches of the other approaches.Portfolio managers may well decide in a few weeks that asset prices have been beaten up enough, and will once again fear that other PMs will start viewing stocks as attractive.