Englander: "If You Take Today's Data Literally, We Are At The End Of The Business Cycle"

If you take today's data literally we are at the end of the business cycle. Core inflation is picking up, the Fed's hand are tied, and demand seems to be slowing. The flattening of the yield curve suggests a inevitable sad ending, with the Fed unwilling and unable to provide stimulus and the US economy inexorably slows down. (For those of you who desperately need silver linings, it looks as the US savings rate is likely to be revised up.)

It is hard to read the inflation numbers as soft, despite all the noise in the components that pushed it up. So investors have to live with the view that price inflation may finally be moving up.

We would argue that the view of an impending business cycle end is wrong. If we are correct that retail sales provides a distorted view of activity then we are more likely to be in a 1994 scenario than a typical end of cycle. We don't expect anything like the Fed hawkishness of 1994, but the key point is that the economy did well and even equities were pretty stable, despite the rates move. In other words activity and Fed rate hikes can coexist peacefully. If that is the case, the business cycle is not doomed to fail soon. You may want to apply a higher discount factor to future equity earnings but you do not necessarily want to adjust the profits path sharply downward to reflect a cyclical downturn in profitability. In rates terms, the cycle end story is a flattener, the peaceful coexistence of tightening and activity is a steepener.

FX is more complicated -- my conjecture is that higher rates and end of cycle fears would doom USD. Higher rates, but the expansion carries on, is more ambiguous. The typical bond portfolio manager would be on a plane to Pyongyang, if North Korean bonds carried 50bps more risk-adjusted yield than Treasuries. The same logic would suggest that if Treasury yields are rising versus other DM economies, USD should be supported. Currently, I think the near-term USD outcome is clouded by investor concerns on fiscal expansion and the durability of the economic pickup. But if activity is sustained and the Fed tightening not so harsh, the current universal USD negative sentiment may be overturned. (I am attending a FX conference in Miami and dollar bulls are as rare as undrunk mararitas.)

Why we are skeptical on retails sales weakness 

Initial prints of retail sales tend to be low. Figure 1 shows three month averages the initial release of control retail and the most up-to-date estimate. (We use three month averages to smooth the data and make the differences more visible.) 

We suspect the weather played a big role in the retail sales weakness. Much of the US was historically cold in late December and early January. The cold snap began after the December payroll survey and pretty much finished before the January survey (although I think weekly hours may have been affected). Retail sales are based on whole month sales, if no one goes to the mall when it is freezing outside. 

Consider my US counterpart to the Li Keqiang index. It is a geometric average of the overall ISM manufacturing and non-manufacturing indices and the NFIB small business survey. We use both the headline and the employment components so there are six elements of the index. (The characteristic of a geometric index is that each component has the same weight at all points in time. We damp down the impact of the NFIB employment component by adding 100 to the published level.) 

The advantage of surveys is that they look past weather related disruptions, anticipating that things will go back to normal when the weather improves. 

Comparing the 'Englander' activity index with retail sales shows that the survey based indicator is much less erratic, has accelerated sharply and is close to 20 year highs -- all in contrast to the indications from retail sales. 

Arithmetically, the retail data are likely to lead to sharply revised down GDP numbers, although that does not look plausible given the survey data. We would go with the surveys.

Big Reset Looms for Corporate Credit Market

Market still blows off Fed, Treasury selloff, and volatility in stocks.

"Leveraged loans," extended to junk-rated and highly leveraged

companies,are too risky for banks to keep on their books. Banks

sell them to loan mutual funds, or they slice-and-dice them into

structured Collateralized Loan Obligations (CLOs) and

sell them to institutional investors. This way,the banks get 

the rich fees but slough off the risk to investors, such as

asset managers and pension funds.

This has turned into a booming market. Issuance has soared. And

given the pandemic chase for yield, the risk premium that investors

are demanding to buy the highest rated "tranches" of these CLOs has

dropped to the lowest since the Financial Crisis.

Mass Mutual's investment subsidiary, Barings, has packaged leveraged

loans into a $517-million CLO that is sold in "tranches" of different risk levels.

The least risky tranche is rated AAA. Barings is now selling the

AAA-rated tranche to investors priced at a premium of just 99 basis

points (0.99 percentage points) over Libor, according to S&P Capital,

cited by the Financial Times.

Also this week, New York Life is selling the top-rated tranche of a CLO

at a spread of less than 100 basis over Libor. And Palmer Square Asset

Management sold a $510-million CLO at a similar premium over Libor.

In the secondary markets, where the CLOs are trading, red-hot demand

has already pushed spreads below 100 basis points. These are the

lowest risk premiums over Libor since the Financial Crisis.

These floating-rate CLOs are attractive to asset managers in an

environment of rising interest rates. If rates rise further, Libor rises

in tandem, and investors would be protected against rising rates by

the Libor-plus feature of the yields.

Libor has surged in near-parallel with the US three-month Treasury

yield and on Monday reached 1.83%. So the yield of Barings CLO

was 2.82%. While the Libor-plus structure compensates investors

for the risk of rising yields and inflation, it does not compensate 

investors for credit risk!

These low risk premiums over Libor are part of what constitutes

the "financial conditions" that the Fed has been trying to tighten

by raising its target range for the federal funds rate and by unwinding

QE. It's supposed to make borrowing a little harder and a little more

costly in order to cool off the credit party.

One of the measures that track whether "financial conditions" are

getting "easier" or tighter is the weekly St. Louis Fed Financial

Stress Index. In this index, zero represents "normal." A

negative number indicates that financial conditions are easier

than "normal"; a positive number indicates that they're tighter than

"normal."

The index, which is made up of 18 components – including six

yield spreads, including one based on the 3-month Libor – had

dropped to a historic low of -1.6 on November 3, 2017. Despite

the Fed's rate hikes and the accelerating QE Unwind, it has

since ticked up only a smidgen and remains firmly in negative

territory, at -1.35.

The Financial Stress Index and the two-year Treasury yield usually

move roughly in parallel. But since July 2016, about the time the

Fed stopped flip-flopping on rate hikes, the two-year yield began

rising and more recently spiking, while the Financial Stress Index 

initially fell.

The chart below shows this disconnect between the St. Louis 

Fed's Financial Stress Index (red, left scale) and the two-year

Treasury yield (black, right scale). Note the tiny rise of the red

line over the past few weeks (circled in blue):

The horizontal blue line marks zero of the Financial Stress

Index (left scale). At or above zero is where I — after 

reading the tea leaves — think the Fed would like to

see the index at this point. But the index is far from it.

And the CLOs mentioned above are examples of just how

ebullient corporate credit markets still are at every level.

A similar ebullience is still visible in junk bonds as well.

The corporate credit markets are starting to take into

account the risk of slightly higher inflation – hence the

appetite for these floating-rate CLOs. But the risk

premium over Libor and other risk premiums show

that credit markets are still totally in denial about 

the bigger risk for junk-rated credits: the risk of default.

And this risk of default surges when rates rise and 

financial conditions tighten as these companies have

trouble refinancing their debts when they come due.

But for now, investors are blithely ignoring that they're

in for a big reset.

The chorus for more rate hikes is getting louder. But

no one will be ready for those mortgage rates.

Conspiracy "Fact" - VIX Manipulation Runs The Entire Market

Ever since Simon Potter's 2012 arrival as head of The NYFed's trading desk, the manipulation of VIX (and thus its reflexive levered tail wagging the algo-driven dog of the indices) has been front-and-center day-after-day in the so-called US equity 'market'. Since the introduction of VIX ETFs there has been an almost inexhaustible supply of conspiracy theory coincidental evidence of a mysteriously well-capitalized market participant always willing to step on the neck of any volatility-spike, thus protecting poor market participants from any prospective plunge. While only fringe-blogs have noticed this in the past, now The FT admits that not only was recent volatility in markets exacerbated by VIX ETFs (thus confirming the tail-wagging-dog analogy), and further, the nature of the link between VIX ETFs and VIX Futures (rebalancing) enables frontrunning which serves to reinforce any trend into the close and thus manipulate the markets.

Since Simon Potter's arrival at The NY Fed in 2012... the rather amusing correlation between the collapse in net VIX futures non-commercial spec interest (yes, the traded VIX, which courtesy of the New Normal's relentless synthetic reflexivity has a huge impact on the trillions in underlying assets: think massive leverage) as per the CFTC's weekly commitment of tradersreport, and the arrival of Brian Sack's replacement as head of the NY Fed's trading desk, Simon Potter, the same former UCLA Econ PhD who recently delivered a very ornate speech explaining central bank interactions with financial markets "through the prism of an economist." Now at least we know how said "interactions" look outside of "Market Manipulation for Econ PhD Dummies" and in practice.

So-called VIX-terminations have bcome ubiquitous...

VIXtermination: Vol Banged To Lowest Close Since June 2007

VIXterminated - Fear Collapses By Most In 31 Months

Mickey Mouse Market Pops-n-Drops As Crude Carnage Follows VIXtermination

Volumeless VIXtermination Fuels Stock-Buying Frenzy To Record Highs

Biggest Short Squeeze Since 2008 Bank Bailout And Epic VIX Rigging Sends Stocks Green For The Week

Which all look - to some extent - like this...

VIX ETFs were screwed with...

To ensure S&P closed Green!!!

And notice the noise in VIX from this week...

But, this ability to exaggerate the upside of any momentum, has its downside.

As The FT reports, the upsurge in stock market turmoil during August was exacerbated by specialised exchange traded funds that track volatility and use leverage to magnify investor returns,according to some analysts.

Some analysts argue that the magnitude of the move in the Vix was fuelled by certain types of ETFs, and similar exchange traded notes, that track the index but use futures contracts to multiply investor's returns.

There is rising concern over the bigger role played by passive or systematic trading strategies in equity markets — given the current uncertain global economic and financial backdrop — with some fund managers arguing that their techniques are aggravating market movements.

Four products, two run by ProShares and two run by VelocityShares, totalling $2.8bn in assets, bought close to 35,000 Vix futures contracts on August 24, according to calculations from public data by Macro Risk Advisors, a broker dealer. Total trading volume in the futures contracts that day reached 569,000.

Which explains the unprecedented record net longs in VIX Futures...

Speculative traders have never - ever - been this net long VIX futures... and traders have not been this net short S&P futures since Summer 2012.

It's all great when VIX is getting smashed lower - and implicitly stocks surged higher - but it appears the only "volatility" that gets any real attention is "downside" moves...

"It exacerbated the move higher in the Vix, and has contributed to high volatility in the Vix itself," said Pravit Chintawongvanich, a strategist at MRA. "Volatility of Vix at one point reached 2008 levels. The effect of levered ETFs is one reason that the Vix is less useful as a barometer of financial stress than in the past."

BlackRock, the largest mutual fund in the world, has previously warned about the risks of levered ETFs, and in a policy paper in July reiterated recommendations, "that these products not use the ETF label".

And the manipulation is simple and cost-effective...

Futures contracts only require a small amount of money, or "margin", to be paid up front to cover potential losses, rather than having to pay the full amount of the investment, allowing an ETF to buy a larger value of futures contracts than investors have paid into the fund.

For example, investing $100 in an ETF offering twice the returns of the Vix futures index will mean the ETF provider buys $200 worth of futures. If the price goes up 10 per cent then the investor receives 20 per cent back, or $20. The investment is now worth $120 and the ETF is worth $220, so at the end of the day it has to go out and buy another $20 worth of futures contracts to maintain the same leverage for the next day.

But here is the potential for froint-running and manipulation (especially from a deep-pocketed vol seller)...

It requires ETF providers to buy as prices rise and sell as prices fall, which critics claim exacerbates market movements, filtering back into the closely-related options markets that the Vix is priced from.

But providers of levered volatility products played down the relationship.

"There is a layer of separation between the Vix and Vix futures, and the ability to uncover any effect is challenging," said Scott Weiner, head of ETP quantitative strategy at Janus Capital, which own VelocityShares. "It's a small impact, if at all."

The CBOE, which runs the Vix index, said that it allows investors, including ETFs, to agree trades during the day where the price is determined by the settlement price of a contract once the market closes, allowing ETFs to rebalance without having a significant impact on the price... and critics say this does not work...

because the amount ETFs need to rebalance each day is publicly disclosed. "If people know someone has to buy in large size at the end of the day, then they will simply buy the contracts ahead of them," said Mr Chintawongvanich. "It has the same effect."

So, whether by direct manipulation (sparking the most modest of momentum knowing that VIX ETF rebalancing into the close will extend any move), or learned rigging by the algos(following the same pattern), it appears yet another conspiracy theory become conspiracy fact.

* * *

But there is a silver lining to the recent smashing of fingers trapped trying to pick up pennies in front of steamroller...it appears The VIX Manipulation has begun to lose its mojo...

A 1.5 vol crush in VIX managed a mere 6 point rise in the S&P 500 (20% of what would have been expected!!)

Warning: The Fed will "Let Stocks Go.", but not now.....

The Fed will "let the stock market go." As I've outlined multiple times, if the Fed has to choose between supporting the bond bubble or supporting stocks, it will choose bonds Every. Single. Time. The fact is that in a debt-saturated world such as the one we live in today, if stocks collapse, investors and Wall Street get angry. If bonds collapse, entire countries go bust.

Cue NY Fed President Bill Dudley last week:

Judging by remarks this week from policy makers, who were unmoved by rising yields and the losses in stocks, the Powell Fed isn't rushing to signal that tendency. New York Fed President William Dudley on Thursday called the stock selloff "small potatoes" and said it has no economic implications.

Source: Bloomberg

This is Bill Dudley talking… the guy who was pushing for more QE non-stop and who routinely appeared to verbally "prop up" the markets anytime they took a nose-dive from 2008-2016.

And now he's calling last week's sell-off "small potatoes." And he's ALSO saying that the Fed believes the markets could dive without impacting the economy in any significant way.

Renaissance Tumbles Despite Correctly Predicting Market Correction

Things have sure been strange in the world of hedge funds lately.

Take Bridgewater, whose founder on January 23 was mocking cautious investors everywhere saying "we are in this Goldilocks period right now. Inflation isn't a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax laws. If you're holding cash, you're going to feel pretty stupid."

It has since emerged that during this exact time, Bridgewater was building - and continues to build - a massive short position against European corporations which is now fast approaching $15 billion and includes such giants as Deutsche Bank, Siemens and Total.Meanwhile, after warning that the "we'll probably have a much bigger shakeout coming"over the weekend, on Monday a contrite Ray Dalio admitted that he was wrong to mock thosehodling cash, and explained the reason for his bearishness - and hypocrisy - stating in a LinkedIn post that everything "had changed" in the ten days since the Payrolls report, with inflation suddenly a far greater risk.

Of course, that does not explain why Bridgewater was already bearish and was alreadybuilding what is shaping up to be the hedge fund's largest thematic short in history.

End result: the world's largest hedge fund made a substantial paper profit on the short side thanks to its multi billion European short (that's the only short the fund is required to disclose, so one can only speculate where else it may be shorting).

Now take that "other" hedge fund, quant giant Renaissance Technologies (also known as the "Puppetmaster Behind The US Presidential Election"). Unlike a mocking Dalio, in January, RenTec's head of risk control, Ed Hubner, penned a letter issuing a red alert to investors in RenTec's public-facing Institutional Equities Fund, RIEF, warning them to brace for "possible market turbulence" and the "significant risk" of a correction, and that while accelerating global growth, corporate tax reform and a business-friendly administration in the U.S. have contributed to market gains, "it's not clear these factors justify current valuations, especially in light of sovereign debt levels."

Further, in a surprisingly accurate preview of things to come just days later, Hubner warned that "the downward technical pressure on the VIX, due to the growth of strategies that bet against market volatility, and lower correlations within the S&P 500, shouldn't be confused with unshakable economic calm."

On Monday 5, the day of the volocaust, the world understood precisely what he meant.

And yet, while RenTec was dispensing with warnings, it refused to put its - and its investors' money - where its mouth was. In fact, as Bloomberg reports, the hedge fund that in January warned clients of a "significant risk" of a correction, lost 5.4% this month through Feb. 9, as a result of the correction it correctly predicted would happen.

Since Jan. 1, the Renaissance Institutional Equities Fund is down 3.4 percent, according to an investor document seen by Bloomberg News. Known as RIEF, the strategy trades only U.S.-listed equities and is biased toward stocks that Renaissance's models expect to rise. It's designed to outperform the S&P 500 Index by 4 to 6 percentage points and managed about $22 billion as of the end of last year.

So to summarize: Bridgewater mocks market skeptics as it covertly builds a major short bet, and then - to much fanfare - announces that its bullishness was misplaced, and that the business cycle is much further along that it had expected... meanwhile RenTec warns there is a "significant risk" of a market correction, that market correction hits just days later, and the result is a major hit for RenTec which, just like Dalio, refused to practice what it was preaching, and immediately suffered the consequences.

Moral of the story: at any and every opportunity, hedge funds will lie to you, and the bigger the hedge fund, the bigger the lie.

The Fed's Impossible Choice, In Three Charts

Critics of "New Age" monetary policy have been predicting that central banks would eventually run out of ways to trick people into borrowing money.

There are at least three reasons to wonder if that time has finally come:

Wage inflation is accelerating

Normally, towards the end of a cycle companies have trouble finding enough workers to keep up with their rising sales. So they start paying new hires more generously. This ignites "wage inflation," which is one of the signals central banks use to decide when to start raising interest rates. The following chart shows a big jump in wages in the second half of 2017. And that's before all those $1,000 bonuses that companies have lately been handing out in response to lower corporate taxes. So it's a safe bet that wage inflation will accelerate during the first half of 2018.

The conclusion: It's time for higher interest rates.

The financial markets are flaking out

The past week was one for the record books, as bonds (both junk and sovereign) and stocks tanked pretty much everywhere while exotic volatility-based funds imploded. It was bad in the US but worse in Asia, where major Chinese markets fell by nearly 10% — an absolutely epic decline for a single week.

Normally (i.e., since the 1990s) this kind of sharp market break would lead the world's central banks to cut interest rates and buy financial assets with newly-created currency. Why? Because after engineering the greatest debt binge in human history, the monetary authorities suspect that even a garden-variety 20% drop in equity prices might destabilize the whole system, and so can't allow that to happen.

The conclusion: Central banks have to cut rates and ramp up asset purchases, and quickly, before things spin out of control.

So – as their critics predicted – central banks are in a box of their own making. If they don't raise rates inflation will start to run wild, but if they don't cut rates the financial markets might collapse, threatening the world as we know it.

There's not enough ammo in any event

Another reason why central banks raise rates is to gain the ability to turn around and cut rates to counter the next downturn.

But in this cycle central banks were so traumatized by the near-death experience of the Great Recession that they hesitated to raise rates even as the recovery stretched into its eighth year and inflation started to revive. The Fed, in fact, is among the small handful of central banks that have raised rates at all. And as the next chart illustrates, it's only done a little. Note that in the previous two cycles, the Fed Funds rate rose to more than 5%, giving the Fed the ability to cut rates aggressively to stimulate new borrowing. But – if the recent stock and bond market turmoil signals an end to this cycle – today's Fed can only cut a couple of percentage points before hitting zero, which won't make much of a dent in the angst that normally dominates the markets' psyche in downturns.

Most other central banks, meanwhile, are still at or below zero. In a global downturn they'll have to go sharply negative.

So here's a scenario for the next few years: Central banks focus on the "real" economy of wages and raw material prices and (soaring) government deficits for a little while longer and either maintain current rates or raise them slightly. This reassures no one, bond yields continue to rise, stock markets grow increasingly volatile, and something – another week like the last one, for instance – happens to force central banks to choose a side.

They of course choose to let inflation run in order to prevent a stock market crash. They cut rates into negative territory around the world and restart or ramp up QE programs.

And it occurs to everyone all at once that negative-yielding paper is a terrible deal compared to real assets that generate positive cash flow (like resource stocks and a handful of other favored sectors like defense) – or sound forms of money like gold and silver that can't be inflated away.

The private sector sells its bonds to the only entities willing to buy them – central banks – forcing the latter to create a tsunami of new currency, which sends fiat currencies on a one-way ride towards their intrinsic value. Gold and silver (and maybe bitcoin) soar as everyone falls in sudden love with safe havens.

And the experiment ends, as it always had to, in chaos.