He Warns The Fed Is About To Lose Control

In a striking interview with Goldman's Allison Nathan, legendary trader Paul Tudor Jones argues that US inflation is set to accelerate sharply, making bonds a very poor investment, and that the Fed must act swiftly to tackle financial bubbles created by prolonged monetary easing.

Joining such luminaries as Bill Gross and Ray Dalio, who have both claimed the bull market in bonds is over, PTJ joins the choir and warns that "markets disciplined Greece for its budget transgressions; it's just a matter of time before they discipline us" and as a result he sees the 10-year yields rising to 3.75 percent by year-end as a "conservative" target amid the now traditional and widely discussed bogeymen: supply outweighing demand, economic momentum outpacing the monetary policy response, and "glaring" bond valuations. Oh, and central banks ending the party, of course:

Beginning next September, when the ECB concludes its asset purchases, the aggregate balance sheet of the main central banks will start contracting after nearly a decade of expansion. That will be a major data break, making it a horrible time to own bonds.

PTJ also pours cold water on the repeated suggestion that higher yields will lead to more buying from pension funds: "Bond pension buying, for example, is very pro-cyclical. When stock prices rise, pensions reallocate their capital gains from stocks into bonds. As we've seen, this depresses the term premium and fuels more gains in the stock market. If and when the Fed raises rates enough to stop and reverse the stock market rise, that virtuous circle predicated on increasing capital gains will reverse, and bonds and stocks will decline together like they did in the 1970s."

The biggest factor, however, which is preventing PTJ from owning any risk assets is today's unnaturally low rates: "with rates so low, you can't trust asset prices today. And if you can't tell by now, I would steer very clear of bonds."

There is another reason PTJ is not deploying capital: last month's vol shock was just the beginning:

In my view, higher volatility is inevitable. Volatility collapsed after the crisis because of central bank manipulation. That game's over.With inflation pressures now building, we will look back on this low-volatility period as a five standard- deviation event that won't be repeated.

When would Tudor buy stocks? "When would I want to buy stocks? When the deficit is 2%, not 5%, and when real short-term rates are 100bp, not negative"... in other words not for a while.

So what is he buying: "I want to own commodities, hard assets, and cash... The S&P GSCI index is up more than 65% from its trough two years ago. In fact, relative to financial assets, the GSCI is at one of its lowest points in history. That has historically been resolved by commodities putting on a stunner of a show, stoking inflation. I wouldn't be surprised if that happened again."

In other words, PTJ and Gundlach agree on two things: stay away from bonds, and buy commodities.

But the most notable part of the interview, and where PTJ's most apocalyptic sentiment shines through, is his description of where he sees Fed Chair Powell right now: as General Custer before the Battle of Little Big Horn, a battle which - at least in the history books - was lost.

Let me describe to you where I think Jerome Powell is right now as he takes the reins at the Fed. I would liken Powell to General George Custer before the Battle of the Little Bighorn, looking down at an array of menacing warriors. On the left side of the battlefield are the Stocks—the S&P 500s, the Russells, and the NASDAQs—which have grown, relative to the economy, to their largest point not just in US history, but in world history. They have generally been held at bay and well-behaved, but they are just spoiling to show their true color: two-way volatility. They gave you a taste of that in early February. Look to the middle and there waits the army of Corporate Credit, which is also larger than ever relative to the economy, as ultra-low rates have encouraged it to gain in size, stature, and strength. This army is a little more docile right now, but we know its history, and it can be deadly when stressed. And then on the right are the Foreign Currency Fighters, along with the Crypto Tribe, an alternative store of value that only exists because of the games central banks are playing; the opportunity cost of Crypto is so low, why not own some? The Foreign Currency Fighters have strengthened by 10% over the past year. Compounding the problem, they have a powerful, ascending leader, the renminbi, to challenge the US dollar's hegemony as the reserve currency. All of these forces have been drawn to the battlefield because of our policy experiment with sustained negative real rates.

So Powell looks behind him to retreat. But standing there is none other than Inflation Nation, led by the fiercest warmongers of them all: the Commodities. He might take comfort that he is not alone on the battlefield. But then he looks over at the Washington, DC, fiscal battalion and realizes they are drunk on 5% deficit beer. That's what Powell is facing, whether he recognizes it or not. And how he navigates this is going to be fascinating to watch.

* * *

His full must read interview is below:

Interview with Paul Tudor Jones

Allison Nathan: You've said that you would rather hold a burning coal than a 10-year Treasury. Why?

Paul Tudor Jones: The bear market in bonds is the natural upshot of the bull market in monetary and fiscal laxity. My view on bonds is based on three major factors. First, there is a huge flow of funds imbalance with supply overwhelming demand. We are in a unique historical situation with the Fed stepping away from the market while the  US government is significantly increasing its auction sizes. I assume bonds will fall until the peak in full Treasury  auction sizes, which I don't think will be before 2Q2019. At the current pace, next February we might have a quarterly auction of $20bn 30-years vs. $15bn recently. That is so big it will only clear at substantially lower prices.

Second, economic momentum is now overwhelming the pace of the monetary policy response. We're in the third-longest economic expansion in history. Yet we've somehow managed to pass a tax cut and a spending bill, which together will give us a budget deficit of 5% of GDP—unprecedented in peacetime outside of recessions. This reminds me of the late 1960s when we experimented with low rates and fiscal stimulus to keep the economy at full employment and fund the Vietnam War. Today we don't have a recession, let alone a war. We are setting the stage for accelerating inflation, just as we did in the late '60s.

Finally, and most importantly, adverse valuations are becoming more glaring. Bonds are the most expensive they've ever been by virtually any metric. They're overvalued and over-owned. Valuations haven't been that relevant in recent years because of central bank manipulation outside of the US, but with the Fed in motion and the US economy in fifth gear, they start to matter a lot. I believe we're at that critical threshold right now.

Allison Nathan: Inflation expectations have been very well-anchored; does that make history a less useful guide?

Paul Tudor Jones: No. I think we're experiencing a hysteresis effect in global groupthink, led by the Fed, believing that we can depress term and risk premia without consequences for inflation or financial stability. That may have been the case for the past six to seven years. When it comes to inflation, you need to be careful what you wish for. At the end of other big asset price booms—Japan in 1989 or the US in 1999—inflation did not increase in a measured way. Rather, it accelerated in a non-linear fashion until the central bank had to come in and stop it with substantially higher real rates than we have today.

Allison Nathan: Is the market underestimating commodity-related inflation today? 

Paul Tudor Jones: Absolutely. The S&P GSCI index is up more than 65% from its trough two years ago. In fact, relative to financial assets, the GSCI is at one of its lowest points in history. That has historically been resolved by commodities putting on a stunner of a show, stoking inflation. I wouldn't be surprised if that happened again.

Allison Nathan: Some argue that it will be difficult to overcome structural deflationary forces, like technological progress or demographic change. You don't agree?

Paul Tudor Jones: On technology, what I've seen during this disinflationary period is the concentration of economic power into a few corporate hands. Once they have cleared the playing field of their competitors, they could ratchet up prices to decompress margins.So I am not sure these technological disruptions will continue to bring disinflation. In terms of demographics, economists at the Bank for International Settlements (BIS) have shown that it is the relative size of the working-age population that influences long-term trends in inflation.Unlike the prior decade, the share of the working-age population globally is beginning to shrink, and that would argue for inflation trending up.

Allison Nathan: Does all of this just boil down to the Fed being behind the curve?

Paul Tudor Jones: Central banks love to look in the rearview mirror. They typically operate by waiting for the most obvious moment they can to make a decision to fight yesterday's battles. Heck, the ECB hiked rates in July 2008! It is why price targeting is such a bad idea in rate decisions, as is its first cousin, gradualism. There is little in human nature that is linear, so why should rate policy be that way?

But the elephant in the room—the most important point that doesn't get discussed enough—is the level of real interest rates. The peacetime 10-year real interest rate that has determined the efficient allocation of capital averaged 3½% since 1790 and 2½% in modern times. Yet in 2018, with the economy operating at full employment, our real 10-year rate is 0.64%, well below historical averages. Why? It seems the reason is the Fed is trying to bring core inflation from a smidge below 2% to a smidge above it. But since 1790, US inflation has averaged 1.3% in peacetime. And yet somehow we have this magical 2% inflation target.It's a unicorn we keep chasing at the expense of everything else.

Sitting where we are today, this grand experiment with negative real rates might seem successful: We have the strongest economy in 40 years, at full employment. The mood is euphoric. But it is unsustainable and comes with costs such as bubbles in stocks and credit. Navigating these bubbles will be one of the most difficult jobs any Fed chair has ever faced.

Allison Nathan: Is the Fed up to the task?

Paul Tudor Jones: Let me describe to you where I think Jerome Powell is right now as he takes the reins at the Fed. I would liken Powell to General George Custer before the Battle of the Little Bighorn, looking down at an array of  menacing warriors. On the left side of the battlefield are the Stocks—the S&P 500s, the Russells, and the NASDAQs—which have grown, relative to the economy, to their largest point not just in US history, but in world history. They have generally been held at bay and well-behaved, but they are just spoiling to show their true color: two-way volatility. They gave you a taste of that in early February. Look to the middle and there waits the army of Corporate Credit, which is also larger than ever relative to the economy, as ultra-low rates have encouraged it to gain in size, stature, and strength. This army is a little more docile right now, but we know its history, and it can be deadly when stressed. And then on the right are the Foreign Currency Fighters, along with the Crypto Tribe, an alternative store of value that only exists because of the games central banks are playing; the opportunity cost of Crypto is so low, why not own some? The Foreign Currency Fighters have strengthened by 10% over the past year. Compounding the problem, they have a powerful, ascending leader, the renminbi, to challenge the US dollar's hegemony as the reserve currency. All of these forces have been drawn to the battlefield because of our policy experiment with sustained negative real rates.

So Powell looks behind him to retreat. But standing there is none other than Inflation Nation, led by the fiercest warmongers of them all: the Commodities. He might take comfort that he is not alone on the battlefield. But then he looks over at the Washington, DC, fiscal battalion and realizes they are drunk on 5% deficit beer. That's what Powell is facing, whether he recognizes it or not. And how he navigates this is going to be fascinating to watch.

Allison Nathan: So, what should Powell do?

Paul Tudor Jones: Unlike his predecessors, he needs to be symmetrically fearless. Policy unorthodoxy needs to be reversed as quickly as it was deployed. After Alan Greenspan ignored the NASDAQ bubble, it crashed and led to this incredible foray into negative real rates. That created the mortgage bubble, which was initially ignored by Ben Bernanke and ultimately spawned the financial crisis, leading us to fiscal and monetary measures that were unfathomable 20 years ago.

Today, we need a Fed chair who is proactive, not reactive. Policy-wise, that means moving as quickly as possible to  raise rates and restore appropriate risk premia so as to promote the long-term, efficient allocation of capital. While this will hurt a bit in the short run, it is better than the intergenerational theft that is being perpetrated now with the combination of low rates and high deficits. And it definitely will promote a more stable long-term economic equilibrium.

It also means having honest discussions about financial stability. A "symmetrical" way to signal that our policy path is unsustainable is to conventionally use what has now become an unconventional tool through its disuse: raise margin
requirements on stock borrowing. Whether you're an individual or a corporation, now is not the time to be aggressively leveraging your balance sheet. In fact, for individuals, given the record-low personal savings rate, now is the time to be doing the exact opposite. Remember, saving is the seed corn of future investment and worthy of as much discussion as inflation. If the Fed doesn't change its course, the systemic threat to the economy will only increase, making the eventual unwind that much more painful.

Allison Nathan: You've repeatedly mentioned fiscal policy. Can you elaborate on your views on that?

Paul Tudor Jones: I think the recent tax cuts and spending increases are something we will all look back on and regret. And I lay them firmly at the feet of the Fed for encouraging such a fiscal transgression by pursuing this experiment with negative real rates at full employment. With central banks globally experimenting with negative rates, zero rates, quantitative easing, and price targeting, it is easy to see how central governments could feel green-lighted to pursue unconventional fiscal policies. Certainly, central banks are not in a position to criticize them… If real rates had been at their long-term averages, would we have enacted a $1.5tn tax cut? My guess is the Congressional Budget Office's scoring of the increased interest burden would have nixed it.

Allison Nathan: In this context, what do you want to own?

Paul Tudor Jones: I want to own commodities, hard assets, and cash. When would I want to buy stocks? When the deficit is 2%, not 5%, and when real short-term rates are 100bp, not negative. With rates so low, you can't trust asset prices today. And if you can't tell by now, I would steer very clear of bonds. Just think, Greece will have a budget deficit below 2% of GDP by the time ours grows to 5%-plus. The markets disciplined Greece for its budget transgressions; it's just a matter of time before they discipline us. I think that time could be starting now with 10-year Treasuries rising to 3.75%, and 30-years to 4.5%, by year-end, and those are conservative targets.

Allison Nathan: Won't easier monetary policy in Europe and Japan cap the rise in US yields?

Paul Tudor Jones: I don't think so. Beginning next September, when the ECB concludes its asset purchases, the aggregate balance sheet of the main central banks will start contracting after nearly a decade of expansion. That will be a major data break, making it a horrible time to own bonds.

Allison Nathan: Won't rising yields attract some buyers?

Paul Tudor Jones: No. Bond pension buying, for example, is very pro-cyclical. When stock prices rise, pensions reallocate their capital gains from stocks into bonds. As we've seen, this depresses the term premium and fuels more gains in the stock market. If and when the Fed raises rates enough to stop and reverse the stock market rise, that virtuous circle predicated on increasing capital gains will reverse, and bonds and stocks will decline together like they did in the 1970s.

Allison Nathan: You are well-known for calling Black Monday. Is the recent surge in volatility behind us?

Paul Tudor Jones: In my view, higher volatility is inevitable. Volatility collapsed after the crisis because of central bank manipulation. That game's over. With inflation pressures now building, we will look back on this low-volatility period as a five standard- deviation event that won't be repeated.

"Don't Try To Make Sense Of This": Major Bank Give Up On Today's Market

Confused by today's whipsawed market action, which as much about month end flows, as it is about newsflow, post Powell jitters, breakevens, inflationary fears, and of course, whatever it is that Gartman may be doing? You are not alone: in its intraday macro update, the bank that is also the world's largest currency trader, had some (very) simple advice for its clients: "Don't try to make sense of this."

It then clarifies, and we use the term loosely: "Price action today has been messy to say the least. The shortest explanation is, it's month end and so there is little point in making sense of the move."

Still, it highlighting a few notable moves:

• Looking at broader markets, there's a sense of risk reduction. It's a sea of red in equities, yields and commodities. After discouraging signs in the DoE inventory report, the bears have taken WTI through one big figure to trade below $62, which seems to be weighing on energy shares. Some market observers have attributed this to be the trigger behind equities turning red. Elsewhere, bear flatteners have characterized the yield curve in the US, while European yields have sold off across the board.
• Month end models suggested USD buying today, and we can see that has clearly played out. GBPUSD is the biggest underperformer today. The pair has traded through three big figures since the EU withdrawal agreement draft suggested further Brexit drama. The pair now trades at 1.3790, although major supports are approaching around 1.3765-1.3780 (converging 55d MA, trend line and February low). USDCAD meanwhile is above 1.28 for the first time since the Christmas period. The oil rout is unlikely to help and we could see a move towards 1.29
• GBP performance in the crosses is arguably worse. GBPJPY has squeezed through the 200d MA at 147.78 to trade at 147.17 currently, levels we haven't seen since September 2017. This has helped JPY be today's top performer against USD, with the pair trading at 106.73 at time of print. 106.60-70 big level on the downside to break, contrasting sharply to CHF performance. USDCHF is back to testing the neckline of a major double top around 0.9440.

What is however most troubling - and fascinating - by far, is that having gone short overnight, Gartman appears to be right this time.

A 58% Wipeout Is “Best Case”!

Two of of the best "tried and tested" ways to rapidly grow your wealth are to:

Use leverage in a rising market and

Flog equity at ever rising prices (à la Tesla)

Both methods work, but leverage is not unlike that smoking hot girlfriend you used to have who was, let's admit it, pretty unhinged.

Hanging about too long was always going to get you into trouble — serious, call-the-police-NOW trouble. But the allure was so strong and kept pulling you back. The decision was really tough. Not because it didn't make sense, but because you weren't really thinking with you brain.

Enter the Allure of Ever-Rising Prices (and the Debt That Fuels It)

That debt, like the smoking hot but unhinged girlfriend, may be about to do what it always promised to do — damage!

Australia's household debt-to-income level has reached a spectacular new high, hitting 200% for the first time. Total household debt now stands at an eye-watering record $2.47 trillion… or nearly $100,000 for every man, woman, and child in the lucky country.

Even after debt-free households are factored in, the average Aussie household now owes twice the amount they bring in annually from wages, welfare, and other sources of income.

I get it — Joe Sixpack isn't skilled in managing money. Hell, he's a plumber, or a lawyer, or works in IT, or maybe he makes overpriced lattes for soccer moms. Whatever it is he does, he's not the time to think about (or even know about) the eurodollar market or global capital flows, let alone price to income ratios.

What's more, Joe's got 2 and a half kids, a wife with a shoe fetish, and all these things take up a lot of his time.

What he does know is that he needs somewhere to kip at night and so do his family. So he needs a house. But he figures this is an investment (poor sod) and so he understandably makes it as BIG as he possibly can.

For many folks it's the only time in their life they actually think about making a capital allocation to literally anything other than weekend beer and the odd family holiday to Fiji. And maybe it's a good thing as it is the only asset that may actually leave him with something when the nurse wheels him around with tubes up his nose feeding him mushy peas.

Gasoline on the Fire

Now, the Aussies realised a long time ago that actually the government were and are completely isht at managing pensions, and unless they did something and did it quickly, they were all going to end up like all the other Western economies. Screwed and pretending they have pensions when their own balance sheets make the assertion completely laughable. And so they instituted something called "self-managed super".

This meant that individuals would manage their own superannuation funds where they'd contribute money and towards that the government would assist via multiple ways including tax breaks and various other incentives.

The mechanics don't matter for the purposes of this article. What matters is that over 600,000 self-managed super funds (SMSFs) are now in operation, managing over $7 billion in assets.

So, in that respect the Aussies are waaaay better off than many of their Western counterparts. But just when you thought, hooray for them, they went and doubled down on that one bet they'd already made: Australian housing.

You see, there has been an explosion in SMSF borrowing to buy into the property market amid surging house prices earlier this decade.

How bad?

Well, borrowing by SMSFs has grown from $2.5bn in 2012 to more than $24bn today.

This is like having the crazy girlfriend, marrying her, and then — in what can only be described as a period of deranged insanity — going out and getting a couple (yes, two more) mistresses who make her look positively boring and sane.

Now, if this all sounds crazy, it's because it is.

The sheer odds of something going wrong are right up there with patting your head and rubbing your tummy while trying to defuse a bomb with your teeth. Try it.

An Interesting Number

3.5, that is.

All (yes, all) property bubbles that have exceeded 3.5x GDP have subsequently fallen by at the smallest 58%.

All property bubbles that have exceeded 3.5x GDP have subsequently fallen by at least 58%.CLICK TO TWEET

The reasons are as simple as Paris Hilton.

Joey with negative equity is no longer a buyer. The only way this entire squadron of buyers remain buyers is when property prices go up.

When they begin to go down, however, they completely vaporise from the market. Perhaps this is why property prices rarely fall by 15% or even 25% at the end of a spectacular boom. They go down hard.

Some other interesting numbers for you to consider.

35.4% of home loans are interest-only. This figure has already dropped from above 40% following APRA's cap on the amount of new interest-only loans. As one professor at the University of New South Wales recently pointed out:

Interest-only loans in Australia typically have a five-year horizon and to date have often been refinanced. If this stops then repayments will soar, adding to mortgage stress, delinquencies, and eventually foreclosures,

Even if that is true, we are still left with highly indebted households who have nearly $2 of debt for every $1 of GDP, a raft of interest-only loans that will soon involve principal repayments, and stagnant wage growth.

What to Watch

Given that Sydney property prices have enjoyed their fifth straight month of price declines, clocking in a 3% slide over the last quarter, it's reasonable to ask ourselves the question: Is this it?

What is really interesting to note is that all of this is happening while rates have not yet moved for mortgage holders.

I wrote extensively before about how the Aussie banks are subject to international funding markets, and as such the RBA's power to re-inflate the market when the rates are effectively set in the eurodollar market will work with the power of an asthmatic in Bangladesh blowing at you through a straw.

And then here's what LIBOR looks like (LIBOR being a rough measure of that interbank lending market I wrote about):

Source: http://www.macrotrends.net/1433/historical-libor-rates-chart

To understand how important the eurodollar market is to this whole "fustercluck" of financial puzzlement, is mandatory.

Failure to Make New Highs

Now, I'm fully aware many of you look at squiggly lines the same way you look at that bloke with his bum cleavage showing, but there looks like a fairly significant head and shoulders formation on ALL of the major Australian banks.

Westpac Banking Corp (orange); ANZ Banking Group (purple); Commonwealth Bank (green)

These are the folks who actually own the vast majority of both residential and commercial housing stock in the country.

People mistakenly think they own their own home even when they have mortgages on the place. Silly, I know, but we, humans can imagine the darnedest things when it suits us.

And one more thing: I — along with every other investor, money manager, hedgie, banker, and of course let's not forget home owner — don't know for sure what comes next. Those who profess they do know are to be trusted in the same way you'd trust gas station sushi or a prostate exam from Captain Hook.

Bank of America: This Is The Only Number That Matters For The Market

When it comes to his recent forecasting track record, BofA's Michael Hartnett is - as of this moment - a force to be reckoned with. Exactly one month ago, the bank's Chief Investment Strategist warned clients that the bank's "Biggest sell signal in 5 years was just triggered" and warned of a correction as much as 12% in the coming 3 months. Just a few days later, he was proven right as the S&P tumbled 10% the very next week.

Fast forward to today, one day the Jerome Powell "hawk shock" which resulted in yet another broad market plunge, when in a note titled aptly "Throwing in the Powell"...

... Hartnett takes us back in time 2 years, and writes that the 2nd day of Yellen's Humphrey-Hawkins testimony on Feb 11th 2016 marked the last great "entry point" into the credit & equity bull market.

At the time the meltdown in China/EM/oil/HY induced extremely bearish Positioning (the BofAML Bull & Bear Indicator was 0), tumbling global Profit estimates (-7% YoY), and a big Policy stimulus (Chinese/ECB credit easing)…all of which swiftly followed Yellen's defense of the Fed's decision not to resort to a Negative Interest Rate Policy in the winter of 2016.

And what an entry point it was: little more than two years later on the 1st day of incoming Fed Chair Powell's testimony, global stock markets are up 58% (a remarkable $30 trillion in market cap), CCC-rated US high yield bonds 69%, bank stocks 68%, Emerging Market equities 81%, tech stocks 92%, oil prices 139%. Only two asset classes have been in bear markets since Feb'2016: the US dollar (-8%), and volatility (both the MOVE & VIX indices recently hit 50-year lows).

* * *

However, this time around "Positioning, Profits, & Policy drivers are now the mirror image of Feb'16." Specifically, according to the BofA CIO, the Fed is signaling the "Powell put" has a much lower strike price, "and as the Fed accelerates and leads the end of the global QE era, the bullish consensus is likely to capitulate to a more defensive posture through 2018."

So what should traders worry about as the market starts digging to uncover what the Fed's new - and reduced - Powell Put is?

Well, according to Hartnett, 2018 year-to-date global asset returns have thus far been more prosaic: stocks 3.3%, bonds 0.4%, US dollar -2.5%.

In the absence of a stock market bubble (which remains a big risk given a dormant $10tn of negatively-yielding debt that can be reallocated to equities), muted and more volatile returns seem likely this year.

Still, for now at least the general direction of risk assets remains higher. But for how much longer? The answer for traders - according to Hartnett - lies in the magic number which is....3

Between bullish Positioning, peaking Profits (in the absence of Productivity gains), & Policy tightening, the likely cocktail in coming months of:

real GDP forecasts >3%,

wage inflation >3%,

10-year Treasury yields >3%,

and the S&P500 >3000

... will mark a big top in equity & credit prices, the BofA CIO predicts.

* * *

Here's how this endgame to the biggest asset bubble in history will play out according to Hartnett in terms of Positioning, Profits and Policy.

On Positioning

Positioning is extremely bullish: the BofAML Bull & Bear Indicator is 8.1, in stark contrast to the "0" level of early-2016 (Chart 2).

The Icarus trade of 2017 has fueled "greed": BofAML GWIM private client equity allocations are close to all-time highs (61.3%), global equity funds saw $103bn of inflows in Jan, and tech, financials, Emerging Markets & Japan funds have all seen record inflows in recent months.

And market structure concerns continue to grow: short equity volatility AUM ($66bn) + volatility-based & risk parity equity leverage ($200bn) + CTA AUM ($250bn) + risk premium/factor allocation ($300bn; link) = $816bn of "market structure" that could make the recent VIX ETF/ETN implosion a dress rehearsal for a major market correction if volatility becomes contagious next time (our equity derivatives team estimates that in the Feb'18 correction, quant funds had to unwind $200bn in 2 days).

On Policy

The central bank "liquidity supernova", the primary driver of credit & equity prices in the past 9 years, will peak in 2018; central bank purchases of $4tn in the past 2 years will shrink to $0.4tn in 2018; assets such as tech stocks & high yield bonds, which have been the biggest winners under QE.

"Don't Fear the Fed" has been central to the BTD (Buy-The-Dip), FOMO (Fear-Of-Missing-Out) & TINA (There Is No Alternative to stocks) trades of recent years; yet Powell signaled in his Humphrey-Hawkins testimony that US "headwinds" have turned into "tailwinds". The Fed is signaling the "Powell put" has a much lower strike price and as the Fed accelerates and leads the end of the global QE era, the bullish consensus is likely to capitulate to a more defensive posture through 2018.

And note the central bank establishment (see Borio's recent Bank for International Settlements link) has started to make the case that low policy rates have created "zombie companies" (estimated to now represent more than 10% of all OECD nonfinancial firms), leading to a misallocation of resources and low productivity…i.e. the "central bank of central banks" is making a positive case for a regime shift to higher rates

On Profits

Profits remain the last visible bull catalyst, and thus the biggest risk to consensus in 2018 is weaker growth & lower interest rates (few predict Treasury yields below 2.5% and S&P500 below 2500 by end-year).

We believe EPS growth is very close to a peak. A reversion to the mean in US manufacturing business confidence (i.e. ISM back to 54), payrolls (NFP back to 150K), and Asian exports (proxy for global trade) implies US EPS growth falling from 20% YoY% to 8% through 2018 (Chart 3). And Asian exports are now weakening: growth peaked last September at 21%, while the Feb China export PMI was below 50 for 2nd consecutive month signaling China exports stalling and weaker CNY once again ahead of us.

The gloom and doom from Hartnett continues as the strategist then warns that "the magnitude and duration of the bull market makes stocks more vulnerable to the peaking 3Ps in 2018":

S&P500 bull market became 2nd largest of all time on Friday Jan 26th (@ 2873).

S&P500 bull market will become longest ever on August 22nd, 2018.

Should equities outperform bonds for a 7th consecutive year in 2018 it would be the longest winning streak since 1928 (equities most certainly underperformed in 1929).

Put differently, BofA can see only two catalysts to make this the greatest bull market of all time (3498 on the S&P500):

An unanticipated surge in productivity growth.

A speculative bubble from a Great Rotation out of negatively yielding debt into stock markets.

* * *

So what should traders watch to decide when it's time to bail? Well, if three is the magic number for the market, the decision when to get out of it depends - appropriately - on three letters: ABC. Here's why"

Volatility set to increase in coming weeks with macro, policy & political events: US ISM March 1st, Italy elections/German coalition vote 4th, ECB 8th, BoJ & US non-farm payroll 9th, Pennsylvania special congressional election 13th, FOMC 21st. Key to watch: "ABC": Average Hourly Earnings, Bond Sensitives & Chips (the semiconductors)…

A for Average Hourly Earnings: further wage growth acceleration is negative for bonds & equities, deceleration is positive for bonds & equities; in Feb payroll data AHE>0.3% is thus negative, AHE<0.3% would be positive.

B is for Bond Sensitives: assets hyper-sensitive to interest rates such as utilities (UTIL), REITs (BBREIT), homebuilders (XHB), preferred shares (PFF) need to rally to confirm "bond shock" is over; in addition corporate bond spreads remain the "glue" that holds the bull market together…fresh weakness would be negative for all risk assets (watch European High Yield bonds, HE00, where yields have backed up 75bps since Oct 30th).

C is for "Chips" aka the semiconductors; if semiconductor (SMH) & tech stocks (XLK) cannot make new highs in the next week or two, particularly at a time of soaring consumer confidence, then market highs could be seen in for the next couple of months.

Finally, here is Hartnett's pair trade as we enter a period of extreme volatility: "Our favorite 2018 long remains volatility, our favorite short is credit, and the last move up in stocks should be led by a tech-banks barbell."

Warning: the Fed Just All But Admitted That It's WAY Behind the Curve

Jerome Powell knows the Everything Bubble is in serious trouble.

In his prepared comments for US Congress, released yesterday, Fed Chair Jerome Powell stated:

If we do get behind and the market does, the economy does overheat... then we'll have to raise rates faster, and that raises the chances of a recession…

First and foremost, Powell is "floating" this idea because he knows full and well that the Fed IS already behind the curve on inflation. Several of the Fed's own in-house inflation metrics are already well north of 2% if not 3%.

Buckle up, because Treasury yields are exploding higher having broken their long-term trendline.

Let's be clear here. The Fed is terrified of the Everything Bubble bursting. And we're a lot closer to a crisis than most realize.

The Failure Of Fiat Currencies

We work hard for our money, as we think it has long-lasting value. That value can buy us other things that we want. It seems like a good exchange. However, few of us consider how extrinsic the value of money really is. In reality, we are dealing in valueless fiat currencies. 

At one time, our money was backed by the tangible value of gold or other precious metals, legal tender for anything of equal value.

That is not the case any longer. The value of a dollar bill these days is what the government says it is. This arbitrary value is dependent on the whim of the government. And the government can print money like a copy machine run amok. There are no limits to how much money can be put into circulation. That is because this money isn't backed by any real value, it's called fiat currency.

The US dollar became fiat currency when it stopped being backed by gold over 46 years ago and it has lost 97 percent of its value since the establishment of the Federal Reserve in 1913.

Apart from cryptocurrencies, all the world's major countries are using fiat currency.

Since Roman times, fiat money has failed spectacularly throughout history due to the same pattern of rapid devaluation and then total collapse. The Romans used a 100 percent pure silver coin called the denarius at the start of the first century. By mid-century, during Nero's rule, the denarius only contained 94% silver. By 100 A.D., the silver content had been reduced to 85%. The value of the coin was decreasing steadily. This worked well for Nero and his followers, who no longer had to pay their debt at the full, actual value while additionally increasing their own wealth. During the next century, the coin was made of less than 50% silver. By 244, Emperor Philip the Arab had reduced the amount of silver in the denarius to 0.05%. When the Roman Empire finally fell, the denarius contained only 0.02% of silver.

The devaluation of currency invariably is the precursor to economic ruin.

China was the first country to use paper money in the 7th century. Until that time, they used copper coins but switched to iron due to a copper shortage. The easy availability of iron caused it to be overissued, until it too, collapsed. During the 11th century, a Szechuan bank began to issue paper currency in exchange for the iron currency. This worked briefly since the paper could be traded for rare, valuable metals, such as gold and silver, or for valuable silk. Then, China entered into a costly war with Mongolia and was eventually defeated by the Mongol leader, Genghis Khan. In an effort at expansion, Genghis's grandson, Kublai Khan, started to flood paper money throughout the empire. As China's trade increased, the influx of fiat paper – currency backed by no value – caused even the wealthiest of families to be ruined.

France may be the only country that has been defeated by fiat money three times. The Sun King, Louis XIV, left his successor heavily in debt. Poor Louis XV took the advice of the Scottish economist John Law and simply flooded the country with paper currency instead of the previously acceptable coins. The paper money devalued the actually valuable coins, causing the heir to the Sun King to bankrupt his own country. Yet France didn't learn its lesson well the first time. More than 100 years later, France gave paper money another try, creating an inflationary spiral of 13,000 percent. Napoleon, and the introduction of a gold-backed Franc came to the rescue. Was France now convinced of the negative effects of fiat currency? Not quite. In the 1930's, paper currency was again issued, causing inflation to devalue the paper Franc by 99% in 12 years.

Another country faced with huge, unmanageable, and unpayable debt was post-WWI Germany. Germany did not learn from history. Instead, it created a state of unheard of hyperinflation. One hundred and thirty printing companies churned out paper money as fast as they could, devaluing the German Mark so much that its only real value was to be used as kindling.

America has a long history with fiat currency, starting with the Massachusetts Colonial notes of the 1600s. Other colonies quickly followed suit. The notes were to be redeemable for tangible goods, but they weren't backed by any tangible commodity. Repeating a long, historical sequence of events, too many printed notes soon made the currency worthless. America's next venture into unbacked paper currency was to finance the Revolutionary War. It, too, crashed.

It seemed American might finally have learned a lesson. Up until 1913, American currency was rigorously backed with actual gold. The establishment of the Federal Reserve Bank that year reduced the amount of gold officially backing the dollar. Owning gold became illegal. In 1971, any gold standard was eliminated as the US dollar officially became another piece of paper. Its value has decreased by 92% since 1913.

With history being the best indicator of the future, America is primed for another currency collapse.

We are facing a debt as out-of-control as Weimar Germany while the government keeps the printing presses busy. At this time, China and Russia are supporting their respective currencies with gold. In addition, both countries are using a new money transfer system, CIPS (China International Payment System), to replace the western SWIFT (Society for Worldwide Interbank Financial Telecommunication) system.

Western countries, all of whom use SWIFT for money transfers, have had a monopoly on the manipulation of international money transfers. With Washington and SWIFT's help, hedge fund billionaire Paul Singer was able force a debt-ridden Argentina to pay 20 cents on the dollar for his bonds, valued at $3 billion, making it virtually impossible for Argentina to pay its other debtors.

The current Argentine President Macri reopened negotiations for the long-time debts, settling at 30 cents on the dollar. The manipulation of fiat money can quickly result in the manipulation of fiat debt, benefitting a select few and ruining the rest.

In the meantime, China and Russia's use of gold-backed currency and the use of their own money-transfer system have improved both economies. The possibility of CIPS being used worldwide and serving as an alternate monetary transfer method offers hope that the Western fiat money scheme may soon be halted. Western fiat money manipulation has turned into an unsustainable Ponzi scheme that is holding on by a thread. Approximately 97% of the Western money is printed randomly as needed, in effect creating play money.

If the system falls, it will be the fall of a monster. When banks try to call in their huge fiat debts, it could cause an avalanche of repercussions. The elite will be safe, but the vast majority will be left in dire straits.

Perhaps digital payments will take the place of paper currency. The global monetary future is still developing, but drastic changes are inevitable.