FED TIGHTENING CYCLE TRIGGERS EMERGING MARKETS DEBT DISLOCATION

An interesting contribution to the debate on the impact of Fed balance sheet contraction on emerging markets' US dollar funding came early last month in the form of an article by Urjit Patel, the governor of the Reserve Bank of India, published in the Financial Times ("Emerging markets face a dollar double whammy" June 4, 2018).

This article argued that the combination of Fed balance sheet contraction and the increase in net Treasury bond issuance to finance the Trump administration's tax cuts, had created the unintended consequence of a "double whammy", resulting in dollar funding for emerging markets being "in turmoil".

 

THE DOUBLE WHAMMY

The RBI Governor argued that the rate of Fed balance sheet contraction is at roughly the same pace as the increase in net Treasury bond issuance. The Fed's current plan is to reduce its debt securities holdings by a cumulative US$1.05 trillion by the end of 2019 (US$30 billion in 4Q2017, US$420 billion in 2018 and a further US$600 billion in 2019, see following chart).

While the US fiscal deficit is projected by the Congressional Budget Office (CBO) to be US$793 billion in this fiscal year ending September 30 and US$973 billion in FY19, implying net issuance of government debt of US$1.17 trillion in each of these two years (see following charts).

FEDERAL RESERVE BALANCE SHEET REDUCTION PLAN

Source: Federal Reserve

US FISCAL BALANCE

Source: Congressional Budget Office

US GROSS FEDERAL GOVERNMENT DEBT

Source: Congressional Budget Office

There is very little evidence that long-term Treasury bonds are influenced by supply considerations with nominal GDP growth trends being the far more important factor.

In actual fact, based on the above data, the Fed's planned balance sheet reduction is "only" US$1.05 trillion over a 27-month period compared with a one-year projected increase in federal government debt of US$1.17 trillion. Still such statistical nitpicking aside, Patel uses the above argument to propose that the Fed should now adjust itsbalance sheet contraction to take account of the increase in net Treasury bond issuance which was not known about when the American central bank originally announced its schedule for quantitative tightening in September 2017, three months before the Trump tax cuts were passed. He wrote: "The Fed has not adjusted to, or even explicitly recognised, the previously unexpected rise in US government debt issuance. It must now do so."

There is a certain logic to Patel's argument. But it is extremely unlikely that the Fed will make such an adjustment. For one reason the Fed is raising rates and remains committed to ongoing balance sheet contraction — precisely to offset the risk posed by what most Fed governors view as excessive fiscal stimulus at this point in the American economic cycle.

Patel's argument also implies that rising Treasury bond net issuance, combined with balance sheet contraction, will lead to higher Treasury bond yields. But there is very little evidence that long-term Treasury bonds are influenced by supply considerations with nominal GDP growth trends being the far more important factor.

As is clear from the chart below, the last time Treasury bond yields were at the current low levels in the early 1950s, US Treasury securities outstanding as a percentage of GDP was also around the current high level of 80% (see following chart). While the Treasury securities to GDP ratio rose in 1980s, Treasury bond yields were collapsing. By contrast, the correlation between US nominal GDP growth and the 10-year Treasury bond yield has been 0.70 since 1980 (see following chart).

US TREASURY SECURITIES OUTSTANDING AS % OF GDP AND 10-YEAR TREASURY BOND YIELD

Source: Federal Reserve

US NOMINAL GDP GROWTH AND 10-YEAR TREASURY BOND YIELD

Source: Federal Reserve, US Bureau of Economic Analysis

It is also the case that quantitative tightening is likely to prove bullish for long-term Treasury bonds because it is another form of monetary tightening, and therefore will result in due course in a slowdown in the economy.

LIQUIDITY A MAJOR RISK FOR CORPORATE BONDS

Meanwhile, the Fed would view as an exaggeration Patel's description of the dollar funding markets as being "in turmoil". But such turmoil is certainly possible if not probable during this tightening cycle, most particularly if the US dollar rallies further, since foreign governments do not have the luxury, enjoyed by the US, of being able to print dollars.

The potential for turmoil in the fixed income world is also increased considerably by a technical factor.  That is the underlying severe lack of liquidity in credit markets, which has been a feature of the fixed income world since the global financial crisis as a result of both post-crisis regulation and the related post-2008 "de-risking" of banks' balance sheets.

This vulnerability is best highlighted by the chart below which shows, in the US context, the collapse in corporate bonds owned by brokers/dealers relative to the surge in such bonds owned by mutual funds and ETFs. The ratio of US mutual funds' and ETFs' holdings of corporate bonds over brokers' and dealers' holdings has soared from 1.7x in 2Q07 to 40x in 3Q17 and was 37x at the end of 1Q18, according to the Federal Reserves' flow of funds data (see following chart).

US brokers' and dealers' holdings of corporate bonds have collapsed by 84% from a peak of US$418 billion in 2Q07 to US$59.7 billion in 3Q17, the lowest level since 1Q95, and were US$65 billion in 1Q18. While mutual funds' and ETFs' holdings have surged by 240% from US$708 billion in 2Q07 to US$2.41 trillion in 1Q18.

RATIO OF US MUTUAL FUNDS' & ETFS' HOLDINGS OF CORPORATE BONDS OVER BROKERS & DEALERS' HOLDINGS

Note: Not including money market mutual funds. Source: Federal Reserve – Flow of Funds Accounts

But this lack of liquidity is a global phenomenon and not just an American one. It means that when everybody wants to sell the same bond there will be a lack of buyers. And remember bonds, unlike stocks, are not listed on exchanges.

 

Italy's Stagnant Economy The Most Likely Trigger To Europe's Existential Crisis

With the focus on Turkey and the potential related fallout in other emerging markets in recent weeks, it is easy to forget about the Eurozone. Yet the current Italian government is likely to trigger a renewed existential crisis in the Eurozone once the Europeans return from the beach and the Italian Government comes up with a budget for 2019 which is likely to put it in direct conflict with the Maastricht Treaty.

BROKEN BRIDGES UNDER THE EURO

The collapse of a motorway bridge in Genoa last month resulting in 43 deaths, and Italian Interior Minister Matteo Salvini's exploitation of that event by blaming Brussels-imposed austerity, is a reminder of what is coming.

Having driven over that particularly rickety bridge on more than one occasion, this writer is not surprised to hear about what happened. Similarly, driving through Italy in recent years always serves as a reminder just how poor Italy has become under the euro. Remember, Italy has recorded almost no growth since the formation of the euro at the beginning of 1999, nearly 20 years ago. Italian real GDP has risen by only an annualized 0.4% since 1Q99 and is up only an annualized 0.1% in real GDP per capita terms over the same period (see following chart).

ITALY REAL GDP AND REAL GDP PER CAPITA

Source: CLSA, Datastream

The Italian issue is raised again in part because it is timely with the end of the summer holiday season. The view here remains that a systemic event in financial markets is more likely to be triggered by Italy and the Eurozone than other candidates currently discussed by pundits, be it a Donald Trump-triggered trade war, a much anticipated (by talking heads) Chinese currency collapse or overvalued Wall Street FANG stocks.

Still, they are all interconnected phenomena since, for example, a renewed focus on the existential risks in the Eurozone is likely to put renewed downward pressure on the euro which, if what happened in the second quarter is any guide, will then lead to broader US dollar strength against emerging market currencies. This will in turn make it more challenging for China to manage the capital outflow issue.

BURNING THE BRIDGE TO EUROPE, BUILDING A BRIDGE TO THE US

Returning to the Eurozone issue it is also important to remember what is easily forgotten in the financial markets. That is that the anti-euro, anti-immigration populists in Europe now have a supporter in the White House who is openly encouraging them to pursue their agendas. This is, of course, the exact opposite of what was the case under Barack Obama who, unfortunately, intervened in the Brexit debate in Britain with negative consequences for the 'Remain' cause he was supporting.

Donald Trump could not have made it clearer that he supports the cause of those in Italy wanting to leave the euro – just as he could not have made it clearer that he supports Brexit. This is not unimportant since a potential future decision by, say, Italy to walk out of the euro looks a lot less risky politically and economically if it has the support of the American president. This will be particularly the case if that particular American president's political position has been strengthened by the outcome of the November mid-term elections. This is one reason, among many others, why those elections are becoming rather important. The base case here remains that the Republicans will maintain control of the Congress. But, clearly, that is not consensus.

It is also important to remember that Europe has its own upcoming election cycle. Grizzle refers again to the potentially hugely important May 2019 European parliamentary elections. While the focus of financial markets in the coming quarter will likely be on the Italian Government's budget, and how Brussels and Berlin will respond, next May's parliamentary elections are likely to be by far the most significant ever.

This is because the anti-euro populist parties are likely to run a far more coordinated campaign. The result could be the emergence of a populist alliance in the European parliament determined to attack from within many of the foundations of the Eurozone, be it the Maastricht Treaty in the economic sphere or 'free movement' in terms of the politically charged issue of immigration.

A reminder of this comes from reading a recent article on the growing activities in Europe of Steve Bannon, Trump's former political strategist (see International New York Times article: "In Europe, a best friend for Bannon", August 21, 2018 by Ivan Krastev). This article reported how Bannon announced in late July that he plans to establish in Europe a foundation, called The Movement, to create a formal alliance of populist right-wing parties ahead of next May's European elections.

The mooted foundation will aim to provide polling and policy support. His main ally in Europe in this venture is, according to the same article, Hungarian Prime Minister Viktor Orban who was re-elected in April for his third consecutive four-year term.

Obviously, turning such an alliance into an effective political force is easier said than done, most particularly as there will be different views on specific policies. Still, there will be an easily achieved consensus among the populists on the related issues of immigration and Islam. On this point, the same article reports that Orban intends to make next May's elections "a referendum on migration and Islam".

THE SHIFTING TIDE OF IMMIGRATION

This is where the renewed crisis in Turkey, with its focus on a collapsing currency and macro imbalances, meets the issue of European politics. This is, of course, because the main reason the flow of migrants into Europe, and in particular Germany, has declined significantly since late 2016 due to the EU-Turkey migration deal Angela Merkel negotiated with Turkish President Recep Tayyip Erdogan in March 2016.

Under the deal, the EU agreed to pay Turkey €6 billion to halt the human flow with some 3.5 million Syrian refugees remaining in Turkey. As a result, the number of asylum applications lodged in Europe declined by 44% YoY to 728,470 people in 2017 and were down 15% YoY to 301,390 in 1H18, according to the European Asylum Support Office (see following chart). As for Germany, total asylum applications declined by 70% from a peak of 745,545 people in 2016 to 222,683 in 2017 and were down 15% YoY to 110,324 in the first seven months of 2018, according to the Federal Office for Migration and Refugees (see following chart).

ASYLUM APPLICATIONS LODGED IN EUROPE

Source: European Asylum Support Office (EASO)

GERMANY – TOTAL NUMBER OF ASYLUM APPLICANTS

Note: Data up to July 2018. Source: Federal Office for Migration and Refugees

The above creates obvious leverage for Erdogan to apply against Merkel and the Eurozone. This explains why Merkel in her public comments has taken a conciliatory tone in response to recent developments in Turkey in stark contrast to the provocative posture adopted by the Donald Trump.

Peso Set To Disintegrate After IMF Tells Argentina To Stop Supporting Currency

On May 11, three days after Argentina secured a $50 Billion IMF bailout - the largest in the fund's history - we jokingly noted that with the peso resuming its slide, an indication the market did not view the IMF backstop as credible, the ECB would need to get involved.

ARGENTINE PESO EXTENDS LOSS, HITS NEW ALL-TIME LOW AT 23.16/USD

Time to add ECB to IMF bailout

— zerohedge (@zerohedge) May 11, 2018

In retrospect, it now appears that this may not have been a joke, because with the Peso plummeting, and surpassing the Turkish Lira as the worst performing currency of 2018 having lost half its value YTD...

... with the bulk of the collapse taking place in August...

... Christone Lagarde had even more bad news for Buenos Aires and Argentina president Mauricio Macri: the IMF now insists that after burning through billions in central bank reserves, Argentina should stop using funds to support the peso, and float it freely.

According to Infobae, the Argentine foreign currency reserves have declined below the level demanded by the IMF, with Argentine authorities selling $2.5BN to support the peso in August; meanwhile the overall level of reserves has slumped even more, approaching the levels before the IMF bailout while failing to prop up the currency which, as shown below, has collapsed in a move reminiscent of what is taking place in hyperinflating Venezuela.

Worse, the Argentine Peso suffered its latest sharp drop in the days after the central bankunexpectedly hiked rates to 60% - the highest in the world - and another indication that the market is firmly convinced that not even the IMF backstop will force Argentina into a painful, and politically destabilizing structural program.

After all it is less than two decades after the IMF tried the exact same playbook with Argentina and the result was a default.

Meanwhile, as the IMF tells Argentina to let the peso "drop dead", fears of an economic depression are growing, and as Infobae notes, "unable to defuse the bomb left by the Kirchner regime, the government now faces the obligation to make a painful structural adjustment , as has happened so many other times in Argentina. Everything that the government wanted to avoid with its gradualist policies was ushered in by the market: mega-devaluation, high inflation and a collapse in purchasing power" as IMF enforces another round of austerity in Argentina; the same Argentina which defaulted the last time the IMF was in charge. The result, Infobae laments, is well known: "a fall in activity and increase in poverty."

Even before the IMF shift, the administration of Mauricio Macri was preparing to implement the painful measures, with TN reporting that after a seven-hour meeting with advisers on Saturday to discuss currency crisis, Macri would raise export taxes to take advantage of the one silver lining from the collapsing currency, a boost to Argentine exports, and close 10 to 12 ministries, including Science and Technology, Culture, Energy and Agro-Industry. The president would also remove deputy Cabinet Chiefs Gustavo Lopetegui and Mario Quintana.

Of course, the export taxes mean that much of the peso devaluation will be offset by the government taking its own pound of flesh, as per IMF instructions.

Here Infobae does not mince its words, warning that the result of this tax reform will be disastrous, as next year the tax pressure will increase again, instead of falling, and will add further pressure on the exchange rate that in less than three months has left the country in the middle of a deep recession.

The deterioration is so great, the publication notes, that all the government can do is hope to avoid a "knock out blow", and another sovereign debt default.

Now event are set in motion that would result in a new default, which would not only have tremendous consequences for an already weakened economy, but also pose a big question mark how president Mauricio Macri reaches the end of his term.

Meanwhile, further pressuring the economy will be the "strong fiscal adjustment" that will be enacted per IMF instructions in 2019. "Start with 0" , explained the Government when asked how it will achieve a fiscal balance. That would mean not only higher taxes, but slashing spending, and a wave of popular unrest and political chaos. As Infobae predicts, the 1.3% primary deficit is now a thing of the past, and the government is hoping to reach levels between 0.4% and 0.5%, "a fiscal goal that is as ambitious as it is difficult to meet."

But while the government agrees with the IMF on the need to launch a highly unpopular fiscal adjustment, it certainly disagrees on the IMF's demands that Argentina reserve be used exclusively for the payment of the debt; here the Government insists on the necessity to have flexibility to intervene in the exchange market when it is necessary.

And this is where the IMF's unexpected order to stop intervening in the peso came in: there were heated discussions between the staff of the IMF and the president of the Central Bank, Luis Caputo, as the IMF "bureaucrats" were alarmed not only by the rate of rise of the dollar, but by the loss of reserves, Infobae reports.

Specifically, the IMF is alarmed that in August alone, Central Bank reserves fell by $5.3 billion, from $58 billion at the end of July, to just $52.7 billion one month later. This level is $2.5 billion below the goal of reserves that the IMF had "instructed" the Government to keep by the end of September; this has been seen as a "flagrant breach of the commitments promise to Washington", as the terms of the agreement did not even last three months.

A big reason for this slide is that, as noted above, the Central bank was extremely active in the market, supporting the peso even as it plunged, and intervened through a series of tenders: throughout August, it sold almost $2.5 billion, even as the peso lost over a third of its value in August.

This prompted the IMF to insist on its original idea: the dollar must float freely, the price of the currency must be fixed by the market, and in addition, the Fund's loan should not be used to finance the flight of capital." The message is clear: if investors want to buy dollars, make it very expensive for them to do so.

The bigger problem is that the Argentina Central Bank has already lost control: last Thursday, the dollar soared from $34.50 to $42 against the peso, underscoring the fragility of the exchange policy, because even as the central bank sold $400 million, the currency plunged 20%. Then the central bank was forced to urgently sell another $300 million before the USDARS closed at 40.

Hence the dilemma faced by the IMF and Argentina: for the Fund it is essential to preserve to avoid sending a signal of weakness, and leading to a collapse in the local bond market. But for central bank head Luis Caputo, allowing the dollar to rise so quickly leads to an even worse outcome, generating fear among investors and accelerating the collapse of local assets.

Meanwhile, the recent unprecedented rate hike became irrelevant, as it is useless to offer a 60% rate on pesos if the dollar rises 30% or 40% in a month.

Therefore, to Argentina it is essential that the monthly devaluation be well below the level of rates in the coming months. Only then - the bank claims - it will be possible to attract investors who are willing to buy Argentine risk.

"With bonds that yield 11% annually in dollars and bonds in pesos at 60%, it is the ideal time to awaken greed". But for that to happen it is necessary to ease the panic the behavior of the exchange rate.

That won't happen if the IMF does not back off its latest position; in fact, if the market sees the peso as no longer having the support of the central bank, the ARS could disintegrate as soon as the Monday open, plunging by a record amount.

This is why the president of the Central Bank, Luis Caputo, and his deputy, Gustavo Cañonero, scrambled to urgently get on the plane to the IMF's Washington HQ, where Finance Minister Nicolás Dujovne will also bepresent. The Argentina officials will go to Washington to convince the IMF authorities that they need much more leeway to intervene and calm the exchange market.

If they don't get it, the Emerging Market currency crisis is about to get far worse, and another Argentina default would be inevitable. As Infobae concludes, "it is an open-ended fight that is keeping in suspense not only the negotiators, but all the Argentines who will suffer the ravages of the mega-devaluation of the last month."

Real Gold and Silver Are Hedges Against the "Stupidity of the Elites" - Kiyosaki

Real Gold and Silver – 7 Reasons Robert Kiyosaki Owns Them

In Robert Kiyosaki's just-released book 'FAKE – Fake Money, Fake Teachers, Fake Assets',the best selling 'Rich Dad' author and respected personal finance expert details the seven reasons he owns "real gold and silver."

The book is designed to deliver insights and answers to help the millions of people – many of whom have had little in the way of financial education — determine what is 'real' and relevant to their financial future.

Kiyosaki is the inspirational author of "Rich Dad, Poor Dad," the No. 1 selling personal finance book of all time, and therefore always worth listening to.

Kiyosaki believes in the law of attraction and the principle that 'like attracts like' and focusing on the purest forms of wealth - gold and silver - attracts like and brings more wealth into gold owners lives.

He believes that holding real gold coins and bars attracts wealth to gold bullion owners through the law of attraction and is the best way to attract wealth and have a steady income.

In the book, CHAPTER 3 of which was released on Saturday (September 1st), Kioyosaki considers the 7 Reasons I Own Real Gold and Silver and we feature an short extract in our market update today:

REASON #1: Real gold and silver are not investments.

I do not own gold and silver to make money. They are insurance, a hedge against the stupidity of the elites… and myself.

I have insurance on my car, just in case someone hits me, or in case I hit someone else. Gold and silver serve a similar purpose.

I do not trust the elites. They believe they know everything. They believe they are always right In their minds, they do not make mistakes. They will never admit they are wrong.

Elites are not the only ones with this affliction. All of us are afflicted with the "I am right and you are wrong" disease. We all know someone who is always right.

At times, I am that person, too.

 

Kiyosaki is a consistent, long-time advocate of owning gold and silver bullion coins and bars as a way to protect and grow wealth, especially during uncertain financial times.

This Decoupling Has Never Been Greater

The divergence between financial conditions in the U.S. and Asia ex-Japan has got to extreme levels, according to the Bloomberg data.

As Bloomberg's Ye Xie details, the tighter the conditions are, the harder it is for companies to raise capital, the higher the risk of a growth slowdown, which appears to be getting priced into US and Asia stocks...

Conditions in the U.S. are about one standard deviation more accommodative than normal, while Asia is tighter by a similar amount.

The euro-zone is about neutral. Bloomberg doesn't have data for Latam, but it wouldn't be a stretch to assume it's a similar situation as in Asia, if not worse.

This is another way of saying that global growth is becoming less synchronized.

The question is, whether the U.S. pulls the EM up, or EM pulls it down.

One way or the other, the current divergence won't last long.

New High In Stocks Brings Warning From Volatility Market

While stocks are finally back testing new all-time highs, the volatility market is well off of its yearly lows, a divergence that has been problematic for stocks the past 2 decades.

The S&P 500 (SPX) made its long-awaited (& much heralded) return to its January all-time highs this week. But while stocks are back at their highs, volatility expectations (specifically, the VIX, or S&P 500 Volatility Index) — which tend to trend in the opposite direction — remain well above their 52-week lows. Now, there are always bound to be divergences at new highs in the equity market  — and, thus, divergences that matter very little, or none at all. However, the extent of the recent SPX/VIX divergence has got our attention.

Specifically, on Tuesday, the SPX touched a new all-time high (intraday). However, the VIX closed more than 40% above its 52-week closing low of 9.14 set last November. Over the last 20 years (actually 19-plus years), there have been just 3 other similar occurrences, though, the prior occurrences experienced clusters of such days. As the chart indicates, those prior occasions were very inauspicious times to be investing in the stock market, to say the least.

As one can see in the chart, the only other such divergences since mid-1999 came at the following junctures:

• December 1999-March 2000: Cyclical Top

• April-October 2007: Cyclical Top

• December 2014-February 2015: Major Intermediate-Term Top

We don't have to tell you how poorly the equity market did following these periods, but we will...

The long-term returns were the worst, especially the 1-year median return of -11.3%.Just 1 date (11/3/2014) saw a positive 1-year return and just 7 of the prior 26 saw a positive 6-month return. The short-term was also very weak with median 2-week and 1-month returns of -2.6% and -3.8%, respectively.

The intermediate-term saw a bit of a dead-cat bounce in some cases, mostly in December 1999, April-July 2007 and December 2014. That point highlights the fact that, while this signal has eventually been a warning sign for stocks, it has not necessarily been an immediate one. Indeed, the mere presence of clusters of signals around the aforementioned occurrences indicates that the first instance is not typically an immediate longer-term death knell for stocks. As tops are processes, we have seen these divergences take time to play out into negative ramifications during events in the past 19 years. However, overall, this divergence has been an extremely consistent and accurate warning sign eventually for stocks over the past 2 decades.

Now, along with the "cluster caveat", we have another caveat to consider — the pre-1999 period. That's because we observe a large sample of divergences occurring between 1987 and early-1999 that did not carry such negative consequences, at least not with the same consistency.

As the chart indicates, if we take the chart back another decade-plus, we observe an abundance of signals, particularly during the mid-1990's, that accompanied mostly a rising stock market. There were a few good intermediate-term warning signs (that may be difficult to see), e.g., 1987, 1989, 1996, 1997, 1999. However, the majority of signals saw little to no ill-effects on the stock market.

The question is, are we currently in that mid to late-90's melt-up stock market scenario, or more of the post-1999 environment. Our (strong) opinion is that we are in that latter market environment. Therefore, while this signal may just be the first of several clustered occurrences yet to come, our analysis would lead us to believe that this signal will indeed eventually have negative ramifications for the stock market.