Friday, 9 July 2021

How far behind the curve is the Fed?

Over the last few months Treasury yields have dropped and retraced a large amount of the Q1 sell off.

Commodity prices have peaked, in my view, stimulus has or is peaking, and the usual suspect deflationists are calling for lower bond yields. 

Set against this is the ongoing economic recovery and, in my experience, without a massive unexpected shock and with the ongoing fiscal and monetary stimulus, its hard to see why the US economy would relapse into a recession and deflation. 

The fact that the US Current Account has widened suggests that there is ongoing excess demand in the economy.

Instead, the drop in US 10yr yields since March is probably more down to the combination of a normal consolidation phase following a large move and then some short term supply/ demand technicals, concentrated positioning, stop losses and regulated buyers vs the fact that the 10yr-plus part of the Treasury market is a relatively small amount of the outstanding, with 10-30 year bonds being about 20% of new Treasury issuance.

Instead we are likely to see a normal reflationary cycle of unemployment falling, capex rising/ service industry job creation, wages rising and ultimately a hiking cycle followed by a recession. 

So where are we in this cycle? 

The Fed today published its monetary policy report. Their ongoing conviction is that yes the economy needs more support in the form of ZIRP and continuing QE and that they are not ready to commit to tapering, but might be later in the year. In fact, over half of the FOMC participants expect Fed funds to have zero to two hikes by the end of 2023 with 5 of those expecting zero hikes! 

Unfortunately for them, the strong recovery in the US economy has now led the number of job openings to be larger than the number of U3 unemployed.

The last and only time this has happened before was in early 2018 when Trump was stimulating the late cycle economy and the Fed was half way through their hiking cycle. US 10yr Treasuries were yielding around 2.4-2.5% and fed funds were at 1.4%. 

So even by the Fed's own track record in the most recent cycle, they are far behind the curve, their projections are absurd and the excess stimulus and Fed balance sheet growth is causing many asset bubbles to extend. 

The excess balance sheet growth in the last cycle never really led to a wage-price inflation spiral. So the Fed never got trapped with a large balance sheet leading to excess reserves in the system that then lead to credit growth and rising monetary velocity. 

When asked about when the Fed would unwind its balance sheet, Bill Gross famously quipped 'never'. And for the most part he was right. 

In this cycle however the starting point is with over 3% wage growth whereas in 2009 it was well under 2%. In the last cycle job switcher wage growth almost hit 5% before the recession. 

In this cycle, given we already have more job ads than employable unemployed, most probably wage growth will exceed 5%.

If that combines with credit growth and a weak Dollar then the Fed will be forced to act much earlier than expected. 

Dec 2022 and Dec 2023 Eurodollar futures have diverged this year but Dec 2023 is only pricing in 3-4 hikes and Dec 22 only 2.


As mentioend above the last time the employment market was this strong the Fed was already at 1.40% in early 2018 and by year end had hiked to 2.4%. That sent the 10yr from 2.4% in early 2018 to 3.2% by year end, the cycle high, as in 2019 the economy slowed and manufacturing went into recession.

Fed funds rate:

So if wage inflation starts to rise and point towards higher inflation going into 2022 the Fed will be under immense pressure to speed up policy normalization and hike rates.

Wednesday, 24 March 2021

Inflation? What inflation?

I had a break from posting, partly due to other commitments and partly as I had similar views as what the market was doing, namely looking for a liquidity fueled recovery. 

I did expect a correction in the summer or Autumn, particularly into the Corona re-outbreaks and US election, but in the end the power of stimulus was too much and it was more of a temporary sideways move. 

So in a world of ZIRP, QE, unprecedented fiscal deficits, modest curve steepness, sky high asset values, what can derail this?

We hear a lot about inflation and the impending USD collapse, but the USD has risen this year against the majors on the yield differentials. 


Modern inflation

Under the gold standard, with mostly industrial economies, inflation was certainly a monetary phenomenon and the gold standard prevented it. 

As we have moved towards a services economy with open goods trade and a fiat monetary system where credit, the financial system and the money supply can grow faster than the real economy for long periods, there has become really two forms of inflation; firstly money supply/ credit/ financial economy growth and secondly skilled wages.

QE and base money creation cause, by the portfolio channel effect, asset price inflation as investors seek higher returns than available in fixed income. To the extent that, with fiscal stimulus, delivers a recovery then broad credit/ M4 growth also happens. So you have credit supply and asset inflation underwritten by QE/ ZIRP/ fiscal stimulus. I think ZIRP/ QE is most relevant for financial assets while fiscal stimulus is most important for the real economy cycle. 

As Steve Keen has shown, in a financialised economy, private sector credit going from growth to contraction causes a final demand shock and that can lead to a deeper real economy recession and a credit crisis in the financial economy. So governments have stepped into the Covid crisis with unprecedented fiscal stimulus to support final demand. 

This demand support combined with supply chain issues had pushed up commodity prices. However rising or falling commodity prices, while they impact CPI, are really just a relative pricing power shift between goods producers.

So when people predict inflation from QE/ fiscal deficits, is it showing up in credit or the money supply?

The Fed's H8 survey suggests not, while Treasury supply is growing, large parts of private sector credit is contracting and overall bank credit is growing ~6%. So while the inflation has shown up in asset prices, there is no sign of it creating inflation in the real economy. 


The Fed's recent projections forecast a 6.5% GDP growth this year on a $21Tn Q4-20 economy, while bank credit is growing about 6% on a $15.6Tn banking balance sheet. So bank credit is currently growing at a disinflationary pace vs the economy. Mainly due to private sector deleveraging. I dont think non-bank credit will be doing much differently given the broad deleveraging by private borrowers. 

Q2 inflation outlook

The Fed is expecting YoY inflation numbers to peak in Q2, which is when the difference in commodity prices will be highest and there will likely still be some supply chain disruptions for goods. I agree and also expect inflation to drop back in the second half. 

The NY Fed UIG inflation prices only metric is at 2.3% and looks to be rising, while CPI is only 1.7%. If you look, CPI ranges and mean reverts around the red coloured UIG prices measure, so should overtake and overshoot to the upside, maybe 2.5-2.7% in Q2 or early summer. The Atlanta Fed's 1yr forward inflation expectation is rising strongly to 2.4%.  

Treasury yields should peak a month or two before all of this, so likely April or May in an upside squeeze. 

The recent topping in oil and renewed real estate foreclosures and rising mortgage yields should also soften owner equivalent rent and normalising supply chains should take the edge off goods price inflation. Service inflation has been sticky at a little under 2%. 

So I think 1.95-2.05% on the 10yr TSY is a reasonable target. It would give almost 200 bps steepness for the 10yr-2yr TSY spread, which is more or less as high as curve steepness gets in recent initial recovery phases before the spread moves into a range. 


After that I would expect some of these inflationary pressures to drop and TSY yields should also drop back to maybe 1.40-1.50% on the 10yr and the weak USD/ commodity reflation/ EM reflation trade should be back on. 

Service wages

However, if monetary inflation is not an issue, perhaps later this year going into next year skilled service wages will be. In most recessions wage inflation has reduced by about 2%:

But in this recession it has hardly moved and most of the job losses have been lower skilled jobs. 

Skilled worker employment is only down 2-3% YoY now while lower skilled it is more like 4-5%. The JOLTs job survey is also showing strong job growth, so over this year a lot of the employment slack should go and we get a tight market for skilled jobs. 

In fact the Atlanta Fed's job switcher wage inflation metric which peaked at 4.3% has hardly moved down this time. The last two recessions it dropped 3%.

To going into next year if job switcher wages are growing 4.5% or maybe more, the pace of the recovery is slowing, service inflation is picking up, maybe 10yr yields go for 2.5-3% with the market looking for a hiking cycle starting in mid-22. 

If this is coinciding with fiscal deficit reduction, while equities are likely to rally as the USD weakens in H2, maybe in 2022 if margins come under pressure, the outlook will be for lower equity valuations.

In the end it will be skilled wage inflation that will force the Fed to hike and tighten financial conditions and this wage pressure leading to hike pressure will only end with a genuine labour market recession.  





Tuesday, 7 July 2020

A little market update

The Nas pulled back as the leading market on a technical signal. Most of the day was showing a doji reversal signal though but ended the session weak.

S&P looks like it is being banged between the daily chart levels on level 3 until it breaks out in August/ September either way.

But watch the 10yr for confirmation, I think a break below 60bps is key.

Yen from before March (when the US curve inverted QE was repatriated):

Rebased from after:

Friday, 19 June 2020

Where does the bear market rally stand?

Fed QE is over for now but might not matter that much for a few months. Treasury crowding out last time showed up with a curve inversion and its a little hard to invert the curve at ZIRP, but anything below 40-50bps on the 10yr I would see as major warning sign. In fact any break below 60bps.

But other CBs still expanding so USD may slightly rise over summer? 

In the short term today we had the quad witching and with VIX in low 30s and dealers rebuilding theta it should drop next week and technicals push the market higher. I would really like to see the VIX in the teens and CTAs fully long in the next move higher. 

S&P might break through the resistance at 3214 which is the January low it was struggling with but normally you get a risk off in the summer holidays, then perhaps a bounce into election as both sides promise deficit spending, but then not make a new high while internals weaken. 

Many other assets might not rally much from here. Look for a flattening TSY curve, reasonably supported USD and peripheral assets start to flatline.

In 1929 the market bounced for about 5 months after the initial sell off, and that was under a hard money standard with no QE.

I have no idea how many of the jobs losses will be recovered in 3-6 months but it will be far less than 100%, even 60-70% would be a borderline miracle and after that, it will be the slow grind that can take years.

After the election, Trump, who I assume wins, doesnt really need to care about the stock market, he has the real economy to worry about and he cant magic up corporate margins during the worst recession since 1929. Particularly when it becomes clear the recovery is drawn-out, defaults are picking up and Schumpeter comes back from the dead like the ghost from Christmas past. 

Friday, 15 May 2020

Has my equity contribution gone to money heaven or the land of the living dead?

Low rates, QE, fiscal deficits have forced institutions up the risk curve and down the liquidity one in this cycle and two of the worst areas, in my opinion, are LBOs and blue-chip CRE yielding 4-5%, particularly in 'Global Gateway Cities' like London which are so inflated ordinary people can't afford to live in them.

We were late-cycle before Covid hit. I don't actually think Covid is that big a deal if you are not vulnerable -we don't shut the economy down every Winter due to flu. But the lock-downs initially to stop ICUs being overwhelmed with otherwise survivable working-age patients, has now transformed into a huge recession and soon a solvency and default cycle.

So I think this year corporate margins will fall heavily and then not fully recover. Additionally, the demand for CBD office space will permanently fall. The exodus of ordinary people from Gateway cities will be accelerated etc. Potentially decades of change are being catalyzed by a few weeks shutdown and its aftermath.

So what should the impact be on these two popular LP plays, LBOs and blue-chip CRE?

LBOs have been done recently at 11-12x pro-forma EBITDA, late cyle, with more or less peak margins.

I present a few charts below from the prior blogs:

Longer run average after-tax profits as a percent of GDP are 5-7% vs 8.7% in Q3 2019, i.e. 5% after a downturn and 7% after a growth cycle. If US profits fell to the middle of that range, 6%, from 8.7% in Q3 19, profits would fall 41%, after the recovery

EDITDA is not as sensitive as after-tax profits, but let's assume a 41% profit drop equates to roughly a 30% EBITDA drop for an average LBO company. 
Let's assume a recent LBO with $1 of EBITDA was done at $11 enterprise value, financed with a $5.50 senior loan and $5.50 of equity. Then after a downturn the loan market is only willing to finance LBOs at 8.5x EBITDA. 
Using the $1 of current EBITDA, this drops to 70c. At 8.5x the 70c EBITDA the company is worth just $5.95. But the senior debt was $5.50, so the equity residual has fallen to just 45c, vs the original LP commitment of $5.50; that's over a 90% loss of equity driven by a fall in margins and a fall in mulitples. 
So you would assume this would breach loan covenants and the deal would be toast?
But here is where it gets more interesting. LBO GP's are judged, in part, on how many deals go to zero. So if a company's business has not blown up and the issue is more the amount of debt/ EBITDA, then the GP's have a huge incentive to keep a bad deal alive.
Over 5-10 years, as nominal GDP grows, most companies should see substantial revenue and therefore EBITDA growth, so by keeping a bad deal alive, even if it involves drip-feeding more equity in after a the downturn, it keeps management fees coming to the GP, a positive carry option for the GP on recovery and avoids difficult conversations with LPs, but all at the cost of the fund IRR and liquidity to the LP. 
In conclusion, with the incentives and ability of the GPs to keep bad deals alive, this looks more like a land of the living dead outlook for LBO LPs.

The situation is broadly similar in blue-chip CRE. 

With 4-5% yields recently and 7-8% post-GFC for several years. Land Securities in the UK predict a 20% drop in rent values as a function of remote working lowering overall demand levels. 
Setting aside whether I think 20% is a big enough rent drop:

Building rent: $1
4.5% yield value: $22.20
60% LTV CM: $13.30
40% equity: $8.90

Building rent: $0.80
7.5% yield value: $10.70
60% LTV CM: Capital loss of $0/ -$2.60 if no Directors Guarantee
40% equity: -$2.60 if there is a Directors Guarantee

In a 50% debt, 50% equity capital structure the debt would still be under the water by $0.40.

This scenario ignores anything like skipped rents this year leading to non-payment of mortgages, rental drops of more than 20%, occupancy slumps, auctions changing hands for higher yields than 7.5% yield or Class B or C properties performing worse or going empty... 

In conclusion, Commercial Real Estate looks more like a money heaven scenario - for existing investors. 

Wednesday, 13 May 2020

Equity rally is flagging in May, while Business Loans explode higher

So far in May its only really the Nasdaq that is up. So its a fairly narrow market post the April bounce.

The Corona shutdown fall out is starting to hit the headlines.

For example a Reuters report showed 10% of Spanish businesses closed in March.

If it creeps lower for now and then starts to sell off, people will panic sell and we could easily punch through the March lows.

This chart shows Business Loans in the US. 

Prior to Covid they had fallen to almost flat YoY. Business loans normally shrink in a recession. 

But now they are growing almost 30% YoY. That is debtor in possession type financing whether it is PPP type loans or revolvers being drawn, its debt (a liability and part of the capital structure) being used to cover lost cash flow (an asset and part of the current flow/ activity of the business). 

Basically businesses are being bled dry and will have to drastically cut costs, which makes a second leg of contraction more likely than even a U-shaped stabilisation.

Additionally, some of the most hit areas like Casual Dining or Hotels will take a lot of time to get back to prior operating volumes, so are likely to be defaulting in Q4.