Sunday 25 March 2018

QE unwind, Libor and credit demand

For the most part in the West the governments have been the big borrowers in this cycle and the leveraged lenders to them have been banks; commercial and central. The Fed is now selling and that is acting as a transmission mechanism to tighten funding conditions and raise yields in some areas of fixed income. 

The problem some banks have now is negative carry assets and duration losses. DB as of last Dec, for example, seems to have a TSY/ agency portfolio yielding 1.4%, over EUR180bn of fixed-rate loans and overall a EUR630bn financial markets balance sheet. 

The Central Banks have a looming problem, perhaps in 2019 for the Fed, if they go to a neutral interest rate for the real economy they hike the interest bill on the host government (about $150bn cash interest I believe for every 100bps on sub-$4Tn Federal revenues) and cause duration losses for leveraged and real money holders of debt, including pensions and state pension systems. If they dont hike enough rates are still very loose for the real economy. 

Overall I expect them to let rates creep up and Fed balance sheet to shrink until something goes bang. I think that is when Fed funds are over 3%. Then the Fed will be stuck and I think the market sees the 'LBO Whitehouse' for what it is later this year or early next year; keep rates low and grow nominal GDP to get debt/ GDP down and wages as a % of GDP up while avoiding a bad recession at all costs. You can grow nominal GDP over 150% in a decade if you really want to...

Trump's recent spending bill has probably injected $500bn or so of extra demand into the economy at a time of full employment. I think initially that will support demand and corp profits, and looking above at the 1970s, initially, equities rallied. But ultimately wages go up, and when margins fall equities fall; the Wiltshire index above fell about 50% in its bear market and never really performed well vs inflation after that until Volker hiked interest rates to kill inflation in the early 1980's.  

It is interesting that the Fed tax cuts and spending bill have come at a time when demand for bank credit has stalled or even started shrinking: 

So far the first to shrink has been marketable securities, obviously. But business credit is hardly growing, the consumer is holding up so far though.

They really need the wage inflation to come through to support the economy from here, otherwise the hiking cycle will end in a recession when corporates cut back. After a good start last year, the last 9 months have been really subdued for wages though. 

Saturday 24 March 2018

Cold war defense spending

The new deficit heavy spending bill increases significantly big ticket, set-piece conflict type item spending. Someone on twitter remarked it was like we are back to 1986.

The truth is we are in 1986, except we are the Russians fighting the Muj in the mountains, there is no real threat from large standing armies.

None of the big ticket items are designed to fight asymmetric warfare. Asymmetric warfare calls for more drones, robots and better armour and more equipment to the on the ground local allies. You wonder how much of the R&D money will go on that type of equipment.

Here is a summary of the big-ticket items:

The Department of Defense is set to gain $61 billion more than last year's enacted funding for a top line of $700 billion.

The funding will be spread over the Pentagon's base budget of $589.5 billion and $65.2 billion for the overseas contingency operations, or OCO, budget. The remainder of the $700 billion is appropriated to other defence-related programs outside the Department of Defense.

The omnibus allocates $144.3 billion for military equipment procurement, including big-ticket items such as:
  • $23.8 billion for 14 Navy ships
  • $10.2 billion for 90 F-35 fighter jets
  • $1.8 billion for 24 F/A-18 fighter jets
  • $9.5 billion for the Missile Defense Agency
The defense-friendly bill also provides $238 billion for operations and maintenance, $89.2 billion for research and development, and $137.7 billion for personnel pay – a 2.4 percent increase from fiscal year 2017.
Source CNBC

So basically its equipment to menace Russia, challenge China and threaten North Korea and Iran. There is $45bn or so there for the Navy to bomb standing armies with.

Russia in my view is no real threat. China has zero intention of intervening anywhere. North Korea is a weak paper tiger. Iran could be attacked from ground bases and is likely better off boxed in and isolated than attacked.

In terms of China's influence, they are expanding their influence via OBOR across Asia, Africa and Central Asia. And they are exporting heavy industrial, infrastructure, clean energy and cheap finished goods.

What does America export to these countries? Generally services, branded goods, IP, some high-end industrial goods.

Put simply China and the US are not directly competitive anyway.

The only real way to explain this is a mix of boondoggle waste for the military-industrial complex, paranoia in the deep state about China and Iran and a generalised effort to stimulate manufacturing related industries. 

What would Bernie have spent $45bn on? Clean energy, EV, energy storage, efficiency technologies, education, supporting exports to EM perhaps?  Or just not spent the money.

Thursday 22 March 2018

Fed funds, Libor and MAGA economics

USD 3-month Libor is currently up to approximately 2.25%, outpacing Fed funds and OIS, as it seems a mix of high Treasury issuance, Fed QE unwinds and maybe some other bank funding factors pushed up Libor.

The FOMC projections now show a terminal Fed funds rate of 3.25-3.5% as the central tendency. If Libor trades 25-50bps higher at that time, then Libor will be at 3.5-4%. 

If the Fed hikes three more times this year to 2.25% and Libor is 2.75-3% at that time, then effectively most of the hiking cycle will have been done, the end of which normally involves a recession. 

3-4% while it is a big move for highly valued asssets and a financial system that is in the hundreds of percent of GDP, it is still loose for an economy growing, 4.5, 5 maybe 5.5% in nominal terms.

However, the Fed's projections don't make any real allowance for a wage-inflation-investment cycle starting, which is what Trump's MAGA policies are trying to support, ie they are trying, in my view, to create a new economic cycle with new drivers, without having a Fed-induced recession in the middle. If those policies are successful then wages should rise, which will squeeze margins and in turn force companies to invest. That should also result in a higher default rate for weaker companies.

If nominal GDP rises to a 5.5, 6 or 6.5% range, the Fed will really be cornered and financial markets very pressured.

Every 100bps in increased Treasury yields costs the Federal government something like $150bn in interest costs on a rounded up $4Tn Federal revenue base.

That said MAGA aims to reduce the CA deficit in favour of domestic jobs and production. If the deficit can improve by a $500bn delta, that could be worth $150bn in taxes and partly offset the rise in interest costs. 


Wednesday 21 March 2018

Fed funds

The terminal level crept up 25bps to 3.25-3.5%.

Now forcasting higher GDP growth, lower unemployment, no impact on Core PCE...

Makes perfect sense with all the tax cuts, stimulus, import tariffs...

If they forecast 2% inflation and 2% GDP growth, and 3.25-3.5% Fed funds, its still easy at the terminal level for the real economy. Perhaps not so much for the financial economy.

Overall seems the Fed dont believe in MAGA, ie tax cuts, tariffs and infra spending aiming to push wages up via a wage/ inflation/ investment cycle. Lets see who is right.

Tesla ready for a short squeeze?

Rising lows suggest accumulation. It could be setting up for a short squeeze irregardless of long term chances vs the majors.

In fact Musk would be well advised to merge with a 2nd or 3rd tier player like Chrysler. Mazda would be the only other logical choice as it has US domestic manufacturing and a market cap in the low teen billions and 9x P/E. Mazda is also building a plant with Toyota in Alabama.

Teslas 30m short interest is wide open for a VW/ Porsche squeeze. Would certain traders miss the opportunity should it present itself?

Thursday 8 March 2018

Duration losses on banks, political push backs and the EUs coming existential crisis.

Governments have been the big borrowers in this cycle, effectively reinflating the pre-08 credit bubble as opposed to dealing with the structural problems. 

Has anyone seen research on how big the duration losses would be if US rates go through 3% and flat to positive term structure? I haven't seen much if any.

The banks, if they are holding duration as a carry trade, will have negative NIMs/ carry plus mark to market losses. 

For example, European banks bought >$600bn of Treasuries since 2012. For now, I think most of the US curve near-term sell-off has happened, in fact, we could even have a counter-trend position clear out/ rally, but into year end perhaps we see another sell-off. 

In the interview below Yannis Varoufakis talks about the mark to market triggers in Europe. European banks are currently relying on EUR760bn in ECB LTRO funding which is collateralised and EUR800bn of TARGET2 funding which is un-collateralised at the moment. Most of that borrowing is by periphery banks. 

I have maintained that the real existential crisis in Europe will be politically triggered by a core member, Italy, France or Spain are the only real candidates, aside from Germany obviously. 

In this recent election, 57% of Italians under 44 years of age voted for M5S or Lega, both anti-EU parties. 

Mark Blythe and David Kertzer discuss Italy below:

We just have to see what happens in terms of a coalition in Italy and whether they are serious this time around (I doubt it) or whether we need to a see a few more years of Germany product dumping into the rest of the EU as the US and UK reduce imports.  Perhaps Italy has a short parliament now based on coalition and then another election in 9 to 18 months time. 

Trade wars

The US is a fairly closed economy and while their trade deficit hurts certain parts of the economy (suppressing low wage earnings and the manufacturing sector), a trade war cant really have that big a negative impact and there are positive impacts associated with the wage/inflation/ investment cycle rebalancing. 

Germany, on the other hand, is operating an intra-EU supply chain and labour arb business model and exports total over 45% of GDP. 

(Discussed here: and here:

Germany's trade balance with some of its largest trading partners:

Germany's export surplus to the top 3 alone is EUR145bn a year alone in 2016. That 4.1% of Germany's GDP just in trade surplus to 3 countries. 

If the US and UK impose tariffs/ hard Brexit tariffs what will happen?

Will, as Varoufakis suggests, the EU use the EIB to support EUR500bn of pan-EU infrastructure spending? Will the EU engage in a Belt and Road initiative in East Europe, the Middle East and Africa? 

Of course not, the private sector will immediately product dump into France, Italy and Spain. Maybe after an existential crisis, the EU's politburo will do the EIB infra plan. 

The political, business and employment consequences of Germany's private sector product dumping tens of billions of Euros in products principally into 3 EU countries will be the trigger for real EU crisis. 

So assuming nothing much happens stemming from this Italian election as whoever is in charge probably wont have enough authority to do anything serious, then we have Brexit in Q2 next year and the potential for an EU crisis going into year end or early 2020 triggered by the onsequences of German product dumping. The Fed should have raised rates into the 2.5-3% range as well by then.


Tuesday 6 March 2018

Toronto off 17% in under a year

Coming to a global mega city near you soon..

Worth bearing in mind that people who bought at the top of the bubble in 1997 in Hong Kong had negative equity until 2011. The market more than halved before bottoming in mid-2003. And FWIW the Hong Kong bubble is bigger now than it was then.

Thursday 1 March 2018

Core-PCE starts to firm up

Core-PCE has been held back in the last year by weakness in autos, durable goods, apparel and food, while the service parts of the economy were seeing inflation more in the 2-2.5% range. I wrote an article on what was holding back the numbrs last year:

The BEA stopped publishing sub-tables last August but some are in the CPI release. January numbers suggest prices improving in the durable goods sector, while apparel has also improved. 

The Census Bureau also shows durable goods orders/ shipments up 8/9% YoY with broad-based growth.  

Without hedonic adjustments and the few pockets of weakness, some of which seem to now be improving, Core-PCE would already be above 2%, maybe closer to 2.5%, vs 1.5% Fed funds. If we get some improvement in wages it will further underpin it. 

Wages grew faster than GDP the first half of last year but then seemed to stall in the second half and grow more or less inline with GDP resulting in onlt a small increase in wages/ GDP in the second half. 

You simply cant 'MAGA' without wages growing as a % of  GDP. Seems to be off the bottom, but there is a long way to go yet. 

Government transfers muddies the picture on total income, but put simply, higher domstic manufacturing, less imorts, higher savings, more capex and more domestic high quality jobs will increase wages as a % of GDP and also reduce transfer payment bills for the government.