Sive Morten
Special Consultant to the FPA
- Messages
- 18,564
Fundamentals
Obviously there are two moments that have made the weather this week - NFP and Fed. While we've briefly talked about Fed recent statement and found that it was a bit dovish, NFP report is a bit different story and has some tricky moments that we need to clarify. For example, how it is possible the simultaneous rising of vacations and unemployment at all time lows, accompanied with low rising wages... do you think that something is hidden there?
First is, lets focus on the swamp that Fed stands in. The basic results of meeting are as follows:
The Fed does not consider the rate change by 0.75%
The neutral rate (according to the Fed) is about 3%
▪ Supposed shedule of rate increasing suggests possible increase by 0.5% at the next two meetings, then by 0.25%, bringing it to 2.75% by the end of 2022. The next meetings are on June 15, July 27, September 21, November 2 and December 14
Suggestion on balance sheet decreasing - starts with 47.5 billion from June 1, 2022, then 63.5 billion from July 1, 79.5 billion from August 1 and 95 billion from September 1 and thereafter.
There is no certainty on the timing of the reduction of the balance after September 1. All this can be quickly closed if there are risks to the system. Risks in the Fed's understanding are falling markets, the threat of financial stability (credit spreads, demand for debt instruments, recession in the economy).
According to Spydell finance, the most interesting stuff is absence of exact timing and volume of the reduction of the balance sheet. The Fed tells in comments and press release that the reduction of the balance sheet will be stopped if any risks to the system become evident. The quote "there will be a reduction in the balance sheet until the Committee decides that the remaining reserves are at a sufficient level" is a soft veiled form of refusal to compress the balance sheet. They just plan to start and promise to stop if something goes wrong.
As we've mentioned previously, we expect massive defaults on junk bonds as the first obvious sign of recession as soon as interest rates keep climbing higher. Thus this week the price of a major U.S. junk bond exchange traded fund (ETF) fell to its lowest in over two years this week, as concerns over the impact of a hawkish Federal Reserve on the economy led investors to pull out of riskier assets.
Meanwhile the yield spread on the ICE BofA U.S. High Yield Index , a commonly used benchmark for the junk bond market, rose to 405 basis points on Monday from 393 bps last week, widening to its highest since March 15, when the spread hit a 15-month peak at 421 bp. A widening of the spread of junk bond yields over Treasuries is an indication of risk aversion in financial markets.
This, in turn should lead to collapse of assets and an economic crisis. Therefore, It is low doubt that Fed hardly finishes their work at desirable result. It seems more probable that it capitulates immediately at the first signs of jitter in the financial system. Therefore, between fighting inflation and supporting the market, the Fed has chosen markets. This means that inflation wins.
So, if we filter out regular trash-talk that "economy is strong, demand is strong, supply is recovering, the Fed is strong, markets are strong, everything is stabilizing, all problems should resolve and life once again become fervent and prosperous", then another interesting point is about neutral rate, which Fed suggests now stand around 3%. Actually, the neutral rate should be equal to inflation, at least, which means that now it should be no less than 7-8%.
Fed already has risen the rate to 1%, but it changes nothing. The real fund rate is "-5.5%", real bond rate is "-7.5%". This gives not good signal to the market, suggesting that Fed is loosing control over situation:
Source: Spydell Finance
Ultimate negative rates bring a lot of problems. Particularly speaking, they drastically decrease demand for the debt, as investors do not believe to J. Powell on inflation stabilization and that Fed has enough tools to control it. Now their promises confront to the fruits. As a rule, when economy is healthy, the households' cashflows to the stock markets and debt are opposite. Now we have situation when stocks cashflows are at the peak while flows to the bonds at 5 years low, despite rising interest rates. Fed vitally needs to recover cashflows to the bonds. But who will buy bonds now with the yield of "-8%"? This is rhetoric question. Last report we already said that demand for Treasuries and MBS has dropped for ~ 35-40% this year. The net Gov debt issue is amounted just $29 billion in Mar-Apr compares to $290 billion in 2021 and 1.6 trillion in 2020. They same we could say about High-Yield bonds, where demand has dropped 5 times from 150 Bln per month on average to ~30 Bln. The sanctions policy also play negative role as other countries, such as China and S. Arabia start to worry on safety of their currency reserves that they store in the US.
Using 2008 subprime crisis as example, Fed needs to make a big bada-boom crush on stock market to return investors back to the debt financing. As QE is already closed - they do not have any other way.
Source: Spydell Finance
As rates will keep rising, the debt servicing expenses will be rising as well which reduces the operating margin (difference between earnings and expenses) of the companies. With a record debt load, this destroys low-margin businesses and "zombie" corporations, which have bred widely on a background of unlimited QE. Energy cost grows, salaries grows because of lack of qualified personnel in the deteriorating labor market. Taxes rise in an attempt to close the budget deficit. All costs rise. What profit can we still talk about?
Just to make you better understand the scale of the problem, lets take a look at dry numbers on the US Debt. Over the past 2 years, the Fed has absorbed more than the half of the total bonds of all national issuers. There were 8.9 trillion bonds were issued by all national resident issuers in Dec 2019 to Dec 2021 period. This 8.9 trillion consists of US Treasuries - 6.26 trillion, MBS and agency securities - 1.23 trillion, corporate securities - 1.32 trillion, and others. During this time, the Fed's balance sheet increased by 4.6 trillion, i.e. the Fed has bought up to almost 52% of the total debt that was issued by residents and 62% of the debts that were bought up in a way of QE (treasuries + MBS)!
In mid-March 2022, the Fed stopped buying assets, sales will begin on June 1, they will sell about 190 billion dollars in the summer and are going to reach sales rates of 95 billion from September 1.
Now a new reality is coming – post-QE syndrome. The current needs of the US economy is the new debt emission about $2.7-3 trillion per year, not including the 9-10 trillion needs to be refinanced annually. Now we meet the situation when on a background of dropping demand for the bond and ultimately negative interest rates market has to absorb no just new emission of debt but Fed's selling from its balance sheet. How it is possible? The pressure now on the debt market is huge and even more with additionally sales from the Fed. It seems that everything goes accurately with our long-term view and there will be a lot of blood and pain in summer. The process is stretched in time, but it seems that degradation is inevitable.
Now we hope that our position on Fed policy and why we think that it is loosing control over situation becomes more clear.
Next topic is employment and why we also see a lot of tricks here. We suspect that it might be another driver for recession, although social. Take a look at what disbalances we have. They are not some special and separate factor but the result of the same uncontrolled QE and pandemic emission. Now we see the situation when vacancies stand at the all-time higher together with the record low employment. This is unprecedented case in the history. How is this possible?
The answer is as follows. QE money have accumulated in pockets of households that let them to invest on bubbling stock market, bringing the "investing" welfare and
let them to not search the job. On the background of QE this group of people who relates to working population but do not included in labor force statistics group jumps to 10 Mln although now gradually is decreasing:
Source: Spydell Finance
At the same time, the employment in private sector (ADP) stands at record low:
It means that we need to add 10 Mln to unemployment amount right now. With simple maths using and 3.6% unemployment stands for ~ 6 Mln people, 16 Mln will be around 9.6% - this is the reality, but it comes to statistics when stock market bubble blows and new "Buffets" loose their "welfare" starts to search the job. As you understand when big boom happens - 9.6% unemployment is just a starting point.
Market overview
Here, guys, just few moments from the market. Signs of fear are already visible on the stock market. The gyrations come as investors are faced with an array of potentially combustible factors, chief among them whether the Federal Reserve will be able to tame surging inflation without driving the economy into recession.
Thursday's selloff was extraordinarily broad with every S&P sector down on the day and more than 95% of the index constituents in the red. The Fed is hardly the only worry facing markets. Prices for oil and many other commodities remain sky high, partially as a result of repercussions from the war in Ukraine. Markets remain focused on inflation, with key U.S. consumer price data coming next week.
Ten-year Treasury yields nudged up first thing on Monday after clocking in April the largest gain since 2009, further extending its lead on S&P 500 dividend yields. The dollar also rose against a basket of currencies after scoring its best month since 2015 in April.
"Our currency, your problem," were the words of a former U.S. Treasury secretary in 1971 to other finance ministers aghast at the dollar's surge. More than 50 years on, relentless dollar strength is again leaving a trail of destruction in its wake. The U.S. currency vaulted to two-decade highs this week, and its strength is tightening financial conditions just as the world economy confronts the prospect of a slowdown.
The surge threatens "to damage the broader market environment and expose the economic and financial cracks in the system," said Samy Chaar, chief economist at Lombard Odier. The 8% gain in the dollar index this year may not reverse in the near future. Safe-haven appeal for the greenback is intact, with a dollar financing stress indicator from Barclays near its highest level in seven years. And analysis of past peak-to-trough ranges implies the dollar index could rise another 2% to 3%, Barclays said.
While currency weakness normally benefits export-reliant Europe and Japan, the equation may not hold when inflation is high and rising, as imported food and fuel become costlier as do companies' input costs. Euro zone inflation hit a record 7.5% this month and Japanese lawmakers are fretting that the yen, at 20-year lows, will inflict damage on households. Half of Japanese firms expect higher costs to hurt earnings, a survey found. But growth concerns may prevent central banks, especially in Europe and Japan, from tightening policy in line with the Federal Reserve. Many reckon that could push the euro down to parity with the dollar, a level unseen since 2002.
The Bank of England warning of recession risk and inflation rising above 10% only exacerbated concerns about the growth outlook, sparking the biggest one-day drop since March 2020.
COT Report
While last week we saw net long position drop on the back of decreasing of open interest - this time we see harder combination. Short positions increase by speculators, hedgers increase possession against EUR drop, and all this stuff happens on the back of rising open interest. This suggests strong bearish sentiment on the market, decreasing chances on any meaningful reversal in near term.
Actually net position turns bearish:
Source: cftc.gov charting by Investing.com
Next week the major data that we need to focus is the US CPI. March CPI came in at 8.5% on an annualized basis, as gasoline costs hit record highs. On a monthly basis, CPI jumped 1.2%, the biggest gain since September 2005. Early forecasts are for a 0.2% monthly rise. The March inflation surge probably sealed the Fed's 50 basis-point rate rise on May 4. The upcoming inflation print could sway expectations for how monetary policy will be adjusted going forward.
Conclusion
That's being said, the recent Fed position and their comments on situation are not necessary reflect the reality. They show no intelligent solutions for current situation. It has not discussed any real problems, all the arguments are quite abstract and impracticable. The situation in the European Union is even worse. At the same time, there is no doubt that, given the Fed's decision on the rate, next week's data will be even worse.
Some analysts suggest that the Fed could try escape discussion of the economy deterioration until the next meeting, and then, by raising the rate by another 0.25% in June, postpone the drastic steps to the summer. But it might just not work, as negative processes are going too fast. Actually, this is the main intrigue of the next two months: whether the awful situation force the US monetary authorities to take at least some additional measures, and which ones.
At the same time we do not exclude the scenario when the US could involve geopolitical steps for economy support. For example, spreading the conflict over Eastern Europe could support dollar for longer. Drop of net US debt purchases makes us think that China reducing investing activity as major buyer of the US debt. This could be the sign that China government expects imposing of the US sanctions due rising activity around Taiwan and Solomon Islands.
Speaking on EUR/USD strategy - currently we do not see any reasons to change our view, at least for 2-3 months perspective. When the US problems become evident - a lot of things depend on EU decisions. If they keep going on the course of the US foreign policy, downside trend on EUR could slow a bit but continues. Conversely, any attempt of EU to step out from the US control and follow with its own national interest definitely supports EUR, leaving the US one-on-one with their problems. But somehow it is difficult to believe that this happens. The Russian military operation terms also could play important role. Thus, if Russia takes the control over Ukraine before the US meets obvious recession signs - this will be in favor of the EUR. But if operation still will be lasting and US will try to wide it, involving Poland, Romania and Baltic countries with Finland as new NATO member - this hurts EUR even stronger.
Obviously there are two moments that have made the weather this week - NFP and Fed. While we've briefly talked about Fed recent statement and found that it was a bit dovish, NFP report is a bit different story and has some tricky moments that we need to clarify. For example, how it is possible the simultaneous rising of vacations and unemployment at all time lows, accompanied with low rising wages... do you think that something is hidden there?
First is, lets focus on the swamp that Fed stands in. The basic results of meeting are as follows:
The Fed does not consider the rate change by 0.75%
The neutral rate (according to the Fed) is about 3%
▪ Supposed shedule of rate increasing suggests possible increase by 0.5% at the next two meetings, then by 0.25%, bringing it to 2.75% by the end of 2022. The next meetings are on June 15, July 27, September 21, November 2 and December 14
Suggestion on balance sheet decreasing - starts with 47.5 billion from June 1, 2022, then 63.5 billion from July 1, 79.5 billion from August 1 and 95 billion from September 1 and thereafter.
There is no certainty on the timing of the reduction of the balance after September 1. All this can be quickly closed if there are risks to the system. Risks in the Fed's understanding are falling markets, the threat of financial stability (credit spreads, demand for debt instruments, recession in the economy).
According to Spydell finance, the most interesting stuff is absence of exact timing and volume of the reduction of the balance sheet. The Fed tells in comments and press release that the reduction of the balance sheet will be stopped if any risks to the system become evident. The quote "there will be a reduction in the balance sheet until the Committee decides that the remaining reserves are at a sufficient level" is a soft veiled form of refusal to compress the balance sheet. They just plan to start and promise to stop if something goes wrong.
As we've mentioned previously, we expect massive defaults on junk bonds as the first obvious sign of recession as soon as interest rates keep climbing higher. Thus this week the price of a major U.S. junk bond exchange traded fund (ETF) fell to its lowest in over two years this week, as concerns over the impact of a hawkish Federal Reserve on the economy led investors to pull out of riskier assets.
Meanwhile the yield spread on the ICE BofA U.S. High Yield Index , a commonly used benchmark for the junk bond market, rose to 405 basis points on Monday from 393 bps last week, widening to its highest since March 15, when the spread hit a 15-month peak at 421 bp. A widening of the spread of junk bond yields over Treasuries is an indication of risk aversion in financial markets.
This, in turn should lead to collapse of assets and an economic crisis. Therefore, It is low doubt that Fed hardly finishes their work at desirable result. It seems more probable that it capitulates immediately at the first signs of jitter in the financial system. Therefore, between fighting inflation and supporting the market, the Fed has chosen markets. This means that inflation wins.
So, if we filter out regular trash-talk that "economy is strong, demand is strong, supply is recovering, the Fed is strong, markets are strong, everything is stabilizing, all problems should resolve and life once again become fervent and prosperous", then another interesting point is about neutral rate, which Fed suggests now stand around 3%. Actually, the neutral rate should be equal to inflation, at least, which means that now it should be no less than 7-8%.
Fed already has risen the rate to 1%, but it changes nothing. The real fund rate is "-5.5%", real bond rate is "-7.5%". This gives not good signal to the market, suggesting that Fed is loosing control over situation:
Source: Spydell Finance
Ultimate negative rates bring a lot of problems. Particularly speaking, they drastically decrease demand for the debt, as investors do not believe to J. Powell on inflation stabilization and that Fed has enough tools to control it. Now their promises confront to the fruits. As a rule, when economy is healthy, the households' cashflows to the stock markets and debt are opposite. Now we have situation when stocks cashflows are at the peak while flows to the bonds at 5 years low, despite rising interest rates. Fed vitally needs to recover cashflows to the bonds. But who will buy bonds now with the yield of "-8%"? This is rhetoric question. Last report we already said that demand for Treasuries and MBS has dropped for ~ 35-40% this year. The net Gov debt issue is amounted just $29 billion in Mar-Apr compares to $290 billion in 2021 and 1.6 trillion in 2020. They same we could say about High-Yield bonds, where demand has dropped 5 times from 150 Bln per month on average to ~30 Bln. The sanctions policy also play negative role as other countries, such as China and S. Arabia start to worry on safety of their currency reserves that they store in the US.
Using 2008 subprime crisis as example, Fed needs to make a big bada-boom crush on stock market to return investors back to the debt financing. As QE is already closed - they do not have any other way.
Source: Spydell Finance
As rates will keep rising, the debt servicing expenses will be rising as well which reduces the operating margin (difference between earnings and expenses) of the companies. With a record debt load, this destroys low-margin businesses and "zombie" corporations, which have bred widely on a background of unlimited QE. Energy cost grows, salaries grows because of lack of qualified personnel in the deteriorating labor market. Taxes rise in an attempt to close the budget deficit. All costs rise. What profit can we still talk about?
Just to make you better understand the scale of the problem, lets take a look at dry numbers on the US Debt. Over the past 2 years, the Fed has absorbed more than the half of the total bonds of all national issuers. There were 8.9 trillion bonds were issued by all national resident issuers in Dec 2019 to Dec 2021 period. This 8.9 trillion consists of US Treasuries - 6.26 trillion, MBS and agency securities - 1.23 trillion, corporate securities - 1.32 trillion, and others. During this time, the Fed's balance sheet increased by 4.6 trillion, i.e. the Fed has bought up to almost 52% of the total debt that was issued by residents and 62% of the debts that were bought up in a way of QE (treasuries + MBS)!
In mid-March 2022, the Fed stopped buying assets, sales will begin on June 1, they will sell about 190 billion dollars in the summer and are going to reach sales rates of 95 billion from September 1.
Now a new reality is coming – post-QE syndrome. The current needs of the US economy is the new debt emission about $2.7-3 trillion per year, not including the 9-10 trillion needs to be refinanced annually. Now we meet the situation when on a background of dropping demand for the bond and ultimately negative interest rates market has to absorb no just new emission of debt but Fed's selling from its balance sheet. How it is possible? The pressure now on the debt market is huge and even more with additionally sales from the Fed. It seems that everything goes accurately with our long-term view and there will be a lot of blood and pain in summer. The process is stretched in time, but it seems that degradation is inevitable.
Now we hope that our position on Fed policy and why we think that it is loosing control over situation becomes more clear.
Next topic is employment and why we also see a lot of tricks here. We suspect that it might be another driver for recession, although social. Take a look at what disbalances we have. They are not some special and separate factor but the result of the same uncontrolled QE and pandemic emission. Now we see the situation when vacancies stand at the all-time higher together with the record low employment. This is unprecedented case in the history. How is this possible?
The answer is as follows. QE money have accumulated in pockets of households that let them to invest on bubbling stock market, bringing the "investing" welfare and
let them to not search the job. On the background of QE this group of people who relates to working population but do not included in labor force statistics group jumps to 10 Mln although now gradually is decreasing:
Source: Spydell Finance
At the same time, the employment in private sector (ADP) stands at record low:
It means that we need to add 10 Mln to unemployment amount right now. With simple maths using and 3.6% unemployment stands for ~ 6 Mln people, 16 Mln will be around 9.6% - this is the reality, but it comes to statistics when stock market bubble blows and new "Buffets" loose their "welfare" starts to search the job. As you understand when big boom happens - 9.6% unemployment is just a starting point.
Market overview
Here, guys, just few moments from the market. Signs of fear are already visible on the stock market. The gyrations come as investors are faced with an array of potentially combustible factors, chief among them whether the Federal Reserve will be able to tame surging inflation without driving the economy into recession.
"There is a lot of uncertainty with what is going on, with inflation, oil, global macroeconomic events," said Matthew Tym, head of equity derivatives trading at Cantor Fitzgerald. "I think we are in for some volatility going forward, probably for the whole year."
Thursday's selloff was extraordinarily broad with every S&P sector down on the day and more than 95% of the index constituents in the red. The Fed is hardly the only worry facing markets. Prices for oil and many other commodities remain sky high, partially as a result of repercussions from the war in Ukraine. Markets remain focused on inflation, with key U.S. consumer price data coming next week.
"It's pretty awful in the equity markets," said Brenner, saying that the selling was a response to Powell's remarks, as investors viewed him even more "behind the curve" in raising rates.
Ten-year Treasury yields nudged up first thing on Monday after clocking in April the largest gain since 2009, further extending its lead on S&P 500 dividend yields. The dollar also rose against a basket of currencies after scoring its best month since 2015 in April.
"Our currency, your problem," were the words of a former U.S. Treasury secretary in 1971 to other finance ministers aghast at the dollar's surge. More than 50 years on, relentless dollar strength is again leaving a trail of destruction in its wake. The U.S. currency vaulted to two-decade highs this week, and its strength is tightening financial conditions just as the world economy confronts the prospect of a slowdown.
The surge threatens "to damage the broader market environment and expose the economic and financial cracks in the system," said Samy Chaar, chief economist at Lombard Odier. The 8% gain in the dollar index this year may not reverse in the near future. Safe-haven appeal for the greenback is intact, with a dollar financing stress indicator from Barclays near its highest level in seven years. And analysis of past peak-to-trough ranges implies the dollar index could rise another 2% to 3%, Barclays said.
While currency weakness normally benefits export-reliant Europe and Japan, the equation may not hold when inflation is high and rising, as imported food and fuel become costlier as do companies' input costs. Euro zone inflation hit a record 7.5% this month and Japanese lawmakers are fretting that the yen, at 20-year lows, will inflict damage on households. Half of Japanese firms expect higher costs to hurt earnings, a survey found. But growth concerns may prevent central banks, especially in Europe and Japan, from tightening policy in line with the Federal Reserve. Many reckon that could push the euro down to parity with the dollar, a level unseen since 2002.
The Bank of England warning of recession risk and inflation rising above 10% only exacerbated concerns about the growth outlook, sparking the biggest one-day drop since March 2020.
COT Report
While last week we saw net long position drop on the back of decreasing of open interest - this time we see harder combination. Short positions increase by speculators, hedgers increase possession against EUR drop, and all this stuff happens on the back of rising open interest. This suggests strong bearish sentiment on the market, decreasing chances on any meaningful reversal in near term.
Actually net position turns bearish:
Source: cftc.gov charting by Investing.com
Next week the major data that we need to focus is the US CPI. March CPI came in at 8.5% on an annualized basis, as gasoline costs hit record highs. On a monthly basis, CPI jumped 1.2%, the biggest gain since September 2005. Early forecasts are for a 0.2% monthly rise. The March inflation surge probably sealed the Fed's 50 basis-point rate rise on May 4. The upcoming inflation print could sway expectations for how monetary policy will be adjusted going forward.
Conclusion
That's being said, the recent Fed position and their comments on situation are not necessary reflect the reality. They show no intelligent solutions for current situation. It has not discussed any real problems, all the arguments are quite abstract and impracticable. The situation in the European Union is even worse. At the same time, there is no doubt that, given the Fed's decision on the rate, next week's data will be even worse.
Some analysts suggest that the Fed could try escape discussion of the economy deterioration until the next meeting, and then, by raising the rate by another 0.25% in June, postpone the drastic steps to the summer. But it might just not work, as negative processes are going too fast. Actually, this is the main intrigue of the next two months: whether the awful situation force the US monetary authorities to take at least some additional measures, and which ones.
At the same time we do not exclude the scenario when the US could involve geopolitical steps for economy support. For example, spreading the conflict over Eastern Europe could support dollar for longer. Drop of net US debt purchases makes us think that China reducing investing activity as major buyer of the US debt. This could be the sign that China government expects imposing of the US sanctions due rising activity around Taiwan and Solomon Islands.
Speaking on EUR/USD strategy - currently we do not see any reasons to change our view, at least for 2-3 months perspective. When the US problems become evident - a lot of things depend on EU decisions. If they keep going on the course of the US foreign policy, downside trend on EUR could slow a bit but continues. Conversely, any attempt of EU to step out from the US control and follow with its own national interest definitely supports EUR, leaving the US one-on-one with their problems. But somehow it is difficult to believe that this happens. The Russian military operation terms also could play important role. Thus, if Russia takes the control over Ukraine before the US meets obvious recession signs - this will be in favor of the EUR. But if operation still will be lasting and US will try to wide it, involving Poland, Romania and Baltic countries with Finland as new NATO member - this hurts EUR even stronger.