Sive Morten
Special Consultant to the FPA
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Fundamentals
This week was relatively quiet, as we haven't got a lot of drivers, just some stats on Thu and Friday to name. ECB/Fed speeches were not decisive as well. It seems that summer and vacations time is coming and amount of market drivers is decreasing. Still, besides, of recent statistics, there are few moments to mention that are not widely covered in media, but it could open the view on what to expect from the Fed. Also we need to take a look at the US liquidity, what is going on there.
Market overview
The dollar index was lower on Friday following two straight days of gains, after economic data showed a cooling in consumer spending, raising some doubt about the potential aggressiveness of the Federal Reserve in fighting inflation. U.S. Treasury yields were also mostly lower after the data.
The Commerce Department said consumer spending ticked up 0.1% in May while data for the prior month was revised to show spending accelerated by 0.6% versus the previously reported 0.8%. The personal consumption expenditures (PCE) gained 0.1% for the month after an 0.4% rise in April while advancing 3.8% on an annual basis, slowing from a revised 4.3% the prior month.
Expectations for a 25 basis points hike at the Fed's July meeting dipped slightly, with markets now pricing in an 84.3% chance of a hike, down slightly from the 89.3% on Thursday, according to CME's FedWatch Tool. Chicago Federal Reserve Bank President Austan Goolsbee said Fed officials will be parsing "a lot of data" leading up to the Fed's next meeting to assess whether borrowing costs need to be pushed up higher to tamp down inflation.
Euro zone inflation data fell for a third consecutive month, but showed a small drop in underlying inflation and was unlikely to keep the European Central Bank from hiking rates at its July meeting. Inflation in the 20 countries that share the euro fell to 5.5% this month from 6.1% in May, chalking up its seventh decline in the last eight months, with Germany the only country to report an increase, Eurostat's flash estimate showed. Annual inflation in Germany accelerated to 6.4% in June from 6.1% in May.
But "core" inflation excluding energy and food, which ECB policymakers see as a better gauge of the underlying trend, only edged lower, to 6.8% from 6.9% - far from the sustained drop the central bank wants to see.
ECB President Christine Lagarde said this week that the central bank was unlikely to call a peak in rates any time soon, and most policymakers see a further hike in September as likely.
On Wednesday, Powell said at a European Central Bank meeting of central bankers he did not see inflation getting back to the Fed's 2% until at least 2025.Other central bank heads at the meeting, including ECB President Christine Lagarde and Bank of England Governor Andrew Bailey, also supported more rate hikes, with the exception of Bank of Japan (BOJ) chief Kazuo Ueda.
The U.S. dollar's share of currency reserves reported to the International Monetary Fund rose in the first quarter of the year, in the midst of a still aggressive rate-hike cycle from the Federal Reserve aimed at curbing uncomfortably high inflation. The greenback's share of reserves rose to 59% in the first quarter of the year, from 58.6% in the last three months of 2022. The euro's share, however slipped to 19.8% in the first quarter, down from 20.4% in the previous three months.
STRUCTURAL CRISIS UPD
Despite some relief in EU CPI numbers and US PCE, we have to acknowledge that the structural crisis is underway. Wider view on recent data shows the clear tendency - strong deflation in production sector and stable inflation in consumption with deterioration of major indicators. Usually we're focused on the US, but today let's take a look mostly on EU - you'll see that absolutely the same tendencies here:
Why it is happening? The latter is understandable ( PPI and CPI divergence) — this is a drop in real demand, which spreads through technological chains. Moreover, most likely, the further away from the end consumer, the greater the drop in prices, because otherwise it is absolutely impossible to save their consumers.
But why is there no deflation in the consumer sector? The growth of costs in the structural crisis stands. But it is a large variation in the real cost among industrial companies (someone was able to save on something and survived, and someone went bankrupt) and therefore one company is doing (relatively) well, while others are quite bad. In full accordance with the theory of working in falling markets.
But it doesn't work that way in consumer markets, where everything is based on demand, which needs to be met and international competition. Roughly speaking, American consumers of intermediate industrial goods compete not only with each other, but also with Chinese imports, which are a priori cheaper than American products. Accordingly, the demand for intermediate goods of American production is falling. And China is increasing exports.
This does not help China, since this export growth is insufficient to compensate for falling domestic subsidies (and they, in turn, cannot be increased due to the danger of inflation). But it allows you to partially compensate for internal problems, while in the USA it's the opposite.
In general, it can be noted that the structural crisis is developing in all its glory, and in some details it is accelerating. However, it is possible that this is a consequence of the fact that the previous months the recession was hidden in the hope that it would end. And now we have to admit the obvious.
Meantime, de-industrialization of Germany continues. Now EU and UK economies together are less than the US one, while not too far ago, in 2008 the EU economy was greater. Without UK contribution, EU economy now is two times smaller than the US. The overall trend is clear.
US LIQUIDITY UPD
Not any big changes this week. Based on data that have been released yesterday - it seems that major inflows come from tax revenues, for IQ that gradually are coming on US Treasury accounts. Take a look that Fed Balance has dropped and retraced all of the increase from the SVB bailout, shrinking for the 3rd straight week (-$21.1 billion)... QT continues, but with very small value this week, around just $8 Bln. Fed emergency liquidity programmes have solid demand and stand stable around 106 Bln, slowly increasing week by week:
Meantime, money market funds mostly stands stable, according to recent ICI data, showing just minor outflows around $3 Bln. Besides, the dynamic differs. Retail saw a 10th straight week of inflows (+5.8 billion) while institutional funds saw $8.7 billion of outflows (3rd straight week)..., supposedly this is due corporate taxes demand or maybe chasing of AI stocks.
There remains a significant decoupling between bank deposits and money market funds...
The US equity market is starting to catch down to the contraction of bank reserves at The Fed...
Meantime, we do not see another big contraction in Reverse Repo accounts, while US Treasury TGA account has increased for ~ 350 Bln in just a single month:
M2 also starts climbing higher, approximately for ~ 200 Bln:
So, it seems that we get ~ 170 Bln out of Reverse Repo market in June, 130 Bln from bank reserves, which is approximately equals of US Treasury account growth. Since M2 also has increased slightly, it could mean that US Treasury by financing US Government's spending send some money back in the system. While US Treasury keeps borrowing on low level, system feels more or less good, and remains balanced. But it can't stay in this way for too long.
WE'RE TIRED TO WAIT (instead of conclusion)
It is many talks about crisis. Everybody tells that everything stands bad, or at least point of definite problems as we do. But the major question remains the same - when the situation will explode finally? This month, in three months, in a year, or when? Based on recent data we do not see that this should happen in a month or so. Because the situation is strange. The fight against inflation is going somehow wrong. The decrease in the most liquid components of the money supply is insignificant as we see from analysis above, and the drop in M2 was explained by the overflow from savings accounts to reverse repo. Now also M2 began to grow.
The population continues to drain their savings, supporting demand. Now the state has joined in after the debt ceiling and continues to stimulate demand with increased government spending. And that's a problem for the Fed. A rate hike does not act as quickly on demand as it does on the financial sector, as we saw with the banking crisis in March 2023. The cost of servicing debt for companies and households is rising slowly as cheap credit is replaced by expensive credit. Basically, the Fed has always raised rates until something breaks. The main question is when it will happen this time and where exactly.
Meantime, they expect something. Yellen recently said that Banks to lose money from problems in the real estate sector. According to the stress test of the US financial system, which is conducted annually by the Fed, in the most negative scenario, the largest US banks will lose $541 billion. The most affected are Deutsche Bank USA, UBS Americas and Commerce Bank. Goldman's doomsday scenario has fallen the most among US-headquartered banks, followed by Morgan Stanley.
So far, not everything is ripe for a recession. Government spending has increased, consumer spending due to savings is still strong. Maybe we will see zero or a minimal minus in growth, but this will not be enough to break into a full-scale crisis.
In order for everything to go down like in 2008 or worse, some kind of financial trigger is needed, popularly called "bang" and the Fed is taking a confident step towards this, announcing 2 more rate hikes in July and September.
After all, even the (regional) banking crisis or the commercial mortgage crisis itself are not "banks". Yes, there is a systematic identification of all holes, but the loss from the depreciation of assets can be realized for a very long time, as the bankruptcy of borrowers on commercial mortgages and the growth of deposit rates and the default of corporate borrowers, and the issue of liquidity is solved by the discount window and BTFP.
Where it will break and because of what is still unclear. It is likely that the reason may be a change in the regulatory framework, such as, for example, capital requirements for banks, which was adopted recently. Maybe it will just be an avalanche-like deterioration of credit conditions due to an increase in the number of defaults. Or, maybe it will be some international events.
But trigger is preparing. The world’s top central bank chiefs signalled their readiness to increase interest rates further and keep them high, as they warned tight labour markets are still pushing up wages and prices. IMF warns central banks to not even think about an easing of the policy.
Major central banks will have to keep interest rates high for much longer than some investors expect, Geeta Gopinath, First Deputy Managing Director of the International Monetary Fund, told CNBC.
For the IMF, however, it is clear that inflation should be a priority. “It takes too long for inflation to return to its target, which means that central banks will have to continue to fight inflation, even if it means the risk of weaker growth or much more cooling in the labor market,” Gopinath said. She called the current macroeconomic picture "highly uncertain."
So, it seems that we could get few ways. Banks either cannot return expensive financing (and it is expensive at this stage already) and the Fed will have to sanitize them as it opened at the time. Or, after some time, banks will start to whine terribly and frighten the Fed with a general collapse and the Fed will lower rates. This will allow no one to be sanitized, but the Fed will become the largest lender of the banking system for some time. Finally, following the Fed's rate hike, money market rates will rise so much that the Fed's already issued funding will no longer seem expensive. However, if you raise the rate even more, new loans may be required at all.
Now 2nd scenario seems as less probable. It will be either 1st or 3rd way. Obviously we see that liquidity is draining out. Even gold market turns down, equity market stumbles and only households money and corporate buybacks keep it on surface. But something is preparing. Too many talks about tighter bank capital requirements, CBDC, high interest rates. Besides, there is some mismatch that brings indirect hints on coming "bang". If everything so good, Fed is near pivot, PCE is dropping, GDP is rising - why US yields are not dropping? Something is wrong here.
I suggest that something big is preparing, and preparation needs time. US financial authorities have this time, because available liquidity reserves give comfortable margin safety - Reverse repo together with Bank reserves are around 4 Trln. Of course they can't be dried totally, but, even 2 Trln in reserves gives around 6-8 months for preparation. Strong speeches from central banks and IMF, rising US yields and inflationary expectations promise nothing good. Because it means that big "bada-boom" will be later, but it will be stronger. And we should see the starting point as soon as mismatch appears in "Fed balance &QT - TGA account-Reverse Repo - Bank Reserves-M2" chain. This month "Fed Now" should be launched. As we've mentioned in our recent BTC Fundamental report, there are three moments are needed for CBDC start - Global dollar deficit, Massive Insolvency Crisis and Destruction of the Crypto Ecosystem. All steps that we see now fit well to this task. Meantime we should have few months still when markets do not change drastically.
This week was relatively quiet, as we haven't got a lot of drivers, just some stats on Thu and Friday to name. ECB/Fed speeches were not decisive as well. It seems that summer and vacations time is coming and amount of market drivers is decreasing. Still, besides, of recent statistics, there are few moments to mention that are not widely covered in media, but it could open the view on what to expect from the Fed. Also we need to take a look at the US liquidity, what is going on there.
Market overview
The dollar index was lower on Friday following two straight days of gains, after economic data showed a cooling in consumer spending, raising some doubt about the potential aggressiveness of the Federal Reserve in fighting inflation. U.S. Treasury yields were also mostly lower after the data.
The Commerce Department said consumer spending ticked up 0.1% in May while data for the prior month was revised to show spending accelerated by 0.6% versus the previously reported 0.8%. The personal consumption expenditures (PCE) gained 0.1% for the month after an 0.4% rise in April while advancing 3.8% on an annual basis, slowing from a revised 4.3% the prior month.
Expectations for a 25 basis points hike at the Fed's July meeting dipped slightly, with markets now pricing in an 84.3% chance of a hike, down slightly from the 89.3% on Thursday, according to CME's FedWatch Tool. Chicago Federal Reserve Bank President Austan Goolsbee said Fed officials will be parsing "a lot of data" leading up to the Fed's next meeting to assess whether borrowing costs need to be pushed up higher to tamp down inflation.
Euro zone inflation data fell for a third consecutive month, but showed a small drop in underlying inflation and was unlikely to keep the European Central Bank from hiking rates at its July meeting. Inflation in the 20 countries that share the euro fell to 5.5% this month from 6.1% in May, chalking up its seventh decline in the last eight months, with Germany the only country to report an increase, Eurostat's flash estimate showed. Annual inflation in Germany accelerated to 6.4% in June from 6.1% in May.
But "core" inflation excluding energy and food, which ECB policymakers see as a better gauge of the underlying trend, only edged lower, to 6.8% from 6.9% - far from the sustained drop the central bank wants to see.
ECB President Christine Lagarde said this week that the central bank was unlikely to call a peak in rates any time soon, and most policymakers see a further hike in September as likely.
On Wednesday, Powell said at a European Central Bank meeting of central bankers he did not see inflation getting back to the Fed's 2% until at least 2025.Other central bank heads at the meeting, including ECB President Christine Lagarde and Bank of England Governor Andrew Bailey, also supported more rate hikes, with the exception of Bank of Japan (BOJ) chief Kazuo Ueda.
The U.S. dollar's share of currency reserves reported to the International Monetary Fund rose in the first quarter of the year, in the midst of a still aggressive rate-hike cycle from the Federal Reserve aimed at curbing uncomfortably high inflation. The greenback's share of reserves rose to 59% in the first quarter of the year, from 58.6% in the last three months of 2022. The euro's share, however slipped to 19.8% in the first quarter, down from 20.4% in the previous three months.
STRUCTURAL CRISIS UPD
Despite some relief in EU CPI numbers and US PCE, we have to acknowledge that the structural crisis is underway. Wider view on recent data shows the clear tendency - strong deflation in production sector and stable inflation in consumption with deterioration of major indicators. Usually we're focused on the US, but today let's take a look mostly on EU - you'll see that absolutely the same tendencies here:
Why it is happening? The latter is understandable ( PPI and CPI divergence) — this is a drop in real demand, which spreads through technological chains. Moreover, most likely, the further away from the end consumer, the greater the drop in prices, because otherwise it is absolutely impossible to save their consumers.
But why is there no deflation in the consumer sector? The growth of costs in the structural crisis stands. But it is a large variation in the real cost among industrial companies (someone was able to save on something and survived, and someone went bankrupt) and therefore one company is doing (relatively) well, while others are quite bad. In full accordance with the theory of working in falling markets.
But it doesn't work that way in consumer markets, where everything is based on demand, which needs to be met and international competition. Roughly speaking, American consumers of intermediate industrial goods compete not only with each other, but also with Chinese imports, which are a priori cheaper than American products. Accordingly, the demand for intermediate goods of American production is falling. And China is increasing exports.
This does not help China, since this export growth is insufficient to compensate for falling domestic subsidies (and they, in turn, cannot be increased due to the danger of inflation). But it allows you to partially compensate for internal problems, while in the USA it's the opposite.
In general, it can be noted that the structural crisis is developing in all its glory, and in some details it is accelerating. However, it is possible that this is a consequence of the fact that the previous months the recession was hidden in the hope that it would end. And now we have to admit the obvious.
Meantime, de-industrialization of Germany continues. Now EU and UK economies together are less than the US one, while not too far ago, in 2008 the EU economy was greater. Without UK contribution, EU economy now is two times smaller than the US. The overall trend is clear.
US LIQUIDITY UPD
Not any big changes this week. Based on data that have been released yesterday - it seems that major inflows come from tax revenues, for IQ that gradually are coming on US Treasury accounts. Take a look that Fed Balance has dropped and retraced all of the increase from the SVB bailout, shrinking for the 3rd straight week (-$21.1 billion)... QT continues, but with very small value this week, around just $8 Bln. Fed emergency liquidity programmes have solid demand and stand stable around 106 Bln, slowly increasing week by week:
Meantime, money market funds mostly stands stable, according to recent ICI data, showing just minor outflows around $3 Bln. Besides, the dynamic differs. Retail saw a 10th straight week of inflows (+5.8 billion) while institutional funds saw $8.7 billion of outflows (3rd straight week)..., supposedly this is due corporate taxes demand or maybe chasing of AI stocks.
There remains a significant decoupling between bank deposits and money market funds...
The US equity market is starting to catch down to the contraction of bank reserves at The Fed...
Meantime, we do not see another big contraction in Reverse Repo accounts, while US Treasury TGA account has increased for ~ 350 Bln in just a single month:
M2 also starts climbing higher, approximately for ~ 200 Bln:
So, it seems that we get ~ 170 Bln out of Reverse Repo market in June, 130 Bln from bank reserves, which is approximately equals of US Treasury account growth. Since M2 also has increased slightly, it could mean that US Treasury by financing US Government's spending send some money back in the system. While US Treasury keeps borrowing on low level, system feels more or less good, and remains balanced. But it can't stay in this way for too long.
WE'RE TIRED TO WAIT (instead of conclusion)
It is many talks about crisis. Everybody tells that everything stands bad, or at least point of definite problems as we do. But the major question remains the same - when the situation will explode finally? This month, in three months, in a year, or when? Based on recent data we do not see that this should happen in a month or so. Because the situation is strange. The fight against inflation is going somehow wrong. The decrease in the most liquid components of the money supply is insignificant as we see from analysis above, and the drop in M2 was explained by the overflow from savings accounts to reverse repo. Now also M2 began to grow.
The population continues to drain their savings, supporting demand. Now the state has joined in after the debt ceiling and continues to stimulate demand with increased government spending. And that's a problem for the Fed. A rate hike does not act as quickly on demand as it does on the financial sector, as we saw with the banking crisis in March 2023. The cost of servicing debt for companies and households is rising slowly as cheap credit is replaced by expensive credit. Basically, the Fed has always raised rates until something breaks. The main question is when it will happen this time and where exactly.
Meantime, they expect something. Yellen recently said that Banks to lose money from problems in the real estate sector. According to the stress test of the US financial system, which is conducted annually by the Fed, in the most negative scenario, the largest US banks will lose $541 billion. The most affected are Deutsche Bank USA, UBS Americas and Commerce Bank. Goldman's doomsday scenario has fallen the most among US-headquartered banks, followed by Morgan Stanley.
So far, not everything is ripe for a recession. Government spending has increased, consumer spending due to savings is still strong. Maybe we will see zero or a minimal minus in growth, but this will not be enough to break into a full-scale crisis.
In order for everything to go down like in 2008 or worse, some kind of financial trigger is needed, popularly called "bang" and the Fed is taking a confident step towards this, announcing 2 more rate hikes in July and September.
After all, even the (regional) banking crisis or the commercial mortgage crisis itself are not "banks". Yes, there is a systematic identification of all holes, but the loss from the depreciation of assets can be realized for a very long time, as the bankruptcy of borrowers on commercial mortgages and the growth of deposit rates and the default of corporate borrowers, and the issue of liquidity is solved by the discount window and BTFP.
Where it will break and because of what is still unclear. It is likely that the reason may be a change in the regulatory framework, such as, for example, capital requirements for banks, which was adopted recently. Maybe it will just be an avalanche-like deterioration of credit conditions due to an increase in the number of defaults. Or, maybe it will be some international events.
But trigger is preparing. The world’s top central bank chiefs signalled their readiness to increase interest rates further and keep them high, as they warned tight labour markets are still pushing up wages and prices. IMF warns central banks to not even think about an easing of the policy.
Major central banks will have to keep interest rates high for much longer than some investors expect, Geeta Gopinath, First Deputy Managing Director of the International Monetary Fund, told CNBC.
For the IMF, however, it is clear that inflation should be a priority. “It takes too long for inflation to return to its target, which means that central banks will have to continue to fight inflation, even if it means the risk of weaker growth or much more cooling in the labor market,” Gopinath said. She called the current macroeconomic picture "highly uncertain."
So, it seems that we could get few ways. Banks either cannot return expensive financing (and it is expensive at this stage already) and the Fed will have to sanitize them as it opened at the time. Or, after some time, banks will start to whine terribly and frighten the Fed with a general collapse and the Fed will lower rates. This will allow no one to be sanitized, but the Fed will become the largest lender of the banking system for some time. Finally, following the Fed's rate hike, money market rates will rise so much that the Fed's already issued funding will no longer seem expensive. However, if you raise the rate even more, new loans may be required at all.
Now 2nd scenario seems as less probable. It will be either 1st or 3rd way. Obviously we see that liquidity is draining out. Even gold market turns down, equity market stumbles and only households money and corporate buybacks keep it on surface. But something is preparing. Too many talks about tighter bank capital requirements, CBDC, high interest rates. Besides, there is some mismatch that brings indirect hints on coming "bang". If everything so good, Fed is near pivot, PCE is dropping, GDP is rising - why US yields are not dropping? Something is wrong here.
I suggest that something big is preparing, and preparation needs time. US financial authorities have this time, because available liquidity reserves give comfortable margin safety - Reverse repo together with Bank reserves are around 4 Trln. Of course they can't be dried totally, but, even 2 Trln in reserves gives around 6-8 months for preparation. Strong speeches from central banks and IMF, rising US yields and inflationary expectations promise nothing good. Because it means that big "bada-boom" will be later, but it will be stronger. And we should see the starting point as soon as mismatch appears in "Fed balance &QT - TGA account-Reverse Repo - Bank Reserves-M2" chain. This month "Fed Now" should be launched. As we've mentioned in our recent BTC Fundamental report, there are three moments are needed for CBDC start - Global dollar deficit, Massive Insolvency Crisis and Destruction of the Crypto Ecosystem. All steps that we see now fit well to this task. Meantime we should have few months still when markets do not change drastically.
