Sive Morten
Special Consultant to the FPA
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Fundamentals
This week a lot of important events have happened. It could sound a bit surprising, but most of them are not of financial sphere. Yes, we've got Fed meeting, special ECB meeting, important statistics release, but all of them are not major drivers. We see that real drivers are drastic drop of gas supply to the EU and Putin, Xi and other leaders speeches on S-Petersburg economy forum. I suspect that this event was ignored by western media, but it doesn't changes the importance of this event. We skip political background and focus on economical shifts that it should have direct impact on the value of major currencies.
So, I think that gas question and Putin speech we consider tomorrow in Gold report, as it has more relation to geopolitical tensions. Here we just tell two things. Putin said that global financial system transforms from financial economy to real-assets economy. Second - he said that cunning strategy of "robbing of the century" is over.
He means that western countries just printing money and buying all goods across the board in fact for the piece of paper, for free. Money supply of G7 have increased twofold, as they have printed together 20% of global GDP, more than $20 Trln. They even do not bother to think on cutting consumption and stubbornly finance deficits by just printing it. Since the GDP of all developed countries includes 50-70% of services that, in fact, can't be treated as the real assets - major currencies are overpriced at least for 2 times now and have to be devaluated. This is the core of Putin thesis that relates to global economy system.
In the shed of recent events, it becomes clear why OPEC countries are not hurry up to increase supply to the west. The US sets the price of hydrocarbons as all of them are traded in the US exchanges, and payment currency is also controlled by them, which is US Dollar. But oil&gas suppliers know about printing, and know that barrel now costs two times higher, if it wouldn't be controlled artificially through the US quoting system on the ICE, NYMEX and other exchanges.
The US understands it, but EU beurocrats are too slow-minded, living in virtual reality. But soon the real things catch up with them.
Still, this is long-term strategic, tectonic shifts that have long lasted and extended effect in the future. You could think about it if you're interested. Now let's take a look at more actual questions.
Market overview
Let's start with ECB special meeting, when they have tried to fight the fire of coming policy change. As a result of ECB hints on PEPP programme stop and rising interest rates - default spreads of indebted countries, such as Italy and Greece have jumped few times, and reached 5%+ level above Germany yields.
The European Central Bank promised fresh support for the bloc's indebted southern rim on Wednesday, tempering a market rout that threatened a repeat of the debt crisis that almost brought down the single currency a decade ago. Government borrowing costs have soared on the 19-country currency bloc's periphery since the ECB unveiled plans last Thursday to raise interest rates to tame painfully high inflation.
But the bank failed to reassure investors it would contain the rise in borrowing costs, making only a vague pledge and stoking fears it was abandoning more indebted nations, such as Italy, Spain and Greece, which have struggled for years under the weight of massive debt piles. Reversing course just six days later, the ECB said it would direct cash to more indebted nations from debt maturing in a recently-ended 1.7 trillion euro ($1.8 trillion) pandemic support scheme and it would work on a new instrument to prevent an excessive divergence in borrowing costs.
Dutch central bank chief Klaas Knot said that policymakers instructed staff to work at an accelerated pace on the new tool, in case sending reinvestments south were not enough.
As a result - markets suspect new ECB tool to address bond stress could mimic old tools. With the bloc clearly facing that fragmentation problem, it is important for any new bond-buying tool from the ECB to be flexible, investors said. So just like the pandemic-era PEPP emergency stimulus scheme, it would need to ditch the capital-key principle of buying bonds in relation to the size of economies, instead buying debt from countries which most need help.
If we translate this initiative on common language it means that ECB switches the backpedal. As Spydell Finance comments this event - they retreat yet starting rate change and close of PEPP. Rates on 10-year Greek government bonds reached 4.7%, Italy 4.3% (max since 2013), Spain 3% (max since 2014). Absolute levels are not as important here but the relative change in very short period of time. Default spreads hit 4% level with the all time maximum speed, it's a collapse, guys.
It is not the levels themselves that are important here (there is still room to fall before 2011), but also the speed of movement – the spread reaches 4 percentage points, which is the maximum margin in history, as well as the rate of change in rates. Yes, it's a collapse, and ECB in panic thinks how to fight the fire. This is just the beginning.
Meanwhile, commodity prices in euros (including euro drop against the dollar) are at new highs, accelerating inflation. The loss of control over inflation and the collapse of confidence in the ECB are inevitable. If the Fed tires to do everything that they could, the ECB is in total oblivion.
It means that ECB postpones printing machine stop. With the EU PPI around 40% -
...and record trade deficit, what do you think should happen with the EUR? This is rhetoric question..
The rate decision from SNB that is made prior (!!!!) than ECB tells everything, as SNB policy is major barometer of financial sentiment in Europe. This is exceptional decision that clearly shows of high inflation risks and structural economical crisis.
The Swiss National Bank raised its policy interest rate for the first time in 15 years in a surprise move on Thursday and said it was ready to hike further, joining other central banks in tightening monetary policy to fight resurgent inflation. The central bank increased its policy rate to -0.25% from the -0.75% level it has deployed since 2015, sending the safe-haven franc sharply higher. Nearly all the economists polled by Reuters had expected the SNB to keep rates steady.
So, if SNB hikes for 0.5%, what ECB should do, and where the EU rate has to be? Just try to compare EU and Switzerland economy risks...
What about the FED?
Next question is the Fed policy and its courage to stay on the course, that we have some doubts about. Market showed no reaction in a moment of rate decision. As we've suggests this event has been priced-in few days before when all markets have shown collapse that couldn't be justified by expectations of just 0.5% interest rate change.
The dollar slipped against a basket of currencies on Wednesday, after the Federal Reserve raised interest rates by 75 basis points in a historic move to fight inflation and projected a slowing economy and rising unemployment in the months to come. The rate hike was the biggest made by the U.S. central bank since 1994, and was delivered after recent data showed little progress in its inflation battle. U.S. central bank officials also flagged a faster path of increases in borrowing costs to come, more closely aligning monetary policy with a rapid shift this week in financial market views of what it will take to bring price pressures under control.
Here we have to acknowledge, that all Fed forecasts concerning inflation rate is a junk. Since the problems have started they were repeating mantras on "temporal" inflation and that PPI should drop to converge CPI. While the economic theory suggests the opposite, that CPI should climb as it is lagging behind Production inflation:
Take a look what they forecast now:
As you understand - their forecasts have no relation to reality. We already said that they have to rise rates to 8% to get an effect. This is, if we talk about consumer inflation. In production, they have to reach the ceil of 70's - up to 15-18% to stabilize situation. Now let's take a look at some details.
Last week, we've mentioned that the US banking sector should feel real stress while interest rates keep going higher, because of too low interest profit margin. Today Reuters reports that problems are started:
An indicator of credit risk in the U.S. banking system may be showing signs of stress, as the Federal Reserve's aggressive rate hike path ratchets up expectations of economic pain. The so-called FRA-OIS spread , which measures the gap between the U.S. three-month forward rate agreement and the overnight index swap rate, increased to 29.55 basis points on Thursday, its widest since May 23, according to data from Refinitiv. The measure was at -11.66 bps earlier in the week.
Spreads on five-year credit default swaps (CDS) of JP Morgan , Goldman Sachs , Morgan Stanley , Citigroup , Wells Fargo and Bank of America peaked to fresh two-year highs on Thursday. Some strategists are concerned that these might point to "stress under the surface".
Concerns are growing that U.S. corporate earnings are increasingly at risk from dizzying inflation, a strong dollar and rising interest rates, complicating the outlook for investors already reeling from the S&P 500's bear market confirmation earlier this week.
Speaking on stock market, we already said that by our view it is doomed, and we should see 2 times drop of S&P index within 1-2 years. The reason is greed, as investors were taking loans and invest them in shares buybacks, pushing stocks higher. And market is still strongly overpriced, despite 20% plunge:
In general we could get something like in 1929 (Sometimes it is interesting ideas in TW):
Two other moments that would like to consider here. First is explosive growth of supply credit with highly negative consumer sentiment. This is unnatural combination, because usually these indicators move together:
What does it mean? Previously we already said that personal savings stand at historical lows. To keep the same level of consumption that people are inhabit of, they take loans. Inflation is rising and people suggest to buy goods until they are relatively cheap. But, it is inflationary factor, when you support consumption activity via loans. But on a way of rising interest rates - it unavoidably leads to defaults, and inability to payout debts. That, in turn, leads to consumption drop, rising of banking provisions and write-offs.
Second - the employment sector. One of the component of our long-term view is rising unemployment, which we suggest should be now 8-9% but not 3.5% as it officially showed. One of the our favorite sources - Zero Hedge publishes the article that problems begin:
Last weekend we showed something remarkable (or delightful, if one is a stock bull): with the US economy on the verge of recession, with inflation topping, with the housing market about to crack, the last pillar holding up the US economy (and preventing the Fed from continuing its tightening plans beyond the summer), the job market, had just hit a brick wall as revealed by real-time indicators - such as Revello's measure of total job postings - which plunged by 22.5%, the biggest change on record (we also listed several other labor market metrics confirming that the job market was about to crater).
Fast forward to today when one day after we found that initial jobless claims continue to rise after hitting a generational low in March, and as company after company is warning that it will freeze hiring amid a historic profit margin crunch - if not announce outright layoff plans - Piper Sandler has compiled all the recent company mass layoff announcements. They are, in a word, startling.
Here are the stunning implications according to Piper Sandler:
Conclusion:
So, guys, we just briefly run through major economical data, but even this view is enough to understand the scale of the tragedy. In fact, Fed has only two ways to stabilize situation - the Correct way, and Fed's way. Correct way suggests rising rates until at least of 8%, tightening policy and set tough financial conditions, that suggest increasing of funding cost and setting barrier, some threshold for obtaining financial resources. This scenario assumes an accelerated rates growth, a radical collapse of markets, "zombie" companies due to rising debt service costs.
Within the correct scenario by Spydell Finance, the demand in the economy should collapse by at least 15-20% compares to 2021. Over 30% of companies with a high debt burden and without a steady cash flow should go bankrupt within 12-15 months, market capitalization will collapse by at least 35-40% from the levels of June 13 (minimum 2400 on the S&P 500). The cryptocurrency will crash twice more to 450-500 billion dollars compared to 3 trillion at the end of 2021. The revenue of the companies will decrease by 10% at face value, the profit will fall by 30-35%.
This should lead to the sterilization of excess cache, normalization of the demand/supply balance in the economy and a gradual decrease in inflation. With this scenario, it should be possible to keep the basic confidence with fiat currencies and the existing structure of the financial system, the stability of debt markets can be maintained against the background of the Great Redistribution of capital of wrong "Fed" scenario, when cash flows artificially flow out of the stock market into the debt markets, what we see now. In general this process could take years. However, a chain of bankruptcies, demand collapse should lead to a drop in GDP by 7-10%. Politically, this option hardly looks preferable.
Second, "Wrong" or "Fed" scenario suggests an imitation of the fight against inflation, and at the first threat of a recession and a collapse of markets, they will inevitably put the backpedal, stopping the cycle of policy tightening. As ECB did, depending on the scale of markets' collapse, we could get verbal interventions with promises to flood the markets with unlimited liquidity again.
In this scenario, they can stabilize asset bubbles in the short term, but the accumulated imbalances will be fully realized. Inflation will continue to rise, real interest rates will go even more into negative territory, the open capital market will be blocked, and the debt market will begin to collapse.
In the future, this will lead to a total collapse of the entire modern architecture of the world economy system, with total lost of faith in fiat currencies and the stability of the debt market. In the future, this will lead to incomparably worse conditions. The crisis is much bigger and deeper than the Great Depression. As a result, Fed has the choice between bad and worse, but it is almost certain that they will choose the second one, because of political reasons. Keeping it simple, we could call the first scenario as "disease treatment" while the second one is just a "headache pill".
To be continued...
This week a lot of important events have happened. It could sound a bit surprising, but most of them are not of financial sphere. Yes, we've got Fed meeting, special ECB meeting, important statistics release, but all of them are not major drivers. We see that real drivers are drastic drop of gas supply to the EU and Putin, Xi and other leaders speeches on S-Petersburg economy forum. I suspect that this event was ignored by western media, but it doesn't changes the importance of this event. We skip political background and focus on economical shifts that it should have direct impact on the value of major currencies.
So, I think that gas question and Putin speech we consider tomorrow in Gold report, as it has more relation to geopolitical tensions. Here we just tell two things. Putin said that global financial system transforms from financial economy to real-assets economy. Second - he said that cunning strategy of "robbing of the century" is over.
He means that western countries just printing money and buying all goods across the board in fact for the piece of paper, for free. Money supply of G7 have increased twofold, as they have printed together 20% of global GDP, more than $20 Trln. They even do not bother to think on cutting consumption and stubbornly finance deficits by just printing it. Since the GDP of all developed countries includes 50-70% of services that, in fact, can't be treated as the real assets - major currencies are overpriced at least for 2 times now and have to be devaluated. This is the core of Putin thesis that relates to global economy system.
In the shed of recent events, it becomes clear why OPEC countries are not hurry up to increase supply to the west. The US sets the price of hydrocarbons as all of them are traded in the US exchanges, and payment currency is also controlled by them, which is US Dollar. But oil&gas suppliers know about printing, and know that barrel now costs two times higher, if it wouldn't be controlled artificially through the US quoting system on the ICE, NYMEX and other exchanges.
The US understands it, but EU beurocrats are too slow-minded, living in virtual reality. But soon the real things catch up with them.
Still, this is long-term strategic, tectonic shifts that have long lasted and extended effect in the future. You could think about it if you're interested. Now let's take a look at more actual questions.
Market overview
Let's start with ECB special meeting, when they have tried to fight the fire of coming policy change. As a result of ECB hints on PEPP programme stop and rising interest rates - default spreads of indebted countries, such as Italy and Greece have jumped few times, and reached 5%+ level above Germany yields.
The European Central Bank promised fresh support for the bloc's indebted southern rim on Wednesday, tempering a market rout that threatened a repeat of the debt crisis that almost brought down the single currency a decade ago. Government borrowing costs have soared on the 19-country currency bloc's periphery since the ECB unveiled plans last Thursday to raise interest rates to tame painfully high inflation.
But the bank failed to reassure investors it would contain the rise in borrowing costs, making only a vague pledge and stoking fears it was abandoning more indebted nations, such as Italy, Spain and Greece, which have struggled for years under the weight of massive debt piles. Reversing course just six days later, the ECB said it would direct cash to more indebted nations from debt maturing in a recently-ended 1.7 trillion euro ($1.8 trillion) pandemic support scheme and it would work on a new instrument to prevent an excessive divergence in borrowing costs.
"We cannot surrender to fiscal dominance," Lagarde said at a forum in London. "Neither can we surrender to finance dominance; we have to deliver on our mandate."
Dutch central bank chief Klaas Knot said that policymakers instructed staff to work at an accelerated pace on the new tool, in case sending reinvestments south were not enough.
"If it will not be enough, rest assured that we stand ready," Knot told a conference.
As a result - markets suspect new ECB tool to address bond stress could mimic old tools. With the bloc clearly facing that fragmentation problem, it is important for any new bond-buying tool from the ECB to be flexible, investors said. So just like the pandemic-era PEPP emergency stimulus scheme, it would need to ditch the capital-key principle of buying bonds in relation to the size of economies, instead buying debt from countries which most need help.
If we translate this initiative on common language it means that ECB switches the backpedal. As Spydell Finance comments this event - they retreat yet starting rate change and close of PEPP. Rates on 10-year Greek government bonds reached 4.7%, Italy 4.3% (max since 2013), Spain 3% (max since 2014). Absolute levels are not as important here but the relative change in very short period of time. Default spreads hit 4% level with the all time maximum speed, it's a collapse, guys.
It is not the levels themselves that are important here (there is still room to fall before 2011), but also the speed of movement – the spread reaches 4 percentage points, which is the maximum margin in history, as well as the rate of change in rates. Yes, it's a collapse, and ECB in panic thinks how to fight the fire. This is just the beginning.
Meanwhile, commodity prices in euros (including euro drop against the dollar) are at new highs, accelerating inflation. The loss of control over inflation and the collapse of confidence in the ECB are inevitable. If the Fed tires to do everything that they could, the ECB is in total oblivion.
It means that ECB postpones printing machine stop. With the EU PPI around 40% -
...and record trade deficit, what do you think should happen with the EUR? This is rhetoric question..
The rate decision from SNB that is made prior (!!!!) than ECB tells everything, as SNB policy is major barometer of financial sentiment in Europe. This is exceptional decision that clearly shows of high inflation risks and structural economical crisis.
The Swiss National Bank raised its policy interest rate for the first time in 15 years in a surprise move on Thursday and said it was ready to hike further, joining other central banks in tightening monetary policy to fight resurgent inflation. The central bank increased its policy rate to -0.25% from the -0.75% level it has deployed since 2015, sending the safe-haven franc sharply higher. Nearly all the economists polled by Reuters had expected the SNB to keep rates steady.
So, if SNB hikes for 0.5%, what ECB should do, and where the EU rate has to be? Just try to compare EU and Switzerland economy risks...
What about the FED?
Next question is the Fed policy and its courage to stay on the course, that we have some doubts about. Market showed no reaction in a moment of rate decision. As we've suggests this event has been priced-in few days before when all markets have shown collapse that couldn't be justified by expectations of just 0.5% interest rate change.
The dollar slipped against a basket of currencies on Wednesday, after the Federal Reserve raised interest rates by 75 basis points in a historic move to fight inflation and projected a slowing economy and rising unemployment in the months to come. The rate hike was the biggest made by the U.S. central bank since 1994, and was delivered after recent data showed little progress in its inflation battle. U.S. central bank officials also flagged a faster path of increases in borrowing costs to come, more closely aligning monetary policy with a rapid shift this week in financial market views of what it will take to bring price pressures under control.
Here we have to acknowledge, that all Fed forecasts concerning inflation rate is a junk. Since the problems have started they were repeating mantras on "temporal" inflation and that PPI should drop to converge CPI. While the economic theory suggests the opposite, that CPI should climb as it is lagging behind Production inflation:
Take a look what they forecast now:
As you understand - their forecasts have no relation to reality. We already said that they have to rise rates to 8% to get an effect. This is, if we talk about consumer inflation. In production, they have to reach the ceil of 70's - up to 15-18% to stabilize situation. Now let's take a look at some details.
Last week, we've mentioned that the US banking sector should feel real stress while interest rates keep going higher, because of too low interest profit margin. Today Reuters reports that problems are started:
An indicator of credit risk in the U.S. banking system may be showing signs of stress, as the Federal Reserve's aggressive rate hike path ratchets up expectations of economic pain. The so-called FRA-OIS spread , which measures the gap between the U.S. three-month forward rate agreement and the overnight index swap rate, increased to 29.55 basis points on Thursday, its widest since May 23, according to data from Refinitiv. The measure was at -11.66 bps earlier in the week.
"The recent spike in the spread between forward rate agreement and overnight index swap rate is concerning," said Jordan Jackson, a global market strategist at J.P. Morgan Asset Management. "As the Fed turns more hawkish, there is a rise in recession concerns and that is increasing the underlying credit risk. Now that quantitative tightening has officially started, we have seen reserve drainage pretty persistent over the last several months," Jackson said, adding that he expects the FRA-OIS spread to widen even further.
Spreads on five-year credit default swaps (CDS) of JP Morgan , Goldman Sachs , Morgan Stanley , Citigroup , Wells Fargo and Bank of America peaked to fresh two-year highs on Thursday. Some strategists are concerned that these might point to "stress under the surface".
"The overall underpinnings of the economy are quite shaky," said Ryan Detrick, senior strategist at LPL Financial. "The next six months could be quite perilous."
Concerns are growing that U.S. corporate earnings are increasingly at risk from dizzying inflation, a strong dollar and rising interest rates, complicating the outlook for investors already reeling from the S&P 500's bear market confirmation earlier this week.
Speaking on stock market, we already said that by our view it is doomed, and we should see 2 times drop of S&P index within 1-2 years. The reason is greed, as investors were taking loans and invest them in shares buybacks, pushing stocks higher. And market is still strongly overpriced, despite 20% plunge:
In general we could get something like in 1929 (Sometimes it is interesting ideas in TW):
Two other moments that would like to consider here. First is explosive growth of supply credit with highly negative consumer sentiment. This is unnatural combination, because usually these indicators move together:
What does it mean? Previously we already said that personal savings stand at historical lows. To keep the same level of consumption that people are inhabit of, they take loans. Inflation is rising and people suggest to buy goods until they are relatively cheap. But, it is inflationary factor, when you support consumption activity via loans. But on a way of rising interest rates - it unavoidably leads to defaults, and inability to payout debts. That, in turn, leads to consumption drop, rising of banking provisions and write-offs.
Second - the employment sector. One of the component of our long-term view is rising unemployment, which we suggest should be now 8-9% but not 3.5% as it officially showed. One of the our favorite sources - Zero Hedge publishes the article that problems begin:
Last weekend we showed something remarkable (or delightful, if one is a stock bull): with the US economy on the verge of recession, with inflation topping, with the housing market about to crack, the last pillar holding up the US economy (and preventing the Fed from continuing its tightening plans beyond the summer), the job market, had just hit a brick wall as revealed by real-time indicators - such as Revello's measure of total job postings - which plunged by 22.5%, the biggest change on record (we also listed several other labor market metrics confirming that the job market was about to crater).
Fast forward to today when one day after we found that initial jobless claims continue to rise after hitting a generational low in March, and as company after company is warning that it will freeze hiring amid a historic profit margin crunch - if not announce outright layoff plans - Piper Sandler has compiled all the recent company mass layoff announcements. They are, in a word, startling.
Here are the stunning implications according to Piper Sandler:
- We could see a million layoffs or more, as many goods sectors that benefited from the pandemic now realize they added too much capacity (as involuntary admissions make clear).
- Low-income workers - who enjoyed the hottest wage gains during the crisis - are now most at risk of layoffs, with remaining job holders to see much slower wage growth.
- Payrolls gains are poised to downshift to just 100k/month on average in the second half of the year, from about 515k/month through April.
Conclusion:
So, guys, we just briefly run through major economical data, but even this view is enough to understand the scale of the tragedy. In fact, Fed has only two ways to stabilize situation - the Correct way, and Fed's way. Correct way suggests rising rates until at least of 8%, tightening policy and set tough financial conditions, that suggest increasing of funding cost and setting barrier, some threshold for obtaining financial resources. This scenario assumes an accelerated rates growth, a radical collapse of markets, "zombie" companies due to rising debt service costs.
Within the correct scenario by Spydell Finance, the demand in the economy should collapse by at least 15-20% compares to 2021. Over 30% of companies with a high debt burden and without a steady cash flow should go bankrupt within 12-15 months, market capitalization will collapse by at least 35-40% from the levels of June 13 (minimum 2400 on the S&P 500). The cryptocurrency will crash twice more to 450-500 billion dollars compared to 3 trillion at the end of 2021. The revenue of the companies will decrease by 10% at face value, the profit will fall by 30-35%.
This should lead to the sterilization of excess cache, normalization of the demand/supply balance in the economy and a gradual decrease in inflation. With this scenario, it should be possible to keep the basic confidence with fiat currencies and the existing structure of the financial system, the stability of debt markets can be maintained against the background of the Great Redistribution of capital of wrong "Fed" scenario, when cash flows artificially flow out of the stock market into the debt markets, what we see now. In general this process could take years. However, a chain of bankruptcies, demand collapse should lead to a drop in GDP by 7-10%. Politically, this option hardly looks preferable.
Second, "Wrong" or "Fed" scenario suggests an imitation of the fight against inflation, and at the first threat of a recession and a collapse of markets, they will inevitably put the backpedal, stopping the cycle of policy tightening. As ECB did, depending on the scale of markets' collapse, we could get verbal interventions with promises to flood the markets with unlimited liquidity again.
In this scenario, they can stabilize asset bubbles in the short term, but the accumulated imbalances will be fully realized. Inflation will continue to rise, real interest rates will go even more into negative territory, the open capital market will be blocked, and the debt market will begin to collapse.
In the future, this will lead to a total collapse of the entire modern architecture of the world economy system, with total lost of faith in fiat currencies and the stability of the debt market. In the future, this will lead to incomparably worse conditions. The crisis is much bigger and deeper than the Great Depression. As a result, Fed has the choice between bad and worse, but it is almost certain that they will choose the second one, because of political reasons. Keeping it simple, we could call the first scenario as "disease treatment" while the second one is just a "headache pill".
To be continued...