Sive Morten
Special Consultant to the FPA
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- 18,664
Fundamentals
So, it is no needed to be a prophet to suggest that CPI should make the week, as it has happened, actually. Now we're entering time, when not only absolute numbers are important but the structure of the CP Index, because it could either confirm or disconfirm our long term view on the crisis. Also today we show why this is not a recession, but structural crisis. Word "structural" suggests multiple divergences and skews among basic economical components, when you try to fix one of them but suddenly problems appear in another. Europe has absolutely the same problems but with higher magnitude that hasn't peaked yet. The data that we've got this week totally fits to our long term view, we do not need to change anything, including 0.9 target on EUR/USD. Besides, on Thursday we've put technical background as well, taken view on Dollar Index and its 113+ target on monthly chart.
CPI Universe
Here is the picture that lets you easily understand why current crisis is structural - just compare nominal CPI and core CPI. While nominal numbers are decreasing for the three months from 9.1% to 8.3% YoY, core CPI is rising in the same three months from 5.9 to 6.3%. What does it mean? This is actually what we've talked about already - inflation could start dropping in energy sector due government efforts, economy slowdown and some seasonal factors, but inflation is spreading over all other sectors, pushing price higher.
This is not the problem of gas and oil - the problems are deeper, which are big disbalances in economy, when economy capacity, its productivity hardly lagging behind consumption power, boosted by liquidity printing. The yellow line is Industrial Production index, i.e. how much the US economy produces, while orange line is - how much households consume - the lag shows the disproportion and on how much these line have to converge to set the balance. Just take a look at consumption acceleration - it is totally out of long term natural trend, which is flow into inflation level. Thus, consumption has to drop for ~ 15% to more or less normalize situation.
Another interesting moment - no real growth in Production since 2010 but this is a bit different story...
This explains why financial markets have collapsed at the release day, despite that nominally, inflation has decreased. There are two reasons. The first is well-known, August is the month of falling business activity, prices always fall (although it is not a reason for optimism anyway). But. The fact that they have fell less than expected suggests monetary authorities lack of control over situation.
The second reason is more complicated. Fed is rising the rate and monetary inflation is turned down. But the structural component that we're talking about has not gone away. The US monetary authorities do not see the structural component. Consequently - the indicators levels are underestimated. And yes, inflation has really decreased, as can be seen from the indicators of the cumulative growth of industrial prices:
But this is not all yet. Based on these indicators, it is clear that consumer inflation is artificially underestimated, because producers do not work with a loss for a whole year. The growth of prices for services may lag behind the growth of industrial prices (which reduces the indicators of consumer inflation), but such a bias cannot be for a long time. Therefore, supposedly the real consumer inflation in the United States at the beginning of the summer is at 15-16%, although today it has decreased, somewhere to 12% percent.
This, of course, is personal assessment. But it shows that the difference between real inflation and official figures is quite large (although it has decreased over the past month). What will happen next — we need to look, because, on the one hand, summer (inflation, recall - August to August), and on the other — the midterm elections are coming soon. And no one, by the way, can guarantee that the total industrial inflation couldn't be artificially underestimated as well…
That's being said - the structural crisis is under way, moreover, it is becoming more difficult for official statisticians, who reluctantly try to hide it from the majority of citizens. This is very clearly could be seen in the indicators of retail sales and GDP, which are already falling in almost all (more or less) large economies of the world. And this is with underestimating of inflation rates, as we've said above.
At the same time, it is becoming more and more difficult to maintain the level of households' consumption even at the current levels. Theoretically the budget could be filled by money emission — but this accelerates the inflation. Other source, such as a sale of government securities is also closed, because that they are really unprofitable because of deep negative yield (which is much lower even than official inflation).
But crisis now is exposing more serious problems than statistics' faking. The yield on the real estate market is becoming comparable to the yield on government bonds. Another fruit of structural crisis - distortion of interest rates:
Question: who will invest in real estate in such a situation, given that it is absolutely incomparable risks in these sectors? In fact, we are talking about possible stop of the Real Estate market in the United States. Because the yield of Treasury bonds will grow (since they are lower than official inflation), while the demand for real estate will fall, so the yield in this market will not grow. Could it be stopped as open market and taken under state control? And how much will it cost the budget?
This is a typical fruits of a structural disproportions in economy, when traditional proportions of the ratio of profitability and the volume of financial flows in different industries are violated. Accordingly, risks are growing sharply, which leads to rising of the costs despite of the Fed monetary policy. Roughly speaking, regardless of demand, if your costs have increased by 15-20%, you cannot decrease price, you have to raise them …
It means that big sell-off of real estate by investors is coming. Especially among Wall Street owners. In markets such as Dallas, Austin, Denver, Salt Lake City, Seattle and Los Angeles, the 6-month treasury obligation is already exceeding the marginal rate. This means that investors have very little incentive to work in these markets. Especially now, when prices are falling. Even worse - many Wall Street real estate investors finance their strategy using floating-rate credit lines. Thus, every time the Fed raises rates, their cost of capital in the EXISTING portfolio becomes more expensive. It's like with Gas in Europe.
There are similar processes in the economy of the European Union, in which the tightening of monetary policy lags behind the United States. And inflation there is underestimated, with the same inevitable problems. Now it is absolutely indifferent what country you're watching - the same process GDP drop and Inflation stands across all of them, although with different degree.
Now we have a record of 10.1% annual inflation. But not the nominal number is important - take a look at components. 36% rise prices on energy is not surprising, but 11% rise in food sector - that's what important. Particularly in Germany we have 8.8% inflation but structure looks scaring a bit - the most significant price change stands for heating oil (+111.5%), gas (+83.8%), edible fats and edible oils (+44.5%), dairy products and eggs (+26.8%) meat and meat products (+18.6%), bread and grain products (+17.1%). Drop out energy doesn't help as overall inflation stands around 12-15%.
The worst is yet to come, because in October high wholesale prices for gas and electricity will start to drift into retail prices.
It is impossible to stop it, an increase in the rate could reduce the monetary component of inflation, but will increase the structural one. As a result - an accelerated decline in the wealth and living standards of the population is inevitable, which could cause social problems, strikes, unrests … So the politicians have to solve very difficult problems in the conditions of information clearly limited by liberal experts. The Households wealth has dropped for ~ 6 Trln in IIQ , which is already one of the most big drop in the history.
Epic flows on capital markets
With recent CPI numbers, investors sentiment has changed drastically. Now we consider not 0.5-0.75% Fed move but 0.75-1.0%. The most brave banks that first has said about 1% Fed move was Nomura:
Nomura calls for 100 bps Fed hike in September as speculation rises
In a research note Nomura also said it was raising its forecast for the terminal rate by 50 basis points to 4.50%-4.75% by February 2023. Now take a look again at the chart of Real Estate rates above...
Now about capital flows...
First is, recall that few months ago, when all these stuff just has started, we said that Fed will take any efforts to stabilize debt market as it is the core and foundation of any economy. If something goes wrong, Fed is ready to pump out liquidity out of any market to stabilize debt. Additionally we've shown you BofA chart showing that households have not started yet to sell their assets on stock market. And without it crush on the stock market is impossible. But now it seems, time has come.
Redistribution of cash flows occurred in the United States is started. In the conditions of problems in the debt market, a steady growth of the stock market is impossible. The flows of American households into the debt market set a record ($440 billion for Q2 2022). Simultaneously with the record flows into bonds, the record outflows from shares has happened - and set in the amount of $ 290 billion for Q2 2022, which became one of the triggers of the record fall in the markets at that time.
Annual flows have turned around – there is a decline in stocks, and an increase in cash flows in bonds. Usually flows move with a negative correlation, i.e., if there is an inflow in stocks, then there is an outflow in bonds and vice versa. In order to redistribute flows, it is necessary to create unacceptable conditions for being in assets and negative expectations, which was created in the first half of the year. In the second half of the year, the debt market was supported by primary dealers, but their margin of safety is limited, because the printing press is disabled.
Rates in the US will explode at an unprecedented pace in the next three months – this is the fastest tightening from the Fed in the last 40 years. The system is extremely vulnerable, because for 13 years economic agents have adapted to zero rates and unlimited liquidity in unlimited volumes.
There are two fundamental problems – an increase in the cost of debt servicing and problems in financing due to a shortage of demand for debt instruments due to record negative real rates and tough financial conditions. One of the solutions, as we've said, is to make unacceptable conditions in the stock market in order to create zero variability of maneuvers for capital flows in order to channel liquidity into debt markets (in the absence of alternatives). In other words, when losses and pain are everywhere, but there is less in bonds (other things being equal) than in stocks. What is the volume of the bond market in the USA? National issuers - 53.4 trillion dollars. The growth of rates is not just some abstract processes and events. The increase in rates directly affects $53 trillion, and only in the bond market. The whole thing needs to be refinanced.
At the moment, it is difficult for me to say how much of this amount is used for refinancing annually. According to preliminary calculations, about 12 trillion, plus a significant part is tied to floating rates. It is also necessary to take into account the annual need for debt increment. Therefore, an increase in rates to 3.5% is at least an additional 500-600 billion overloads in the coming year.
That's being said, The Fed can return back to 2% inflation if it does the following things:
About the oil problems we will talk tomorrow in our Gold report, and on few other political issues. Now we could say that everything goes in a row with our long-term view. Problems in the US economy are not disappear and crisis effect starts spreading over all economy spheres. Now it seems unnecessary to recall EU situation, which has no chance to overcome the US in strong economy measures. US will squeeze out all financial juices out from EU to support domestic economy, no doubts. Should we change our 0.9 target on EUR/USD? I guess not. That's what about the tactical vision, in perspective of 6-9 months.
Strategic view tells that this game can't last forever as Fed resources are exhausting fast, especially when rate becomes higher. Final collapse is inevitable, but follows after all other markets will be in a ruins. Recall The Economists September 2021 cover - Luna is already in the pit, ETH and BTC are next, stocks come after them, and last queue stands for US Treasury and Fed (i.e. Bond market). And only extraordinary political events could intrude in this process, changing the scenario but not the final result.
So, it is no needed to be a prophet to suggest that CPI should make the week, as it has happened, actually. Now we're entering time, when not only absolute numbers are important but the structure of the CP Index, because it could either confirm or disconfirm our long term view on the crisis. Also today we show why this is not a recession, but structural crisis. Word "structural" suggests multiple divergences and skews among basic economical components, when you try to fix one of them but suddenly problems appear in another. Europe has absolutely the same problems but with higher magnitude that hasn't peaked yet. The data that we've got this week totally fits to our long term view, we do not need to change anything, including 0.9 target on EUR/USD. Besides, on Thursday we've put technical background as well, taken view on Dollar Index and its 113+ target on monthly chart.
CPI Universe
Here is the picture that lets you easily understand why current crisis is structural - just compare nominal CPI and core CPI. While nominal numbers are decreasing for the three months from 9.1% to 8.3% YoY, core CPI is rising in the same three months from 5.9 to 6.3%. What does it mean? This is actually what we've talked about already - inflation could start dropping in energy sector due government efforts, economy slowdown and some seasonal factors, but inflation is spreading over all other sectors, pushing price higher.
This is not the problem of gas and oil - the problems are deeper, which are big disbalances in economy, when economy capacity, its productivity hardly lagging behind consumption power, boosted by liquidity printing. The yellow line is Industrial Production index, i.e. how much the US economy produces, while orange line is - how much households consume - the lag shows the disproportion and on how much these line have to converge to set the balance. Just take a look at consumption acceleration - it is totally out of long term natural trend, which is flow into inflation level. Thus, consumption has to drop for ~ 15% to more or less normalize situation.
Another interesting moment - no real growth in Production since 2010 but this is a bit different story...
This explains why financial markets have collapsed at the release day, despite that nominally, inflation has decreased. There are two reasons. The first is well-known, August is the month of falling business activity, prices always fall (although it is not a reason for optimism anyway). But. The fact that they have fell less than expected suggests monetary authorities lack of control over situation.
The second reason is more complicated. Fed is rising the rate and monetary inflation is turned down. But the structural component that we're talking about has not gone away. The US monetary authorities do not see the structural component. Consequently - the indicators levels are underestimated. And yes, inflation has really decreased, as can be seen from the indicators of the cumulative growth of industrial prices:
But this is not all yet. Based on these indicators, it is clear that consumer inflation is artificially underestimated, because producers do not work with a loss for a whole year. The growth of prices for services may lag behind the growth of industrial prices (which reduces the indicators of consumer inflation), but such a bias cannot be for a long time. Therefore, supposedly the real consumer inflation in the United States at the beginning of the summer is at 15-16%, although today it has decreased, somewhere to 12% percent.
This, of course, is personal assessment. But it shows that the difference between real inflation and official figures is quite large (although it has decreased over the past month). What will happen next — we need to look, because, on the one hand, summer (inflation, recall - August to August), and on the other — the midterm elections are coming soon. And no one, by the way, can guarantee that the total industrial inflation couldn't be artificially underestimated as well…
That's being said - the structural crisis is under way, moreover, it is becoming more difficult for official statisticians, who reluctantly try to hide it from the majority of citizens. This is very clearly could be seen in the indicators of retail sales and GDP, which are already falling in almost all (more or less) large economies of the world. And this is with underestimating of inflation rates, as we've said above.
At the same time, it is becoming more and more difficult to maintain the level of households' consumption even at the current levels. Theoretically the budget could be filled by money emission — but this accelerates the inflation. Other source, such as a sale of government securities is also closed, because that they are really unprofitable because of deep negative yield (which is much lower even than official inflation).
But crisis now is exposing more serious problems than statistics' faking. The yield on the real estate market is becoming comparable to the yield on government bonds. Another fruit of structural crisis - distortion of interest rates:
Question: who will invest in real estate in such a situation, given that it is absolutely incomparable risks in these sectors? In fact, we are talking about possible stop of the Real Estate market in the United States. Because the yield of Treasury bonds will grow (since they are lower than official inflation), while the demand for real estate will fall, so the yield in this market will not grow. Could it be stopped as open market and taken under state control? And how much will it cost the budget?
This is a typical fruits of a structural disproportions in economy, when traditional proportions of the ratio of profitability and the volume of financial flows in different industries are violated. Accordingly, risks are growing sharply, which leads to rising of the costs despite of the Fed monetary policy. Roughly speaking, regardless of demand, if your costs have increased by 15-20%, you cannot decrease price, you have to raise them …
It means that big sell-off of real estate by investors is coming. Especially among Wall Street owners. In markets such as Dallas, Austin, Denver, Salt Lake City, Seattle and Los Angeles, the 6-month treasury obligation is already exceeding the marginal rate. This means that investors have very little incentive to work in these markets. Especially now, when prices are falling. Even worse - many Wall Street real estate investors finance their strategy using floating-rate credit lines. Thus, every time the Fed raises rates, their cost of capital in the EXISTING portfolio becomes more expensive. It's like with Gas in Europe.
There are similar processes in the economy of the European Union, in which the tightening of monetary policy lags behind the United States. And inflation there is underestimated, with the same inevitable problems. Now it is absolutely indifferent what country you're watching - the same process GDP drop and Inflation stands across all of them, although with different degree.
Now we have a record of 10.1% annual inflation. But not the nominal number is important - take a look at components. 36% rise prices on energy is not surprising, but 11% rise in food sector - that's what important. Particularly in Germany we have 8.8% inflation but structure looks scaring a bit - the most significant price change stands for heating oil (+111.5%), gas (+83.8%), edible fats and edible oils (+44.5%), dairy products and eggs (+26.8%) meat and meat products (+18.6%), bread and grain products (+17.1%). Drop out energy doesn't help as overall inflation stands around 12-15%.
The worst is yet to come, because in October high wholesale prices for gas and electricity will start to drift into retail prices.
It is impossible to stop it, an increase in the rate could reduce the monetary component of inflation, but will increase the structural one. As a result - an accelerated decline in the wealth and living standards of the population is inevitable, which could cause social problems, strikes, unrests … So the politicians have to solve very difficult problems in the conditions of information clearly limited by liberal experts. The Households wealth has dropped for ~ 6 Trln in IIQ , which is already one of the most big drop in the history.
Epic flows on capital markets
With recent CPI numbers, investors sentiment has changed drastically. Now we consider not 0.5-0.75% Fed move but 0.75-1.0%. The most brave banks that first has said about 1% Fed move was Nomura:
Nomura calls for 100 bps Fed hike in September as speculation rises
In a research note Nomura also said it was raising its forecast for the terminal rate by 50 basis points to 4.50%-4.75% by February 2023. Now take a look again at the chart of Real Estate rates above...
The market sees the policy rate reaching the 4.00%-4.25% range by the end of this year, and 4.25%-4.5% by March. Nomura predicted that the U.S. central bank would raise its fed funds target rate by 50 basis points at both the November and December meetings.
Now about capital flows...
First is, recall that few months ago, when all these stuff just has started, we said that Fed will take any efforts to stabilize debt market as it is the core and foundation of any economy. If something goes wrong, Fed is ready to pump out liquidity out of any market to stabilize debt. Additionally we've shown you BofA chart showing that households have not started yet to sell their assets on stock market. And without it crush on the stock market is impossible. But now it seems, time has come.
Redistribution of cash flows occurred in the United States is started. In the conditions of problems in the debt market, a steady growth of the stock market is impossible. The flows of American households into the debt market set a record ($440 billion for Q2 2022). Simultaneously with the record flows into bonds, the record outflows from shares has happened - and set in the amount of $ 290 billion for Q2 2022, which became one of the triggers of the record fall in the markets at that time.
Annual flows have turned around – there is a decline in stocks, and an increase in cash flows in bonds. Usually flows move with a negative correlation, i.e., if there is an inflow in stocks, then there is an outflow in bonds and vice versa. In order to redistribute flows, it is necessary to create unacceptable conditions for being in assets and negative expectations, which was created in the first half of the year. In the second half of the year, the debt market was supported by primary dealers, but their margin of safety is limited, because the printing press is disabled.
Rates in the US will explode at an unprecedented pace in the next three months – this is the fastest tightening from the Fed in the last 40 years. The system is extremely vulnerable, because for 13 years economic agents have adapted to zero rates and unlimited liquidity in unlimited volumes.
There are two fundamental problems – an increase in the cost of debt servicing and problems in financing due to a shortage of demand for debt instruments due to record negative real rates and tough financial conditions. One of the solutions, as we've said, is to make unacceptable conditions in the stock market in order to create zero variability of maneuvers for capital flows in order to channel liquidity into debt markets (in the absence of alternatives). In other words, when losses and pain are everywhere, but there is less in bonds (other things being equal) than in stocks. What is the volume of the bond market in the USA? National issuers - 53.4 trillion dollars. The growth of rates is not just some abstract processes and events. The increase in rates directly affects $53 trillion, and only in the bond market. The whole thing needs to be refinanced.
At the moment, it is difficult for me to say how much of this amount is used for refinancing annually. According to preliminary calculations, about 12 trillion, plus a significant part is tied to floating rates. It is also necessary to take into account the annual need for debt increment. Therefore, an increase in rates to 3.5% is at least an additional 500-600 billion overloads in the coming year.
That's being said, The Fed can return back to 2% inflation if it does the following things:
- Brings down the stock, bond and real estate markets.
- Allows a serious recession without any external stimulus and money emission.
- Allows a worse financial crisis than in 2008.
- Allows the collapse of large banks without saving anyone, including allowing customers to lose their deposits.
- Force the federal government - cut costs, including drastically reducing spending on social security and medical care.
- Force the US Treasury to default and restructure the national debt, while Treasury bondholders will have to significantly reduce costs.
About the oil problems we will talk tomorrow in our Gold report, and on few other political issues. Now we could say that everything goes in a row with our long-term view. Problems in the US economy are not disappear and crisis effect starts spreading over all economy spheres. Now it seems unnecessary to recall EU situation, which has no chance to overcome the US in strong economy measures. US will squeeze out all financial juices out from EU to support domestic economy, no doubts. Should we change our 0.9 target on EUR/USD? I guess not. That's what about the tactical vision, in perspective of 6-9 months.
Strategic view tells that this game can't last forever as Fed resources are exhausting fast, especially when rate becomes higher. Final collapse is inevitable, but follows after all other markets will be in a ruins. Recall The Economists September 2021 cover - Luna is already in the pit, ETH and BTC are next, stocks come after them, and last queue stands for US Treasury and Fed (i.e. Bond market). And only extraordinary political events could intrude in this process, changing the scenario but not the final result.
) on how to build a trade context and other trade related matters. (You were my first real role model in this industry, in my over 15 years journey. You helped keep my dream of becoming a profitable trader alive when I was very frustrated and almost gave up. God bless you abundantly)