A lengthy video but some top-quality speakers like former British foreign secretary, Lord William Hague (0:04) and Stan Druckenmiller (2:05).
https://players.brightcove.net/2821697658001/pUgNKzNJLT_default/index.html?videoId=6326209869112
Transcript of Stan Druckenmiller’s talk.
Almost every recession in history has been preceded by speculation that the economy is in for a “soft landing.” After the early warning signs, nothing much happens. The stock market keeps climbing despite rising interest rates, raising hopes of a “lucky escape”.
The four most expensive words in the English language are: “This time it’s different.” ~ Sir John Templeton
The economy takes time to adjust to changed circumstances and there can be a lag of two years or more between the first rate hikes and the inevitable rise in unemployment. Plenty of time for self-delusion as stocks keep rising and unemployment stays low.
The difference between a hard and soft landing is best measured by unemployment. At 3.5%, the March reading shows no sign yet of an approaching recession.
The lag between an inverted yield curve — caused by Fed rate hikes — and unemployment can vary quite widely between recessions, depending on other influences. The chart below shows how an inverted yield curve in July 2000 was followed by the first sign of rising unemployment in January 2001, and shortly afterwards by a recession in March. The next yield curve inversion started in February 2006, the first sign of rising unemployment in July 2007, and the recession only in December of that year. Red bars below represent the lag between yield curve inversion and the first sign of rising unemployment.
The current yield curve inversion (10-Year minus 3-Month Treasury yield) started in November 2022, so the earliest we are likely to see a rise in unemployment is late-2023.
Why is unemployment expected to rise?
Every yield curve inversion (10-Year minus 3-Month above) since 1960 has been followed by the NBER declaring a recession within two years.
Every time the Conference Board Leading Economic Index declined below the red line at -5.0% has signaled recession.
Why do we expect a hard landing?
Every economy runs on credit and the US is no different. The severity of a recession is determined by the extent of the contraction in credit growth, as shown by the red circles below. Note how late the contraction generally is, often occurring after the official recession (gray bar) has ended.
What determines the size of the credit contraction?
Firstly, bank net interest margins.
Banks tend to borrow short-term and lend long, enhancing their net interest margins in good times. But an inverted yield curve pulls the rug from under them, with short-term rates spiking upwards.
The more that net interest margins of commercial banks are squeezed, the more they avoid risk, restricting lending to only their best clients.
The percentage of domestic banks tightening lending standards on C&I loans climbed to 44.8% in March 2023.
Second, is the level of uncertainty facing banks.
The S&P 1500 Regional Banks index plunged after the collapse of Silicon Valley Bank (SVB), Silvergate Bank and Signature Bank.
Shocks in the financial system tend to occur in waves. Latest is the threatened collapse of First Republic Bank (FRC) which has lost almost 100% of value in the past few months**.
The CSBS Community Bank Index of Business Conditions is lower than at the height of the pandemic.
Third is liquidity.
A strong surge in money market assets, warns that money (+/- $450 bn) has flowed out of the banking system and into the relative safety of money market funds.
Money market funds are primarily invested in Fed reverse repo and Agency and Treasury securities, bypassing the banking system.
Bank net interest margins are being squeezed, uncertainty is rising following the Silicon Valley Bank collapse, liquidity is being squeezed, and banks are tightening lending margins. The only party who can prevent a severe credit crunch is the Fed. By reversing course and injecting liquidity (QE) into financial markets, the Fed could attempt to create a soft landing for the economy.
But the Fed is bent on taming inflation and restoring their lost credibility after their earlier “transitory” error. The cavalry is likely to arrive late and low on ammunition.
We expect a hard landing.
EPB Research for the Conference Board LEI chart.
Here is a summary of Colin Twiggs’ presentation to investors at Beech Capital on March 30, 2023. The outlook covers seven themes:
We focus on three key indicators that warn of elevated risk in financial markets:
The chart below plots the difference between 10-year Treasury yields and 3-month T-Bills. The line is mostly positive as 10-year investments are normally expected to pay a higher rate of investment than 3-month bills. Whenever the spread inverted, however, in the last sixty years — normally due to the Fed tightening monetary policy — the NBER has declared a recession within 12 to 18 months1.
The current value of -1.25% is the strongest inversion in more than forty years — since 1981. This squeezes bank net interest margins and is likely to cause a credit contraction as banks avoid risk wherever possible.
We find the VIX (CBOE Short-term Implied Volatility on the S&P 500) an unreliable measure of stock market risk and developed our own measure of volatility. Whenever 21-day Twiggs Volatility forms troughs above 1.0% (red arrows below) on the S&P 500, that signals elevated risk.
The only time that we have previously seen repeated troughs above 1.0% was in the lead-up to the global financial crisis in 2007-2008.
The bond market has a far better track record of anticipating recessions than the stock market. The MOVE index below measures short-term volatility in the Treasury market. Readings above 150 indicate instability and in the past have coincided with crises like the collapse of Long Term Capital Management (LTCM) in 1998, Enron in 2001, Bear Stearns and Lehman in 2008, and the 2020 pandemic. In the past week, the MOVE exceeded 180, its highest reading since the 2008-2009 financial crisis.
Regional banks in the US had to be rescued by the Fed after a run on Silicon Valley Bank. Depositors attempted to withdraw $129 billion — more than 80% of the bank’s deposits — in the space of two days. There are no longer queues of customers outside a bank, waiting for hours to withdraw their deposits. Nowadays online transfers are a lot faster and can bring down a bank in a single day.
The S&P Composite 1500 Regional Banks Index ($XPBC) plunged to 90 and continues to test support at that level.
Bank borrowings from the Fed and FHLB spiked to $475 billion in a week.
Financial markets are likely to remain unsettled for months to come.
European banks are not immune to the contagion, with a large number of banking stocks falling dramatically.
Credit Suisse (CS) was the obvious dead-man-walking, after reporting a loss of CHF 7.3 billion in February 2023, but Deutsche Bank (DB) and others also have a checkered history.
The root cause of financial instability is cheap debt. Whenever central banks suppress interest rates below the rate of inflation, the resulting negative real interest rates fuel financial instability.
The chart below plots the Fed funds rate adjusted for inflation (using the Fed’s preferred measure of core PCE), with negative real interest rates highlighted in red.
Negative real interest rates cause misallocation of capital into unproductive investments — intended to profit from inflation rather than generate income streams. The best example of an unproductive investment is gold: it may rise in value due to inflation but generates no income. The same is true of art and other collectibles which generate no income and may in fact incur costs to insure or protect them.
Residential real estate is also widely used as a hedge against inflation. While it may generate some income in the form of net rents, the returns are normally negligible when compared to capital appreciation.
Productive investments, by contrast, normally generate both profits and wages which contribute to GDP. If an investor builds a new plant or buys capital equipment, GDP is enhanced not only by the profits made but also by the wages of everyone employed to operate the plant/equipment. Capital investment also has a multiplier effect. Supplies required to operate the plant, or transport required to distribute the output, are both likely to generate further investment and jobs in other parts of the supply chain.
Cheap debt allows unproductive investment to crowd out productive investment, causing GDP growth to slow. These periods of low growth and high inflation are commonly referred to as stagflation.
The chart below shows the impact of unproductive investment, with private sector debt growing at a faster rate than GDP (income), almost doubling since 1980. This should be a stable relationship (i.e. a horizontal line) with GDP growing as fast as, if not faster than, debt.
Even more concerning is federal debt. There are two flat sections in the above chart — from 1990 to 2000 and from 2010 to 2020 — when the relationship between private debt and income stabilized after a major recession. That is when government debt spiked upwards.
When the private sector stops borrowing, the government steps in — borrowing and spending in their place — to create a soft landing. Some call this stimulus but we consider it a disaster when unproductive spending drives up the ratio of government debt relative to GDP.
Research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggests that states where sovereign debt exceeds 100% of GDP (1.0 on the above chart) almost inevitably default. A study by Cristina Checherita and Philip Rother at the ECB posited an even lower sustainable level, of 70% to 80%, above which highly-indebted economies would run into difficulties.
Inflationary pressures grow when government deficits are funded from sources outside the private sector. There is no increase in overall spending if the private sector defers spending in order to invest in government bonds. But the situation changes if government deficits are funded by the central bank or external sources.
The chart below shows how the Fed’s balance sheet has expanded over the past two decades, reaching $8.6 trillion at the end of 2022, most of which is invested in Treasuries or mortgage-backed securities (MBS).
Foreign investment in Treasuries also ballooned to $7.3 trillion.
That is just the tip of the iceberg. The US has transformed from the world’s largest creditor (after WWII) to the world’s largest debtor, with a net international investment position of -$16.7 trillion.
To keep inflation under control, central bank practice suggests that the Fed should maintain a policy rate at least 1.0% to 2.0% above the rate of inflation. The consequences of failure to do so are best illustrated by the path of inflation under Fed Chairman Arthur Burns in the 1970s. Successive stronger waves of inflation followed after the Fed failed to maintain a positive real funds rate (green circle) on the chart below.
CPI reached almost 15.0% and the Fed under Paul Volcker was forced to hike the funds rate to almost 20.0% to tame inflation.
The Fed was late in hiking interest rates in 2022, sticking to its transitory narrative while inflation surged. CPI is now declining but we are likely to face repeated waves of inflation — as in the 1970s — unless the Fed keeps rates higher for longer.
There are two possible outcomes:
The Fed caves to political pressure and cuts interest rates. This reduces debt servicing costs for the federal government but negative real interest rates fuel further inflation. Asset prices are likely to rise as are wage demands and consumer prices.
The Fed withstands political pressure and keeps interest rates higher for longer. This increases debt servicing costs and adds to government deficits. The inevitable recession and accompanying credit contraction cause a sharp fall in asset asset prices — both stocks and real estate — and rising unemployment. Inflation would be expected to fall and wages growth slow. The eventual positive outcome would be more productive investment and real GDP growth.
Stocks have been distorted by low interest rates and QE.
Warren Buffett’s favorite indicator of stock market value compares total market capitalization to GDP. Buffett maintains that a value of 1.0 reflects fair value — less than half the current multiple of 2.1 (Q4, 2022).
The S&P 500 demonstrates a more stable relationship against sales than against earnings because this excludes volatile profit margins. Price-to-Sales has climbed to a 31% premium over 20-year average of 1.68.
Elevated risk is expected to cause a flight to safety in financial markets.
The most obvious safe haven is cash and term deposits but recent bank contagion has sparked a run on uninsured bank deposits, in favor of short-term Treasuries and money market funds.
Gold enjoyed a strong rally in recent weeks, testing resistance at $2,000 per ounce. Breakout above $2,050 would offer a target of $2,400.
A surge in central bank gold purchases — to a quarterly rate of more than 400 tonnes — is boosting demand for gold. Buying is expected to continue due to concerns over inflation and geopolitical implications of blocked Russian foreign exchange reserves.
Defensive sectors normally include Staples, Health Care, and Utilities. But recent performance on the S&P 500 shows operating margins for Utilities and Health Care are being squeezed. Industrials have held up well, and Staples are improving, but Energy and Financials are likely to disappoint in Q1 of 2023.
Commodities show potential because of massive under-investment in Energy and Battery Metals over the past decade. But first we have to negotiate a possible global recession that would be likely to hurt demand.
Our outlook for Australia is similar to the US, with negative real interest rates and financial markets awash with liquidity.
The RBA is still living in “transitory” land. The chart below compares the RBA cash rate (blue) to trimmed mean inflation (brown) — the RBA’s preferred measure of long-term inflationary pressures. You can seen in 2007/8 that the cash rate peaked at 7.3% compared to the trimmed mean at 4.8% — a positive real interest rate of 2.5%. But since 2013, the real rate was close to zero before falling sharply negative in 2019. The current real rate is -3.3%, based on the current cash rate and the last trimmed mean reading in December.
Unproductive investment caused a huge spike in private credit relative to GDP in the ’80s and ’90s. This should be a stable ratio — a horizontal line rather than a steep slope.
Private credit to GDP (above) stabilized after the 2008 global financial crisis but was replaced by a sharp surge in government debt — to create a soft landing. Money spent was again mostly unproductive, with debt growing at a much faster rate than income.
Money supply (M3) again should reflect a stable (horizontal) relationship, especially at low interest rates. Instead M3 has grown much faster than GDP, signaling that financial markets are awash with liquidity. This makes the task of containing long-term inflation much more difficult unless there is a prolonged recession.
We have shown that risk in financial markets is elevated and the recent bank contagion is likely to leave markets unsettled. Long-term causes of financial instability are cheap debt and unproductive investment, resulting in low GDP growth.
Failure to address rising inflation promptly, with positive real interest rates, is likely to cause recurring waves of inflation. There are only two ways for the Fed and RBA to address this:
The high road requires holding rates higher for longer, maintaining positive real interest rates for an extended period. Investors are likely to suffer from a resulting credit contraction, with both stocks and real estate falling, but the end result would be restoration of real GDP growth.
The low road is more seductive as it involves lower interest rates and erosion of government debt (by rapid growth of GDP in nominal terms). But resulting high inflation is likely to deliver an extended period of low real GDP growth and repeated cycles of higher interest rates as the central bank struggles to contain inflation.
Vulnerable asset classes include:
1. Which is the most likely path for the Fed and RBA to follow: the High Road or the Low Road?
Answer: As Churchill once said: “You can always depend on the Americans to do the right thing. But only after they have tried everything else.” With rising inflation, the Fed is running out of options but they may still be tempted to kick the can down the road one last time. It seems like a 50/50 probability at present.
2. Comment on RBA housing?
We make no predictions but the rising ratio of housing assets to disposable income is cause for concern.
3. Is Warren Buffett’s indicator still valid with rising offshore earnings of multinational corporations?
Answer: We plotted stock market capitalization against both GDP and GNP (which includes foreign earnings of US multinationals) and the differences are negligible.
Luke Gromen’s FFTT newsletter quotes this March 19 article from Bloomberg:
Fed and five global Central Banks announce move to boost USD funding
The Federal Reserve and five other central banks announced coordinated action Sunday to boost liquidity in US dollar swap arrangements, the latest effort by policymakers to ease growing strains in the global financial system.
Central banks involved in the dollar swaps will “increase the frequency of 7-day maturity operations from weekly to daily,” the Fed said in a statement coordinated with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank.
Gromen points out that the likely purpose of the swap lines are to forestall foreign sales of US Treasuries.
Foreigners short [of] USDs have up to $7.3T in USTs they can sell into a UST market that could not withstand $450B of foreign selling without becoming dysfunctional in 2022. As such, the USD swap lines were at their core, another de facto UST market bailout, the fourth such bailout in the past 3.5 years (Sep-19, Mar-20, Sep-22, Mar-23).
Foreign investors hold $7.3 trillion of US Treasuries.
Long-term investors like the Bank of Japan have recently been sellers to support the falling Japanese Yen. Treasury Secretary Janet Yellen in recent months expressed concern about the lack of liquidity in Treasury markets. Swap lines between the Fed and other central banks may boost USD liquidity but also forestall sales of US Treasuries into an illiquid market by foreign central banks.
Excellent advice from Rebecca Patterson, former chief investment officer at hedge fund Bridgewater Associates.
The MOVE Index has jumped to the fore as the best measure of financial market volatility. While the VIX measures volatility in equity markets, the equivalent MOVE Index measures volatility in the far larger bond market which as a better track record as a leading indicator of the economy. Here are some quotes from MOVE creator Harley Bassman that explain how the MOVE works:
The MOVE and the VIX are very similar in that they basically measure short dated one month volatility. The key thing is that these indices are mostly coincident indicators as opposed to forward looking, because they tend to track realized volatility……
When you have a very steep [yield] curve, so a two year of, call it two, and a 10 year of four, that creates a forward rate that’s much higher than today.
When we get that, the steeper the curve or the more inverted, the bigger the distance between today’s interest rates and tomorrow’s interest rate. Time only goes one way. So the future becomes the present, which means that forward rate got to come to the spot, today’s price, or today’s spot price has to go up to the future price. The bigger the distance, the bigger the spread, the more movement there has to be, and therefore the more uncertainty you have; and the price of uncertainty is implied volatility. (ICE.com)
As the creator of this Index, let me say that both 50 and 150 are the “wrong number”. A level near 50 can only occur when the FED actively constrains risk, while a level near 150 occurs when the FED has lost control. The MOVE at 150 infers interest rate changes of about 9.5bps per day, a volatility that is unsustainable if only because human beings cannot tolerate such stress for long periods of time. (ConvexityMavens.com)
SVB Financial Group (SIVB) reported Thursday that it needed to raise $2.5 billion to cover losses on security investments. Its subsidiary, Silicon Valley Bank was closed Friday, with regulators appointing the FDIC as administrator.
Total liabilities of the group are $195 billion, according to its last report, including $173 billion of deposit liabilities. The FDIC guarantees deposits up to $250,000 but many silicon Valley tech companies and hedge funds had far larger deposits at SVB. Assets consist of $74 billion in net loans after provisions and $121 billion in securities investments, including $92 billion of mortgage-backed securities (MBS).
It appears that the bank suffered capital losses due to its maturity-mismatch: investing in longer-term securities which they funded with far shorter-term deposit liabilities and loans. This a typical bank scenario, borrowing short at low rates and lending long to profit from the interest rate margin. Steep rate hikes by the Fed scuppered the bank’s strategy, with interest margins turning negative as short-term rates spiked.
The FDIC are auctioning the failed Silicon Valley Bank, with bids due late Sunday afternoon.
Treasury Secretary Janet Yellen suggested in an interview that a bailout is out of the question but regulators are discussing the creation of a backstop for uninsured deposits.
We consider it unlikely that uninsured deposit holders will incur losses. Even if we double the capital shortfall to $5 billion, this represents only 2.6% of total liabilities. The bank is worth more than the sum of its assets as a going concern, with a strong client base amongst tech companies and hedge funds in the greater San Francisco area. We expect auction bids to reflect this.
If strong bids fail to materialize, regulators are likely to organize a rescue by a consortium of banks — as has been done many times in the past — backed by incentives from the Fed/Treasury (despite Yellen’s protestations).
This was not a liquidity crisis, with the bank holding large amounts of readily-marketable securities — this was a solvency issue.
Other regional banks may have been similarly impacted by the sharp rise in interest rates and we expect the Fed to hold a review (stress test) to assess the impact of rate hikes on other banks, to allay market fears.
The long-term impact is that financial market nervousness will remain high, with banks increasingly reluctant to lend to their peers other than through (secured) repo markets. The problem is far wider than just banks, with many highly-leveraged hedge funds and private equity firms having gorged themselves on cheap debt. If there is going to be a crisis it is likely to emerge from the unregulated shadow banking sector — as has happened many times before* — and not from the regulated banking sector.
We are edging closer to a credit contraction that would precipitate a recession.
From Wolf Richter, March 12:
….Now we got it officially, in a joint announcement by Yellen, Fed Chair Jerome Powell, and FDIC Chairman Martin Gruenberg. The bailout of uninsured depositors has arrived, so now all depositors of Silicon Valley Bank and Signature Bank, which was shut down today, will be made whole, not just insured depositors. The banks that are still standing can borrow from the Fed under a new facility. But investors in failed banks are on their own.
“After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13,” the statement said.
* Shadow banks precipitating a financial crisis go as far back as 1907, when collapse of the Knickerbocker Trust caused a widespread banking crisis that led to creation of the Federal Reserve in 1913. The LTCM collapse of 1998 is another such example. More recently, the sub-prime crisis of 2008 led to the absorption of highly-leveraged major investment banks into the regulated banking system.
“During the decade ending in 2021, the United States Treasury received about $32.3 trillion in taxes while it spent $43.9 trillion. Though economists, politicians and many of the public have opinions about the consequences of that huge imbalance, Charlie and I plead ignorance and firmly believe that near-term economic and market forecasts are worse than useless…..Berkshire offers some modest protection from runaway inflation, but this attribute is far from perfect. Huge and entrenched fiscal deficits have consequences.”
~ Berkshire Hathaway Newsletter to Shareholders, 2022
There are three potential sources of funding for fiscal deficits of which two are inflationary:
The danger with forecasting is that our analysis may be accurate, based on the evidence at hand, but the outcome may be completely different because of some unforeseen event. Someone at a live food market in Wuhan develops a respiratory fever, crude oil falls to minus $37 per barrel, the Fed dumps $3 trillion into financial markets in just three months, China imposes economic sanctions on Australian coal, and Russia launches a full-scale invasion of Ukraine — all of these events are unforeseeable and likely interconnected.
So why do we persist in making forecasts and basing investment decisions on them?
Consider the alternative.
An inability to make forecasts would destroy the global economy. A farmer consults weather forecasts when planning what crops to plant, how much to plant, and what fertilizers are required. A retailer may similarly consult economic forecasts when making decisions to stock her shelves. Forecasts are necessary to plan for future events, whether they be crop harvests, retail sales or longer-term investments.
We need to recognize the uncertainty surrounding forecasts. The more complex the environment, the higher the degree of risk.
Attempting to accurately forecast future events is futile. And anchoring investments to a particular outcome is risky. It is safer to simply estimate whether the risk of a particular outcome is high or low.
For example, we may believe that the risk of a hard landing in the next 12 months is high and position our investments accordingly. But bear in mind that no particular outcome is certain and we need to retain sufficient flexibility to adjust our strategy if the probability of an alternative outcome should increase.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” ~ Samuel Clemens
The S&P 500 retreated from resistance at 4100. Reversal below 4000 would warn of another test of primary support at 3500. We remain in a bear market, with 12-month Rate of Change below zero.
The recent rally was caused by falling long-term yields, with 10-year Treasuries testing support at 3.5%. Rising yields are now precipitating a retreat in stocks.
Slowing Treasury issuance, ahead of debt ceiling negotiations, may have contributed to declining yields but this has been offset by foreign sales, notably by the Bank of Japan.
The Treasury yield curve remains inverted, with the 10-Year minus 3-Month at an alarming -0.97%, warning of a recession in 6 to 18 months.
Commercial banks borrow short, with most deposit maturities less than a year, while lending on far longer terms in order to capture the term premium. When the yield curve inverts, net interest margins are compressed, making banks willing to lend only to the most secure borrowers. Credit standards (green below) are being tightened but credit growth (pink) remains strong. Credit growth is likely to decline in the months ahead and would warn that a recession is imminent.
Fed operations reduced liquidity in financial markets but this has been partially offset by Treasury’s running down their General Account (TGA) at the Fed (which injects money into the economy). The net result is a $1.2 trillion reduction in liquidity.
The breakdown is illuminating, with the Fed reducing its balance sheet (blue below) by $469 billion to the end of January, while reverse repo operations (green below) removed $2.4 trillion. Treasury, however, partially offset this by running down their TGA account (red) from $1.8 trillion in July 2020 to $0.5 trillion in January 2023.
The net effect is a fall in the money supply (M2) relative to GDP, from 0.90 to 0.82. But there is still a long way to go. The ratio of M2 to GDP should ideally be a constant, with money supply growing at the same pace as GDP. Lax monetary policy instead allowed money to grow at a faster pace than national income, resulting in high inflation as aggregate demand runs ahead of output.
The primary cause of bull and bear markets is liquidity. Stock prices could well remain high, even while the Fed hikes interest rates, if financial markets are awash with cash. Only when credit growth slows, and the Fed sells more Treasuries, are prices likely to collapse. External factors, like foreign investor sales, may also shrink liquidity but are a lot harder to predict.
The pig is still in the python. The large gap between deposits at commercial banks (blue below) and bank lending to private borrowers (pink) is represented mainly by commercial bank holdings of Treasury and agency securities. Only when that has been worked out of the system will financial conditions be restored to some semblance of normality.
Christophe Barraud for the Bloomberg link on BOJ Treasury sales.
