Author: Colin Twiggs

Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters. Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis. Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events. He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
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Luke Gromen | Another UST Bailout

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).

Conclusion

Foreign investors hold $7.3 trillion of US Treasuries.

Foreign Investment in 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.

 

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Rebecca Patterson | Sell the Rallies, Buy Defensives & Gold

Excellent advice from Rebecca Patterson, former chief investment officer at hedge fund Bridgewater Associates.

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Harley Bassman | The MOVE Index

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)

MOVE Index

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)

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SVB update

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.

Conclusion

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.

Latest News

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.

Notes

* 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.

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Warren Buffet: Fiscal Deficits and Runaway Inflation

“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

Comments

There are three potential sources of funding for fiscal deficits of which two are inflationary:

  1. The private sector. Deficits funded by the private sector have no impact on inflation. The rise in public spending is offset by a decline in private spending/increase in savings.
  2. Commercial banks. Inflationary. The bank simply swaps one asset on their balance sheet for another: bank reserves at the Fed are exchanged for Treasury securities. Public spending rises but is not offset elsewhere.
  3. Foreign investors (including banks). Inflationary. Public spending rises but there is no offset. The inflow on capital account is matched by an outflow on current account.
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Forecasting risk

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.

Conclusion

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

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Stocks retreat as Treasury yields rise

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.

S&P 500

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.

Treasury Yields: 10-Year

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.

Bank of Japan Sales

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.

Treasury Yields: 10-Year minus 3-Month

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.

Domestic Banks Tightening Standards & Credit Growth

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.

Fed Net Asset Purchases

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.

Fed Net Asset Purchases

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.

M2/GDP

Conclusion

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.

Bank Credit & Deposits

Acknowledgements

Christophe Barraud for the Bloomberg link on BOJ Treasury sales.

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Debt default and currency devaluation

“The first recorded credit bubble popped in 594 B.C. Athens. Threatened with a civil war of creditor versus debtor, the Athenian ruler Solon pulled down the mortgage stones to free the debtors and devalued the drachma by 27% to relieve the bankers. Every credit collapse since – from the Panic of A.D. 33 to John Law’s Mississippi Bubble to the Great Depression and many others besides – has followed Solon’s template of debt default and currency devaluation….”

~ Myrmikan Capital LLC

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A bear market for bonds?

In 2009, Warren Buffett wrote:

“Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation…..”

He was wrong about inflation. The next decade enjoyed low inflation, despite loose monetary policy, for two reasons. First, globalization had flooded the global economy with hundreds of millions of Chinese workers — earning a fraction of Western wages — a huge deflationary shock that depressed wages growth. Second, a contracting US economy, after the global financial crisis, added to deflationary pressures. The combined effect offset the inflationary impact from profligate monetary policy.

Manufacturing wages

The world has now changed. On-shoring of critical supply chains and geopolitical tensions with Russia and China are stoking inflationary pressures. Warren Buffett’s warning now seems prescient as the Fed struggles to cope with inflation fueled by combined fiscal and monetary policy during the pandemic.

The abrupt reversal in Fed monetary policy has increased the risk of recession. All traces of the word “transitory” have disappeared from press announcements, switching to the mantra “higher for longer”. The Fed funds rate is expected to reach 5.0% in the next few months, causing job losses later in the year.

Fed Funds Target Rate

10-Year Treasury yields broke former resistance at 3.0%, reaching 4.0% before retracing. Respect of support at 3.0% would confirm that the almost forty-year bull market in bonds is over.

10-Year Treasury Yield

Falling long-term yields caused a massive surge in private debt during the bull market, with non-bank debt more than doubling relative to GDP.

Non-Financial Debt/GDP

Federal debt, even worse, grew four times relative to GDP.

Federal Debt/GDP

The surge in debt inevitably fueled speculation in real assets, with a similar rise in stock market capitalization relative to GDP.

Stock Market Capitalization/GDP

Conclusion

The significance of debt to GDP ratios should not be underestimated.

Increasing debt to fund investment in real assets is a sound investment strategy in a bond bull market, so where’s the harm?

When an individual or corporation invests, their goal is to generate income from the investment. The income stream is applied to pay the interest on the debt and repay loan capital over a reasonable period. An investment that fails to generate sufficient income and requires the borrower to capitalize interest against the loan is generally considered a failure. And likely to lead to a forced sale when the economy contracts and access to credit dries up.

The overall economy is headed for a similar predicament. When debt growth outstrips income, it warns that borrowers are capitalizing interest and headed for a disaster. The Fed can attempt to postpone the day of reckoning by suppressing interest rates and injecting liquidity. But this just encourages more debt growth and investment in even riskier assets, compounding the problem.

We are now approaching a watershed. An inverted yield curve warns that credit growth is about to dry up. Banks borrow short and lend long, so a negative spread between long-term and short-term interest rates discourages lending.

Treasury Yields: 10-Year minus 3-Month

The Fed faces a tough choice: (A) allow a bond market to cause a sharp fall in asset prices and an inevitable deep recession; or (B) kick the can down the road, suppressing long-term yields to postpone the inevitable collapse, but make the problem even bigger.

Recent falls in CPI do not mean that the Fed has won the fight against inflation. This is likely to be a long, protracted battle. Winning the first round is a good start, but does the Fed have the political cover to stay the distance?

The bond market is pricing in rate cuts by the end of the year, expecting that the Fed will pivot to plan B.

Gold investors appear to share their conviction.

Spot Gold

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Nouriel Roubini: “We are in a debt trap”

Nouriel Roubini was mocked by the media — who christened him “Dr Doom” — because of his prescient warnings ahead of the 2008 global financial crisis.

He has now published a book identifying 10 mega-threats to the global economy.

First and foremost is the debt trap. Private and public debt has expanded from 100% of GDP in the 1970s, to 200% by 1999, 350% last year — advanced economies even higher at 420%, China at 330%. Inflation forces central banks to raise interest rates. High rates mean many debtors will be unable to repay.

If governments print money to bail out the economy they will cause further inflation — a tax on creditors and savers [negative real rates threaten collapse of the insurance and pension industry].

We face prolonged high inflation.

Central Banks hiking rates is misguided, economic crisis will be so damaging they will be forced to reverse course.

Supply shocks from pandemic, Russia-Ukraine war and China zero-COVID policy.

Fiscal deficits will rise due to increased spending on national security and reducing carbon emissions.

Twenty years of kicking the can down the road [short election cycle incentivizes this], with politicians unwilling to support short-term costs for long-term gain because they are unlikely to be in power to reap the rewards. Older voters are also unlikely to support change as they may not be around to reap the benefits.

Carbon emissions are increasing due to the energy crisis from Russia-Ukraine war. Carbon tax of $200/tonne required, currently $2.

We need to reduce our energy consumption.

Also increase productivity. Technology is the only solution. AI and automation could lift GDP growth, providing sufficient income to fund the changes needed.

But technology is also a threat. It provides more dangerous weapons which risk greater destruction in the next conflict.

Democracy is still the best system. Autocracies are often corrupt and way too much concentration of power [echo chamber] leads to mistakes. They also increase inequality and political instability.

Nouriel seems bullish on gold because of geopolitical tensions. Also “green metals” because of the need to reduce CO2 emissions.

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