Macro Digest: Liquid Insolvent Markets

Macro

Steen Jakobsen

Chief Investment Officer

Summary:  This morning's opinion piece from Gillian Tett of The Financial Times reminded me of something my friend Mark Voller said during a recent conversation in a macro conference call. When talking about the Japanese banking sector he made the remark that "they have been kept liquid insolvent for decades".


https://www.ft.com/content/cc31fe38-8adb-11ea-9dcb-fe6871f4145a

Link to The Financial Times

Eureka! My brain said… That’s it! That’s our new world order in a nutshell: The Fed and its merry men can keep endless liquidity flowing, but its efforts are only restoring lost capital from the demand shortfall, not injecting new capital to already zombie companies which have been kept alive by zero-bound and QE policy nonsense since the GFC in 2008 and before that by the worst enemy of markets ever – Mr. Greenspan since 1987.

There are few things I, or the market can predict, but ironically the monetary future is known, as everything Japan has ever done will be repeated by other G-10 banks, in particular the US. The fault line of course comes from Japan system never having been a real market based economy, historically in feudal times, but even in more recent times through keeping competition and foreigners out of the C-suites and through massive cross holdings controlled indirectly at all times by the political powers. In other words: also here welcome to the future.

Through copying Japanese monetary policy and becoming dependent on the flow of new debt we have made the market based economy impotent and in the process risked the real economy as the bigger and more important victim.

Tett’s article also points to the massive disproportional gap between Wall Street and Main Street. It is important to realize that the Fed and US Treasury are now the one and same entity. The Fed is now merely an extension of the Treasury for funding purposes and it’s now conducting policies that at best would be in violation of the spirit of the Federal Reserve Act and at worst a direct overreach of its mandate that was not intended nor ever legislated for.

Lines from article:

  • “….. Citi estimates that global central banks have unleashed $5tn of asset purchases in recent week, with the Fed accounting for half”…”
  • “.. Meanwhile, the Treasury is pumping out more than $650 bn of loans to small business….”
  • “Nevertheless, a cascade of missed payments is under way. About half of ordinary US companies will miss their scheduled rent payments for May…”
  • Tett ends.. .”But I find it hard to believe these sunny rebound scenarios while medical progress remains mixed, at best. And, crucially, until this medical miracle appears, it will be solvency and not liquidity problems that haunt the economy. Woe betide investors or politicians who confuse the two.”

The always excellent Gillian Tett remind me how badly we need insightful, critical analysis in this sea of pundits and forecasts. Then you may ask, if you know the future, can you tell us about it ? Of course...

The next policy will be YCC, Yield Curve Control, a program the Bank of Japan introduced in 2016. To be fully transparent and fair, the US used YCC in the 1940s (to control US treasury yields after WWII while lifting price controls and in order to haircut real value of savings in war bonds to pay for the war effort). If you would like to read more, here is brand new paper from Federal Reserve Bank of New York, research department: How the Fed managed the Treasury yield curve in the 1940s.

The global crisis has now fast forwarded the adaptation of this which I formally expect to be introduced as a tool as soon as we have started to reopen the economy. Current Fed governors Richard Clarida and Lael Brainard (who is considered the “proxy” for present Fed policy) have both recommended using YCC in speeches here and here plus the old guard of Yellen and Bernanke is also aboard the YCC train to nowhere.

Conclusion

  • YCC will cap interest rates, most likely  @0 bps in 5 yrs. and  @50 bps in 10 yrs.
  • This will make price discovery useless in bonds and probably create an exodus of investors from treasuries as the Fed/Treasury duo will try to get away with providing negative real rates forever, with inflation above the policy rate. This is hardly the material fortunes or even marginal returns is made from.
  • I expect considerable pick up in corporate credit in companies outside the long arms of governments. They will be the new “sovereign in fixed income” – i.e. companies not taking or needing government funding.
  • The stock market is currently a zany, “party island” stocked up on policy punch and detached from reality, but one day a bridge will be built to the mainland where water, food, and reality come from. This “inflection” point will be driven by the demand drag on the economy from profound levels of unemployment, which few really understand. There are very few of us in the market who lived through the high unemployment and disconnected 1970s the last time the economic crisis could not be escaped through yet lower interest rates - see my previous post.
  • The stock market has also become a policy target of the government. The SPX level is really decided by the government more than the market. The overreach is making them ever bigger stake holders in ownership, behavior, bonuses, etc.
  • Solvency works slowly but this week’s headlines on chapter 11 filings (also mentioned in Tett’s article) are not a good sign
  • Remember that earnings for Q1 are based on only about 20 of the 90 days of the quarter about – or 22% of the quarter – impacted directly by the Covid19. US jobless claims were completely benign for both of the first two weeks of March before exploding into the millions by mid-month. The real impact and guidance will come in Q2 reports starting in July. Yes, but I doubt it will take that long for market concern to grow, even if it is possible.

Risk /Allocation:

Like everyone I admit to confusion on what to do here. I liked and understood the binary risk at the lows, which made me long, then came the expected all-in, which then became too much. The Fed/Treasury seem to operate under the illusion that: --“if a little of something is good, then a lot of it is extremely good”. This defies all math and nature rules, which dictates that it’s the marginal change, improvement, price, data that makes the difference not the momentum or the amplitude.

But… I’m:

  • Neutral equity (Mentally short, technical long) = Neutral
  • Very Negative EM currencies: Short ZAR, TRY, HUF vs. USD and EUR
  • Like selective credits outside realm of Fed/Treasury’s reach
  • Neutral on GOLD (first time in more than year)
  • Negative WTI Crude (for coming few months’ contracts in particular)
  • Negative global growth
  • Long inflation expectations
  • Long volatility

I change views rapidly these days, so use the above as a snapshot, for what it’s worth.

Take care, enjoy and nice weekend,
Steen

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