What the hell is happening? September 2022
What the hell is happening? September 2022
Fed Policy Error #2 and the Fed Put. Japanese CPI and the Yen. European Failures. Real assets are hedges for currency debasement. QE is IRREVERSIBLE.
This is the fifth post in the WTHIH series. The previous one was sent August 15th.
In the previous WTHIH we talked about the definition of recession and if that should concern you as an investor. We also talked about inflation (i.e. currency debasement) and its effect on business and how that should shape your thinking in terms of investing. The gist? Don’t try to predict market moves but rather aim to invest in high quality assets at good prices.
We touched upon German gas turbine troubles and energy weaponisation by Russia, as well as shifts in German voter intention since the invasion. As I explained, something’s gotta give.
Lastly, I used the analogy of shadows and non-fixed relationships between economics and the stock market to explain my view that you should not try to time the stock market by using economic data, sentiment etc.
In this issue we talk about:
Inflation in Japan, interest rates and movements in the Yen.
Powell’s comments at Jackson Hole and in the FOMC meeting of September 21st.
Confusion around the “pivot” and what it means.
Is inflation falling or not?
The Fed Put.
Progress in bringing down inflation to 2%.
The EU energy summit’s effect on energy markets.
Will the current German coalition hold or will it break?
Not all yield is made the same.
Bonus: BoJ intervenes in the Yen!
QE is irreversible.
Japan is trashing the Yen 🇯🇵
The interest rate differential between the US and Japan is causing the Yen to sell-off hard. The BoJ has made it clear that they will not raise rates regardless of market moves. This rigid signalling has told forex traders to sell sell sell.
“The Bank of Japan continued to stand by its ultralow interest rates as it further isolated itself from a global wave of policy tightening, fueling a slide in the yen to a fresh 24-year low and ramped-up warnings of possible intervention.”
The BoJ is running a yield-curve control policy where it sets the 10-Year JGB (Japanese Government Bond) at 0.00% and intervenes in the market by offering to buy an unlimited amount of bonds at the 0.25% rate.
The 10-Year U.S. treasury currently trades at 3.5% (a 3.25% spread from the JGB) and the Yen is falling.
And the BoJ balance sheet is massive, close to 100% of Japanese GDP.
I have previously commented on Japan’s monster of a government debt burden which can never be repaid. The Japanese budget is just so tight, leaving no room for cuts. At least no room for budget cuts that are politically palatable. And up to now no Japanese government has shown the willingness to do what is necessary.
In fact, they are piling on their previous unsustainable ways. My work on Shinzo Abe’s Three Arrows revised here. Revision: they failed miserably.
What is Jerome Powell up to?
The Fed just won’t let the stock market move up! It seems they believe the wealth effect is one of the reasons inflation has been high, and by signalling their unrelenting hawkishness (🤣), they are trying to tighten financial conditions
The August CPI report which rose by 0.1% month-to-month while core CPI (ex-food and energy) rose by 0.6% gave the market another excuse to sell off.
The 0.6% move in the Core CPI meant the Fed needed to hike rates further lest inflation became more entrenched. In my opinion, Core CPI moved because businesses used this inflation spike to hike their prices to catch up with inflation - and in some instances even more than catch up with inflation..
But why the panic in stocks? If this Core CPI figure shows that inflation is entrenched and will be higher for longer, aren’t equities the best place to keep your money in? For me the answer is obvious, for others no.
But more on this later in the article..
The Pivot Obsession & Simplicity
The market moves in mysterious ways.. In the first sign of a possible pivot, stocks rally with no end in sight. And in the first sign of no pivot near, stocks dump in perpetuity.
You can try trading that relationship, knowing that the correlation is not fixed and could cause you to end up selling bottoms and buying peaks. Or you could take a value-oriented approach to investing by buying good assets at good prices.
There are great companies out there with a lot of growth ahead of them trading for rock-bottom valuations. “Yes, but why?” you ask. Well it’s not easy owning stocks when every headline is negative and every Fed official is trying to make the stock market drop.
But don’t confuse business and capitalism with the proclamations of pseudo-intellectual myopic central bankers that have never got anything right.
You can’t buy the bottom and you can’t sell the peak. Better go with intelligent risk/reward.
Is inflation falling?
We previously spoke about the reasons for this spike in inflation, and that it’s not all up to the Fed.
The “transitory inflation” story was Policy Error #1 which caused yields to rally out of hand as the Fed kept rates too low in the face of a changing inflation backdrop.
Now we are going through Policy Error #2 where the Fed, overcompensating for Policy Error #1, is too hawkish and will end up over-tightening hence damaging the economy.
Energy prices are dropping across the board, and that should do a lot to relieve some inflationary pressure. Gasoline is 50% below its June peak. And Crude just breached $80 from peaking at $120 in June. Not too bad.
But inflation seems to have momentum while input costs (i.e. energy) have a lag until they find themselves in CPI reports. The problem with that is the Fed is hiking rates so fast it’s not in a position to see that.
Hence my tweet below before this week’s Fed meeting:
If the Fed didn’t hike, financial conditions would loosen increasing inflationary pressures.
If the Fed hiked (which it did), financial conditions would tighten too much risking an outcome which is far removed from what the Fed targeted in the first place!
The 30-Year Mortgage Rates in the United States is at 6.3%. It hasn’t been at these levels for 15 years. Won’t this do something for contracting the economy enough to relieve some inflation? Absolutely.
Which brings us to the new “Fed Put”
The term Fed put, a play on the option term put, is the market belief that the Fed would step in and implement policies to limit the stock market's decline beyond a certain threshold.
But now it’s not about limiting the stock market’s decline, it’s about limiting the treasury bond market’s decline. The Fed’s fear was that inflation expectations would get out of hand, causing a negative spiral in the economy and the financial system…👇
Letting inflation out of hand would result in a cracking bond market and a loss of confidence in Treasuries. For those that can’t see the connection here - that would increase the cost of lending for the U.S. Treasury and severely affect the U.S’s ability to finance its government debt pile.
This is why the Fed is sacrificing the economy and the stock market by being hawkish - to save the Treasury market. As rate hikes manage to keep inflation down - or if the Fed puts the economy deep into recession, the Fed will reverse their hawkishness and start to become more relaxed.
The point is, Fed Policy Error #2 gives you the opportunity to buy treasuries into weakness and selling as the Fed reverses its tight policy.
The risk/reward of the trade is good because the Fed has signalled it won’t let inflation get out of hand, so you know the yield can’t increase too much. This protects your downside risk. As policy relaxes, the yield will drop (Treasuries will move up), giving your profits.
Disclaimer: This is a very tricky trade as the environment we are currently going through is dynamic and in flux. If you don’t feel confident trading treasuries, go for something that you are more experienced in. And always do your own due diligence.
🇪🇺 The EU Energy Summit response - Is it enough?
European officials came back from their holidays and realised energy markets were out of hand. They decided to hold an “energy summit” where they would take measures against the energy crisis.
They decided to:
Subsidise energy consumption of households and struggling businesses by taxing “windfall” profits of energy companies.
Apply gas price caps.
Accelerate transition to clean energy by investing more money in building green energy infrastructure.
Apply a mandatory reduction of 10% in European electricity demand to lower prices.
Whether these measures are enough to solve Europe’s problem doesn’t matter, because this Summit seems to have done the job for now. European gas prices have corrected ~50% from their parabolic highs, and European 1-year forward baseload electricity is down the same.
But German industry is severely wounded from this episode, and energy uncertainty is still too high for businesses to have sufficient predictability in their investment calculations. Many businesses are closing up shop, choosing to pause production and look to relocate operation to other safer geographies.
While the EU thought it has done the job by talking, drafting laws, taxing energy producers and intervening in energy markets - German industry is crumbling fast. The euro is too.
As the euro drops, imported inflation goes up and Europe’s problems are compounded. This uncertainty is hurting the German coalition which has started to take punishment in the polls.
The Chancellor’s party (i.e. SPD) is losing support fast, while the Greens seem to have benefitted from a post-Invasion bump. Meanwhile the FDP is sliding. As I covered one month ago in a piece on German energy politics, this is not good for the future of the traffic light coalition! 🚦🪃💥
Let’s have a look at the total percentages below.
The coalition’s total is down by 7%, and I expect it to fade even further as German industry suffers together with the economy and the Euro.
The CDU/CSU is up 4% while the right-wing AfD (Alternative for Deutschland) is up 3%. This tells me things are changing under the surface and that the Chancellor’s rhetoric is not finding enough supporters.
The German rhetoric is showing cracks…
The German government tried to connect economic uncertainty and energy crisis together with the war in Ukraine, suggesting to the people that they must suffer so the Russian aggressor is defeated.
But the problem is that at the same time, Germany is trying to transition to clean energy away from fossil fuels and nuclear energy. With Russia shutting Nord Steam 1, it is just impossible.
Will German voters stick with the plan till the end? Doubtful. Because cracks have already started to show. Wolfgang Kubicki, member of the FDP and VP of the Bundestag (i.e. German Parliament) said Nord Stream 2 should be allowed to re-open.
The FDP is the biggest loser since the 2021 election and sliding in the polls fast. Will they stay around until they get to 3%? It remains to be seen.
Even Robert Habeck, German Minister of the Economy is feeling the pressure.
German businesses are failing day by day, while Olaf and Robert don’t know what stance to take. It seems unlikely that they would U-turn, so they try to double down. The pressure is building within German government.
Enter power company bailouts
The spike in electricity derivative markets during the summer caused by the Nord Stream 1 crisis and its subsequent complete shut caused big problems for power companies.
These companies were effectively short forward electricity, which was spiking through the roof. This resulted in heavy losses for them and skyrocketing margin requirements. So what did the government do?
BAILOUT power companies, BAILOUT households, BAILOUT businesses.
Now Habeck (German Economy Minister), says that the government must utilise fiscal spending to support the dwindling economy. Putting out ever-increasing fires is unsustainable. Germany was always the most fiscally conservative European nation, but at this rate Germany will reach levels not seen since the 2008 crisis and its subsequent fallout.
I remain vigilant to developments within Germany and the EU in the meantime.
Conflating treasury yields with equity yields.
Investors argue that one should own treasuries and not equities when the yield on the former is higher than the latter. The argument goes, “Why take equity risk to make a yield one can make buying risk-free treasuries?”
If only life were that simple! The cash flows coming from bonds are fixed into the future while cash flows from real assets are not. And especially in times of high inflation, you need the protection of high quality businesses.
Treasuries are great for parking money on a risk-free basis until you shuffle that capital into productive assets, but not good for parking money and keeping it there because on a real basis the value depreciates over time.
And what better time to buy real assets than when they are on sale?
You see, sovereign debt loads are at all-time highs and the only way to handle them is by engaging in money printing. If that money printing pauses for a while, that doesn’t mean it won’t come back. These economic policies are hurting purchasing power and taking money from your pocket.
A 5% bond yield is far from the same as a 5% on a real asset.
Bonus: the BoJ intervenes in the Yen!
As I was writing this piece, the BoJ intervened in the Yen for the first time since 1998.
At a time where major central banks are tightening policy and hiking rates, the Bank of Japan is sitting put. After this week’s 0.75% hike by the FOMC, the BoJ kept their ultra-loose monetary policy nudging forex traders to sell the Yen in the market. But after a sudden Yen drop, the BoJ intervened and bought back Yen and sold Dollars.
BoJ officials have previously talked about intervention as the Yen continued to slide, but I gave my opinion about it here.
Need I say more? I expect the Yen to continue to slide for the time being. I will keep you up to date on my thoughts on Japan here on WTHIH.
How much fire power does Japan have?
Japan is the biggest holder of U.S government bonds and owns $1.2 trillion dollars of them. But this week when they intervened in the Yen, the U.S. 10-Year yield spiked to 3.7% (a %5 move), showing the lack of liquidity in treasuries as well as the fragility of large size.
This basically tells me that even if Japan wants to sell a big chunk of its foreign holdings to prop up the yen, it cannot as contagion would cause much more damage than the intervention.
Q.E is irreversible
It is becoming more and more evident that quantitative easing is irreversible. The expansion of a central bank’s balance sheet to monetise debt is not something that can simply be undone.
First, stopping Q.E in its tracks means price discovery re-appears taking the cost of money to the natural interest rate. And after years of Q.E, the state cannot sustain that cost of debt if it were to pay a non-artificial interest rate.
Second, sovereign debt is at monstrous levels resulting in large fragility (i.e. small changes in variables result in big effects in the system) resulting in a lack of flexibility and optionality.
Third, it is simply unpalatable. The resolve required to actually go through with the reversal of Q.E. is massive, and needs the coordinated will of all stakeholders consistently over time. At a time when we cannot even agree on basic social issues, I don’t expect this to be possible.
Fourth, the risks are asymmetric to the upside (for debt levels). There is an asymmetry between the efforts required to reduce debt, compared to the requirements for more of it. Whenever there is a crisis debt balloons, and it takes years of hard work and pain to reduce that by even a fraction.
Conclusion
Financial markets are in flux and high interconnectedness between geographies and economic actors increases the chance as well as the magnitude of policy ABC, action DEF or event 123 resulting in side-effect XYZ. The world is getting more fat-tailed and unintended consequences are the norm.
I aim to keep my thinking as fluid as possible and my ultimate goal is to understand and act in an intelligent manner.
Look out for more Philoinvestor pieces going forward on financial markets and developments.
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Sincerely,
Philo 🦉