Category: Financial Markets

Headline:
You Can Ignore Reality…But You Cannot Ignore The Consequences Of Ignoring Reality.

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Bank Capital Structures = Debt + Equity…

Both Are Fortified + Supported By Deposits.

Deposit Instability/Outflows = Stress + Weaken Bank Capital Structures.

Currently Compromised Capital Structures = Prompted + Amplified By…

“Mark To Market” Losses…On Banks’ Enormous U.S. Treasury Note + Bond Portfolios [AKA Reserves].

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Reserve Losses = A Function Of…

Sloppy Reserve Portfolio Structure = Too Long In Duration…

As Banks Stretched For Yield During 10 Years+ Of A Positively Sloped Yield Curve…Anchored By ZIRP.

Fixed Income Investment Script + Yield Curve Flipped Violently Last Year…

Brisk + Steep U.S. Interest Rate Increases Pressured/Punctured Reserve Valuations…

SIVB Reserve Disclosure = Sudden Capitulation + Liquidation Of Entire $20B Portfolio =

Catalyst For Regional Bank Deposit Flight + Panic.

SIVB Investor Perception = “Tip Of The Iceberg” For Regional Bank Universe.

Thus…Severely Rattled Investor Confidence.

Furthermore And Importantly…

Regional Banks Are Subject To A Less Stringent Regulatory Framework…Than The Systemically Important TBTF Mega-Banks…

Resulting…For Now…In Much Harsher Financial Market Punishment For The Regional Banks.

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So…UNTIL Investors/Traders Perceive Banks As Sufficiently Capital Fortressed…

And Architected By A Diversified + Stable Depositor Base…

Confidence In Most Financial Capital Structures…Especially The Regional Banks …

Will Continue To Be Tremendously Scrutinized + Tested By Market Actors.

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However…When Investor Confidence + Perception Nadir…

The Subsequent Rally In Financial Equities Will Be Exceptionally Steep + Swift.

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Contact The Author: [email protected]

Headline:
Free-Falling Markets In Full Fear Mode.

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Global Financial Markets Have Recently Been Slammed…

Especially Equities…As Beta Dominates + Dispersion Is Generally Non-Existent.

The SPY Has Cratered Almost 16% In The Past Month…

Longs Have Nowhere To Hide…Other Than Than A Well Bid $US…

And An Increasingly Spooked Volatility Complex…

Contributing To A Brutal Fixed Income Rout…

In All Likelihood…These 1-Way Price Movements Are Turbo Charged By Margin Calls + Counter-Party Settlement Concerns.

Meanwhile…Investor Sentiment Is Dismal…Probing Spring ’20 COVID Lows.

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“If It Bleeds It Leads”…Captures Global Market Headlines

1. Terminal Fed Funds Rate Expectations Ramp Toward 4.5%.
2. U.S. Quantitative Tightening Amplifies Rate Increases.
3. U.S. Financial Conditions Constrict To Contain Inflation.
4. Europe Is Natural Gas “Boxed” By Nuclear Russia.
5. British Politicians Panic With Absurd Budget Proposals.
6. Japanese Yield Curve Control Is Fortified…Despite Inflation’s Bite.
7. China COVID Lockdowns Perpetuate…Stifling Supply Chains.
8. Taiwan Braces For China Aggression.

And…No Doubt…It ALL Contributes To Much Market Angst.

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However…The Primary Culprit For Current Financial Market Volatility =

The Federal Reserve’s Bloated Balance Sheet…

BECAUSE 12 YEARS OF RIDICULOUSLY EXCESSIVE DOLLAR PRINTING + ZIRP PROVIDED THE FOUNDATION FOR TODAY’S INFLATION CONUNDRUM…

And Was Compounded Globally…As Domestic Debt Monetization Policies Were Intellectually + Practically Exported To Almost All Developed Economies.

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Since ’09…QE/ZIRP Proponents Frequently Articulated There Was Little Legacy Based Inflation Risk…Confirmed By Very Soft Traditional Price Metrics…

1. CPI +
2. PCE +
3. PPI

…Despite Stunningly Sharp Increases In The Money Supply.

Further, They Also Argued That A More Legitimate Longer Term Price Concern Was…Deflation/Dis-Inflation…Especially Due To Globalization Trends…

Thus…Validating Their Money Printing + ZIRP Strategies.

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However, There Was Plenty Of High Flying Inflation…Initiated By Their Monetary Policies…

IN PLAIN SIGHT…

That Central Bankers Elected To Simply Ignore…Defined As…

GLOBAL FINANCIAL ASSET INFLATION …Comprising…

1. Equities = Private + Public
2. Fixed Income = Private + Sovereign
3. Real Estate = Commercial + Residential

…AND ALL DRAMATICALLY

1.  Ascended +
2.  Distorted +
3.  Inflated

…Which…Finally…Post COVID…

Transmitted To John Q. Public’s Real Economy…

…With Increased + Persistent Momentum…During Calendars ’21/’22.

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Then Suddenly…After 12 Months Of Consistent Denial…About The Durability Of Heightened Legacy Based Inflation Measures…

THE FED GOT REAL SMART…REAL FAST…

As The Monetary Baton Seamlessly Flipped…

From…Powerful Stimulus…

To…Bold Contraction…

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Fed Officials Broadly Articulated It Was Wise To “Front-End” Load Hefty 75 Basis Point Rate Hikes Combined With An Aggressive Balance Sheet Reduction Schedule.

In Actuality…With Headline Inflation Already Stampeding For 1+ Year…

During Which Time…The Fed Continued With Robust Monetary Stimulus…

Their Policy Tightening Is/Was As “Back-End” Loaded As The Caboose On A Freight Train.

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Recently…The Fed’s Hawkish Chatter Ratcheted Up…Especially After Last Month’s CPI Data…Which Was Just A Bit Firmer/Wider Than Market Expectations.

Then…Chair Powell Jawboned…At Last Week’s Fed “Presser”…That Real Interest Rates Ought To Be Positive Across The Entire Yield Curve…And That Did It.

Subsequently…Already Heavy Fixed Income Markets Tanked Again…The Dollar Received Another Adrenaline Boost + Fatigued Equity Markets Collapsed From A Further Lack Of Any Bullish Oxygen.

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So…Global Dollar Liquidity Is Currently Being Withdrawn…

At A Frenzied + Record Pace.

Financial Markets Now Price-In Dire Economic Consequences…And Risk Premiums Naturally Skew To The Downside…

As Borrowing Costs Quickly + Very Steeply Escalate.

Asset Managers…Dizzied By The Rapidly Changing Macro-Dynamics…Are Selling First + Asking Questions Later.

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So…When Will This Period Of Financial Market Dislocation…At Least…Begin To Subdue?

ONLY WHEN EXPECTATIONS OF U.S. INTEREST RATE INCREASES INITIALLY SLOW…AND THEN PEAK…

ALLOWING THE US DOLLAR TO WEAKEN…AND FINANCIAL CONDITIONS TO RELAX…

Of Which…We Are Likely…Closer Than Many May Conceive…

As Post COVID’s Incredibly Dramatic “Bull-Whip” Economic Impact Normalizes.

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Contact The Author: [email protected]

Headline:
An Obsessive Investor Focus…Naturally.

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The Short Answer To The Title’s Question =

When EXPECTATIONS For U.S. Interest Rate Increases + Federal Reserve Balance Sheet “Run-Off” PEAK.

Because Higher Rates + Balance Sheet “Run-Off” = Reduced Financial Market Liquidity.

And Reduced Financial Market Liquidity = Universally Lower Financial Asset Prices [Equities + Fixed Income + Real Estate].

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The Monthly Price Chart Of The S&P 500 [see above]…Especially Since The Spring Of 2009….Steeply Ramped…

Without Much Of A Meaningful Capital Draw-Down…As The Fed Frequently + Quickly Modulated The Quantitative Easing Dials…Whenever It Deemed Necessary…To Stimulate U.S. Economic Activity.

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But Then…Without A Doubt + Collectively

…U.S. Domiciled Publicly Traded Corporations Are The Most:

1. Dominant +
2. Innovative +
3. Profitable Companies

…In The World.

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But Do Not Confer A Company’s Equity Performance Strictly To Operational Acumen…As A Much More Explosive Element…To Share Price = Market Liquidity.

Because Since The Spring Of 2009…The Liquidity Hose Of The Federal Reserve Has…For The Most Part…Run At Close To 100% Capacity…

Toggling Between “Flow” And/Or “Stock” Of Printed Dollars…Without Much Of An Abolute Liquidity Draw-Down…

Versus The Current Federal Reserve Plan To Shrink The Balance Sheet At $95B/Month…Which Is Much More Dramatic Than The 2015-2019 Episode [see chart below].

Further Complicating Matters…A Challenging Inflationary Backdrop + Slowing U.S. Economy.

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For Now…The “Flow” Of The Federal Reserve’s Balance Sheet Has Quickly Reverted To Zero…Soon Becoming Negative.

And The Balance Sheet’s “Stock” Has Most Definitely Crested.

Equity + Fixed Income Investors/Traders…Cower + Flee In Anticipation…As The Cliched “Wall Of Worry” Has Rarely Been More Fortified…

Hence…That “Wall” Could Be Climbed + Negotiated + Scaled…But Only…Very Carefully.

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Contact The Author: [email protected]

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Headline:
Wealth Effect In Jeopardy.

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The Bond Market Was Destroyed In Q1 ’22.

The Worst Quarter For Fixed Income In Nearly 40 Years.

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So After 1 Year Of Determined Inflation Denial…The Fed Suddenly Flipped + Folded To A Hawkish Monetary Position.

The Fixed Income Sell-Off That Followed Was Well Deserved…As Investor Complacency Was Deeply Rooted In All Products…Private + Public…Including:

1. Investment Grade Corporate Bonds +
2. High Yield Corporate Bonds +
3. Municipal Bonds +
4. U.S. Treasury Bills + Notes + Bonds…

Thanks To A 13 Year Federal Reserve Policy Of Ultra Easy Money…Punctuated By A Capitulative Dollar Printing Binge To Address Covid’s Detrimental Economic Impact.

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Now…Liquidity…The Primary Short Term Catalyst For Asset Prices…Is Being Sharply Reduced.

Naturally…The Bond Market’s Greatest Fears Have Come True…As The Sell-Off In Q1 ’22 Was Both Merciless + Relentless [see above chart].

Interest Rates Sharply Ramped Early In The Quarter…Even Further…After It Was Indicated The Severely Bloated $9T Federal Reserve Balance Sheet Will FINALLY Be Culled…By $95B/Month [see below chart].

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Nevertheless…There Is Much Market Chatter About…POSSIBLE…Peak Fed Hawkishness.

Perhaps…In The Near Term…As The Sell-Off Has Been So Rapid…& Fixed Income Sentiment Is So Bearish…That A Counter-Trend Rally Is Plausible.

Still…Consider The Following…Inflation Grips With An “8” Handle & The Current Fed Funds Rate Target = Just 25-50 Basis Points.

Historically…In Order To Tame A Sharp Inflationary Impulse…The Fed Funds Rate Ought To Be ABOVE The Annualized Rate Of Inflation.

Obviously…We Are Not Anywhere Close To That Level…Even If You Halve The Normalized Inflation Rate To 4%…And Fed Governors Have Acknowledged As Much.

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Of Course Capital Markets Are Well Skilled At Discounting Future Expectations…And Current Expectations Are For Short Term Interest Rates To Approximate 2.48%…By The End Of Calendar ’22.

That’s A Lot Of Actual Fed Tightening In The Next 8 Months…Just To Catch-Up With Real Time Market Pricing.

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Anyway…The Most Critical Unanswered Bond Market Question =

In Order To Dramatically Slow Inflation…Must The Fed Move Beyond The Perceived Terminal Fed Funds Rate…That Is…The Interest Rate That Is Neutral…Neither Stimulating Nor Restricting U.S. Economic Activity…In Order To Dampen Inflation?

And Therein…Lies The Answer To Future Bond Market Pricing…

Because Right Now…Though The U.S. Economy Is Indeed Slowing…The Fed’s Current Monetary Policy Is Still Massively Stimulative.

Despite The Steep Q1 Sell-Off…Market Actors…For Now…Presume A Terminal Interest Rate Of Just 2.50-2.75%.

But That Presumption Will Vacillate With Forthcoming Inflation Data…

And If/When The Market Merely Senses That The Terminal Interest Rate Might Reside At A Much Higher Level…Then…

…The Fixed Income Market Rout Will Resume.

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Furthermore…Much Intellectual Capital Has Been Recently Spent Comparing/Contrasting Inflation Of The 1980’s To Today’s Inflation…

And 1 Item To Seriously Contemplate…Regarding This Issue…Is That Inflationary Measures Have Adjusted…Quite A Bit…In The Last 40 Years.

If One Were To Apply The Same…More Liberal…Inflation Measuring Criteria To The 80’s…As Is Now Calculated In 2022…That 14% Inflation Rate In The ’80’s Currently Translates To Around 9.5%.

So Inflation…No Doubt…Is Currently Perched Near Generational Highs.

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As To How Inflation Evolves…Here Are Some Crucial Facts To Ponder:

1. The War In Ukraine = Inflationary…
As Global Supplies Of Agricultural Commodities + Commercial Fertilizers + Industrial Metals + Oil Are Curtailed.

2. Global Supply Chain Bottlenecks = Inflationary…
As The Uncertainty Of Input Supply Leads To Over-Ordering + Purchasers Aggressively Adjusting To Diminished + Unreliable Allocations.

3. The “Green Agenda” = Inflationary…
Primarily Because The Implementation Is Too Fast…And Discourages Oil Production Despite Still Robust Global Petroleum Demand.

4. Global Central Bank Balance Sheet Volumes = Inflationary…
vis-a-vis Richly Valued Financial Assets + Real Estate.

5. Tight Labor Markets = Inflationary...
As Demand Continues To Dramatically Outstrip Supply

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So…How To Combat This Daunting List Of Inflationary Challenges?

First Things First…The Fed Has Zero Control Over #1 & #2 Listed Above.

As For The Green Agenda [#3]…That’s A Political Issue…That Only Pivots If The U.S. Executive Branch Reverses In The Next U.S. Presidential Election.

So…Tactically…The Only Flanks For The Fed To Attack Are #4 & #5.

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In The Meantime…Fed-Speak Is As Hawkish As Ever…Though Never Precise.

But If You “Read Between Their Ambiguous Lines”…It Is Quite Clear That They Intend To…At The Very Least…Severely Dent The U.S. Residential Real Estate Market…

As Its 12 Year Bull Run Almost Perfectly Mirrors The Fed’s Balance Sheet Expansion…And Has Strongly Contributed To Legacy Based Goods Inflation + Financial Asset Inflation Too.

Consider This…

Existing Home Sale Prices…On A Year/Year Basis…Have Increased EVERY MONTH For The Last 120 Months/10 Years.

And The Price Increases Are Primarily Well Distributed Nationally & Ridiculously Exceed GDP Growth.

Thus…Residential Real Estate Is Classic “Low Hanging Fruit” For The Fed To “Harvest“…In Its Attempt To Bring Inflation Down.

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And What Makes Residential Real Estate An Even More Obvious Target Is That…Generally…It Is A HIGHLY LEVERED “LONG” TRANSACTION…

And While Leverage…

Amplifies Gains In A…

Rising Price Environment…

It Inversely Amplifies Pains In A…

Decreasing Price Environment.

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Residential Real Estate Is Even Further Levered As New Home Construction & Development Is Debt Financed.

And Real Estate Development Consumes Many Commodities… That Have Contributed To Goods Based Inflation…Such As…Concrete + Gypsum Board + Lumber + Metal + Plastics [Chemicals].

Even Then…Developers Compete For These Commodities With Existing Homeowners [a much larger market]…Further Driving Prices Upward…As The Lure Of High Home Prices + Low Financing Costs…Provide Great Incentives To Improve + Remodel Existing Dwellings.

So This Connection Between Housing Prices + Inflated Materials Cost = Highly Elastic…And Easily Susceptible To A Higher Interest Rate Regime.

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Moreover…Rock Bottom Interest Rates…While Encouraging New Home Purchases Also Stimulate Home Refinancing For Existing Homeowners…

Placing Even More Disposable Income In Their Pockets…Though That Has Already Reversed Quite A Bit [see Mortgage Bankers Association weekly data].

And Do Not Forget That Homeowners Also Spend Much Discretionary Income On Home Goods + Furnishings [Indoor & Outdoor]…Adding Another Stimulant To Aggregate Demand…That Ought To Wane With A Slowing Residential Real Estate Market.

So The Beautifully Levered Multiplier Effect Of Real Estate…That So Stimulates The U.S. Economy…Transmitted Through Developers + 1st Time Home Buyers + Existing Homeowners…Will Be …In All Likelihood…Harshly Slayed…As The Positive Feedback Loop Steeply Reverses.

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The Second Piece Of The Previously Mentioned “Low Hanging Fruit” For The Fed To Harvest…In Order To Fight Inflation Is:

Financial Asset Prices…Beyond Fixed Income + Real Estate…So Equities.

And The Cornerstone Of Equity Price Appreciation = Low Interest Rates…Combined With The Expectation That Rates Will Remain Low…

Obviously….That Investment Ethos Has SHARPLY INVERTED.

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For Equities…Generally…Higher Interest Rates Are Not Friendly To Share Prices…Especially Those That Do Not Generate Any Free Cash Flow.

Even Then…Higher Interest Rates Depress Valuation Metrics Almost Universally…Despite Free Cash Generation.

Plus…The Valuation Set-Up…After 13 Years Of QE + ZIRP…Is Not Compelling…

As Metrics Are Still Broadly Stretched…Especially In The Top Heavy Technology Sector…Predominant In Most Major Equity Indices.

And As Earnings Expectations Reset Lower In A Slowing Economy…Valuation Metrics Will Likely Get Clipped Further As Interest Rates …Ironically Rise…Thanks To The Fed’s Much Tardy Application Of Inflation Fighting Tools.

Finally These All Important Metrics Will Likely Overshoot To The Downside As Investor Anxiety Continues To Build.

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So This Troika-ed Wealth Effect Comprising:

EQUITIES + FIXED INCOME + REAL ESTATE =

Under INCREASINGLY INTENTIONAL PRESSURE…

And Ought To Remain So Until The Current Inflationary Impulse Is Quashed…And That Will Take Some Time…And Maybe Some Luck Too.

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Contact The Author: [email protected]