Right in the midst of the summer doldrums, some concerning news can be found this year. You just have to read between the lines of the infamous short-sighted essays of traditional economic analysis.
In my last post, I suggested that the days of extending and pretending, whilst playing the missionary role in the investors common knowledge game (that the Central banks have the investors back), were close to a point of no return. The game has evolved towards a bifurcation. I stand firm behind the assertion that CB’s will soon have to make a choice, opting either for deflation, and a falling domino of debt write-downs, or an explicit dilution of debt via hyperinflation.
After a fortnight of intense sail racing, and some sober thinking, I have concluded that the Fed’s next move will be crucial. The main Central Bank (sorry for the political sensibilities that might be injured when reading this) is the Fed, the issuer of what, up to now, is the reserve currency of our seriously flawed fiat currency global system. The rest are secondary players (more or less additional printing by Kuroda or Dragui, or a load of new credit via lower reserve requirements by the PBOC, will not change things substantially).
It’s the Fed that plays the cards now. Regardless of the eternal confrontation on SDR’s and everything related to the role of the reserve currency, what the immediate future may bring in this matter, is still to be seen. The USD is still the most relevant currency, notwithstanding the fact that its position is wobbly, and many other currencies are eager to take its place (CNY would love to).
But things are the way they are, at least at the time of writing this. An entirely new setup (show) is coming soon to your local cinema, but not before we write down most of the cosmic debt, or alternately dilute it seriously Zimbabwe style. My advice to candidates for taking up the USD’s role in a brave new world, would be “being careful for what you wish”. Advice that I am assured would not be heeded, even if I played a prominent role in the institutional infrastructure of this global fiat currency and credit Ponzi.
Even though being the reserve currency ever since Bretton Woods (in fact since WW II), has been great business in the past, in this particular case, past performance is certainly not indicative of future performance. It all comes at a cost, and the cost of dominance is rich today. I would not apply for the role. We live a world of accelerating change. Nothing lasts forever. Ask Eastman Kodak, Nokia, and the likes.
Banks, utilities (electricity providers in particular), or central banking, share a meager future. This is a strong conviction call I will go all in for. They are businesses of the past. Of course not immediately, it will take time for the crowd to realize that a new world order is emerging. Letting go of ideas, beloved ones, habits, or nearly everything else, is one of the most difficult things in human psycology. Just like a simple man -Graham Nash- once sung: “they Just Want to Hold on” even while saying and pretending “they Don’t Want to Hold things Down”.
But it is game over. Come what may, the Federal Reserve (FOMC) will have to pick their poison soon (September to December time frame). They are late for this final decision in the crazy easy money environment they embarked in (in order, or so they said, to mitigate the critical consequences of the GFC). Whatever they do, the end is a serious deflationary depression or a wild Zimbabwe style reflationary period. Their options for the immediate meetings are:
1. End the party (Stanley Fisher’s choice).
Lift interest rates moderately, one-off, or in small incremental steps, even in a scenario of serious cycle weakness (see actual Atlanta Fed GDPNow forecast below). With this potential move they are trying to stave off
- Gargantuan share buy-back levels (and balance sheet gearing up) by listed companies (that are the equity market only support right now).
- Risk mispricing (with increasing market internals deterioration, and incongruent HY and ERP discrepancies).
- Fading volume in unreal markets. No price discovery and no market depth (vide JGB market) rapidly extending to other instruments.
- and lastly, preserve the value (trust) of (in) the greenback.
And when I talk about value of the USD, I am not pointing to the actual dollar index pricing, but meaning its value as a trusted currency of choice, and (fiat) anchor of the global monetary system. After all it is better to be the anchor of a sinking ship, than be used as fuel for heating or electricity generation (like d-mark notes in the Weimar republic). On top of that, it would be really nice to reinstate the time-worn concept of interest rates, or else in a couple of years our children will not know what they were.
I have read “ad nauseam” that this is not the moment within the ordinary business cycle, to raise rates. They are absolutely right, the problem being rates should not have been brought to their actual ZIRP level any case. And we shouldn’t be here six years later. They just miss the point. All the FOMC is trying to do, is save face on previous gruesome errors, not tame the actual real economy’s point in the cycle. So it’s not about ordinary cycle overheating. It’s all about trying to backpedal on some enormous mistakes of the Greenspan-Bernanke era (of course without conceding or even hinting to some previous missteps)
2. Sit back, and keep business as usual (the “hold on/hold down” option)
Continue with the POMO stealth interventions, and incongruent -but timely- fedspeak, to conduct and keep markets near their politburo target prices. In nautical terms -follow up on the actual course and bearing to mark. POMOs and Bullard would continue to take center stage. Jim would be delighted for sure, he loves to contradict himself once a week. I still hold last october’s “Bullard moment” in a very special protected file in my mental SSD. The stock marketd literally levitated on his wording.
Doing more of the same is a highly unstable and precarious excercise, with a clear outcome -they will end up opting for one of the other alternatives -only later on. The latest events in commodity markets, energy prices, or the CNY are flashing warning signals of ever higher intensity.
The new semifloated CNY is a particularly relevant event. Count the PBOC as the second public KO (knock out) for a Central Bank after the SNB’s staggering defeat this January. Both were clearly anticipated in this blog, but, to be honest, I made no money on the yuan’s demise. It was a very tough play. In an economy were all the statistics are anything but true, I declined to time the moment of truth for the CNY. I am old and tired of fighting the tape, but nevertheless the outcome was clear to me. This is what I had to say about China on the 24th of november last year.
“In China today, they cannot possibly grow credit much more, they cannot improve exports (the developed world is stagnant), the yen devaluation is hurting their competitiveness, their malinvestments are coming to haunt them, and the real estate sector is imploding. The PBOC is the last tool left to keep things running smoothly, in spite of the malinvestment and real estate disaster that is now evident if you visit the country. … Bankruptcies are just around the corner. The consequences of a hard landing will be very severe. They will do their best to postpone/avoid it.”
And, once again, this is what I said four months ago, in my March sixteenth post:
“4. The Chinese Yuan is in a precarious position. I see USDCNY above 6.40 by year end. The rest of Asia will be pressured to devalue further against the USD. South Korea is generating some loud noises of discomfort already. All in all it points to USD strength continuing, or at least consolidating, in Asia and Europe. The CNY and the JPY are important wild cards today. I expect a stable JPY, and a devaluation in the CNY, but it’s really anybody’s guess.”
I sure got the CNY and JPY pricing right. What I did not expect in the latter post, is the large bounce back in the value of the EURUSD. The pair was oversold, but I expected the down-move to continue much earlier. It could well be that my macro and money-flow thinking was wrong, or simply the CB POMO desks won again. It doesn’t really make much difference -it cost me money. Unless the Fed goes for option three direct, I still think the USD is one of the currencies of choice, and euro shorts should be a basic pillar of your long term portfolio.
Let’s not deviate from the three basic choices for the fed this autumn. This second choice is clearly nothing new. The issue is that doing more of the same, the Fed can rest assured that other CB’s (and sovereigns) will go under, one after the other, on our way to a total systemic collapse. Maybe they can maintain the “statu-quo”, and gain a last tranche of extra time (working overtime in their worldwide POMO desks), but the risks of an outrageous collapse in prices (read repricing of risk premiums and future revenue estimates) are approaching the red zone. Market internals and volatility spikes all around the world stink. And it ought to be hard not to notice (unless you don’t want to do so).
In this scenario, currency wars will continue to engender new conflicts, as more and more countries join the fray. More tensions are to come that will take us all into currency world war one. It’s very simple. There will not be any incremental Aggregate Demand to be found before the global debt reset. Freshly printed money (or credit), and beggar thy neighbor currency moves, is all that’s left if you want to improve your country’s revenue figures.
Also to be mentioned, any break in any of the weak links of the financial risk chain can alter the landscape instantaneously.
It is thus clear that I think business as usual is a suicidal approach. The whole farce will continue to degrade until they lose control of the angry mobs, or somebody makes it evident that most of the debt in the global balance sheet is in fact worthless. A terrible financial death, with no dignity, and a lot of angst in the meantime. I hope they don’t do it.
3. Provide some more alcohol (easy money/credit) to keep the party going, all the way into hyperinflation (the “Leaving Las Vegas” option).
From the very minute the Fed ceased to print, liquidity has been deteriorating. There is no longer too much money chasing too few bonds, but the other way around. That is a change indeed. The US has lost the constant flow of USD heli-printing, and all the Chinese USD bond buying (now turned into selling for as long as I can anticipate -see graph).
Less dollars (PBOC USD bond buying was a covert additional QE), combined with Dragui-Kuroda printing, and Asian and BRIC currency problems, have brought the exchange rate up, and that is also a serious tightening factor. USD strength is also spoiling the party in EM and BRICS (one of the main disadvantages of being the reserve currency is that you cannot have a strong currency in easy money environments (and nowadays we live in a permanent one).
It should come as no surprise that the US economy is weakening seriously (not that it was strong at any time after the disruption caused by the GFC eight years ago). We keep on flirting with “stall speed” a lot more than we do with “escape velocity”. Recession is very, very close.
So they will be tempted to let go of CB balance sheet orthodoxy (again) in short time. If they try QE4 they are fully into the “Leaving las Vegas” choice. You know the end, but you can still enjoy yourself for a little longer. In this “Leaving las Vegas” choice they will keep drinking (in financial terms, printing, nirping and crediting) to a certain hyperinflationary death. But at least they will enjoy life all the way to their last breath. Like Nic. Cage did, it will be women and whiskey for as long as it goes.
I have also read hard line Austrians and gold bugs repeatedly write that the Fed will get back into the money printing business. It makes sense to say so, because any tightening will immediately tilt us into a recessionary environment. Even doing nothing (holding on) will take us there sooner or later. Reigniting “extend and pretend” will require some fresh money printing in the reserve currency very soon. That is the opposite of what they are trying to do, so they might change their mind in the last minute. I hope not, or at least, not yet.
In truth I wonder what the FED will do.
The FOMC is desperate to lift rates, if they can do it without being accused of wreaking havoc in the real economy. They are in a bind. Maybe that’s why it surprises me when analysts opt clearly for one of the choices. My preferred bet is that they will tighten first and then, maybe, make a last trip to Las Vegas -if the ensuing depression is too extreme, but it’s only a bet. Getting the FOMC behavior right is a risky business.
Highly respectable Druckenmiller obviously thinks they will drink to death and they will not try to reign in first (or else he would not hold gold big time). Soros apparently plays the deflationary option (it is said he is also trying to short the S&P). Gold bugs are fixated in a straightforward “leaving las Vegas” scenario. It is hard to say. If they tighten up (even slightly) deflation will be with us in a nanosecond, and holding gold makes no sense at all. All prices will go down (gold and crude included). But if they print again, I will consider buying gold myself (together with a basket of real assets)
I loved the film “The last samurai”. In fact, if I was to die I would assume the hara-kiri decision (Stanley Fisher option) and, if required, die (financially) with dignity. Our society has precluded honor as a very relevant goal. I miss the samurais. Drinking and dancing till passing away (option 3) would be my clear second choice. But “holding on” all the way till the defeat of the last Central Bank, sounds to me like dying in Auschwitz -a long slog to a certain death.
It is clear that I think the Fed will raise rates for the previously outlined reasons, and do their best to get themselves out of this reckless money management mess. But I also think, that there is a fair chance that it may switch later into “Leaving las Vegas” mode -if the pain is too severe. And, paraphrasing Dragui, believe me, the pain will indeed be severe enough. Will they do it, or allow for a falling domino of write downs?
What am I doing at this juncture?
Well, with a fair chance (fat tail on both sides of the distribution) of deflationary or inflationary developments, it is tough to play your hand. I hate casinos. Both future environments are plausible enough to me. Investing is about making choices, but it is also about minimizing uncertainty, particularly when a fat tail risk is involved. There is one thing I am sure about, and that is that debt will have to be written-down or diluted, so I have set up a strategy to try to avoid getting massacred in any of the two outcomes. I have cash, and will deploy that cash fast if the Fed signals they will go for money printing again. My investment allocation,
- Only short term (up to three year) bonds. In a deflationary environment, long yields can fall big. Particularly if they lift short term rates, because there has been no correlation between rate levels at the beginning and the end of the curve for at least the last decade. So I will certainly miss the chance to make some nice money if that’s the case. But if they decide to “leave for Las Vegas” you are out of the money (nearly all of your money) real fast. Chinese selling of foreign reserves (mainly treasuries) won’t help either.
- Only liquid bonds. Liquidity is speedily drying up. I want the best starting point I can get, in order to ensure capital mobility if things get out of control. It makes me nervous to see emergency doors getting closed every day. Bid-ask spreads are getting worse, and depth is a disaster.
- Only ultra-safe bonds from a credit risk perspective. That excludes a high percentage of sovereigns and virtually all high yielders. I will only take the highest quality credit in debt reset time.
- Short only. If you want to sleep well, just stand aside. But no long commitments save for singular investments in which you are very sure there is a lot of alpha involved. I continue to hold a significant short in the S&P500. At least I haven’t been stopped out for a couple of weeks!
- If long in any particular security, I stick to liquid stocks (same reasoning as with bonds) or to stocks in which you can hedge your beta exposure with derivatives.
- Avoid high beta stocks. More than ever, you want a high alpha and a low beta portfolio.
- Avoid banks in a debt reset environment. Greek banks are the canary in the coal mine. Their real NAV is zero.
- Electricity producers are toast as we know them. With cheap solar electricity and cheap storage (tesla, Mercedes energy etc…) electricity will be produced/distributed bottom up, not top down.
- When shorting, I do it with the index. Liquidity has to be guaranteed in every single trade you commit to. Trading volumes could get real thin out there.
Remain flat to short. No lasting energy rally to be seen for, at least, a year or two. High petrol prices are a thing of the past. I have been and still am bearish energy, even though I admit the bear market is already mature. New shorts would not comply with my strict risk-reward criteria.
The interesting thing is that energy is driving other global markets. See the side chart via the daily shot.
Yet another correlation that makes me feel uneasy about market stability.
Flat to small longs -if they keep plunging. They are excellent protection against reflation, and begin to offer some value after their price correction. But serious deflation could take them further down, so load up very small and gradual if you do. This chart is a little dated (24th of July daily shot) but shows the carnage in all its splendor.
- Long to flat the USD. Some smart people think the euro can trade back to somewhere near 1.20 levels. It may happen, but I will not play that. Strategically the USD is a long, and the EUR is a short. You can time your size, entry points, and stop losses, but always in debt meltdown protection mode. No way I am going to be long one single euro.
- EUR is a short in any event, anyway you look at it. POMO desks will not be able to hold it up much longer, even with the biased/self-interested help of other central Banks (Danish, Rijksbank, SNB, Fed …). Sooner or later, it is doomed. The European periphery is also a basket case, coming up right after Greece (with a time lag).
- Safe currencies must be supported by healthy economies, with low credit exposure against other sovereign debt, and low outstanding debt themselves. Small balance sheets are to be preferred at all levels.
With all this in mind, I have discarded CAD and AUD because of their commodity links, The JPY because of the debt overhang, the NZD/CHF because they are too expensive, and the CNY because its demise has just started (bad news is just beginning in China).
I also think their currency debasement is closer to the end than to the beginning (see balance sheet below). But of course there is no cosmic limit that we know of to potential Central Bank Balance Sheet expansion. They can lever up to any figure they choose.Long SEK is my main call, and I feel reasonably safe there. But I also hold a decent short in USDEUR because dollar shortage is set to continue unless we leave for Las Vegas.
Lastly, I am long small in SGDEUR (I have to diversify somehow into Asia as well, but am worried about the links between CNY and SGD). I plan to keep my SGD position light, because the linkage to the CNY makes me feel uneasy. China is a “papier mâché” (house of cards) economy.
This moment in time is very important. We are getting closer and closer to the deflationary bust, or a last minute reflationary desperate printing and currency manipulating alternative outcome. If the Fed stays the course, expect a recession over the next two or three quarters. If they print or engage in easy money again, go buy gold, farmland, real estate, or anything that can protect you from a bolivarian currency system. Things might move fast after the FED shows its cards.
Good luck to everybody. We are all going to need tons of it, before this is debt reset is done and over.