Bonds Keep Winning Their Battle With Economists

Bonds Keep Winning Their Battle With Economists
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The stock market was rocked by another piece of bad news, and that was only the beginning. Key NASDAQ darling, one of the so-called FANGs, Apple announced quarterly earnings that included a rare cut to its sales forecast. It unleashed a flash crash yesterday morning in several currencies, importantly the Japanese yen among them. JPY rose against several other pairs, suggesting illiquidity and a high degree of fear.

Apple’s CEO Tim Cook may take the blame for it, though he’s not really culpable. By merely telling the truth, Cook confirmed what has been increasingly suspected. Globally synchronized growth wasn’t real and there’s now nothing left of it.

“While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in greater China.”

Neither the slowdown nor its magnitude was truly unforeseen, though. Except for the last four decades, it had been widely known throughout history that there are consequences to getting monetary values wrong. In this modern case, the issue is money itself. A global currency system of sorts arose from this intellectual darkness only to maintain itself deep within those shadows.

For more than a year, we’ve been chronicling serious disorder indicated by whatever touches those shadows. I often tell people the best way to see what might be happening in them is to open up the PBOC’s balance sheet. China’s central bank is the single best dollar indicator available anywhere.

Not through some determined and intentional effort, mind you, it is by accident and accounting. The nature of this global system had allowed the Chinese a short cut. They gained credibility and deniability simultaneously by acquiescing to this credit-based, offshore global currency paradigm.

So long as dollars, actually eurodollars (of various forms), flow into China they find their way onto the PBOC’s balance sheet. This forms the basis for the country’s internal pecuniary system. By arranging monetary affairs this way, a rapidly industrializing economy gained the nominal “backing” of the dollar, credibility absolutely required for the economic miracle to be sustained.

It also removed responsibility from the central bank for any rapid monetary growth. If anything, the PBOC came to be viewed as the adult in the room for the many years of it. Those were dollars ballooning China’s money supply, not reckless RMB printing, the central bank simply acting responsibly in trying to contain them. In private, I am certain, officials were only too happy to have such enviable problems.

This is where any sympathy for the country’s current predicament ends. They signed up for this. But they did so thinking the good times would last forever, their chief concern would always be how to handle the constant situation of too much eurodollar. It’s all fun and games on the way up. Nobody ever knows what to do after midnight.

The eurodollar squeeze of the last eleven years has been four dollar squeezes intermittently. The first for China in 2008 and 2009 was severe but short-lived. The second in 2011 registered more so as a change of direction, the monetary system slowed in 2012 and so did the economy. The third was intense, 2015 and 2016 far more challenging than 2008.

Now we arrive at this fourth.

This isn’t a Chinese problem, that’s just where it is most visible and direct right now. Briefly, as eurodollars become scarce (not for anything the Federal Reserve has done, is doing, or ever will do in its current format) China’s central bank must decide: intervene with its own “dollar” stash or let the country’s vast trade sector, financed by its biggest banks, flounder into insolvency and liquidity crisis.

As in 2015 and 2016, over the past several months the PBOC has chosen increasing intervention (trading the artificial outward stability of CNY for inward financial instability across several dimensions). Therefore, a simple matter of accounting, the reduction of foreign assets required for intervening is mechanically transposed to the liability or money side. Both currency and bank reserves are constrained.

The numbers for November and December 2018 are egregious. I’ve written before about this but there still isn’t any sense or appreciation about why or how any country let alone one like China would stop the printing press. It doesn’t calculate, an incomprehensible scenario that doesn’t even compute as a possibility. Nobody would ever do this, and never voluntarily.

Yet, the PBOC’s balance sheet tells you everything you need to know about cause and effect. Foreign reserves are down and so is RMB. Outstanding currency in December 2018 rose by just 2.1% year-over-year, bringing the 6-month average down to 2.6%, another lowest on record (outside of months exhibiting Golden Week skews). Physical currency.

Bank reserves crashed again, down 6.3% year-over-year last month after falling 7.9% year-over-year the month before.

These changes are all reminiscent of 2015-16, as is the PBOC’s futile attempt to offset crashing money with banking. The central bank has tried to alleviate its monetary crunch by reducing the balance of funding each bank is required to hold in reserve (RRR). It has unleashed gross money market volatility instead, also like 2015-16.

Grave monetary constraint plus serious financial volatility only equals “we did not foresee the magnitude of the economic deceleration” if you weren’t paying attention to the shadow stuff.

What has Tim Cook been paying attention to?

Obviously, I have no real idea what he reads or absorbs but I can reasonably guess it originated in ferbus and with Jay Powell like everything else. Companies like Apple have been talking about globally synchronized growth ever since whoever came up with the term came up with the term. They’ve been expecting an economic boom when so many key pieces kept denying it as even a small probability.

For well over a year, going on two years, the world’s self-proclaimed bond kings have been predicting a massive, epic bond rout; one that would put 1994 to shame. And yet, while nominal yields rose somewhat the yield curve here and elsewhere around the world grew flat, flatter, and flattest.

We could (and should) spend a whole lot of time dissecting the yield curve and all the wondrous, crucial information it contains but in this kind of general overview a flattening curve at an unusually low nominal level is incredibly simple. What it says is that the most important market(s) in the world believes there is a far, far better chance the global economy sours than skyrockets. That was 2018 in a nutshell.

What we didn’t know, or couldn’t tell by the flattening yield curve alone, was timing. For that we had to look elsewhere to related markets like interest rate swaps or eurodollar futures. The curve constructed from the latter has been slightly inverted since mid-year, suggesting that souring economy was perhaps a little closer at hand than many were “foreseeing.”

In December, though, the eurodollar futures curve went from a little inverted (never more than 6 bps) out around the June 2020 to June 2021 contracts to massively inverted the whole way down to June or September 2021. As I write this, in the wake of yet another tumultuous session, that curve is a tick over 46 bps inverted, front month (January 2019) to September 2021.

Not only is this curve signaling massive distress, it is escalating quickly to begin this new year.

We can spend a lot of time on this curve, too, but again its message here is really simple. Eurodollar futures are money futures, tied to 3-month LIBOR. These are global banks hedging their various exposures who have a great deal riding on setting these hedges correctly. An inverted curve says they expect, and are hedging for, the Federal Reserve to reduce interest rates.

Not in 2021, but a very good probability by the end of this year if not some decent probability for sooner. The level of inversion in near months is already alarming. The April 2019 contract, for example, trades 10 bps less than the front month which is itself already trading for lower than where 3-month LIBOR is today.

Now ask yourself, what would force Jay Powell, a man who in “raising rates” in December basically called the markets flat out wrong about his “strong” economy view, force him to give up on it performing instead a complete 180-degree reverse to join them? Not just that, but do it maybe over the next few quarters. How do you go from unshakably “strong” economy to rate cuts that quickly?

The answer to all those questions is of the same type as what caused Ben Bernanke to say subprime was contained in March 2007 and then only six months later prove it wasn’t by undertaking a similar frantic U-turn (the FOMC’s first “rate cut” came in September 2007).

The last wrinkle to all of this is actually elevation. What I mean by that is pretty straightforward, too. Despite all the rhetoric and constant cajoling, neither the US nor global economy really got going the past few years. If it was a boom, it was the most fragile boom ever conceived. Globally synchronized growth was a marketing slogan not rational analysis, a plea for self-fulfilling activity in place of economic and monetary competence.

Very little economic growth and expansion was gained during the 2017-18 intermezzo between the last global downturn (2015-16) and the current one (let’s date it tentatively as 2019, with an eye to revision back into perhaps the last few months of 2018). In other words, the worldwide economy is starting downward again from a low height. That’s not good, leaving very little cushion to absorb still intensifying monetary and financial volatility, as well as what will be a huge blow to expectations.

There was always a downside to globally synchronized growth as a matter of expectations. If you set them so very high as central bankers were doing intentionally especially in late 2017 (it’s been left to Jay Powell almost alone to carry the torch to as far as 2019) you run the risk of triggering a far more intense backlash when everyone finds out it was all so hollow and empty.

You might just sell and retreat in orderly fashion if things start to go badly after a period when things were actually good and plentiful; you might instead run for the exits, increasingly fixated on how narrow they suddenly seem, and sell everything at any price if (when) the world turns sour forcing you to violently accept how everything you thought before was all a (haphazardly constructed) lie. Sounds very 2007-ish.

It is impossible right now to overstate just how forcefully markets have turned in a matter of weeks. These are not stock markets, either, they are of the very players who make up the guts of this global currency system. What we are now seeing are no longer warnings about future risks, they have been transformed into flat out negative predictions about the intermediate term and even short run.

May 29’s massive collateral call was a warning. WTI futures flipping into contango in October was a warning.

China’s PBOC spelling out the rationale behind its last RRR cut was a very specific eurodollar warning. I wrote on October 8 in the wake of that announcement just why Chinese officials were so openly desperate:

“Because the dollars just aren’t flowing to China. They didn’t last year, either, at least not directly (HK) even though CNY rose as if everything was normalizing to globally synchronized growth. Take away the Hong Kong option, what’s left for the Chinese? Or for globally synchronized growth?

“Like 2015, these RRR cuts are showing us the eurodollar condition. China’s money problems aren’t really Chinese. They are money problems.”

That’s exactly what has unfolded over the last few months of 2018 and all around the world not just in one place here or there. Money problems are market problems. Therefore, the global economy isn’t poised to skyrocket as Powell keeps claiming, it has already soured. In the battle between bonds and Economists, the former is still undefeated. Four to nil.

I’ll have (a lot) more to say about what might be next. For now, it’s important to note we are all but certain to have finally arrived at next. And they (Economists) still have no idea what they are doing. At one of these intervals just maybe people will stop listening to the Jay Powell’s of the world. Perhaps it will start with Tim Cook tiring of being caught unprepared for the perfectly predictable negative consequences to moneyless monetary policies.

Fourth time’s a charm? 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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