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The topic of geopolitics and the world order is endlessly surprising because it does not submit readily to a formulaic approach. In fact, it is just when one thinks the future is most visible, that events transpire to muddy the outlook.

Debt markets are increasingly sorting US leveraged loans into two categories: money good, and distressed. 

A growing proportion of prices in the market are either very high, or very low. About 5% of the market is trading under 80 cents on the dollar, a share that has more than doubled since June, according to a JPMorgan Chase & Co. analysis. And more than half the market is trading above 96 cents on the dollar, an amount that has also more than doubled.  

With more loan prices reaching extremes, companies that run into any sort of difficulty can see their loans plunge quickly. That can translate to surging borrowing costs, boosting the chance of corporations defaulting. 

“This puts the worst companies at risk, as they’ll have a harder time refinancing,” said Roberta Goss, senior managing director and head of the bank loan and collateralized loan obligations platform at Pretium Partners LLC, in an interview.  

I used to live around the corner from “Nakatomi Plaza” and always got a kick out of driving past the setting for the Die Hard movie. This property is a prime example of the issues facing many commercial properties. Occupancy rates are spotty. Regions depending on the tech sector are most at risk of high vacancy rates. That is going to put pressure on owners are they refinance loans in a tight liquidity and high interest rate environment.

Good morning, Eoin I would welcome your perspective if I may. I have been long only forever, 40 years and counting. In view of the current global challenges, I am thinking of taking the remaining 60% (40% currently in cash or cash equivalents) off the table and holding all in cash for the time being. I would welcome any observations you may have. I look forward to hearing from you.

Thank you for this important question which may be of interest to the Collective. The biggest argument for remaining long forever is the market always comes back…eventually. Being an investor requires an optimistic mindset. That means there is always a risk of selling too late. There is also the risk that the sectors which lead a recovery are not those you currently own.

The yen whipsawed in Monday trade after reports on a potential change to a key agreement between the government and central bank fueled speculation policy makers are moving closer to a hawkish pivot. 

Japan’s currency jumped as much as 0.6% after Kyodo said on Saturday that Prime Minister Fumio Kishida may seek to revise a decade-old accord with the Bank of Japan and consider adding flexibility to the 2% inflation goal, potentially paving the way for an end to its ultra-dovish policy. The yen pared gains after a top government spokesman denied the report.

The existing agreement commits the government and the BOJ to achieving its 2% inflation goal as early as possible. 

The BOJ has long since missed Kuroda’s original timeline of around two years. Still, removal of the phrase would go a step further in recognizing that achieving stable inflation is a longer term goal while implying that factors other than time also need to be considered.

Japan has been trying to achieve its inflation target for a lot longer than two years. The challenge in the past was the global economy was going through a long-term disinflationary trend at the same time Japan was going through a deflating property bubble. Attempting to inflate while companies were moving jobs and manufacturing capacity offshore was a challenge. Today, the aging population and depressed consumer demand are headwinds to inflation.

As I’ve written many times about the economy and markets, we never know where we’re going, but we ought to know where we are. The bottom line for me is that, in many ways, conditions at this moment are overwhelmingly different from – and mostly less favorable than – those of the post-GFC climate as described above. These changes may be long-lasting, or they may wear off over time. But in my view, we’re unlikely to quickly see the same optimism and ease that marked the post-GFC period.

We’ve gone from the low-return of 2009-21 to a full-return world, and it may become more so in the near term. Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets. Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21. And importantly, if you grant that the environment is and may continue to be very different from what it was over the last 13 years – and most of the last 40 years – it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.

That’s the sea change I’m talking about.

There is really only one big question. Will the Fed relent and revert to the GFC playbook when unemployment rises and economic hardship stokes deflationary fears? 2023 will probably deliver an answer.

The product is known as a “collateralised fund obligation” and its aim is to diversify risk by parceling up the companies’ providing returns. CFOs are, in some ways, a private equity variant of “collateralised debt obligations”, the bundles of mortgage-backed securities that only reached the public consciousness when they wreaked havoc during the 2008 financial crisis.

So far, CFOs have flown largely under the radar. Although some of private equity’s largest names such as Blackstone, KKR, Ares and the specialist firm Coller Capital have set up versions, this is often done privately with little or no public disclosure of the vehicle’s contents — or even, in some cases, of its existence, making it all but impossible to build a full picture of who is exposed and on what scale. CFOs introduce a new layer of leverage into a private capital industry already built on debt. Their rise is one illustration of how post-crisis regulation, rather than ending the use of esoteric structures and risky leverage, has shifted it into a quieter, more lightly regulated corner of the financial world.

In the world of investment banking everything can be made better with leverage. Private equity offered rich rewards in the decades before zero interest rates. Then the volume of cash available to the sector ballooned and valuations for the assets they acquired rose in tandem. Leverage is the easy answer for how to sustain returns despite high valuations, which would normally compress yields.

Morgan Stanley projects that a multi-asset income fund can now find some of the best investing opportunities in nearly two decades in dollar-denominated securities, including inflation-linked debt and high-grade corporate obligations. The interest payments on regular 10-year Treasuries, for example, has hit 4.125%, the highest since the global financial crisis.

Meanwhile Pacific Investment Management Co. reckons long-dated securities, the biggest losers in this era of Federal Reserve hawkishness, will bounce back as a recession ignites the bond-safety trade, with government debt acting as a reliable hedge in the 60/40 portfolio complex once more.

“People are excited, believe it or not,” said Maribel Larios, founder and CEO of Fiduciary Experts, a Murrieta, California-based registered investment advisor. “It’s all relative, as they’ve seen these fixed-income accounts pay little to nothing in the past. So, 4% — or even about 2% to 3% in some cash accounts — is relatively good now.”

Banks like Deutsche and Morgan Stanley are taking an axe to their earnings estimates for the S&P500 next year. Corporate earnings have been resilient, even as the Fed has hiked rates faster than at any time in the last 40 years. That is unlikely to persist as the lagged effects of tightening catch up.

Professional investors are loading up on bets that an economic recession can be avoided despite all the warnings to the contrary. It’s a dangerous bet -- for a variety of reasons.

Money managers have been favoring economically sensitive equities, such as industrial companies and commodity producers, according to a study from Goldman Sachs Group Inc. on positioning by mutual funds and hedge funds with assets totaling almost $5 trillion. Shares that tend to do well during economic downturns, like utilities and consumer staples, are currently out of favor, the analysis shows.

The positions amount to wagers that the Federal Reserve can tame inflation without creating a recession, a difficult-to-achieve scenario often referred to as an economic soft landing. The precariousness of such bets was on display Friday and Monday, when strong readings on the labor market and American services sectors drove speculation the Fed will have to maintain its aggressive policies, increasing the risks of a policy error.

“Current sector tilts are consistent with positioning for a soft landing,” Goldman strategists including David Kostin wrote in a note Friday, adding that the fund industry’s thematic and factor exposures point to a similar stance. 

I am reminded of 2007 and 2008 when commodities were surging and banks beginning to roll over. At the time commodity inflation was running rampant but there was relatively little upward pressure on wages. The growing weakness in the housing sector effectively kept wage demand growth under control. Nevertheless, the spike in energy prices and overleverage in the financial system caused a significant problem.

“There will be geographic expansion as these markets continue to evolve along a similar trajectory with a lot of the same trends we saw in the US,” Michael Arougheti, chief executive officer of Ares Management, said of private credit in an interview on Bloomberg Television. “If we continue to demonstrate durable performance through cycles then the appetite for the asset class will continue to grow significantly.”

Yet it is not without risk. With the US economy slowing, more companies that private credit funds lend to may begin defaulting on their repayments next year as earnings decline and interest on their floating-rate loans rises.

“Private credit is a place people can go to benefit from rising rates,” Arougheti said. “The flipside of that is that as rates are going up, debt service becomes more challenging.”

An additional problem is the less stringent valuation process for private credit portfolios compared with assets in public markets, which can leave poor investments hidden for longer.

Private credit ballooned in size following the credit crisis as big banks retreated from riskier parts of the lending market and quantitative easing flooded the market with liquidity. Non-bank lenders now dominate the US mortgage markets. Companies like Citadel dominate market making in stocks. Private equity groups are now some of the largest property owners in the world. Private credit groups are now also dominating commercial credit markets. The fact they are migrating to international markets suggests the domestic US market is at capacity.

In Australia, where the pace of housing declines has eased, the outlook for mortgagees is similarly tough: borrowing capacity has fallen and monthly repayments have surged. In addition, a large chunk of loans that were fixed at record-low rates during the pandemic are due to roll over in 2023 at a much higher rate. 

With the full impact of past hikes yet to be felt, rates still rising and the economy set to weaken, there’s likely still some way to go before prices bottom, said Shane Oliver, chief economist at AMP Capital Markets in Sydney. 

Given expectations that rates will rise higher in both countries, some economists see home values dropping more than 20% from their peaks. 

Rolling fixes is likely to be a major topic of conversation in Australia, Canada, and the UK in 2023. The impending step higher in mortgage payments for millions of consumers is the central dilemma for their respective central banks. They need to raise rates to try and tackle inflationary pressures but every hike makes the problem of consumer debt sustainability worse.

The threshold of 2.52 francs is “the ‘hard underwriting’ price for the consortium of 19 banks,” JPMorgan & Co. analysts said in a research note. If Credit Suisse’s shares keep trading above that level until “the last day of rights trading on Dec. 6, 2022, we can assume at that point the capital raise was most likely a success.”

Having a large number of underwriters makes it easier to find buyers and reduces the risk for the investment banks to get stuck holding a large amount of the shares. As part of the lender’s capital raise plans, Saudi National Bank to invest up to 1.5 billion francs in the lender, becoming a top shareholder. 

Credit Suisse Chairman Axel Lehmann, speaking at a conference in London on Thursday, said that the stock would stabilize after the rights issue is completed and that investors should expect volatility until then. The new shares are due to start trading on Dec. 9. 

“I cannot predict where the share price is going,” Lehmann said. Until the end of the capital raise process, “we will have a little bit of volatility, but then I think it will start to somewhat stabilize and bottom out, and then we go from there.”

Credit Suisse’s share price continues to accelerate lower. A catalogue of management errors has seen the share lose close to 90% of its value since 2013. Tightening global liquidity is a proximate cause of stress, but the bank also needs to address many of the internal controls that led to this condition too.

Since returning from the Chart seminar in London I have spoken to several people who work in the Israeli high-tech industry, They all tell me that about 10% of their colleagues have lost their jobs recently. Today you referred to your MIIN index. How can we invest in these countries?

Thank you for this additional insight. The market for big ideas ballooned with the delivery of free money. Suddenly, no idea was too grand, or time to delivery/commercialization too long. That trend was looking tired in 2019, as the Federal Reserve’s quantitative tightening was siphoning liquidity from the global economy.

“The time for moderating the pace of rate increases may come as soon as the December meeting,” Powell said in the text of his speech. “Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.”

Policy-sensitive 2-year Treasury yields fell on Powell’s remarks, erasing increases on the day, and the S&P 500 index reversed losses to trade higher. The dollar slipped in value against major rivals on foreign-exchange markets.

The Fed’s actions -- the most aggressive since the 1980s -- have lifted the target range of their benchmark rate to 3.75% to 4% from nearly zero in March. Powell said rates are likely to reach a “somewhat higher” level than officials estimated in September, when the median projection was for 4.6% next year. Those projections will be updated at the December meeting.

Jerome Powell confirmed today that the pace of Fed hikes will moderate; not reverse or pause. Nevertheless, cashed-up traders are more than willing to take anything less than outright hawkishness as good news.

I see a third question more related to the protests, not COVID, and I apologize in advance for the potential false equivalency. When comparing Europe's energy situation and the global supply chain / China sourcing situation how will each unfold in future years? Certainly both are heading directions (reversing) that will not turn. Are Europe's hooks deeper into the Russian supply habit or is the global supply chain China habit even deeper?

I am most interested in the impact similarities these two withdrawal themes may have on the West, and the length of time change will take. I have long thought North America "has it all" when you look at materials, labor, and markets.

Thank you for this question which raises some important points. The conclusion that Europe is in a more difficult position than North America is clear but nothing is ever so simple.

Europe relied on Russia to supply much of its energy and much of the money spent on imports was recycled through European countries. That is over. Europe now needs to mirror the USA’s success in becoming energy-independent.

Global bond yields will likely fall slightly in 2023 as the balance between demand and supply will improve by $1 trillion, strategists at J.P. Morgan said in a note.

There will be a $700 billion contraction in global bond demand next year compared to 2022, while bond supply will likely drop by $1.6 trillion, J.P. Morgan strategists, led by Nikolaos Panigirtzoglou, estimated in the note issued on Thursday.

"Based on the historical relationship between annual changes in excess supply and the Global Aggregate bond index yield, a $1 trillion improvement in the demand/supply balance would imply downward pressure on Global Aggregate yields of around 40 basis points," the Wall Street bank said.

J.P. Morgan said that while major central banks trimming their balance sheets in 2022 was the single largest contributor to deterioration in bond demand, sell-offs by commercial banks and retail investors were also much higher than estimates.

There is a strong likelihood inflationary pressures will fall next year. There are three major reasons for believing that.

By March, it will be a year since the Bank of Canada began raising interest rates — meaning ever more of the record number of people who took out short-term or floating-rate mortgages at historically low rates will find themselves fully exposed to the roughly fourfold jump in borrowing costs since then, a potentially catastrophic shock to their personal finances.

The fate of Canada’s housing market will depend on whether or not they can hold on. And just as the country was a leader in the years-long global real estate frenzy, how its downturn plays out — a relatively orderly correction, or a brutal crash — may be a harbinger for what awaits the rest of the world.

Housing markets around the globe are wobbling under the weight of central bank rate-hike campaigns, with a handful of frothy countries joining Canada in already seeing precipitous price declines. More than a dozen developed economies, from Australia to Sweden to the US, are in the midst of downturns — defined as two consecutive quarters of falling prices — or will be by the beginning of next year, according to Oxford Economics. If those slumps prove worse or more widespread than expected, it would deepen a potential global recession. 

 

The Canadian 10-year yield appears to have reached a near-term peak in the region of 3.5%. The rate is coming back towards the trend mean so this will be a significant region to test whether demand dominance has returned beyond short-term steadying.

On the income side, if you earn more than £100,000, you really should be looking at how to put as much of your salary as you can above that amount into a pension via salary sacrifice. Why’s that? Because contrary to what you might think, you’re not paying a 40% marginal tax rate. As the team at tax advisors Blick Rothenberg point out, your marginal tax rate is in fact closer to 60%, because £100,000 is the point at which your personal allowance starts to get whittled away. (This is also why the 45% rate was cut to £125,140 rather than £125,000 — so that it aligns with the point at which your personal allowance is all gone.)

As a result, any money you can shield from this rate is doing a great deal more work than any other pound you save. That said, given that your mortgage is probably going up, and your heating bill is through the roof, it’s quite possible that you are already doing as much as you can on that front without causing a major liquidity crisis in your household.

On the investment side, falling squarely into the “be thankful for small mercies” category, at least the chancellor didn’t mess around with the annual allowances for tax-efficient “wrappers” — you can still put up to £20,000 a year into an individual savings account, and up to £40,000 a year into a pension (assuming you earn that much each year). The latter of course is still subject to the (frozen) lifetime allowance, so do be careful if you’re in danger of breaching that £1.073 million lifetime cap.  

So if you have grown a bit sloppy with your admin, and you are holding any shares outside a tax wrapper (i.e. an Individual Savings Account or a pension), then now is the time to get a handle on that and move them. At least then you’ll be shielded from dividend or capital gains taxes. If you have already exhausted these allowances, you might want to start looking at venture capital trusts or enterprise investment schemes, though those are a topic for another day. 

Government rules tend to change investor behaviour. The perversion, that is the tax system, means the incentive to make a lot of money from working is actively under attack. Instead one is being encouraged to invest as much as possible to shield assets from the tax regime. That basically means outsourcing the job of making money to companies rather than individuals. That’s not great news for hard workers, but it certainly benefits the asset management sector.

Interested in your investment purchase of DoubleLine Income Solutions Fund. as a long term subscriber I’ve now moved into another investment age whereby I am now an income & growth investor and the timing of your purchase appears to be potentially beneficial.

I have checked with a number of UK online investment portals and they do not appear to offer access to this closed end fund and therefore my question is whether you accessed this via a US trading platform or direct?

Any help will be appreciated.

Thank you for this question which may be of interest to the Collective. Growing up in Ireland in the last 1970s and early 1980s interest rates were very high. My grandmother used to buy national savings certs for all her grandchildren. They automatically rolled over the interest at maturity. As a teenager, I cashed them in and found they had risen by over 300%. That taught me the simple lesson. Buying bonds when rates are high and before inflation peaks is very attractive.

For lower-earning families unaffected by the child benefit clawback, but perhaps struggling even more, it is usually possible to transfer £1,260 of a non-working spouse’s personal income tax allowance to the working partner. This can potentially save £252 a year. Again though, this is not automatic, it must be claimed.

And these are far from the only tax anomalies. Since 2009, those earning more than £100,000 a year have had their personal income tax allowances clawed back at the rate of £1 for every £2 earned above the threshold. Worse still, the threshold has been unchanged for more than 13 years. Anyone earning £125,140 or more loses the entirety of their personal income tax allowance. 

Here again, making additional pension contributions is a good option for reducing your taxable income — and for those earning more than £100,000, it might be a more realistic option. The sweetener is that the effective tax relief for those affected can be up to 60%. For these people, the government effectively contributes £60 for every £40 they pay into their pensions.

Stealth taxes make things more complicated for everyone. Many lower-earners end up paying far more tax than necessary, or not receiving a benefit to which they might otherwise be entitled, often both.

Unfortunately, especially during periods of rapid inflation, such tax strategies are the gift that keeps on giving for governments, raising additional revenue without having to increase tax rates. .

As an old ad for Morgan Stanley once claimed, “You must pay taxes. But there’s no law that says you have to leave a tip.”

I saw this chart from Eurostat yesterday and it surprised me that the European aggregate tax haul had risen so much ahead of the pandemic.

With the overwhelming spending patterns of the pandemic and the resulting inflation, there is clear need to fiscal consolidation. At present that is focusing on tax hikes but the ultimate nettle that needs to be grasped is spending cuts. That’s not just true of the UK, it’s an issue most European countries and the USA have to deal with eventually.

Even though markets gained on Zhao’s tweet, such a fund may not be best for the industry, said Quantum Economics founder and Chief Executive Officer Mati Greenspan. Binance already has too much control in a decentralized market, he said.

“That sort of concentration of power makes me uncomfortable,” said Greenspan. “It’s the kind of thing crypto was designed to avoid and one of the lessons we should have learned from last week.”

Meanwhile, Elon Musk’s tweet that Bitcoin “will make it” also gave crypto markets a boost, said Greenspan. Dogecoin, a token the Tesla CEO has touted in the past, gained as much as 7.9%.

This is yet another example of the paradox of decentralized finance. It’s appealing in theory but the benefits of centralized control become evident during crises. A truly decentralized system does not have a buffer against bank runs. It is looking likely Binance will come through this crisis with a dominant position in the “decentralized” finance market.

Thanks a lot for another very informative Friday video. Could you please kindly comment on the Chinese Construction Companies’ default situation. How serious and general are the defaults of their international bonds. Thanks in advance.

Thank you for this topical question which may be of interest to the Collective. This Reuters article, dated September 2nd, included a table of the biggest bond defaults up to that point in 2022.
 

As the hosts point out, the best time to buy bonds is when yields are high and inflation is peaking. The higher yield offers a margin for error even if it takes time for the macro details to work themselves out.

Treasury bill supply could rise by $1 trillion by the end of 2023, but the impending debt ceiling episode will complicate the timing, according to Bank of America strategists. 

Strategists Mark Cabana and Katie Craig estimate Treasury will issue about $193 billion of bills in 4Q 2022 and $257 billion in 1Q 2023, with particularly strong months of supply in November, February and March because they are typically heavy deficit months that require additional issuance to sustain the cash balance

However, bill supply projections and the associated market impact are complicated by uncertainty around the timing of the debt limit, another round of money-market reform and the Federal Reserve’s quantitative tightening

Positive quarters of bill supply should help cheapen bills relative to overnight index swaps, and strategists estimate spreads should narrow by 10 basis points or more

Still, the monthly path of bill issuance is “much less clear” because of the debt ceiling, which could become constraining as early as December 2022

At that point Treasury would enter a debt issuance suspension period, which would restrict their ability to issue debt -- likely cutting bills to keep coupon sizes unchanged

Strategists project the potential default, or x-date, would be in August or September 2023. After that, there would be a surge of bill supply to replenish the cash balance

The big question for anyone issuing debt is whether there is a sufficiently large pool of willing buyers to support the market. The Bank of Japan has been buying bonds for so long that it has largely crowded out the domestic market. Liquidity in the 10-yeasr is at an all time low. This condition raises important questions for the US government because $1 trillion deficits appear to be the norm.

“This is a devil’s bargain,” said Steve Chiavarone, senior portfolio manager at Federated Hermes. “Size of rate hikes will likely fall, but terminal rate is likely higher -- the implication is a greater number of smaller rate hikes. That is not dovish.” 

Jay Powell said in plain English it is better to overtighten, and cut later, than to under tighten and risk allowing inflation to become entrenched. That’s about as hawkish as it gets. The Fed wants a recession and they will keep going until they kill demand.

Turkey was the biggest buyer of gold during the quarter, followed by Uzbekistan (26.13 tons) and India (17.46 tons). Not all countries report their gold purchases regularly, so it’s difficult to know how much, for example, China and Russia bought during this same period.

India is also shoring up its gold reserves.

Indian consumers habitually purchase gold jewelry ahead of the festive season every October. But that aside, the Reserve Bank of India (RBI) bought 13 tons of gold in July and 4 tons in September, pushing its reserves to 785 tons, according to the WGC.

Any foreign exchange and gold reserves Russia had overseas have been confiscated. That’s a big lesson for every country that is suspicious of NATO’s motives now and in the future. It is therefore reasonable for countries to favour gold over holding foreign currency because at least the gold is a physical entity that can be held internally. Nuclear weapons are now also a must have to defend against invasion for any country that holds opposing views to NATO.

The surprise pickup in vacancies highlights unrelenting demand for workers despite mounting economic headwinds. The persistent imbalance between labor supply and demand continues to underpin robust wage growth, adding to widespread price pressures and reinforcing expectations for yet another large rate hike on Wednesday.

The latest increase in openings erased much of August’s slide, which, at the time, had suggested a notable moderation in labor demand.

“After the shock of last month’s report, the September JOLTS data is returning to a familiar story: demand for workers remains robust,” Nick Bunker, head of economic research at Indeed Hiring Lab, said in a note. “By all the key metrics in this report, the labor market is resilient.”

There is no easy way to address a shortage of workers because someone is going to be upset by whatever solution is suggested. Immigration is the most expedient but it comes with significant political pitfalls and will invariably change the culture of wherever migrants congregate most.

In September, a sharp slide in the yen following the policy statement and dovish comments by Kuroda prompted Finance Minister Shunichi Suzuki to order Japan’s first entry into markets to prop up the currency in 24 years. While the governor moved the market again during Friday’s briefing, his tone was more cautious and his remarks weren’t preceded by falls in the currency like the previous month. 

Kuroda continues to hold firm as the last anchor of low global rates just a day after the European Central Bank went ahead with another jumbo rate hike. But the governor is walking on a tightrope as his stance risks putting further downward pressure on the yen despite billions of dollars spent by the government to support the currency.  

“The likelihood of the BOJ pivoting toward tightening is still small as Japan’s inflation is not broad based at all and is only rising about a third of the pace seen in Europe and US,” said Kyohei Morita, chief Japan economist at Nomura Securities.

The speed of the Yen’s decline since March has alarmed politicians and not least because the price of oil is in the region of the 2008 peak when redenominated into the currency. The Bank of Japan’s challenge is much of the inflation is imported. Domestic demand needs a cultural change and that will not be achieved by transient price pressures.

Inversions of this segment of the Treasury curve typically occur late in Fed tightening cycles as three-month bills track the policy rate while longer-term borrowing costs reflect expectations for economic growth and inflation. While other widely-watched yield curve segments such as the two- to 10-year and five- to 30-year have been deeply inverted for much of this year, the Fed follows this one more closely.

“We are certainly in territory with the Fed’s official barometer of the yield curve that will raise concerns,” said Gregory Faranello, head of US rates trading and strategy at AmeriVet Securities. “The Fed will definitely watch this, and there is a sense in the bond market that they will soon throttle back the pace of rate hikes and take a step back.”

The 10-year – 3-month spread spent part of today inverted following an 11.65 basis-point contraction. The spread was at 223 basis points in May so this tightening has been the fastest in decades. The fact there was such a wide divergence between the 10-year – 2-year and the 10-year – 3-month was regarded as an oddity but reflected the stresses in the bond market.

The US economy does not appear to be on the brink of recession at the moment. In thinking about the odds of a recession next year, we break the risks into three categories: (1) the risk that a recession will prove necessary to bring inflation down, (2) the risk that the Fed will cause a recession that is not necessary, and (3) the risk that something else will cause a recession.

The odds that a recession will prove necessary have fallen a little because the first two steps of the required adjustment—slowing GDP growth to a below-potential pace and rebalancing supply and demand in the labor market— have gone remarkably well so far. But it would be premature to say that this risk has fallen too much until we see consistent evidence that labor market rebalancing is slowing wage growth and breaking the wage-price feedback loop.

The odds that the Fed will cause a recession that is not necessary have likely risen somewhat. It is increasingly clear that shelter and health care inflation— and by extension commonly used measures of the underlying inflation trend such as trimmed-mean inflation—are likely to remain uncomfortably high throughout 2023 and would even if the labor market rebalanced tomorrow. While it is not our base case, we see some risk that too great a focus on lagging indicators, too little patience, or tightening too quickly to gauge the impact on the economy could result in a recession that is not necessary.

A link to the full report is posted in the Subscriber's Area.

I used this slide in my IFTA conference slide deck a year ago. At the time, worry about inflation was not urgent even through the 5-year has broken highs and had first step above the base characteristics.

As I thought about what to talk about at the NAAIM conference today, I thought it would be time to update my chart. In the last year, yields have surged and instead of the illusory dragon, today Jay Powell is being tasked with slaying the inflation dragon.

“Credibility is hard won and easily lost,” Ramsden said. “That credibility is being recovered. That has to be followed through. A return to the kind of stability around policy making and around the framing of fiscal events will be really important.”

He said the issue with the Sept. 23 statement was that “it had one side of the fiscal arithmetic in it” and that the decision to include forecasts from the Office for Budget Responsibility will help underpin the confidence investors have in assessing the UK budget due out next week.

“What we are going to get on Oct. 31 will be very important,” Ramsden said. “My sense is that will take account of all the statements on both the revenue and on the spending side.”

 

The bond market has become relevant in politics again for the first time in decades. Liz Truss was unfortunate to find that out in real time. Donald Trump demonstrated that you could engage in procyclical policies and manufacture a swifter expansion. Now most politicians think they can do the same thing. The problem is he did that before inflation took off. Now, the quantity of debt has multiplied, inflation is problematic and fiscal austerity is back on the menu.

Nochu dominated the CLO market until 2019, when it exited amid regulatory and political scrutiny. The Japanese bank would buy all the top-rated securities in a deal. It returned to the US market in late 2021 and to Europe in recent months, but it was buying far fewer securities. 

But with Nochu backing out again, a critical buyer is gone, potentially slowing down CLO sales, money managers said. And others are buying existing deals in the secondary market.

“In a tight CLO liability market the loss of any buyer makes a difference,” said Dagmara Michalczuk, an investor at Tetragon Financial, in an interview. CLO issuance for the remainder of the year is likely to be more uneven than in the last quarter of 2021, she said.

Big institutional buyers will buy every day as long as they are making money. When a favoured strategy stops working it causes a crisis of confidence. Whole business lines have been developed to thrive from the trade. When it stops making money the best performing sector becomes an internal problem that requires a remedy.

Banks in Switzerland sought the most dollars since 2008 using an emergency dollar swap facility provided by the Federal Reserve in what is likely to be a bid for easy profits.

In Wednesday’s auction conducted by the Swiss National Bank, 17 institutions took up $11.09 billion. That’s the most since October 2008, when the Global Financial Crisis was raging in the wake of Lehman Brothers’ collapse. 

This is the fourth week in a row when banks have accessed the facility. Last Wednesday, 15 banks took up $6.27 billion in funds. 

According to economists at Credit Suisse, Swiss banks swap the dollars into francs in order to generate a profit. The lenders can even sell the cash back to the SNB using its reverse repo auctions, or deposit it at the institution to benefit from a positive interest rate.

“We do not believe that the increased demand for US dollar liquidity by domestic banks reflects any liquidity issues in the Swiss banking system”, Credit Suisse economist Maxime Botteron wrote in a report last week.

The dollar swap facility was created during the crisis that began in 2007 as a lifeline to provide safe access to Greenback liquidity, while the SNB’s cash-taking repo auctions are designed to drain excess liquidity from the market. 

It’s not clear that Swiss officials are likely to act to stop banks from taking advantage of the facility. Conditions of the dollar auctions are controlled by the Fed, and the reverse repos are a core instrument in the SNB’s current tightening of monetary policy.

All Swiss and foreign banks which have a branch in Switzerland or are registered with Swiss authorities are entitled to participate in the dollar auctions. Credit Suisse expects predominantly smaller banks to take advantage of the profit play.

The world is dealing with falling supply of Dollars as rates rise and money supply shrinks. Tapping swap lines to source dollars which can then be sold for a profit is a handy money making exercise for banks. 

A rally in the S&P 500 faded after Philadelphia Fed President Patrick Harker said officials are likely to raise interest rates to “well above” 4% this year and hold them at restrictive levels to combat inflation, while leaving the door open to doing more if needed.

Traders also sifted through a mixed bag of corporate earnings, with Tesla Inc.’s sales disappointing and International Business Machines Corp. surging on a bullish forecast. Several market observers remarked that the bar has been lowered quite a bit ahead of the current earnings season, boosting the odds of upside surprises. It’s also worth pointing out that there’s been no shortage of warning signals about the economy when it comes to corporate outlooks.

Alcoa Corp. -- which is a dependable barometer of US economic health across industries including construction, automotive, aerospace and consumer packaging -- said demand for the world’s heavy industries is falling. Union Pacific Corp., the largest US freight railroad, cut its forecast for volume growth to reflect a “challenging year.”

As traders wade through corporate results, “with an extra eye on guidance, expect volatility to remain elevated,” said Mike Loewengart at Morgan Stanley Global Investment Office

Earnings are holding up but guidance is being lowered. CEOs are at their most bearish in years but investors have cash to burn and are eager to salvage a dire year for their performance. Appetite for buying the dip following upside key day reversals for mega-cap stocks last week is still evident.

We study the impact of remote work on the commercial office sector. We document large shifts in lease revenues, office occupancy, lease renewal rates, lease durations, and market rents as firms shifted to remote work in the wake of the Covid-19 pandemic. We show that the pandemic has had large effects on both current and expected future cash flows for office buildings. Remote work also changes the risk premium on office real estate. We revalue the stock of New York City commercial office buildings taking into account pandemic-induced cash flow and discount rate effects. We find a 45% decline in office values in 2020 and 39% in the longer-run, the latter representing a $453 billion value destruction. Higher quality office buildings were somewhat buffered against these trends due to a flight to quality, while lower quality office buildings see much more dramatic swings. These valuation changes have repercussions for local public finances and financial sector stability.

San Francisco commercial real estate occupancy is below 40% while New York and Los Angeles are just higher than that figure. This is a looming issue for the owners of vacant properties, many of whom are pension funds and other private investors. 

Despite the drop in valuation, the listing is set to be one of the year’s biggest IPOs. Amid heightened volatility and disappointing debut performances of last year’s listings, IPO volume in the US has plummeted to $22.3 billion this year, compared with $277 billion at this point in 2021, according to data compiled by Bloomberg. Instacart Inc., another highly anticipated IPO, last week cut its valuation for the third time, to $13 billion, and is waiting for the markets to settle before going ahead with a listing. Another deterrent for new listings is the fact that many companies that went public in 2020 and 2021 are trading below their IPO prices.

But some analysts said it was reasonable for Intel to go through with the listing despite the poor market timing. Analysts at Bernstein said Intel likely needs the money it will receive from the deal, “given the way their own business is currently trending.” And Vital Knowledge analysts wrote that the “headline is negative, but keep in mind the $50B valuation was floated back in December, so no one should be shocked that the number is now lower today.” Intel shares were up about 1.4% in early trading in New York. 

At present we have straws in the wind but the issues with alternative asset valuations are going to become pressure points for investors over the next couple of years. The LDI debacle in the UK where pensions engaged in financial engineering to avoid leverage rules is the thin end of the wedge.

The reality is QE and the low interest rate environment robbed savers, like pension funds, and forced them to become speculators. At the same time it favoured risk takers and inflated their assets. That allowed both to prosper for a long time but rising rates and tighter liquidity mean the party is over.

Margin calls for more collateral are still coming through, though at a less aggressive pace than two weeks ago, according to market participants, who asked not to be identified. Funds are still selling assets to meet them, managers are trying to lobby the BOE, everyone is bracing for next week when the central bank support has gone, they said. 

Many funds are making tough choices in the run up to the deadline. Almost daily they have been having to decide whether to dump assets to raise cash for possible future margin calls, which would weigh on returns; reduce their LDI positions, which would leave them more exposed if rates turn back around; or find other ways to get some cash.

Some have asked the corporates, whose employees pensions they manage, for emergency short-term loans so they don’t have to sell prized assets. Others have agreed that the companies could accelerate already-agreed payments they would have made to their pension schemes over several years, according to consultants, who asked not to be identified discussing their clients. This means some companies have been stumping up large one-off payments to their pensions, the people said.

“For instance, if they had a pre-agreed payment plan to put in cash on a monthly schedule, some have decided to make an advanced contribution equivalent to one year’s deficit recovery payment,” Norbert Fullerton, a partner at Lane Clark and Peacock said.

“Across the industry there are schemes that can’t raise enough cash and have had to reduce their leverage and hedge ratios,” he said. “It’s an unfortunate situation to be in but some don’t have sufficient liquid assets to sell.”

Every pension fund has been faced with the same challenge. They need an assumed return of 7-8%. When bond yields collapsed and stayed down for a decade, the scope for compounding disappeared. Quantitative easing was often described as favouring traders at the expense of savers and the dilemma faced by pensions is a vivid example of that.

European Central Bank Governing Council member Pierre Wunsch said interest rates may eventually have to top 3% to get record inflation under control. 

“My bet would be it’s going to be over 2%, and I would not be surprised if we have to go to above 3% at some point,” Wunsch told CNBC in an interview in Washington. 

Wunsch also said:

The ECB’s deposit rate, currently 0.75%, will “most probably” need to exceed 2% year-end

“Frankly on the basis of our base case, which is now more or less a technical recession in Europe, I think we are going to have to go real positive somewhere”

“We’ve been claiming that what happens in Europe is different from the U.K., from the U.S. But over the last six months basically the direction we’ve been taking was not that different”

The ECB’s rate peaked at 4.25% in 2008. That suggests the anticipated peak of hiking, at 3%, will be well below that 2008 peak. That’s only relevant because the Fed Funds rate could exceed its 2007 peak at 5.25% before this hiking cycle has ended. That raises the question why is the Euro rebounding?

“Has the government finally heeded the calls from markets and the Bank of England? Price action in gilts and the pound suggests markets believe so,” said Simon Harvey, head of FX analysis at Monex Europe. 

The plan to freeze corporation tax next year has come in for particular attention from detractors within Truss’s own Tories. Under a strategy set out by the previous Conservative administration, the levy on companies was due to rise to 25% from 19% in April. But scrapping that move was one of the key measures in Kwarteng’s fiscal plan announced Sept. 23.

The initial market reaction on Thursday suggests that a U-turn on corporation tax -- along with the bank’s greater buying activity this week -- could help ease any turbulence next week after the Bank of England halts its bond purchases on Friday. Investors will be focused on the details of the plans the government is drawing up, and that may determine whether the broad market rally can be sustained.

“Given investors are short, the reaction of sterling is not a surprise,” said Gareth Gettinby, portfolio manager at Aegon Asset Management. “Ultimately, the UK has an extremely negative external balance that remains reliant on foreign funding which remains a negative. So a short term bounce on government noise and then expect the currency to weaken.”

Confidence in the standard of UK governance has taken a beating recently. The government has few options when the bond market is throwing a fit at the prospect of modern monetary theory gone wild. They will inevitably have to walk back the commitment to lower taxes and will hopefully double down on deregulation.

“Bailey’s words did sound harsh but from the BOE’s perspective they need to sound stern,” said Pooja Kumra, rates strategist at Toronto-Dominion Bank. “The BOE has been very receptive to markets. If chaos continues we doubt that they will run away.”

The Bank of England is in a very difficult position. They desperately need to act against inflationary pressures but are constrained from using the tools at their disposal because of the risk posed by leverage in the financial system, not least in the pension sector.

Russia’s President Vladimir Putin said any energy infrastructure in the world is at risk after the explosions on the Nord Stream gas pipelines.

The attacks were an act of terror that set “the most dangerous precedent,” the Russian president told a Moscow energy forum on Wednesday. “It shows that any critically important object of transport, energy or utilities infrastructure is under threat” irrespective of where it is located or by whom it is managed, he said.

Putin blamed the sabotage on the US, Ukraine and Poland, calling them “beneficiaries” of the blasts that caused major gas leaks in the Baltic Sea. The US and its allies have rejected those allegations and suggest Russia may have been behind the underwater blasts.

The attacks on two strings of Nord Stream and one string of Nord Stream 2 at the end of September have raised concerns over the future of Europe’s gas supplies. Other critical infrastructure in the region has also suffered damage in recent weeks. 

Earlier this month, an act of sabotage halted train services across northern Germany and the government has said it can’t rule out foreign involvement. A pipeline that carries Russian oil through Poland was found to be leaking on Tuesday. Investigations continue, and Poland’s top official in charge of strategic energy infrastructure said he assumed it was an accident.

This is a none too subtle threat to expect escalation of attacks on energy infrastructure for as long as the EU is supporting Ukraine’s resistance efforts. The sabotage of Germany’s rail network with specialized interruptions conducted simultaneously at locations 200km apart is a display of Russia’s extraterritorial ability to sow disruption.

It will be interesting to see whether the higher gilt yields (and turbulent stock markets) lead to an increased demand for fixed pension annuities and thus a new demand for gilts

Thank you for this email which may be of interest. Annuity sales in the USA set a record in the 2nd quarter of this year at $79.4 billion. With so much volatility in stock markets there has been significant demand for guaranteed returns and particularly now since bonds pay a modest yield. 

Should Social Security beneficiaries see an 8.7% increase in their monthly checks next year, it would mark the steepest annual adjustment since 1981, when recipients saw an 11.2% bump. An increase of that magnitude would raise the average retiree benefit of $1,656 by about $144 per month or roughly $1,729 annually, the group said.

"A COLA of 8.7% is extremely rare and would be the highest ever received by most Social Security beneficiaries alive today," Mary Johnson, a policy analyst at the Senior Citizens League who conducted the research, said. "There were only three other times since the start of automatic adjustments that it was higher."

However, the decades-high benefit increase is not always good news for recipients, according to Johnson.

Higher Social Security payments are a bit of a Catch-22. They can reduce eligibility for low-income safety net programs, like food stamps, and can push people into higher tax brackets, meaning retirees will pay more taxes on a bigger share of their monthly payments.

There is a lot of complication in the US tax code but one thing is certain, if you make more you pay more. That both increases compliance costs and ticks people off when they believe they should not have to pay taxes. It’s likely to become a political factor in coming elections.

Thank you so much for a superb and invaluable service. I’ve been a subscriber since the ‘80s. I’ve just recently renewed my subscription again after a short break of a couple of years. Just so enjoying hearing your thoughts and steady guidance through these volatile times, thank you. I’d really enjoy your thoughts re this recent article from Reuters ‘Pension fund blowup faces brutal second act’ which may also be of interest to the collective

Thank you for your kind words and this question which I’m sure others have an interest in. The short answer is the blowup of pension funds in the liability-driven investing (LBI) sector is likely to have a long tail. Pensions are now going to be much more wary about taking on leverage so they are forced sellers of illiquid assets. 

Investors counting on a Federal Reserve pivot any time soon are bound to get burned again, according to PGIM Fixed Income.

“We’ve seen this movie time and time again,” said Greg Peters, co-chief investment officer at the Newark-based firm, in an interview. “The market gets hyped up on different narratives between inflation releases. I’ve been surprised by it, and we’ve been using it as an opportunity to sell into.”

The firm, which manages assets of $790 billion, sold US Treasuries after a rally earlier this week sparked by speculation the Fed was about to turn more dovish. The market move proved short lived, backing its view that there’s still not enough evidence to suggest policy makers will rein in aggressive interest-rate hikes.

The speculation -- fueled by a smaller-than-expected rate hike in Australia -- drove action across global markets in the first two days of this week, driving down two-year Treasury yields by nearly 30 basis points at one point to below 4%.

Neel Kashkari, who has historically been viewed as a dove, was quoted today as saying "more work to do" on bringing down inflation, and is "quite a ways away" from being able to pause its aggressive interest-rate hikes.

Such maneuvers had been a decade in the making. Easy money after the global financial crisis made debt investors hungry to buy loans and bonds that provided higher yields. Funds began to agree to weaker protections in their creditor agreements. Loan and bond documents riddled with loopholes and imprecise language gave borrowers more flexibility in times of stress.

The documents didn’t explicitly allow future creditors to grab collateral. But they left just enough ambiguity, sometimes called “trap doors,” for lawyers with a bit of ingenuity and a lot of motivation to move assets to new entities and give dying companies some fresh capital. Because of these often-overlooked provisions, some creditors were surprised to discover they’d been left with almost worthless loans and bonds after struggling companies restructured.

“Loose documents have become the norm rather than the exception,” says Damian Schaible, co-head of restructuring at Davis Polk & Wardwell. “If we go into a real recession, we are going to see more and more borrowers and sponsors seeking to exploit document loopholes to create leverage against and among their creditors.”

Covenant light debt issuance has dominated the post Global Financial Crisis bond markets. That hasn’t mattered until now. Default rates were low, successive waves of new money ensured rates stayed low, and credit remained abundant. 

Upgrade from Cautious to Attractive: No one knows exactly when this downturn will end and we find it difficult to get ahead of macro events, but we see signals that suggest we should no longer be overly pessimistic: (1) the cyclical sell-off has already been punitive in an historical context; (2) the magnitude of the valuation correction (YoY) is approaching extremes relative to the last two decades; (3) earnings risks are now well understood and it is surprises that will drive stocks from here; (4) green shoots are emerging while some consumer parts of tech are close to bottoming; (5) we are upgrading our top down EM strategy view on IT, Korea, and Taiwan; these are set-up for a reversal in returns in the coming weeks. What is not understood is cycle turns and the market's willingness to increasingly look through this late stage of the downturn and, hence, our focus on the other side of the cycle.

An inflection is near and we see reasons to be constructive on a 2H23 recovery. (1) Macro headwinds are fading with the bulk of the Fed’s heavy lifting likely to be done by year-end and benefits from China’s reopening; (2) demand elasticity and replacement cycles will be driven by the sharp fall in pricing, especially consumer products; and (3) supply adjustment is accelerating via significant production and capex cuts that are underway. We have clearly worked through the slowdown in the consumer and are most positive on 'first-in, first out' exposure in LCD panels bottoming now, followed by memory in 4Q22, while the trough for foundry, auto and semicap should come with a lag in 1H23.

As the fourth quarter begins and investors position for how they hope to salvage returns for 2022, questions are already arising about the prospects for 2023. There is no doubt, steep declines in asset prices, particularly within the tech sector, have improved valuations. In normal circumstances that would be sufficient to create attractive entry points. Therefore, the question is whether this is a normal correction following the excesses of the pandemic or the end of the cycle. 

Dear Eoin, In the 1960s and 1970s subscribers to the David Fuller Chart Service received a booklet containing hundreds of charts each week or each month. I used to come into the office at 6a.m. and complete the point and figure charts each day. Thanks to this work, I gained a reputation among my colleagues for being the first one to spot changes in the long-term trends of both overall markets, sectors and individual shares. As of this morning, I am getting up one hour earlier and I will start by looking at all the daily charts of the Autonomies in the Chart Library. Let's hope that this will produce the same result. This morning's work show very small blue upward marks in almost every chart. These are tiny upward movements in the year-long major decline in all these share prices. This "summer's swallow" has not yet started chirping. Regards,

Thank you for this account. David was still having chartbooks printed in 2003, when we began working together. By that stage they were a very niche product that had become obsolete with the development of charting software. Nevertheless, the practice of looking at lots of charts is as useful today as it has ever been.

In following your program of activity, I would suggest taking one day to look at point and figure charts. They will give you clear confirmation of a change of trend.

Even if new buyers step into purchase these bonds, they’re likely to demand a higher yield for doing so — potentially adding to government deficits and mortgage rates at a time when they’re already soaring.

“All this points to a somewhat higher resting level for the mortgage/Treasury basis—and potentially for other related assets like IG corporates, which finally caught up with some of the mortgage widening over the past few days,” the analysts conclude.

2-year yields at over 4% are sufficient incentive to drag cash into the sovereign markets. When the alternative is to lose double digits in the stock market and see cash eroded by inflation, the allure of a guaranteed 4% is reason enough to invest.

The price of deeper out-of-the-money insurance in equities is falling, implying lower demand for
crash insurance. This suggests the market believes the Fed put is getting closer.

A conundrum all year has the been the relatively low level of the VIX despite equity markets being in a bear market. The VIX has been low relative to implied volatility, relative to longer-term volatility, and remains low compared to cross-asset volatility. Most notably, though, the VIX has been low -- and
continues to fall -- versus at-the-money volatility.
 
This is due to the price of further out-of-the-money put options falling by more than options that are less out of the money. We can see this by looking the difference in volatility between 80% and 90% out-of-the­-money put options and see it has been falling.

As the VIX is a weighted average of all S&P options with approximately 1-month to expiry and that have a non-zero bid, the lower price of these deeper out-of-the-money options is keeping the VIX lower relative to at-the-money volatility than it otherwise would be.

Puts have still been in demand though. The put/call volume ratio has been rising, showing that investors are buying more puts relative to calls. But the put/call price ratio has been falling, showing that investors have been paying relatively less for those puts.

Investors have therefore not been paying up as much for crash insurance, and buying puts that are less out of the money. The Fed is now well into its hiking cycle, and the market is inferring it believes the Fed put is getting nearer.

Certainly, current oversold conditions suggest a short-term bounce is at hand. But while excess liquidity remains depressed, it will be hard for the market to make new highs. The Fed put may be closer, but that does not mean the bear market is over.

No two crises are the same and yet the temptation to think “this time is different” has been proved wrong on so many occasions that the term is a cautionary tale. The Bank of England intervened to support the domestic pension system this week. Several schemes required £100 million in additional capital each and others were looking at closing. The central bank had no choice but to wade in and provide some stability. The ramifications of this move raise more questions than answers.

I've spent some long days and nights this week on this very subject (work as an investment actuary in DB [Ed. Defined Benefit] pension fund space)...

Fiscal policy context: mini-budget, with expected energy price cap but surprise revenue cuts (tax, NI, duty, etc.); cost of the latter might be in the vicinity of c£40bn pa (without OBR numbers its hard to say though).

Monetary policy context: TBC regarding rate hikes from November MPC meeting; QT expected to be of the order of c£80bn over next 12months, in an effort to combat inflation. So we have fiscal loosening amid a longer term aim from the BoE to tighten.

As above, the surprise cuts cost, and the DMO has therefore had increase it's expected gilt issuance significantly. This huge increase in supply led to an increase in gilt yields, which move inversely vs price and hence inversely vs relative demand. But, that was only the start...

DB pension schemes facing substantial deficits post-GFC typically have portfolio divided into two parts:

one part seeks excess return in order to make good the deficit
the other part "hedges" the liabilities, which behave like typically long duration bonds (insomuch as they have interest and inflation sensitivities) - their long duration makes them susceptible to quite large changes in value (e.g. 20y duration with a 1% increase in rates at that duration would lead to a 20% fall) - it's therefore a good idea to minimise risk, but you need to minimise risk relative to your specific liabilities (i.e. jurisdiction, duration, realness, etc.)

But, if you're trying to hedge 100% of your liabilities (or even something less) with <100% of your assets (in practice this number is often in the 25-50% range), then you need to use leverage. Two (not exhaustive) ways of gaining exposure to interest rates and inflation using leverage are: 

To enter into swaps whereby I agree with you that I'll pay you x% each period and you'll pay me whatever a floating interest rate or inflation is. I haven't actually bought anything in doing so and therefore haven't actually used any money = leveraged exposure

Another option is that we use a "repo". I sell you my gilt on the understanding that I'll buy it back on a known future date at a specified future (higher) price. In other words, I am paying to borrow over the period whilst still exposed to the price move of the asset repo'd. With that borrowing I can go and buy another gilt. I've therefore effectively doubled my exposure to gilt price moves = leveraged exposure.

In practice, to ensure that these synthetic hedges don't pose excessive credit risk either way, you are usually required to maintain a pool of collateral (the gilt in the repo, or a pool of assets backing a swap portfolio).

With both these techniques, if rates rise/fall, then the value of my liabilities falls/rises. So too do my assets. If I had used these synthetic techniques to ensure my asset sensitivity = liability sensitivity then the move will be similar on both sides, so my deficit won't have changed.

So, what's the problem? As yields rise, the value of my gilts fall. So, when I close out the positions on a repo for example: I make a loss on the second gilt; I then can't repay the lender in the repo arrangement. You can see how this ends if I hadn't repo'd once, but more...

That means then that when yields rise people are forced to close out positions and you end up with a load of gilts sold. Those additional sales push the price down further (DB funds are massive players in the gilt markets - less so in other risk asset markets - so move prices materially). This forces those next up the chain to close out, pushing the price down further. Repeat. You end up in a spiral that collapses pretty spectacularly and pretty quickly.

The only way to avoid having to close out in such situations is to keep posting more collateral. But, that means selling those assets you're using to seek excess returns. Can you do that quickly enough, allowing for settlement times and the necessary transfer of cash over to your leveraged gilt portfolio? Normally yes when markets are moving gradually, but not in the last week and certainly not in a fully fledged spiral sell-off.

So far, it's not a pension fund solvency issue - just a liquidity one - they have the cash/liquid assets but can't put them to work in time. But, you really don't want to be the last one out in these spirals as you come out at the worst price without much ability to get back in for the ride back down (in yields/up in prices). You either want to be out from the start or in all the way and still in at the top. If you do end up closed out in the spiral, then you most likely will struggle to buy back in before yields fall. And that is where the long term damage is done: when yields fall back down, the value of your liabilities is going back up, but you no longer have the hedging assets to match that rise, so your scheme funding worsens.

In this week's episode, we eventually saw the BoE step in. Probably a day late and after much pressure, but understandable given to calm things they are committing to buying gilts to whatever extent is necessary - effectively QE, and the opposite of what they are trying to do medium term to curb inflation. But, their purchase has calmed things substantially, so that's good. It's just unfortunate that there will have been some casualties on the way - we'll find out over the coming days. There will be large variation: those that were "underhedged" a month ago will have won big time; those that were forced sellers immediately before the BoE statement will be big losers; others will be somewhere between.

Here's the 20y nominal gilt yield. You can very clearly see when the budget was and when the BoE stepped in around 11am this morning. Worth also flicking to "all" to see quite how sharp this is in historical context. 

When people talk about how central banks have distorted the fixed income markets this is a perfect example. Pensions need reliable returns to meet their obligations. That’s especially true of defined benefit programs which occupied 45% of the UK market in 2019. The alternative to goosing returns with leverage or moving further out the risk curve into private assets.

The price of refusing to take these risks would be to demand much higher contributions to cover the shortfall and nobody wants to do that. Faced with the possibility of angry retirees, at the prospect of not receiving their dues, or relying on the central bank to bail them out, the answer is always going to be the latter.  Quantitative easing introduced significant moral hazard and yesterday Bank of England action, while necessary, compounded it

Let's do a little rule of three.
Debt service is now at about three percent of GDP per year and the ECB can no longer manipulate Italy's rates downward, to keep Italy's head above water, since the US is raising its rates.
On today's growth figures (which will fall), and with interest rates rising over the next five years, debt servicing will rise to six percent of GDP, which means that the standard of living of every individual will fall by at least three percent, which is impossible.
And there is no solution as long as Italy remains in the Euro, and everyone in Italy knows this.              
And Italy can easily get out because it has a primary budget surplus and a trade surplus. It does not need the financial markets to make ends meet, unlike France.
In any case, make no mistake: the Italian elections are about one thing and one thing only: the euro. "Always think about it, never talk about it" seems to be the watchword in Italy.
And so, the more "right-wingers" are elected, the higher the probability that Italy will abandon the euro.

Yield curve control is the topic of the moment. The UK has just introduced it, so the logical question is which jurisdiction will deploy it next. In this regard, Japan’s refusal to abandon its program looks particularly inspired. Another way to frame this question is what will Germany do to ensure everyone continues to use the Euro? So far, the answer has been whatever is necessary.

Congrats on your opinion on a larger correction and acting on it with put purchases.

Last week Double Line presentation  had a chart that showed the performance of equity and the different credit subclasses, Ags., EM, HY, ClOs and so forth. Showed  the large move by equities compare to credit over the same time period. It made me wonder how much further the equity correction can go.

You often follow interesting companies, you mention EQNR from Norway. have you ever looked a Freyr. It is also Norwegian and is involved in batteries. During  the last days because of a report on its possible growth it had a huge move , but during this correction it may be a good opportunity, let me have your thoughts. Based on your comments  how much the market has already priced in the EVs maybe it is not a good idea.

The move on copper is not a good signal  

Trust all is well for you  and your family

Thank you for these well wishes and questions which may be of interest to the Collective. Of my nine different long-dated put positions, the only one not in profit is Tesla and yet that is the one I have the greatest hopes for. They all have maturities in 2024, but I expect the point of maximum pessimism will arrive while they still have some time value.

Brookfield is looking to multiply its current 4 GW renewable portfolio by 3 to four times in India within the next decade in generation as well as help corporates make the transition to decarbonise and invest in building large scale supply chain in the country, said a top executive.

The renewables current assets under management is approximately $1 billion.

Earlier this year, Brookfield Asset Management announced that it raised a record $15 billion for its inaugural Global Transition Fund. This marks the world's largest private fund dedicated to the net zero transition, signaling that investors are still committed to establishing cleaner portfolios. Brookfield is the single largest sponsor of the fund having deployed $2 billion itself.

Brookfield deals with state utilities but sees incremental green power demand coming from corporates who are increasingly becoming bulk consumers. For example, as part of its road map to achieve 100 per cent dependence on renewable energy by 2025. Amazon on Wednesday announced its first utility-scale projects in India — three solar farms located in Rajasthan. These include a 210-megawatt (Mw) project to be developed by India-based developer ReNew Power, a 100 Mw project to be developed by local  developer Amp Energy India, and a 110 Mw project to be developed by Brookfield Renewable Partners.

Brookfield is the name that comes up in almost every conversation I have with investors. The name is treated reverentially because the team so artfully plotted a route through the Global Financial Crisis and the subsequent boom.

on today's video you highlighted the virtues of the NOBL Dividend Aristocrat index, but on closer inspection the yield on this is just 2%. A year ago, that was 4x the yield on short term treasuries in the US, but with 1 and 2- year treasuries yielding 4% now, double that of NOBL, there seems to be far less support from those seeking out yield.
The TINA approach is fast coming to an end. With that in mind, and with the Sterling continuing to take strain, what investment vehicles are available to us in the UK to invest in 3M, 1Y an 2Y US Treasury paper?

Thank you for this question which may be of interest to the Collective. There is of course a big difference between capturing a high yield now and buying with the expectation of dividend increases in future. It is essentially the difference between current yield and yield to cost.

I have been thinking a lot about the aspects of the market we all tend to take for granted. The types of conclusions we have been conditioned to draw, because that is always how markets work. It strikes me as a big question because we should be asking if these market norms are the result of the decades-long process of disinflation or are they rules that transfer between big secular themes.

The basic working hypothesis of the markets is the Fed will rescue its stock market. The EU will rescue its bond market and China will rescue its property market. The rationale for all three is the same. That’s what they have always done because those are the biggest asset classes owned by consumers in all three jurisdictions.

In the Big Picture Roundup, you shared this wonderful chart.

The problem is that the way that you shared it, means that we could not see the date axis.

It would be great if you could share a better version of this chart e.g., on Comment of the Day

Thank you in advance

Thank you for pointing this out. The aspect ratio between my monitor and the recording software is not always one to one. Here is the chart you were asking about.

What I like about this chart is it starts in 2000. It graphically illustrates that some property markets completely sidestepped the housing crash associated with the global financial crisis in 2008. These same markets, notably Australia, Canada, New Zealand and Sweden are expensive on a price/income and price/rent basis.

The global economy may face a recession next year caused by an aggressive wave of policy tightening that could yet prove inadequate to temper inflation, the World Bank said in a new report.

Policy makers around the world are rolling back monetary and fiscal support at a degree of synchronization not seen in half a century, according to the study released in Washington on Thursday. That sets off larger-than-envisioned impacts in sapping financial conditions and deepening the global growth slowdown, it said.

Investors expect central banks to raise global monetary policy rates to almost 4% next year, double the average in 2021, just to keep core inflation at the 5% level. Rates could go as high as 6% if central banks look to wrangle inflation within their target bands, according to the report’s model.

When quantitative easing was first introduced there was a lot of handwringing at the thought of moral hazard. The Federal Reserve waded into public markets to buy sovereign bonds with the stated aim of back stopping government spending and encouraging speculation. It was viewed as a very risky endeavour that would send the wrong signal to speculators; that they can’t lose. In 2012/13 the EU went in the opposite direction and withdrew liquidity for fear that debtor nations would not mend their ways if assistance was too generous. 

Dear Eoin, I may not be the only Europe-based investor who is currently facing the following dilemma. My income and expenditure are both in Euros. I have protected and increased my wealth and income by investing in USA stocks which have given me both capital appreciation and currency increase. Now the USA dollar looks over-valued and all equity options appear to be unfavourable. In addition, inflation is high and so holding liquidity means losing real spending power. What are the alternatives on offer?

Thank you for this question which touches on a topic everyone has an interest in at present. Inflation has been described as the thief which comes in the night, but lately it feels like bandits are roaming around the house in broad daylight.

I think it looks like interest rates will have to rise a lot (toward the higher end of the 4.5 to 6 percent range) and a significant fall in private credit that will curtail spending. This will bring private sector credit growth down, which will bring private sector spending and, hence, the economy down with it.

Now, we can estimate what that rise in rates will mean for market prices and economic growth. The rise in interest rates will have two types of negative effects on asset prices: 1) the present value discount rate and 2) the decline in incomes produced by assets because of the weaker economy. We have to look at both. What are your estimates for these? I estimate that a rise in rates from where they are to about 4.5 percent will produce about a 20 percent negative impact on equity prices (on average, though greater for longer duration assets and less for shorter duration ones) based on the present value discount effect and about a 10 percent negative impact from declining incomes.

Now we can estimate what the fall in markets will mean for the economy i.e., the "wealth effect." When people lose money, they become cautious, and lenders are more cautious in lending to them, so they spend less. My guesstimate that a significant economic contraction will be required, but it will take a while to happen because cash levels and wealth levels are now relatively high, so they can be used to support spending until they are drawn down. We are now seeing that happen. For example, while we are seeing a significant weakening in the interest rate and debt dependent sectors like housing, we are still seeing relatively strong consumption spending and employment.

The upshot is that it looks likely to me that the inflation rate will stay significantly above what people and the Fed want it to be (while the year-over-year inflation rate will fall), that interest rates will go up, that other markets will go down, and that the economy will be weaker than expected, and that is without consideration given to the worsening trends in internal and external conflicts and their effects. 

US rail workers are about to go on strike. By now the pattern is familiar. The companies they work for are making record profits and the wages have not kept up with inflation. This will also again highlight the disparity between the benefits of union workers versus less well represented groups. This is exactly the kind of evidence of a wage price spiral the Fed is seeking to avoid by hiking rates aggressively.

US consumer prices were resurgent last month, dashing hopes of a nascent slowdown and likely assuring another historically large interest-rate hike from the Federal Reserve.

The consumer price index increased 0.1% from July, after no change in the prior month, Labor Department data showed Tuesday. From a year earlier, prices climbed 8.3%, a slight deceleration, largely due to recent declines in gasoline prices.

So-called core CPI, which strips out the more volatile food and energy components, advanced 0.6% from July and 6.3% from a year ago, the first acceleration in six months on an annual basis. All measures came in above forecasts. Shelter, food and medical care were among the largest contributors to price growth.

The acceleration in inflation points to a stubbornly high cost of living for Americans, despite some relief at the gas pump. Price pressures are still historically elevated and widespread, pointing to a long road ahead toward the Fed’s inflation target.

Inflation probably has peaked but that is not a commentary on how quickly it comes back down. The bullish narrative for inflation is that the pandemic was an anomaly. The surge in inflation was created by supply shocks and liquidity-fuelled asset price appreciation. With the end of the pandemic and less money supply, inflation will fall back as quickly as it rose, so buy the dip.

After the discussion around earnings trajectory for the S&P 500, the focus then typically turned to how to trade it. Here, we have some sympathy for the view that markets may potentially hold up very tactically until the EPS cuts actually happen. As already noted, conference season is upon us and investors are ready for some bad news at least with regard to how 3Q is progressing. However, the degree of that deterioration is more debated now given the recently announced $500 billion student debt forgiveness and extended moratorium on loan payments until December, combined with the energy subsidy announced this past week in the UK to help consumers through the winter. Both of these are rather large fiscal stimulus packages that could keep the "tone" of company commentary less bearish than feared, and potentially delay the eventual cuts. Nonetheless, we have high conviction that EPS cuts will play out in earnest over the next 2-3 months, and as a reminder from our note last week, mid-September through October is a particularly challenging seasonal period for EPS revisions.

The yield curve (10-year – 2-year) inverted for a week in April and has been persistently inverted since June. The classic version of the yield curve (10-year – 3-month) is not yet inverted but it is still trending lower. This spread collapsed from an artificially elevated level in May. It tends to be much more volatile than the longer-dated version because short-term interest rates can whip around a lot.  

Actually, it all started moments before the ECB released its policy statement. The euro dropped like a stone by around 40 pips in a move that got me wondering whether there had been a leak. Most likely, it’s one of those trades that was going to be very directional, but it’s telling that the move was bearish the euro when most expected a jumbo hike and shows that investors expect the euro to remain under pressure, with high conviction on the trade.

Then came the unprecedented interest rate increase. And for everyone that expected some lively action, it seemed that screens were frozen. Little reaction from the common currency, same picture with the bond monitors. Was it down to some great communication by the ECB that there was little reaction? Or did the market just wait for more info before trading in size? The answer came a few minutes later when euro area bond yields felt some pressure as the decision by the Governing Council was unanimous.

It became totally evident when short-end yields led a double-digit advance across the curve and the euro didn’t budge. The current narrative goes that there’s little the ECB can do to support the euro given the energy crisis. And especially if inflation remains supply-driven in the euro area, higher rates won’t do the trick. Not as much as they can do for a demand-driven inflation, like the one in the US, as Lagarde said. After all, there’s been a deep breakdown of the correlation between the common currency and bond yields since mid-August, and yesterday just highlighted this divergence. Given natural gas prices fell to the lowest in almost a month as politicians draw plans to intervene in regional markets, it could be that the euro manages to set a medium-term bottom soon.

The ECB only has one mandate which is to control inflation. It has taken on a wide range of additional responsibilities over the last twenty years but the central mandate to target a 2% rate has not changed. 

Of course, they never accounted for the possibility of mass hysteria among the ruling class during a pandemic and a war on the border of the EU shortly afterwards. 

Thanks for another very informative comment of the day. do you expect the SP500 to test the lows of 2020? I would very much like to hear your views on this. Thanks in advance. Best rgds.

Thank you for this topical question. As a repeat delegate at the Chart Seminar, you will remember that targets are more a reflection of personal bias than an accurate predictor of where prices are likely to trade. Since I am short the Nasdaq-100 I am keenly aware of the influence that has on my personal psychology and that is likely to affect how I view downside potential. Let’s look at the chart facts.

According to a Bloomberg News report, Truss has drafted plans to cap annual electricity and gas bills for a typical household at or below the current level of £1,971 ($2,300). That would have a significant impact on inflation, which our baseline scenario forecasts will reach 15% in January. Mechanically inputting the cap freeze into our forecast shows inflation peaking in July (at 10.1%) and then falling back at a faster pace -- approaching 2% within a year.

The cost of implementing that measure would be a whopping £130 billion over the next 18 months, according to Bloomberg News. If we then add fresh support to businesses, which may total £40 billion based on draft government plans, the full size of the package could reach 7% of GDP. That’s a massive fiscal boost, close to the level of government support seen during the pandemic.

But it’s early days. There’s a high probability that the reported plans will face significant push-back from the Treasury or from within the Conservative Party -- especially as these measures would be poorly targeted. A key question will be how the energy cap is funded. It could be clawed back from households later, keeping energy prices higher for longer, or purely financed by government borrowing. The latter option would create a significant hole in the government’s finances -- even if the cap delivers around £30 billion of savings from lower inflation-linked debt payments in 2023-24.

Another possibility is the government intervening in wholesale energy markets. That could dampen the impact on the public finances, because it would open up the possibility of reducing bumper profits from some electricity producers. The snag here is it would be akin to a windfall tax, which Truss has previously said she would not pursue.

7% of GDP is a lot of money to spend on standing still. The fact the £170 billion price tag coincides almost identically with the excess profits for energy companies quoted last week. It suggests the government is aware of what sector can be targeted should financing this stimulus become an issue.  

Aside from fanning inflation, the biggest energy crisis in decades is sucking up capital to guarantee trades amid wild price swings. That’s pushing European Union officials to intervene to prevent energy markets from stalling, while governments across the region are stepping in to backstop struggling utilities. Finland has warned of a “Lehman Brothers” moment, with power companies facing sudden cash shortages. 

“Liquidity support is going to be needed,” Helge Haugane, Equinor’s senior vice president for gas and power, said in an interview. The issue is focused on derivatives trading, while the physical market is functioning, he said, adding that the energy company’s estimate for $1.5 trillion to prop up so-called paper trading is “conservative.”

Many companies are finding it increasingly difficult to manage margin calls, an exchange requirement for extra collateral to guarantee trading positions when prices rise. That’s forcing utilities to secure multi-billion euro credit lines, while rising interest rates add to costs.

“This is just capital that is dead and tied up in margin calls,” Haugane said in an interview at the Gastech conference in Milan. “If the companies need to put up that much money, that means liquidity in the market dries up and this is not good for this part of the gas markets.”  

The ECB is looking primed to begin hiking rates while at the same time it will also be prevailed upon to provide significant additional liquidity. This is akin to taking with one hand and giving with the other. Even that’s a stretch.

Thanks for joining us as we took you through the results of the Conservative leadership race. Liz Truss will take office Tuesday and give a speech outside her new home -- No. 10 Downing Street. In the meantime, these are the key takeaways so far:

Liz Truss won the race to be the UK’s next prime minister, but achieved a smaller-than-expected margin of victory over Rishi Sunak, with 57.3% of Tory members’ votes.
She vowed to cut taxes, grow the economy, and address the crises in energy and the National Health Service.
Truss will visit Queen Elizabeth II in her Scottish castle to be formally appointed on Tuesday, after which she will make a speech to the nation and appoint members of her cabinet.
She inherits a forbidding in-tray: surging inflation, predictions of a recession and a record squeeze on living standards spurred by soaring energy prices.
Truss has promised to announce how she would help Britons through the cost-of-living crisis in her first week -- reports suggest she could freeze energy bills and offer targeted financial help to low-income households and pensioners.

The Pound and Gilts have sold off aggressively over the last month as traders priced in the rising potential Liz Truss would succeed Boris Johnson. The most urgent issue is the massive impending jump in electricity costs. No prime minister can survive through that kind of living standard decline, so price caps are inevitable.

My theory is that the breaking of these superbubbles takes multiple stages. First, the bubble forms; second, a setback occurs, as it just did in the first half of this year, when some wrinkle in the economic or political environment causes investors to realize that perfection will, after all, not last forever, and valuations take a half-step back. Then there is what we have just seen – the bear market rally. Fourth and finally, fundamentals deteriorate and the market declines to a low.

Let’s return to where we are in this process today. Bear market rallies in superbubbles are easier and faster than any other rallies. Investors surmise, this stock sold for $100 6 months ago, so now at $50, or $60, or $70, it must be cheap. Outside of the late stage of a superbubble, new highs are slow and nervous as investors realize that no one has ever bought this stock at this price before: so it is four steps forward, three steps back, gingerly exploring terra incognita. Bear market rallies are the opposite: it sold at $100 before, maybe it could sell at $100 again.

The proof of the pudding is the speed and scale of these bear market rallies.
1. From the November low in 1929 to the April 1930 high, the market rallied 46% – a 55% recovery of the loss from the peak.
2. In 1973, the summer rally after the initial decline recovered 59% of the S&P 500's total loss from the high.
3. In 2000, the NASDAQ (which had been the main event of the tech bubble) recovered 60% of its initial losses in just 2 months.
4. In 2022, at the intraday peak on August 16th, the S&P had made back 58% of its losses since its June low. Thus we could say the current event, so far, is looking eerily similar to these other historic superbubbles.

Have we seen the secular peak in this market? That’s the only real question investors need to concern themselves with. The above statistics are certainly compelling, but the size of the rebounds should also be considered relative to the size of the initial declines from the peaks. Let’s round out that data.

1. The Dow Jones Industrials Average accelerated to the peak on September 3rd 1929. It fell 47.87% to the initial low on November 13th
2. The peak in 1973 was a failed upside break from a range that had been forming since 1966; with the Dow failing at the psychological 1000 on several occasions. That failed upside break resulted in a deeper pullback than any (25% & 36%) posted during the ranging phase. The failed downside break in 1974 resulted in a 75% rebound. It was another six years before a breakout to new highs was sustained.
3. Between March 10th and May 26th 2000 the Nasdaq Composite fell 40.72%.
4. Between January 7th and the low on June 17th the S&P500 declined 24.52%.

With regard to increasing the pace of QT, the past attempts were undertaken during periods of much lower inflation. With inflation currently much higher, dare I say it, might this time be different?

Thank you for this question which is highly relevant since the Federal Reserve will be doubling the pace of balance sheet run-off to $95 billion a month within weeks. We only have two examples of significant balance sheet contraction by central banks. That was the ECB between 2012 and 2014 and the Fed between 2018 and 2019.

Deutsche Bank estimates that subtracting the rebate will reduce the Retail Prices Index, which determines payments on UK inflation-linked debt, by about 2.7 percentage points. That would lower the debt interest bill by around £14 billion this year, according to Bloomberg calculations based on Office for Budget Responsibility data. RPI is also tied to some consumer products, such as mobile phone tariffs.

Such savings would be welcomed by the government, which is under intense pressure to spend even more in response to the surge in energy costs. A similar reduction in the Consumer Prices Index, and a potentially lower path for interest rates as a result, could also save the government billions.

Based on CPI, UK inflation is already above 10%. The Bank of England forecasts that it will top out just above 13%, although a surge in gas prices in recent weeks mean officials will almost certainly have to increase that forecast. That means the ONS decision may impact the peak rate this winter, but not change the direction of the outlook for prices. 

Persistent inflation has a long tail. The longer it lasts, the greater the effects for government finances in future. Index-linked pensions, tariffs and utilities all push higher with a lag from a current bout of inflation. That’s both a near-term headache and medium-term challenge for most governments. That greatly increases potential for government intervention. It is starting with subsidies and will quickly transition to price caps if prices fail to decline.  

The price of Germany’s electricity over the next year has climbed over $1000pb in Brent oil energy equivalent terms. This is far from normal. It’s a crisis that stems not only from restrained energy supply from Russia but a series of unfortunate issues elsewhere too. In addition to energy restraints, the euro area is facing the full brunt of climate change with flash floods and record droughts, combined with slowing trade with China and US recession risks. However, we think the bigger challenge Europe will face this winter is not inflation, but stagflation. Altogether it’s why we expect EUR/USD to fall to 0.90 this winter, inflation to climb further to multi-decade highs before peaking, GDP to decline over the coming year and the ECB to first raise rates in response to higher inflation, and then cut next year as the energy-induced recession continues. Will Germany run out of gas? Probably not. That's due to LNG supply, but even more due to falling industrial demand. High prices and falling demand of an essential such as energy is not good for growth, but it gives hope that blackouts in Germany won't be the story of early 2023.

This report shares the downbeat consensus view that Europe is going to endure a profound winter of discount. There is no doubt the challenges are immense but so have been the efforts to overcome them. For example, the EU has reached its November target for natural gas reserves. That suggests some slowdown in demand following indiscriminate buying over the last few months.

Officials attending the Federal Reserve’s Jackson Hole gathering signaled the ECB is prepared to at least repeat the 50 basis-point hike enacted in July, with some not excluding an even larger increase. Executive Board member Isabel Schnabel urged “strong determination to bring inflation back to target quickly.”

While Lane didn’t spell out whether he’d oppose a 75 basis-point step, his comments suggest officials would need to see the need for a higher “terminal rate,” or high point of the current hiking cycle, for him to support such a move.

The Irish official said a “multi-step adjustment path towards the terminal rate also makes it easier to undertake mid-course corrections if circumstances change.” If new data called for a lower terminal rate, “this would be easier to handle under a step-by-step approach,” he said. 

Among the more cautious voices on the Governing Council is Executive Board member Fabio Panetta, who said last week that policy maker must tread carefully as a significant economic slowdown would ease inflationary pressure. 

The ECB has one of the most out of control inflation problems in the world. The pressure being exerted on the region from Russia’s energy war is not about to disappear. However, the successful filling of gas storage facilities ahead of schedule will moderate the risk of shortages this winter.  

With just 10 days to go until Boris Johnson’s successor as premier and Conservative Party leader is announced, neither candidate has detailed how much assistance they’ll provide to families and businesses who face soaring energy costs, despite Chancellor of the Exchequer Nadhim Zahawi conceding that the current support package is “not enough.”

Whichever candidate wins the Tory leadership contest, addressing the impact of rocketing energy bills will be at the top of their in-tray after Ofgem said on Friday that a price cap on average annual energy bills would rise to £3,549 ($4,206) in six weeks’ time. That’s 178% higher than last winter and 80% more than at present. 

The only questions considered are how much support to provide. Fiscal discipline is out of favour at present. With inflation and energy prices hitting living standards so aggressively, the UK government is under extraordinary pressure to ease the pain.

Any sign from this week’s Jackson Hole symposium of more aggressive rate hikes to come will whack credit markets, which have already started to give back summer gains. Misplaced optimism about the US inflation and economic outlook squeezed spreads to unsustainably tight levels, leaving debt vulnerable to a fall that will be exacerbated by dwindling liquidity.

US high-grade bonds got overbought as fund inflows chased better returns, despite a barrage of issuance which will likely resume in September. The high-duration debt stands to lose most from a more hawkish Fed.

Spreads have almost 25 bps to go before hitting the July wide at 160 bps, but investors are keeping powder dry for a move back to May 2020 levels above 180 bps. That would be a fairly extreme move for a market that tends to move in 1-2 bps daily increments, but pre-Labor Day lack of liquidity provides scope to gap out.

Junk’s summer gains were led by the riskiest bonds, which would be battered most by a higher rates/lower growth environment. Some are waiting for a pummeling to 800 bps -- from 432 bps currently -- before buying in.

The biggest factor in the underperformance of portfolios from the beginning of the year had been the strong correlation between bonds and equities. They both fell at the same time and played havoc with the 60/40 portfolio set up. That relationship stopped working from early this month. Treasury prices resumed falling but stock prices rebounded.

We have a large number of people who are estranged from our economy. In 1960, 5% of men were not working between the ages of 25 and 54. Today it’s more like 15%. If 15% of men are not working at any point in time, then a quarter of the people will have been out of work for a year or more over a four or five-year period. That’s destructive to the economy's productive potential. It’s destructive to their families. It’s destructive to the areas in which they live. It’s destructive to the moral fabric of our national life.

I recently finished reading Coming Apart by Charles Murray. It’s a harrowing account of how the polarization in the economy is manifested in a growing rift between the privileged, insulated upper class and a benefits-dependent underclass.  

That’s a key finding from a survey released Thursday by consultant PwC, which last month polled more than 700 US executives and board members across a range of industries. Half of respondents said they’re reducing headcount or plan to, and 52% have implemented hiring freezes. More than four in ten are rescinding job offers, and a similar amount are reducing or eliminating the sign-on bonuses that had become common to attract talent in a tight job market. 

At the same time, though, about two-thirds of firms are boosting pay or expanding mental-health benefits. The most common move: making remote work permanent for more people.

The primary argument being used to say a recession has not already begun is the Purchasing Manager’s Index and the low unemployment rate. It is reasonable to say a recession is not underway if companies are buying more on a month over month basis and unemployment is close to a record low.

“UK CPI inflation surged in July amid rising food prices that helped lift the rate above market expectations. The peak is still likely come in October, when energy prices are due to be increased again -- we see annual CPI moving to a little below 13% at that point. With inflation now more than five-times the Bank of England’s target, the question isn’t whether the central bank will tighten, it’s by how much? Today’s reading makes it more likely than not that the BOE lift rates by 50 basis points in September -- our baseline ahead of the data release was for a 25-bp move.”

Economists are growing increasingly pessimistic about the UK, with the risk of a recession now seen as far more likely than not due to rising cost pressures. The BOE expects a recession to start in the fourth quarter, lasting into the early part of 2024.

The central bank expects inflation to surpass 13% later this year when regulators allow energy bills to rise again. That would mark the worst reading since September 1980, when Margaret Thatcher’s government struggled to bring a wage-price spiral under control.

 

In the normal course of events UK inflation should have peaked already. Money supply growth peaked on a year over year basis 18 months ago and on a month over month basis is now negative. At the same time the Bank of England has been raising rates, albeit modestly, for the last eight months and is now also talking about reducing the size of its balance sheet.

Q: Are we in a bear or a bull?

Thank you for voicing the question I believe everyone is asking. The short answer is yes, the long answer is more nuanced. Let’s frame this discussion in terms of the yield curve spread. The 10-year – 2-year is sharply negative. The 10-year – 3-month and the 10-year – Fed Funds Rate have both accelerated lower but are not yet negative. All three point toward significant monetary tightening. That is before the impending acceleration in the contraction of the Fed’s balance sheet is 

Strategists at Citigroup Inc., using a mix of spot and forward curves to help construct a predictive model, now say that there’s a greater than 50% chance of a recession over the next year. 

“It’s a perfect storm now with both sides of the curve causing the inversion, and making it likely to continue,” said Jason Williams, a strategist at the New York-based bank. “Given the strength of the labor market and still high inflation, there’s no reason for the Fed to slow down it’s hiking.”

Investors have been conditioned to expect the “Fed put” because they have underwritten the stock market following every significant decline since the 1987 crash. The challenge today is inflation is way above the Fed Funds rate and also outstripping wage growth. Providing the normal liquidity surge into that environment is counterproductive to ensuring stable prices.

I know you have consistently highlighted the challenges that UK households will experience in relation to their energy bills, and just today they are saying that "typical" households could be paying nearly £600 in January, money that most just can't find. Already consumers are a collective £1.3 billion in arrears on their bills, with an expected 86% hike in the energy cap expected on 1 October.

But far less is said of the impact on businesses, and on this I can shed some very specific light. I own a small business, an indoor children's play centre. On 1 December last year I renewed my energy supply contract, and faced with an increase then from 15p/kwH to 20p/KwH I opted to take just a 1 year renewal, with gas prices fairly stagnant until then as you know.

I have been informed today that when I come to renew once more on 1 December, I am going to staring at a tariff of anywhere between 50p/kwh to as much as 89p/kwh. I was also told in no uncertain terms by the 'sales' person at my current supplier, that they are trying to migrate away from small and medium business in this environment, and are deliberately pricing us away. the daily fixed standing charge will move from £83 per month, to potentially as much as £1,000.

For context, my own energy bill is going to shift from £20k per year to closer to 60k-£70k. This is going to be catastrophic for U.K. businesses, as many will be left in dire straits, unable to keep the lights on, and customers cool (in summer) or sufficiently warm in the winter. So many businesses in the hospitality sector especially are saddled with the burden of Covid "bounce back loans", delayed VAT repayments, and of course huge inflation on input costs with a consumer at breaking point. Business closures = higher unemployment...it is looking particularly dire here in the U.K.

Thank you for sharing this visceral experience of price increases business owners are experiencing. The challenges are significant and options to raise prices are inhibited so many businesses will close. The strike action in the UK which has been building for months and will escalate further. They are a symptom of how much living standards are being impacted by the rising cost of living.

“This is a necessary print for the Fed, but it’s not sufficient,” Pond said. “We need to see a lot more. You can think about this print as sort of like the weather -- it’s better today than it has been over the past few days. But it’s still summer. There’s still a lot of humidity out there. It’s not great. So it’s in the right direction. But we’re certainly not there yet.” 

For Diane Swonk, the chief economist at KPMG LLP, the Fed is now hedging against risk of future supply shocks as well as combating current inflation and will likely favor a 75 basis-point increase.

“The Fed is no longer willing to rest on their laurels on a one-month move,” she said. “The greater risk for the Fed is to stop too soon than stop too late. It will take a lot more cooling than this for the Fed to shift its decision rule, although in this economy, September seems an eternity away.”

The big question for investors is whether the Federal Reserve will focus on core or non-core items in how much they decide to raise rates in September. Commodity price inflation is less urgent today than earlier this year. Lumber prices have made a full round trip. Wheat has fully unwound the Ukraine invasion surge. Palm Oil is steadying in the region of the 2008, but the price has almost halved from the peak level. 

Bond investors in New Zealand are not as sanguine. Yields on two-year debt are just two basis points below 10-year rates, the narrowest gap since 2015 when the curve last inverted. The difference between Australia’s 10- and three-year bond futures stands around 17 basis points.

Much of the fears in Australia and New Zealand are centered on concerns about the housing market, which experienced a post-pandemic boom when borrowers piled in to take advantage of record-low interest rates. The two central banks have indicated that borrowing costs will continue to rise.

“The Australian economy is already showing some cracks -- weak consumer sentiment, falling dwelling prices, cooling consumer spending -- and New Zealand’s economy is showing more,” said Andrew Ticehurst, a rates strategist at Nomura Holdings Inc. in Sydney. “Australia will slide into recession in the second quarter of next year under the weight of recent and prospective RBA rate hikes, which will expose Australia’s Achilles’ heel, an extended housing market and highly leveraged consumers.”

Australian consumer confidence dropped for a ninth straight month in August to reach a two-year low, according to a report released Tuesday by Westpac Banking Corp.

The yield curve spread (10-year – 2-year) is a reliable lead indicator for US recessions. It does not have nearly the same strong record of predicting recessions for other countries. That is probably because other countries do not rely so heavily on their banks for credit creation. 

Lawmakers appear close to passing into law the Inflation Reduction Act of 2022. The legislation is born out of the Build Back Better agenda that President Biden proposed more than a year ago. It raises nearly $750 billion over the next decade through higher taxes on large corporations and wealthy individuals and lower Medicare prescription drug costs, to pay for nearly $450 billion in tax breaks and additional government spending to address climate change and pay for lower health insurance premiums for Americans benefiting from the Affordable Care Act (see Table 1). The remaining more than $300 billion goes to reducing the federal government’s future budget deficits (see Chart 1). Broadly, the legislation will nudge the economy and inflation in the right direction, while meaningfully addressing climate change and reducing the government’s budget deficits.

The renewable energy sector rebounded emphatically on the prospect of additional subsidies last week. Removing the limitation on EV rebates so every buyer gets a $7500 discount and reinstating the 30% tax credit for solar installations are both stimulative for their respective sectors.

Gold inched higher as Treasury yields pared their recent surge, with traders temporarily looking beyond the Federal Reserve’s aggressive interest-rate hike path. 

Bullion rose as much as 0.8%, rebounding from the worst daily loss in two weeks in the previous session. On Friday, a stronger-than-expected US jobs report added to the case for more Fed monetary tightening, pushing up the dollar and bond yields while crushing gold since it pays no interest and is priced in the greenback. 

Still, a bigger rate hike isn’t a done deal, and investors are now waiting for a US inflation report later this week to gauge how hawkish the Fed may be at its September meeting. That allowed a pause for Treasury yields and the dollar, lifting gold prices on Monday.

A hike of 75 basis points at next month’s Fed policy meeting “is far from locked in,” TD Securities commodity strategists led by Bart Melek said in a note. For now, “the yellow metal has been able to hold firm.”

The precious metal has rallied for the last three weeks, as concerns over a global recession and heightened US-China tensions boosted demand for the haven asset.

Holdings of bullion in exchange-traded funds have remained under pressure, however, falling for an eighth straight week.

Spot gold rose 0.7% to $1,788.34 an ounce as of 10:49 a.m. in New York. The Bloomberg Dollar Spot Index and the 10-year Treasury yield edged lower. Silver, palladium and platinum all advanced. 

I spent a lot of time thinking about gold over the weekend. I’m not happy with how my trading of the metal has gone over the last year. Despite significantly offsetting my loss with success in other trades, I still feel the pang of failure in gold more acutely than with other instruments. This is the 2nd time in four years I have sold at the wrong time, so I am resolved to do better in future.

Yields on two-year Treasuries surged in response to the jobs report, a reflection of the expected Fed rates over that period. Market pricing indicated a 75 basis-point increase to the Fed’s key rate is now seen as a more likely outcome in at the central bank’s September meeting than 50 basis points.

Powell has described the labor market as “tight to an unhealthy level,” and has been seeking a moderation to help bring demand for products and services more in line with supplies that have been constrained by Covid-19 disruptions. He and other Fed leaders are worried about the potential for a wage-price spiral, with higher wages feeding into inflation in a cycle that is hard to break.

“This number is so comprehensively strong with a pretty significant uptick in wages,” said Mark Spindel, chief investment officer at MBB Capital Partners LLC in Chicago. “Companies are paying up for labor. Income matters most. When you look at the breadth of the employment report, and the earnings, this is an enormous tailwind for income.” 

It has been widely reported that the USA has missed out on 2 million immigrants following the isolationist policies adopted by President Trump’s administration. At least 1 million of those would have been highly educated/skilled individuals.

The Bank of England is reminding the world what a politically independent central bank can and should do: act as a “trusted adviser,” willing to share analytically honest views that other more politically sensitive institutions are either unable or unwilling to do.

Of course, this is not a risk-free approach. Such honesty — rather than catalyzing appropriate responses from policy-making agencies that lead to better economic and social outcomes — can provoke household and corporate behaviors that accelerate the bad outcomes. Yet the risks involved are worth taking, especially when the alternative is a central bank that loses institutional credibility, sees the effectiveness of its forward policy guidance erode and becomes even more vulnerable to political interference.

It should also be noted that the UK’s situation differs in some important way from those of other countries. The country’s economic challenges are complicated not only by the energy price catch-up but also by the political transition and the changing nature of the country’s relations with its trading partners.

In the last six weeks gilt yields have pulled back aggressively from 2.75% to test the region of the trend mean around 1.75%. This is the first area of potential resistance and is the point at which traders will begin to question how likely a long-term low interest rate environment is.  

The drumbeat of recession grew louder after the US economy shrank for a second straight quarter, as decades-high inflation undercut consumer spending and Federal Reserve interest-rate hikes stymied businesses and housing.

Gross domestic product fell at a 0.9% annualized rate after a 1.6% decline in the first three months of the year, the Commerce Department’s preliminary estimate showed Thursday. Personal consumption, the biggest part of the economy, rose at a 1% pace, a deceleration from the prior period.

“The more important point is that the economy has quickly lost steam in the face of four-decade high inflation, rapidly rising borrowing costs, and a general tightening in financial conditions,” Sal Guatieri, senior economist at BMO Capital Markets, said in a note. “The economy is highly vulnerable to slipping into a recession.”

It is always dangerous to say this time is different in markets. However, on this occasion there really is some justification that claim. Two consecutive quarters of negative growth meets the technical definition of a recession. However, there are some important mitigating circumstances. For one, unemployment has not risen significantly. There has also never been a recession when the PMI was among 50. That suggests muddier perspective than we might be accustomed to.

For Slimmon, the beat-down in consumer sentiment has gone far enough to warrant betting on a turnaround.

“There’s a very low expectations in those stocks right now. What if the direction of change is actually higher for consumer sentiment?” he said. He views the risk-reward as attractive.

“Those stocks might recover dramatically because they’re down so much.” He plans to snap up shares “well into the weakness” in August, which is among historically the worst months for equities as volumes are thin and workers are on vacation.  

Stock market moves during this period are usually dominated by macro events. “The macro story this year is not very good,” he said, citing a global geopolitical crisis and the lack of an August meeting among Fed officials.

“The focus of the market shifts from what ultimately long-term drives stocks, which is earnings. And when the shift goes to other things like macro events that creates volatility.”

As for those areas he will likely stay away from, he offered two sectors. “If you think about what’s worked year-to-date on a relative performance basis, there are two groups that have really done well: energy and defensives,” he said. “It’s a little late to be selling the energy stocks. They’ve been so creamed. I wouldn’t be aggressively buying those stocks.”
 

Many investors are anticipating the Jackson Hole conference in August will be a time for central bankers to declare the peak for inflation is in. The most risk tolerant traders are initiating long positions today to ensure they have the cushion of rebound ahead of that event. There is clear scope it will be a buy the rumour and sell the news event if central bankers fail to deliver.

While Morgan Stanley strategists say it’s too early to expect the Fed to stop tightening its policy even as fears of a recession grow -- suggesting stocks have more room to fall before finding a bottom, JPMorgan Chase & Co. strategists say bets that inflation has peaked will lead to a Fed pivot and improve the picture for equities in the second half.

Sticky inflation is what will keep the Fed hawkish for longer this time around, according to Morgan Stanley’s Michael J. Wilson. While during the past four cycles the US central bank had stopped tightening its policy before the start of an economic contraction, triggering a bullish signal for stocks, current historic levels of inflation mean the Fed will likely still be tightening when a recession arrives, Wilson wrote in a note.

Equity markets “may be trying to get ahead of the eventual pause by the Fed that is always a bullish signal,” Wilson said. “The problem this time is that the pause is likely to come too late.”

Over at JPMorgan, Mislav Matejka said in a note on Monday that challenging activity momentum and softer labor markets could open doors to a more balanced Fed policy, leading to a peak in the US dollar and inflation.

Inflation may well have peaked or be close to a peak because the consensus is that it is entrenched. What we do not know is how quickly inflationary figures will come down and where they will subsequently stabilise.

The publication of the June bond figures by China Central Depository & Clearing Co. took place about a week later than in previous months. Interbank-bond-market figures released by the central bank’s Shanghai head office on Friday were also delayed, as they are typically sent out in the first half of each month. In May, China’s bond-trading platform for foreign investors quietly stopped providing data on its transactions.

Foreign investors still held 2.32 trillion yuan of Chinese debt at the end of June, well above the 221 billion yuan they owned in 2014. The opening up of China’s capital markets and the inclusion of the nation’s debt in more global bond indexes has attracted central banks and global investors eager to tap its higher yields.

“The bulk of the remaining foreign holdings of Chinese fixed-income assets reflects reserve manager, sovereign wealth fund and index tracking demand,” said Lemon Zhang, a strategist at Barclays Plc in Singapore. Looking ahead, large inflows are unlikely as investors aren’t optimistic on duration or China’s currency, while higher global yields provide alternatives, she said.

Demand for Chinese bonds has waned in recent months as US 10-year yields surged above 3%, while similar-maturity yields in China remained stuck in a range of 2.7% to 2.85% due to the People’s Bank of China’s accommodative monetary policy.

There has been a popular belief among institutional investors that China was for bonds and the US was for equities. The logic is that China is a creditor nation with vast reserves, strong growth and low debt/GDP ratios while the US is encumbered with massive debts and seems incapable of correcting the gaping deficit.

What you were saying about the huge migration to Texas makes me wonder if this isn't the right time to buy home builders who are active in that area? Or REITs?  What about NXRT, an old favourite of mine which has now come right done (fortunately I got out)? It specialises in refurbishing multi-family properties in the sunbelt. Is it too early to buy again do you think?

Thank for this question which may be of interest to the Collective. A realtor friend of mine shared his rationale. If a buyer is worried about interest rates rising, then buy now before they go higher. If they are worried about rates falling buy now because that will inflate prices and you can always refinance. I think it is safe to say a realtor will always have a convincing rationale to buy

Former Treasury Secretary Lawrence Summers issued one of his harshest criticisms yet of the Federal Reserve’s slowness in moving to raise interest rates, and warned that policy makers are still presenting forecasts that are unrealistic.

“In 2021, our central bank let us down quite badly,” hurting policy makers’ credibility, Summers said on Bloomberg Television’s “Wall Street Week.” “It made mistakes in the core functioning of a central bank,” including in its failure to lean in against fiscal stimulus last year, he said.

Among the errors has been a “repeated poor forecasting record -- and I have to say that it’s not something that’s been fully fixed,” Summers said. The June median Fed official predictions showed inflation coming back toward the 2% target but unemployment only reaching a high of 4.1% by 2024 -- a “highly implausible” result, he said.

“Frankly I think in 2021 our central bank lost its way. It was talking about the environment, talking about social justice in a range of things,” Summers, a Harvard University professor and paid contributor to Bloomberg TV, said. “It was confidently dismissing concerns about inflation as transitory.”

Turning to Japan, which has seen its currency tumble to the weakest since 1998 as the Bank of Japan declines to join its peers in tightening policy, Summers said it’s likely to be a challenge to exit the current zero-yield targeting regime.

Dollar’s Impact
“Sooner or later they’re going to leave the yield curve control strategy and I’m not entirely sure what’s going to happen when they do,” Summers said. “In the meantime, the pressures are likely to build,” with the potential for “an even weaker yen,” he said.

While some emerging markets are also suffering from a strengthening dollar, Summers said that he didn’t see a “systemic” crisis along the lines of 1998. Still, countries with “particularly unsound policies” including Turkey and Argentina are a concern, he said.

The world as it is, the reactions of traders to evolving stimuli, and the world as we would like it to be, are three very different places.

The reality of massive money supply growth in 2020/21, and the subsequent decline in supply growth represent the background for market. The absence of clear sources of new liquidity suggest it is unproductive to expect sharp rebounds on par with those seen in 2021.

Historically, gold prices have often come under pressure in the early stages of a slowdown as central bank policy is still tightening or is tight and real interest rates are rising. Of course, this dynamic reverses when policy rates are cut. We expect a further lift to real interest rates this year, particularly as inflationary risk fades in 2H22. As such, additional liquidation of exchange-traded funds can be expected. We advise protecting the downside to longer-term holdings in the yellow metal into year-end. However, we see opportunities to be more positive though 2023 as the Federal Reserve pivots to an easier stance and the US dollar weakens.  

Gold is often regarded a perpetual zero coupon bond. It therefore thrives in an increasingly negative real interest rate environment and struggles when a rates trend towards positive real rates.

You are sending out comprehensive information that I am not finding anywhere else, addressing multiple markets, which is quite helpful for me as an investor. So that brings up two questions: First, I wonder if you agree that the Fed has already reduced its balance sheet by about $1 trillion dollars? (As I heard recently from one analyst, which, given the rise in the dollar could explain the decline in values of multiple assets...) And, second, given the drop in so many assets: Bitcoin, gold, stocks, uranium recently, metals on the LME, to name a few, are we already actually in a recession, even though not officially labeled by the powers that be, is this, in fact a recessionary event we are proceeding through regardless on any official labeling, in your opinion?

Thank you for this question which may be of interest to the Collective. The Fed only began reducing the size of its balance sheet in July. They are starting at a pace of -$47.5 billion and plan to double that to $95 billion in the autumn. The bulk of global quantitative tightening so far has been achieved through the strength of the Dollar.

Your daily talks, now focusing on the probability of a recession, are as always full of interest. I never miss them, or if I have to, I at least read the Comments of the Day.

I've been struggling to decide on some "investments" that could profit from the recession scenario, and which could remain there for the medium term, without my having to watch them every day for sudden reversals. Any suggestions? Shorting a commodity ETF?  Shorting the US banking sector? I'm sure you have other ideas.

Thank you for this long-term patronage and this question which may be of interest the other subscribers. The phrases “buy and forget” and “shorting” don’t normally go together. Shorting necessarily means leverage. You can’t walk away from a leveraged position because they can go against you in a hurry.

New chancellor Nadhim Zahawi has urged unity after his predecessor, the health secretary, and several junior ministers walked out.

But the prime minister has been hit by six further resignations, taking the total to 16 in the past day.

It comes as he prepares for PMQs later and a grilling by senior MPs.

Mr Johnson's premiership has been plunged into crisis following the dramatic resignations of Chancellor Rishi Sunak and Health Secretary Sajid Javid.

They quit within minutes of each other on Tuesday following a row over Mr Johnson's decision to appoint Chris Pincher deputy chief whip earlier this year.

Their departures triggered a wave of resignations from more junior roles that has continued on Wednesday.

In six further departures ahead of PMQs, education ministers Will Quince and Robin Walker, Justice Minister Victoria Atkins, Treasury minister John Glen, and ministerial aides Laura Trott and Felicity Buchan have all walked out.

Boris Johnson is a proven vote winner, but it was widely reported when he became Prime Minister that he is not well liked by his party colleagues. That later point is now becoming relevant as demand for solutions to unfolding economic issues are in high demand. Regardless of efforts to remove him, the range of possible options to mounting economic, inflationary and energy challenges will be the same.

“The 10-year yield may have been depressed for a large part of the past 15 years or so because global central banks have increased their balance sheets substantially and have reduced the term premium at the long end of the curve. And so you can get around these possible distortions by focusing more closely on how the market is pricing central bank policy.”

“What you will see is, three to six months from now, most if not all of these recession-probability metrics that we get from the yield curve will begin to start flashing at least orange, if not red.”

No Sense
“The Fed is telling us that they want to go to 3.8% sometime in early 2023; the two-year yield is over 100 basis points below that level right now,” noted Jim Caron, chief fixed-income strategist at Morgan Stanley Investment Management.

“This doesn’t make any sense whatsoever -- unless one of two things: one, the market just doesn’t believe that the Fed is actually going to be able to hike in the way that they’re saying they will, or, something’s going to happen along the way.”

More broadly, “the markets are right now are surrendering to the fact that we’re likely to have a hard landing or a recession,” he said.

 Long-dated yields have generally tended to rise during periods of quantitative easing because the Fed crowds out other investors and reduces the risk in other asset classes. Therefore, there is less inclination to hoard bonds and more incentive to buy risk assets; both public and private. That suggests the argument QE depresses long-dated yields is wrong. 

“It is hard to find much positive to say about the EUR,” said Dominic Bunning, the head of European FX Research at HSBC. “With ECB sticking to its line that we will only see a 25bp hike in July – at a time when others are hiking much faster – and waiting for September to deliver a faster tightening, there is also little support coming from higher yields.” 

Money-market traders are betting ECB will deliver around 140 basis points this year, down from more than 190 basis points almost three weeks ago. The repricing gathered pace after a string of weak economic data last week, with traders trimming bets again on Tuesday after French services PMI was revised lower. 

Investors have also been more cautious on the euro due to the risk of so-called fragmentation, when economically weaker nations see unwarranted spikes in borrowing costs as financial conditions tighten. The ECB is expected to deliver further details of a new tool to backstop more vulnerable countries’ debt at their policy meeting later this month.

The losses Tuesday were compounded by poor liquidity and selling in euro-Swiss franc, according to three Europe-based traders. The euro fell as much as 0.9% against the Swiss franc to 0.99251, the lowest level since 2015. 

“The FX market is not back up to full liquidity given the US holiday,” said Mizuho’s Jones. “Any given size of trade is likely to have a greater impact on market movement.”

Russia’s calculus is simple enough. They are betting the economic pain European countries are enduring because of their support for Ukraine will be so great they will be willing to make a deal sooner rather than later.

The latest leg of the bond-market rally came after Fed Chair Jerome Powell said on Wednesday that the risk of harm to the economy from higher rates was less important than restoring price stability. Traders continue to expect another 75-basis-point rate increase in July, and swaps referencing Fed policy
meeting dates price in a peak rate near 3.5% in March 2023, followed by a drop to about 3% by year-end.

“The market is digesting increasing odds of recession,” said Janet Rilling, senior portfolio manager at Allspring Global Investments, which manages $541bn in assets. And it’s likely that “inflation will stay pretty elevated. So the Fed will continue to be aggressive” raising rates. 

In turn, she said the extent of the recent drop in Treasury yields means shifting to a more defensive posture. “Watching today’s movement, this could be presenting an opportunity here
to reduce duration.”

The market added to gains, amassed before the US trading day began as European bond markets rallied, after the release of personal income and spending data for May. Spending rose 0.2%, half the expected increase. The price index for purchases rose 0.6% versus an expected 0.7%, supporting the view that an
inflation peak is being established. 

I’ve seen a lot of commentary in the financial media about where R-star might reside. It’s a valuable discussion. Afterall, we all want to know what the real inflation-adjusted neutral rate of interest is. However, the discussion must be grounded in accepting that it is impossible to prove until after the fact.

Money supply doubled in the month to April 2020 and remained at an elevated month-over-month level for a year. That quantity of money printing has resulted in a significant inflation scare. It overstimulated demand at a time when supply was constrained from responding as quickly. The volume of outstanding debt is higher today than during any previous cycle, so investors are understandably troubled.  

Could you please explain how the Fed US Treasury H15 Constant Maturity 10 Yr Real Yield (H15X10YR Index) is calculated?

Thank you for this question which others may have an interest in. A lot of the answer can be found by comparing the chart of the constant maturity real yield with the TIPS chart.


The only difference I can see is that the constant maturity imputes an accurate bond yield with exactly 10-years to mature even when there is no bond that matches that exact maturity. I am growing progressively more distrustful of these kinds of measures which rely on TIPS. It's a very small market and the Federal Reserve is very active in it so it is unlikely to give an accurate depiction of what the real yield in fact is.

There was one necessary condition underlying the bond market’s ability to shrug off the worst inflation numbers in a generation after only a week; nobody is really sure if they believe the Fed. Credibility is vital to central banks, and I argued for Businessweek on Thursday that it is indeed as important an anchor to the monetary system as gold used to be. A round trip like this showed extreme hesitance to accept the Fed’s guidance; arguably, the currency of its forward guidance has been adulterated.

That said, the Fed can’t have lost all credibility. The rebound in bond yields started Thursday morning as Jerome Powell began taking his second day of questions from Congress. Unlike on Wednesday, he said that his commitment to get inflation back down to 2% was “unconditional.” That, like many central banking pronouncements in the past, had an effect. But it's still concerning that the Fed needs to be more shrill to get its message across; it does look as the coinage of forward guidance is being debased:

Meanwhile, a telling indicator of how far sentiment has swung back toward bracing for a (disinflationary) recession comes from inflation breakevens. German inflation expectations have receded after a dramatic surge over the last 12 months, although they still remain higher than they were at the beginning of the year. The same is not true of US breakevens for average inflation over the next 10 years, and for the five years starting five years hence. Both are now lower than they were in May last year — an extraordinary fact given the extent of the inflationary shock since then, and the new geopolitical drivers for inflation that have arisen this year. If you’re convinced that much higher rates of inflation are on the way, along with higher interest rates to combat them, then the market is still making it very cheap for you to bet on that outcome

There is talk of the ECB raising rates in July, but Europe is already in a recession and Germany is fearful Russia will stop natural gas exports through the original Nordstream pipeline altogether. Against that background the ensuing economic contraction would make the case for interest rate hikes moot.