Investing in Macro Tipping Points

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JAPAN - Funding Games

US PUBLIC POLICY - Mid-Term-Election Turns Control of Senate to GOP

What The Election Means For the Markets  11-05-14 Graham Summers Phoenix Capital Research

The GOP took the Senate yesterday. This will mark the first time the GOP controlled both bodies of Congress since 2007.

The question now for investors is how this will impact the Federal Reserve going forward.

The current Fed is run by the very liberal Janet Yellen, who believes firmly in wealth redistribution. Yellen proudly considers herself and her policies to be liberal and states as much in interviews and speeches.

With the GOP now in control of both houses of Congress, the Yellen Fed will soon be facing increased scrutiny and oversight.

In July of 2014, two GOP Congressmen introduced a bill that would require the Federal Reserve to follow the Taylor Rule regarding interest rates. While the details of this rule are not worth delving into at this time, the key ideas are that:

1)   Interest rate policy would no longer be subject to the whims of Fed officials.

2)   The Fed and its policies would be regulated by Congress for the first time in history.

In September, just two months later, the GOP-controlled House passed an “Audit the Fed” bill.

The House on Wednesday passed legislation to audit the Federal Reserve System.

Passed 333-92, the bill would require the comptroller general to conduct an audit of the Federal Reserve's board of governors and banks within one year and submit a report to Congress on the findings. A total of 106 Democrats joined all but one Republican in support of the measure.

A version of the bill sponsored by then-Rep. Ron Paul (R-Texas) passed in 2012 by a vote of 327-98. Paul's son, Sen. Rand Paul (R-Ky.), has introduced companion legislation in the Senate. 

Rep. Paul Broun (R-Ga.), who failed to advance in a Senate GOP primary earlier this year, said the measure would increase transparency at the Federal Reserve.

http://thehill.com/blogs/floor-action/house/218047-house-passes-bill-to-audit-the-federal-reserve

The political winds have begun to shift against the Fed. It is telling that the US Dollar began to rally soon after this legislation was introduced. A less active Fed means a stronger US Dollar. Between the end of QE, negative interest rates in Europe, and legislation that would rein in the Fed’s lack of accountability, the US Dollar has hit a four-year high.

A strong Dollar is VERY NEGATIVE for stocks. The stock market has yet to really catch on to this, but it will... and it won't be pretty.

Be prepared!

SENTIMENT - Historically Excessive Risk Taking

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THESIS 2014: The Globalization Trap

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It Begins: German Bank 'Charging' Negative Interest To Its Retail Customers

It Begins: German Bank 'Charging' Negative Interest To Its Retail Customers 11-04-14 Simon Black via Sovereign Man blog,

Don Quixote is easily one of the most entertaining books of the Renaissance, if not all-time. And almost everyone’s heard of it, even if they haven’t read it.

You know the basic plot line- Alonso Quixano becomes fixated with the idea of chivalry and sets out to single-handedly resurrect knighthood.

His wanderings take him far across the land where he gets involved in comic adventures that are terribly inconvenient for the other characters.

He famously assaults a group of windmills, believing that they are cruel giants. He attacks a group of clergy, believing that they are holding an innocent woman captive.

All of this is based on Don Quixote’s completely delusional view of the world. And everyone else pays the price for it.

Miguel de Cervantes’ novel is brilliantly entertaining. But the modern-day monetary equivalent is not so much.

Central bankers today have an equally delusional view of the world. Just three months ago, Mario Draghi (President of the European Central Bank) embarked on his own Quixotic folly by taking certain interest rates into NEGATIVE territory.

Draghi convinced himself that he was saving Europe from disaster. And like Don Quixote, everyone else has had to pay the price for his delusions.

On November 1st, the first European bank has passed along these negative interest rates to its retail customers.

So if you maintain a balance of more than 500,000 euros at Deutsche Skatbank of Germany, you now have the privilege of paying 0.25% per year… to the bank.

We’ve already seen this at the institutional level: commercial banks in Europe are paying the ECB negative interest on certain balances.

And large investors are paying European governments negative interest on certain bonds.

Now we’re seeing this effect bleed over into retail banking.

It’s starting with higher net worth individuals (the average guy doesn’t have half a million euros laying around in the bank). But the trend here is pretty clear– financial repression is coming soon to a bank near you.

It almost seems like an episode from the Twilight Zone… or some bizarre parallel universe. That’s the investment environment we’re in now.

Bottom line: if you’re responsible with your money and set some aside for the future, you will be penalized. If you blow your savings and go into debt, you will be rewarded.

If we ask the question “cui bono”, the answer is pretty obvious: heavily indebted governments benefit substantially from zero (or negative) rates.

Case in point: the British government just announced that they would pay down some of their debt that they racked up nine decades ago.

In 1927, then Chancellor of the Exchequer Winston Churchill issued a series of bonds to consolidate and refinance much of the debt that Britain had racked up from World War I and before.

This debt is still outstanding to this day. And the British government is just starting to pay it down– about $350 million worth.

Think about it– $350 million was a lot of money in 1927. Thanks to decades of inflation, it’s practically a rounding error on government balance sheets today.

This is why they’re all so desperate to create inflation… and why they’ll stop at nothing to make it happen. (It remains to be seen whether they’ll be successful, but they are willing to go down swinging…)

What’s even more extraordinary is how they’re trying to convince everyone why inflation is necessary… and why negative rates are a good thing.

On the ECB’s own website, they say that negative interest rates will “benefit savers in the end because they support growth and thus create a climate in which interest rates can gradually return to higher levels.”

I’m not sure a more intellectually dishonest statement could be made; they’re essentially telling people that the path to prosperity is paved in debt and consumption, as opposed to savings and production.

These people either have no idea how economies grow and prosper, they’re outright liars, or they’re completely delusional.

I’m betting on the latter. Either way, this assault on windmills has only just begun.

As Don Quixote himself said, “Thou hast seen nothing yet.”

GLOBAL RISK - World Economic Forum

Who Will Suffer From A Leveraged Credit Shakeout? 10-31-14  Charlie Hennemann via CFA Institute blog, via ZH

Of all the noteworthy moments from the 2014 CFA Institute Fixed-Income Management Conference, the bombshell may have been the default call from Martin S. Fridson, CFA.

Fridson, CIO at Lehmann Livian Fridson Advisors, has been a leading figure in the high-yield bond market since it was known as the “junk bond” market — and he sees as much as $1.6 trillion in high-yield defaults coming in a surge he expects to begin soon.

“And this is not based on an apocalyptic forecast,” he assured the audience.

High-yield bonds, typically issued with credit ratings at the bottom of the scale, tend to suffer default surges during troughs in the credit cycle. The first high-yield default surge occurred from 1989 to 1992, and encompassed thecollapse of Drexel Burnham Lambert. The second surge ran from 1999 to 2003, following the bursting of the dot-com bubble, and the third happened in the midst of the global financial crisis, from 2008 to 2009.

Fridson suggests the next default surge will be larger than the last three combined. Each surge saw an average annual high-yield default rate above 7% (which, if extended over a multi-year period, can add up to real money).

Fridson currently projects that 1,155 issuers will default in the next wave. Over a four-year period that easily surpasses the 644 defaults in 1999–2003, the largest of the three prior default surges.

For context, Fridson points to the last default surge of 2008–2009: It lasted only two years, and the market swung from a record number of defaults in 2008 to a below-average number in 2009, something Fridson “would have said was impossible.” The reason, of course, was that interventionist policies did as intended in the wake of the financial crisis, cutting the credit cycle short and giving new life to many issuers that were staring default in the face. In the absence of a strong cyclical recovery, this may only have delayed the inevitable.

Fridson noted that since 2010, the high-yield market has seen deterioration in the credit-ratings mix even as it has grown at a compound annual growth rate exceeding 10%, fueled in part by European issuers accessing the high-yield markets in lieu of bank credit, which has been harder to get thanks to more conservative bank capital requirements.

One key assumption behind Fridson’s forecast is that the Fed ends its program of quantitative easing (QE) and allows interest rates to rise. QE may have ended, but Fed guidance calls for interest rates to remain low for a “considerable time.” Fridson was asked about QE and the persistence of low rates during Q&A after his presentation, and the answer left the audience murmuring.

“If we’re in this Fed rescue mode [in 2016–2019], then I think we’re in a lot of trouble. Very serious trouble.”

The final presentation at the Fixed-Income Management Conference was from Paul Travers, a manager of bank loans and collateralized loan obligations (CLOs) at Onex Credit Partners. Travers was quick to offer his thoughts about Fridson’s forecast, which would have a profound impact on the bank loan market if it comes to pass.

“I hope he’s wrong,” Travers exclaimed, noting that high-yield issuers are often also issuers of syndicated loans. “I don’t know if I can live through another four-year default wave.”

In a typical default situation, the holders of senior-secured bank debt would be expected to have much better recoveries than holders of the same issuer’s high-yield bonds, because bank loans have higher priority in the company’s capital structure. But investors in loans may not do as well in the next credit trough as they have in the past, as leverage multiples in the loan market have steadily climbed since 2011.

Unlike fixed-rate high-yield bonds, leveraged loans typically offer floating rates indexed off of Libor, usually resetting monthly, which provides some protection for investors against the prospect of a rising interest rate environment. Travers considers the current credit environment “relatively benign,” and said the current low-rate, low-growth environment is the “sweet spot” for the leveraged loan market — positive growth that isn’t rapid enough to threaten a rate increase. Under these conditions, the S&P/LSTA Leveraged Loan Index par amount outstanding increased to $768 billion in July of this year, adding $76 billion in the first half of 2014.

During his presentation, Travers noted that “Covenant Lite” loans now exceed 50% of the  S&P/LSTA Leveraged Loan Index. According to Travers, fewer loan covenants wouldn’t necessarily lead to a higher incidence of defaults, since loan holders in most instances would be inclined to waive covenants rather than force an issuer into default. But over time, the lack of tight covenants could allow cash to flow out of the company, resulting in lower loan recoveries for investors in the event of default.

Of more immediate concern to Travers was the impact of retail fund flows on the leveraged loan market, which had seen 14 consecutive weeks of negative flows at the time of the conference after a long period of inflows. A fairly recent phenomenon in the leveraged-credit market, these retail flows from large loan managers — forced to buy and sell large blocks of loans to put cash to work or meet fund redemptions — contribute to volatility.

In addition to the underlying loan market’s volatility, Travers suggested the CLO market was experiencing volatility itself as a result of just-announced risk retention provisions under section 941 of Dodd–Frank, which would require managers of CLOs to own at least 5% of the risk in their portfolios. Anticipation of this rule was a contributing factor in the rush of CLO issuance in 2014, which equaled 187 deals at the time of the conference.

While the risk-retention requirement isn’t expected to kick in immediately, Travers suggested that going forward, investors should determine whether CLO managers have the capital to comply with this new requirement as part of their due diligence process.

Fridson and Travers approached the leveraged credit market from different perspectives, but their talks suggested that the placid environment encouraged by low interest rates and accommodative credit won’t persist. The next credit cycle will pose some serious challenges for leveraged-credit investors, regardless of their place in the capital structure.

Under the circumstances, the retail component of leveraged credit investments — absent from prior default surges — is probably not a positive development.

BUYBACKS - Take out Buybacks and Dividends (Financed by Corporate) Debt and Market is Nowhere!

CENTRAL BANKS - Manipulation?

PATTERNS - Equities No Longer Follow Earnings

SENTIMENT - "Consistency Breeds Complacency"

"Consistency Breeds Complacency" 11-05-14 Zero Hedge

SENTIMENT - Historically Excessive Risk Taking

CURRENCIES - Dollars Effect on US Stocks

A RISING DOLLARS IS NORMALLY BAD FOR STOCKS??

DRIVER$ - Commodities

A STRONG US$ IS CERTAINLY BAD FOR COMMODITIES!

Global Commodity Prices Are Collapsing At The Fastest Pace Since Lehman

Global Commodity Prices Are Collapsing At The Fastest Pace Since Lehman 11-05-14 Zero Hedge

We are sure it's nothing to worry about, and in now way indicative of any global aggregate economic weakness, but global commodity prices (that would be the 'stuff' that is used to make the 'stuff' we all buy every day) are collapsing at the fastest rate since Lehman...

Of course, it's all about over-supply, not under-demand... just like the Baltic Dry was not low because of shitty trade volumes but because of too many ships... but it's just the other side of an uncomfortably real mal-investment-driven fiasco...

Maybe it is the economy stupid and with US GDP expectations being ratcheted down after construction spending and trade deficit data, maybe the US is not decoupling after all.

PATTERNS - NYAD Divergence

PATTERNS -Eerie 2007 SPX Comparisons

2014

This move is very reminiscent of the 2007 top. At that time we had a top, followed by a quick correction and then a final blow off to eke out new record highs:

2007

It is not merely the market that is mirroring the 2007 top.

1.     Corporate debt is back to 2007 PEAK levels.

2.     Stock buybacks are back to 2007 PEAK levels.

3.     Investor bullishness is back to 2007 PEAK levels.

4.     Margin debt (money borrowed to buy stocks) is at 2007 PEAK levels.

5.     The leveraged loan market is flashing major warnings.

6.     Corporate insiders are dumping shares at a pace not seen since the TECH BUBBLE TOP

7.     Numerous investment legends have warned of a coming crash.

8.     Investor complacency is at a record LOW.

9.     The Fed has confirmed QE is ending this week, so the juice is cut off for now.

The Fed has succeeded in recreating the same environment that existed in 2007. Once again we have

• Rampant risk taking,
• Excessive leverage, and
• A stock market bubble.

PATTERNS -Megaphone Fractal at a Smaller Degree

SOURCE

The market looks like it’s topping out. We have a clear megaphone pattern in the S&P 500. We could always stage a final blow off top, but we’re at or near the top already. The next leg down should take us to the low 1800s. If things really begin to accelerate, we could easily go below 1700:

There is certainly no shortage of potential catalysts for this.

1)   Mario Draghi’s “bazooka” in Europe is looking more and more like a water pistol. There may in fact be something of a mutiny going on at the ECB as more and more national central bank heads grow tired of Draghi’s secrecy and policies.

2)   Japan’s economy is an absolute disaster. More importantly, the Japanese Bond market is heading towards an implosion. Risk is so mispriced by the Bank of Japan’s policies (QE efforts greater than 24% of Japan’s GDP) that even a general move to market rates could blow up the whole mess.

3)   Based on un-massaged data, China is growing at HALF of the official rate. Given than half of all future global GDP growth is expected to come from China, this doesn’t bode well for the world.

4)   The US Dollar is rallying hard. We’re already at a four-year high. With the global dollar carry trade somewhere over $3 trillion, this has the potential to blow up a massive amount of investments (see the current commodity meltdown).

WATCH THE CURRENCY MARKETS FOR THE BIG MOVES

The financial world focuses far too much on stocks. The stock market, despite being at record highs (meaning record market capitalizations) remains one of the smallest, and least sophisticated markets on the planet.

Consider that stocks, even at current lofty levels, have a global market capitalization of slightly over $60 trillion.

In contrast, the global bond market is well over $100 trillion.

And the global currency market trades OVER $5.3 trillion per day.

It is currencies, not stocks, where the most significant moves occur. The currency markets are the largest, most liquid markets in the world. They are always first to move when things change.

And the US Dollar is moving up RAPIDLY. Will this blow up the financial system as it did in 2008? We’ll soon find out

CURRENCIES - Major Funding Currencies Nearing Multi-Decade Trend Violations

DRIVER$ - USD Index Breaks 30 YEar Trend Resistance

Dollar smashes through resistance as mega-rally gathers pace 11-0314 Ambrose Evans-Pritchard, Telegraph

HSBC says we are at the early stages of a dollar bull run that will change the world

The index - a mix of six major currencies – hit 87.4 rising above the key level of 87. This reflects the plunge in the Japanese yen since the Bank of Japan launched a fresh round of quantitative easing last week.

SEISMIC SHIFT - "20% OVER NEXT 12 MONTHS"

David Bloom, currency chief at HSBC: "STEALING INFLATION"

"A 'seismic change' is under way and may lead to a 20pc surge in the dollar over a 12-month span. The mega-rally of 1980 to 1985 as the Volcker Fed tightened the screws saw a 90pc rise before the leading powers intervened at the Plaza Accord to cap the rise. “We are only at the early stages of a dollar bull run. The current rally is unlike any we have seen before. The greatest danger for markets and forecasters is that they fail to adjust their behaviour to fully reflect a very different world,” he said. The stronger dollar buys time for other countries engaged in currency warfare to “steal inflation”, now a precious rarity that economies are fighting over. The great unknown is how long the US economy itself can withstand the deflationary impact of a stronger dollar. The rule of thumb is that each 10pc rise in the dollar cuts the inflation rate of 0.5pc a year later.

EM ECHO BOOM - "A BOOMERANGE

The dollar revival could prove painful for companies in Asia that have borrowed heavily in the US currency during the Fed’s QE phase, betting it would continue to fall.

Hans Redeker, from Morgan Stanley

"The dollar rally is almost unstoppable at this stage given the roaring US recovery, and the stark contrast between a hawkish Fed and the prospect of monetary stimulus for years to come in Europe.

“We think this will be a four to five-year bull-market in the dollar. The whole exchange system is seeking a new equilibrium,” he said. “We think the euro will reach $1.12 to the dollar by next year and will be even weaker than the yen in the race to the bottom.”

Mr Redeker said US pension funds and asset managers have invested huge sums in emerging markets without considering the currency risks. “They may be forced to start hedging their exposure, and that could catapult the dollar even higher in a self-fulfilling effect.”

UNHEDGED CARRY TRADE - GLOBAL USD "SHORT SQUEEZE"

Data from the Bank for International Settlements show that the dollar “carry-trade” from Hong Kong into China may have reached $1.2 trillion. Corporate debt in dollars across Asia has jumped from $300bn to $2.5 trillion since 2005.

More than two-thirds of the total $11 trillion of cross-border bank loans worldwide are denominated in dollars. A chunk is unhedged in currency terms and is therefore vulnerable to a dollar “short squeeze”.

The International Monetary Fund said $650bn of capital has flowed into emerging markets as a result of QE that would not otherwise have gone there. This is often fickle “low-quality” money that came late to the party.

Many of these countries have picked the low-hanging fruit of catch-up growth and are suffering from credit exhaustion. They have deep structural problems and a falling rate of return on investment. The worry is that a tsunami of money could rotate back out again as investors seek higher yields in the US, possibly through crowded exits.

EARNINGS - Broken & Will Get Worse With a Stronger US$

The following chart should clarify just how bad the outlook for Q4 EPS is.

As Factset notes, "the decline in the bottom-up EPS estimate recorded during the course of the first month (October) of the fourth quarter was higher than the 1-year, 5-year, and 10-year averages." That is not a 'good' thing..

GOLD - Strong Dollar is Hurting Gold Price Denominated in US$ - Discouraging Investment

This chart provides some long-term perspective on the gold market since the turn of the century. The chart illustrates, gold's parabolic bull market came to an end in 2011 and has been trading within the confines of a downtrend channel ever since.

Over the past year and a half, however, gold found support at around the $1,200 per ounce level -- bouncing off this level on a total of three occasions.

That support has now come to an end as a result of economic weakness in both Europe and Asia coupled with relative economic strength in the US. All this encouraged global investors to allocate some of their funds into the relative safety of the US dollar thereby reducing the cost in dollars of commodities such as gold. The chart illustrates, there is now room (i.e. no nearby support) for gold to move lower.

GLOBALIZATION - A Changing Landscape

"Globalization Is Turning In On Itself And It Is Each Man For Himself" 11-02-14 Raoul Pal, author of the Global Macro Investor and creator Of RealVisionTV via ZH

At The Margin

A few things are also appearing on my radar screen – future visions if you like – that I want to share with you. These are not conclusive, but rather a stream of unfiltered thoughts, which will develop over time.

I virtually never use geopolitics to assess asset markets. I have learned the hard way over time that it is the way to the poor house. Economies run financial markets, not wars.

But I do note that at the margin, the world’s geopolitics is changing.

• Gone are the fluffy days of Putin shaking hands with George Bush agreeing to keep the world supplied with oil,
• Gone are the days of China helping US firms make profits using their cheap labour,
• Gone are open-for-business days of Europe,
• Gone is the Japanese military neutrality,
• Gone are the Saudis as an unshakeable ally,
• Gone is Israel also a steadfast ally, etc.

What is happening is something deeply concerning. Globalisation is turning in on itself and it is each man for himself.

This was always going to be the outcome of an imbalanced, debt-drowning world. Everyone wants a cheap currency and since that doesn’t work then everyone wants to find some way to get the upper hand on their own terms.

I have had recent conversations with a long-term strategy group within the Pentagon about economic threats to the US and the risk of global collapse, and the potential for it to turn into a military outcome. It seems that the Department of Defence’s deep thinkers are mulling over the kinds of issues we all are – is the inevitable outcome a military one? They don’t know either but they give it a probability and thus need to understand it and plan for it.

My issue has been for a long time that the true threat to the world is not the Muslim nations we so like to beat as a scapegoat (gotta have an enemy, right?) but China.

The Pentagon’s think-tank also agrees.

If China has an economic collapse, which again is a high probability event, then what are the odds of massive civil unrest? And would a military conflict put the people back on the side of the government (i.e. how the Nazis came to power)?

I agree. I think this is the risk somewhere down the road.

I also, along with this defence strategy group, think that there is a risk that the Western powers meddling in the time of bad economic crisis will form strong alliances between let’s say Russia and China.

In direct opposition to the government, many people inside the Pentagon are saying, “Please don’t fuck with Russia, they are not threatening us militarily but securing their own borders, we cannot control the outcomes, and most of them are bad, probably not militarily but economically, and economic instability causes outcomes we can’t forecast – even seizing the assets of powerful Russians has unintended consequences”.

Here, here. The law of unintended circumstances is a bitch.

Everyone is also looking carefully at the risk of Catalonia now having a referendum that is deemed to be unconstitutional, and then trying to enforce it in the streets.

Europe is trying to hold itself together yet the member states themselves are in danger of splitting up. How does that manifest itself? What are the risks? We just don’t know.

I think the trend of each nation for itself, a move away from globalisation either in terms of global trade, or in terms of global finance and a move towards military build-ups, is well under way. I don’t know how far it will go but I do know that I am uncomfortable with it, and that it poses some considerable risk to the stable economic system that so many have enjoyed since the late 1980s.

* * *

For some further observations on the role of globalization and what its unwind would mean..

... Gordon T. Long's take on the "Globalization Trap" is a worthwhile read.

GOVERNMENT PAPER REFERS TO FINANCIAL REPRESSION AS THE

"LIQUIDATION TAX"

(NBER #16893 - Page 35)

"THE LIQUIDATION OF GOVERNMENT DEBT"

"The saving (or “revenue”) to the government or the “liquidation effect” or the “financial repression tax” is the real (negative) interest rate times the “tax base,” which is the stock of domestic government debt outstanding."

Working Paper 16893, National Science Foundation Grant No. 0849224

ESTIMATE 3-4% of US GDP Y-o-Y

"Such annual deficit reduction quickly accumulates (even without any compounding) to a 30-40 percent of GDP debt reduction in the course of a decade"

"Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of “financial repression.” Financial repression includes:

1. Directed lending to government by captive domestic audiences (such as pension funds),
2. Explicit or implicit caps on interest rates,
3. Regulation of cross-border capital movements, and (generally)
4. A tighter connection between government and banks.

In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards). For the advanced economies in our sample, real interest rates were negative roughly ½ of the time during 1945-1980. For the United States and the United Kingdom our estimates of the annual liquidation of debt via negative real interest rates amounted on average from 3 to 4 percent of GDP a year."

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