THINGS THAT SCARE ME

2016-05-17 3pm EDT  |  #bonds #yield curve #Yellen #Fed #gold

I am hopeful the global economy is about to bottom and start to tick higher. I believe most market participants are way too pessimistic, and it wouldn’t take much to exceed downtrodden expectations.

Just this morning another hedge fund manager spouted a typical end of the world headline that is all too common these days:

“Markets Have No Purpose Any More” Mark Spitznagel Warns “Biggest Collapse In History” Is Inevitable

Maybe Mark will be right. Perhaps markets are about to crash in an epic spectacular fire ball that most of these hedge funds seem to be perfectly positioned for. If it does, it will be the first time a crisis occurs in which the majority of hedgies profit. Usually crises are caused by hedgies or other levered market players having positions that need to be unwound. A large decline today would be unusual in that hedgies would be there to catch the falling knife. Even good ole’ Uncle Carl would be buying stocks to cover his 150% net short position.

The last thing you need is another post warning about the dangers of the stock market. I agree that valuations are dumb, but they are no less dumb than stupid low interest rates. How do you price equities in a world of negative 10 year rates? Instead of focusing on the dangers in the stock market, I think investors should be worried about the dangers in the bond market.

But what really worries me is the Federal Reserve’s refusal to understand the critical role they play in setting global inflation expectations. Like it or not, the US dollar is the world’s reserve currency. When the Federal Reserve tightens, either by outright raising of rates, or even through hawkish rhetoric, it causes credit to be destroyed. In this balance sheet constrained world, it does not take much to unleash a deflationary vicious feedback loop. Japan has spent the last two decades learning old rules no longer apply. Even the slightest hint of raising rates causes credit creation to run scampering back into its hole.

Some of the more hawkish market pundits believe we need to raise rates before inflation gets going. They correctly understand if inflation takes root, it will be difficult to control. I couldn’t agree more. When inflation comes, it will be wicked. The years of throwing fuel on the monetary base means once the fire is lit, it will be monstrous.

Yet the alternative of not allowing inflation is probably worse. We all know our record high level of debt will never be repaid in real terms. There is simply no way we can grow our way out of the problem. That leaves us with two choices. Either allow the economy go through a painful 1930’s style debt destroying depression, or inflate it away. The longer we pretend there is a third choice, the worse the problem becomes.

Which brings me back to the current environment. What scares me most is the Federal Reserve’s naive belief there is a third choice. Since becoming Chair of the Federal Reserve, Janet Yellen has steadily withdrawn monetary stimulus and methodically tightened. That is a not a popular analysis of Janet’s actions, but just look at the yield curve.

If she really was as dovish as all the Cassandra’s claim, wouldn’t the bond market be revolting? Dalio, Gundlach and a host of other smart guys have all warned Yellen was making a 1937 style mistake. Although she has slowed down her implicit tightening with a recent speech, the yield curve is still flattening.

This scares me. The market does not believe Yellen will be successful in inflating. Without the market’s optimism, credit will not expand, and inflation will struggle. Do not forget the natural state of the economy is for credit to contract. We have hit a point where everyone is reluctant to borrow more. Whether it is governments, individuals or corporations, real credit creation is especially hard to encourage.

Which is why the velocity of money keeps plummeting. All of these negative forces are worsened with an overly tight Federal Reserve. Yellen & Co. keep assuming we are living in a pre-2008 crisis world.

The economy cannot handle higher rates, and the bond market knows this better than anyone. This morning a bunch of economic releases indicated a stronger economy and higher inflation. This should be negative for the long end of bond curve. Yet instead of selling off, long bonds are rallying! What’s amazing is that twos are down and 30s are up! The yield curve continues to flatten.

We are now challenging the lows in the 210 Treasury yield curve spread. The bond market knows economic strength will cause the Fed to panic and raise rates too aggressively.

Ironically long bond investors now welcome economic data that typically causes rates to back up.

The long bond knows better than Yellen, and yet she doesn’t listen. Until the Federal Reserve changes its tune and allows the yield curve to steepen, we will struggle with the same stop and start problems that have plagued other balance sheet constrained economies.

Although I am hopeful the Fed can sit on their hands long enough to kick start the credit creation process, the flatter the yield curve gets, the more worried I become. Keep watching the yield curve. There is no better predictor about the true state of the economy. It’s smarter than me, smarter than all the hedgies, and most definitely smarter than Yellen and the other clueless knobs at the Federal Reserve.


Peeling off some gold

Although I have been a big gold proponent, I am peeling off a bit of my position up here. By no means am I suggesting the price of gold will collapse. I am sticking with my long term position, and still view it as core position. Yet recently the party has become worryingly crowded.

Have a look at the CFTC commitment of traders report:

Specs are now longer than during the heyday of the 2011 bull market.

And we are entering a seasonally bearish period for gold:

I wrote some June and July calls and sold a little bit of gold to trim my exposure. I am still long, but a little less so. I will look to increase it again later this summer. Hopefully we can shake out some of these new bandwagon jumpers and pick up their position a little lower.

Thanks for reading,
Kevin Muir
the MacroTourist