Annoying Peasant

July 21, 2019 – Weekly comment

King Arthur: I am your king.

Peasant Woman: Well, I didn’t vote for you.

King Arthur: You don’t vote for kings.

Peasant Woman: Well, how’d you become king, then?

[An angelic choir begins…]

King Arthur: The Lady of the Lake, her arm clad in the purest shimmering samite, held aloft Excalibur from the bosom of the water, signifying by divine providence that I, Arthur, was to carry Excalibur. [singing stops] That is why I am your king.

Dennis: Listen. Strange women lying in ponds distributing swords is no basis for a system of government. Supreme executive power derives from a mandate from the masses, not from some farcical aquatic ceremony.

Arthur: Be quiet!

Dennis: You can’t expect to wield supreme executive power just ’cause some watery tart threw a sword at you!

Arthur: Shut up!

Dennis: I mean, if I went around saying I was an emperor just because some moistened bint had lobbed a scimitar at me, they’d put me away!

There are a lot of parallels between Monty Python’s Holy Grail and repressive monetary policy.  “How’d YOU become the one to set interest rates then?  I didn’t vote for you.” 

I for one, am becoming annoyed by the fixation on inflation, but even more so by the continuous blather about the neutral rate.  THAT’S your new communication plan?  “Listen.  Strange data that can’t be seen or measured is no basis for a system of monetary policy.  I mean, if I went ‘round saying I should be on the Fed board just because I had a magical conjecture for r-star, they’d put me away.  It’s no wonder markets ignore your farcical dots ceremony.”

As you all know, it wasn’t NY Fed President William’s discussion of the neutral rate that sparked a violent reaction in short rates, it was his theoretical discussion of what to do for signs of a slowdown when near the ZLB:  “Don’t keep your powder dry.”  The market immediately adjusted to the real possibility of a 50 bp cut until the NY Fed put out a statement saying ‘Nevermind’.  Then Rosengren capped it all off at the end of the week by saying he didn’t see why the Fed needed to cut at all.  An anarcho-syndicalist commune would make clearer decisions. 

That’s enough about The Holy Grail of monetary policy. “He’s already got one, you see?  Oh yes, eet’s very nice.” Let’s move on.  Below is a chart I created from St Louis Fed data.  It’s Household (and Non-Profit) Net Worth over GDP.  In the 1980’s this ratio was around 2.5 to 3.0x.  In the unsustainable dotcom bubble it got to nearly 3.5.  At that time, the FF peak in 2000 was 6.5%.  Then, by 2003, as the Fed cut to 1%, smoldering embers caught fire, and the ratio peaked just under 4.5x pre-crisis in 2008, even as the Fed had hiked to 5.25%.  By the end of 2008, the Fed effectively cut to zero.   The ratio levitated.  So here we are at 5.7x.  Does this make any sense?  Is it sustainable?  Does reversion to the mean hold sway?  Creating paper wealth as a means to generate economic activity could be running out of steam. 

The reason for the 2008 crisis was pretty clear: explosive growth of mortgage debt without equity, which caused an unsustainable upward spiral in real estate prices.  Income was not adequate to service the debt. Since that time, households became rather frugal, notwithstanding student loan debt.  From the Fed’s quarterly Z.1 report, the peak of HH Mortgage debt in 2007 was $10.433T.  Twelve years later, in Q1 of 2019, that amount is just $10.390T.  Consumer Credit was $2.609T in 2007 and is now $4.052, with most of the change coming from student loans.  The Household Debt Service and Financial Obligation Ratio (FOR) is now just 15.38% (of personal disposable income). It has never been below 15 and in 2007 hit 18.13%.  HH Equity in Residential Real Estate was at a high of 61.1% in 2001, plunged to 36.8% in 2009 and has now nearly fully recovered to 60.4%.  In aggregate, HH finances are fine. Just one more note, since 2015 the Fed raised the FF target by 225 bps.  The average credit card rate has gone from 12% to 15%, a nice protection of margin.

Now let’s consider the other big debt categories. Total business debt went from $10.115T in 2007 to $15.579T now.  We all know that Corp debt is at a record of GDP.  We know that a lot of debt went into share buybacks.  For now, earnings are comfortably servicing the debt and spreads are tight.  A further increase in rates or a decline in GDP would change that in a hurry. 

The most explosive growth has been in Fed’l Gov’t debt, which surged 3x, from $6.074 in 2007 to $18.248 in Q1. It appears from these data as if all of the growth and wealth since 2009 has been engineered by the Federal Govt and central bank. 

This “wealth” we speak of always has some carrying costs.  Real estate has to be maintained, and the King comes for the taxes.  The crown needs his army.  Art and precious metals need to be stored and insured.  The wealth represented by share prices has overhead, some of it in the form of debt service.  Of course, the debt service of one man is the asset of another.  At the extreme, and I don’t know where that is, “wealth” becomes such a multiple of “income” that all that occurs is swapping of assets.  Financial engineering.  The rats eating the rats. 

In order to keep the merry-go-round spinning the central banks have to keep feeding money in at an accelerating rate to try to bring income more in line with asset prices.  Demographics are a headwind, as we are always reminded.   

Here’s an excerpt of Ray Dalio’s ‘Paradigm Shifts’

A classic one of those is an unsustainable rate of debt growth that supports the buying of investment assets; it drives asset prices up, which leads people to believe that borrowing and buying those investment assets is a good thing to do. But it can’t go on forever because the entities borrowing and buying those assets will run out of borrowing capacity while the debt service costs rise relative to their incomes by amounts that squeeze their cash flows. When these things happen, there is a paradigm shift. Debtors get squeezed and credit problems emerge, so there is a retrenchment of lending and spending on goods, services, and investment assets so they go down in a self-reinforcing dynamic that looks more opposite than similar to the prior paradigm

To me, it looks like the Fed’l government is the entity that could be constrained in terms of borrowing capacity, unless the Fed comes in like the Bank of Japan and buys everything.  And puts rates back down to ZLB, (or in the case of the ECB, cuts the funding rate to an even more negative level). The implication, as Dalio mentioned, is that it’s a good idea to add gold to the portfolio.  The implication in US short rates is that after they ease by 25 bps at the end of the month, cuts of 50 in a shot will be priced as a possibility every time weak data points print.  Who knows where it all ends.  It all reminds me of the old medieval maps where the edge of seas were unknown and they just made the notation, “Here be dragons.”


We’re now a week and a half away from the FOMC.  Locked at 25 bps at this point.

This week 1/3rd of the SP 500 companies report.  Q2 GDP released on Friday, expected +1.8%.  The NY Fed is forecasting 1.4% and the Atlanta Fed GDPNow is 1.6%. 

The largest event now likely concerns events surrounding Iran and the US/UK.  Oil fell $4.50 bbl this week, but downside from here is limited.  Stock index futures closed on a weak note, with the Russell making a new low for the month of July. 

I continue to favor steepening positions as the Fed gets painted into an easing corner.  However, an uncertain geopolitical landscape should cap risk assets.   

7/12/2019 7/19/2019 chg
UST 2Y 183.7 181.2 -2.5
UST 5Y 185.9 180.3 -5.6
UST 10Y 210.6 204.7 -5.9
UST 30Y 263.3 257.7 -5.6
GERM 2Y -72.3 -76.8 -4.5
GERM 10Y -21.0 -32.4 -11.4
JPN 30Y 39.0 37.2 -1.8
EURO$ Z9/Z0 -32.0 -39.0 -7.0
EURO$ Z0/Z1 6.5 4.0 -2.5
EUR 112.88 112.34 -0.54
CRUDE (1st cont) 60.30 55.76 -4.54
SPX 3013.77 2976.61 -37.16
VIX 12.39 14.45 2.06

Posted on July 21, 2019 at 12:56 pm by alexmanzara · Permalink
In: Eurodollar Options

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