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Investors wary of inflation trend

Stock markets have turned a little more negative on Wednesday, with Chinese data overnight dealing a blow to sentiment. It seems there’s a growing list…

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This article was originally published by Market Pulse

Stock markets have turned a little more negative on Wednesday, with Chinese data overnight dealing a blow to sentiment.

It seems there’s a growing list of concerns for investors that spans beyond simply what the Fed is going to do. And this comes despite certain Fed officials giving the impression that they are undeterred by this. That may well change over the coming months.

Inflation is at the forefront of those concerns, perhaps why policymakers are so reluctant to wait, which makes it even more of a concern. Investors have been cracking on under the impression that inflation is transitory – as they’ve repeatedly been told – and tapering will come as a result of the economic recovery rendering it no longer necessary.

Regardless of whether the result is the same, the change in narrative is a worry for investors. Persistent inflation, a slower economic recovery and higher interest rates is not the recipe for stronger equity markets but that appears to be the way we’re heading.

Coming at a time when Covid cases are already rising going into the winter period, potentially meaning more restrictions – or at the very least more cautious behaviour – we may be in for a difficult end to the year for risk assets.

Two hikes priced in as UK inflation surges

The UK is among those experiencing a surge in inflation, with the August reading jumping to 3.2%, ahead of market expectations. One of the drivers is the timing of the Eat Out to Help Out scheme last year, which makes it look worse than it is but this also won’t be where it peaks, which is why some are growing more concerned.

The result is that traders are now pricing in two rate hikes next year, taking the base rate to 0.5% by year-end. While there are areas of concern as far as inflation is concerned, such as higher input prices and the struggle to fill vacancies with skilled workers, I’m still unconvinced by the stickiness of the inflation we’re seeing.

While this won’t necessarily deter policymakers from gradually removing emergency stimulus measures, I still think it will be done with great caution and only as the economy warrants it. Still, that doesn’t mean it won’t be a nervy few months, with inflation expected to peak later in the year.

Bitcoin showing incredible resilience

Bitcoin shows incredible resilience at times and it certainly feels like we’re seeing that right now, with the cryptocurrency making gains for a second day and approaching USD 48,000. This comes despite USD 44,000 once again coming under pressure earlier this week before bulls fought back once more.

A failure at USD 48,000 could be another blow though and perhaps a further correction warning. A move above here could spur more optimism and fuel another rally towards USD 50,000 where it has repeatedly run into resistance.

For a look at all of today’s economic events, check out our economic calendar: www.marketpulse.com/economic-events/

Economics

Finally The Taper Tantrum, Or What’s Wrong With August?

If you’re fortunate to be able to do this long enough, you’re absolutely assured to get caught with your pants down and almost certainly more than once….

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If you’re fortunate to be able to do this long enough, you’re absolutely assured to get caught with your pants down and almost certainly more than once. In the short run, it’s all a crapshoot anyway. Markets fluctuate and never, ever go in a straight line. And just when you claim to be right on top, they yank the rug right out from under your conceit(s).

I’ve spent the past few weeks, really months pointing out how Federal Reserve policymakers via their compliant media hasn’t been able to provoke anything out of bonds. Not for lack of trying. Zilch. Nada. Forget tantrum, a whole lot of nothing even though taper – we’re always told – would spell the death of the bond “bull.” I’ve been almost gleefully highlighting how this policy farce has been greeted as a complete non-issue across all of those markets.

Until yesterday.

Finally, yields backed up both then and today in a notable selloff. Is this the long-awaited tantrum? Could it be something else?

For the former, start with Fed Governor Christopher Waller. Recall on August 2nd how Mr. Waller had appeared on CNBC and became the first voting FOMC member to encourage not just taper but a very quick one so as to clear enough calendar for a hard 2022 liftoff in rates.

Just two days later, it might appear his “go early, go fast” mantra caught on with at least some parts of the yield curve. From August 5 forward, the long end of the Treasury curve has been backing up from that recent mid-year low. August 4 was the last time before what is now a multi-week somewhat modest possibly reflationary action.

Before crowning Waller’s confidence, that particular date – August 4 – should ring a bell. Wasn’t it just last year, 2020, that longer-term bond yields had likewise bottomed out on this same day?

Yes, yes it was:



Obviously, the past two years began under very different circumstances; 2020 taking over from 2019 already close if not in recession (especially outside the US) and then the COVID errors. This year, 2021, opened in nearly opposite fashion with allegedly the whole world picking itself back up from all that damage and doing so boosted by every “stimulus” means known to man. Not just rebound, a fiery inflation-filled recovery. 

Yet, in the middle of both there’s more the same than different – questions about the initial “V” shaped recovery (which did not pan out) last year and then a pretty conspicuous “growth scare” this year many are plain hoping they can blame on delta COVID for the “unexpected” soft patch.

You probably also remember how that same label “growth scare” was also thrown around quite liberally in 2019, too. Back then, the only part of the yield curve anyone is told to pay attention to had inverted, not just provoking rate cuts out of a befuddled Jay Powell but raising mainstream alarms as to impending recession (which may actually have happened, but we’ll never know for sure given the timing of the coronavirus pandemic).

Wouldn’t you know it, the low point for LT UST’s in 2019 turned out to have been…August 28!



If twice could be random coincidence, yet three times is a pattern, what is four or five? Believe it or not, this same calendar shape can be found inside every one of the last five years – even 2018 when yields were more distorted as they neared their Reflation #3 peak. That year, the same sort of mid-year downward drift reaching its floor by August 20, 2018.

And the year before, during globally synchronized growth’s reported arrival, UST rates were, for the most part, moving lower (curve flattening) as the market kept rejecting the idea that there was some legitimately inflationary recovery taking shape. The low in yields for 2017? September 5 (OK, so not August but more than close enough).



Even 2015 and 2016 were pretty close in matching this seasonality; during the latter, yields bottomed out early July and then went up (a lot) later in the Autumn. The year before, 2015, as Euro$ #3 “matured”, again a mid-year low on August 24 (following CNY’s big theatrics) which had been the same day as the eurodollar shortage striking Wall Street equities (flash crash).

While there were a couple days later on in 2015 when the 10-year yield dropped a few bps lower than August 24, still the same general trend overall.

And that trend seems to have become intriguingly normal, manifested as a regular uptick in yields especially during September and October and then lasting through the end of each year (2018 the obvious exception given the eruption of Euro$ #4’s landmine). Quite simple enough, LT yields go up after August

Given this clear regularity, could any of these annual BOND ROUTs!!!! be considered reflationary?

Getting back to the original question, there’s quite a lot of evidence for something(s) other than Governor Waller’s melodramatic CNBC interview – or even the taper announcement and dots this week – which seems more likely to account for the bond market’s longer end behavior over the past five weeks. And this would also encompass the “big” selloff yesterday and today.

These last two days, then, have not been some unusual, tantrum-y eruption (look above at how far yields jumped in early September 2019 even as recession moved into the global forefront). Quite to the contrary, what’s happened so far over the past two months is entirely consistent with what seems to happen every year. Taper doesn’t. 

This could even mean I’m actually off-the-hook, my britches still fashioned tightly right where they need to be. The Fed’s people will continue trying to provoke a bond tantrum because of their need for the public to believe taper is in charge of interest rates, yet right at this moment there’s only evidence that bonds are just doing what they normally do without regard for dots and QE’s.

This only raises the question, of course, what the hell must be going on during the month of August? Sorry for the cliffhanger, but that I’ll save for another day. Feel free, however, to tweet or comment your theories and hopefully during next week’s podcast Emil Kalinowski and I will be able to discuss them.

 



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Precious Metals

Your cash will lose at least 5% of its purchasing power in the next year

Earlier this week, Fed Chair Jerome Powell announced that the real yield on dollar cash and cash equivalents is likely to be -5% or less over the next…

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Earlier this week, Fed Chair Jerome Powell announced that the real yield on dollar cash and cash equivalents is likely to be -5% or less over the next 12 months. Yes, your cash balances will lose at least 5% of their purchasing power over the next year, and that's virtually guaranteed. So what are you—and others—going to do about it?

Assumptions: This forecast of mine optimistically assumes that 1) the first Fed rate hike of 25 bps comes, as the market now expects, about a year from now, and 2) the rate of inflation slows over the next 12 months to 5% from its year-to-date rate of 5.9%. Personally, I think inflation next year likely will be higher, if only because of the delayed effect of soaring home prices on Owner's Equivalent Rent (about one-third of the CPI), the recent end of the eviction moratorium on rents, and the continued, unprecedented expansion of the M2 money supply.

I'm a supply-sider, and that means I believe in the power of incentives. Tax something less and you will get more of it. Tax something more and you will get less of it. Erode the value of the dollar at a 5% annual rate and people will almost certainly want to hold fewer dollars than they do today.

I'm also a monetarist, and that means I believe that if the supply of dollars (e.g., M2) increases by more than the demand for dollars, higher inflation will be the result. We've already seen this play out over the past year: the M2 money supply has grown by more than 25% (by far an all-time record) and inflation has accelerated from less than 2% to 6-8%. Massive fiscal deficits have played an important role in this, but so has an accommodative Fed. Between the Fed and the banking system, 3 to 4 trillion dollars of extra cash were created over the past 18 months. At first that was necessary to supply the huge demand for cash the followed in the wake of the Covid shutdowns. But now that things are returning to normal, people don't need or want that much cash. Yet the Fed continues to expand its balance sheet, and they won't finish "tapering" their purchases of notes and bonds until the middle of next year. That means that there will be trillions of dollars of cash sitting in retail bank accounts (checking, demand deposits and savings accounts) that people will be trying to unload.

If we're lucky, the inept and feckless Biden administration will be unable to pass its $1.5 trillion infrastructure and $3.5 trillion reconciliation bills in the next several weeks. This will lessen the pressure on the Fed to remain accommodative, but it's not clear at all whether it will encourage the Fed to reverse course before we have a huge inflation problem on our hands. Non-supply-siders (like Powell) view an additional $5 trillion of deficit-financed spending as an unalloyed stimulus for the economy. Supply-siders view it as a virtually guaranteed way to increase government control over the economy and thereby destroy growth incentives and productivity.

Amidst all this potential gloom, there are some very encouraging signs, believe it or not. Chief among them: household net worth has soared to a new high in nominal, real, and per capita terms. Also, believe it or not, the soaring federal debt has not outpaced the rise in the wealth of the private sector. See the following charts for more details:

Chart #1

Chart #1 is a reminder of just how low today's interest rates are relative to inflation. Terribly low! In normal times, a 4-5% inflation rate would call for 5-yr Treasury yields to be at least 4-5%. yet today they are not even 1%. The incentives this creates are pernicious: holding cash and/or Treasuries implies steep losses in terms of purchasing power. That in turn erodes the demand for cash and that fuels more spending and higher inflation.

Chart #2

Chart #2 shows the growth of the non-currency portion of M2 (currency today is about 10% of M2). Currency in circulation—currently about $2.1 trillion—is not an inflation threat, because no one holds currency that they don't want. The rest of M2, just over $18 trillion, is held by the public (not institutions) in banks, in the form of checking, savings, and various types of demand deposits. For many, many years M2 has grown at an annual rate of 6-7%. But beginning in March of last year, M2 growth broke all prior growth records. As the chart suggests, the non-currency portion of M2 is about 25% higher than it would have been had historical trends persisted. That means there is almost $4 trillion of "extra" money in the nation's banks. This extra money has been created by the same banks that are holding it: banks, it should be noted, are the only ones that can create cash money. The Fed can only create bank reserves, which banks must hold to collateralize their deposits. Today banks hold far more reserves than they need, so that means they have a virtually unlimited ability to create more deposits. And they have been very busy doing this over the past 18 months. 

For most of the past year I have been predicting that this huge expansion of the money supply would result in rising inflation, and so far that looks exactly like what has happened. People don't need to hold so much of their wealth in the form of cash, so they are trying to spend it. But if the Fed and the banks don't take steps to reduce the amount of cash, then the public's attempts to get rid of unwanted cash can only result in higher prices, and perhaps some extra spending-related growth. It's a classic case of too much money chasing too few goods and services. And Fed Chair Powell has just added some incentives for people to try to reduce their cash balances. He's fanning the flames of inflation at a time when there is plenty of dry fuel lying around.

Chart #3

Now for some good news. Chart #3 shows the evolution of household balance sheets in the form of four major categories. The one thing that is not soaring is debt, which has increased by a mere 20% since just prior to the 2008-09 Great Recession. 

Chart #4

With private sector debt having grown far less than total assets, households' leverage has declined by 45% from its all-time peak in mid-2008. The public hasn't had such a healthy balance sheet since the early 1970s (which was about the time that inflation started accelerating). Hmmm....

Chart #5

In inflation-adjusted terms, household net worth is at another all-time high: $142 trillion. 

Chart #6

On a per capita and inflation-adjusted basis, the story is the same (see Chart #6). We've never been richer as a society.

Chart #7

Total federal debt owed to the public is now about $22 trillion, or about the same as annual GDP. It hasn't been that high since WWII. So it's amazing that, as Chart #8 shows, federal debt has not exploded relative to the net worth of the private sector. As I've shown in previous posts, the burden of all that debt is historically quite low, thanks to extraordinarily low interest rates. 

Chart #8

Chart #8 adds some color to my prior post, "What's wrong with gold?" What it suggests is that gold prices are weak today because the market is anticipating higher short-term interest rates. The red line shows the yield on 3-yr forward Eurodollar futures contracts (inverted), which is a good proxy for where the market thinks the federal funds rate will be in three years' time. Gold peaked when forward interest rate expectations were at an all-time low. Why? Because super-low interest rates pose the risk of higher inflation. With the Fed now talking about raising rates (albeit sometime next year, and very slowly thereafter), gold doesn't make as much sense because forward-looking investors are judging the risk of future inflation to be somewhat less than it was a few years ago.

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Economics

The Post-Mortem on Evergrande and the Fed

Will Evergrande contagion impact your portfolio? … be wary of commodity trades for now … what the Fed’s statement means for the fourth quarter

It’s…

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Will Evergrande contagion impact your portfolio? … be wary of commodity trades for now … what the Fed’s statement means for the fourth quarter

It’s been a rollercoaster week for investors.

Monday and Tuesday brought panicked selling as the Chinese Evergrande debacle roiled markets. All three major indices dropped, with the Nasdaq leading the losses with a 2% haircut.

But come Wednesday afternoon following the Fed’s statement release, investors were back to “buying the dip,” as they’ve done ever since the March 2020 low.

As I write Friday afternoon, investors seem to be digesting all the news, with the markets flat to slightly down.

In today’s Digest, let’s look closer at both Evergrande and what we learned from the Fed with the help of our technical experts, John Jagerson and Wade Hansen, of Strategic Trader.

Though the market has largely brushed off Evergrande concerns, and no longer fears an unexpected announcement from the Fed, there are lingering issues investors should watch.

Today, let’s shine a light on them and see how our technical experts are sizing up the fourth quarter.

***The fallout of the Evergrande implosion

For newer Digest readers, Strategic Trader is InvestorPlace’s premier trading service. It combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.

This week, we’ve seen all of these directions, beginning with “down” thanks to Monday’s news that Chinese real estate developer, Evergrande, was struggling to meet its debt payments.

Here are John and Wade with more details:

Evergrande is a massive Chinese property developer with subsidiaries in a variety of other businesses. Depending on the day, they have assets of $1.3 trillion and liabilities of $300 billion.

Despite its size, Evergrande has become over-extended and has been effectively insolvent for quite a while.

Evergrande’s stock has been imploding this year. Below, you can see it losing 80% of value and counting since we began 2021.

Source: StockCharts.com

This issue here is the ripple effect of Evergrande’s demise. Yesterday, we learned that Beijing will be hesitant to bail out the giant developer.

From the Wall Street Journal:

Chinese authorities are asking local governments to prepare for the potential downfall of China Evergrande Group, according to officials familiar with the discussions, signaling a reluctance to bail out the debt-saddled property developer while bracing for any economic and social fallout from the company’s travails.

The officials characterized the actions being ordered as “getting ready for the possible storm,” saying that local-level government agencies and state-owned enterprises have been instructed to step in to handle the aftermath only at the last minute should Evergrande fail to manage its affairs in an orderly fashion.

They said that local governments have been tasked with preventing unrest and mitigating the ripple effect on home buyers and the broader economy, for example by limiting job losses—scenarios that have grown in likelihood as Evergrande’s situation has worsened.

***As bad as this sounds, John and Wade believe the wider issue is the impact this will have on Chinese interest rates

Back to the Strategic Trader update:

Without massive intervention, corporate borrowing in China is likely to remain expensive.

High yield debt is already back to COVID-19 crisis levels, and we don’t expect that to come down.

In the short-term that should drag on commodity prices because higher rates will slow demand in the Chinese economy.

John and Wade point out that this is already weighing on commodity stocks, so they’ll be avoiding commodity-related trades for the time-being in Strategic Trader.

We made this same point here in the Digest earlier this week. The battery metals trade, which we believe will be a massive winner this decade, is under pressure from Beijing’s efforts to tamp down commodity inflation in China.

Long-term, the Chinese government can’t keep a lid on commodity prices. But shorter-term, which is where John and Wade are focusing, yes, commodity stocks could be weak.

For shorter-term trades, keep your eye on this.

***If Evergrande does implode, will it bring down U.S. stocks?

Returning to the broader, macro picture, what’s the potential fallout if Evergrande goes belly-up?

Back to John and Wade:

Yes, Evergrande is massive and there are a lot of Chinese, European, and US banks that will suffer losses if they fully default on their debt. However, in our view, there is no way that the Chinese government will allow that to happen.

We agree that an Evergrande default would create some risk of contagion, but the Chinese government is managing a delicate balance. Evergrande’s troubles have reduced the price of housing as real estate speculators have been burned, which is good for them. However, broader financial instability would be unthinkable.

We expect the Chinese government to step into the market and “rescue” Evergrande before things get much worse. While we don’t think that will bring Chinese interest rates down, it should be plenty to avoid a meltdown. Intervention in September or early October appears most likely.

If we are correct about an Evergrande bailout, then the volatility hitting U.S. stocks that has been triggered by the Evergrande default should calm down in the short-term.

I’ll point out that the Wall Street Journal article quoted above reported that local Chinese officials were instructed not to step in and help until “the last minute.” To John and Wade’s point, such language does suggest that China won’t allow a complete melt-down.

***Switching gears, what about the Fed, tapering, and interest rate hikes?

On Wednesday, the Fed held its benchmark interest rate near zero, but indicated that hikes could be on the way sooner than some had expected.

Here’s John and Wade with more:

The committee kept things vague (Wednesday) by saying “a moderation in the pace of asset purchases may soon be warranted,”. The Fed keeps things very vague when they are pushing the timeline for a change out further into the future.

So, we feel that (Wednesday’s) statement adds confidence to the estimate that the Fed will resist a taper until late this year or once the hiring picture improves.

After the Fed’s announcement on Wednesday, stocks rallied. But John and Wade, who wrote their update on Wednesday afternoon, suggested caution:

Drawing conclusions from today’s market action will be difficult. Fed days are always volatile and are prone to price reversals.

It will likely take investors a day or two to settle down before we can get a good read on how the Fed’s forecast that tapering should begin “soon” and that some members of the committee expect that rates could start to rise in 2022 will affect sentiment. 

To John and Wade’s point, yesterday the buying continued, with all three major indices climbing. But as I write Friday, the markets are either flat or down.

***Wrapping up, weighing all these factors together, how do John and Wade size up today’s market, and where we’re headed in the fourth quarter?

Here they are with their bottom-line:

Despite the outstanding issues of the Fed’s announcement today and the Evergrande crisis in China, the pullback in the S&P 500 has remained within normal ranges for a bull market retracement.

Market volatility is always frustrating, but we expect investors to start pricing in another stellar earnings season in October; that should lead to a bounce in the major indexes in the short-term…

We remain optimistic that monetary policy will remain stable enough to support stock prices in the fourth quarter.

Have a good evening,

Jeff Remsburg

The post The Post-Mortem on Evergrande and the Fed appeared first on InvestorPlace.

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