QE Black Hole

There will be $433 billion in US government debt issued from July to September 2019.  That is a run rate of $1.7 trillion in new US government debt per year.  That is the biggest pace of debt issuance ever.  No wonder the US economy is stronger than all the other developed economies.  The US fiscal stimulus is already massive, and yet, its not enough.  They want more.  Infrastructure.  Medicare for All.  Student debt loan forgiveness.  Universal basic income.  Tax cuts 2.0.  Bigger budgets. 

As the US population gets older, entitlement spending will go through the roof.  Even without the big increase in government spending, the trend in entitlement spending guaranteed a big increase in budget deficits.  But you have both.  That is a debt bomb.  And it will happen under either Republican or Democrat control. 

There is only one long term solution to fund these deficits.  No, not higher taxes.  Never higher taxes.   The populists who are now running the show will never accept higher taxes.  That leaves only one solution: 

Debt monetization.  Or the more common euphemistic term:  quantitative easing.  The only way to ensure ample liquidity while the US government sucks up most of it through its huge deficits is to cut interest rates and do QE.  That is the only way out.  You raise taxes at the end of the cycle like we are in right now and you are asking for a monster  recession. 

The White House and Congress are like the Fed:  they will do anything to mortgage the future, pull demand forward, in order to prevent a recession.  QE is where debt goes to die a silent and peaceful death.  There is no pain, only pleasure....if you have either 1) the reserve currency, or 2)ample current account surpluses.  If you have neither, you are a Turkey, or an Argentina.  Your currency crashes, there is rampant inflation, and financial chaos. 

The United States is turning into a gigantic banana republic, a country that relies on a reserve currency to maintain currency strength while running extremely loose fiscal policy and what will soon be extremely loose monetary policy.  If the dollar reserve currency status fades away, the US consumer will be in for a rude awakening. 

The big event for the week is the FOMC meeting tomorrow.  I am neutral on the outcome, as I expect Powell to cut 25 bps and be dovish, but that is what almost everyone else expects, so I don't expect any big moves.  There is a lot of easing priced into the Eurodollars futures curve, so it will be difficult for the front end to rally much on a dovish Powell, and there is a lot of room for the front end to selloff if Powell doesn't meet market expectations, which is unlikely, but a small possibility. 

So not much of an edge going into the FOMC meeting, but I do expect a sell the news reaction in the following days as other global equity markets continue to deteriorate (Monday it was Asia, today it is Europe) as the S&P 500 lingers near all time highs.  The tension is building, and the SPX is ready to blow.   

1-month returns:  SPX (black) +2.7%, Eurostoxx 50(blue) -0.4%, Emerging Markets ETF (EEM)(orange) -0.6%. 

Battle with the Final Boss

After the NY Fed clarified that John Williams was off his rocker by going supernova dovish in his speech last Thursday, the Fed wanted to finally tamp down the expectations for 50 bps on July 31 and called Blue Horseshoe (WSJ) and told them its going to be 25 bps on Friday. 

Yet the market is still pricing in about a 15% chance of 50 bps on July 31, so they aren't completely eliminating the possibility of a shock and awe easing cycle from Powell.   Now the ECB and their meeting today:  they are giving what the market expects.  The market wanted hints, anticipation of monetary goodies to come.  Who cares if the negative rates, TLTRO, QE, and TLTRO 2 have done nothing for the European economy.  Of course the counterfactual from the ECB officials:  if they did nothing then Europe would be in a depression, all hell would break loose, etc. 

I hear the argument about low rates justifying high valuations.  But if you question their argument by asking why US stocks are massively outperforming lower interest rate Europe and Japan, they are speechless.  Or they spew some crap about better growth in US and fiscal stimulus and tax cuts, etc.  Its not a logical crowd out there, and it never will be.  Even with all the algos running amok, at the end of the day, humans are the ones turning on the machines, and can change and turn them off whenever they feel like it.. 

It's the central bankers' world, and we're just living in it.  You can tell Fed and ECB officials love to mouth off and move the markets.  It gives them a sense of self-importance, trying to validate their existence and ego by giving out their two bit views on the economy and monetary policy.  However, they are outclassed by bond traders, both intellectually and psychologically.  That's why they have an inferiority complex towards them, obeying the bond market's directives at the drop of a hat. 

We got some good news this week with the US China trade discussions going "well", with a meeting in China scheduled for next Tuesday.  I'm sure it will be the same old song, China asking for tariffs to be removed and unwilling to change its laws to stop IP theft.  You have to give China a lot of credit, they are playing the White House like a fiddle.  Xi is playing the long game, willing to string out Trump and his chumps until they run out of patience and totally capitulate.  Its just a matter of time, as the global economy is weakening and the weakness is about to hit the shores of the US.  A weaker stock market will be the trigger for the White House to capitulate and make a quick deal with China to try to keep the stock market bubble inflated at least till November 2020 (Presidential election).  Until then, Trump will keep kicking the can, as the stock market isn't yet upset that there's no progress in trade talks. 

I have finally decided to enter the ring against the nearly invincible monster, the SPX. 
SPX has finally gotten back to levels (3015-3020) where I was waiting for to put on shorts, so I got short yesterday.  This is a longer term trade, so I won't be covering on any minor dips.  I am looking for a bigger move lower into autumn, as the lagging global equity indices I mentioned on Monday and the already high easing expectations built into the STIRs and Treasury market make it a good risk/reward shorting opportunity.  I am leaving room to add more in the next couple of weeks if I like what I see. 

SPX vs the World

Interesting comparison charts for the SPX (blue) with China H-Shares Index (black):

Similar pattern seen with the Eurostoxx 50 over the last 2 years:  SPX (blue), Eurostoxx (black)

Notice SPX going higher in July to October 2018 while both H-Shares and Eurostoxx traded sideways.  Then the SPX crash from October to December 2018. 

Seeing similar pattern of SPX rallying while both H-Shares and Eurostoxx trade sideways since early June.  Another repeat of the pattern would lead to an SPX crash this fall. 

This is an unsustainable trend of SPX outperformance vs the world.  It has been going on since 2010.  It reminds me of emerging markets outperformance vs SPX from January 2006 to August 2008.  There is a nasty SPX bear market looming. 

Attached at the Hip

These are unusual times for the stock and bond market.  The correlation between stocks and bonds has been extremely high for 2019.  It is especially pronounced on FOMC meeting days, when Powell was more dovish than expected (January, March, and June meetings), and when Powell was more hawkish than expected (May meeting).  Stocks and bonds rallied strongly in the dovish meetings, and sold off hard in the hawkish meeting.

Every time Powell has come out dovish, stock and bonds have screamed higher, the latest case being the Humphrey Hawkins testimony last Wednesday, July 10.  The times when bonds have been weaker, which is few and far between this year, it led to a quick equity market selloff almost immediately (early May, this past Tuesday).  Yesterday afternoon you had a dovish double barrel from Williams and Clarida which rocketed bonds higher which of course caused stocks to squeeze higher along with it.

It is now seered into the brains of equity traders that a dovish Fed is a buy signal.  But this is not a sustainable pattern, because as I mentioned before, the low rates fuel which has been driving stocks higher is mostly used up.  The stock market is going higher under the premise that the US economy is not weak, and therefore the Fed rate cuts are insurance cuts, which will ensure a longer expansion and continued earnings growth.  Thus, any dovish words from Fed officials is taken as a positive for both stocks and bonds.  The assumption is that the Fed rate cuts are a bonus for an economy that doesn't really need them, just added rocket fuel for the SPX.

I disagree with the assumption.  Not because I am a permabear.  I am looking at the leading indicators and they are all flashing red.  That is despite a face ripper of rally over the past 6 months.  Usually the leading indicators follow the stock market, as there is wealth effect from higher stock prices, as well as higher bond prices.  But despite both stocks and bonds up huge this year, the US leading indicators are SURPRISINGLY weak.
In fact, the leading indicators are hovering near the lowest levels since 2010, despite a booming stock market.

The relative strength in utilities and consumer staples, and the relative weakness in financials and energy are flashing amber lights.

Next year, you have the uncertainty that comes from the 2020 Presidential election, where the possibility of a non-Biden Democratic president becomes a palpable threat to the status quo of corporate welfare.  The short side is looking very appealing right now, and what better time than when most stock traders expect the Fed to save the market, when the insurance cuts are already priced into the market.  In order for the Eurodollars and Fed funds futures market to price in more cuts, there has to be real stock market weakness, not just 3-5% pullbacks.  I am talking at least 10% corrections.  So I don't see anymore bonds up, stocks up action for the rest of the year.  The correlations for stocks and bonds will become negative, as weak economic data is no longer treated as good news.  Bad will be bad again soon.

Above 26,000 Feet

We have now reached the "death zone", above 26,000 feet, where the air is too thin for long term survival.  An area where trivial tweets can cause out of the blue selloffs.  Yesterday, it was another maybe? tariff threat tweet from Trump.  When the oxygen levels are this low, the body collapses under the weight of even the most insignificant bit of news. 

After a 4 week pullback, the SPX bottomed on June 3, which was 6 weeks ago.  That is in the general 5-6 week time frame where rallies end and stall out.  Another ominous sign is the psychological break of the 3000 level, which pulls in more bulls to fall into the trap door lower. 

The biggest negative for the current stock market is the recent weakness in bonds despite a super dovish Powell last Wednesday.  Yes, the invincible bond market is finally showing signs of weakness as the recent economic data has beaten expectations.  It is not hard to guess why recent economic data is coming in stronger.  When you have simultaneous face ripping rallies in stocks and bonds for 6 months, the wealth effect is going to be double what it normally is.  That is finally seeping into the data.

As I have stated before, the economy is in a zombie-like steady state of low growth, the only thing that changes in this new economy are financial markets, so they are the only thing that matters.  Employment numbers, inflation, retail sales, etc. are not barometers for the new economy.  The new economy is the S&P 500 and bond yields.  The higher the S&P 500, the better, and the lower the bond yields, the better. 

There is no more dynamism in the economy.  The central banks have printed there way to a steady state condition, where the lack of meaningful down cycles mean that there is not enough pent up demand for big up cycles.  So the economy flat lines, with central banks feeding it more and more drugs to keep the dying patient alive. 

We are getting closer to the end game for this bull market, as the drugged up economy can't generate more growth unless you get even more massive deficit spending (1 trillion is not enough) and even lower rates (2.1% 10 year is not low enough).  On the fiscal side, there is not likely to be a fiscal stimulus until at least 2021, when we find out who the next President is, and betting markets are giving higher odds on it being a Democrat.  As for even lower rates, I don't see the 10 year yield going significantly lower unless you see an earnings recession, which means that stocks are going to be in trouble anyway despite lower rates. 

While I would like to see more optimism among the investment community to make it a slam dunk short at current levels, there are enough negative factors to overwhelmingly support the short side here.  Macro hedge funds have more long equity exposure than average which is always a good sign that there is almost no upside left. 

A few more days of slow trading will be enough to convince me to enter a short position.  I have waited longer than usual just because of the strength in bonds, and that now seems to be ending.  So I have my trigger finger on the sell button.  I plan on entering a short before the July 31 FOMC meeting, which will probably be 25 bps and be disappointing for both stock and bond markets.   

A Follower Not a Leader

In 2018, Powell bought into the strong economy story and raised rates 4 times while continuing the balance sheet runoff.  In 2019, Powell is buying into the economic slowdown story and will do rate cuts, coming up with any lame excuse he can find from the pile of BS reasons used for QE/rate cuts in the past. 

Their favorite excuse is low inflation, forgetting the fact that most of the government inflation measures are butchered beyond recognition to print out a steady stream of low numbers. 

In June, Powell came up with a new one: sustain the expansion.  But lowering interest rates from 2.25% to 1.5% doesn't really move the needle.  If he really wanted to sustain the expansion and be a leader, not a market slave, he would go straight to 0% Fed funds rate and jolt the economy for a few months.  Cutting 75 bps as the market already expects isn't going to do the job, it will probably end up disappointing the stock market which is full of excitement and anticipation waiting for rate cut goodies. 

Going to 0% will sustain the expansion, maybe for another 6-9 months, until the 2020 election gets closer, at which point the threat of an anti-corporate welfare President starts worrying corporations and thus, the stock market, and therefore the economy. 

Powell has clearly shown that he is a slave to the bond market, more than the stock market.  When the bond market was pricing in 3 more rate cuts in October 2018, he was still hawkish and only made a dovish pivot when both the stock and bond markets dropped a sledge hammer on his head to rethink his view. 

Don't expect Powell to surprise on the hawkish side anytime soon.  Fed chairmen are always looking in the rear view mirror when determining monetary policy.  December 2018, and to a lesser extent May 2019, are firmly branded into Powell's skull.  Those memories aren't going to fade away for a while, which means that rate cuts will be happening in July and September, and probably also October if the stock market doesn't make new highs. 

Powell is a follower.  Bernanke was a follower at first, and became a leader, a horrible leader, but a leader nonetheless.  He regularly surprised markets on the dovish side, leading them to forecast continuous low rates, because he saw another Great Depression around every corner, because he was afraid of the deflation boogeyman that didn't exist, and because he's a coward who took the easy way out by pumping up the stock and bond markets, thus pulling forward demand, ensuring a lackluster economy for decades after his tenure was over. 

You trade what is, not what you want.  It would make for great trading to see a Fed that defies the markets by not giving them the rate cuts that they want, causing occasional plunges lower, to keep speculators at bay.  Now its a Fed that just rolls over to whatever the market demands.  The financial markets hold a gun to Powell's head, and he's scared shitless.  Of course he's going to take the easy way out, and give in. 

100% Pure Adrenaline

Let's not call it monetary policy anymore.  Its a drugging.  100% Pure Adrenaline!  Bunds hit an all time record low in yields at -0.40%.  Behind the velvet curtain, after a lot of horse trading between Germany and France, the next ECB president is Christine Lagarde, so basically a retread from another corrupt institution. 

Germany figured the ECB is stuck at negative rates forever, so what was the point in putting their guy in there when he would be managing a monetary cemetery of opiate patients who died of overdoses. 

As the SPX hits all time highs, the 10 year yield hits the lowest levels since fall of 2016.  We have come full circle as the Fed has gone from an excruciatingly slow rate hike cycle to now being shoved in a corner by bond traders with a machine gun to their heads asking for 50 bps rate cuts ASAP. 

This is how the patient, in critical condition, is being given massive doses of morphine, combined with uppers to keep them alert and awake, trying to force life into a dying patient.  And it is working for now, as the SPX is at an all time high, even without a trade deal, just a can kick and delay of further tariffs.  All that matters is that the bond market goes up, and that is enough to make stocks happy. 

The last 2 years have told us one thing:  monetary policy is the biggest game in town.  The trade war is Division 3 college basketball.  Monetary policy is the NBA Finals.  Yes, it is much more exciting to talk about the trade war and look at what this politician says, and what that politician says.   In the end, they are all nonfactors compared to printing presses at the ECB, Fed, and all the other central banks in the world.  This is a money game.  The central bankers have full control now, and they aren't going to give up their power easily.  Only an eventual realization of the mess and a total riot from the masses can change the course of monetary history.  Which means it won't be changed.  The masses are idiots.  They got what they deserved.  NIRP forever in Europe, NIRP lite/ETF buyer forever in Japan, and a Fed that will soon follow course. 

This is the reality of the current market.  If bonds don't go down, then stocks can't either.  Bonds are a huge part of investors' portfolios.  If it acts like a super hedge like this year, there is no impetus to sell stocks.  Just hold stocks, and hold bonds.  That is what is happening among fund managers.  These are the toughest markets to crack for the bears.  Until I see some bond weakness, I dare not enter short stocks.  Because investors are in a very strong position.  Everything is working for them.  Even long term worthless bitcoin has been going much higher this year. 

These are nosebleed SPX levels, and the economy is weakening, but bond strength covers for all those flaws.  Easily.