Tonight, I’d like to expound on the recent musings from Chris Whalen, titled, “Bank Earnings &Volatility.” Whalen stresses that the FED will not be selling assets but merely ending “its reinvestment of cash when securities are REDEEMED,” (emphasis mine). In what I consider a key point raised, Whalen said, “Yet as we and a growing number of investors seems to appreciate, the FED cannot force up long-term rates so long as it is sitting on $4 trillion worth of securities THAT IT DOES NOT HEDGE. More given that the Treasury intends to concentrate future debt issuance on short-term maturities, downward pressure on long-term bonds yields is likely to intensify.” Whalen also said, “What the FOMC has done to the markets via QE is essentially reduce potential volatility by holding securities and not hedging these securities.” The key point is enhanced by the fact that both the ECB and BOJ do not hedge their security exposure either so volatility has been diminished by the reduced hedging.
Dynamic hedging by market participants is an important piece of the signaling mechanism to the debt markets. It is a dimension of the market that has been suppressed by the will of the FOMC to control prices through the massive accumulation of debt. Its importance will only grow as the bond vigilantes return. Those involved in risk parity trades are being put on notice. Whalen concludes with the following: “More important for Chairman Powell, a flat yield curve will demonstrate to the markets and Congress that the majority on the FOMC has not the slightest idea how their policy moves impact the real world of money and credit.”
It has been a mantra of NOTES FROM UNDERGROUND that no matter how sophisticated the math of the FED‘s models IT ‘S NOT ROCKET SCIENCE. Unlike NASA, the FED has no clue how to return the space vehicle to a specified landing site. But if Whalen is correct then the YIELD curves will play a very significant role in our trading/investing strategies this year.
As an aside to this analysis, I want to point out a recent paper by the St. Louis Fed titled, “FOMC Dissents: Why Some Members Break From Consensus.” The traditional bastion of monetary analysis tries to establish some pattern to dissenting votes at FOMC meetings but fails to establish anything that FED watchers don’t intuitively anticipate (i.e. Esther George and now Minneapolis President Kashkari). What the paper revealed is that since 2005 NO FOMC GOVERNOR HAS DISSENTED. In the most tumultuous period of monetary policy in the history of the Federal Reserve not one sitting GOVERNOR has disagreed. It suggests that the central bank is an insiders’ club tolerating zero dissonance, which is what Bernanke means about zero as the lower bound. Where have you gone Larry Lindsey? Our nation turns its lonely eyes to you.
***There were recently two important stories out of Europe. The Financial Times ran a story in Tuesday titled, “German Metal Workers Strike Over Pay and Conditions.” It has been more than a decade since German industrial workers have had the temerity to even ask for a significant wage increase, let alone pursue the picket lines. German unions were always much stronger than everywhere else until the Hartz IV initiative invoked by SPD Chancellor Gerhard Schroeder forced labor to accept wage freezes and tighter work conditions in order to keep jobs from moving to the newly liberated workers of Eastern Europe (NAFTA on the Rhine). The labor market is tight and the unions are pressing for their share of the German boom. “Uwe Houck, the chairman of the Porsche workers’ council, told a rally outside the carmaker’s Stuttgart plant: ‘Our demand for 6 per cent more money is more than fair. Earnings are soaring, the coffers of employers are full. To offer us only 2 per cent is not just quixotic–it is a disgrace.'”
The French, Italians, Spanish and others will be cheering on the German unions as they want wages to rise far above the rest of Europe in an effort to make their products more competitive. The German corporations and Bundesbank will try to thwart the will of the unions because the Bundesbank cannot counter higher wages with increased interest rates in an effort to slow the economy. Germany is booming, inflation and wages are rising at the expense of German savers. Remember to ask: Whose currency is it: The Germans’ or the Italians’?
Second, as the Italian election campaign begins, Silvio Berlusconi has decided to pull a page from Donald Trump and put forth the idea of a tax cut/flat tax as a platform for his center/right party. The problem is that with the Italian debt-to-GDP ratio at an elevated 132% it is difficult for the Italians to cut taxes since it will increase the Italian debt (yes, Kudlow I know, Arthur Laffer), causing angst in Brussels and Berlin. It seems that Berlusconi wants to cut taxes because it is the only avenue to stimulate growth. Since the end of World War II the Italian response to a slow economy was increase spending and depreciate the currency (then the lira). The Italians no longer have control of their currency so the only path is increasing the debt.
Berlusconi knows he can violate all the rules of the Maastricht accord because if the Europeans were terrified of having the Greeks default and leave the euro there is nothing that the EU can do to harm the Italians. A debt default or exit from the EURO by the Italians would send tremors through the global financial system causing a major financial collapse. The ECB is loaded with Italian debt, public and private, while the Bundesbank is laden with Target2 assets from Italy of nearly 400 billion euros. The Germans are the creditors to massive amounts of Italian liabilities and through the efforts of President Mario Draghi. Silvio Berlusconi knows he is too big to fail. This is the state of Europe as we head into the political season. (Read the Rotten Heart of Europe in order to know the European actors and political economic landscape.)
***Two rumors from SOURCES: First, China is said to not buy a full load of U.S. Treasuries (this was unnamed Chinese sources). I believe it was planted by somebody short bonds who wanted an opportunity to cover short positions (sarcasm intended). The second rumor was reported by unnamed sources to Reuters was that U.S. will probably leave NAFTA. I used this opportunity to buy Canadian dollars as it dropped 1% on the chatter. I also bought some more Kansas Southern Railroad stock (KSU), a company I recommended at $91 as a play on Mexico. These are trades within my risk tolerance as I believe that Trump will not leave NAFTA, especially since he has just received feedback from the U.S. agricultural sector, which has greatly benefited from trade with Mexico. Trump’s base consists of RED STATES that are weighted toward the agrarian economy.
The Republicans are already worried about losing the Senate and possibly the HOUSE so Trump would not be a “stable genius” if he harms the pocketbooks of the red states. Low risk at today’s levels but I was patient and found an opportunity in the rubble caused by unsubstantiated rumors. Also, KSU is interesting because all the auto manufacturers yesterday announced December’s results and the constant was the enormous increase in exports out of Mexico to many different countries. Those autos are carried on KSU freight trains. In addition, KSU is the missing piece to Berkshire Hathaway’s complete dominance of the North American railroad puzzle.
***Warning to all traders about central banks: They are not to be believed. A few days before the Swiss ended the EUR/CHF PEG, SNB Chairman Thomas Jordan stressed that the 1.20 PEG remained the cornerstone of Swiss monetary policy. The SNB removed the peg three days later. In its release on January 29, 2016 meeting the Bank of Japan adopted a negative interest rate policy for the first time.
When the Guardian reported the results of the meeting, the paper cited the close vote of 5-4 to enact the shock decision. It also noted that, “The surprise decision came just days after the bank’s governor, Haruhiko Kuroda, suggested he had dismissed any drastic easing measures to boost business confidence.” The YEN dropped 3 percent on the “surprise.” The bottom line is do your analysis and don’t believe what your ears hear when your work reflects otherwise. There is always some narrative being promoted by those who desire access to the rich and great. Not at Notes From Underground, where 2+2=5.