Paradigm Shift

According to our calculations, the first three months of 2021 was the worst time to be invested in long-dated Treasuries since at least the Great War, with a holding of notional, constant maturity, current coupon, 20-year bonds losing no less than 14% and so beating even the Paul Volcker-inspired 13.8% rout suffered in early 1980.

Notably, the back-up in yields was accompanied by the Primary Dealers dumping $62 billion in their own net longs in the three weeks to Mar 24th and cutting their joint UST & MBS financing needs by $200 billion in the six weeks to that same date.

Perhaps of greater import, those categorised as ‘Asset Managers’ by the CFTC, jettisoned net longs in record amounts, dumping a notional $96.4 billions’ worth of 5-year to 30-year note and bond contracts in a liquidation which – in combination with the shortening of duration on the balance which the rising yields implied – cut their exposure by a whopping $1.3 trillion of 1-year equivalent risk.

In arithmetical terms, the 75bps long-end move surpassed anything more recent than the exceptional bounce back from the panicky ’flight to quality’ provoked by the Lehman collapse; it matched the storied bond rout of early 1994; and it was last significantly surpassed by the quarter leading to the fabled Crash of ’87. In percentage terms, it was of course much worse than anything then experienced, hence the damage to prices and returns.

Despite the many coincident predictions of Armageddon which, we were assured, would be the immediate consequence of any substantial rise in yields, the quarter also notably saw the broad US stock market gain 5.5% and the rest of the world’s equities add 3.6%, of which latter the EM component managed a 2.3% rise (all calculations using the MSCI indices on a total return basis).Continuing our theme of buying neutrons and protons, rather than electrons, ‘Growth’ managed an increment of something less than 2%, while ‘Value’ put on more like 10% (dependent upon whose indices you use).

Though the final days of the quarter inevitably saw some slippage, the everyday useful commodities returned 6% (agriculture), 9% (industrial metals), and 21.5% (energy) while the more financialized kind (precious metals) shed 9% in round numbers.

Again defying the doom-mongers’ prognostications, we should note that the S&P financials index put on 15.4% to reach new highs and finally take out the pre-GFC/pre-COVID double top, a break also achieved – if with progressively less conviction – as we move down from the large-caps through the mid- and onto the small-cap ones.

Rising yields were clearly not enough of a potential drag to offset the benefits of a steeper yield curve and, for the bigger beasts, the juicy extra fee income to be earned by participating in, e.g., a record breaking QI for M&A ($1.3 trillion globally) as well as on the (yes, record) $346 billion in equity offerings and the $2.5 trillion of new debt issuance (of which another record $205bln came in the fatter -fee’d high-yield sector).

Nor was there much evidence of dampened enthusiasm in the rowdier sections of the market as evidenced by the barn-busting 298 SPAC launches worth a total of $96.7 billion – a sum already 15% greater than that accumulated during the whole of 2020’s then-record year and 40% ahead of the entire take for the 17 years preceding that.

Wondrous indeed are the effects of the systematic destruction of market pricing and the removal of capital discipline which the central banks of the world have accomplished through their historic levels of money creation, exemplified by the Fed and ECB’s joint, $100 billion-a-WEEK expansion of the monetary base, or their $7.4 TRILLION, 75% joint balance sheet growth since late February last year. [The usual caveats apply about the fuzziness of these two measures when it comes to the creation of actual, spendable money but it is clear that such hyperactivity can hardly fail to make itself felt, up where the wonga hits the wallet]

Since the final week of the quarter, some signs of stability have at last been evident with both Primary Dealer and Asset Manager positions showing a modest accumulation of risk – an amelioration which, so price action tells us, has carried forward into the new month.

The combined influence of portfolio ‘rebalancing’, the renewed wave of lockdowns afflicting Europe, the presumably snow-affected slackening of tempo in the US data for the final winter months and some hints of a cooling of the Chinese economy have therefore brought a little calm to fixed income – not least in reversing some of the rapid curve steepening, as well as in dampening down volatility readings.

Will it last? Have we seen the end of the liquidation, or is this just a lull in the tempest, a regathering of will and a time for reassessment before the onslaught begins anew?

A purblind Argus, all eyes and no sight

The central bankers who have brought us to this pass through long years of mission creep, mandate stretching, and outright, ultra vires arrogance are now trying to play it both ways.

On the one hand, they are not only still fixated on pushing CPI gains lastingly higher, but they are now beginning to salivate at the prospect of driving social and economic re-engineering on an unimaginable scale by chiming in, not just for traditional New Dealerism, but by hopping aboard that bandwagon of bien-pensanterie which is pulled along by the paired hobby horses of ‘climate’ and ‘social justice’.

On the other, they are anxious lest the rise in bond yields both signal the end of the market’s forced deference to their will and bring the whole, increasingly over-leveraged superstructure of inflated asset prices crashing about their ears. They are increasingly, therefore, to be heard talking out of both sides of their mouth – promising to keep ‘stimulus’ measures in place until their arbitrary targets for CPI growth are met and even exceeded, yet simultaneously trying to reassure that the probable overshoot of that gauge in the coming months will be merely a ‘transient’ phenomenon, to employ that suddenly ubiquitous term of pre-emptive exculpation.

A particularly striking example of this came from the ECB’s chief tea-leaf reader, Philip Lane, the other day, as he engaged in a series of economic and terminological contortions in order to say that the Camp Covid incarceration project had boosted a selection of prices more strongly than it had reduced others and that while the coming months would add to this a series of ‘basis’ effects (unfavourable one-off comparisons), the associated upswing would not alter his blind adherence to the doctrine that inflation was structurally ‘too low’.

At least, that‘s the gist of the apologia we think the following word salad was intended to convey:-

“It is also plausible that the relative price movements in the pandemic had a net impact on aggregate inflation due to a convexity effect. To the extent that some production inputs cannot be adjusted quickly, production functions will exhibit convex marginal costs, due to diminishing returns. In this situation, the price increases for those items experiencing a surge in demand will be larger than the price declines for those items experiencing a drop in demand: this convex pattern… may have contributed to some ‘missing disinflation’ during 2020, given the relatively limited decline in overall inflation compared to the drop in overall expenditure. This convexity pattern is not likely to be persistent: to the extent that the shift back to normal expenditure patterns is anticipated, demand-supply mismatches should be less severe.”

“Missing disinflation” is a nice touch, as I’m sure you will agree, as its spurious sophistication allows Lane to avoid the direct admission that prices actually went up, not down, as he seems to have expected.

Even more mealy-mouthed was the blatant piece of special pleading which this next passage displayed:-

“Analysis of the recent evolution of some reference measures of market-based inflation compensation shows that similar but more pronounced upward moves were observed in the United States, with inflation expectations in advanced economies exhibiting a striking correlation with the price of oil.”

I had to wipe my cornflakes from the monitor on reading THAT piece of effrontery. As regular readers will no doubt be aware, the over-veneration of break-even inflation measures and especially the solemn invocation of the 5-year 5-year forward version as some sort of macroeconomic Oracle is a particular bugbear of mine – one that I routinely disparage by pointing out that, far from representing some profound, carefully calculated assessment of likely future conditions, IT TENDS TO SHADOW TODAY’S SPOT PRICE OF OIL!   

Out of thine own mouth will I judge thee

More in that vein came from Vitor Constâncio, ex-VP of the ECB, using a Twitter thread to try to debunk the fears of a ‘growing chorus’ of those foreseeing troubled times ahead. We shall deal with his arguments here in some detail, not because the man himself is some peerless fount of knowledge but because it so typifies what the members of the Apparat are thinking.

“Inflation is increasing this year because of oil and pent-up demand one-off effects. Still, the hawks are invoking all possible inflation causes to justify their warnings.”

Calm yourselves, children, he begins: your Elders and Betters do not share your worries:-

“However, all official institutions, national and international, are not forecasting high inflation. Taking into account this years one-off shocks, the FED projects inflation this year and next to be only 2.4% and 2%, and the ECB forecasts the low levels of 1.5% and 1.2%.” 

Apparently, those of us led to disregard such emollient predictions through some combination of a working knowledge of economic theory, a degree of direct personal experience, and a familiarity with economic history, are to be seen as “hawks… attempting to resurrect zombie monetarism of yore based on recent temporary money increases.”

Did the man say, “temporary”? Temporary?? Where has he been this last twelve years or more?

To help us overcome our paranoia, Señor Constâncio kindly proceeds to try to ” assuage [our] misplaced and exaggerated concerns” by asserting that “…historic [sic] high inflation episodes in the US and the EA [were], clearly linked either to wars or significant oil shocks… What shock could possibly lead to a process of sustained high inflation?”

Leaving aside the hopefully remote prospect of large-scale military hostilities breaking out (pace, Taiwan and the Ukraine], He seems to have overlooked the so-called “War on Covid”, the “War” on Carbon, the “Wars” for “Social Justice”, “Inclusion”, “Diversity” and so forth, each of them demanding of large-scale, open-ended government outlays of a kind which his former colleagues at the relevant central banks are currently all too eager to finance. In respect of this, he might do well to recall the old 1960s quip that Lyndon Bird Johnson declared Wars on both Vietnam and Poverty and ‘lost them both’, leading the US into inflationary ruin as he did.

One might also note that to blame ‘oil shocks’ for the disasters of the 70s and early 80s is patently to over-trivialise matters which, for one thing, overlooks the whole vexed issue of the ‘stagflationary’ disproof of  four decades of Keynesian dogma.

Moreover, why were the results of the oil price hikes also not ‘transient’? Why was there not simply a shift – albeit a disruptive one – in relative, not average, prices? Why did ‘core’ CPI spike higher in 1981 even though oil was by then DOWN on the year? Why was there no reaction to the comparably sizable rebound in 1999/2000? Why did the dogs not bark particularly loudly when oil rallied all the way from 2002-2008? Could it possibly have had anything to do with the failings of monetary policy at the time?

The truth is that the monetary breakdown of 1968-71 was arguably as much a cause of the oil price rise as an effect thereof – not least in that OPEC members were publicly fretting over their loss of purchasing power well before the Yom Kippur War broke out. Notably, too, the Soviets’ ‘Great Grain Robbery’ of 1973 – a demarche by which they bought up much of America’s inventory before the world realised they had suffered a major failure of their own harvest -contributed arguably as much. Indeed, over the course of the 70s nearly every major agricultural product underwent dramatic rises in prices, doubling, trebling, quadrupling and more to touch extremes which, in some cases, were to take until the 2000s’ rally to better; some of which (e.g., sugar, coffee, canola) have still yet to be o’ertopped. Additionally, at last freed of (overt) official intervention, the explosive moves in silver and gold were both a symptom of and a stimulus to the rush out of currency which was underway.

But our Vitor will not be halted now he has the bit between his teeth. He next tries to show that ‘inflation’ (rising consumer prices) have not in any way responded to an expanded monetary base.

But this too, is jejune. In a world where traditional reserve requirements have long been annulled and are therefore no longer binding, being replaced instead by a hodge-podge of bolted regulatory stable doors pertaining to such things as supplementary leverage ratio, more general liquidity ratios, and notional capital adequacy targets, the flood of the archaically-denominated ‘high-powered’ money churned out by the Fed and its peers has often turned out to be a substitute, not a catalyst, for commercial bank money creation.

This functional sloppiness has further been aggravated by the idiotic imposition of ZIRP and NIRP policies –  a folly which has removed all distinction between relatively passive savings accounts and the more economically active ‘transactional’ kind, much as Sho-Chieh Tsiang warned would be the case, well over half a century ago when Milton Friedman first proposed such a measure.

Ironically, in light of Philip Lane’s comments, discussed above, Vitor  next tells us not to fear inflation because the Delphic 5y5y forward reading has NOT, in fact, moved substantially higher. Oh, là là!

Whichever of these two you trust to read the entrails correctly and so divine the true will of the Gods, we would point out, once again, that the housewife who lays in an extra store of baked beans or the entrepreneur who borrows to buy a new machine tool based on their knowledge of this piece of financial market arcana simply does not exist.

Io, Saturnalia!

At this point, Constâncio permits himself a moment of self-assurance as well as an exhortation to adopt policies which are highly likely to negate any grounds for it:

Naturally, there will be (hopefully) a moderate increase in inflation in the next few years and consequently on nominal on market interest rates, while low real market rates can continue to help a robust recovery. Both the EA and EA must be run as “high-pressure economies”

Excuse me? “Low real market rates… continue to help a robust recovery”??

Aside from the fact you and your ilk have effectively precluded the establishment of healthily self-generated ‘market’ rates (now very much ‘unreal’ in the other sense of the word), why then have we not enjoyed such a Nirvana these past 12 years of their imposition? Did ‘whatever it takes’ turn out to be too much for you to accomplish? Or do you perhaps suppose that falsely suppressed, low ‘real’ rates have been as much the cause as the cure of the Continent’s long malaise?

But now, we are building to a final crescendo – one which, like all career-minded declamations, advocates ever more intervention by the state and an ever more rapid progress along the Road to Serfdom.

“US authorities are indeed working to achieve a demand-driven ‘high-pressure economy’ even risking some overheating. The Fed said it is aiming to inflation ‘moderately above 2%’ for some time. The whole experiment can be seen as an attempt to overcome secular stagnation.”

Again, one wonders why our enduring, low (sub-zero, even) ‘real rates’ which are supposedly so salutary,  have not long since ‘robustly’ dispelled any fear ‘stagnation’. Ah, but wait! Here come the usual pantomime villains to take the blame for the shortfall:

“Unfortunately, Europe is preparing for a largely insufficient fiscal policy. The ‘Next Generation EU’ package is being delayed by the German Constitutional Court, and no country intends to use its loan part of €350bn, as the rules of use would imply increases in deficits. The US is trying to experiment with policies to fully overcome the crisis, while Europe is lingering under the burden of its ghosts and fears. The EU, a relatively closed economy [so NOT the world’s ‘largest free trade zone’, then?] disposing of a strong currency and a sizable external surplus, could do more for its citizens.”

Yes, indeed. The EU could return to the lessons of the Wirtschaftswunder and La Dolce Vita. It could ponder upon Erhard, Einaudi and other guiding sprits of the era of post-war prosperity and cast aside the stultifying, weather-vane intrusions of Macron, Merkel, and Mario Draghi. But, as we know, what we are going to get is not just ‘more of the same’, but the ‘same’ magnified as much as the ECB’s printing presses will allow. As the Teflon Technocrat, Madame Lagarde herself boasted, in a pale imitation of her Italian predecessor: “The markets can test us as much as they like.” Words which may well come back to haunt her.

In conclusion, we must also note that the concept of ‘secular stagnation’ was a Keynesian canard the first time around when Hansen proposed it in the 1940s – a fallacy soon revealed by the post-war ‘inflationary’ boom and even more discredited by the long years of expansion – ‘Les Trente Glorieuses’  – which succeeded it.

Once again, irony abounds in the fact that he most recent, most fervent advocate of the thesis has been none other than former Treasury Secretary and one-time member of the ‘Committee to Save the World’, Larry Summers. In a rather delicious reversal, Summers himself is now being excoriated by the Biden Brain Trust for his vocal criticism of their man’s ‘stimulus’ proposals – fulminating in a recent TV interview that:-

“What is kindling is now igniting. I’m much more worried that we’ll have either inflation or a pretty dramatic fiscal-monetary collision. I think this is the least responsible macroeconomic policy we’ve had in the last 40 years.”

For once, Larry, we’re with you on that one.

All bond and privilege of nature, break!

As the debate intensifies over whether all this will lead to overheating or whether there is just too much ‘slack’ and ‘scarring’ in the economy, there is one crucial, psychological point to consider. The crux of this is the degree to which the ‘narrative’ has now changed among market participants, many of whom have spent their entire careers being acclimatised to the idea that central banks action comes with very few malign consequences – at least, for financial markets themselves. If you can drive the yields on an effectively bankrupt Greece under 1% and still attract buyers, you can go a long way toward persuading them of your omnipotence.

However, the re-emergence of inflationary concerns may at last be challenging this assumption. If you really are worried that the Lender of Last Resort has not only become the Lender of First Resort, but that has now placed itself fully at the command of the Spender of First, Last and Every Resort – i.e., the government – then you no longer see the central bank’s repeated avowals of their intention to keep the throttle wide flat out as a put option, at worst underpinning the nominal value of your bond holdings, at best driving their only significant source of returns, but rather as a call on the destruction in real terms of whatever value still resides there.

Just as the hapless Reichsbank destroyed the mark in the 1920s by vainly trying to make up for in volume what the currency was daily losing in value, the perilous notion of trying to cap long yields while covering an increasingly large fraction of ever expanding government outlays is eventually going to lead to fiscal-monetary chaos.

As a pithy encapsulation of the open-ended nature of those expenditures, we need look no further than a Tweet pertaining to Biden’s spending plans which was posted by a ‘progressive’ (read: extreme leftist) US Senator, Kirsten Gillibrand. In this, she proudly declared: “Paid leave is infrastructure. Childcare is infrastructure. Caregiving is infrastructure.”

Though this ludicrous utterance instantly drew much well-deserved ridicule it was also widely retweeted and ‘liked’. In essence, it shows that politicians now think they have discovered an inexhaustible trove of fairy dust; that whatever causes they espouse, whatever fantasises they indulge, whatever ambitions harbour; whatever favour they have to curry, whatever the quid they must now render for their past pro quo’s, Jerome Powell’s Federal Reserve will be only too happy to write the necessary cheques to the enthusiastic applause of innumerable practising ‘economists’.

Nor should we imagine that such a mentality is solely an affliction of those inside Washington’s Beltway. As Constâncio bemoans, the EU may well prove as inept as ever in putting such policies into action, but we would be foolish to assume they will not eventually find a way to throw the ECB’s limitless alms at any chancer astute enough to ask for it. For its part, Britain is already looking well beyond the debacle of its Stop-Start COVID responses and, having already ‘spaffed’ £300 billion or so of the monies so thoughtfully provided by Governor Bailey at the Bank of England, has acquired a dangerous taste for a Hogarthian level of profligacy. Nor are Canada, Australia, or many other countries lagging too far behind.

The problem here is evident. The initial rise in prices will be ignored, as we have repeatedly been assured. But, if they do not indeed prove to be ‘transient’ as advertised, the impact on grandiose programmes of state ‘investment’ will be substantial, not least because these will typically be inefficiently (if not actually corruptly) managed by too many people with no financial – rather than merely electoral – skin in the game wielding too many blank cheque books. Sunk cost fallacies will predominate (as they arguably have with regard to COVID ‘lockdowns’ and other NPIs, for example).

Once costs begin to spiral, the pressure on the budget will intensify and with it will grow the temptation to indulge in even more monetary financing of the mounting shortfalls – something which will naturally only serve to increase costs and widen the deficits yet further. Moreover, if we are to undertake a complete re-engineering of the industrial world’s energy provision, power delivery, logistics network, transport systems, and construction methods all at the same time and all under the same ‘soft budget’ lack of financial discipline, the scope for confusion, misscheduling, resource misallocation, bottlenecks, labour militancy, dog-eat-dog competition, export bans, and other sources of both domestic and international friction are likely to be immense.

Before you start enthusing too much about ‘Building Back Better’, ‘Green New Deals’, and ‘Fourth Industrial Revolutions’, bear in mind that, in a series of detailed analyses of what they term ‘megaprojects’, teams variously led by Flyvbjerg, Ansar, and Budzier found that, in decreasing order of budget-busting, half of all IT schemes overrun by a median 107% in REAL terms and take 37% more time than foreseen to complete while 9 of every 10 rail projects come in 45% over their (constant dollar) budget and 45% over schedule. For energy, three-fifths of all undertakings overrun to a typical tune of 36% and take almost two-fifths longer to deliver than had initially been planned. Close behind we get bridges and tunnels: 9 out of 10 require a third more money and the timeline stretches by a quarter. Road projects, finally, see another 9 out of 10 overshooting and typically cost 20% on top of the accepted bid price while taking 38% longer to bring to fruition than promised.

Imagine what it will be like when we try to do all of these at once.

As if all THIS is not enough to generate misgivings, consider, too, that all of this Five-Year Plan, soft Stalinism will be taking place alongside a body of genuine, private investment which may initially  become more aggressively optimistic when entrepreneurs see all those newly-printed dollars beginning to burn holes in the pockets of the government’s army of employees, contractors, and suppliers.

If something of this sort does take root – and if it is accompanied by a continued insistence on capping nominal, much less real, interest rates at risibly low levels, we will not so much be burning the economic candle at both ends as setting light to something made from dynamite rather than beeswax.

Under such circumstances, your precious 2 3/8% of May 2051 may well still trade around but what that meagre coupon, much less the notional principal, will buy you when you try to spend  it, might be a very different matter entirely.

Economic Snapshot

Given the above graphs, showing just how far below par many of the world’s most heavyweight industrial and commerical powers still are, what do suppose will happen to resource availability – and hence prices – if and when their shops, offices, restaurants, and theatres ARE ever allowed to re-open?

Market Observations

[NB: Market charts courtesy of TradingView.com and Investing.com]