MACRO DIGEST: FED: One-and-done? / Stress Indicators / Credit cycle peaked in June 2014

First the analysis of FOMC: There remains only one question of relevance for the future cost of capital: Will Fed do one-and-be-done (or max two) or will they start traditional rate hike cycle?

 

Yesterday FOMC gave us a clear indication: They believe they will hike twice this year. (September /December) – and then go slower at 100 bps per year.

 

In the chart below yellow represents the slower hike cycle now in place – It's of course still above the "consensus of Wall Street" but even Wall Street is beginning to understand that FED hikes will not be based on economic data alone but an almost desperate need to normalize the monetary policy.

 

 

I personally think both are wrong – to me the higher and more aggressive Fed in balance of 2015 will "kill" the nascent growth pulling US and Europe back towards zero growth which will give us one more look at all-time low interest rates before we start new secular change.

 

Of course, the more direct play is to wait for Fed to hike twice and then go short "cost of capital" as in short equity and bond vs. long commodities and EM with a weaker US Dollar….but I still see total move of +100 bps from low in Germany and US yields to top in 2015 – then a sell off / recession, then the REAL START on a new cycle based on the true improvements coming into the micro economy:  Better lending demand, monetary aggregates rising, Silk Road closer to being online, big and improved current account balance, lower average price of energy… The move of money from non-productive "paper money" in Wall Street, to Main Street. The reversal of the 80/20 rule I so often have mentioned.

 

The reason this recent move higher in yield is "false" is that it's only  the "term premium" which is going up or in plain English: It's the inflation compensation in the bonds market which is rising without economic growth to support it….Interest going up on higher demand and growth is fine, interest going up as monetary derivative is often dangerous, please remember we come from zero inflation, zero growth and zero reform. The move out from zero bound will be full of false starts and disappointments.

 

The consensus and Fed position is now roughly like this:

 

Fed: Two hikes in 2015 – then 100 bps per year from there onward.

Wall Street Consensus:  One hike this year and then 125/150 bps next year and then 100 bps onwards. (Why is it sell side always sees next year as the time to "change" – never this year?)

 

Part of the difference in future path is based on your premise/assumption of long term growth potential. The US used to be 3.0-3.5% but now it's more likely 2.0-2.5% - this has big implication on FED and the analysis of it: Of course if "new lower growth" is accepted to be 2.0-2.5% the threshold for hiking is also equivalently lower! The study supporting this claim was the following:

 

Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy by the FED economist': Dave Reifschneider,William L. Wascher and David Wilcox

 

 

 

 

The more pertinent question however – and the major risk to Fed expected slow and gradual rate hike cycle is lack of trading liquidity. Citibank did excellent job this morning of putting it into context and graphs in a report called:  US Economic Views: FOMC Edition:

 

 

This chart shows how the biggest eight market makers VaR has gone from 1.4 Billion US$ before the crisis to less than 400 million. This is one of the "quantative" charts I have seen on this illusive "risk capital". This VaR is the grease which keeps the trading engines humming. We are basically playing the game of musical chairs – not in its traditional version with one chair missing when the music stops, but…… four chairs missing. This makes for more volatility and excessive moves when investors moves their money across asset class'. Trust me – there is simply too small a market to cater to a world of finance where every mom and pop have major portfolio in ETF and Mutual funds and where everyone like in 2000 is either major real estate developer or "major trader/investor" – a good example being that in the last three month in China more than 5.000 Hedge Fund has been started. 5.000! There is just about 8.000 hedge fund active at any time in the rest of the world!

 

 

 

 

 

 

 

Comment: Test of 50 support line – we had nice bounce today, but "marginal cost of capital" is rising…

 

 

Comment: As expected we see sign of classic seasonal mean-reversion in US data…….

 

 

Comment: Citigroup's Surprise Index supports the mean-reversion theory-  Nice bounce and timely for FED September hike

 

Comment: New chart – Merrill Lynch Option Volatility Index – Note and reference – the 2013 spike was the Taper-tantrum – keep an eye on this one for "Musical chairs in bonds"

 

 

Comment: Financial stocks didn't like the slightly higher probability of September hike…

 

 

Comments: Reflection of credit cycle? Peak was in June 2014---- A year go!

 

Closing with my latest bigger macro calls:

 

Here's a reminder of the main points of my major strategy change as detailed in an article on May 18:

 

The headlines for the next 6-7 months say:

• US, German and EU core government bonds will be 100 bps higher by and in Q4 before making its final new low in H1 2016. US 10-year yield will trade above 3.0% and bunds above 1.25% 
• Energy: WTI crude will hit US $70-80/barrel, setting up excellent energy returns. 
• US dollar will weaken to EUR1.18/1.20 before retest of lows and then start multi-year weakness. 
• Gold will be the best performer in commodity-led rally. We see 1425/35 by year-end. 

 

 

Med venlig hilsen  |  Best regards
Steen Jakobsen  |  Chief Investment Officer

 

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