Tagged: Federal Reserve

Bait and Switch

If I could explain monetary policy using mainly actual English words, would you still rather slit your wrists than read it?

Tough one, huh. As you consider it, people everywhere are wondering if the Federal Reserve will lift interest rates in June. You’ve no doubt heard the chatter at the grocery store and in line at Starbucks.

No? Well, since the Fed looms over the stock market like a thunderhead on the plains, we better weigh it too. Whatever the Fed decides, it’ll be contradictory.

Here’s why. Suppose you got a credit card with a low introductory rate meant to encourage you to use it. You rack up bills at Nordstrom and Amazon. To thank you for doing as it hoped – spending – your card company raises the rate.  Now you’re paying a lot more interest.  So you spend less, to the dismay of Nordstrom and Amazon.

The Fed is the credit card company and you and your spending beneficiaries are the economy. But where the credit-card company wants future income via interest on your spending, the Fed hopes sustained teaser rates will drive permanent growth by causing businesses to hire people and make more stuff.  Ah, but teaser-rate spending is temporal.

The logical hard-drive crash gets worse. The Fed follows how much you make and spend. To track inflation, it meters the latter with what’s called “Personal Consumption Expenditures” (PCE). But PCE is also the largest part of how we measure economic growth. How can it be both?

Good question – and one I’ve not heard an economist ask a central banker. But it implies that much of GDP is just higher prices. Your money doesn’t go as far as it did.

Think about it. The Fed on one hand targets inflation around 2% (PCE is 1.6%), trying to create it with teaser-rate credit-card spending. But if it passes 2%, then the Fed wants to slow it down – and yet personal consumption is key to economic growth.

The credit card company must say when your teaser rate ends.  The Fed?  It’s kept everyone guessing, periodically yanking us this way or that, for seven years. Perhaps the reason the Fed is in a logical do-loop is because measuring consumption as both growth and inflation is an impossible balancing act.

Economic growth was 0.5% in the first quarter, and PCE is 1.6%.  If prices are rising faster than economic growth, isn’t that actually contraction?  Rising debt and rising prices are the enemies of prosperity because they diminish the capacity of consumers to buy things. Yet the Fed encourages rising debt and rising prices.

No wonder the stock market is consumed with arbitrage. And now, US consumers have as much debt as in 2007 but can afford it less because money doesn’t go as far.

What should the Fed do? Raising rates is baiting and switching. Not raising is robbing savers (and inflation steals from everyone). The Fed should not have offered a seven-year teaser rate without telling anyone. But the damage is done. Let’s stop.  Purchasing power is the engine of wealth, so we need monetary policy that preserves the value of money – the opposite of current programs. Let’s reverse course.

Hard? Yes. But it beats a do-loop of rising prices and rising debt.

Dollar Ratios

My friend’s dad joked that kids are the most destructive force in the universe.

For stocks, the most powerful (and sometimes destructive) force is the movement of the dollar. The Federal Reserve and the Bank of Japan both meet today so it could soar or swoon. Since the buck holds sway, we should all of us in the capital markets from investors to issuers understand how and why.

Stocks react to the dollar because they’re opposite sides of the ledger. Debits and credits.  If money buys less, a debit, then what preserves value (stocks) increases in price, a credit.  So a “strong dollar” means more value resides in the currency and less in stocks.  A weak dollar is the opposite, and value transfers at higher risk into stocks to offset diminishing purchasing power – the quantity of things money buys.

It’s about ratios.  In the past, countries would scrounge around for a gob of gold. Then they could issue paper currency at a ratio. Played poker?  Chips are an asset-backed currency. Pay money, get chips.  Want more chips? Pay more money. The ratio is always the same so chips have fixed value and supply varies with the number of players.

Not so with money.  If Europe has spent more than it makes, its debts depressing the economy (like credit card debt constrains discretionary income), the European Central Bank can manufacture more money – bump up the chip stack without paying.  Remember our ratios?  Increase the supply of euros and prices of risk assets that preserve value, like stocks and bonds, rise to compensate.

Follow that reasoning. When money declines in value, stuff costs more. When stuff costs more, the revenues of the businesses supplying the stuff increase.  And since consumption – buying stuff – is the core way we count “economic growth” today, economies grow when prices rise.

Get it?  Yeah, it’s balderdash that selling the same unit at a higher price is growth. But that’s how governments now measure it. All central banks including the Federal Reserve thus have inflation targets. They are trying to create growth, without which most governments go broke.

Think I’m making this up?  Follow the math. You can’t print a batch of Benjamins. That’s counterfeiting. So how do central banks create money?  They issue money against the most widely available commodity in the world today:  Debt.

When you buy dinner on a credit card, the bank doesn’t reach into somebody’s savings account to pay the restaurant. It creates money. Pay the balance and that money vanishes.

Remember the ratios? Burn money and there are fewer dollars, which means the dollar rises in value, and prices fall, and economies contract (not really but that’s how we count now), and stocks swoon. Create money and the opposite occurs – everything rises.

Investor-relations people, you know the term “multiple-expansion?” It describes stocks that cost more without any change to underlying fundamentals.  This is a product of money-creation. In effect, central banks are trying to induce us all to pay more for things than they’re worth.  Value investment is the opposite: buying at a discount.

For perspective, JP Morgan is leveraged about 8 to 1.  Citigroup, about 7 to 1.  The Fed? With capital of $40 billion and liabilities of $4.54 trillion, its leverage ratio is 113 to 1.  Where money before depended on assets, like gold, now it’s backed by liabilities – debt.

The European Central Bank is buying eighty billion euros of debt a month to create money. What happens to debt? Its value skyrockets and interest rates plunge. It’s the opposite in the real world. You’re in hock, you pay the vig.  Bigger debts, more cost.

Japan is way beyond that, financing the government by directly trading yen for government debt, and now it’s buying exchange-traded funds, shifting to equities with infinite supply (ETFs can theoretically create as many shares as demand requires – but inevitably leverage increases). Japan is even contemplating paying banks and businesses to borrow. Why? Because debt creates money and more money keeps prices from falling.

The effort fails because consumers buy more when prices fall and less when they rise. So the very attempt to drive economic growth is in fact undermining it. Plus, the soundness of our currencies today depends on the capacity of governments to pay on their debts.

Summarizing, the world is indebted so it needs money. Central banks supply money by exchanging it for debt.  Creating money paradoxically reduces the capacity of consumers to buy things because prices rise. So they have to go into debt.  The cycle repeats like two parties munching opposite ends of a strand of spaghetti.

Back to stocks. When they vary inversely with the dollar it’s contraction or expansion of multiples, not real growth.  And that means consumers are losing purchasing power.  Since consumption drives economies now, it inevitably leads to slower growth.

And that’s what the planet’s got. Circular reasoning obfuscates facts.  The solution is a stable currency so all of us can understand fair value for stocks and everything else. But we’ll start with identifying the destructive force – and it’s not the kids.

Stuck Throttle

Imagine you were driving and your throttle stuck.

Our market Sentiment gauge, the ModernIR 10-pt Behavioral Index (MIRBI) has manifested like a jammed accelerator, remaining above neutral (signaling gains) since Feb 19. At Apr 15 it was still 5.4, just over the 5.3 reading at Feb 19, which proceeded to top (Positive is overbought, roughly 7.0) four consecutive times without ever reverting to Neutral (5.0) or Negative (below 5.0). That’s unprecedented.

Speaking of stuck throttles, I first drove a John Deere tractor on the cattle ranch of my youth at age seven.  It was a one-cylinder 1930s model B that sounded like it was always about to blow up or stall. My dad let me drive it solo and I was chortling down our long driveway with the throttle set low and the clutch shoved forward.  I was approaching an irrigation ditch. I yanked at the clutch (on these old tractors, it’s a long lever, not a pedal). Nothing.  I shouted to my dad that I couldn’t budge it, looking wildly at the ditch.

“Turn the wheel!” he yelled.

Disaster averted. I felt sheepish for not thinking of it. But it illustrates the dilemma a stuck throttle (or a stiff clutch) presents.  No matter that sense of stolid progress, something with a mind of its own will run out of road.

Another time decades later I had driven myself from Cancun through the jungle of Quintana Roo west of Belize to a resort called the Explorean Kohunlich (awesome place). After two beautiful days, I hopped in the rental car and headed north.  I became gradually aware that the little Chrysler was bogging down. I mashed the throttle and yet the car wheezed and slogged. Then it died.

Took me two hours to hike back to Kohunlich.  “Mi coche expiró en la selva,” I explained in my ill-fitting Spanish. Your car died in the jungle? Yup. It all worked out to another day in paradise. Nothing lost.

Gained: Two contemporary lessons about the stock market.  Stocks should generally describe fundamentals. If they don’t, we’re all lacking “price discovery,” the jargoned term meaning a good understanding of valuations.  It’s as vital to companies as investors, else how do any of us know if shares are fairly valued?

No matter what some say, global economic fundamentals are like a wheezing car with the throttle mashed flat. In the US right now, economic growth projects below 1% for the current quarter, and inflation is over 2%, so consumers are losing purchasing power. And consumption is our engine (purchasing power is the key to growth).

Across the planet, from Europe to Asia to the emerging markets, debt-to-GDP ratios are up and economic growth is down.  So why has the market been a tromped throttle on an unprecedented positive run? Meaning resides in patterns and correlations. It’s the central lesson of data (which we study for a living).

And there is one.  Emerging-market central banks have sold foreign currency reserves at unprecedented rates (matching our Sentiment), and the US Federal Reserve has pushed hundreds of billions of dollars into bank reserves (by buying debt from them) in recent months.  And the dollar has fallen sharply off December highs. When other central banks sell dollars, it weakens our currency, and when our Fed buys assets from banks, it weakens our currency.  And when the dollar falls, stocks, commodities, and oil rise.

On one hand central banks have mashed the monetary accelerator to the floor and still everything is wheezing and coughing and slowing down.  It’s taken unprecedented effort to create this gaseous cloud.

But it’s on the other hand a two-by-four jammed on the equity market throttle, sticking it in Positive and disconnecting it from reality, and sending it screaming up the road out of control.  It’s entertaining, and good for our portfolio values, all of us, and it makes the pundits breathlessly rave about returns to all-time market highs.

But the throttle is stuck.  I’m reminded of a funny bit from a set of paraprosdokian sentences, witty combinations of unexpected or opposing ideas, sent to me by good friend Darwin:  “I want to die peacefully in my sleep like my grandfather. Not screaming and yelling like the passengers in his car.”

It’s better to have a market with its own throttle controlled by facts and fundamentals than one flattened by a bail of depreciating currency. Because we don’t want it dying in the jungle.

Bad Forecast

There’s a mistake in last week’s Market Structure Map. We never made it to Boston!

The forecasters missed it and snow walloped us with a ferocity that shut Denver International Airport by air and land and we were stranded for nine hours before daring “impassable” Pena Boulevard and four-wheeling home.  We felt like Loggins and Messina: Please come to Boston in the springtime and she (Mother Nature) just said no.

Speaking of ferocity, yesterday Janet Yellen yelled the dollar down a percentage point. One would expect to see in response stronger equity indexes (SPY rose the inverse of the dollar’s move) and emerging markets (EEM up 1.4%), gold bear bets crushed (DUST dropped 16%), gold bull bets up (GDX up 5.7%), growth stocks up (IWM up 2.8%) and VIX volatility trades taking a beating (VXX off 5.7%, UVXY off 10.7%).  The only thing that didn’t rise that should have is oil – but all the leveraged oil exchange-traded products, which dominated equity volumes Jan 7-Mar 11, have vanished from the most active stocks. Oil trading-stocks like MRO and WLL did jump.

Save for the two stocks – which are influenced heavily by arbitrage – these are all derivatives. ETFs are proxies for assets – instruments derived from but not comprised of stocks. Assets didn’t change hands, just paper. We could call ETFs stock currencies. They are flexible, mutable simulations of investment behavior.

Similarly, monetary policy has become a flexible, mutable simulation of economic behavior. The supply of dollars didn’t alter. Currency relative-values are metered through futures contracts, which are derivatives. Futures on bucks devalued, so relative dollar-value dropped.  Economic growth or contraction was not changed by Yellen’s speech.  You can’t talk tires and trucks and jobs into existence.

Compare to stocks. What’s changed since Jan 20 or Feb 10? Money simulating investment behavior through ETFs and options and futures were a whistling inhalation that then reversed and exhaled and the bellows of derivatives blew and a fiery market manifested, charging up about 12%.

If anything, fuel for the market has diminished. The Atlanta Fed’s model for first-quarter economic growth is at 0.6%, less than half a revised 1.4% for Q4 (compared to the first read of 0.9% that’s a 56% revision, worse than a coin flip or a weather forecast). Earnings expectations are meager.

But the strong dollar is crushing others. Brazil is on the brink of collapse. China could run out of cash in a year. It’s convenient to cast blame for money manipulation but dollars are the reserve currency, the Big Kahuna. The Fed has thrown the world akimbo and infected equities with its policy susurrations.

Economies and markets work when currencies don’t move and supply and demand do. Instead the rest of us humans not in charge of monetary policy are like kids stuck in a room with a bipolar parent off the meds. After all, functionally the Fed tightened policy last week by reducing excess reserves and borrowing from banks through reverse-repurchase agreements. Which is it, Ms. Yellen?

For public companies, yesterday’s trading is an archetype of the modern era.  Our growth clients with higher Risk Management (derivatives) sharply outperformed the market. Tech soared (lumped with growth and a recent laggard). But utilities jumped too.

It’s not rational. The whole market depends on derivatives. The ultimate planetary derivative is money – currency. Central banks have taken to manipulating it in unfathomable ways to create the appearance of things they desire.

I don’t know how it ends but from a structural standpoint in the stock market, the influence of derivatives has reached a fever pitch. It happened in real estate too.

Root Cause

Karen and I are in the Windy City visiting the NIRI chapter and escaping gales on the Front Range that were delaying flights to Denver and blowing in spring snow due Friday while we’re in Palo Alto for the Silicon Valley NIRI Spring Seminar (we sponsor both chapters). Hope to see you!

I’m going to challenge economic orthodoxy. Whatever your reaction as an adult to hearing the term “Santa Claus” (follow me here; it’s a mechanism, not commentary on religion or culture), you know the imagery of adolescent expectations is a myth. Even so, parents perpetuate it generationally.

Today we’ll unravel the Saint Nicholas Theory of economics. Because at root equities reflect economics even when the barometer is errant. Economic orthodoxy – conventional wisdom on economies – says we need rising prices. For businesses selling things it’s called “pricing power,” the capacity to increase the cost of goods and services. The Federal Reserve and other global central banks have an “inflation target,” and bureaucrats wearing half-glasses at droll news conferences pore over boorish scripts about “structural malaise” and the exigency of combating deflation.

Few know what they’re saying except we gather they think prices should rise. Yet we consumers stop spending when things cost too much. If our spending is the engine of the economy – what economists call consumption – how is it that rising prices are going to drive more of it? In fact when stuff’s not selling, businesses hold sales. They cut prices.QuastCurve

Big Economic Idea No. 2 (we all know from childhood what “number two” means) is that access to credit – borrowed money – is the key to more consumption. If the economy slows, the problem, we’re told, is we need more spending. Central banks the world round want you whipping out a credit card lest the global economy slip into falling prices.

This is Santa Claus Economic Theory. It says spending drives the economy, which grows when prices rise. There is only one reliable way to drive up prices: Inflation.  Milton Friedman taught us “inflation is always and everywhere a monetary phenomenon.” While prices temporarily increase when more buyers chase fewer goods (say, Uber at rush hour), costs will revert when supply and demand equalize. So inflation – rising prices – is sustainable only if the supply of money increases faster than economies produce things.

Money as we presently know it can only expand one way:  Through debt. If the Federal Reserve wants to increase currency in circulation, it buys debt from the Treasury with cash it manufactures (backed by you and me).  Likewise, when you use a credit card, you create money. A bank isn’t reaching into dInflationeposits to pay a bill you incurred. The bank creates electronic funds.  When you pay your bill, that electronic money disappears.

Stay with me. We’ve almost arrived at the bizarre and impossible logic that animates the entire global monetary system, as I’ve illustrated with three charts here.  Today Janet Yellen will try to convince us we need inflation.  Rising prices. What drives prices up? More money. How does the global monetary system create money? Through debt.  So we’re left to conclude that prosperity can only happen if debt and spending perpetually rise. Because if you pay off debt, money is destroyed and prices fall.

Two weeks ago I was on CNBC with Rick Santelli declaiming how rising debt and rising prices are the enemies of prosperity, and purchasing power is the engine of growth. Purchasing power is when your money buys more than it did before, not less.  Example:  Uber.  It used to cost $100 for a cab to the Denver airport. Uber is about $40. Guess what? Cabs are coming down.  Purchasing power is improving.

Central banks are perpetuating a myth that will destroy the global economy, and I’ve proved it with three charts. The first – call it the Quast Curve – shows what happens to the US economy if the value of the money denominating goods and services is consistently diminished over time.  Growth rises but then collapses (eerily, in this model it topped in the 1960s before we left the gold standard and hit zero around 2008). USDebt

What will follow from the Quast Curve is rising debt and rising prices, illusions of growth – exactly what images two and three show. As money buys less and less, prices go up, and consumers have to replace the missing money with debt, a terminal cycle.  It’s now on the balance sheet of the Federal Reserve.

Real economies are simple. If money has stable value, and enterprising humans create things that improve lives, costs should stay steady or decline, not rise, which increases purchasing power and wealth rather than debt.  It’s infinitely sustainable.  Economist Herb Stein said if something cannot last forever it will stop.  You never want an economy built on things that will stop. What should stop instead are bad policies.

Receding

The X-Files are back on TV so the pursuit of paranormal activity can resume. Thank goodness, because the market appears to be paranormal (X-Files theme in background).

Volatility signals behavioral-change, the meaning of which lies in patterns. Sounds like something Fox Mulder would utter but we embrace that notion here at ModernIR. It’s not revolutionary, but it is universal, from ocean tides to personalities, weather forecasts to stock-market trading.  Volatility, patterns.

Stocks are volatile. Where’s the pattern?

Let’s find it. A headline yesterday splashed across news strings said CEOs have “unleashed recession fears” on earnings calls. Fact Set’s excellent Earnings Insight might buttress that assertion with data showing S&P 500 earnings down 5.8% so far, revenues off 3.5%. It marks three straight quarters of declines for earnings, the worst since 2009, and four in a row for revenues, last seen in late 2008.

What happened then was a recession. That’s a pattern, you say.

Hard to argue your reasoning. We’re also told it’s oil pulling markets down. China’s slowing growth is pulling us down.  Slowing growth globally is the problem, reflected in Japan’s shift to negative interest rates. First-read fourth-quarter US Gross Domestic Product (GDP) last week was a wheezing 0.6%.  Slowing is slowing us, is the message.

But what’s the pattern?  One would expect a trigger for a recession so where is it?  In 2008, banks had inflated access to real estate investments by securitizing mortgage debt on the belief that demand was, I guess, infinite. When infinity proved finite, leverage shriveled like an extraterrestrial in earth atmosphere. Homes didn’t vanish. Money did. Result: a recession in home-values.

It spread.  In 2007, the gap between stock-values and underlying earnings was the widest until now, with the S&P 500 at 1560 trading more than 10% higher than forward earnings justified. Oil hit $150.

But by March 2009 oil was $35 and the S&P 500 below 700. To reverse this catastrophic deflation in asset prices, central banks embarked on the Infinite Money Theorem, an effort to expand the supply of money in the world enough to halt the snapping mortgage rubber band.  Imagine the biggest-ever long-short pairs trade.

It worked after a fashion. By the end of 2009, a plunging dollar had shot oil back to $76.  The S&P 500 was over 1100 and rapidly rising earnings justified it. Trusting only broad measures, investors in pandemic uniformity stampeded from stock-picking to index-investing and Exchange-Traded Funds (ETFs).

The Infinite Money Theorem reached orbital zenith in Aug 2014 when the Federal Reserve stopped expanding its balance sheet.  The dollar shot up.  Oil began to fall. By Jan 2015 companies were using the words “constant currency” to explain why currency-conversions were crushing revenues and profits.  In Aug 2015 after the Chinese central bank moved to devalue the yuan, US stocks caterwauled.

On Nov 19, 2015, the Fed’s balance sheet showed contraction year-over-year. Stocks have never returned to November levels. On Dec 16, 2015, the Fed lifted interest rates.  Stocks have since swooned.

Pattern? Proof of the paranormal?  No, math. When a trader shorts your stock – borrows and sells it – the event raises cash but creates a liability. Borrow, sell shares, and reap cash gain (with a debt – shares to return).  When central banks pump cash into the global economy, they are shorting the future to raise current capital.

How?  Money can’t materialize from space like something out of the X-Files. The cash the Fed uses to buy, say, $2 trillion of mortgages is from the future – backed by tax receipts expected long from now. That’s a short.

We’re getting to the root.  Say the global economy fell into a funk in 2008 from decades of overspending and never left it. Let me explain it this way.  One divided by one is one.  But one divided by 0.9 is 1.11.  The way the world counts GDP , that’s 11% growth.  But that growth is really just a smaller denominator – a weaker currency.

Now the dollar is revaluing to one and maybe more (it did the same in 2001 and in 2008). Why? Since the financial crisis trillions of dollars have benchmarked markets through indexes and ETFs.  In 2015, $570 billion flowed to Blackrock and Vanguard alone.  All that money bought rising markets until the excess money was used up by assets with now sharply higher prices.

The denominator is reverting and the economic growth we thought we had is receding back toward its initial shape, such as $35 oil (with stretch marks related to supply/demand issues). That’s what’s causing volatility. This is the pattern.  It’s colossally messy because the dollar is the world’s reserve currency and thus affects all other currencies (unevenly).

Volatility signals behavioral-change, the meaning of which is in patterns. This is it. A boomerang (read Michael Lewis’s book by that title for another perspective).  The dollar was made small to cause prices to grow large and create the illusion of growth in hopes it would become reality.  At the top of the orbit nothing had really changed and now that seven-year shadow on the planet is receding.

We’ll be fine. We humans always are.  But this is no short-term event. It’s a huge short.

Dollars and Sense

I looked back at what we wrote Dec 2, 2008. It was two weeks before Madoff (pronounced “made off” we’d observed bemusedly) became synonymous with fraud. Markets were approaching ramming speed into the Mar 2009 financial-crisis nadir.

In that environment on this date then, we introduced you to Ronin Capital, a Chicago proprietary trader. It had exploded through the equity data we were tracking. Today it’s a top-twenty proprietary trader in equities but not the runway model.

Yet it’s thriving. It has 350 employees. Its regulatory filings show $9.5 billion of assets including financial instruments valued at $6.4 billion, with government securities comprising $4.5 billion, derivatives about $1.1 billion, and equities about $700 million.

As the Federal Reserve contemplates a rate-increase in two weeks, Ronin Capital is a microcosm for the whole market. Its asset-mix describes what we see behaviorally in your trading, clients: Leveraged assets, dollars shifting from equity trading to derivatives, producing declining volumes and paradoxically rising prices. In a word, arbitrage.

The Fed Funds rate is the daily cost at which banks with reserves at the Fed loan them to each other.  The Fed last raised it June 29, 2006 to 5.25%, marking a pre-crisis zenith. As the housing market trembled, the Fed backpedaled to 4.25% by December 2007. On Dec 16, 2008 the Fed cut to 0.00%-0.25%, where it remains.

Since the Fed began tracking these rates following departure from the gold standard in 1971, the previous low was 1% in June 2003 as the economy was trudging up from the 9/11 swale. The high was 20% (overnight!) in May 1981.  It’s averaged about 5%.

Now for almost ten years – the life of the benchmark US Treasury – there has been no rate-increase. Since 2008, it’s been close to free for big banks to loan each other money. Backing up to Nov 30, 2006, the Fed’s balance sheet showed bank reserves at $8.9 billion, lower than (but statistically similar to) $11.2 billion at Nov 29, 1996. But at Nov 27, 2015, the Fed held $2.6 trillion of bank reserves, an increase of 29,000%.

Lest you seethe, this money was manufactured by the Fed and paid to banks that bought government debt and our mortgages.  It didn’t exist outside the Fed.

The construction of the financial instruments held by Ronin Capital describes how these polices have affected market activity.  First, the pillar of the asset base is government debt, the most abundant security in the world (a commodity – something available everywhere – cannot be the safest asset, by the way).  Governments need buyers for debt so rules manufacture a market. All the big banks hold gobs of government debt.

Second, Ronin holds equity swaps, equity options, options on futures, and currency forward contracts which collectively are 34% greater than underlying equity assets. We infer that Ronin makes money by leveraging into short-term directional trades in options and currencies. It’s worked well. It did in real estate too ten years ago, until mortgage-backed derivatives devalued as appreciation in the underlying asset, houses, stalled.

Ronin Capital, big banks, derivatives, currencies, equities and interest rates are interlaced. When money lacks inherent worth, speculation increases. Government debt is today’s real estate market underpinning massive leverage in today’s mortgage-backed securities, the sea of derivatives delivering short-term arbitrage profits.

To see the potential Fed rate increase Dec 16 as but a step toward normalization is to misunderstand the foundation of capital today. Raising rates to 0.25%-0.50% is good. But it’s at least 29,005% different from raising rates to 5.25% in 2006.

You don’t have to grasp all the mechanics, IR professionals. You do have to understand that if fundamentals have been marginalized by arbitrage the past seven years, wait till the calculus in arbitrage changes.  It’s happening already. We saw a steep drop in shorting the past two weeks. Sounds good, right? But it means borrowing is tightening.

Don’t blame Ronin Capital for adapting.  In fact, forget blame, though it’s apparent where it lies. Let’s instead think about the implication for our task in the equity market. It’s about to get a lot more interesting, and not because of fundamentals.

The good news is that it’s never been more vital to measure your market structure and report facts to management. This is when IR careers are made.

The Escalator

As the US investor-relations profession’s annual confabulation concludes in the Windy City, we wonder how the week will end.

The problem is risk. Or rather, the cost of transferring it to somebody else. Today the Federal Reserve’s Open Market Committee Meeting adjourns with Janet Yellen at the microphone offering views on what’s ahead. The Fed routinely misses the economic mark by 50%, meaning our central bank’s legions of number crunchers, colossal budget and balance sheet and twelve regional outposts supporting the globe’s reserve currency offer no more certainty about the future than a coin flip.  That adds risk.

The Fed sets interest rates – not by ordering banks to charge a certain amount for borrowing but through setting the cost at which the Fed itself lends to banks. Higher rates paradoxically present lower risk because money can generate a return by doing nothing.  Idle money now wastes away so it’s getting deployed in ways it wouldn’t otherwise.

If you’re about to heave this edition of the Market Structure Map in the digital dump, thinking, “There goes Quast again, yammering about monetary policy,” you need to know what happens to your stock when this behavior stops. And it will stop.

When the dollar increases in value, it buys more stuff. Things heretofore made larger in price by smaller dollars can reverse course, like earnings and stock-prices.  As the dollar puts downward pressure on share-prices, derivatives like options into which risk has been transferred become valuable. Options are then converted into shares, reversing pressure for a period. This becomes a pattern as investors profit on range-bound equities by trading in and out of derivatives.

Since Sept 2014 when we first warned of the Great Revaluation, the apex of a currency driven thunderhead in things like stocks and bonds, major US equity measures have not moved materially outside a range. Despite periodic bouts of extreme volatility around options-expirations, we’re locked in historic stasis, unmatched in modern times.

The reason is that investors have profited without actually buying or selling real assets. This week all the instruments underpinning leverage and risk-transfer expire, with VIX volatility expirations Wednesday as the Fed speaks. The lack of volatility itself has been an asset class to own like an insurance policy.

Thursday, index futures preferred by Europeans lapse. There’s been colossal volatility in continental stock and bond markets and counterparties will charge more to absorb that risk now, especially with a sharpening Greek crisis that edges nearer default at the end of June. Higher insurance costs put downward pressure on assets like stock-prices.

Then quad-witching arrives Friday when index and stock futures and options lapse along with swap contracts predicated on these derivatives, and the latter is hundreds of trillions of notional-value dollars. On top of all that, there are rebalances for S&P and Nasdaq indices, and the continued gradual rebalancing of the Russell indexes.

Expirations like these revisit us monthly, quad-witching quarterly. That’s not new. But investors have grown wary of trading in and out of derivatives. Falling volumes in equities and options point to rising attention on swaps – the way money transfers risk. We see it in a trend-reversal in the share of volume driven by active investment and risk-management. The latter has been leading the former by market-share for 200 days. Now it’s not. Money is trying to sell but struggling to find an exit.

Here at the Chicago Hyatt Regency on Wacker Drive, when a NIRI General Session ends, the escalators clog with masses of IROs and vendors exiting. Index-investing, a uniform behavior, dominates markets and there is clogged-escalator risk in equities.

It may be nothing.  Money changes directions today with staccato variability. But our job as ever is to watch the data and tell you what we see.  We’ve long been skeptics of the structure wrought by uniform rules, and this is why.  It’s fine so long as the escalator is going up.  When the ride ends, it won’t impact all stocks the same way, however, because leverage through indexes, ETFs and derivatives – the power of the crowd – has not been applied evenly.

This year’s annual lesson then is no new one but a big one nonetheless. Investor-relations professionals must beware more than at any other time of the monumental uniformity-risk in markets now, wrought not by story but macroeconomics and structure.

So, we’re watching the escalator.

New Answers

What’s the purpose of life?

We want simple answers to complex questions.  Such as when management asks why the stock price is up or down. Since elementary explanations are often incorrect, there’s been a loss of confidence.  “We broke through our moving averages” wears thin with the CEO.

I’ll give you a couple examples. Yesterday an energy master limited partnership trading on the NYSE announced an unchanged cash distribution for the first time in years. This company is known for steadily ratcheting up quarterly outlays to holders.

The stock tanked. Right?  Nope, it doubled the modest sector gains in energy yesterday. Maybe investors thought the company would trim the distribution?  Now we’re speculating because the opposite of what was expected occurred.

We’re also assuming price depends on rational thought, which if the feds now contending a trader spoofing the futures market with placed and canceled trades caused the Flash Crash, is the exact opposite of reality.  Do you know the SEC’s own trading data show at least 25 cancels for every completed trade in stocks of all market-caps (250 per trade in high dollar-volume issues), and over 1,000 cancels-per-trade in big ETFs?

Another company last week dropped sharply amid block volumes, prompting conventional stock soothsayers to conclude big holders were selling. Seems logical, right? If your stock trades 8,342 times daily on average your closing price is the 8,342nd trade.  It’s where the day’s music stopped and useless as a central tendency – and yet closing price is the de facto measure of action (we prefer midpoint price, by the way).

In the 1961 science fiction novel Solaris by Polish writer Stanislaw Lem – made into a 2002 movie starring George Clooney – Kelvin the protagonist questions his sanity. Seeing things that appear real but seem impossibly so, he begins to believe his entire journey may be occurring in his own mind.  To establish a reality baseline he performs some calculations. He reverts to the math.

Back to the stock above, the math showed the opposite of what reality appeared to say. Active value investors had been buyers. When buying stopped, traders abruptly quit lifting prices, prompting a brief plunge. Short volumes, which had jumped 40% in two days, sharply retreated at once, implying block prints reflected short-covering – by the very brokers who’d just filled buys for Value money.  The stock is now trading higher, which would be unlikely if big holders were sellers.

Ah for simple answers – but we don’t live in that world. Which brings us to today. Two vital macro events collide like matter in a particle accelerator: In the morning, we’ll get a first read on US GDP this quarter.  Then later the Federal Reserve via the non-apparitional personage of Janet Yellen will pronounce something about monetary policy.

Beneath the surface the market is on pins and needles. The Fed represents the supply of money, economic growth its cost.  The US dollar has been coming off decade-highs for days now, indicating some see growth drearier than hoped.  In the ModernIR 10-point Behavioral Index, sentiment is still weakly over neutral, meaning investors think whatever happens will be accommodative and therefore helpful to stocks.

But hedging is breathtaking – radically greater in the past five days than any other behavior. Investors are in fact in sharp retreat as price-setters. Effectively, everyone but the Fed has transferred the risk of being wrong to somebody else. Where that hot potato lands will determine the fate of equities. Moves either direction could be large.

Data suggest the economy will offer a limp pulse, perhaps wheezing in below 1% despite expectations from the Fed itself last December of 3%. If the Fed is off by 70% nobody there will get fired, which is good news for the jobless rate.

What’s it all mean? We pine for Easy, Simple. We’re sure as IR officers our shares stand out, and I hear all the time, “My stock is different.”  Like doctors studying angiograms we see the data and say, “You look like the typical patient to us. The good news is that means we’ve got answers.”

The great modern opportunity for the IR profession is the same presented to any generation, scientist, philosopher or explorer challenging convention.  We first face complex reality and then translate it into refreshing value for those we serve.

It’s not simple – but it’s exhilarating. So today, whatever your stock does in response to Janet Yellen’s invigorating oratory and the probable whiff from the economy, ask the question – why? – and if you’re still laboring along the flat earth of old-fashioned perspectives, stop.  Seek new answers. They exist!

Then the CEO will again ask you for them – a measure of value from those you serve.

The Fulcrum

The teeter-totter with the moving fulcrum never caught on.

The reason is it wasn’t a teeter-totter, which is simple addition and subtraction, but a calculus problem. The same mathematical hubris afflicted much talk surrounding US economic growth last autumn when it seemed things were booming even as oil prices were imploding.

“The problem is oil is oversupplied,” we were told, “so this is a boon for consumers.”

“What about the dollar?” we asked.

Oil prices are a three-dimensional calculus problem. Picture a teeter-totter.  On the left is supply, on the right is demand.  In the middle is the fulcrum: money. Here, the dollar.

In January 15, 2009 when the Fed began to buy mortgage-backed assets, the price of oil was near $36.  Supply and demand were relatively static but the sense was that economies globally were contracting. On Jan 8, 2010, one year later, oil was about $83. Five years removed we’re talking about the slow recovery. So how did oil double?

The explanation is the fulcrum between supply and demand. Dollars plunged in value relative to global currencies when the Fed began spending them on mortgages.  Picture a teeter-totter again. If I’m much heavier than you, and the fulcrum shifts nearer me, you can balance me on the teeter-totter.  Oil is priced in dollars. Smaller dollars, larger oil price, or vice-versa.

As the Fed shifted the fulcrum, the lever it created forced all forms of money to buy things possessing risk, like stocks, real estate, art, commodities, goods and services.

As we know through Herb Stein, if something cannot last forever it will stop. On August 14, 2014 the Fed’s balance sheet had $4.463 trillion of assets, not counting offsetting bank reserves. On Aug 21, 2014, it was $4.459 trillion, the first slippage in perhaps years.

Instantly, the dollar began rising (and oil started falling). At Jan 22, 2015, the Fed’s balance sheet is $4.55 trillion, bigger again as the Fed tries to slow dollar-appreciation. But the boulder already rolled off the ridge. The dollar is up 22% from its May 2014 low, in effect a 35% rise in the cost of capital – a de facto interest-rate increase. (more…)