Tagged: Monetary Policy

A New Construct

What a week back from Switzerland.

We lost historian David McCullough and singer Olivia Newton-John. Meme stocks went berserk anew.

And speaking of berserk, after juicing Demand till inflation surpassed 9%, the Senate ratified a giant Supply-side bill that’ll ramp the cost and production of goods just as everybody is out of money.

The bill also erects a multitude of new offices and sends thither swarms of agents to harass our people and eat out their substance.  No wait, that was Thomas Jefferson writing in the Declaration of Independence about the Crown.

Oh, and the FBI demonstrated that nobody is secure in their persons, property and effects from unreasonable search and seizure.

Just another week in the USA. And everybody wants to know:  Is the bottom in for stocks? 

Did you laugh?  I did.  It’s a curious juxtaposition.

Illustration 17689963 © Ashdesign | Dreamstime.com

And maybe none of that is as consequential as a Wall Street Journal opinion (subscription required) by Johns Hopkins Professor Steve Hanke, global authority on currencies.

Wait, Quast. You’re not going to talk about money.

I’ll bring it back to stocks, which are denominated in dollars.

Strange but true, the US dollar will inevitably rise versus other currencies, no matter what economic buffoonery issues like effluvia from government. The dollar, euro and Swiss franc are at parity.  Professor Hanke notes that eight countries have seen their currencies lose 65% or more of their purchasing power.

Why? As the dollar rises, other global banks sell dollars to weaken it. And then they run out of dollars to sell. And their currencies devalue.

The Fed creates dollars by buying government debt, which lowers interest rates. To reverse that course, the Fed sells debt for dollars. Which makes the dollar stronger.

There’s no way out – like that Kevin Costner movie from 1987. 

I’ve said that what will happen after our long experiment in creating money – much like stock is created out of thin air in the US market – is our currency model will fail.

Well, Steve Hanke has now proposed a new one because the current one is at risk.  He’s the creator of most of the currency boards – ways to peg currencies – operative around the planet.  He knows money.  This is no shrill jester in the court.

He says the dollar/euro currency pair should stay in a range.  The Fed and the European Central Bank should buy and sell each other’s currencies to keep it around $1.30 to the euro.

Whoa.

The USA has enjoyed a massive monetary advantage. We alone create currency without having to buy or sell anybody else’s.

The Federal Reserve can whipsaw other currencies while propagating the external belief our resources are endless and the internal capacity to live beyond our means.

Professor Hanke is saying it needs to end. That the only way to constrain US government profligacy is to limit the dollars it can produce – by pegging it to the euro.

What’s this got to do with a bottom for stocks?  A big monetary guy is writing about the end of our monetary regime. Maybe we should be concerned about that?

Which brings us to stocks.

Meme Stocks are repeating microcosms of the lifecycle of currencies. They soar and crash. Value isn’t determined by economic activity but by currency supplies – shares.

And the supply is artificial, like dollars.

How? The US stock market is a “continuous auction” of tiny trades. Brokers by rule stand ready to buy or sell even when no one else is buying or selling. 

To make that happen, the SEC exempts brokers from legal constraints on “naked shorting” – loaning stocks without locating them.

That latter is illegal for you and me.  But for broker-dealers, creating stock to fill buy or sell orders is part of the job the SEC has given them, keeping the artifice of the continuous auction going and bloating and cratering Meme names.

Realize, “continuous auction” is an oxymoron. An auction by definition is a periodic aggregation of buy/sell interest, not a continuous one. So the market depends on artificial – nonexistent – supply to function.

The flip side is, without it you wouldn’t be able to buy or sell stocks at times. There just wouldn’t be any.  Of course, that’s how we understand supply and demand (you can’t buy a house if there aren’t any).

Money works the same way. Central banks create artificial supplies to foster unnatural outcomes disconnected from economics. Stuff soars, and collapses, but over a long arc.

Meme stocks do all of that in months, weeks, days. They surge on artificial supply and then collapse. We measure the market’s Supply and Demand for both companies and investors, so we can predict and observe the behavior.

The money?  Well, Dr. Hanke has fired the first warning volley. 

The market? It’s on a slow arc away from Momentum again, the data say.

Elasticity

CNBC is running a second-by-second countdown to the Federal Reserve decision on rates today.

Seems like a market too dependent on the few. Risk disperses through decentralization.  We’re counting on a central bank to disperse risk.  Hm.  Whatever the Fed does today, from 50 basis points to a hundred, we know risk is concentrated.

In what?

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I’ll come to that. First, every public company should have reliable, accurate market intelligence on what’s driving – or harming – shareholder-value.  With just 5% of trading volume manifesting as ownership-changes, you need quantitative market analytics.

We have them.  You may need them in coming months as much or more than at anytime you’ve occupied the chair, investor-relations professionals. Send me an email and ask about our special deal through Dec 31.

So, where is risk?  It’s been transferred from every part of the economy, from all assets, into our currency, thanks to the central bank’s effort to be on both sides of the Supply/Demand teeter-totter simultaneously.

And since our currency denominates risk assets and all economic interaction including trading time for money, and trading money for good and services, we didn’t transfer it anyplace.  It’s a grenade, pin pulled and hucked, that bounces right back.

The Panic of 1873 collapsed proliferating railroads and the banks and investors backing them. Investors started selling the railroad bonds they owned and pretty soon there were too many bonds around and nobody wanted them.

But it didn’t spread to other parts of the economy. It didn’t threaten the currency, which by 1880 had gained BACK all the lost purchasing power resulting from the Civil War and paper banknotes.

Imagine getting some purchasing power back. Wow.

Anyway, in 2022, people are selling off bonds. But they’re not railroad bonds. They’re government bonds. And the Federal Reserve, which hasn’t started selling its giant trove yet, will follow suit.

The yield, which moves inversely to price, on the five-year US Treasury, for instance, is up from about 70bp last summer to 3.6%. It reflects plunging demand for bonds.

The banks that sold railroad bonds in 1873, and the railroad companies that used the proceeds to lay rails, and the investors who owned the paper backing transportation capital-spending went broke.

Of course nobody bailed them out. The destruction of speculation and overbuilding is a necessary part of any healthy economy.  Otherwise you end up with assets that don’t produce returns.

That’s what happened during the Pandemic.  Assets that were not producing returns were kept afloat by the Fed, which issued bonds to create currency to keep stuff alive through payroll protection plans.

Then the Fed took the unprecedented step of just sending everybody checks (the Treasury did it but that money came from nothing – poof, just like the metaverse), shifting from keeping the supply side going, to juicing the demand side of the teeter-totter.

So you have unproductive assets getting money, and unproductive people getting paid.  And consuming stuff, and trading stocks, and buying bitcoin, blah blah.

At some point, that process stops.

I’m not knocking emergency efforts. But the government gave no thought to having to undo what was done. Elastic money was the Great Elixir that would “promote growth.” The truth might be closer to setting one’s house afire to stay warm.

Leading into 1873, the banks and the builders and the bond-buyers were seeing big future demand for rails.  Instead, there was an economic slowdown, and people had to sell bonds to raise money.

It’s not 1873, because that was only railroads.  I don’t know what will happen here.  But the whole world depends on the dollar.  It’s the only reserve currency. We transferred the entire perceived – which proved wrong – effects of the Pandemic to it.

Bailing stuff out is bad because it compounds until it comes around and what was just a little jab that didn’t land in a boxing match is now a Mike Tyson upper cut.

And who bails out the dollar?

In 1913, the Federal Reserve was created to give money the elasticity to absorb panics. It absorbed WWI. That collapse in output coupled with the explosion of money sent us galloping into the Roaring Twenties.

And the equal and offsetting reaction was the 1930s.

Human nature tends to do things until they blow up. We may have exhausted the elasticity of modern monetary policy. And the snapback could be intense.

Be prepared. We’ve got data for navigating turbulence.

Clear the Room

Winter is coming.

But autumn is mighty fine this year in the Rockies, as my weekend photo from Yampa Street in Steamboat Springs shows.

Winter follows fall and summer. Other things are less predictable, such as economic outcomes and if your Analyst Day will do what you hope (read from last week).

Here, two of my favorite things – monetary policy, market structure – dovetail.

Steamboat Springs. Photo by Tim Quast.

If you want to clear the room at a cocktail party, start talking about either one.  In fact, if you’re trapped talking to somebody you’d rather not, wanting a way out, say, “What’s your view of the fiat-currency construct?”  or “What do you think of Payment for Order Flow?”

I’ve told you before about the daily noon ET CNBC segment Karen calls the “What Do You Think of THIS Stock?” show.  Guests yammer about stocks.

Some weeks ago the host said, “What do you think of Payment for Order Flow?”

Silence.  Some throat-clearing.

Nobody understands it!  These are market professionals. Decades of experience. They don’t know how it works.

Not our topic. But so I don’t leave you hanging, PFOF is as usual with the stock market an obfuscating way to describe something simple.  Retail brokers sell a product called people’s stock trades so those people can trade stocks for free.

This is why you’re brow-beaten to use limit orders at your online brokerage.  Don’t you dare put in a market order! Dangerous!  Not true. Fast Traders, firms wanting to own nothing by day’s end and driving 53% of market volume, eschew limit orders.

They know how the market works. Brokers want you to use limit orders because those get sold. Most market orders don’t.

Pfizer wants everybody to be vaccinated and retail brokers want every trade to be a limit order, because both get paid. Same thing, no difference.

Now, back to the point.  If you tell your corporate story to a thousand investors, why doesn’t your price go up?  Similarly, why can’t we just print, like, ten trillion dollars and hand it out on the street corner and make the economy boom?

Simple. Goods and services require two things:  people and money. Labor and capital. Hand out money and nobody wants a job. Labor becomes scarce and expensive.

And if you hand out money, you’re devaluing the currency.  Money doesn’t go as far as it used to.  You need more to make the same stuff.

The irony is that handing out money destroys the economy.  You can’t make stuff, deliver it, ship it, pack it, load it, unload it, move it – and finally you can’t even buy it because you can’t afford it.

Got it?

The best thing we could do for the economy is put everything on sale.  Not drive prices up and evacuate products from shelves.  But that requires the OPPOSITE action so don’t expect it.

What does market structure have in common with monetary policy?

Too many public companies think you just tell the story to more investors and the stock price goes up.  We’re executing on the business plan. The trouble is too few know.

Wrong.  That’s a controllable, sure.  But it’s not the way the market works. AMC Theaters is a value story.  It was a herculean growth stock in early 2021 and along with Gamestop powered the Russell 2000 Value Index to crushing returns.

I was looking at data for a large-cap value stock yesterday.  The Exchange Traded Fund with the biggest exposure is a momentum growth ETF. It’s humorous to me reading the company’s capital-allocation strategy – balance-sheet flexibility with a focus on returning capital to shareholders – and looking at the 211 ETFs that own it.  It’s even in 2x leveraged bull ETFs (well, the call-options are, anyway).

Your story is a factor.  But vastly outpacing it are your CHARACTERISTICS and the kind of money creating supply, and demand. If you trade $1,500 at a time, and AMZN trades $65,000 at a time, which thing will Blackrock own, and which thing will get traded and arbitraged against options and futures?

Your CFO needs to know that, investor-relations people. And we have that data.

That large-cap I mentioned? We overlaid patterns of Active and Passive money.  Active money figured out by May 2021 that this value company was a growth stock and chased it. They were closet indexers, the Active money. PASSIVE patterns dwarf them.

And when Passive money stopped in September, the stock dropped like a rock.

It wasn’t story. It was supply and demand.

Same with the economy. Flood it with cash, and it’s hard to get that cat back in the bag once you’ve let it out.  You cannot reverse easy monetary policy without harsh consequences, and you can’t shift from momentum to value without deflation.

The good news is when you understand what’s actually going on, you can manage the controllables and measure the non-controllables. Both matter.  Ask us, and we’ll show you.

Money Highway

Is Jay Powell the new Investor Relations Officer for all public companies? 

Before we answer, the tranquil image at right free of the Federal Reserve and all the travails of modern economics and politics (and investor relations) is Catamount Lake near Steamboat Springs.  I love this time of year, the way the mountains glow verdant and lakes lie full among the meadows.

Back to the Fed and IR, the gaping deficit in investor-relations today is an application of quantitative and behavioral analytics. We have them. You can use them.  They tell us just about everything one would want to know about the equity market.

For the hermitic amongst us, the Fed chair takes the mic today to end a two-day policy meeting. Some have asked about the impact of monetary policy on Market Structure Sentiment, our ten-point gauge for share supply and demand in your stock, peers, industry, sector, and the whole market, so we’ll address it briefly.

For those not reading the Fed’s balance sheet, you should know it’s $7.993 trillion currently, and includes commitments to buy mortgage-backed securities running north of $200 billion continuously (no wonder mortgage rates are low despite a dearth of homes), reverse repurchases are a record-shattering $720 billion, and excess reserves are nearing $4 trillion.

In 2007, excess reserves averaged $10 billion. It’s 400 times more now, money with no place to go save begging for 10-12 basis points of interest from the Fed, which gave it to banks to begin.

Yeah, weird, right?  Why would you create money and then pay interest on it? Because your models have convinced you this is “good for the economy.”

The Fed’s yearly calendar typically includes four meetings with policy statements in March, June, September and December. The Fed doesn’t convene in May or October and calls an abbreviated November conclave ahead of the US election cycle.

Central banks were considered lenders of last resort under the Thornton-Bagehot (badge-it) model from the UK. They took only good collateral for monetary support (limited by gold and silver) and charged high interest rates.  Central banks were not seen as the fiscal pantheon but a lifeline for only those capable of surviving.

Thus, economies washed out failure.  Economic crises throughout history always trace to the overextension of credit. They are normal parts of the tension between human fear and greed.

Today, central banks take bad collateral and offer low rates. They prevent failure. That truncates the market mechanisms wanting to remove excess capacity when credit is overextended. It obviates competition and promotes monopolism (then government decries business practices).

Failure transfers from economies to the public balance sheet (and citizens bemoan these bailouts that are only possible through the central bank). I’m sure it’ll all work out.  Cough, cough.

Market Structure Sentiment is a constant meter of human fear and greed, through stock-picking, macroeconomic musings, quantitative models and speculation.  We don’t need to make monetary policy a separate input. The behavior of money already tells us what people think.

Money is the drug. The Fed is the dealer. 

Broad Market Sentiment told us in April the monetary party was over. That’s when money stopped flooding to equities and Broad Market Sentiment stopped rising toward 7.0 and stalled near 6.0.  Broad Market Sentiment is falling at an accelerating rate now.

We like to track daily behavioral change in the S&P 500.  Most times it runs from basis points to a few percentages. June 14, with Sentiment accelerating down, behavioral change mushroomed to 14%.

Not good.

We’re all on the Money Highway, public companies. You can have the best strategy for driving 55 (Sammy Hagar notwithstanding! Musical humor for you oldsters like me.). But if the Fed governs the freeway to 30mph, you’ll be stuck in the traffic, no way out.

And you should be measuring the behavior of money because it will tell you what everyone is doing. It’ll tell you what your stock pickers think. It’ll tell you if Passive money is coming or going. If you’re in deals, it’ll tell you if that deal gets done or gets competition.

So, is the Money Highway crumbling? The dollar is rising despite the Fed’s best efforts.  It gets hoarded into assets, and then prices stop rising. I don’t know if we’re about to tip over. I do know that every market correction in the modern era has been preceded by the same data we see now.

I wish we could all get off the Money Highway and take the backroads.

Sneeze Cloud

I know this Friday will be good.

I’ll let you think about that one. By the way, markets are closed then.

For a decade we’ve written about the way the stock market has disconnected from reality.  Nothing lays bare the truth like a Pandemic.  More on that later.

First I’ve got to get something off my chest.

I’m not a doctor. But ModernIR is as good at the physiology of American equities as those medically trained are with humans. We’re experts at threshing dense, complicated information for central tendencies, patterns.

We’ve studied and validated data around this Pandemic.  The Centers for Disease Control reports (statistics as of 2017) that in New York annually more than 4,500 people die from the flu and pneumonia.

I saw a headline yesterday saying New York City Covid-19 deaths had surpassed those on Sep 11, 2001, as if the two were related.  At least seven morbidities kill more New Yorkers every year.

I’m proud of my fellow Americans for their indefatigable patience. And I’m also tired of hysteria, propaganda turning mask-wearers against non-mask-wearers, false correlations.

Over 115,000 New Yorkers die per annum, chiefly from heart disease (a co-morbidity with Covid-19) and cancer. And 3.5 million Americans die every year.

Now we find that our rush to respirators for a Coronavirus response may be wrong.  Read about Cytokine storms. See this. We put our haste to confront a threat ahead of understanding it.

You know viruses are inanimate?  We think they’re “bugs,” malevolent living things. In fact they’re hunks of protein, sequences of RNA or DNA coated in a fatty lipid layer. They’re inert unless they encounter susceptible hosts like mucosal cells.

In the truest sense, computer viruses are like human viruses, both meaningless unless they encounter code to corrupt, incapable of corrupting otherwise.

Healthy skin is impervious to them. Alcohol dissolves lipids, proteins decay under foamy soap. Sunlight and air are also enemies of proteins.

One could say, “Yeah Quast. But they’re transmitted by people.”

True. Viruses replicate in host cells and spread through human contact.  As ever.  Karen and I joke that every time we board a plane we leave our little antibody bubble world.

Fifteen million people die yearly around the globe from viruses.  The CDC offers vastly greater numbers falling ill from virally triggered maladies. It’s always true and will be tomorrow as much as today.  We’re ever walking into someone else’s sneeze cloud.

This paper’s opening salvo says: “Influenza-like illness (ILI) accounts for a large burden of annual morbidity and mortality worldwide (WHO 2020). Despite this, diagnostic testing for specific viruses underlying ILI is relatively rare (CDC 2019). This results in a lack of information about the pathogens that make between 9 million and 49 million people sick every year in the United States alone (CDC 2020).”

Yet we’re telling people, “Trust the government. We’ll find a vaccine.” Coronaviruses cause the bulk of the one billion common colds in the USA annually.  Look it up.

“Big Short” Michael Burry, an MD turned hedge fund manager famed for betting against mortgage securities before 2008, says our response to Covid-19 is worse than the virus.

A bigger sneeze cloud.

We stipulate that any Presidential administration would be excoriated for less than pulling out all the stops, whatever that phrase means.

Today it means monetizing any economic deficiency.  Or in English, having government compensate loss with money it borrows or creates. Yet government has only the money the people surrender to it.

So the government instead reaches far into the future through the central bank and hands the future the Coronavirus and takes from the future its money, for us.

We might laugh and say, “Suckers!”

But the Constitution that’s ostensibly the supreme law of this land prohibits taking private property for public use without just compensation. No scepter for any mayor or governor or other official exists under it. There is no authority to order people to do anything unless the people first agree to it. That’s the bedrock of self-government.

In this crisis we’ve taken millions of businesses for public use (here, safety) without just compensation, offering people who expended their lives building restaurants, bars, salons, hotels, stores, gyms, on it goes, on which they depended for retirement, inheritance to pass on to children, a loan.

I’m heartsick. It will take a generation to recover, not a quarter or two.

Most people think viruses are alive and it’s untrue. Most people think the stock market is a barometer for economic outcomes, and it’s untrue. Too many suppose government can save us from life, or death. And it’s untrue.

In a way, the stock market is a sneeze cloud. Trillions in Exchange Traded Fund transactions aren’t counted as turnover (thus Blackrock is unchanged in your 13Fs when it trades frantically). Half the volume is borrowed. Fast Traders set prices. Arbitrage dominates trading. You can’t trust what it signals.

We’re going to show you the behaviors driving stocks during this Pandemic next Wed Apr 15 via a NIRI-sponsored webcast.  We’ll post details at our website, or visit NIRI.org. If you want an email update sent to you, let us know.

I can live with sneeze clouds.  Or die.  We all do someday.  I can’t live with our markets, monetary policy, crisis-response, as masquerades. We can do better.  And we better.

Bucking the Mighty

Federal Reserve Chairman Jerome Powell, keeper of the buck, speaks today. Should we care, investors and investor-relations folks?

There’s been less worshipfulness in the Powell Fed era than during the Yellen and Bernanke regimes. Out of sight, out of mind.  We tend in the absence of devotion to monetarists to forget that the mighty buck is the world’s only reserve currency.

Yet the buck remains the most predictive – besides ModernIR Market Structure Sentiment™ – signal for market-direction. So we have to know what it’s signaling.

When we say the dollar is the reserve currency, we mean it’s proportionate underpinning for other currencies. Effectively, collateral. The European Central Bank owns bucks and will sell them to weaken the dollar and strengthen the euro, and vice versa.

The USA alone holds no foreign currency reserves as ballast to balance out the buck. Instead, if the Fed wants to hike rates, dollars have to become a little rarer, harder to find.

The Federal Reserve as we noted when oil dove has been selling securities off its balance sheet.  It receives Federal Reserve Notes, bucks, in return, and that money comes out of circulation, and dollars nudge higher (forcing other central banks to sell dollars).

Combine what the Fed has sold and what banks are no longer leaving idle at the Fed as excess reserves (at the height $2.6 trillion but now below $1.8 trillion) and the supply of bucks has shrunk $1 trillion, and since banks can loan out about nine dollars for every one held in reserve, that’s a big decline out there – effectively, trillions.

So the dollar rises, and markets falter, and oil plunges.  We wrote about this back in January and said to watch for a rising dollar (even as others were predicting $100 oil).

Now why do stocks and oil react to relative dollar-value?  Because they are substitutes for each other.  As famous value investor Ron Baron says, investors trade depreciating assets called dollars for appreciating ones called stocks.

If the dollar becomes stronger, you trade fewer of them for stocks. Or oil. That means lower prices for both. Conversely, when interest rates are as low as a doormat, credit creates surging quantities of dollars, and the prices of substitutes like stocks and oil rise.

It raises a point I hope future economics textbooks will recognize: The definition of inflation should be “low interest rates,” not higher prices. Low rates surge the supply of dollars via credit, so even if prices don’t rise everywhere, inflation exists, which we find out when rates rise and prices of things used as substitutes for dollars fall.

Those people saying “see, there’s no inflation” do not understand inflation. By the way, Exchange Traded Funds have exactly the same condition, and risk. They are substitutes for stocks that expand and contract to equalize supply and demand.

Presuming Chairman Powell wants interest rates higher so we can lower them furiously – and wrongly – in the next crisis, we can expect more deflation for things that substitute for dollars.

It won’t be linear.  ModernIR Market Structure Sentiment™ signals a short-term bottom is near. There may be a rush to the upside for a bit. Credit will go to “strong sales expectations for the holiday season” when it’s likely market-makers for ETFs trading depreciated stocks for the right to create ETF shares.  Like the buck, the stocks come out of circulation – causing stocks to rise – which in turn boosts ETF shares tracking those prices.

The problem as with currencies is that we can’t get a good view of supply or demand when the medium of exchange – money, ETF shares – keeps expanding and contracting to balance out supply and demand.

The market loses its capacity to serve as an economic or valuation barometer, just as money loses its capacity to store value.

I’ve said before to picture a teeter-totter. One side is supply, the other, demand. When currencies have fixed value, we know which thing is out of balance. When the fulcrum moves, we have no idea.

That distortion exists in stocks via ETFs and economies via the mighty buck, which both must buck mightily to equalize supply and demand. Who thought it was a good idea to equalize supply and demand?  I hope Jerome Powell bucks the mighty.

Vinnie the Face

How do you know macroeconomists have a sense of humor?  They use decimal points.

While you ponder, it’s that time again when the Federal Reserve meets to wring its figurative hands over decimal points, VIX expirations hit as volatility explodes anew, and Brits consider telling Europe to pound sand.  Wait, that last part is new.

And by the way, what’s with these negative interest rates everywhere?

I’d prefer to tell you how computerized high-speed market-makers have made “the rapid and frequent amending or withdrawing of orders…an essential feature of a common earnings model known as market making,” according to Dutch regulators studying fast trading (that nugget courtesy of Sal Arnuk at Themis Trading). If you as a human do that, they throw you in jail for spoofing. If it’s a machine programmed by humans, all’s well.

We’ll instead talk macro factors today because they’re dominating. Negative interest rates, the Brexit, currencies, stocks, share a seamless narrative.

First, the Brexit looms like a hailstorm in Limon, Colorado, not because the UK and Europe are terminating trade. No, nerves are rattled because it represents a fracture in the “we’re all in this together” narrative underpinning global monetary policy. All that’s needed – infinitely – if everybody lives within their means are currencies that don’t lose value over time. There’s not a single one like that right now.

Suppose on your street some neighbors were prosperous and others deep in financial trouble, and block leaders built a coalition around a mantra: The only way for us all to prosper is if the neighbors with money give some to the neighbors without.

It altruistic. It’s also untrue.  That will ensure nobody prospers. The EU strategy has been to get countries like the UK to agree to principles that let wastrel nations offload their profligacy on responsible ones.  It doesn’t matter how one views it ideologically. What matters is the math and the math doesn’t work.

The UK is threatening to quit the block coalition on a belief that the best way to ensure that the UK prospers is to stop taking responsibility for others.

Negative interest rates tie to the EU strategy. Contrary to what you hear from droning economists and central bankers, low interest rates aren’t driven by low growth prospects. If growth prospects are low and therefore risky, capital costs should be high.  Low growth is a product of lost purchasing power, defined as “what your money buys.” If what your money buys diminishes, you’ll be buying less, which leads to low growth.

The reason money buys less is because governments are filching from their citizens by trading money for debt, and falling behind on their payments.

I’ll explain in simple terms.  If you miss a credit card payment, your creditor doesn’t receive money it’s owed. Driving interest rates to zero is tantamount to skipping payments because it reduces the amount owed.  Interest is money owed.

Suppose you told your credit card company, “I will pay you only 1% interest.” That would be nice but generally debtors don’t get to set the terms.

The world’s largest debtors are governments, and they do get to control the terms.  What’s more, they alone create money. Heard of the California Gold Rush, the Alaska Gold Rush?  Why none now?  Governments outlawed the use of gold as money. Gold is valuable, yes. But it’s not legal tender. So you can’t mine for legal tender anymore.

It’s a great gig if you can get it, spending all you want and borrowing and telling creditors what you’ll pay, and then whipping up a batch of cash to buy out your own debt.

Except even governments can’t just prestidigitate cash like a single item in a double-entry ledger. It used to be central banks offset created cash with things like gold.  Now, the entire global monetary system including the dollar, euro, UK pound, Japanese yen, Chinese yuan, etc., is backed by debt.

What does that mean?  To create money, central banks manufacture it and trade it for debt. Why? Because much of what is measured as growth today is really just rising prices. So if prices stop rising, growth stalls, and economies slip into recession and then governments have an even harder time funding bloated budgets.

More money chasing goods drives up prices. So central banks attempt to encourage spending and borrowing by creating money to buy the debts of their governments and now private companies too. The idea is to relieve banks and businesses of debts, thus enabling them to borrow and spend more, which, the thinking goes, will produce growth.

This cycle creates extreme demand for debt, which becomes so valuable that the interest rates on it turn negative.  What happens to ordinary people who borrow and spend beyond their means is the opposite. The cost of debt keeps rising until you’re paying Vinnie the Face the 20% weekly vig in an alley as he smacks a baseball bat in a hand.

So you see, it’s all related. The strangest part is that all financial crises are products of overspending.  Yet governments and central banks cannot manufacture money to save us from our largess unless we rack up debts they can buy with manufactured money.

It’s like an episode of CNBC’s American Greed in which people engage in bizarre and irrational behavior to perpetuate fraud. The world’s money is entirely dependent on more debt. It manifests for you and me in how little our money buys now.  That’s stealing as sure as someone reached in your wallet and took money out. I was just commiserating with a client about the cost of NIRI National.  Our money doesn’t go as far as it did.

What’s it mean for the equity market? It fills up with arbitragers, who see uncertainty as opportunity rather than threat.  They’re not trading fundamentals but fluctuations. They can sustain stocks for a while. But sooner or later Vinnie the Face shows up with a bat.

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.

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.

Market Facts

Volatility derivatives expire today as the Federal Reserve gives monetary guidance. How would you like to be in those shoes? Oh but if you’ve chosen investor-relations as your profession, you’re in them.

Management wants to know why holders are selling when oil – or pick your reason – has no bearing on your shares. Institutional money managers are wary about risking clients’ money in turbulently sliding markets, which condition will subside when institutional investors risk clients’ money. This fulcrum is an inescapable IR fact.

We warned clients Nov 3 that markets had statistically topped and a retreat likely would follow between one and 30 days out. Stocks closed yesterday well off early-Nov levels and the S&P 500 is down 100 points from post-Thanksgiving all-time highs.

The point isn’t being right but how money behaves today. Take oil. The energy boom in the USA has fostered jobs and opportunity, contributing to some capacity in the American economy to separate from sluggish counterparts in Asia and Europe. Yet with oil prices imploding on a sharply higher dollar (bucks price oil, not vice versa), a boon for consumers at the pump becomes a bust for capital investment, and the latter is a key driver in parts of the US that have led job-creation.

Back to the Fed, the US central bank by both its own admission and data compiled at the Mortgage Bankers Association (see this MBA white paper if you’re interested) has consumed most new mortgages coming on the market in recent years, buying them from Fannie Mae and Freddie Mac and primary dealers.

Why? Consumption drives US Gross Domestic Product (GDP), and vital to recovery in still-anemic discretionary spending is stronger home prices, which boost personal balance sheets, instilling confidence and fueling borrowing and spending.

Imagine the consternation behind the big stone walls on Maiden Lane in New York. The Fed has now stopped minting money to buy mortgages (it’ll churn some of the $1.7 trillion of mortgage-backed securities it owns, and hold some). With global asset markets of all kinds in turmoil, especially stocks and commodities, other investors may be reluctant successors to Fed demand. Should mortgages and home-values falter in step with stocks, mortgage rates could spike.

What a conundrum. If the Fed fails to offer 2015 guidance on interest rates and mortgage costs jump, markets will conclude the Fed has lost control. Yet if a fearful Fed meets snowballing pressure on equities and commodities by prolonging low rates, real estate could stall, collapsing the very market supporting better discretionary spending.

Now look around the globe at crashing equity prices, soaring bonds, imploding commodities, vast currency volatility (all of it reminiscent of latter 2008), and guess what?  Derivatives expire Dec 17-19, concluding with quad-witching. Derivatives notional-value in the hundreds of trillions outstrips all else, and nervous counterparties and their twitchy investors will be hoping to find footing.

If you’ve ever seen the movie Princess Bride (not our first Market Structure Map nod to it), what you’re reading seems like a game of wits with a Sicilian – which is on par with the futility of a land war in Asia. Yet, all these things matter to you there in the IR chair, because you must know your audience.  It’s comprised of investors with responsibility to safeguard clients’ assets. (more…)