I take August mostly off. But with such profound changes unfolding across the world, and the end of the Fed’s rate cycle approaching, I hit the road to hunt. Asia, Middle East, UK, East Coast, West Coast. Most markets are back to pricing a world not unlike what once was, equities, inflation markets too. But interest rates have moved in earnest, with the world awash in debts, deficits, entitlement obligations. For quite some time the Fed moved with purpose, confidence. But now that our central bankers have signaled they are more or less finished, uncertain, we enter a new period, where the market will start challenging, probing, launching incursions to test their resolve. And of course, such moments are the most interesting.
It was a boring summer. Each Monday, on our firmwide call, I yawned, repeating my previous week’s observation. The Fed was still hiking, investor sentiment remained defensive, markets were climbing a wall of worry. A multitude of concerns occupied investors’ attention. NATO was engaged in a hot war with Russia. China and the West were fighting an escalating technology/economic war. And central banks around the world were racing to normalize policy from wildly inappropriate settings. But the immutable nature of markets is such that these sorts of things don’t matter until they matter. And in late July, when the Bank of Japan signaled a change to its yield curve control policy, and the world failed to come to an end, it reminded us that it was still not time to care. Inflation was grinding lower, job growth still strong, and investors desperately clung to the hope that we will return to the great moderation. It’s a comforting hope, to be sure. It allows those deploying capital to make the same decisions they have made throughout their careers and led to gluttonous post-2008 returns. But such things were only possible in a world racing toward deeper integration, globalization, when governments were content to sacrifice the security of their supply chains in return for greater economic efficiencies, excessive corporate profits. Those days are long gone. America’s Inflation Reduction Act and the CHIPS and Science Act are just two of the most obvious examples of this new paradigm. Building economic redundancy through massive fiscal stimulus, funded by the sorts of deficits seen only in wartime, in a tight labor market, with the President of the United States on the picket lines with UAW workers, is rather different from anything today’s investors have ever seen. The opportunities and risks ahead will take years to play out before what today seems improbable appears prosaic.
US congress surprises mkt by passing extension to fund the gov’t through mid Nov, BOJ conducts unscheduled bond auction to contain 10y rate as yields press above 75bps, Fed’s Bowman says multiple hikes may be needed – in part due to oil / Barr says rates are likely sufficiently restrictive, BoE’s Mann (hawk) reiterates that policy should stay tighter for longer, Japan’s Tankan survey shows inflation expectations holding above 2% (record highs), TSLA deliveries missed forecasts, Japan All industry capex 13.6% (13.5%e), UK House Px -5.3% (-5.6%e), Italy unemp 7.3% (7.7%e), EU unemp 6.4% as exp, US mfg PMI 49.8 (48.9e), US ISM mfg 49.0 (47.9e) / prices paid 43.8 (49.0e), S&P +0%; McCarthy ousted as speaker / no clarity on who’s next, JPY jumps temporarily on suspected intervention, RBA unch as exp / slightly dovish rhetoric, FT reports European commission is preparing to unlock some of Hungary’s development funds, Fed’s Bostic says need to hold rates ‘for a long time’ / Mester backs a Nov hike if economy holds steady, ECB’s Lane says need to maintain rates for ‘as long as needed’, strong JOLTS data sends US rates to fresh highs, Turkey CPI 61.53% (61.60%e) / Core 68.93% (67.20%e), US JOLTS 9.61m (8.815m exp), S&P -1.4%; RBNZ on hold / little change, 75k Kaiser Permanente workers begin strike, SBF trial begins, MOF declines to confirm or deny JPY intervention, Indonesia CB bought bonds to build confidence and stabilize FX rate, sharp correction in Crude oil following weaker ADP, EU retail sales -2.1% (-1.0%e), EU PPI -11.5% as exp, US ADP 89k (150k e), US factory orders 1.2% MoM (-0.3%e) / durable goods orders 0.1% (0.2%e), S&P +0.8%; Fed’s Daly says recent rise in yields equivalent to a hike, Mexican government announces a surprise change to airport tariffs, S. Korea CPI 3.7% (3.5%e), France IP -0.5% as exp, US Trade balance -$58.3b (-$59.8b e), US init claims 207k (210k e), S&P -0.1%; US NFP 336k (170k exp) / unemp 3.8% (3.7%e) / AHE 4.2% (4.3%e) – US yields moved double digits bps higher before turning around to finish only modestly higher, RBI unch as exp / hawkish tone – announced OMO sales to manage liquidity, Peru CB cut 25bp as exp, Japan Labor earnings 1.1% (1.5%e), Germany Factory orders -4.2% (-7.9%e), Hungary IP -6.1% (-2.9%e), Canada emp chg 63.8k (20.0k e) / unemp 5.5% (5.6%e), US consumer credit growth -$15.62b (+11.7b exp), S&P +1.1%; Hamas launches attack on Israel and Netanyahu declares Israel is at war, UAW announces concession from GM that puts EV plants under labor contracts.
India 57.5 (previous month 58.6), Russia 54.5 (previous mth 52.7), Norway 52.49 (previous 51.19), Indonesia 52.3/53.9, China 50.6/51, Greece 50.3/52.9, Singapore 50.1/49.9, South Korea 49.9/48.9, South Africa 49.9/51, Mexico 49.8/51.2, Vietnam 49.7/50.5, Turkey 49.6/49, Hong Kong 49.6/49.8, US 49/47.6, Brazil 49/50.1, Japan 48.5/49.6, Spain 47.7/46.5, Canada 47.5/48, Hungary 47.4/46.7, Italy 46.8/45.4, Taiwan 46.4/44.3, Switzerland 44.9/39.9, UK 44.3/43, France 44.2/46, Poland 43.9/43.1, Netherlands 43.6/45.9, Sweden 43.3/45.5, Czech Republic 41.7/42.9, Germany 39.6/39.1, Austria 39.6/40.6. India 61/60.1, Russia 55.4/57.6, Ireland 54.5/55, Japan 53.8/54.3, Australia 51.8/47.8, Spain 50.5/49.3, Germany 50.3/47.3, China 50.2/51.8, US 50.1/50.5, Italy 49.9/49.8, UK 49.3/49.5, Brazil 48.7/50.6, Sweden 46.3/48.4, France 44.4/46.
S&P 500 +0.5% and VIX -0.07 at +17.45. Nikkei -2.7%, Shanghai +0.0%, Euro Stoxx -1.2%, Bovespa -2.1%, MSCI World -0.3%, and MSCI Emerging -1.6%. USD rose +4.3% vs Mexico, +3.1% vs Russia, +3.1% vs Chile, +2.3% vs Ethereum, +2.2% vs Brazil, +2.0% vs South Africa, +1.0% vs Indonesia, +0.8% vs Australia, +0.7% vs Turkey, +0.6% vs Canada, +0.5% vs Sweden, and +0.2% vs India. USD fell -2.7% vs Bitcoin, -0.3% vs Sterling, -0.1% vs Euro, flat vs Yen, and flat vs China. Gold -1.1%, Silver -3.2%, Oil -8.8%, Copper -2.9%, Iron Ore flat, Corn +3.2%. 10yr Inflation Breakevens (EU -10bps at 2.24%, US -2bps at 2.32%, JP flat at 1.23%, and UK -5bps at 3.80%). 2yr Notes +4bps at 5.08% and 10yr Notes +23bps at 4.80%.
Argentina +57.5% priced in US dollars (+211.2% priced in pesos), NASDAQ +28.3% priced in US dollars, Hungary +28.1% priced in US dollars (+25.8% in forint), Greece +20.8% in dollars (+22.3% in euros), Italy +15.9% (+17.3%), Ireland +15.2% (+16.7%), Denmark +13.4% (+15.1%), Poland +12.3% (+11.2%), S&P 500 +12.2% in dollars, Taiwan +11.7% (+16.9%), Spain +10.9% (+12.2%), Mexico +9.7% (+2.5%), MSCI World +9.3% in dollars, Germany +8% (+9.4%), India +8% (+8.6%), Czech Republic +8% (+10.9%), Euro Stoxx 50 +7.9% (+9.2%), France +7.7% (+9.1%), Brazil +6.5% (+4%), Russia +6.1% (+46%), Venezuela +4.8% (+112.3%), Japan +4.2% (+18.8%), Turkey +4.2% (+53.7%), Netherlands +4.2% (+5.5%), Saudi Arabia +3% (+2.7%), Switzerland +2.3% (+1%), UK +1.7% (+0.6%), Korea +1.1% (+7.7%), Sweden +0.1% (+5.4%), Indonesia -0.3% (+0.6%), Chile -0.8% (+7.6%), Russell -0.9% in dollars, Austria -1.4% (-0.2%), Canada -1.7% (-0.7%), Colombia -3.7% (-14.3%), Singapore -4.3% (-2.4%), UAE -4.5% (-4.5%), Norway -4.8% (+6.1%), China -4.8% (+0.7%), Philippines -6.3% (-4.7%), Israel -6.7% (+2.5%), Belgium -6.9% (-5.7%), New Zealand -7.4% (-1.6%), Australia -7.6% (-1.2%), Portugal -8.2% (-7.1%), Malaysia -11.4% (-5.3%), HK -11.9% (-11.6%), South Africa -13.2% (-1.5%), Finland -14.3% (-13.2%), Thailand -19.2% (-13.8%).
Imagine that there are three states of a highly indebted world. The first is the one we experienced for over a decade in the pre-pandemic world. Low inflation, low wages, low interest rates, high asset price growth, rising income and wealth inequality, rising generational conflict. To support this state, the Fed needed to continually expand its accommodation, which lifted asset prices, but in an increasingly unequal state, this did not materially lift the real economy. It amplified the growing political divide, conflict. It hit its practical limit.
Now imagine a second state of the world, where politicians and policy makers recognized that the pre-pandemic policy mix was unsustainable. To restore balance to the system, the decision was taken to adopt less profligate policies, step away from supporting asset prices, and let the system cleanse itself. Defaults would race through those sectors of the economy that had been artificially supported by policy. The weakest would fail. The wealth divide would narrow dramatically as paper wealth contracted. This would cause a depression and there is no appetite for this state.
The third state is what we see today. A deliberate effort to boost nominal growth through fiscal expansion, and policies to lift investment and consumption, while praying that the private sector delivers a miraculous productivity boost before markets erupt. It’s understandable and even logical for politicians and policy makers to choose this path given that America has a habit of producing productivity booms. Plus, what else could they choose? The first state led to this third state, which is why there’s no returning to it. And the second state is something that they will choose only if forced to by financial markets, which is where we head if the third state fails.
This is super boring unless you’re a nerd. 10yr US interest rate swaps currently yield 4.5%. If you buy one 2yr payer swaption on 10yr US interest rate swaps at 5.5% (an option that allows you to borrow at that rate) and sell 1.5 payer swaptions at 6.5% (an option that requires you to lend at that rate if swap rates are higher than 6.5%), it will cost you 7bps today. You breakeven on the trade if 10yr swaps are at 5.57% in 2yrs. You make a maximum profit of 93bps if 10yr swaps are 6.5% in 2yrs. And if rates head higher still, you make less profit until 10yr swaps rise above 8.43% in 2yrs time (this is your 2nd breakeven level).
As we all know, nerds rule the world, so congrats on making it to this section. When option markets price trades so that 10yr interest rates need to move from 4.5% today to 8.43% in 2yrs time before you lose money on a structure like this, you know traders/investors are damn scared. Most of the time this means we’re approaching a correction/retracement/reversal. In a very small percentage of the time, it means the market is sensing something much bigger. A lurking fat tail that few can see. A true debt crisis, a massive inflation, a run on the US.
The UK swap market is priced identically to the US market which is odd. 10yr UK interest rate swaps yield 4.5% today and the 2yr 1x1.5 ratio payer spread (described above in Nerds) costs 7bps (5.5% vs 6.5% payer strikes) and the upper breakeven is identical to the US at 8.43%. Nerds tend to hunt for opportunities all over the world. So here are the equivalent levels in the EU and Japan: The EU 10yr swap rate is 3.27%. The 1x1.5 ratio that costs 7bps (4.15%-5.00% strikes) has an upper breakeven at 6.63%. The Japanese 10yr swap rate is 1.00%. The 1x1.5 ratio that costs 7bps (1.50%-2.25% strikes) has an upper breakeven at 3.68%.
“We need options, so we’re doing the work to ensure we can operate no matter what may unfold,” he said, Hong Kong far below, Kowloon across the shrinking harbor. “All our people, millions of them, day to day economic life, we must ensure we can function in any scenario.” It was an unusually clear day for late September, typhoon season. The pollution was light, extending our view so that in my decades of travel, Macau had never appeared so crisp. “In recent years, the disruptions to SWIFT and related actions have forced us to develop alternative systems. And even if our earliest versions are not as efficient as the existing financial rails, even if our Plan B is not as good as Plan A, we must have the ability to transition to it.” Some meetings are intended for specifics, this was not one. We were covering ground quickly, macroeconomics, geopolitics, technological change, blockchain, AI, the staggering shifts underway. Central bank digital currencies and stablecoins will play a central role in the evolution of global payment and settlement rails. The weaponization of the dollar and the monetary infrastructure that supported half a century of ever closer global economic integration, globalization, has catalyzed efforts to develop alternatives -- Newton’s Third Law of action and reaction. “Competition is good, and we are on the cusp of an exciting and volatile period,” I said. “China is a far more formidable competitor than the Soviets ever were, and existential struggles between advanced economies produce remarkable innovations.” We might want to believe that cooperation between great nations is the path to solving humanity’s multitudinous problems, but history suggests that the path to progress will come through competition, confrontation. Advances in miniaturized nuclear power plants, cold fusion, robotics, life sciences, agriculture, AI. “Huawei’s latest phone and its advanced chip design likely overstates the speed at which China can catch up to the US, but the race is on, like it was after Sputnik. It will be inflationary, inefficient, as nations transition from profit maximization to economic resiliency, redundancy. But in the end, it will produce remarkable advances, and lead to a much better future for everyone. Provided we don’t destroy one another.”
Good luck out there,
Chief Investment Officer
One River Asset Management