ECB’s Dovish Taper Means Higher Dollar and Higher Inflation

Mario Draghi shocked the market by giving it exactly what it wanted. The ECB tapered the monthly amount of bond buying from EUR80b to EUR60B, but extended the duration of the purchases for another nine months. This effectively increased the total amount of QE to EUR540b. Critically the ECB made two other dovish moves; first it increased the amount of bonds it can buy through the inclusion of 1 year maturity notes; second it announced it will buy bonds that yield below the deposit rate of -0.4%. The effect of these decisions will be that short term rates in the Euro-zone will likely fall below the -0.4% deposit rate.

Euro To Break 1.05
The knee jerk reaction was a significantly stronger Euro and weaker dollar – but once the market realized that this was not really a taper, the move was reverse. On the reversal BK re-entered his short Euro, long Dollar position. In BK’s humble opinion, today’s move by the ECB should be enough of a catalyst to push the EURUSD rate below the critical 1.05 level.

 

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The 1.05 level represents both support since 2015 and the convergence with a major trend line that extends back to the inception of the Euro. A break of this level has the potential to lead to a significantly lower Euro. In particular, over the next year parity with the US Dollar would be a good target. In effect this means that the US Dollar Index will climb substantially higher.

Yuan to Weaken Above 7
A substantially weaker Euro will give China cover to weaken the Yuan further, although China will claim it is maintaining a stable Yuan. Recall that China now pegs its currency to a basket called the CFETS, which is weighted away from the US Dollar and toward the Euro – therefore to maintain stability with a weakening Euro the Yuan must also weaken. In “Shrodinger’s Yuan,” BK explained how this peg to a basket of currencies is pure brilliance on the part of the Chinese. In short, China can claim that it is simply maintaining a stable currency, when in reality most shipments are priced in US dollars.

While shorting the Yuan is a virtually impossible trade for non-institutional investors, there is a way to play the coming weakness…buy bitcoin. China has the largest bitcoin trading markets, in fact, bitcoin trades more daily volume in China than the Gold ETF (GLD) trades on a daily basis in the US. Bitcoin is China’s safe-haven asset. Over the last year, the price of bitcoin has lead the Yuan rate by a few weeks to a few months. At current prices, bitcoin is pricing in a USDRMB rate of 6.94 or 1.24% weaker than current spot prices. BK expects that as the Yuan weakens the price of bitcoin will rise and price a further weakening above 7.

Get Ready for Rising Inflation
One might think that a rising dollar would act as a brake on inflationary pressures but one would be wrong. The truth is that a rising dollar and a weakening Yuan means that China is now exporting inflation – this is a marked change from recent history and the market has yet to realize it. Rising commodity prices and wage pressures in China are increasing factory gate prices or PPI. China has suppressed price pressures for as long as it can and now rising PPI will be passed through to the supply chain. This means that everything from iPhones, drones and clothes will become more expensive for US consumers.

If rising prices for consumer goods is coupled with a robust US economy then we may just be in for the good type of inflation. But if PEOTUS’ trillion dollar stimulus doesn’t do the job, then this inflationary impulse could be labeled bad. In either case, the trade is to buy gold and silver. This is exactly the environment where precious metals rise at the same time as the US dollar rises.

Italy: The Slow Moving Train Wreck

The markets got the Italian Referendum wrong. It’s not that investors were surprised as evidenced by the muted reaction – it’s that investors are not seeing the slow moving train wreck that is the bailout of the Italian bank Monte Paschi. In the days since the NO vote, the private bailout led by JP Morgan has essentially disintegrated, leaving only a state bailout as the option. The market incorrectly assumes that the Italian government will simply step in and provide the EUR5B needed for recapitalization. But there are two problems with this assumption: 1.) Bailouts are illegal under EU law 2.) The amount needed for a recap is double the projection.

 

Illegal Bailouts

Since the Cyprus crisis the EU has required that states “bail-in” banks before a government guarantee – what this means in practice is that the bondholders of the bank will lose money when the Italian government steps in. But isn’t just greedy capitalist hedge funds who hold bank debt? Nope, it’s Italian citizens and depositors at the bank. If you thought there was political chaos after the NO vote, just wait until Monday morning when bank depositors find their life savings have been usurped.

The Italian government recognizes this conundrum and according to the FT, there is a plan:

“To avoid the politically unpalatable option of imposing losses on the €2bn of retail bondholders in Monte dei Paschi, a plan is being drawn up to guarantee full repayment of the first €100,000 to every junior bondholder, according to senior bankers. Senior bonds and deposits would be left unscathed. “

Besides potentially violating EU laws, the problem with this plan is it still leaves retail bondholders holding the bag – anyone with over EUR100,000 will have their money seized by the state. This will play right into the hands of the populist parties like the 5 Star Movement.

 

Need a Bigger Boat

The second problem with the bail-out plan is that it is too small. According to the FT:

“The bank is also likely to press ahead with plans to hive off €28bn in soured loans to a securitisation vehicle supported by a government guarantee.”

This plan sounds great until you realize that the bad loans are probably closer to EUR60b if you believe Steve Eisman of Big Short fame. In a November 19, 2016 interview with the Guardian newspaper, Eisman had this to say:

“Europe is screwed. You guys are still screwed,” says Eisman. “In the Italian system, the banks say they are worth 45-50 cents in the dollar. But the bid price is 20 cents. If they were to mark them down, they would be insolvent.”

Add this to the fact that Italian Debt to GDP is 132%…before any bailout! Given the fact that Italian government debt prices have not cratered, it is obvious that investors are betting the ECB will be the buyer of last resort. But will German citizens really want to bailout Italy?

 

The Trade

The direct trade is to be short of Euros – the only way out is to print a whole bunch more. The second place is to look for short entries in the Italian ETF (EWI). Even if a bailout/bail-in is achieved the odds of it increasing economic growth are quite slim. And finally, where have people turned when their money is seized by the state… bitcoin.

BK: Everything is Awesome!

Everything is cool when your part of a team! Especially if your team is called the “Buy the Dippers.” After Italy plunged into political chaos, the bailout of the banking system was dealt a blow of uncertainty, leaving the world’s third largest bond market vulnerable to a destructive sell-off… until market participants realized that everything is awesome! The half-life of political chaos creating market turmoil can now be measured in minutes.

Coupled with the Quitaly vote, was a diplomatic nose thumbing by the US President-Elect (PEOTUS) when he just happened to be walking by a ringing pay phone and picked it up. Lo and behold the President of Taiwan was on the other line… weird right? And just in case this serendipitous event didn’t drive the message home, PEOTUS went on a Twitter-rant about Chinese currency manipulation. Either of these “negotiating” tactics could have spooked investors into believing that a trade war was imminent… but then we all remembered that Everything is Awesome!

So what is a skeptical (read: sane) trader to do? Trade the market he is given and worry about the long run consequences in private. With the S&P 500 futures up 9 points the conditioning of investors can be declared complete. BK can’t imagine that a 25 bps hike by the FED is going to matter, nor can he imagine another political shock will have any impact on asset prices. At least for now. All these catalysts will now bubble under the surface until one gains enough energy to break investors out of their stupor.

On that note, BK will leave you with the lyrics of Everything is Awesome – while reading and singing (you know who you are) imagine a world where everyone is blissfully unaware…

Everything is awesome, everything is cool when your part of a team
Everything is awesome, when you’re living out a dream
Everything is better when we stick together
Some have said you and I are gonna win forever?
Lets party forever
We’re the same unlike you, you’re like me we’re all working in harmony

The Santa Claus Tax Rally

It’s seasonality stupid. That’s what BK said to himself last night after Karen Finerman brilliantly pointed out that investors might be reluctant to take profits this year due to the potential for a change in the tax code next year. Her elegant insight was that in 2017 there is a high probability that tax rates will be lower and thus selling before year end was not a smart move when viewed from a capital gains tax perspective. In fact, President-elect Trump’s Treasury pick, Steve Mnuchin, stated on CNBC that his top priority was lowering taxes. There are certainly some hurdles to a massive tax code overhaul, but its clear that taxes next year will be no worse than this year, so it behooves investors to wait for 2017 to take profits.

Despite the enormous move since the election, this simple insight could be the fuel for a sustained year end rally in stocks. If the majority of investors also decide not to take profits this year then the supply of equities for sale could be reduced. At the same time that supply is constrained, the demand for US equities continues to rise – especially from those who may have missed the rally. This also means that investors waiting for a pullback might be disappointed. Disappointment coupled with performance anxiety could lead to a FOMO rally. For the millennial-challenged: FOMO = Fear of Missing Out.

The one thing BK will be watching to verify this thesis is volume. In particular, the volume on sell-offs; if this thesis is correct then volume on sell-offs should be anemic as the amount of sellers has dwindled. At the same time, volume on rallies may not live up to historical norms because of the lack of sellers – this could result in a “gappy” market where investors pay up for size.

Market participants have been fearful of a lack of liquidity as a downside risk, but few expect it to be an upside risk.

Trump & Kanye Drop the Mic

Kanye West abruptly cancelled his tour last night and President-elect Trump indicated he would fulfill his promise to pull out of the Trans-Pacific Partnership (TPP). At first blush Kayne’s decision to forgo $30m in ticket sales seems foolish, but he brilliantly just created scarcity of supply for his product. If the supply of concerts can disappear without notice and demand remains the same, then the price of Kanye tickets should rise. Unfortunately, the same maths do not apply to the rejection of the TPP.

While BK is in favor of both fair and free trade, the rejection of the TPP risks significantly higher interest rates (yes, even higher than the recent bond bloodbath suggest). The largest buyers/holders of US debt are China, Japan and the Federal Reserve – the reason that China holds so much debt is because US consumers buy goods at Walmart. The US dollars spent at Walmart filter through the supply chain back to China where the PBoC converts them into Yuan, But now the PBoC has a big stack of “Benjamins” that must be invested into something. What’s the safest most liquid US dollar denominated investment? Yep, US Treasuries.

Trade with China has allowed the US to run massive deficits.

What’s more, central to Trump’s economic plan is a yuuuuge infrastructure spend, financed by selling US Treasuries. In fact, Trump’s chief strategist Steve Bannon has suggested taking advantage of low interest rates to fund projects is a near perfect plan.

But there is a problem.

If the traditional buyers of US treasuries no longer need to buy because of reduced trade, then (absent another yuuuuge buyer) the price of Treasuries should fall and yields rise. So what’s a debt lover to do? Eventually BK expects banks and US pension funds will be forced to buy US debt – or perhaps it will be framed as their “Patriotic Duty” to swallow a bunch of unwanted treasuries – but that is not a problem for today.

The difference between Kanye and Trump is that Mr. West created scarcity of supply in a market with overwhelming demand. On the other hand, Mr. Trump has created scarcity of demand in a market with overwhelming supply.

The US Dollar is the New VIX

The VIX Index is broken. It no longer provides an accurate measure of the amount of leverage in the financial system. This poses a problem because central bankers, regulators, policy makers and economic forecasters all use the VIX as a the central measure of leverage. This is the conclusion of Hyun Song Shin of the Bank for International Settlements (BIS) in a speech presented on November 15, 2016. This speech is one of the most important insights into the global financial system since people began to warn of the coming sub-prime crisis in 2005-2007. BK encourages everyone to read and then re-read this speech…it’s that important.

To be sure, the subject matter is dense and requires the reader to understand things like interbank lending, covered interest parity and cross currency basis swaps. But BK assures you that understanding these concepts and reading this speech will provide an asymmetric return on time invested.

BK also understands that we are all time-challenged so here are the highlights of the speech and BK’s bullet points for understanding:

From the speech:

Given this close association between the VIX index and leverage, a generation of researchers grew up with the VIX as a “wonder variable” in empirical research. The VIX was like the secret sauce that livened up an ordinary dish. The VIX was able to capture the way that risk appetite fluctuated in the financial system. Risk-taking depends on leverage, and if the financial system as a whole goes through a period of ample funding liquidity, even thinly capitalised banks can borrow on easy terms. Since banks borrow in order to lend, easier borrowing conditions translate into easier lending conditions, reinforcing the already easy financial conditions. By the nature of the interactions between liquidity conditions and leverage, the boom phase rides an apparent virtuous circle of greater leverage and easier liquidity. The VIX index was capable of capturing such shifts in sentiment.

However, something has changed in recent months, and the VIX no longer works as a barometer of the appetite for leverage. We can see this from the centre and right-hand panels of Graph 1. The middle panel of Graph 1 shows that in the years after the crisis, the VIX index has been subdued, easing to levels close to the lows seen in the years before the crisis. Despite this, leverage has continued to fall. Leverage of the broker-dealers is now around 18, lower than at any time in the last 25 years.

And here’s some BK Bullets:

  • The US dollar is used as the base currency in international lending.
  • In order to operate long supply chains (i.e. iPhones made in China and shipped to US) working capital is needed.
  • This working capital is financed by the banks and denominated in US dollars.
  • Since manufacturers (like Foxconn) finance in US dollars but pay salaries in local currency (Yuan), when the dollar rises profit margins decrease.
  • The declining profit margins cause the banks to lend less.
  • This creates a forced deleveraging that is NOT captured by a rising VIX.
  • Therefore the higher the dollar rises, the greater the probability of a forced deleveraging similar to 2008.

Bottom Line: The rising US dollar could be a Black Swan that everyone sees, but no one thinks is a problem.

S&P 500, Cleanest Shirt or Lost Sock?

Of the market pundit phrases used to describe the US stock market, “the cleanest dirty shirt in the closet” is by far BK’s least favorite. And by least favorite BK means that it makes him physically ill when he hears it. Don’t worry I am getting help. Despite BK’s distaste for the phrase, it does appear to accurately describe the relative outperformance of US shares. With global PMI’s coming in soft (and US ISM on deck) BK wonders if the S&P 500 is better described as the lost sock that soon will be reunited with its hosiery homies.

The following chart illustrates the outperformance of the S&P 500 against the other major indexes (Japan and Germany) since mid-February.

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Given the interconnected nature of the global economy, it is only a matter of time before these indexes converge. Of course the trillion dollar question is whether that convergence will see the Nikkei and DAX rise to meet the S&P 500,or (gasp) the S&P 500 rejoin its siblings of the stocking variety at lower prices.

Based on what I’ve been saying for the past few months it should be no surprise that BK’s bias is for lower prices, but bias and opinion only become fact when validating by price action. Soooo… WWBKD?

BK will wait and see if US shares falter after the better than expected (feared) ISM report this morning. BK would be tempted to add a SPY short if it fails here.

Two Things Everyone is Missing About Brexit

Brexit is political crisis that has morphed into a economic crisis. The economic crisis is upon us. Another EU member does not need to leave, nor do we need to wait and see how central bankers will respond. Brexit is enough of an economic shock to create a banking crisis in Europe, while the move in the US Dollar is likely to push the global economy into recession.

European Banking Crisis

The epicenter of the European baking crisis has been Italy. The Italian banking system never fully recovered from the Eurozone debt crisis and just a month ago a bailout fund was created to mop up the bad debt. The fund has failed to stop the bleeding. Non-performing loans have been rising and the economic shock from Brexit is likely to accelerate this trend. The probability that Italian banks will need an EU wide rescue has risen substantially. This is why the Italian stock market is down over -15% in just two days!

The bailout of the weaker banks in Europe is just the first phase of any potential banking crisis. The second phase will be a result of the unprecedented volatility that has and will continue to occur. Undoubtedly several hedge funds and possibly large banks have been mortality wounded by the volatility. Brexit was/is a Black Swan – it was not predicted and the moves in asset prices were as high as 6-12 standard deviations. These are unprecedented levels and as such have likely damaged financial institutions.

As this second phase plays out, the larger players (like Deutsche Bank) will seek to reassure investors that they are well capitalized. Moreover, the ECB will also be in defense mode. However, these institutions are not in control. With instruments like COCO bonds, the market is the captain now. It is highly probable that second stage of the European banking crisis will feature several COCO bond induced death spirals.

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The Dollar

IBKHO it is naive to assume that because the UK and Europe are a relatively small portion of US exports that the US will be insulated. This analysis ignores the impact of a strong dollar on both US multinationals and US banks. As the Bank of England, ECB and Bank of Japan are forced into further monetary stimulus the US Dollar has the potential to rally significantly. BK has written before about the $9 trillion worth of US denominated debt that will act like an accelerator as the dollar rises. US multinational earnings will fall not just because of the uncertainty around Brexit, but also because the US dollar is likely beginning a massive short squeeze induced rally.

The second derivative effect of the strong dollar will be weaker commodity prices, especially oil. A global recession as a result of a European banking crisis will erode demand. This demand erosion coupled with a rising dollar could push oil back to its lows. The financial markets (and US banks) will once again be faced with the possibility rising delinquencies in the oil patch.

Where Could BK be Wrong?

The best case scenario would be for UK and EU politicians to cooperate quickly to remove the political uncertainty. As well, a coordinated central bank response to both support the economy and the European banks is needed immediately to stop a banking crisis. If this occurs then we may avoid the most dire outcomes.

Unfortunately it appears that this will be a slow moving train wreck which will be devastating for some and highly profitable for others. Choose your side wisely.