The Narrative Matrix


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It’s 1999, and Mr. Anderson (a.k.a. Neo) has a desk job. His hacking leads him to Morpheus, who suggests Neo’s perceived reality is nothing more than a computer simulation – a virtual reality created by an artificial intelligence (AI) called the Matrix. The AI has created a utopian version of what is a far more dystopian reality. In fact, the AI uses energy from enslaved and unwitting participants’ bodies to sustain itself. Morpheus is convinced Neo is ‘The One’ who can hack The Matrix. Philosophically, the Matrix asks the age-old, philosophical question: is reality the product of some objective truth or is it the product of subjective perception? Perhaps more importantly, does it really even matter? After all, ignorance is often bliss.

The Matrix might be the ultimate narrative – one so pervasive and enveloping that it transforms participants’ reality. It presents an extreme and fictional case study that may be informative of the narratives we see in today’s world – particularly in politics and financial markets. The impetus for this meme was a presentation in Toronto last week hosted by Waratah Capital and featuring Epsilon Theory’s Ben Hunt. As the conversation over dinner unfolded, I perceived a feeling of congenial unease – as if we all knew we are living in a Matrix of sorts. Many narratives today have proponents committed to preventing hacks. The Chinese authorities’ coronavirus narrative, consisting of a controlled and linear disease spread but contrasted by one of exponential recovery, is emblematic of how managed narratives can pose clear and present danger. Central banks have similar incentives towards achieving their own social agenda – the dual mandate. Independent thought or discordant views are often unwelcome or simply not understood.

Understanding how a narrative is structured and how it has evolved is essential to processing the information it contains. Ben characterized his own almost Nietzschean stages of awakening towards a deeper understanding of how narratives work in three phases. First, he characterized himself early in his journey as a ‘weak form narrativist.’ (As I wrote this, I needed to add the word narrativist to my dictionary, but it is a worthy addition.) From there, he moved to a ‘semi-strong form narrativist.’ Eventually, he moved to where he is now: a ‘strong form narrativist.’ As one can easily discern from the moniker, a strong form narrativist believes reality and perception essentially merge within narrative, and for a loooong time.

What I enjoyed most about the stages of awakening was its symmetry to various forms of market efficiency – weak, semi-strong and strong. In a world of strong form market efficiency, there is no room for participants to interpret data. There is no room for narratives to influence perception or interpretation. There is no room for conceptual advantage or disadvantage. By that model, information in its unadulterated form is almost immediately reflected in price. To be clear, as a Columbia graduate (and just because it makes common sense), I have never been a buyer of the notion of efficient markets (especially of the strong form variety).[1] The efficient market narrative itself has become something its creators’ purely theoretical framework never intended. When narratives become a religious devotion, they may persist for what may seem an eternity – until they don’t.

I have come to regard informational perception – often the product of a narrative or narratives – as the key to understanding how markets price assets.  Within this framework, fundamentals provide an equilibrating anchor to which price is ultimately drawn, but sentiment most often drives divergence from that price. These fundamental equilibria are most often short-lived and are an exception to what is more often persistent disequilibrium. Figure 1 illustrates the equilibrating fundamental anchor, around which narrative-driven sentiment may rhythmically diverge. Different kinds of narratives demonstrate different life cycles and have different rhythms.

Narratives may be borne of different causes. What gives birth to a narrative often impacts its persistence and the persistence of the virtual reality it creates. At times, narratives are explicitly crafted ‘by fiat’ (as with the US-China trade deal) or at other times they are more organically grown (as with the organic narratives on Robinhood driving the likes of Virgin Galactic stock). Fiat narratives often evolve quickly and are not always easy to identify, typically because governmental bodies may exert influence over more credible entities who report data and manage the message. Often, the message reads: “It’s for your own good.” On the other hand, organic narratives may take years to evolve. In such cases, after several successful TV seasons, reality TV CEOs of average talent become real life super-star executives. How? People believe the legitimacy of a media-generated reality – especially when it is personalized and becomes pervasive consistently over time. Social media, in particular, may create a computer-generated virtual reality of sorts for many who live their lives through their virtual avatars. Social media and Web-based content may also foster the normalization of extremes. This is a powerful way in which either fiat or organically grown narratives may change social norms.

Fiat news, as Ben characterized it, is particularly powerful – especially in the absence of an offset from free press – as in China. Indeed, it is one of the reasons free press is essential to democracy and to free markets. I might suggest that fiat news is particularly well-understood within a strong form narrative framework because the forces behind the narrative are powerful enough to create a virtual reality. The mechanism of a fiat narrative’s creation may be fiscal or monetary policy, or it may be a governmental or other coordinated media programs. Misinformation campaigns and subliminal messaging has always existed, of course, but their use has seemingly become more pervasive and unabashed. It seems somewhat obvious, especially after the 2016 election and Russian interference in it, that social media plays an important role in the rapid proliferation of fiat narratives. It has enabled messaging that makes extremes (like QE) appear more normal. Once again, extremes become normal.

Whether a fiat narrative or an organic one, it is precisely the impact that narratives have on the interpretation and perception of information – especially when everybody has it – that creates opportunity. As finance professionals might say: this is what makes markets. Said differently, even when everybody in a market has exactly the same information, a ‘bid’ and ‘ask’ can still exist apart from a singular price that reflects all information. Markets are inefficient precisely because they do not price in information in some absolute sense. They price new information based on its context within a narrative. The same information may be interpreted quite differently by different market participants, especially if one participant subscribes to a different narrative than another. When we interpret market information, it is not unlike how we interpret prose. We may all read the same words, but how we interpret and perceive it – often based on experiential bias – may be quite different. That said, it remains my belief that there tends to be an equilibrating fundamental anchor to which price is drawn over time.

Indeed, memories are often more about the emotional response a narrative creates than about specific information one retains. Thus, the weight of information is amplified or diminished by the poignance of the narrative. A well-crafted narrative will create a desired emotional response. So, the strong form adaptation of narratives is precisely about (albeit not limited to) such instances, which are rife in the markets and politics right now. One-line slogans have always been an important part of politics because, if well-crafted, they have the desired emotive impact. So, what of the empirically demonstrable reality? As discussed, the narrative may lead to long-lived divergences. However, even under a strong form narrative paradigm, I remain convinced a narrative may still break. Ultimately, a reversion (at least a brief one) to the fundamental ‘equilibrium’ will occur.

A narrative may break when it creates a dislocation (a surrealistic bubble) that has become so disconnected from reality even its most ardent adopters can no longer consider it credible. This tipping point is hard to identify. Said differently, the narrative ends when its credibility (or the credibility of a key proponent) is lost. This may happen swiftly, as dissonance comes upon the duped forcefully when facts inconsistent with the narrative can no longer be denied. This is why the bubble a narrative has created over a long period may burst so unexpectedly. It may be happening right now as the COVID-19 virus begins to proliferate outside of China, and as it has become clear that scientists do not have a good understanding of how the disease is transmitted. My team at Cantor and I wrote about this on February 12th in a piece available to our institutional clients. The markets were already fragile; it may be the straw that broke the camel’s back.

History is rife with examples – especially in science – that commonly accepted establishment narratives die hard. While revered today, Albert Einstein’s early theories were spurned by peers. Lesser known, Subrahmanyan Chandrasekhar advanced his “crackpot” Black Holes theory in 1930. His colleague, Sir Arthur Eddington, wanted nothing of it. As a knight, his criticism was hard to overcome. Chandrasekhar was eventually awarded the Nobel Prize in 1983. In another example, Christian Andreas Doppler’s theory on the effects of velocity was resoundingly rejected. The Doppler Effect was accepted in 1868, but Doppler had already been dead for 15 years. I could go on and on. The good news might be that while it might take time, empiricism seems to eventually win out – even if post mortem.

In my next In the Trenches, I will address one narrative being used to justify currently extreme equity market valuations. What is that narrative? Low rates justify equity market valuations.

Well, not really …

[1] The theory of efficient markets itself, has taken on a narrative of its own and become a gospel of sorts – interpreted well beyond its intended, initial purpose as a simplified theoretical framework.

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A Cycle of Addiction


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Requiem for a Dream (2000)

A 35-year Secular Trend

Two of the world’s major central banks – namely the Bank of Japan (BOJ) and the European Central Bank (ECB) – have created what is akin to a cycle of addiction to negative interest rates. Moreover, even those developed economies with positive rates appear addicted to near-zero rates. Without them, developed market economies seemingly begin to slip back into growth malaise. [1] Ben Bernanke’s 1999 critique of the Japanese central bank’s failure to act aggressively enough to stop their ‘lost decade’ is arguably one of the first seeds of the ‘do whatever it takes’ mantras now so common amongst global central bankers. [2]  These mantras’ tools include quantitative easing (QE) – also known as Large Scale Asset Purchases (LSAPs) or Permanent Open Market Operations (POMOs) – which have ultimately forced long-rates negative in much of Europe and Japan. This suppression has far longer-lasting effects on capital allocation decisions and investor behavior than traditional rates policy using temporary open market operations (TOMOs). [3]

Step-by-step and slowly over time, the BoJ and ECB followed the Swedes and eventually arrived at negative interest rates policy (NIRP). This policy was not just limited to deposit rates but QE allowed its application to longer duration risk-free (as well as to risky) assets. Similarly, over the past 35-years, the Fed also has been on a march towards zero interest rate policy (ZIRP). However, the U.S. has the luxury of far better demographics than Europe and Japan. The U.S. also has the benefit of fiscal unity, which Europe lacks, and the U.S. has the benefit of possessing the world’s reserve currency. The structural impediments to growth in Japan and Europe have arguably necessitated more aggressive monetary policy. Not all within the central bank community agree with this approach. Former BOJ Governor Masaaki Shirakawa has identified what he calls the global ‘Japanification’ of monetary policy; importantly, he argues it has failed. [4] While Ben Bernanke has since recanted the severity of his 1999 critique, it has mattered little. Once socialized, central bankers seized upon it as an excuse to become even more active economic influencers.

An Anachronism

Traditional monetary policy models are anachronistic. Despite aggressive policy measures, inflation has not met central bank targets in the U.S., Europe or Japan. The closed and static monetary policy models of the past fail to recognize that the Fed is no longer the only large policy actor. They generally assume economies are closed and not reflexively adaptive (i.e. – dynamic). To the contrary, rates markets are open systems subject to cross-border capital flows. For example, negative rates in Europe and Japan have important impacts on U.S. rates. Figure 1 shows how the U.S. 10-year regresses against the Bund (the German 10-year). The repression of long-rates in those geographies has anchored rates here. [5] Lastly, QE killed the traditional relationships between inflation and rates, and it also murdered the Philips curve. In fact, QE has created the unintended consequence of overinvestment, overcapacity and consequent lack of pricing power. Thus, the low rates QE produced have arguably caused the low inflation central banks intended it to cure.

The most extreme deployment of QE results in prolonged periods of negative long-rates, as we currently observe in Europe and Japan. The concept of negative real rates should not be offensive on its face. Negative real rates may occur when inflation exceeds the nominal interest rate. By the Fisher identity, nominal rates = real rates + inflation; thus, real rates = nominal rates – inflation. Real rates have gone negative in the past at various periods in time, and it is one reason why the Fed or other central banks have generally chosen to hike when inflation gets too high relative to the policy rate. Traditional theory holds that negative rates are inflationary. Proponents may argue that because negative real rates have historically required central banks to raise policy benchmarks to prevent inflation (as in the Volker era) that the converse is true. That is, they may argue that the use of negative rates now will create inflation later.  We disagree. Currently, in Germany, real rates = [-.3% – .9%] = -1.1%. These deeply negative rates suggest that the ECB may be profoundly concerned about renewed deflation – ironically, we believe their prescription is producing precisely the opposite of the desired result.

Figure 1: Bunds Regressed against U.S. 10-year

While exacerbated by the trade war, the slowdowns in Europe and Japan are largely structural. If negative rates in the developed world outside the U.S. – especially long-rates – remain pervasive, the bid for U.S. duration should continue. We think low growth and the potential for capital loss will require persistently low rates. Therefore, it is our view that long rates in Europe and Japan will continue to anchor U.S. long-rates, which will trend towards zero longer-term. Over the next three to six months, we forecast the U.S. 10-year yield will approach 1.25%. [6] This likely coaxes the Fed to cut the funds rate more aggressively in 2020, as it will desire to prevent a prolonged yield curve inversion and its impact on banks. We doubt that nominal U.S. rates ever go negative as there appears to be resistance within the Fed, but we posit that real rates most certainly will. Indeed, it seems as if a Lagarde ECB might not be quite as committed to negative rates as a Draghi ECB, but she may have no choice but to force rates more negative given the capital loss that less negative rates will create. [7]


We believe QE has created an addiction to more QE (in both low-rate and negative-rate economies). Negative rates, in particular, necessitate yet more negative rates; they lock central banks and the economies they serve into a cycle of addiction to negative rate policies. [8] An addiction to low or negative rates can occur for several reasons. In order for a firm to invest in a new project, it must believe that low or negative rates will be persistent enough to limit refinancing risk. In the extreme example of negatively yielding debt, holders must also believe that rates will become more negative because they own these securities for capital appreciation rather than yield! Europe exemplifies this problem. These two behaviors are how the addiction to low rates forms.

Negative rates (whether real or nominal) are effectively a tax on capital providers – i.e. on savers. Capital providers that should receive a return for the privilege of a borrower providing stewardship of their capital are instead charged for it. This tax creates unintended consequences and incentives, just as fiscal tax policy often does. Indeed, we’d go a step further and suggest that negative rates are social policy clothed in the guise of monetary policy. Rates policy wasn’t always this way, but the world is here now and the voting public ought to pay as much attention to it as it does to fiscal policy. Democracies are based on the idea that a country’s citizens should determine a government’s decisions to tax, spend and redistribute wealth. Monetary policy has no such constraints, yet it has similar consequences for the redistribution of wealth from savers to consumers.

The costs of persistently low or negative rates may ultimately be far too high. For firms, they promote inefficient capital allocation decisions – specifically, they lead to overinvestment. Importantly, QE distorts perceptions about what rates of return an investment must produce over the long-term. For context, TOMOs distorted (lowered) capital costs for only short duration bonds. Therefore, the impact of lower short-rates was mostly to create a pull forward in demand (i.e. – an intertemporal demand impact) with only minimal impact on firms’ long-term investment decisions. As POMOs suppress term premia, the impact is also to pull forward investment (rather than just demand), as firms now have lower long-term hurdle rates. This appears to have created global overcapacity and oversupply. When industries have excess capacity, firms lose pricing power and inflation becomes difficult to achieve.

Disinflation is not the only risk to low or negative rates. It is particularly important to understand risks to a system where negative yields are common. Currently, there are about $15 trillion in negatively yielding securities. Most of those are in Europe and the rest in Japan. First, bank profitability suffers. Eventually banks pass those costs through to the real economy in the form of potentially higher lending rates (relative to the negative benchmark) and less lending. [9] Figure 2 shows that negative deposit rates are not passed along to borrowers. [10] Market participants ought to be painfully aware that the costs of negative rates may ultimately be borne by European taxpayers when Europe’s banks need to recapitalize. Because the financial system is global, a European bank recapitulation would have important implications for global market liquidity (not unlike in 2011) and the global economy. [11]

The impact of negative rates extends far beyond the banks. Negative real deposit or other policy rates force investors, especially captive audiences like pension funds and insurance companies, to take unwarranted duration or credit risk. For investors like these funds, when purchasing negatively yielding securities, they must receive the benefit of price appreciation to make up for the negative yield. It is the only inducement for such a purchase. In order to induce the purchase, central banks must implicitly guarantee they are committed to such policies. [12] This creates a self-reinforcing cycle that pushes the neutral rate to zero across the entire curve. It becomes a trap from which the central bank can’t escape. This can be said of low rates, but it is particularly true of negative rates. Negative rates necessitate more of the same.

Figure 2: Policy rate in Sweden vs. rates to individuals and corporations


The distortions QE has created (especially where QE produced negative rates) will be difficult to unwind. It is important to remember that the balance sheet expansion needed to execute on QE policies ultimately works through the suppression of term or risk premia. It is not through a quantity of money mechanism. Little firepower is left in most of the developed world for QE to have more impact, and we conclude more harm than good has already been done through negative rates policy. Overall, there are few levers left for central banks short of moving to purchases of equities (as in Japan). That leaves fiscal policy, which is notoriously inefficient and has empirically disappointed as a stimulant to growth when compared to good old fashioned productivity gains. These gains are harder to achieve when low rates keep zombie companies afloat. The seeds of aggressive rates policy and negative rates were sown in the late 1990s, and they have sprung into large dogmatic trees, which should soon be cut down.

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[1] The need for a quick policy reversal here in the U.S. when the Fed funds effective rate hit 2.5% and the U.S. 10-year hit 3.25% is anecdotal evidence of this. Now, we think 2% on UST 10-year yields is the new 3%.

[2] The Swiss actually pioneered the practice back in the 1970s to keep their safe-haven currency from over-appreciating.

[3] For a discussion of the difference between temporary and permanent operations please see Temporary open market operation suppress short rates while permanent operations suppress long rates (QE).

[4] World has learned wrong lessons from ‘Japanification’

[5] While alternate causes for the move in U.S. long rates may be a lack of above trend growth and inflation in the U.S., the move in 10-year yields versus the Bund and 10-year JGB is observable.

[6] It remains our view that European and Japanese negative yields will persist for at least the next eighteen months (and likely for much longer) because global growth will fail to turn. After the recent backup in yields, we foresee Bund yields once again below -50bps by year-end. The secular challenges to growth in Europe and Japan simply will not go away.

[7] The Philips Curve at the ECB. Those cataclysmic results include massive capital loss at pension funds and insurance companies that have purchased negatively yielding securities.

[8] Any withdrawal from these policies is likely to be a painful process for which few policy makers have the stomach. Perhaps, with a new ECB chief at the helm, a policy ‘mistake’ that allows European rates to become less negative too quickly will be the undoing of global risk-on.

[9] The impact of negative rates on banks may be summarized as follows:

  1. negative interest rates destroy NIMs;
  2. upon dipping below the ZLB (zero lower bound), banks no longer pass through negative yield to borrowers but in fact increase lending rates as a way to offset the cost of paying Central Banks for safely storing currency, and
  3. loan volumes may actually decline as rates rise because of the pass-through the costs.

[10] Negative nominal interest rates and the bank lending channel

[11] Tiering is one way the ECB has elected to attempt to ameliorate the negative impact on banks.

[12] The impact on pension fund returns is potentially catastrophic. This is where the duration and credit risk is most concentrated and could easily evolve into systemic risk.


License to Kill Gophers


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License to kill gophers by the government of the United Nations. Man, free to kill gophers at will. To kill, you must know your enemy, and in this case my enemy is a varmint. And a varmint will never quit – ever. They’re like the Viet Cong – Varmint Cong. So you have to fall back on superior intelligence and superior firepower. And that’s all she wrote.

-Bill Murray as Carl Spackler in Caddyshack

The Gopher.

Recessions. Policy makers loathe them. The human costs are real and obvious, but they also lose elections. The desire of central banks to forestall recession at all costs reminds us a bit of the war that groundskeeper Carl Spackler had with the gopher in the 1980 movie Caddyshack. [1] For those of us old enough to remember that classic movie, Spackler won a final pyrrhic victory against the gopher by planting explosives throughout the golf course – eventually destroying the very course he’d sworn to protect.

Today, it seems to us that the allegory for the golf course applies to central bank policy as it relates to financial markets. Initially, Spackler tried to use less dramatic methods to find and kill the gopher, but none of them worked. Those methods are akin to traditional rates policy. It is our view that the concept of a natural or neutral rate is anachronistic in a world where QE is global and in which capital can flow relatively freely based on national comparative advantages. Moreover, monetary policy is reflexive in that lower rates (whether through temporary or permanent open market operations) beget lower rates. The neutral rate is dynamically impacted not just by the real economy but also by policy itself.

Indeed, prolonged application of policy will result in an eventual neutral rate of zero in the United States, just as it has in much of the rest of the developed world. Extraordinary measures in monetary policy, like buying equities (à la the BoJ) are akin to the dynamite that Murray’s Spackler eventually deployed. After all, he had “a license to kill gophers by the government of the United Nations.” Indeed, it a united front of central banks that possess the license, as negatively yielding debt globally has topped $15.6 trillion (up from below $6 trillion in the third quarter of 2018). It’s only a matter of time before the course is left unplayable.

The Groundskeeper.

The Fed’s 25 bps ‘insurance cut’ will do little to prevent the eventual necessity of QE – that is, if the Fed’s goal is to prevent a recession at all costs, it will require dynamite.[2] In my view, a 25 bps ‘insurance cut’ now and another 25 bps in September will do little to prevent the U.S. from succumbing to the global economic malaise (all developed market PMIs we track are now in contraction or neutral with the U.S. stagnant at a reading of 50.4). [3] We’re not alone in our assessment that, short of renewed QE, the Fed has little policy room.  MNI reported just prior to the most recent cut that former Fed director of the division of research, David Wilcox, said: “We’re currently at or near a cyclical peak, and yet the policy rate is still only 2.25% to 2.5%. That’s uncomfortably limited. I hope they will take steps to create more policy space for themselves.” In that same interview, Wilcox estimated the Fed was roughly 250 basis points short of policy space to fight the next recession. He noted that the central bank cut its policy rate by at least 500 bps in each of the past three downturns. Cantor’s global market Outlook expressed this very view in January of 2019. Again, it will be difficult for the Fed to forestall a recession without the use of dynamite.

We’ve already written in Epsilon Theory that ‘late cycle’ cuts are usually followed by recessions in the United States. We debunked analogies to 1995 and 1998 in our previous note Cake. It’s no coincidence that Chairman Powell introduced the concept of mid-cycle cut in his latest statement to avoid the perception that the Fed felt an economic downturn was imminent. Market participants cared little about his characterization. They simply wanted more. Just because Chairman Powell called it a mid-cycle cut doesn’t mean it is one. We now face a policy lull in August through September when many things can happen with the U.S. data. Services ISM recently missed expectations and appears to be following its historical course – tracking manufacturing ISM lower but with a lag. The rates markets have most recently been screaming loudly that the slowdown is about to occur here in the U.S., and they have been doing so globally (in Europe and Japan) for much longer.

We expect the PMI data over the next several days to continue to weaken, and we don’t think Chairman Powell will deliver what the markets want to hear at Jackson Hole. Last week, the spread from 3-month to 10-year treasuries inverted to over -40 bps and the 2-10 spread inverted, as I’ve been suggesting it would since January. As they always do, equity markets in the U.S. will eventually ‘get the joke.’ For those waiting for the real economic data to hit them over the head, it will already be too late. The sole bright spot is the U.S. consumer… but it always plays out this way. The consumer spends until s/he hits the credit wall. Lending standards are already beginning to tighten and labor markets are as good as they will get. That means they will only get worse. While lower rates are cushioning the blow from worsening fundamentals, they have never alone forestalled recession. [4] We believe the recent selloff is the beginning of a deeper correction as there is little to prevent the slide that has already begun

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[1] We’d also characterized central banks inability to spur inflation in the same way. We often written that the inability to catalyze inflation is a function of two principal factors: 1) globalization and 2) supply side effects. Globalization allows for the importation of deflation as capital and labor migrate to lower cost geographies, as the theory of comparative advantage suggests.  Monetary policy, which sets the cost of capital, sets the stage for a world in perpetual productive asset overcapacity – mostly in the developing world.

[2] Of course, the other groundskeeper ahead of the presidential election might be fiscal policy makers. However, with a divided House there is little that the president can do from a policy perspective (like a payroll tax deduction) that would forestall the slowdown. Even a ‘resolution’ of the trade war won’t do the trick as the root causes of the global slowdown are structural issues in places like Europe, Japan and China.

[3] Don’t be fooled; the U.S. economy is reliant on the global economy through a more complex global supply chain than ever before. About 39% of S&P revenues come from outside the United States and the global financial markets are inextricably intertwined.

[4] My one caveat to this assessment would be an immediate renewal of QE in the United States that drove long rates to close to zero. A renewal of QE in Europe is important, but until it includes high yield bonds and equity, it won’t have an efficacy. In the meantime, U.S. high yield has been a massive beneficiary of low global rates.


In the Trenches: Cake


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What’s next for U.S. equity markets, and what historical analogs might provide some insight? There are plenty of bullish pundits citing renewed monetary policy easing as a catalyst for higher equities – some even suggesting a melt-up could yet occur. While a surprise (at least to us) cut this week could propel equities higher for one last gasp, I’d not chase. Since my 2019 Outlook, I’ve been suggesting a ‘tale of two halves’ narrative for risk assets.[1] In it, my team and I described a first half characterized by a correlated risk-on resulting from improved central bank communication, more reasonable valuation, and more favorable optics around China trade. This has largely occurred. In particular, our mid-year target for the S&P 500 was and remains 2,800, while our year-end target remains well below street consensus at 2,500.

The recent rally in U.S. equities is largely a result of market participants believing they can have their rate-cut cake and eat it, too.

Market participants’ Pavlovian response to a cut of any kind – regardless of context – has been well reinforced over the past ten years. As my team and I have pointed out, and as Figure 1 illustrates, a cut now would bode ill (as a signal rather than a cause) for the U.S. economy over at least the next year. Will the Fed cut in June? While in play, we don’t think the Fed will cut, as it would amount to preemptive action.[2] There are three relevant precedents upon which market participants have relied to justify such preemptive Fed action.

Some argue that market conditions are analogous to 1995, when the Fed cut preemptively. I disagree. In our BIG Picture piece entitled Fed Reaction Function (dated April 20, 2019), my team and I presented our view that current conditions did not resemble 1995, and we continue to hold that view. As Figure 2 shows, when the Fed decided to cut in 1995, economic conditions were significantly worse than they are today. ISM manufacturing was deep in contraction, and at 5.6%, the unemployment rate was significantly higher than it is today. That said, the view has consistently been that the Fed will cut if equity markets risk-off by more than 15% or if there is a hard turn in the economic data, neither of which have occurred quite yet. Such conditions will likely manifest later in the year, especially if rates markets are as predictive as we think they are. It’s a matter of when – not if.

Eurodollar futures markets (ED1 – ED3 = 40bps) are implying an 80% chance of two cuts between June and December. This suggests the Fed is too tight relative to economic conditions (Figure 3). The correlation between 10-year rates and ISM manufacturing show that ISM will move into contraction in the near future (Figure 4). Nonetheless, we don’t believe that the Fed will move before that happens – nor should it. The equity markets and rates markets are severely disconnected, and that disconnect is the result of expectations for market intervention from the Fed, upon which markets have become far too reliant. My expectation is that equity market volatility will precede the Fed’s next move. Certainly, with the S&P 500 at ~2,900 amidst a global slowdown and flat U.S. earnings, the risk-reward appears poor to owning U.S. equities.

Looking at another potential historical precedent, I also do not believe that the current situation is analogous to the early 1970s when President Nixon appointed Arthur Burns as the Chairman of the Federal Reserve. While we will leave the reader to his or her own conclusions about the similarities between Donald Trump and Richard Nixon, it would appear that Chairman Powell is far less naïve than the academic, Burns. On February 1, 1970, Burns, known as a Republican loyalist, took office. Preceding the 1972 election, Nixon is alleged to have instructed Burns to cut rates.  Burns lowered funds starting in mid-1971 from 5.75% to 3.5% into March of 1972; GDP growth picked up to 5.6 % in 1972 from 3.3% the year prior. Inflation rates rose to 5.3% from 3.6%. This may have helped exacerbate the impact of the oil shock, which occurred as a result of an OAPEC oil embargo, which was retaliation for U.S. aid to Israel during the Yom Kippur War. While clearly there was a complex brew of potential causes, this policy period was followed by a considerable amount of asset volatility.

Lastly, the kind of central bank coordination that occurred in February 2016 at G20 is unlikely. Recall the backdrop from 2015 into 2016. A burgeoning China slowdown and fears of an aggressive devaluation of the yuan catalyzed two selloffs – one in late summer of 2015 and the other in early 2016. Complicating the U.S. backdrop was a U.S. earnings recession and a rise in default rates amongst energy companies that risked sparking a broader U.S. default cycle.  The G20 meeting that year was in February in Shanghai. At the time, my team and I failed to appreciate just how aggressive and coordinated the global central bank policy response would be. After a largely correct markets call for 2015, we failed to pivot bullishly enough on this stimulus. Could we be making the same mistake here? We don’t think so.

For one thing, global central bank balance sheets are no longer expanding in aggregate. Figure 5 shows that 2015 equity market volatility (green lower panel) was quickly suppressed by an expansion of global central bank balance sheets (on a stable Fed balance sheet). Now conditions are quite different with the ECB no longer buying new bonds and the Fed selling its holdings. While rates volatility caused by higher rates has abated this year, rates are considerably higher here in the U.S. than in the rest-of-the-world and most developed market central banks remain on hold after only recently being in normalization mode.[3] Lastly, there is no longer a post-crisis chorus of Kumbayah coming from world leaders. Instead, the world’s largest economies are embroiled in what appears to be a prolonged trade war. This makes coordination more difficult especially because many central banks are not independent of the governments engaged in the trade dispute. Lastly, we do not think the Fed wants to hand President Trump a rate cut into the G20 meeting simply because he asked for it. There must be an objective basis for Fed action.


Will we see a change in Fed’s modus operandi in June that results in a cut? We believe a cut in June would require a philosophical change in approach, as we would take it to be a preemptive move influenced by the executive branch. This is why June is such an important meeting. Were it to cut, policy would begin the slide down a slippery slope – a slide back to ZIRP and back to QE (quantitative easing). While we hold the unfortunate belief that all central banks will be at zero interest rates and aggressive QE (including the Fed) in the not-so-distant future, we also think the Fed wants to resist moving in that direction too quickly. Why? For one, the Fed understands the inadvertent redistributive effects of its policy decisions.

Wages compensate labor. Interest compensates owners of capital – credit investors, in particular. As a result, rate cuts, which set the cost of capital, implicitly make a wealth redistribution decision from credit investors to labor (in the form of lower unemployment). Moreover, not only do central bank decisions lead to wealth redistribution from creditors to labor, but low rates typically also discriminate against credit investors in favor of equity capital providers (as the ‘Fed model’ implicitly acknowledges). Moreover, a central bank decision to maintain low rates effectively discriminates against retirees in need of income; thus, there is an additional, unintended demographic consequence. Overall, current workers and equity investors tend to be favored over retirees and credit investors.

The unintended redistributive impact of Fed (and all central bank rate policy) comes largely without explicit legislative authority outside the Federal Reserve Act. Thus, in our view, the Fed still recognizes that the bar for central bank action in a capitalist economy should be relatively high. Historically, the Fed has generally viewed it as such through its data dependent approach and through its mandate to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”[4] We would also note that “moderate long-term rates” seems to exclude both extremely high rates as well as extremely low rates. With the current condition of policy (as shown by Figure 6), the Fed would appear not to have cause to act just yet. Indeed, it’s our view that the Fed will eventually be compelled to move back to ZIRP (zero interest rate policy) over the course of the next couple of years as yet lower rates are required to maintain even the most meager of growth rates. Because we believe the Fed wishes to maintain precedent as well as its independence, it will remain reactive to the data – at least for June – but the data continues to evolve as we foresaw it in the beginning of the year.

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[1] The 2019 Outlook was published on January 4th, 2019.

[2] To be clear: I do think U.S. economic conditions will warrant a Fed cut in late summer and another in fall. My team and I have been arguing strenuously since mid-year 2019 that global economic conditions were beginning to deteriorate and the U.S. economy would follow late this year.

[3] While true, the lean is clearly much more dovish than just a month ago, and emerging market central banks have already started to move with Russia, for example, cutting for the first time in 2-years.

[4]  Statement on Longer-Run Goals and Monetary Policy Strategy, adopted effective January 24, 2012; as amended effective January 29, 2019.


In the Trenches: Less Is More


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Narratives can be powerfully emotive influences. Overplayed narratives often lead to extremes in investor sentiment, and extreme sentiment may reverse quickly alongside a change in the narrative.

It has done so twice since mid-year 2018.

Late last year, markets collapsed as the narrative shifted from Fed as dovish father to the Fed as a deadbeat dad. The sub-narrative also changed from one of synchronized global growth to one of synchronized global slowdown. The narrative reversed yet again early this year upon the return of the Fed as a dove.

While U.S. equity markets over-reacted to the Fed’s hawkish December communication, they are now doing the same in response to its dovish pivot.

We see little in the way of catalysts to new U.S. equity market highs as sentiment begins to wear thin on a rollover in data into the second half of the year and as the Fed remains on hold – as it should.

The new narrative around the Fed as dove has helped create some striking cross-asset dislocations. Global rates markets are telling a slowdown story. The U.S. yield curve inverted from 3-months to 10-years just a month ago, even after the Fed pivot. Both JGBs and Bunds are either negative or close to it. Funding markets are also showing signs of strain, as funds trade above IOER more and more often. [1]

Importantly, the dollar has been strengthening despite little change in real rate differentials. Its strength looks to be a product of a U.S. economy that remains strong relative to the rest of the world. The dollar’s strength will also have deleterious impacts on emerging markets (EMs), which are responsible for most of global growth. Economic performance in Europe has on balance continued to deteriorate, even as China stimulated its way to PMI expansion for March (and for April which fell closer to contraction once again). Japanese and European PMI’s have been abysmal, and the rates markets in Europe and Japan reflect it.

Yet, U.S. equity markets just made a new high.

How to reconcile this? What has really changed since January that should lead to a sustained rally in equities beyond current levels?

The bullish narrative for U.S. equity risk makes sense only if one accepts a narrative that the Fed will proactively move to prevent a U.S. slowdown before it happens.

The bullish narrative further presumes that the current global slowdown will somehow miraculously reverse or somehow not touch U.S. growth. (We have argued that U.S. growth will fade alongside its developed market peers as the benefits of the tax cuts wane). With the exception of Japan, central banks generally have been and remain reactive rather than proactive. Before central banks act preemptively using a Japanese-style modern monetary theory (MMT) approach, two things must happen. First, they must lose their relatively well-defined, current mandates. Second, they must lose their independence. We don’t expect this to happen to the Fed until after the next risk repricing is complete. Thus, even though Fed Funds futures markets remain convinced of a cut at well over a 60% probability, market participants ought to be more skeptical.

Former Minneapolis Fed president Narayana Kocherlakota wrote a Bloomberg opinion piece to the contrary the other day, arguing the Fed mandate is broad enough to move away from ‘patient’ and towards proactive. This is simply a bad idea.

He writes: “Ultimately, though, the policy shift could help investors avoid getting lulled into the kind of complacency that leads to ‘Minsky moments,’ such as the 2008 financial crisis. And it would certainly help Main Street, by refocusing the Fed’s efforts on ensuring a stable economy.”

Kocherlakota demonstrates a profound lack of understanding about what caused the 2008 crisis, but that’s a topic for another time.

For today, let’s take his argument to an extreme. Under the ‘full employment’ mandate and at the first sign of any wobble, the Fed could create reserves, and then use them to buy Treasuries. The Treasury sale proceeds could then be earmarked to fund social programs established to guarantee each citizen a job. Kocherlakota’s argument creates a slippery slope towards a central bank that lacks independence and fosters social agendas at the pleasure of incumbent politicians. The hurdles required for each ‘wobble’ in the data would likely be lower and lower until finally anything would qualify.

Last Thursday, Bloomberg wrote an entertaining story about how I am Wall Street’s biggest bear, and Robert Burgess picked it up in his opinion column last Friday. [2] While I am bearish now, I’m neither a bull nor a bear by nature. What I AM is a skeptic of popularly accepted narratives.

As a result, my views have been responsive to the more volatile conditions that may be associated with late cycle equity markets. Further, it’s my belief that late 2018’s volatility was not a denouement; rather, it was the beginning of a deeper slowdown. Let’s take a look at 1995 and 1998 as possible analogies supportive of the narrative that the Fed will cut proactively. In 1995, the Fed cut in response to a string of government statistics that showed a sharp slowdown in business activity, on the heels of a catastrophic Japanese earthquake in early 1995, and after the Tequila crisis late in 1994. In 1998, the Fed cut in response to LTCM’s collapse and the Russian financial crisis. In my view, neither analogy is durable. [3]

There are two major differences: the monetary policy mosaic and globalization.

In stark contrast to the present, 1995 Fed funds were 6%. Today, the Fed has little room to cut already so close to zero, and it has just recently normalized after 9 years of extraordinary policy intervention, which included quantitative easing (QE). Its peer central banks are similarly low on ammunition outside of renewed QE. Moreover, prior to cuts in 1995 and 1998, the Fed had quickly hiked from 3% to 6% on funds at 50bps per month over the course of only a year. This contrasts to a much slower pace of recent hikes (at 25bps per hike over 3 years).

The other important difference is globalization. For example, the Eurozone did not exist, and emerging markets accounted for only a small proportion of global growth (30% versus over 60% today). Thus, neither the European Central Bank (ECB), which did not exist, nor the People’s Bank of China (PBoC) were relevant central bank actors. Even the now frenetic Bank of Japan (BoJ) was sleepy. What’s the point? The Fed has other banks in its corner that are doing some of its work for it. It needs to lead the way towards normalization.

Today, the BoJ stands in an extreme position and currently in stark contrast to the Fed. The BoJ appears to act proactively at the slightest sign of trouble since the global financial crisis. Japan’s central bank is not independent, and its approach has been in response to criticisms it was slow to act after its debt bubble burst in the early 1990s. All things considered, Japan’s strategy hasn’t worked well, as GDP has averaged only 1.4% since September 2009 despite a balance sheet that has grown by $4 trillion dollars since mid-2018 (now $5 trillion). The increase of roughly $365 billion dollars/year is about 7% to 10% of GDP ($4.9 trillion nominal GDP 2018). Since early 2016, after the Shanghai Accord, both 10-year and 2-year JGBs began to yield less than zero. 2-year yields in Japan have yielded no more than 15bps since late 2009. Thus, we are in the fourth year of both 2 and 10-year bonds with negative yields and in the 10th year of near-zero short rates.

Were a recession or equity market panic to lead to a bid for the Yen, Japan might have nothing left but to sell newly created Yen reserves and buy U.S. Treasuries. We’ve had conversations with those close to the Japanese central bank, and they’ve indicated this is an option they might consider.

In contrast, the Fed’s just not there yet on MMT; American exceptionalism prevents it… at least for now. Eventually, as we wrote in our previous Epsilon Theory’s In the Trenches, all of the world’s central banks will eventually buy many different classes of private and publicly held assets. At that point, all central banks will likely have lost their independence and social policy will no longer be an implicit goal but rather an explicit one. It’s simply a matter of when rather than if; however, it’s no time soon.

Indeed, we remain fairly convinced that the Fed will not cut this year. Equity market performance has been just too strong and the data remains just good enough. The Fed will react only if risk assets and the economic fundamental data justify action. U.S fiscal stimulus (the fumes from tax cuts) will prop up U.S data just for long enough to prevent Fed action while the rest of the world is continuing to slow. Inaction is the Fed’s only logical choice right now.

In a world moving towards BoJ-style modern monetary theory (MMT), one might argue that cycle analysis itself is anachronistic. This is the most persuasive challenge to many of the arguments made here. Indeed, because of QE and globalization, things are different this time. Yet, market participants ought to be skeptical that the Fed is willing to proactively prevent all business cycles just yet.

Monetary policy was never designed to set capital costs over long periods of time. That’s what free markets do best. When intervention lasts too long, it creates distortions and bubbles. These distortions were acknowledged in Austrian business cycle theory (ABCT), which views business cycles as the consequence of excessive growth in credit often due to the artificially low interest rates set by a central banks. Historically, the lenses that create these distortions tend to shatter.

I would expect nothing different this cycle, as the Fed will not act preemptively enough to stop the excess its own policies have already created. Sadly, if the Fed and ECB finally decide to go all-in and become proactive rather than reactive, markets will no longer be markets. Markets will no longer price assets or risk based on market information. Social policy will set asset prices. All central banks would then become political, as Japan’s central bank and China’s central bank already have – unless there is a concerted effort to stop it.

At times, less is more when it comes to policy.

This is one of those times.

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[1] We have written and CNBC has now reported Fed officials are considering a new program that would allow banks to exchange Treasuries for reserves, a move that could bolster liquidity during difficult times and also help the Fed shrink its balance sheet. This conversation has occurred as Fed Funds has risen above IOER. As reported, proponents of the so-called standing repo facility see the program as a relatively risk-free way of giving banks a release valve in times of financial tightness, while also allowing the Fed to pare back its bond holdings with minimal market disruption. We view the standing repo facility as a stealthy form of quantitative easing. Indeed, one form of QE is the conversion of long-dated treasuries into Federal Reserve Notes.

[2] Robert Burgess wrote: “Investors are most pessimistic on the Americas, followed by Europe and then Asia. Cantor Fitzgerald strategist Peter Cecchini embodies the current sentiment. In a week when the S&P 500 Index closed at a record of 2,933.68, Cecchini boosted his year-end target for the benchmark, but only to 2,500 from 2,390, according to Bloomberg News’s Vildana Hajric. For those without a calculator handy, the new forecast represents a 15 percent drop from current levels. “We do not foresee an inflection in U.S. economic growth or S&P earnings growth in the second half as global growth continues to slow and costs rise,” Cecchini said. “We also do not foresee a Fed cut as likely. With slower growth and a Fed that is slow to cut, we think equities will struggle in the second half.” It’s not like Cecchini is some foaming-at-the-mouth bear; he rightly urged investors to buy the dip in January after the big sell-off in late 2018.”

[3] Perhaps, a better analogy might be the coordinated global central bank response that began in February 2016 to stabilize the Chinese yuan. The so-called Shanghai accord came in response to two prior shocks in global equity markets in response to fears of a devaluation of the Yuan. Central banks acted in concert with the Chinese authorities to assure that capital could flow into China and prevent a destabilizing depreciation. It worked, and likely prevented what could have been a broader default cycle here in the U.S. on the heels of defaults in the energy industry. I, for one, was too bearish in 2016 on an analogy to pervious default cycles. So could 2019 be a repeat of 2016? It doesn’t seem likely. Central bank policy was synchronous back then, and there was no trade war division. Balance sheets were expanding and central bankers were not in normalization mode. No major pivot was required. Moreover, at that time, there was no fiscal stimulus in the United States. Thus, U.S. growth was arguably more fragile were a global shock to occur. We think a bigger wobble in financial asset markets and the domestic economy is needed (and should be required) before the Fed cuts rates.


In the Trenches: Command and Control


Like it or not, central banks are now the most influential, global financial market participants. Sovereign rates and risk are now only rarely a function of market forces. Central banks have asserted this influence in the name of moderating business cycles and associated financial market volatility. How could such a paternalistic and noble desire for business cycle moderation be misguided? Because the road to perdition is paved with good intentions.

The Great Moderation – a term oft cited before 2008 but little referenced since – was attributed to Fed maestro, Alan Greenspan. Unfortunately, had he still been chairman, his encore would have been the catastrophic meltdown in global financial markets and real economic performance. This discordant meltdown necessitated the use of ZIRP (zero interest rate policy) and QE (quantitative easing). [1] Since then, the move off the zero-interest rate bound in late-2016 marked the end of an almost 40-year secular trend towards lower interest rates.

The end of this secular trend confronts the Fed and other developed central banks with a new challenge. With rates still so close to the zero bound and with balance sheets still so swollen, when an economic downturn comes, what tools will be effective? Central banks have slowly begun to run out of assets to credibly buy. This is leading to a new, creeping narrative: MMT (Modern Monetary Theory), a theory that Larry Fink labeled last week as ‘garbage.’ I agree.

Because there’s so little central banks can do, they are anxious to prevent another downturn before it starts.

As a result, we’ve witnessed the Fed’s most recent dovish pivot, the ECB’s less hawkish tone, and the BoJ’s seeming admission to a QE addiction it has no intention of kicking. For short periods and when used prudently, QE is a useful tool, especially when used to purchase risk-assets that have suffered a liquidity dislocation – such as mortgage-backed securities (MBS) in 2008. It can alleviate this kind of credit crunch by directly targeting and suppressing risk premia. When applied more broadly to suppress risk-free term premia, it may pull forward demand in the real economy. In turn, that ought to help create a virtuous, reinforcing growth cycle.

So, why has growth been so modest in this economic cycle and why has inflation globally, even in economies like Brazil, been somewhat absent (at least for now)? It’s simple. Prolonged monetary policy accommodation (and especially QE) has led to the inefficient allocation of resources, especially in developing economies. They have benefited from lower internal rates as capital flowed from low-rate developed economies to higher rate developing ones. This fueled an investment boom that led to overcapacity, especially in basic industries. China, in particular, is suffering from this hangover right now as it attempts to eliminate overcapacity and associated debt. It’s not an easy task, and it has managed to do it only in fits and starts. In turn, global inflation has been largely absent this cycle as overcapacity persists.[2]

Resurrect the Austrians. Austrian theory, popularized by Nobel prizewinner Friedrich Hayek, generally suggested that market prices reflect a totality of information unknowable to any single policy actor. This information, when available to market participants and economic actors collectively, determines the allocation of resources in an economy. Moreover, the Austrian theory of the business cycle suggests that bank credit issuance is generally the cause of economic cycles. Ludwig von Mises first articulated this idea, and it was later amplified by Hayek. Mises believed that when banks extend credit at artificially low interest rates, business engage in “malinvestment.” According to Mises, “[t]here is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Ben Bernanke got a big laugh from economists in Atlanta on January 4th. A few minutes after Janet Yellen said, “I don’t think expansions just die of old age,” he replied, “I like to say they get murdered.” Strategists cite this idea ad nauseam to support their bullish views. On its face, it appears that Bernanke believes the business cycle rests firmly in the hands of life-preserving central bankers. If this interpretation is correct, it drips of potentially tragic hubris. Finally, even if he’s correct, what’s the role of market forces in a central bank controlled environment?

Let’s consider an extreme scenario: MMT. Consider a world in which all central banks are implementing aggressive QE policies ad infinitum. MMT suggests that as long as a country (and by implication its corporations) issues debt in its own currency, the country should be able to indefinitely fund debt issuance vis-à-vis creation of new reserves. Those reserves are used to purchase the treasury’s issuance. But something just doesn’t feel right about this. What does such a scenario imply for global capital flows and sovereign risk pricing? In such a world, it’s likely that economies would become isolated. What would be the incentive for countries to remain open to foreign capital flows? Rather than a deficit nation relying upon savers in surplus nations to fund deficits, the country’s central bank would simply fund the shortfall with printed currency. Thus, cross border capital flows would atrophy. In fact, global capital flows would be an unwelcome influence on capital costs that central banks would instead want to control. Indeed, the emergence of populist governments globally is also an apparent symptom of globalization’s infringement on sovereignty and the ability of monetary and fiscal policy to control economic outcomes. In an MMT world, a country’s printing press might replace its nuclear weapons as its enemies’ next existential threat. To what lengths would countries go to sabotage each other’s financial systems in an MMT world?

As the Fed attempts to normalize, most other developed or large developing central banks continue to stimulate. Indeed, I have argued that the Fed will act slowly to cut interest rates – precisely because it does not want to resemble Europe and Japan. Thus, it will first start by stopping the balance sheet runoff, but ultimately, economic conditions will force it to cut again – most likely in early to mid-2020. Another likely eventuality is that balance sheet engorgement will resume sometime later. The world has become dependent on low interest rates and central bank intervention. The issuance of debt facilitated by fiat rates has pulled forward future demand – perhaps to its ultimate limit – and a misappropriation of capital has ballooned global goods supply.

How does a QE all-the-time and all-over-the-world exist in seeming perpetuity? How does risk ‘price’ in capital markets when the cost of capital is constantly set too low?

It’s a difficult concept with which to wrestle. In essence, markets are no longer pricing risk; rather, a central command and control mechanism – global central banks – is pricing risk for the markets. I would argue this condition is neither durable nor stable.

[1] As I wrote in my previous In the Trenches, were central banks to articulate policy by explicitly saying they were going to set prices (in the form of capital costs) rather than use monetary policy tools, would not public perception of Fed action be different?… Consider that the Fed funds rates had historically been generally managed into a corridor using what the Fed calls temporary open market operations or OMOs. While QE is simply an extension of this idea to ‘permanent’ OMOs, QE’s suppression of term-premia – over which market forces normally dominate – is a powerful tool. Suppression of term premia enables corporations and individuals to term out maturing obligations and prevent defaults. QE simply allows central banks to fix capital costs lower over longer periods of time. I

[2] Even outside developing economies, firms and individuals have an incentive to overinvest in low ROA projects because capital costs are artificially lower than hurdle rates. Overinvestment tends to suppress inflation – in turn, this keeps term premia low. Importantly, companies adjust their expectations and behavior. They become reliant on low rates, which makes it difficult for the Fed (and other central banks) to move off the zero bound. Market participants adjust their behavior to a low rate environment make marginal investments that depend on low capital costs for prolonged periods of time. This makes normalization without default a difficult task.


In the Trenches: Bridge Out?



  • Heed the sign posts. The global economy is visibly slowing as developed market central banks have become marginally less accommodative. Emerging market (EM) economies have paid the price for higher U.S. short-rates and will continue to do so. As the ECB tapers, Europe’s structural flaws have once again become visible. U.S. housing is slowly crumbling, and large and important parts of U.S. corporate credit market are at frothy extremes.
  • A deceleration in global growth – partially driven by higher funding costs – combined with a plethora of levered IG credits (especially BBBs), a now frothy commercial and industrial (C&I) loan market, and a growing maturity wall in U.S. high yield (HY) is likely to create 2019 credit stress. This stress has challenged and will continue to challenge global equity market returns.[1]
  • While a Santa Claus will likely arrive and deliver a late-year rally for market participants holding U.S. equities, market participants ought to sell U.S. equities on strength (especially on any S&P rally above 2,800).
  • Whilst the end of the bull market is likely upon us, central banks are unlikely to ignore the signs. They will react quickly if they sense a collision is imminent. It appears that the Fed is beginning to sense the danger, and it has walked back its hawkishness in recent communications.[2]


Previously, In the Trenches stated: “It’s a matter of when rather than if – the Minsky moment is becoming more palpable. The stability caused by a decade of central bank financial suppression has led to the unintended consequence of creating a more fragile global financial system – one more vulnerable to shocks. The next shock is likely to be one of central banks’ own collective design” in the form of a harmonized withdrawal of extraordinary stimulus. [3] It bears repeating that negative real rates globally, as a product of both traditional and extraordinary monetary policy measures, have been responsible for the lack of financial asset volatility. Global central banks went to great lengths to keep the global financial system from crashing. They introduced many new safety features after the crisis, making market participants feel safer. Those include QE at-the-ready and overnight swap lines that the Fed can elect to extend to foreign counterparts and banks. Unfortunately, these new safety features have encouraged drivers to take more risk… and the drivers haven’t changed, albeit perhaps the average age is a bit younger. This has arguably created nothing more than an illusion of safety. Market participants have become even more reliant on driver-assist, and they may be prone to ignore the signs.

Caution: Hazards Ahead

So, what are these sign posts? There are at least four, the first of which we began the year sharing with anyone who would listen: capital outflows from EMs. Because U.S. rates have been on the rise, capital has flowed out of emerging markets and growth has slowed this year, and this will matter to developed markets.[4] Emerging markets currencies were the first, observable casualty of the Fed’s interet rate hikes. We simply thought they’d be weaker even earlier. We were overly bearish of emerging market currencies and equities in 2017, but our concern was realized in 2018. In 2017, we underappreciated just how titillating the synchronized global growth narrative would be for dedicated, emerging market investors looking for an excuse to pile in. In 2017, there was a critical regime shift from the usual relationship between developed market rates and EM asset performance. Figure 1’s top panel shows the positive correlation between EM equities and DM rates under the 2016 – 2017 regime versus the 2018 regime, which shows emerging market assets are once again correlating negatively to higher U.S. short rates. The latter paradigm is more often the norm. What is the catalyst for capital flows back into EM economies? With even just another two rate hikes from the Fed, EM markets should continue to experience capital outflows and pressure on their currencies as other developed market central banks continue the normalization experiment. The smaller the EM the more sensitive its currency will tend to be to higher developed market rates; weaker currencies force EM central banks to raise rates to prevent inflation. In turn, growth slows.

Figure 1: EEM Performance versus U.S. 2-year 2016 – 2017 (top) and 2018 (bottom); 
Source: Cantor and Bloomberg HRA

Second, Europe’s structural governance issues are becoming more visible in light of a less accomodative ECB. The European Union has structural flaws related to the monetary-only nature of the union. The necessary move towards a fiscal union (or at least fear of it) is resulting in the spread of populism –even France is not immune. Moreover, even the monetary union itself has a number of chinks is its armour. In particular, all sovereign debt issued within the union – regardless of country of issue – receives the same collateral treatment within the each country’s banking system. The result has been a mispricing of some European severeign debt. Only recently, for example, have Italian BTP spreads begun to widen relative to Bunds. The current tussle between the Italian government and Brussels is the beginning of an existential struggle to maintain the dream of a unified Europe. The ECB faces a hobson’s choice this week as it decides whether or not to end QE. If it does so, it should likely lavish the communication with dovish overtones. If not, who is likley to buy the €300 billion in Italy’s 2019 maturing debt? Its decision comes at the same time the Eurozone economy slows appreciably, as shown in Figure 2. The European statistics agency lowered growth for the third quarter from .7% to .6%. Could it be possible the Fed is walking back its hawkishness in recent weeks to give the ECB some room to end QE despite the weakening economic data?

Figure 2: European PMIs Have Rolled Over

The third signpost is U.S. housing. The median income houshold can no longer afford to buy a home, per Cantor’s proprietary home affordability indicator. In part, this has been caused by artificially low inventories of existing homes caused by homes removed from inventory by HARP refinancings. HARP refinancers are effectively living in subsidized homes they would not otherwise be able to afford, and thus, they have little incentive to sell. An artificial dearth of supply has led to higher prices. As usual, unintended consequences of intervention ultimately present themsleves. Of course, it had also been caused by years of ultra-low interest rates, which have now begun to rise. The 30-year mortgage rate has risen from under 3.5% to recently just under 5%, increasing housing expenses for new entrants by almost 43%. The combination of extended and amended mortage obligations for 3.3 million homeowners and low long-rates facilitated by prolonged QE have produced the illusion that consumers are unlevered. With homeownership rates still stuck below historical averages at ~64%, rent obligations are not captured by debt-to-disposable income statistics. Lastly, consumer sentiment and spending has been unsupported by real wage growth, which has hovered around only 1%, well below post-recession averages. Instead, access to debt (outside the mortgage market) has driven spending and sentiment. This is likely unsustainable.

The final signpost is ‘the bubble’ we see in U.S. corporate credit in the form of corporate commercial and industrial (C&I) loans. Not only have banks aggressively lent to corporations, but companies have also issued record amounts of low-investment grade debt to investors hungry for duration and yield. Sovereign wealth funds (SWFs), which used to buy risk-free U.S. debt, have generally shifted to corporate loans and bonds as they have searched for yield. With the U.S. 2-year yield approaching 3%, and return bogies for many funds in that vicinity, we might expect a rotation out of corporates and equities and into less risky substitutes that represent better risk-adjusted return opportunities. U.S corporate debt-to-GDP is at an extreme that for the past three economic cycles has always resulted in a corporate spread widening, an increase in equity market volatility and ultimately recession. Figure 3 shows this relationship.

Figure 3: Default Rates Spike When Corporate Debt-to-GDP Exceeds 44%;
Source: Cantor, Bloomberg and S&P

Central Banks See the Signs

Central banks won’t sit idly by while the global economy careens off the road. Not unlike the safety systems of the modern automobile, central banks have become more sophisticated when it comes to collision avoidance.  In early October, Fed Chairman Powell confirmed his optimism on the U.S. economy during his interview with PBS’s Judy Woodruff when he said that “there’s no reason to think this cycle can’t continue for quite some time, effectively indefinitely.” He characterized policy as a “long way from neutral,” even based on what is now an unnaturally low neutral rate. Of late, he has seemingly dialed back his optimism. In our previous note, we felt the Fed would likely to stay the course and raise rates relatively aggressively into 2019 based on domestic economic health – largely fueled by the impact of misguided and temporary fiscal policy – at exactly the same time the rest of the world slows. Recent risk-asset voaltility has proven this concern warranted, but we’re less sure now that the Fed will continue to plod on with normalization. As Chairman Powell’s statement at his recent appearance at the Economic Club of New York suggested, rates were ‘just under neutral,’ walking back some of his previously hawkish statements.

Nonetheless, the cat is out of the bag when it comes to developed markets’ central bank policy normalization. In response, EM central banks have been forced to tighten to control capital outflows. Moreover, as we often point out, global central bank balance sheet growth has stalled in dollar terms and is now flat on the year. As we wrote previously: “Market participants have been lulled to sleep by ‘fake news’ based on temporary U.S. fiscal stimulus and the strong U.S. data it is producing. Like a bodybuilder on the wrong side of a steroid cycle, the U.S. economy will struggle if Congress exercises even a modicum of fiscal restraint.  When U.S. consumers feel this good, it’s rarely a good thing.” Whilst the end of the bull market is likely upon us due to the impact of past and current policy normalization, central banks are unlikely to ignore the signs. They will react quickly if they sense a collision is imminent. It appears that the Fed is beginning to sense the danger, and it has walked back its hawkishness in recent communications. Look to the ECB on December 13th as the next bridge global risk assets must cross. We doubt the bridge will be closed, but we are cautious on the overall outcome given the slowdown in Europe and the implications ECB action has as the marginal supplier of global liquidity.

[1]  We began 2018 with an understanding that it would be a far more volatile year, yet we felt it was a bit too early to call the end of the cycle. Thus, we maintained a modestly bullish disposition of the S&P 500. As global central banks became marginally less accommodative, our S&P target has been well-below consensus for most of the year at 2,805.

[2]  Our view is for a hike this week and for only one hike for all of 2019 (in the first half).

[3]  We ended the note by saying that “with the S&P touching 2,600 today, we’d suggest it’s time for a rally, as funds are forced to chase returns into year end. But, make no mistake, this is now a sell-the-rally market.”

[4]  Even with modest capital inflows in November, net foreign capital outflows are on track to be the largest since the GFC. With one month left in 2018, year-to-date outflows totaled $US26.1 billion. Read more at

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Cantor Disclaimers: Prepared by staff of Cantor Fitzgerald & Co. (“Cantor”) and is for information purposes only. It is not intended to form the basis of any investment decision, should not be considered a recommendation by Cantor or any other person and does not constitute an offer or solicitation with respect to the purchase or sale of any investment nor is it a confirmation of terms. Cantor undertakes no obligation to provide recipients with any additional information or any update to or correction of the information contained herein. This material is intended solely for institutional investors and investors who Cantor reasonably believes are institutional investors. Cantor, its officers, employees, affiliates and partners shall not be liable to any person in any way whatsoever for any losses, costs or claims howsoever arising from any inaccuracies or omissions in the information contained herein or any reliance on that information. No liability is accepted by Cantor for any loss that may arise from any use of the information contained herein or derived here from. This product may not be reproduced or redistributed outside the recipient’s organization.

Options involve risk and are not suitable for all investors. Trading in options is considered speculative and it is possible to lose all, a portion of, or funds in excess of your initial investment. Prior to buying or selling an option, a person must receive a copy of the  ODD available from Cantor, by calling (212) 938-5000, or writing to Cantor Fitzgerald & Co., 110 E. 59th Street, 5th Floor, New York, NY 10022.

Sources: Cantor Fitzgerald & Co. and Bloomberg


In the Trenches: A False Sense of Stability

John Nash, “Over the Top” (1918)

“Stability breeds instability.”

— Hyman Minsky’s Financial Instability Hypothesis

“Look out below when fiscal stimulus dissipates and there’s nothing left to support risk.”

— Cantor Fitzgerald


  • It’s a matter of when rather than if – the Minsky moment is becoming more palpable. The stability caused by a decade of central bank financial suppression has led to the unintended consequence of creating a fragile global financial system – one more vulnerable to shocks. The most likely shock is to be one of central banks’ own collective design.
  • The relationships amongst markets are often ‘reflexive.’ Right now, the Fed is likely to stay the course and raise rates into 2019 based on domestic economic health – largely fueled by the impact of misguided and temporary fiscal policy – at exactly the same time the rest of the world slows. The feedback from the global slowdown, which has ironically been caused by higher U.S. rates, will bleed back into the U.S. economy by mid-2019.


Hyman Minsky wrote eloquently about how stability (especially when managed by central authorities) breeds instability. Nassim Taleb has taken that concept and reframed and expanded upon it in his book Antifragile: Things That Gain from Disorder. Stability has been imposed upon markets through the globalization and coordination of rates policy that (until just recently in the U.S.) had overstayed its welcome. The rest of the developed world and China are still largely reliant upon it, with the U.S. the only important economy to have positive real rates. Said differently, negative real rates globally, as a product of both traditional and extraordinary monetary policy measures, have been responsible for the lack of financial asset volatility. For this reason, a potential change in the rates regime has been the focal point of our narrative for most of the year. In fact, we expected rates volatility early in the year to cause a pullback in U.S. equities and emerging markets while also acknowledging that U.S. equity markets had fundamental tailwinds. Specifically, we’d called for a S&P pullback to 2,500 followed by a rally to 2,865. This proved fairly prescient.

Quite clearly, the recent selloff is a function of policy normalization and accompanying rates volatility. Just three weeks ago, the question might have been when will we see rates impact equities more dramatically? Well, recent market action has answered that question. We wrote earlier in the year: “When monetary policy overstays its welcome, it becomes self-defeating: prices fall as idle capacity comes on line [to meet new demand]. It also becomes self-perpetuating; a lack of pricing power forces central banks to keep rates low.” This is why the Fed has been so preoccupied with the concept of a lower neutral rate. It’s really not so complicated. Unnaturally low rates – especially unnaturally low long-rates  – have lowered hurdle rates for companies. As a result, they engage in activities that depend on low rates to earn a profit. This results in overcapacity, which is a common ingredient for eventual company defaults as rates rise. In early October, Fed Chairman Powell confirmed his optimism on the U.S. economy during his interview with PBS’s Judy Woodruff when he said that “there’s no reason to think this cycle can’t continue for quite some time, effectively indefinitely.” He characterized policy as still far from neutral. In our view, the Fed is likely to stay the course and raise rates relatively aggressively into 2019 based on domestic economic health – largely fueled by the impact of misguided and temporary fiscal policy – at exactly the same time the rest of the world slows. We believe the feedback from the global slowdown, which has ironically been caused by higher U.S. rates, will bleed back into the U.S. economy by mid-2019.[1] This external slowdown will be accompanied by the burgeoning roll over in U.S. housing. (The subject of our next note).

Until recently, U.S. sector dispersion picked up due mostly to moves in the public REITs and homebuilders, which tend to suffer directly when rates rise. Broader indices managed to hold up due a rotation out of these sectors and into others. In early October, sector rotation stopped, and correlation began to pick up. Until recently, volatility markets had continued to look fairly complacent. Early in the year, global dispersion also picked up as stresses continued to present in various economies in plodding succession, including India, Brazil, Indonesia, etc. Just as in the U.S., global dispersion has now become correlation. This is an unhealthy sign. We became increasingly concerned for U.S. equities in April, which is why we lowered our S&P target from 2,865 to 2,805. We stubbornly maintained that target in September at a level well below consensus even as many of our peers raised theirs as the market surpassed its late-January high. We maintain this target on what we think will be a hard bounce.


Global central bank balance sheet growth has stalled in dollar terms and is now collectively flat on the year. This may be a bit deceiving because China’s RRR moves are not captured, but nonetheless central banks are clearly far less accommodative. Market participants have been lulled into a trance by ‘fake news’ based on temporary U.S. fiscal stimulus and the strong U.S. data it is producing. Like a bodybuilder on the wrong side of a steroid cycle, the U.S. economy will struggle if Congress exercises even a modicum of fiscal restraint.  When U.S. consumers feel this good, it’s rarely a good thing. Even companies are beginning to revise down estimates far faster than analysts. Look out below when the fiscal stimulus dissipates and there’s nothing left to support risk-on.

That said, while the Minsky moment is nearer, we’d suggest it’s not yet time for disaster. Risky credit markets in the U.S., in particular, have not responded to rates for various reasons. These reasons include low default rates, lack of a maturity wall until 2020, and little supply in the high yield market.  While high yield CDX has widened to level we suggested earlier in the year (390bps), it still remains tight. Despite this strategically bearish view, more tactically, we’d suggest its time for a rally – credit markets remain open and funds are likely to chase returns into year end. But, make no mistake, this is now a sell-the-rally market.

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[1] We’ve consistently spoken about how higher U.S. rates lead to capital flight from emerging markets (EMs) in favor of higher returns from risk-free U.S. assets. This forces EMs to raise rates, which results in slower growth and even recession. India is in that position right now.

Cantor Disclaimers: Prepared by staff of Cantor Fitzgerald & Co. (“Cantor”) and is for information purposes only. It is not intended to form the basis of any investment decision, should not be considered a recommendation by Cantor or any other person and does not constitute an offer or solicitation with respect to the purchase or sale of any investment nor is it a confirmation of terms. Cantor undertakes no obligation to provide recipients with any additional information or any update to or correction of the information contained herein. This material is intended solely for institutional investors and investors who Cantor reasonably believes are institutional investors. Cantor, its officers, employees, affiliates and partners shall not be liable to any person in any way whatsoever for any losses, costs or claims howsoever arising from any inaccuracies or omissions in the information contained herein or any reliance on that information. No liability is accepted by Cantor for any loss that may arise from any use of the information contained herein or derived here from. This product may not be reproduced or redistributed outside the recipient’s organization.

Options involve risk and are not suitable for all investors. Trading in options is considered speculative and it is possible to lose all, a portion of, or funds in excess of your initial investment. Prior to buying or selling an option, a person must receive a copy of the  ODD available from Cantor, by calling (212) 938-5000, or writing to Cantor Fitzgerald & Co., 110 E. 59th Street, 5th Floor, New York, NY 10022.

Sources: Cantor Fitzgerald & Co. and Bloomberg