Flashpoint to Singularity?
From Part 2: "This contraction could be the flashpoint or tipping point, just prior to collapse into singularity, rapid, violent and destructive. Cause and effect, a self reinforcing vortex, wash, rinse, spin, repeat."
Regarding the correlation of ED (eurodollar) futures to the SP500 brought up at the end of Part 5... I can hear it now, as one reader might say, what the hell did I just try and read? Inquiring minds want to know, what the hell do loans (which is what eurodollar futures are) on dollar deposits in a foreign bank have to do with energy, oil, commodities, interest rates, USTs, bonds, high yield, emerging markets, the dollar, market liquidity and asset inflation? As Ricky would say to Lucy, we are going to "splain" the giant elephant sitting in the middle of the room. 3 month ED futures positioning by the large commercial traders is calling for a capitulation in contract prices, starting within the next 30 days.
When shorting, the elephants are borrowing today (locking in at a lower rate) and betting on lower contract prices, meaning higher libor rates (rising) and higher dollar (rising) at the time of expiration. Why? Hmm, the real professionals aren't buying into the media narrative? Perhaps they see some of the following? Contracting economic trajectory across the board, pointing to slowing economic conditions, less petro dollars in the ED market. Resulting in a spiking dollar, and higher risk premia, self reinforcing the cycle and causing a December flash crash in commodities. Pushing oil, energy, HY and EM bonds further into distress, potentially causing a reversion to the mean in defaults, snowballing into higher rates, causing hedging (derivative futures, illiquid ETFs at $18T, now exceeding US GDP) and term mismatches, leading to potentially severe market liquidity issues. And the Fed doesn't even have to raise for any of this to occur, that would be more sauce for the goose. We will visit the asset inflation later.
Caveat, since the profit or loss occurs up front there is no convexity in these instruments, making an unregulated and unaccounted for (at least by central bank standards) ED an imperfect proxy for future rates. Looking at the correlation going back to 1986, and given the recent distortions of ZIRP and QE, and the increased coefficient is worth noting. To reconfirm, a chart from COT's data covering SP500 2007 through 07/28/2015. Again, note: the ED futures data is pushed forward 52 weeks and the pendulum swings from extreme net long to extreme net short uber fast as in parabolic. Is this a glimpse at the SP500 "early edition", TBD.
A Hypothetical in Gravitational and Dark Forces
Disclaimer: No one has a crystal ball, so there are many assumptions and caveats in this hypothetical. This is a guess, in which any similarity or dis-similarity to events which may or may not occur, is purely coincidental. In addition, much of this conjecture might seem counter intuitive or contrarian, because it is. The sole intent is to provoke thought regarding the many possibilities and consequences.
The Gravitational Squeeze
The Fed funds rate is the overnight rate that banks charge each other on overnight loans of deposit at the Fed. Although it is not the primary tool to effect change with, the Fed may discourage the holding of money, first by raising the Fed Funds rate and raising inflation expectations, then slowly selling balance sheet assets.
+ Fed funds rate (raising inflation expectations)
- slow selling of balance sheet assets (MBS, Agency, long-dated USTs)
- monetary base shrinks (reduced excess demand for safe assets)
- aggregate demand for money decreases (reduced excess demand in money)
Baring in mind certain latencies, it would seem that a squeeze and deflation of certain asset classes may be necessary, along with the requisite pain to effect change. There is an old saying, in order to lower heaven, you have to raise hell. Raising will cause liquidation, individuals want to hold less. At the same time, as the base shrinks, and economic contraction continues, there is less buyer's money to chase the sellers' liquidations. Pop go the weasels.
"When looking at cyclical inflections, GDP is the last to know about it.... That zombie-like state seems to have finally relented in 2015 to a more broad-based, traditional slowdown or even recession." - Jeffrey P. Snider
As if the already amply pointed out were not enough, the contractionary economic trajectory includes factory orders, retail sales, non defense capital goods, imports and exports. For obvious reasons, if not handled properly, (see The Fed's Ultimate Balancing Act), raising could be catastrophic. The Fed will be raising into the face of what appears a massive contraction, or forming vortex, being advertised as an economic recovery with "the legs" to raise rates. Is it fortuitous that inflation, advertised through media narrative as threatening deflation, is anything but tame (estimated annual average 6% since 2000)?
The initial raise would probably cause a dollar decline (anticipatory pricing). The associated narrative, anchoring inflation expectations should eventually raise the dollar, precipitating a further drop in commodities; this would be self reinforcing as less petro dollars in the ED market means, a higher eurodollar. The dollar spike, combined with an accelerated seasonal slowdown could not only cause a December commodities "flash crash", but again, also potentially pop the reflated equities bubble and housing market. With the econometric latency, the Fed will probably raise a second time, which will result in further distress, up to the point (and this is an unknown) where despite the narrative, the dollar capitulates (with caveats). If any or all of the above occur, at some point currently unknown, reality of the economic contraction sets in and retracement of the dollar starts.
The Fed may decrease IOER remuneration and increase repo and RR rates. Raising Fed funds and short term paper along with increasing repo costs would discourage banks and non banks from reversing the current arb through excessive repo and short term paper, which would artificially suppress short term rates.
Raising repo and RR costs could be the most effective policy force that the Fed has at its disposal. Why? The difference between the volume of daily repo vs. fed funds transactions is substantial. This is what sets the overnight cost of carrying USTs or the single day return on all government securities. A combination of the above could get the CB's out of the saving business (parking money) and back into the lending business.
The Dark Force
As mentioned in Part 5, if the ED system is not to repeat the tragic record of all previous prudential reserve banking systems then the U.S. dollar must remain acceptable as the world's transactions currency.
It is here that we finally attempt to answer, with the banks and dealers vacating the space, and Fed QE tapering to an end, who or what fills the widening ED market gap? After the squeeze, any popping, contraction continues, it hits the fan, the dollar capitulates, then, we have to prod the herd just a little to help restock the pond.
- value of money decreases (dollar liabilities easier to service)
- IOER is reduced
+ Repo and RR costs increase
- domestic banks, non banks and FOB's repatriate dollar assets in the form of excess reserves to the ED market (muting some dollar decline)
+ ED market contraction may stabilize (it's a balancing act)
As for the BRIC's wants and needs in a global currency to escape the dark forces of dollar hegemony, as the prophet Jagger sang, "you can't always get what you want, but if you try sometimes you just might find, you get what you need." A weaker dollar might enable the gradual ability to "restock the pond" without shocking the waters or eco-system (no pun intended). This would reinforce our dollar hegemony in the ED market by maintaining financing in dollar denominated instruments, while cushioning the dollar's decline. For the dollar, ED market, FOB's, foreign governments and corporations, all good so far, but here is where it gets touchy.
Historically, the Fed has raised or tightened to counter excessive inflation and or speculation. This time the Fed must tighten from a ZIRP position. Despite rates being zero, Bernanke never eased, so Fed policies are already tight, witness reflated asset bubbles while the economy is contracting. Normally, tightening or raising rates have the following effects:
- equities slow down (10% correction or 20% blow off, TBD)
- USTs decline (7-10 yr) +167bps; (2yr) +257bps; frontend +90bps, further flattening the curve.
- HY and EM debt declines, spreads widen, risk premia rise, defaults increase
Due to the global downturn, through a flight to safety, we again see the negative effects on long term USTs and the dollar being cushioned. As the short end rises, the long end would fall, which could lead to a yield curve inversion. Nattering for another day. Moving West....
Baby Steps to Recovery
+ consumer prices gradually increase
+ wages gradually increase *
+ households and corporations gradually spend more (and invest in durable economic activity, while curbing financialism.) *
- household and corporate cash balances decrease
+ long term profit expectations increase
+ loan volumes increase *
+ money velocity increases
+ bank, household and corporate cash balances increase
Wash, rinse, spin and repeat.
* These are caveats and without all of them occurring, game over. Nobody said this was going to be easy.
Initial reduced demand for money, and a ED cushioned decline in the value of the dollar, could result in dollar liabilities and assets deflating, eventually rising consumer prices and potentially increasing velocity through less saving and more lending. A lower dollar would also result in increased exports and a lower trade deficit.
I can hear it now... Oh Nattering One! It's been a long trip down the path, there's alot to chew on here. I can see you have pointed out many potential long and short opportunities in the potential chicanery of the markets. And you have posited a potential scenario for Fed action and consequences. Is there any other takeaway here? More to come as we connect the dots of global monetary and fiscal policy to the potential ultimate consequences in the finale, Part 7: Hyperinflation, Inflation, Deflation, Stagflation; and The Sting. Stay tuned, no flippin.
For the ostrich's out there who will parrot apoplectic "chicken little, yelling doomsday again", we are not. Just pointing out additional subtleties, so carry on as you were. For those in tune on the wavelength, opportunities could abound.
Recommended reading for inquiring minds. Warning: Reading not only those listed below, but every installment of these multi-part missives could lead to a better understanding of the market forces in play and how to profit from them.
- Contractions In Money Flows And Market Liquidity - Part 5
- Contractions In Money Flows And Market Liquidity - Part 4
- Contractions In Money Flows And Market Liquidity - Part 3
- Contractions In Money Flows And Market Liquidity - Part 2
- Contractions In Money Flows And Market Liquidity
- The Fed's Ultimate Balancing Act
- The Emperor's New Clothes Or Econometric Misperception
- The Temple Grandin of Shadow Banking, Part 1
- Connecting the Dots, Part 6
- More Dollar Hegemony, In The Land Of OZ, Part 6
- Peak What? Christmastime in Hell, Part 6
- Peak What? The Quadruple D, The End
- An Unkind Bond Unwind
- The Feds Quandry with Uncle ED (Eurodollar)
For a complete missive series listing click here.
These global economic developments could affect numerous markets, sectors, indexes, commodities, forex, bonds, mutual funds, ETFs and stocks.
A List of Market Plays
- DIA, SPDR Dow Jones Industrial Average ETF
- SPY, SP 500 Trust ETF
- IVE, iShares SP 500 Value ETF
- DVY, iShares Select Dividend ETF
- SHY, iShares 1-3 Year Treasury Bond ETF
- TLT, iShares 20+ Year Treasury Bond ETF
- AGG, iShares Core Total U.S. Bond Market ETF
- TBT, ProShares UltraShort 20+ Year Treasury ETF
- USO, The United States Oil ETF, LP
- OIL, iPath S&P Crude Oil Total Return Index ETN
- XLE, Energy Select Sector SPDR ETF
- UCO, ProShares Ultra Bloomberg Crude Oil ETF
- UWTI, VelocityShares 3x Long Crude Oil ETN
- OIH, Market Vectors Oil Services ETF
- DHF, Dreyfus High Yield Strategies Fund
- EMB, iShares J.P. Morgan USD Emerging Markets Bond ETF
- PCY, PowerShares Emerging Markets Sovereign Debt Portfolio ETF
- BNDX, Vanguard Total International Bond ETF
- DSUM, PowerShares Chinese Yuan Dim Sum Bond Portfolio ETF
- TIP, iShares TIPS Bond ETF
- TMV, Direxion Daily 20+ Year Treasury Bear 3x Shares ETF
- IEF, iShares 7-10 Year Treasury Bond ETF
- TBF, ProShares Short 20+ Year Treasury ETF
- EEM, iShares MSCI Emerging Markets ETF
- VWO, Vanguard FTSE Emerging Markets ETF
- EDC, Direxion Emerging Markets Bull 3X Shares ETF
- EDZ, Direxion Emerging Markets Bear 3X Shares ETF
- GLD, SPDR Gold Trust ETF
- IAU, iShares Gold Trust ETF
- PHYS, Sprott Physical Gold Trust
- SGOL, ETFS Physical Swiss Gold Trust ETF
- UGL, ProShares Ultra Gold ETF
- DGP, PowerShares DB Gold Double Long ETN
- GLL, ProShares UltraShort Gold ETF
- DZZ, PowerShares DB Gold Double Short ETN
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.