Crossing the Rubicon
The market came under pressure yesterday and we are starting to really see some weakness in the Russell index that is the most alarming. While the NDX, Dow Jones, and S&P 500 look fairly strong, weakness in broad-based (RUT) order flow reflects a wider trepidation to continue to buy into this market after recently hitting all-time highs. Continue to watch the RUT closely, as I believe it is the lead indicator.
Crossing the Rubicon
We have used or heard the Crossing the Rubicon idiom in many situations, but I think there is something beyond just the idiom use of crossing the point of no return that warrants further discussion. For history does repeat itself, no matter how many times we wish to believe THIS time it is DIFFERENT!
Courtesy of wikipedia
Function of Interest Rates
To continue on yesterday’s theme I wanted to talk about the risk inversion (equities over bonds) that has happened since the extraordinary measures taken by the Fed and their brethren Keynesian central banks. Before we delve too far into understanding the risk inversion, we must understand both risk and the pricing of risk, namely the function of interest rates.
Interest rates are at their core a hedging mechanism to off-set default and/or delinquent payments and I would go one step further to include DEVALUE, more on that later.
We have all seen the mob movies with loan sharks charging “points” (interest) sometimes on a daily or weekly basis. These loans are not only high risk – because if you don’t pay, someone will literally break your legs – but they are high risk from a financing view as well. Someone going to the mob for money is usually a very high risk borrower and the mob understands this and thus charges interest rates that are very high. Rather than being quoted on an annual basis, it is monthly, weekly, and sometimes daily rates.
Courtesy of wikipedia
In the more real and practical world, as I suspect we don’t have any readers that are going to Tony Soprano for a loan, we as individual borrowers, fully understand how this works. We receive a credit rating based on our ability to pay our debts. That credit rating also helps determine our ability to borrow money; like a mortgage, car loan, or credit card. The better the credit rating (proof that we are responsible borrowers, have income, and have paid debts), the higher the likelihood that we are able to secure a loan, and the interest that we pay would also be lower, as a function of being a lower risk borrower. On the other hand, a history of not paying off debt, defaults, delinquent payments, means that one has a lower credit score. Not only is it harder to secure future loans, but when one is able to with a low credit score, the interest on these loans are typically higher. Regardless of credit scores, the underlying point I wish to make is that one can obtain a loan, the question is how much is someone willing and/or can afford to pay the interest.
In both the mob and real world scenarios the functions of hedging risk as well as the risk of default and delinquency is how interest rates are determined. There is an actual formula and expectation that the payments with higher interest rates will help pay off the initially lent money prior to a default or delinquency. The mob boss charging “10 points” (10%) a week, knows the basic math that in roughly 3 months the interest alone would pay back the initial principal, thus eliminating his lending risk.
This is the basic and core principal of how interest rates work and why they are used to mitigate risk. Many of us only see interest rates as a cost to borrow money and the profits that the banks and mob boss generate, however they serve a second function of hedging the risk of default and/or delinquency. It is a profit and risk mitigating function all warped up into one and it has been used for centuries based on this core principal.
Free Market Rates
Yesterday I focused singularly on leverage and margin. A core determining factor on how much a lending firm is willing to lend and how much a borrower can afford to borrow is the interest rate. The higher the rate the MORE the lender is willing to lend, but the LESS the borrow wishes to borrow. The lower the rate the LESS the lender is willing to lend, but the MORE the borrower is willing to borrower. The supply and demand part the equation is directly impacted by the rates. In a purely free market interest rate environment, interest rates run a gamut of ranges based on the risk of the borrower. The free market creates an equilibrium in which there are an array of borrowers and lenders, all with different amounts of interest rates. Of course even in a free market lending world, some borrowers will default and some lenders will go bankrupt. This is a function of not pricing risk and therefore interest rates properly. However, as more people participate in a lending/borrowing relationship in a free market interest rate environment the better resolution of risk and price discovery, which brings forth equilibrium to the risk equation. In some respects the credit rating of individuals, businesses, and even governments offer guidance to help bring forth a better understanding of risk and therefore set rates for different borrowers appropriately.
Governments are not much different from individuals or even businesses. They have credit ratings and borrow money regularly as well. They do so by issuing government bonds, also known as Treasury Bonds, T-Bills, and a host of names. They have different durations, interest rates, and face values. Historically when government bonds were first issued they had been used for very specific needs; to fund a war or to build infrastructure. Unfortunately something happened, governments began to see issuing bonds as a source of “revenue” to fund their general fund and subsidize their spending. Rather than raise money for a specific needs, many governments started looking at bonds like a revolving credit card or credit line. This fallacious realization brought forth unprecedented borrowing, with no limit and no end. It was easy to raise money and spend it. In some respects I level significant blame to the ability to issue bonds to fund general spending (subsidizing tax revenue) to the largest cause of national debts and massive deficit spending.
Imagine a world in which nations were only allowed to issue bonds to raise money for very specific needs that were budgeted and limited in scope; war or infrastructure for instance. And the rest of government expenses would have to be funded solely by taxes. No doubt the nation would have periodic debt from time to time, but it would be limited and itemized. There would be no deficits, because government would have to spend within their means. We don’t live in such a world, not any more.
Devalue IS Default
I am frequently accosted by my fellow Keynesians that argue that the government will never default on their bonds, so there is NO RISK. From a technical standpoint I agree wholeheartedly with their very simple understanding, but what about devaluation? When I bring forth this concern, they have no answer, no response, and usually fall back on their initial premise that the government will not default. I will usually retort, we have already established and fully agree on that point. Any government that prints (creates) their own currency can always print more, thus avoiding any default.
Looking at historical fiat collapses, nations don’t face problems of default but rather one of devalue? To avoid default, they print more and this usually just feeds on itself and eventually as the laws of supply and demand will dictate, you face hyper-inflation.
And my Keynesian friends are exactly right, Zimbabwe didn’t default! They just massively devalued their currency and literally started printing trillion dollar bills. They were chasing their own tail to avoid default and in doing so created hyper-inflation.
Courtesy of wikipedia
My argument is very simple, a nation may never default on their obligations and pay their bonds, what good is the payment of the bonds if the paper money (fiat) is worth nothing. At the end of the day what is the difference being paid with worthless paper or default? Nothing, in both cases you have a loss of value, hence devalue IS default to a lender. This is a function of inflation.
After studying economic history, I find it interesting when a nation’s treasuries (bonds) become a source of revenue the clock starts ticking to their financial demise. This is quickly followed by a rapid drop in interest rates to spur more borrowing and an attempt to devalue their currency, as Keynesian’s call “inflating” their way out of a problem. It certainly buys time, but at the massive expense of debt and devaluation, a very dangerous game that historical has been a losing strategy. In fact in every historical situation of fiat currencies coupled with bonds for general funding have all ended poorly, in many cases hyperinflation and massive currency devaluation.
No nation in the history of civilization has devalued (inflated) their way to prosperity.
We have made a cursory review of the functions of interest rates and we have briefly discussed the risk of using debt (bonds) by governments for general funding. Yet what has kept government fiat currencies from failing for lengthy periods in history is their backing in combination of the free market interest rates. A fiat currency is backed solely by the “good faith and credit” of the issuing government.
In a free market interest rate environment in which individuals, banks, corporations, and even governments are subject to the free market interest rates – it helps solidify the faith as well as credit of the fiat currency. While I am not a blind faith believer in the long-term sustainability of fiat currencies, one can’t deny how the free market interest rate environment help generate not only a balance, but also a transparency and natural hedge of risk.
The Federal Reserve historically has set the short-term rates, which everything is pegged to. This is called the “Target Rate” or “Fed Funds Rate” and while it is not set in stone as the end-all-be-all rate in which short-term rates are set, it is a “target” that is more of a suggested rate that banking members of the Federal Reserve use for inter-bank lending and the reserve. One can actually monitor the daily fluctuation of the actual over-night lending of the short-term rate, posted daily by the NY Federal Reserve. Historically we see that it is never exactly pegged to the Fed Target Rate, as it fluctuates. Historical these target rates set by the Fed are swayed by the Free Markets. The Fed has been very respectful of the Free Markets and thus has remained neutral in setting the target rates to correspond with the free market forces.
FIX is in!
Those that have argued against the Federal Reserve, like Ron Paul, have been articulating the delicate and very fine line between free markets and fixed markets. The critics have argued for decades about Fed interventionism had not come to pass, because the Fed never crossed that line of full interventionism that had ended free market interest rates, until now.
Lowering target rates to ease and hopefully create some velocity to money (create lending and help pay down debts) is one thing. Yet the Fed stepped far beyond helping guide the Free Market Interest Rate environment. The brought forth rapid and radical change, first by flooring the short-term rate to ZERO and later to flatten the long-term yield curve with Operation Twist. The Fed had, for the first time in its history, eliminated the free market interest rate environment across the spectrum. Ron Paul’s fears have materialized.
Courtesy of FRED
No longer was the core principal of risk mitigation of lending money, regardless to whom, a function of interest rates. Banks were now borrowing directly from the Fed (“Discount Window”) as well as through their inter-bank lending reserve at zero or close to zero. Technically money was and is free, for those that have access to it.
Tickle Down Effect
This had massive and radical consequences across the economic landscape and unfortunately none of it trickled down to the intended citizens and small businesses that were suffering, who we were told it was intended to help.
Here are a list of consequences of removing the free market of interest rates:
1. Broad-based equity market rally. Those with access to borrow money, massively leveraged up their risk positions. Money was free; you could borrow as much as you want. We have seen the NYSE margin index hit all-time highs, not seen since the 2000 dot.com collapse and the 2008 housing bubble collapse.
2. Investors looking for fixed income have become yield chasers. Junk bonds and higher risk bonds have seen yields come down radically, well below their interest rate risk levels. One could argue that junk bonds are far over priced, pushing yields well below the risk curve model.
3. Leveraged margin in private equity has reached massive levels, as cheap money is available to institutional borrowers at 50 bps or even less.
4. Savers in CDs, money markets, or bonds have been severely punished and in fact between fees and inflation adjustments have negative real returns. 401ks, pensions, IRAs, and a host of retirement accounts are seeing REAL negative returns for years.
5. US treasuries paying zero on the short-end of the curve has seen a massive decline in lenders. The Federal Reserve has been forced to print additional money to buy government bonds to fund government deficit spending. Who wants to lend the government free money? No one, so the Fed has no choice but to step in.
6. Banks are unwilling to lend at such low interest rates to those that really need to borrow. Reviewing bank lending in the last 5 years, those companies and individuals with money have access to borrow, those small businesses and individuals that have lower income or fewer assets have zero access to borrow.
7. The low interest rate environment has forced the GSEs and FHA to expand again because banks are not willing to lend to higher risk / lower income individuals, thus again expanding government risk. GSEs are now nationalized and expanding again.
8. The world is now split between those that have access to free / cheap money and those that need access. We have seen a world split between two interest rates; the high risk / high rate and the “fixed” rate for the low risk. I would argue this is the biggest contributing factor of the collapsing middle class.
Crossing the Rubicon
I don’t use the idiom Crossing the Rubicon lightly or just a reference to the Fed’s monetary policy. Many may know the idiom refers to crossing the “point of no return”, but there is an additional parallel I wish to emphasis.
The fall of the Ancient Rome Republic came from a combination of economic woes, inflation, and a will of the people. The Roman Republic had become a Plutocracy at the time of Pompey and Caesar. Three very powerful men, Caesar, Crassus, and Pompey created the first Triumvirate, the unofficial military-political alliance that ruled Rome. The Senate, which supposedly represented the people became, much like our own Senate, a plutocracy supporting these three man, the powerful families (which controlled the large businesses of the time), and the Senate ultimately served the Triumvirate first and the people last. The Republic was failing as the people began to have a less favorable few of the Senate, they wanted change. Crassus’s death left Pompey in Rome with support from the Senate, while Caesar remained far from the capital with his army. It became a power struggle between the two, which always happens when a body of men elected to rule become a plutocracy. You can’t serve two masters; one must serve the people or the powerful families, special interests, corporations, and unions. The Roman Republic had lost their way and forgot to serve the people.
The Senate’s popularity among the people had significantly fallen, people wanted change. There were tired of the seemingly plutocracy that had pervaded the Senate. The economy was struggling and facing inflation and the gap between the wealthy and poor became larger. Caesar had been a war hero, a great general, well respected. The people had begun siding with Caesar based on “hope and change”; unfortunately it was a change that would ever change the course of history.
Rather than disbanding his army and returning to Rome a hero and to serve in a minor role in the plutocracy that he help create, knowing he had the will of the people, Caesar decide to invade Rome in a civil war and claim the power for himself.
The column marking where Caesar told his army they were to march on Rome and start the civil war, to cross the Rubicon!
Courtesy of wikipedia
As his army crossed the Rubicon River it became the literal point of no return, giving birth to the now famous idiom. Caesar was marching on Rome and the Republic which existed for centuries would now become an Empire, there was NO turning back. The Senate and the people would no longer have any power; the people’s voice was once and for all extinguished. The people’s “hope and change” brought forth the unimaginable.
Studying history and understanding the WHY of circumstances is how we draw lessons from our past. Are we to face a huge transition like the one that took place in Rome? I don’t believe it is a probability, but to ignore it as a possibility is to only fool oneself. 10 years ago no one ever thought that Scotland would vote for independence, it was a crazy and absurd idea – yet the vote came to be and while it didn’t pass, the mere fact that the vote not only took place but 45% of the people voted for such an action is proof enough the events can change dramatically and far beyond any absurd predictions. We can’t forget that after World War 2 there was only about 60 recognized countries in the world, today there are almost 200. We also can’t forget that the Sun did set on the English Empire, which no one thought would happen. When I was first in the Navy, Iraq was our ally and then came the first Gulf War. China in the 1970s was a bastion of Communism, it was absurd to think that today they would buy more cars, smartphones, and watch more movies then us – a Chinese company just had the largest IPO in history and does more business than Amazon and Ebay combined, absurd? At one time we funded and supported the Taliban and even Osama Bin Ladin against the Russians who invaded Afghanistan, it was absurd to think that we would ever have to fight against the same rebels we had once supported. The Soviet Union never though the Berlin Wall would come crashing down, literally ripped down by the people. We face radical changes, once thought absurd that have now come to pass and accepted. It is arrogant to NOT accept that what may be improbable is not impossible.
Have we crossed the Rubicon?
We have crossed the Rubicon in monetary policy, going where we have never gone before. There is concern in the Federal Reserve about the unintended consequences of their “extraordinary emergency measures” and even a larger concern of how does one begin to unwind trillions of dollars of accommodation and raise rates without massive disruptions. The Fed has articulated some of these concerns, yet they also remain firmly in the blind ideological Keynesian belief that their policy is working. They use the 4% GDP, the 1.7% CPI, and the 6% U3 unemployment measures as their yard sticks of success and additionally point to the equity markets reaching new highs daily. Yet these data points are fraught with problems that don’t exactly articulate the real economic conditions on the ground. They also ignore the fact that a predominate driver of the equity markets has been a function of their zero interest rate policy and curve flattening interventionism. The massive leverage debt ratios are ignored, yet leverage debt ratios will only expand if rates are very low and money is freely available to borrow. Who is going to turn down a free loan?
On the political spectrum, our Senate and House have reached all-time lows in political approval. The President has all but declared war on ISIS and has launched attacks into another sovereign nation without Congressional approval as this has become the accepted norm. Mean while our Congress decides it is better to go on vacation than to address the pressing concerns of our nation.
We have added nationalized health-care, the largest social program since the New Deal, which remains a distressing endeavor among the states, the people, and businesses. This morning the administration without Congressional approval is shunting tax-inversions, more of a play heading into the mid-terms than with anything of real bite, but the action does not go unnoticed.
Ukraine and the Middle East volatility escalates, which can trickle over to energy prices and bring forth dollar price inflationary pressures, especially in conjunction with Fed monetary policy.
A currency war of devaluation is brewing between Japan (BOJ), Europe (ECB), and our own Fed. For now Yellen has remain quiet and loading for her own broadside to keep the dollar from appreciating. We face an uncertain mid-term election in the short-term, which handcuffs her ability to take open action against the bombardment of Yen and Euros.
What we do know for sure is that we are following down a very well-trodden road of many civilizations and nations in history when it comes to monetary policy. Most recently we are following down the road of lost decades of Japanese monetary policy and we will soon be celebrating our own lost decade. Those that thought we would never follow Japan’s monetary policy and thus suffer from the same results are now eating their hats.
I think we are getting close to an end game in which we could see even more radical monetary and possibly fiscal policies, because the government and the Fed will not relinquish the expanded powers afforded to them. Furthermore they are not willing to accept defeat in their grand experiment and to revert back to a free market interest rate environment, because they are scared and concern of the possible outcomes of a free market interest rate re-balancing of the real risk.
I don’t deny that allowing the free market interest rate environment will cause pain and will hail forth some failed individuals, businesses, and even banks. However, our current monetary policy is only aiding those that should be allowed to fail. The government can’t pick winners and losers and then use tax payer money and debt to cover the problems. I do not have hope in seeing a full return to free market interest rates anytime soon and expect more accommodative policies, interventionism, protectionism, nationalism, and collectivism. The government is reeling in debt and deficit pain, they NEED more revenue and will go after anyone and everyone to collect more; taxes, fines, penalties, fees, tariffs, and any kind of revenue that will help fill its vast depleted coffers and to help continue to fund mass expenditures.
The hidden war!
The larger hidden war is one of the Fed monetary policy and government fiscal policy fighting against the laws of supply and demand. We know the eventual outcome, history is the greatest score keeper and no nation in the history has ever beaten the laws of supply and demand. Sound governments do not attempt to control supply and demand, but rather accept its nature and work to set clear and transparent rules and regulation for navigating its waters. It is when governments build levees, dikes, dams, and try to alter the course of this massive river in which they are inevitable doomed to fail. For the levee may hold for now, but at some point when the levee breaks the watershed moment is so powerful that there is little hope of regaining control. The best have tried through history, they have all failed.
Courtesy of wikipedia
Support & Resistance
We are still above that proverbial safe and happy level of 17,000, but I think we could pull off and visit that level in before the mid-term elections.
Apple seems stuck in the 100 range, yet their iPhone 6 sales are record breaking. Alibaba IPO has looked bad for those that tried the IPO flip game, as the stock has fallen every day since. Yet the tech sector remains robust.
While the market wants to see the 2000 level as a support and ramping point, the 1990 level is the broader level one must pay attention to. The VIX is in the mid-13 range and if we see more weakness we could reach in the mid-to-high 14 range.
If we follow the longer term support/resistance in the Russell this is becoming an area of higher lows that needs to find some support, if we are to expected see any broader rebound in the equity markets heading into the mid-term elections. A break below 1130 means a visit to the 1100 basing level not seen since the first quarter in which we consolidated and rallied from. I also believe a broader breakdown into the 1100 area can incite some panic selling in the narrower indices as we have seen several media stories covering the growing concern in the broader market, namely the Russell, about weakness and now the “death cross”. More eyes are on the RUT, as investors are realizing this is the dominate gauge for order flow. Look for the 1120 – 1130 support area to hold with some volume and consolidation, if we are to get a strong bounce before the next FOMC meeting.
In the Fed’s Court!
The market and the dollar are squarely in the Fed’s court. No massive IPO or iPhone 6 sales will drive the market, as we have passed far beyond geo-politics and real earnings as a driving force or a determinant in market trends and action. It is the Fed, their monetary policy, and response to the BOJ and ECB that will determine the market trend.
We have another FOMC meeting in October before the mid-terms and we will most likely see Fed action, if the markets come under any significant pressure or any significant disruptions. We might not have to wait until the next FOMC meeting, in emergency events that Fed has acted out of turn and so we can’t rule that out, if conditions worsen. This is an election year, so there is less tolerance for market volatility than during non-political election periods.
The Fed is manning the wall, the dam, this levee against the tide of Supply and Demand. It has held and held strongly for years – but the water is not abetting and that means that more money needs to be spent to make this levee bigger, higher, and stronger.
I do not see the Fed raising rates or becoming more hawkish anytime soon, no words will change my opinion – not even an adjective in an FOMC statement. Actions is where the rubber meets the road.