The Great Unwind and the Two Most Important Prices in the World

“The cost of a thing is the amount of what I will call life which is required to be exchanged for it, immediately or in the long run.” – Walden by Henry David Thoreau

 “The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation.” – Vladimir Lenin

“There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation.” – Herbert Hoover

The Federal Reserve for the better part of a decade has been engaged in the business of suppressing interest rates through the use of easy monetary policies and quantitative easing. For US bond market participants all the Fed’s policies entailing interest rate suppression meant that there was a perpetual bid for US treasury bonds and it was always at the best possible price. The Fed has recently embarked on the journey toward unwinding the suppression of interest rates through the process of quantitative tightening. QT has US bond market participants worried that there will be a perpetual offer of US treasury bonds at the worst possible price.

The Organisation of Petroleum Exporting Countries (OPEC) and Russia have, since late 2016, taken steps to prop up the price of oil by aggressively cutting output. With a history of mistrust amongst OPEC and non-OPEC producers and a lackadaisical approach to production discipline, oil market participants did not immediately reward oil producers with higher oil prices in the way bond market participants rewarded the Fed with immediately higher bond prices / lower yields. It took demonstrable commitment to the production quotas by the oil producing nations for oil market participants to gain the confidence to bid up prices. And just as confidence started to peak, Russia and Saudi Arabia signalled that they are willing to roll back the production cuts.

Arguably the US dollar and oil are the two most important ‘commodities’ in the world. One lubricates the global financial system and the other fuels everything else. Barring a toppling of the US dollar hegemony or a scientific breakthrough increasing the conversion efficiency of other sources of energy, the importance of these commodities is unlikely to diminish. Hence, the US (long-term) interest rates and the oil price are the two most important prices in the world. The global economy cannot enjoy a synchronised upturn in an environment of sustainably higher US interest rates and a high price of oil.

In the 362 months between end of May 1988 and today there have only been 81 months during which both the US 10-year treasury yield and the oil price have been above their respective 48-month moving averages – that is less than a quarter of the time. (These periods are shaded in grey in the two charts below.)

US 10-Year Treasury Yield10Y YieldSource: Bloomberg

West Texas Intermediate Crude (US dollars per barrel)

WTISource: Bloomberg

Over the course of the last thirty years, the longest duration the two prices have concurrently been above their respective 48-month moving averages is the 25 month period between September 2005 and October 2007. Since May 1988, the two prices have only been above their respective 48-month moving averages for 5 or more consecutive months on only four other occasions: between (1) April and October 1996; (2) January and May 1995; (3) October 1999 and August 2000; and (4) July 2013 and August 2014.

Notably, annual global GDP growth has been negative on exactly five occasions since 1988 as well: 1997, 1998, 2001, 2009, and 2015. The squeeze due to sustainably high US interest rates and oil prices on the global economy is very real.

Global GDP Growth Year-over-Year (Current US dollars)

global GDP

Source: Federal Reserve Bank of St. Louis

On 13 June, 2018 President Donald Trump tweeted:

“Oil prices are too high, OPEC is at it again. Not good!”

And today, nine days later, OPEC and non-OPEC nations (read: Saudi Arabia and Russia) obliged by announcing that OPEC members will raise output by at least 700,000 barrel per day, with non-OPEC nations expected to add a further 300,000 barrels per day in output.

Iran may accuse other oil exporting nations of being bullied by President Trump but we think it is their pragmatic acceptance that the global economy cannot withstand higher oil prices that has facilitated the deal amongst them. (Of course we do not deny that a part of the motivation behind increasing output is bound to be Saudi Arabia wanting to return the favour to Mr Trump for re-imposing sanctions on Iran.)

Last week the Fed raised the Fed funds target rate by 25 basis points to a range between 1.75 per cent and 2 per cent. At the same time it also increased the interest rate on excess reserves (IOER) – the interest the Fed pays on money placed by commercial banks with the central bank – by 20 basis points to 1.95 per cent. The Federal Open Market Committee (FOMC) also raised its median 2018 policy rate projection from 3 hikes to 4.

With the Fed forging ahead with interest rate increases it may seem that it is the Fed and not OPEC that may squeeze global liquidity and cause the next financial crisis. While that may ultimately prove to be the case, the change in the policy rate projection from 3 to 4 hikes is not as significant as the headlines may suggest – the increase is due to one policymaker moving their dot from 3 or below to 4 or above. Jay Powell, we think, will continue the policy of gradualism championed by his predecessors Ben Bernanke and Janet Yellen. After all, the Chairman of the Fed, we suspect, oh so desires not to be caught in the cross hairs of a Trump tweet.


Investment Perspective


Given our presently bullish stance on equity markets, the following is the chart we continue to follow most closely (one can replace the Russell 1000 Index with the S&P500 or the MSCI ACWI indices should one so wish):

Russell 1000 IndexRussell 100Source: Federal Reserve Bank of St. Louis

If the shaded area on the far right continues to expand – i.e. the US 10-year treasury yield and oil price concurrently remain above their respective 48-month moving averages – we would begin to dial back our equity exposure and hedge any remaining equity exposure through other asset classes.

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

The Contrarian Quartet (Part II)

“You never bet on the end of the world, that only happens once, and the odds of something that happens once in an eternity are pretty long.” – Art Cashin

“A thing long expected takes the form of the unexpected when at last it comes.” – Mark Twain

This week’s piece is a follow up to last week’s Contrarian Quartet (Part I). We outline the remaining two out of the four opportunities where we find the risk-to-return profile in being contrarian is far more attractive than in following the herd.

Rather fortuitously we decided to delay writing about Italy, the first of the two opportunities we discuss below, to this week as the deterioration in sentiment towards the sustainability of the European Union has accelerated.


“In investing, what is comfortable is rarely profitable.” – Robert Arnott, chairman and chief executive officer of Research Affiliates

As recently as three weeks ago, investors were disregarding the risks of political turmoil in Italy and lifting the Italian stock market higher. From the start of the year to market close on 7 May, 2018, the FTSE MIB Index generated a total return of 12.2 per cent in US dollar terms versus a measly return of 41 basis points for the MSCI All Cap World Index. Starting 8 May Italian outperformance started to unwind and the year-to-date return for the market, based on live prices as at the time of writing, is now negative. As the cliché goes, stocks take an escalator up and an elevator down.

FTSE MIB IndexFTSE MIB.pngSource: Bloomberg

Investors were first spooked by the two leading populist parties in Italy – the Five Star Movement and the League – moving to form a coalition to run the country. And then by President Sergio Mattarella’s decision to block the formation of a eurosceptic government and selecting Carlo Cottarelli, an International Monetary Fund alumnus, as prime minister-designate, to try to form a new government.

The selection of Mr Cottarelli, who has consistently defended Italy’s membership in the euro and became known as “Mr Scissors” for making cuts to public spending in Italy during Enrico Letta’s brief period as prime minister, has antagonised the populist coalition.  The populists see the selection as a deliberate attempt by President Mattarella to undermine the Italian people’s will as expressed by them in the recent election. Moreover, choosing Mr Cottarelli flies in the face of the coalition’s desire to put eurosceptics in key cabinet positions – as they tried to do by choosing Paolo Savona, the 81-year-old Eurosceptic economist, as their economy minister.

Given the antagonist nature of the President’s selection, Mr Cottarelli is highly unlikely to win a vote of confidence in parliament. Italy, in all likelihood, will have to hold a new set of elections in the autumn. And the next election has inextricably become about Italy’s membership in the euro. The worry is that the populists will use the bitterness from President Mattarella’s actions to rally their voters and emerge even stronger after the new elections.

Investors have been selling-off all things Italy in apprehension. Most drastically, the yield spreads between Italian and German government debt has blown out.

Italian vs. German 10 Year Government Bond Yield SpreadYield SpreadSource: Bloomberg

This is not the reaction President Mattarella was expecting, we suspect.

While we acknowledge that political risk in Europe is back in vogue, we consider the probability of an Italian exit to be low and with the caveat that Señor Draghi keeps the monetary spigots up and running we see even less risk of financial contagion spreading through Europe.

Consider the state of Italian sovereign debt today versus that at the height of the Euro Crisis. Foreign-ownership of Italian sovereign debt is down from 41 per cent in 2010 to 32 per cent today, with non-European investors holding a paltry 5 per cent. At the same time, Italy’s debt servicing costs as a percentage of GDP are at their lowest level since the euro was instituted – this of course is largely down to the ECB’s benevolence.

The Italian economy has been humming along quite nicely with first quarter GDP year-over-year growth of 1.4 per cent. Italy is also running a primary fiscal surplus and the fiscal deficit for 2017 was just 2.3 per cent of GDP and is likely to fall below 2.0 per cent in 2018.

The possibility of a fiscal blow-out due to extortionate spending by the populist coalition, if it is elected in the next elections, is also highly improbable. Since 2012, the Italian constitution mandates the balanced budget law and the president has the power to veto any decision that is not in adherence with this law. We are almost certain that a Europhile like President Mattarella will not hesitate in exercising the veto should the need arise.

Lastly, there are clear ideological differences between the two coalition parties and it is likely that such differences will be severely tested in the run up to the elections and, if they are elected, by the highly bureaucratic legislative system in Italy.  We suspect that the differing ideologies will impair the populist coalition’s ability to implement policies, which in turn will severely test its survival.

For these reasons we consider the drastic widening of the yield spread in Italian debt relative to German debt to be somewhat unwarranted. Despite this and given where absolute yields are in Europe, we do not think investors should have any sovereign or corporate bond exposure in Europe.

We also think it might still be a bit early to add broad based exposure to Italian stocks. Although selectively we are starting to see opportunities in high quality Italian companies, which we will be monitoring closely for potential entry points.

Where we see the greatest opportunity is to go long the euro relative to the US dollar. We think the current sell-off in the euro is sowing the seeds for the next down leg in the US dollar. The political uncertainty has facilitated the unwinding of bullish euro and bearish US dollar positioning. We suspect positioning will quickly become, if it has not already, very bearish in the euro and bullish in the US dollar. Overly bearish positioning is in our minds a necessary condition for the euro to re-assert its bullish trend.

US Long Dated Treasuries

GS US Financial Conditions Index versus US 30 Year Treasury YieldsGS US FCI vs 30YSource: Bloomberg

In The Convergence of US and Chinese Bond Markets we wrote:

“The shifting secular trend does not, however, warrant shorting US treasuries. The last secular US bond bear market lasted thirty-five years and can be sub-divided into thirteen parts: seven major price declines and six bear market rallies. Moreover, even though short-term interest rates bottomed around 1941, long-term bond yields continued to decline till 1946. We would not be overly surprised if a similar dynamic played out once again, with short-term rates bottoming in 2015 and long-term bond yields bottoming several years after.”

While we remain secular bears on US government bonds, we think long dated US treasuries currently offer a tactical opportunity on the long-side. US financial conditions have started to tighten after the easing induced by the enactment of the Trump tax plan – for instance US companies pre-funded their pension schemes to benefit from the higher tax rate in 2017 and contributed to the easing in financial conditions – is beginning to wear off and the reality of higher rates and higher oil prices squeezes system-wide liquidity. As demonstrated in the above chart, as financial conditions tighten, long-term bond yields tend to decline shortly after. Add to this the near record levels of short positioning in long-dated treasuries by non-commercials and you have a recipe for sharp rally in long-dated US treasuries.

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein   

Quantitative Tightening May Not be as Scary as You Think

“You can be sure of succeeding in your attacks if you only attack places which are undefended. You can ensure the safety of your defense if you only hold positions that cannot be attacked.” – Sun Tzu, The Art of War

“I have absolutely no doubt that when the time comes to reduce the size of the balance sheet we’ll find that a whole lot easier than we did when expanding it” Sir Mervyn King, February 2012


In September, 2017 the Fed announced that it would start paring back its multitrillion-dollar balance sheet. The reduction will start modestly with USD 6 billion in Treasury bonds and USD 4 billion in mortgage backed securities a month. By the end of 2018 the pace of reduction is expected to reach USD 50 billion a month.

Ever since the Fed indicated its intention to gradually begin selling some of its bonds portfolio, opinions on the possible consequences of the balance sheet reduction have been divided. The equity bears argue that quantitative tightening will lead to a severe tightening of monetary conditions causing a recession and a stock market crash. The bond bears on the other hand argue that the added supply of Treasury bonds, at a time when foreign central banks are retreating from the Treasury market, will overwhelm the market, causing bond prices to fall sharply. While there are others that curiously argue that just as quantitative easing was expected to be inflationary but ended up being deflationary, quantitative tightening, which is expected to be deflationary, will cause inflation to spike.

We wonder, however, if quantitative tightening will turn out to be a non-event?

Prior to the global financial crisis, the Fed through the Federal Open Market Committee (FOMC) used open market operations – the buying and selling of government securities – as its primary tool to regulate money supply in the economy. The open market desk at the Federal Reserve Bank of New York would buy securities to increase the level of reserves held by banks – increasing money supply – or sell securities to remove reserves – to reduce money supply. There were also no interest payments on excess reserves.

As banks, in the ordinary course of business, try to maximise income on the given level of available funds, the opportunity cost for holding excess reserves prior to the crisis was high. Instead of holding excess reserves, banks, by lending or investing their assets, attempted to maximise earnings by reducing liquidity to as close to the statutory minimum as possible. According to the Federal Reserve Bank of Cleveland, from 1959 to just prior to the financial crisis, the level of reserves in the banking system remained stable, growing at an annual average of 3.0 percent over the period – in line with the growth rate of deposits. Excess reserves’ share of total reserves, outside periods of extreme uncertainty or economic stress, was also stable, rarely exceeding 5.0 percent.

Under the circumstances prior to the financial crisis, banks did not hold surplus funds needed to buy bonds from the Fed. Their only option to generate funds was to sell other assets or call in loans. So when the Fed sold bonds to the banks, the banks sold other financial instruments, driving down the price of financial assets and pushing up interest rates. This selling tightened monetary conditions and served to cool economic activity.

In response to the global financial crisis, the Fed injected large amounts of reserves into the banking system and introduced new mechanisms that encouraged banks to increase their level of excess reserves. Since December 2008, the Fed pays interest on all banking reserves, including excess reserves, thereby increasing the marginal benefit of holding excess reserves as compared to before the crisis. At the same time, the heightened levels of risk in other securities and lending combined with an increasing regulatory burden reduced the marginal benefit of the alternatives to parking money at the Fed. The decision to pay interest on banks’ excess reserves also ensured that the mass injection of liquidity did not result in short-term rates falling below zero, thereby putting a floor on short-term rates.

Interest on Excess Reserves vs. Fed Funds Rate and 90 Day T-Bill Discount RateIOERSource: Bloomberg

A number of liquidity-easing programs to alleviate some of the stress in the financial system were also implemented by the Fed. The largest of the liquidity programs implemented, quantitative easing, involved the Fed purchasing Treasury securities, federal agency debt and mortgage-backed securities primarily from non-banks. These purchased assets were then converted into deposit liabilities at the banks. As a consequence of these asset purchases and their conversion to deposit liabilities, excess reserve balances at the Fed expanded greatly and as of 25 October, 2017 stood at USD 2.14 trillion.

Excess Reserves of US Depository Institutions (USD million)Excess ReservesSource: Federal Reserve Bank of St. Louis

To undertake quantitative tightening, the quantitative easing process will have to be reversed. This will involve the Fed selling the securities it purchased to banks in order to absorb the excess funds in their current accounts. As bond bears postulate, this selling of government bonds should, in theory, cause their price to fall, driving up interest rates. In practice, however, if the Fed does not shrink its balance sheet by more than the level of excess reserves in the banking system, quantitative tightening will not be a “tightening” of monetary policy. In a tightening phase, the Fed would be selling bonds to banks to soak up market liquidity and reduce the volume of money circulating. However, for any level of quantitative tightening up to the USD 2.14 trillion in excess reserves, the funds are already available in the banks’ accounts with the Fed. As banks will not need to raise funds elsewhere, the operation, in our opinion, is unlikely to have the negative impact of a standard tightening operation, and interest rates should not rise as a direct consequence of quantitative tightening.

The next question that comes to mind then is why undertake quantitative tightening now? The answer to that, we think, lies in the very reason many feared quantitative easing would cause inflation to spike.  Quantitative easing did not result in high levels of inflation as there was little demand for debt financing, other than for corporate share buybacks and mergers & acquisitions. As long as there is no demand from would be borrowers, no amount of quantitative easing will result in inflation. However, as we argued in The Case for a Pickup in US Inflation, the capital expenditure cycle may be picking up and that may spur an expansion in credit issuance.

Of the aggregate reserves of depository institutions held with the Fed, only around USD 127 billion, as of 25 October, 2017, are required to satisfy reserve balance requirements.  Accordingly, the USD 2.14 trillion in additional reserves can potentially support a level of money supply much larger than that exists today. By absorbing these excess reserves, the Fed will reduce the possibility of a drastic expansion in bank lending and money supply that could destabilise the economy.


Investment Perspective

Much like Pavlov’s dog, we, as market participants, have been conditioned by the pairing of a neurologically potent stimulus, such as directional market action, with a neutral stimulus, such as the Fed’s policy decisions, to elicit a response. The nature of our response is ultimately conditioned by our most formative experiences within markets. The direction of market action that was most recurrent subsequent to the application of a particular Fed policy during this time is most likely to become our default expectation whenever the policy is implemented again.

The market regime experienced by the vast majority of market participants today is the one where banks’ excess reserve levels were modest and the Fed selling bonds resulted in interest rates rising. Quantitative tightening involves selling of bonds by the Fed, ipso facto, financial conditions will tighten and interest rates will rise so sell bonds. We consider this to be a systematic error caused by conditioning under an altogether different market regime.

Quantitative easing was a compelling reason to buy long-dated government bonds. Quantitative tightening, on the other hand, is not a sound reason to be selling or shorting long-dated Treasury securities.


This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.