I’m often lumped (I think undeservedly) into the “permabear” category and while that’s not generally somewhere I’m comfortable being, I’ve accepted that some folks are going to summarily assign the “doomsayer” label to me no matter what I write, so what I try to do is soften that image by giving readers little glimpses into my actual life.
That window into the man behind the pseudonym comes courtesy of vignettes and other story telling devices I use to let readers know that anonymity notwithstanding, I’m a real person, who actually cares about delivering value to readers. If you don’t find any value in the persistent cynicism and skepticism towards markets in general, then perhaps you’ll at least appreciate the analysis and barring that, you can always fall back on my humor and engaging style.
That’s probably what makes me so fond of 15-time Extel Survey champion and man from whose cold, dead hand you will have to pry his (in)famous “Ice Age” thesis, Albert Edwards.
Based on reader feedback from last year, some people seem to assume I feature Albert’s commentary in order to perpetuate my own skeptical market narrative or to otherwise enjoy the inevitable click deluge that comes from putting the last name “Edwards” after the the first name “Albert” in the title of posts. That’s not the case.
I feature excerpts from Albert’s commentary because he has an engaging style that he infuses with thoughtful analysis and also because, like me, he sometimes tells fun stories about his travels and adventures and, perhaps most importantly, understands the power of self-deprecating humor. That latter point (the self deprecating humor bit) is key if you’re going to be someone who perpetually calls bullshit on the consensus narrative (something Albert does). While it might be true that “fear sells”, “selling” fear on a daily basis is a good way to make a standing joke out of oneself and one great way to avoid that fate is to let readers know that you’re in on the joke. That disarms critics and paradoxically stacks the deck in your favor as people become aware that you’re aware of your own biases and that in turn fosters trust or at the very least, endears you to readers.
So that’s why I like Albert and in his latest note (dated Wednesday), he kicks things off by telling you what he’s been up to lately. In a testament to what I said above about how Albert can write the jokes before you even think to make them, he immediately delivers the punchline. To wit:
I am just back from a two-week trip to Lake Tahoe and Yosemite/Sequoia Parks. It was significant that we didn’t see any bears at either venue despite doing a 7.30am, 13 mile valley floor hike! I’m sure the absence of fellow bears was a significant countertrend sign.
There you go. He beat you to your “bears” jokes. And much like my own vignettes, there’s a market parallel:
I learned something else on my trip worth sharing. We took the Yosemite Tram tour of the valley floor and the ranger gave a very interesting talk about fire. Until 1970 Yosemite Parks was extinguishing regular small-scale fires to prevent property damage. The resultant rise in dense small tree growth meant that although fires were less frequent, they quickly got out of control. Since 1970 they have allowed more fires to burn, resulting in less damage. Central bankers should learn this lesson.
As regular readers know, I’m no fan of the creative destruction meme (not because I don’t like the concept, but rather because I don’t think it’s politically viable in a world where citizens of developed countries have become so used to creature comforts), but part and parcel of an unanchored system (i.e., a fiat system) is a kind of spiral dynamic where each bubble has to be large enough to subsume the one that came before. Inherent in that characterization is the notion that each successive bust will be larger than its predecessor. Stopping that loop entails allowing the whole thing to burn itself out at some point. Even if that’s not what Albert was driving at with the forest fire story, I think it fits nicely.
Albert goes on to address the dynamics that have led to the dollar’s recent surge. In a recent note, he touched on the rate differentials story and that’s something we’ve been talking about a lot recently.
For a while, the dollar stubbornly refused to keep pace with the favorable shift in rate diffs (thanks in part to market jitters about the deterioration of the U.S. fiscal position and the extent to which Trump’s trade stance amounts to a weaker dollar policy by proxy), but the correlation between the greenback and U.S. yields and also between the dollar and rate diffs has begun to reassert itself of late.
Do note that between decelerating growth in the eurozone and the safe haven bid associated with political turmoil in Italy and Spain, German bunds had their best week since 2015 late last month:
And while U.S. yields fell from recent highs during that same week, that 254bps spread between 10Y Treasury yields and 10Y German yields you see on the blue line in the first chart shown above was the widest level since 1989. Last week, amid the turmoil in Italy, it blew out another 6 or so bps to above 261 before tightening over the past several days.
This is the ebb and flow of the transatlantic policy divergence narrative which has waxed and waned over the past two years.
Once the dollar’s correlation with rate differentials reasserted itself, the greenback began to rise and the short USD trade (the third most crowded trade on the planet, according to BofAML’s survey) began to get squeezed, adding fuel to the fire and putting EM in a truly precarious situation. There’s a ton more on this in “Shaking The Tree: The Fed, ‘Overripe Fruit’ And A Half-Full Snifter“.
Edwards reiterates this as follows:
I believe much of the recent key market movements, or indeed the lack of movement, are due to extreme positioning by speculators. A key theme over the last couple months has been the surge in the US dollar that has been having a particularly damaging impact on emerging markets. Three key factors have driven recent dollar strength: 1) a rapid widening in 2y spreads in favour of the dollar, 2) a surge in negative economic surprises in the eurozone and 3) an unwinding of extreme levels of speculative short positions in the dollar. That third factor is largely now played out. Short positions have been cut for six weeks in a row and so this unwind should no longer be such an important driving factor for a stronger dollar in the near term (see left-hand chart below).
The right-hand chart is the spec TY short which seems to have been squeezed on Thursday (note: there’s a debate going on right now about the extent to which the Treasury short is a contrarian indicator this time around and you can read a couple of interesting points on that from Goldman here).
Whether or not extended spec positioning truly limits 10Y yields from rising sustainably above 3% (or 3.05% or 3.11% or whatever “magic” number you want to assign) is an open question, but it’s surely the case that in the event something spooks everyone (which is what happened on Thursday with the Brazilian real) panic covering could well accelerate the rally and push yields lower in a hurry.
That, despite the fact that wage inflation is likely to show up at some point or another in the U.S. if for no other reason than that Donald Trump has piled fiscal stimulus atop an economy operating at (or at least near) full employment.
For his part, Edwards cites a recent piece by David Rosenberg who flags the “quit rate” in America, but whatever you want to point to, the bottom line is that the Fed is likely to be hyper-sensitive to nascent signs of wage inflation right now due to the potential for expansionary fiscal policy to overheat the economy. Here’s Albert again reiterating what a whole lot of folks have been warning about lately, namely that every time the Fed tightens, something snaps somewhere:
If wage inflation leaps up in the US then it is likely that the Fed will keep tightening. They usually do until they break something. Since 1950, there have been 13 cycles in which the Federal Reserve tightened interest rates and 10 of these ended in recession. The other three tightening cycles saw emerging market blow-ups, like the 1994 Mexican peso crisis.
Finally, Edwards notes something interesting about the shadow rate.
“The Shadow Fed Funds rate hit negative 3% in mid-2014 [and] more importantly a pronounced tightening cycle actually started through 2015, and by the end of that year the Shadow rate had converged back with the effective nominal Fed Funds rate,” Albert writes, citing a colleague.
He goes on to simply add the 300bp rise in the shadow rate to the Fed funds rate in order to come up with a total of 470bps worth of total tightening during this cycle. That’s on par with previous peaks:
You can probably see where this is going. The idea is that if the Fed keeps tightening, the cumulative effect will be larger than other post-inflationary era tightenings and if what we’re already seeing in EM is any indication, that could be dangerous. Here’s Albert one more time:
It is therefore reasonable to argue that the US has already faced a normal tightening cycle and any additional rate hikes are taking us into territory not seen in recent times. This already may be enough for the Fed to have broken something. But if that is not enough and the Fed is to be believed, rates are heading to 3.4% (ie another 170bp rise) for a total of 640bp of tightening at a time when the US corporate sector is drowning in a sea of debt.
If you know Albert’s work, you know that’s actually a pretty tame conclusion comparatively speaking and whether or not you agree with the methodology there, this is food for thought at a time when no one is quite sure what a post-QE tightening cycle will ultimately mean for the various manifestations of the short vol. trade that have proliferated over the past several years.
Coming full circle, the Fed may end up emulating the strategy described by the ranger at Yosemite – even if they don’t mean to.
In closing, it would appear that when it comes to bears and forest fires, Albert and Smokey aren’t necessarily on the same page…