Golden age of Macro

August 16, 2020 – Weekly comment

Great interview of Ben Melkman, founder of Light Sky Macro by Erik Schatzker of Bloomberg last week. (All links at bottom). Quick summary of ideas: Covid has been a catalyst and has “upended big truths”. One core theme is that previously, exchange rates were more or less fixed and interest rates weren’t. The pandemic has forced huge government deficits, thus relegating central banks to a function of accommodation with rates near zero for the foreseeable future. Central bank independence is gone. We’ve gone from fixed exchange rates to fixed interest rates (at zero) which means that volatility will now spill over into FX. Because rates have gone to zero in a world with little growth, present value returns in equities have been pulled forward. Equities thus far have reacted as nominal assets like gold, but despite low rates will likely do poorly going forward. Think of the typical 60/40 portfolio. The bond portion has gone from an asset to a liability vulnerable to an inflation shock; the coupon cushion has evaporated. Equities can similarly be thought of as a long duration asset whose returns have been brought forward by the same dynamics, though that asset class could benefit from high nominal growth. Ironically, if CB’s are successful in their efforts to generate inflation both stocks and bonds could suffer. The virus has been a catalyst in changing structure going forward…big social movements. Fiscal policy is important in terms of rate of change, a 20% increase in deficit this year needs the same sort of increase next year just to keep things even. [I disagree on this point] There is an expanding debt profile with no way to adjust rates up, which will probably lead to curve steepening over time, but not in the near term. Dollar is quite vulnerable. Policy makers have been conditioned to allow deficits because there has been no inflation response. However, in recent history, monetary and fiscal policy were more or less working against each other. Now fiscal and monetary policies globally are moving in the same direction [when was the last time you heard complaints about fiscal austerity as a policy?] Melkman forecasts volatility in the largest most liquid markets in the world, bringing great macro opportunities. Schatzker asked an insightful question near the end: “What would be the most unpleasant surprise” to Melkman’s forecast? Answer was “Japanification”. Despite the goals of the authorities, the debt burden just keeps growing and casts a long disinflationary cloud.

Summary: a weaker dollar, zero to negative returns in equities, a steeper curve eventually as inflation materializes, large government deficits. Melkman surmises the US will begin to look a bit more like Europe.

Regarding the need to continuously grow gov’t deficits at a rapid rate, I don’t believe that’s necessarily true if the private sector can kick in. The pandemic created a huge hole in global economies that governments and Fed have attempted to plug. Perhaps as Covid fades, the private sector will reach escape velocity. However, the immediate question is how big should the response continue to be, and how can we come close to ‘getting it right’? Let me take a minor example: according to a Chicago SunTimes report, it cost $66 million to turn McCormick Place (Chicago’s convention center) into a hospital which could accommodate 2750 patients. However, only 38 patients were treated there before it was shuttered. Obviously a huge miss, but at the time it seemed completely necessary. The point is that both fiscal and monetary have potential to overshoot, but it’s hard to get the genie back in the bottle.

Now consider the suggestion of former Fed officials Simon Potter and Julia Coronado for “recession insurance bonds” that could be distributed to households and monetized by the Fed upon certain triggers like reaching the zero bound, or when unemployment goes up by 0.5%. Here’s Potter from the August 1 interview with BBG: “It took too long to get money to people, and it’s too clunky. We need a separate infrastructure. The Fed could buy the bonds quickly without going to the private market.”

That sounds a lot like helicopter money which bypasses Congress. Perhaps it’s a long way away. But maybe not. As Lacy Hunt said this week (as a caveat to his disinflationary thesis) “There are folks who want to make the Fed’s liabilities legal tender. Now, if that happens, then the inflation rate would take off.” Lael Brainard this week gave a speech titled “An Update on Digital Currencies”. From the speech, “As part of this research, central banks are exploring the potential of innovative technologies to offer a digital equivalent of cash.” China is also deeply involved in the study of digital currency. On that topic, circling back to Melkman and the role of central banks, consider this picture (below) of China’s Credit Impulse overlaid with the US ten-year yield inflation indexed note yield (real yield). This idea is from a ZH article on Friday, “Is China About to Unleash an Inflationary Tsunami in the US”. ZH says China’s Credit Impulse leads US real rates by about twelve months. That appears to be the case in 2012, when China’s credit growth jumped and was followed by the May 2013 taper tantrum, and to a lesser extent in 2015. In any case, it’s clear from the chart that China’s credit growth again went into high gear in 2020 as US real rates made new historic lows.

Getting back to today’s markets, this past week the US ten-year yield rose 15 bps to 70.8 and the thirty year jumped 21.6 bps to 1.442% as the heavy US auction schedule finally caused a bit of indigestion. It’s worth mentioning corporate supply as well. From an August 12 BBG article, “Junk rated companies have borrowed $274.8 billion in 2020, exceeding the sum of cash raised during all of last year.” And from August 14, “High-grade new issue supply is up 76% YoY and less than $10bn away from breaking the new issue volume record of $1.333 tr set in 2017.” On Wednesday the Treasury auctions $25 billion 20-year bonds and on Thursday $7 billion 30-year TIPS. FOMC minutes on Wednesday.

OTHER MARKET/ TRADE THOUGHTS

Last week a client mentioned the need for a cheap hedge due to a structural flattening bias in his book. His concern was that something like the ‘temper tantrum’ could recur. I’m quite sure that Wednesday’s FOMC minutes will further solidify the idea of forward guidance at zero. “Not thinking of (in triplicate) raising rates.” However, when the sentiment changes, as it did in May 2013 when Bernanke hinted at a change in the Fed’s bond purchases, it can happen in a hurry.

In conjunction with this idea, and the growing inkling that inflation may take hold, it was interesting to see a large sale in EDM’25 on Friday at a price around 9930 to 9929. The contract settled at 9926.5, down 2 on the day. Individual contracts in the golds rarely trade in decent size; ordinary volume is 15 to 20k per day, but gold June (20^th quarterly) traded 63k Friday with OI +7200 (suspiciously low).

On the chart below I have overlaid the 30y bond yield with the yield on the gold euro$ pack (the average of the 17^th, 18^th, 19^th and 20^th ED contracts). Both have made record low yields this year with the gold pack dipping below 50 bps! It appears that every time there’s a turn in the market to higher long rates, golds way outperform on the way up. Not so far this month…the bond yield jumped 25 bps from July 31 while golds are only up 13.5. Looks like EDM’25 might have been a great sale, whether as hedge or spec.

	8/7/2020	8/14/2020	chg
UST 2Y	12.5	14.7	2.2
UST 5Y	22.6	29.8	7.2
UST 10Y	55.9	70.8	14.9
UST 30Y	122.6	144.2	21.6

GERM 2Y	-68.3	-64.7	3.6
GERM 10Y	-50.8	-42.1	8.7
JPN 30Y	54.7	61.5	6.8
EURO$ U0/U1	-3.5	-3.0	0.5
EURO$ U1/U2	1.5	4.0	2.5
EURO$ U2/U3	10.0	12.0	2.0

EUR	117.86	118.44	0.58
CRUDE (active)	41.22	42.01	0.79
SPX	3351.28	3372.85	21.57	0.6%
VIX	22.21	22.05	-0.16