November 18, 2019
This issue discusses the causes and impacts of the recent U.S. monetary policy pivot, and then analyzes the economic inflection point we’re currently in; whether we’re likely in a period of stabilization and resumed growth acceleration, or whether recession risk continues to heighten.
And special thanks to everyone: this newsletter now has more than 10,000 email subscribers. I also link to it on Twitter and re-post parts of it on Seeking Alpha, for a circulation of about 25,000 readers for each issue.
The Monetary Policy Pivot
A lot of my work during late September and early October focused on the causes of the liquidity shortage and interest rate spike in the overnight interbank/repo lending market that occurred in mid-September, which I summarized in my article, The Most Crowded Trade.
I also wrote about it in my October newsletter, where I included some shorter summarized versions as well as a link to the full research piece.
Most people haven’t followed the interbank/repo liquidity issue and aren’t familiar with it, nor should they be expected to be. However, I consider it to have been the biggest financial event of the year, even though it’s not really on the front page of financial media. It quietly represents the complete pivot of this entire decade of U.S. Federal Reserve monetary policy.
Investors shouldn’t have to pay attention to global macro issues when it comes to their portfolios. But unfortunately, these global macro issues involving central banks, government deficits, liquidity levels, and so forth, are currently some of the main ingredients dictating stock and bond market direction.
People that have read my work for a while know that I tend to speak in terms of probabilities rather than certainties, because overconfidence is one of the biggest enemies when it comes to successful investing. Everything is really about probability management.
For this liquidity issue and repo lending spike, however, I had very high conviction due to the clarity of the math in my view. It had been a subject that I had been monitoring since early this year, and when the liquidity shortage showed up in the repo lending rate, it pinpointed the focus of my research, and I repeatedly wrote about what would occur.
To back up a bit for those that haven’t followed this chain of events, the U.S. government has been reliant for decades on foreign central banks and other foreign institutions buying our growing government debt. It used to be Europe and Japan buying most of it, and then with the rise of China in the early 2000’s, China became the biggest buyer.
But in late 2014, foreigners mostly stopped buying U.S. treasuries for the first time in several decades. So, for the past five years, U.S. institutions such as banks, pension funds, and corporations had to absorb over $3 trillion in new U.S. debt without foreign buyers helping to take some of the load, at the same time that U.S. deficits were expanding due to tax cuts that were not offset by decreases in spending.
My base case that I started writing about last year was that the Federal Reserve would begin monetizing debt during the next U.S. recession, which is why I started entering large long positions in gold, silver, and their associated mining and royalty companies in autumn 2018 for a portion of my portfolios. Those positions have since performed very well.
Two months ago in mid-September, domestic balance sheets seemingly ran out of space to absorb more and more government treasury bills. So, the U.S. Federal Reserve had to step in and start borrowing those treasuries from large banks in exchange for cash, which had run their cash levels down to regulatory lower limits in order to buy treasuries. As primary dealers, it’s the job of large banks to buy treasuries and make a market for them.
This is all summarized in my October 2 article, The Most Crowded Trade and in my shorter September 21 chart piece, Repo Spike Causes.
During that research process, I wrote on September 19th that the Federal Reserve would start permanently buying treasuries, and then elaborated with more detail over the next two weeks in a variety of articles and comments. For two examples:
This time, balance sheet expansion will be for a different reason, and they’ll need it whether or not there is severe economic deterioration (that would just accelerate their need for it). It’s a more specific problem. Domestic balance sheets, and particularly primary dealers, are tapped out and can’t hold the incoming deluge of more USTs at this point. This problem has been building for a year (and further back, about five years). The recent Treasury cash-refill and corporate tax payment timing are just the straw the broke the camel’s back (like a wave on a rising waterline that was already just under the top of its container, the wave wouldn’t have hit the top if the container wasn’t already 95% full). This will be different than an optional QE for injection. This will be QE to avoid hard limit of running out of liquidity among primary dealers that literally have trouble coming up with cash for more UST.
-Lyn Alden, September 25th, Seeking Alpha
If the Federal Reserve shifts from temporary open market operations “TOMO” to permanent open market operations “POMO” to permanent organic balance sheet expansion (QE by another name), it could address the issue for now. […] The most likely outcome is that the Federal Reserve will begin expanding its balance sheet again by 2020 (or perhaps in this fourth quarter 2019) to relieve pressure from domestic balance sheets, which means that the Fed would essentially be monetizing U.S. government deficits.
-Lyn Alden, October 2, Seeking Alpha
Then, on October 8th, the Fed indeed announced they would begin expanding their balance sheet by buying $60 billion in treasury bills per month starting on October 15th and extending until at least mid-2020. This was on the very early side of my proposed timeline, right at the start of Q4 2019.
When I made my September predictions that the Fed would start buying treasuries and monetizing U.S. deficits, I wasn’t precisely sure about how the Fed would play the timeline out, because they could have pushed the timeline back for a while by continually expanding the size of their overnight and 2-week term lending activities. That’s why my baseline case was 2020 but with a note that it could happen in Q4 2019. That’s the part I wasn’t certain about.
The Fed chose to be rather straightforward about it and begin buying treasuries outright without much of a delay.
All of this may seem rather esoteric and vague (“Inter-bank lending rate? Dollar liquidity shortage? Federal deficits without enough foreign buyers? Just give me stock ideas!”), but it does have practical implications.
The Federal Reserve is creating new money to buy U.S. debt from the large banks, meaning that U.S. government deficits are being monetized by money creation, even though we’re not yet in a recession. This is a complete pivot in U.S. monetary policy.
(I recommend reading my September newsletter issue for more detail on this matter regarding U.S. deficits, current account balances, and so forth.)
Here is a chart of the Federal Reserve’s balance sheet over the past five years, with that big pivot to the upside starting in mid-September:
Chart Source: St. Louis Fed
In the past nine weeks since the repo lending rate spiked up, the Federal Reserve has increased its balance sheet by $277 billion, mostly by buying t-bills. In the past four weeks, it has been about $80 billion, which if sustained would be just over a $1 trillion annualized rate.
If the United States has a recession, tax revenues would likely fall substantially, deficits would rise accordingly, and this monetization rate would accelerate quickly.
To Monetize or Not to Monetize, That is the Question
When Fed Chairman Ben Bernanke performed Quantitative Easing (QE) from 2008 to 2014 during and after the financial crisis (where the Fed created new money and used it to buy U.S. government treasuries and mortgage-backed securities), he defended it in speeches as not monetizing debt due to the fact that it was temporary and would be unwound. The Fed would eventually sell the debt it bought, rather than keep holding it and buying more, it was claimed.
And in a 2013 article, the St. Louis Fed featured arguments that QE was not debt monetization because the Fed balance sheet would return to normal. Here was their conclusion:
So, is the Fed monetizing debt—using money creation as a permanent source of financing for government spending? The answer is no, according to the Fed’s stated intent. In a November 2010 speech, St. Louis Fed President James Bullard said: “The (FOMC) has often stated its intention to return the Fed balance sheet to normal, pre-crisis levels over time. Once that occurs, the Treasury will be left with just as much debt held by the public as before the Fed took any of these actions.” When that happens, it will be clear that the Fed has not been using money creation as a permanent source for financing government spending.
None of that happened, so it’s clear that the Fed has been using money creation as a permanent source of financing for government spending:
Chart Source: St. Louis Fed
During that 2008-2014 period, the Federal Reserve balance sheet increased from $900 billion to $4.5 trillion due to three rounds of quantitative easing. Over half consisted of treasuries.
By 2014, the Fed indeed stopped buying treasuries and other assets, and held its balance sheet flat at $4.5 trillion for several years. And then in early 2018, the Fed began a nearly two-year process of gradually selling off their treasuries and shrinking their balance sheet. They said this would happen on autopilot and that it would be like watching paint dry. It eventually got to under $3.8 trillion after a very gradual pace of selling.
However, two months ago in September, the U.S. repo market broke. It seems that domestic private balance sheets (banks, pensions, corporations, etc) couldn’t absorb any more U.S. debt with $1 trillion per year in new debt supply. The Fed started lending money to them and temporarily taking treasuries for a day or up to two weeks at a time, and then within a month (by mid-October), the Fed announced that they would just start buying $60 billion worth of U.S. government debt per month in addition to continuing their short-term lending operations.
This marks the end of balance sheet shrinking. Within nine weeks from mid-September, the balance sheet increased by $277 billion, and went back over $4 trillion and growing, which is four times higher than pre-crisis levels. By mid-2020, we will likely be at new highs for balance sheet size. The treasury purchases throughout this past decade ended up being permanent, and it was indeed debt monetization, meaning that currency was created to buy government debt.
Practical Implications
For starters, this is a newfound source of liquidity, or at least a halt to the destruction of liquidity. Over the past decade, there has been significant correlation between global stock market performance and liquidity levels. I slightly increased my emerging markets exposure and added U.S. small-cap value exposure in late October. However, now that we’ve had a big run into mid-November, I’m already growing cautious again. There are both risks of a melt-up and risks of a downward correction.
Secondly, this recent $277 billion liquidity injection seemingly helped to halt the increasing strength of the dollar against other currencies, at least for now. Specifically, it began relieving the dollar liquidity shortage, but it’s still in the early phases.
Based on my analysis, the U.S. dollar is likely in a topping process and will eventually head down against many other currencies. It could still go a little higher, but it is essentially capped from going too high for too long in my view. My previously-linked article “The Most Crowded Trade” goes into more detail for this.
This current level of ~$80 billion per month liquidity injection is not yet enough to seriously weaken the dollar, because it’s just treading water at roughly the same rate as U.S. federal debt issuance. In other words, unlike previous rounds of quantitative easing, it is not aggressive enough to refill bank cash levels to higher levels (or at most, only at a gradual pace), and instead is just enough to prevent their cash levels from continuing to decline. Treasuries are flowing from the government into the large banks, and then out to the Fed.
The DXY dollar index peaked in early October and has been flat and choppy since then. We’ll see what it does throughout 2020.
Lastly, it showed that investors need to be prudent about conclusions that they jump to, particularly from sources that tend to be “extreme”. During these past two months, as I’ve predicted these monetary actions, I’ve pushed back on both directions on this particular liquidity issue against some of the “doomsayers” and the “nothing is wrong” folks.
For example, some people have insisted that these repo lending liquidity shortages must be due to one or more acutely insolvent banks somewhere, and that this is like a 2008 bank crash all over again. I have seen no evidence that this is the case so far, and have seen evidence to the contrary. Two months after the repo spike, there have been no major bank crashes in the United States or Europe. Banks in the United States and Europe have a lot of problems, but acute insolvency isn’t one of them at the moment as far as I see evidence for.
On the other hand, during this initial repo lending spike and Fed intervention, many people in mainstream financial media were saying it was not a big deal, just a short-term glitch due to seasonal liquidity issues, etc. The math shows that this is not correct either; this has been building for the past five years and represents a multi-year pivot of U.S. monetary policy due to U.S. deficits that don’t have enough buyers and are being monetized by new capital creation. The Fed has now said they’ll be buying $60 billion or more worth of treasuries each month through at least mid-2020 (and I think that’s just the beginning).
Bullish/Bearish View:
Over the multi-year long-term, I’m bullish on precious metals and most other commodities from current price levels due in part to this dovish monetary policy. Some of the more economically sensitive ones like copper and oil are vulnerable to global slowdowns, but I started carefully scaling into low-cost commodity producers starting in September and October.
I’m also bullish for the long-term on several ex-China emerging markets from current levels (and agnostic about China itself), although I assume at least a partial emerging market sell-off if the U.S. were to enter recession in, say, 2020.
I’m somewhat bullish on select U.S. value stocks, although I expect them to have a bumpy ride.
I’m bearish, or at least very cautious, on the expected long-term inflation-adjusted rate of return for long-term bonds, such as the TLT ETF and similar securities. These are useful vehicles for traders and they will probably see more bullish periods along the way, but long-term buy-and-hold investors should be careful with them, in my view.
I’m also bearish on many highly-valued U.S. cloud computing growth/momentum stocks at current valuations, as well as unprofitable IPOs more broadly, which I’ve expressed since my April newsletter issue when they were peaking.
An Economic Inflection Point
Since the U.S. economy came out of the 2008/2009 recession, we’ve had the longest U.S. economic expansion in history, at over 10 years.
It hasn’t been a straight rise up, though. In year-over-year rate of change terms, we’ve had three mini-cycles of growth that each lasted 3-4 years, which is visually represented quite well with the manufacturing purchasing manger’s index:
Chart Source: Trading Economics
The first mini-cycle went from 2009 to 2012/2013, when it was slowed down by the European sovereign debt crisis.
The second mini-cycle went from 2012/2013 to 2015/2016, when it was slowed down by a variety of reasons and culminated in a big oil price crash. China and the European Union stimulated significantly and helped the world out of this slowdown, and then the U.S. performed tax cuts in 2017 which further stimulated it.
This all began slowing down again in 2018 and reached a dangerously slow point recently in 2019. At the moment, we appear to be stabilizing. The downward trend has halted for now in many countries.
The big question for investor asset allocation at the moment is whether the U.S. business cycle is coming to an end into a recession, or whether we are entering a fourth mini-cycle of growth. In other words, is this period of stabilization for real, or is it a fake-out that will quickly lead deeper into slower growth and eventually negative?
I don’t have a solid answer yet from an investor perspective, and am monitoring data as data comes in. Evidence still seems to indicate that continued economic slowdown is in the cards for the United States. While the PMI has stabilized for now, many other U.S. economic indicators continue to decelerate.
Just recently on Friday, weak industrial production numbers and retail sales numbers caused both the Atlanta Fed and the New York Fed to cut their Q4 2019 GDP growth forecasts. The Atlanta Fed cut theirs from 1.0% to 0.3%. The New York Fed cut theirs from 0.73% to 0.39%.
Debt is the Finisher, But Not for Timing
Although the U.S. economy enjoyed these three mini-cycles of growth, each new mini-cycle wasn’t a fresh start. So, it’s not as though this pattern can continue ad infinitum.
It’s a common saying that expansions don’t die of old age, and that’s partially true. However, they do reach debt saturation, run into areas of excess, and become vulnerable to economic shocks to the downside. Accumulating debt levels are an eventual showstopper for most economic expansions.
Throughout these three mini-cycles of growth during this economic expansion, debt has continued to accumulate rather than get reset each time. Consumer credit and business debt have continued to increase as a percentage of GDP, and are now higher than they were during the heights of the previous economic cycle:
Chart Source: St. Louis Fed
If we zoom out and look back over the past 60 years, we can see these cycles clearly, especially the past three big ones:
Chart Source: St. Louis Fed
The challenge of course is one of timing; we don’t know how high debt levels will reach during this cycle until we look back after the fact. Debt levels are useful to know for broader context and risk management, and forming expectations for roughly where we are in a market cycle, rather than useful as a specific timing signal.
The one debt area that truly improved throughout this cycle was mortgage debt. Since the 2007/2008 financial crisis had its epicenter in the housing and mortgage industry, that’s the one major area of leverage that didn’t reflate to new highs on a % of GDP basis during this cycle:
Chart Source: St. Louis Fed
Mortgage debt as a percentage of GDP is still higher than all pre-2007 cycles in modern U.S. history, but has decreased from over 100% of GDP to under 75% of GDP in the aftermath of the previous 2007/2008 recession.
This is because people actually lost their homes and balance sheets were truly deleveraged in that particular area. The home ownership rate peaked at 69% shortly before the financial crisis, fell to under 63% in 2016, and is still below 65%.
It is the other types of debt that are currently growing as a percentage of GDP: federal debt, business debt, and several types of non-mortgage consumer debt.
Eventually these reach a point where consumers and businesses get tapped out, and the U.S. economy slows or outright contracts. The federal debt has the most flexibility in the near-term because it is being monetized, but the private areas of debt can cause more acute slowdowns.
In fact, corporate profits (blue line below) have already been relatively flat for the past five years or so, but the stock market capitalization (red line below) has been able to keep making new highs due to increasing valuations. This chart shows total corporate profits compared to the U.S. stock market capitalization, with both of them set at 100 in 1975.
Chart Source: St. Louis Fed
As with most late bull markets, we’re in a multi-year period of “alligator jaws” forming, meaning that there’s a big divergence between two things that, over time, should have pretty good correlation (stock prices and corporate profits) and that tend to slam shut eventually, one way or another, to resume their correlation.
Yield Curve Update
As a final note before I dive into portfolio updates, it’s worth mentioning the yield curve once again, because the investing world forgot about it.
Normally, long-term bond rates are higher than short-term bond rates, which makes sense. If you lock up your money for longer, you expect a higher rate of return. However, when economic growth slows, the yield curve tends to flatten, because the bond market starts to anticipate rate cuts by the Federal Reserve, so they load up on longer-term bonds.
Prior to the past seven recessions, the 10 year minus 3 month yield curve has inverted. This is calculated simply as the interest rate on 10-year U.S. government bonds minus the interest rate on 3-month U.S. government bonds; the premium you get for holding bonds that have a lockup period that is 40 times longer.
Some yield curves have had some false positives over the years, but the 10 year minus 3 month spread has not had a false positive since 1967. When it goes negative for a sustained period, it historically signals the beginning of the end of an expansion. The St. Louis Fed has data for the past three recessions:
Chart Source: St. Louis Fed
What I find interesting is that, according to data from Google Trends, people recently stopped caring about the yield curve.
In December 2018, March 2019, and August 2019, there were big spikes in the number of people searching on Google for topics related to the yield curve, because headlines were all over financial media about the curve inverting. But now, we’re back at the baseline with nobody searching for it:
Chart Source: Google Trends
The same thing happened last decade. Searches about the yield curve spiked high in late 2005 and into early 2006 when the yield curve was nearing inversion and then inverted, but after it had been inverted for a while and eventually un-inverted, people had stopped searching for it by then.
The problem with the 10 year minus 3 month yield curve is that although it’s an accurate signal based on the past seven recessions, it’s not great for timing. Typically, a recession occurs anywhere from 0-24 months after the yield curve inverts, and during that time there is often a “melt-up” where the stock market reaches euphoric highs before falling.
However, a less-publicized fact, which is obvious from the yield curve chart, is that the yield curve historically un-inverts shortly before a recession.
Basically, the bond market anticipates an economic slowdown in advance, so they start flattening and inverting the yield curve. Then when the deteriorating economic data become obvious, the Federal Reserve cuts short-term interest rates, which helps to un-invert the yield curve. But by the time deteriorating economic data are obvious, a recession ends up occurring a few months later despite these attempts at intervention. Whether that will happen in the future is uncertain, but historically that’s how it has generally played out.
So, when the yield curve inverts, and then un-inverts, that un-inversion has historically been the short-term signal that a recession is happening within 6 months. The stock market historically peaks 3-6 months prior to a recession, so the yield curve un-inverting is often close to the market top.
Chart Source: St. Louis Fed
It’s important not to base your entire portfolio management strategy on a single data point, though. Perhaps the bond market is wrong about a recession this time. They’ve been correct the past seven times based on this 10 year minus 3 month metric, but maybe they’ll get the eighth time wrong.
However, investors should at least be aware that the un-inverting of the yield curve is not an all-clear signal and instead is a severe warning signal, historically. The un-inversion has typically been the final pat on the back that the party is ending soon. In order for a recession to not occur in 2020, it has to be “different this time” for this metric. Maybe it will be, or maybe it won’t.
This time is already a bit different because the un-inversion of the yield curve has been partially a result of rising yields on the long-end (from under 1.5% to over 1.8%) in addition to a reduction in rates on the short end (from over 2.4% to under 1.6%), so it’s interpreted as more bullish than normal. This chart breaks down the details of the 10-year rates (blue), 3-month rates (red), and the yield curve (green):
Chart Source: St. Louis Fed
Just be cautious about these sorts of CNBC headlines that have come out over the past couple weeks:
I’m watching the economic data and stock valuations, and adjusting my portfolio accordingly as data comes in. I’ve been majority long stocks this whole time, but building a growing defensive base of cash and precious metals on the side.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue every six weeks.
These portfolios include a primary passive/indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and the model portfolio account specifically for this newsletter at M1 Finance that I started last year.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put an additional $1k into it before each newsletter issue, totaling $20k so far.
It’s by far my smallest account, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a great combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)
After adding $1,000 in fresh capital in late October, here’s the portfolio today:
Here is the full list of holdings within those various sections:
Changes since the previous issue:
- I sold Apple from the dividend stock section when it went over $250/share, and added Kohl’s.
- I sold Micron and Visa from the growth stock section (for now), and purchased HDFC Bank, Booking Holdings, and Expedia.
- I added the SPDR Small Cap Value ETF as a 5% position while reducing the Vanguard Total U.S. Stock ETF.
- I tweaked other percentages and ratios a bit. Very small changes.
Primary Retirement Portfolio
This next portfolio is my largest and least active. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 to 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017, in order to preserve capital, I dialed my equity allocation down to 60% (40% domestic, 20% foreign) and increased allocations to short-term bonds and cash. This was due to higher stock valuations and being later in the market cycle more generally. If the U.S. economy encounters a significant sell-off, I would likely increase equity allocations to upwards of 90% once again.
Related Guide: Tactical Asset Allocation
For my TSP readers, this is equivalent to the 2030 Lifecycle Fund. One reason this is so conservative for my age is that my active portfolios below are more concentrated and aggressive, so I consider them together when determining how to allocate assets.
This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years based on market conditions. This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts. I would, for example, have some precious metal exposure in this one in place of some of the bonds if I had that option.
Active Portfolios
My accounts at Fidelity and Schwab are mainly for individual stock selection, single-country ETFs, and selling options, and helps to fill some of the gaps that my index retirement account has:
Changes since the previous issue:
- None.
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