"Risk Off" Making Some Headway

Doug Nolan

Global “Risk Off” has been making some headway. This week saw ten-year Treasury yields drop 15 bps to 2.23%, the low since the week following the election. German bund yields declined another four bps to a 2017 low 19 bps. The Crowded Trade hedging against higher rates is blowing apart. The Crowded yen short has similarly been blown to pieces, with the Japanese currency surging an additional 2.3% this week (increasing 2017 gains to an impressive 7.7%). Japan’s Nikkei equities index dropped 1.8% this week, with y-t-d losses rising to 4.1%.

Meanwhile, this week Gold surged 2.5%, Silver jumped 2.9% and Platinum gained 1.9%. In contrast to the safe haven precious metals, Copper dropped 2.8%, Aluminum fell 2.7% and nickel sank 4.2%.

European periphery spreads (to bunds) widened meaningfully. Italian spreads widened 14 to 213 bps, the widest since early-2014. Spanish spreads widened 13 to an eight-month high 152 bps. Portuguese spreads widened six bps and French spreads seven. Italy’s stocks fell 2.6%, with Italian banks down 5.9%. Spanish stocks lost 1.9%. European bank stocks dropped 2.6% this week.

A little air began to leak from the EM Bubble. Russian stocks were hammered 5.9% to an eight-month low, increasing 2017 losses to 14.2%. Brazilian stocks lost 2.5%. Chinese equities suffered moderate declines, while appearing increasingly vulnerable. For the most part, however, EM held its own. The weak dollar helped. EM equites (EEM) declined only 0.6% for the week, while EM bonds (EMB) gained 0.4%.

U.S. equities trade unimpressively. The VIX rose slightly above 16 Thursday to the highest level since the election. The banks (BKX) sank 3.2%, increasing 2017 losses to 4.1%. The broker/dealers also lost 3.2% (down 0.7% y-t-d). The Transports were hit 2.5% (down 1.9%). 


The broader market continues to struggle. The mid-caps dropped 1.5% (up 1.2%), and the small caps fell 1.4% (down 0.9%). Even the beloved tech sector has started to roll over. At the same time, high-yield and investment grade debt for the most part cling to “Risk On.”

A number of articles this week pronounced the death of the “reflation trade.” It’s worth noting that the GSCI Commodities index gained 2.2% this week, trading to a six-week high and back to positive y-t-d. Rising geopolitical tensions helped Crude rise to almost $54, before closing the week at $53.18. President Trump talked down the U.S. dollar, and I’ll add “careful what you wish for.” The dollar index declined 0.6% this week. Is it a coincidence that the President calls the dollar “too strong” only a few days after meeting with Chinese President Xi Jinping? China is no currency manipulator, not if it can rein in a psycho North Korean despot.

When it comes to global reflation, China continues to play a leading role. Chinese Credit enjoyed a historic 2016 – and, after a record first quarter, Chinese Credit growth is on track to surpass $3.5 Trillion in 2017.

For March, China’s Total Social Finance (TSM) increased a much stronger-than-expected $308 billion. This puts first quarter consumer and corporate Credit growth at $1.014 TN, a record exceeding even 2016’s unprecedented Q1. For comparison, China’s Q1 2017 TSM growth was 50% greater than Q1 2015. TSM ended March at $23.65 TN, up 12.5% y-o-y - expanding at a rate almost double the real economy.

And while Chinese bank loan growth slowed to a 12.4% rate in March, there were notable trends that must worry officials. First, shadow banking components expanded a much stronger-than-expected almost $110 billion during the month. Meanwhile, China’s mortgage finance Bubble continues to prove resilient in the face of various efforts to cool overheated housing markets.

April 14 – Reuters (Elias Glenn): “Loans to households surged to 797.7 billion yuan ($115bn) in March, …accounting for 78% of all new loans in the month. That was much higher than either January or February and even the 50% of new loans in 2016. The rise likely was due to a surge in short-term lending to households, as individuals may be turning to alternative types of loans as banks tighten rules on traditional mortgages, said Wendy Chen, an economist at Nomura in Shanghai. ‘We think (the increase in short-term loans) is possibly due to attempts to circumvent strict regulations on mortgages… The high loans to households reflect that property sales are still very hot, and likely shifting from top tier cities to more third or fourth tier cities.’”

In a precarious “Terminal Phase” Credit Bubble Dynamic, Chinese shadow banking has gone parabolic. Over the past five months, shadow banking assets (compiled by Bloomberg) have expanded $472 billion, or about 35% annualized. For comparison, shadow banking increased about $70 billion for all of 2015. Chinese shadow banking increased $300 billion during Q1.

April 11 – Wall Street Journal (Shen Hong): “China’s battle to counter rising stress in its financial system has escalated this week, with regulators making a fresh warning to banks not to engage in speculation that creates unhealthy asset bubbles and prevents money from flowing to more productive parts of the economy. In a directive circulated to banks Monday, the country’s banking regulator instructed banks to carry out self-checks by late November on their involvement in what it termed ‘irregularities.’ The seven-page document… said such actions include making highly leveraged bets on markets via popular investment products, and the excessive use of a newly popular form of short-term debt that banks are increasingly relying on for funding.”

April 10 – Bloomberg: “Like many individual investors in China, Yang Mo has no idea what’s in the wealth management products that make up a big chunk of her net worth. She says there’s really no point in finding out. Sure, WMPs invest in all kinds of risky assets, but the government would never let a big one fail, she says. ‘It’s not how the Chinese government does things, and it’s not even Chinese culture,’ explains Yang, a 29-year-old public relations professional… Hers is a common refrain in Asia’s largest economy, where savers have poured $9 trillion into WMPs and similar products on the assumption that they’ll get bailed out if the investments sour. Even after news in February that policy makers are drafting rules to make it clear that state guarantees don’t exist, Yang is undaunted… ‘Cracking down on implicit guarantees is just like curbing home prices,’ she says. ‘It’s something that the government needs to say, but it’s not something they will eventually do.’”
For several years now, Chinese policymakers have made myriad attempts at the old “lean against the wind” approach to counter mounting financial excess. They’re now facing a Credit typhoon of their own making. At this point, Beijing must inflict pain if they intend to break what is now deeply ingrained inflationary psychology in housing finance as well as powerful speculative impulses throughout finance more generally. Apparently, everyone – from Chinese citizen to global investor – is confident that no dramatic policy measures will be employed prior to the autumn meetings of the National Congress of the Community Party.

Yet Chinese fragility is but one of what has become a litany of risks to the global Bubble. And while largely numb to Chinese risks, speculative global markets are having more difficulty disregarding the troubling geopolitical backdrop. With North Korea on the brink of another nuclear test and warning of nuclear war – and Trump sending an “armada” to the Korean peninsula and threatening a preemptive military strike if a “looking for trouble” North Korea test appears imminent – it’s enough to take some risk off the table and buy some gold, Treasuries and bunds. That Trump would send a flurry of Tomahawk missiles into Syria, confront Russia on Assad and drop “the mother of all bombs” into the Afghan mountainside have some thinking it’s time to take geopolitical risks more seriously.

Assuming we make it through Easter weekend without tensions ratcheting up in Korea or elsewhere, market attention will turn to next Sunday’s first round French election.

April 12 – Reuters (Sudip Kar-Gupta and Sarah White): “France's presidential race looked tighter than it has all year on Friday, nine days before voting begins, as two polls put the four frontrunners within reach of a two-person run-off vote. The latest voter surveys may raise investor concerns about the outside possibility of a second round that pits the far-right candidate Marine Le Pen against hard-left challenger Jean-Luc Melenchon. The election is one of the most unpredictable in modern French history, as a groundswell of anti-establishment feeling and frustration at France's economic malaise has seen a growing number of voters turn their backs on the mainstream parties. An Ipsos-Sopra Sterna poll showed independent centrist Emmanuel Macron and Le Pen tied on 22% in the April 23 first round, with Melenchon and conservative Francois Fillon on 20 and 19% respectively.”

Basically, there are four candidates all within the margin of statistical error vying for two spots in the May 7th second round head-to-head. For months now, far-right candidate Marine Le Pen has led first round polling numbers. While somewhat unsettling to markets, the assumption has been that Le Pen would lose badly to the leading “establishment” candidate, presently Emmanuel Macron. But with just over a week to go, far-left candidate Jean-Luc Melenchon is enjoying a surge in popularity. This increases the odds that market favorite Macron might not make it out of the first round.

A Le Pen versus Melenchon second round would be a nightmare scenario for skittish markets. Concern would quickly turn to Italy, where the anti-euro 5-Star Party has been rapidly gaining in the polls ahead of next year’s general election.

Plenty of worries globally and here at home. Especially after last week’s release of weak March auto sales data, concern is growing that tightened Credit conditions have begun to restrain the U.S. economy. For the most part, quarterly earnings reports from the major banks confirmed a weakening of loan growth. Yet it isn’t clear how much of this is the result of tightened lending standards and waning demand for borrowings, or instead more a reflection of huge corporate debt issuance (issue bonds rather than borrow from banks) and a slowing of big M&A deals.

It’s worth noting that the recent drop in mortgage rates comes at a most opportune time for the peak home sales period. Mortgage purchase applications jumped last week to the high since last June - and the third highest weekly level since 2009. Mortgage rates remain extraordinarily low, consumer confidence quite high and the inventory of homes for sale unusually low. A significant Treasury market squeeze could further stoke housing markets already demonstrating strong inflationary/Bubble biases.

April 13 – CNBC (Diana Olick): “Homes are flying off the shelves this spring, as demand rises and supply continues to drop. Record high prices in some local markets are not thwarting hungry buyers, as they rush to take advantage of the lowest mortgage rates of the year. Home sales jumped nearly 9% in March compared with March 2016, even as the number of homes for sale plunged 13%, according to… Redfin… That demand dynamic further increased competition in the market, resulting in the fastest average sales pace since Redfin began tracking in 2010. The typical home went under contract in just 49 days, down from 60 days a year ago. Steep competition also pushed the median price of a home sold in March to $273,000, up 7.5% year over year.”

As for the U.S. stock market, it appears a decent amount of hedging has taken place over the past couple weeks. Previously such dynamics often created the firepower to squeeze the shorts and force the risk averse to unwind hedges and scamper back aboard the bull market. 


Complacent markets may have forgotten that put options and myriad “portfolio insurance” strategies can as well provide firepower for a self-reinforcing downside. North Korea, Syria, Russia and France provide potential for clear and present danger.

There is as well the risk of a U.S. government shutdown at the end of the month, along with all the ambiguity surrounding the Trump Administration’s shifting agenda. What appeared a united group determined to go right down the list of campaign promises – keen to focus on tax cuts/reform and infrastructure spending – these days appears confused, less than cohesive and without much of a list. If markets abhor uncertainty, it’s hard to see them enamored with the stunning degree of policy reversals and flip-flopping. Return to healthcare and deal with tax and spending legislation later? Roused from a state of deep depression, the Democrats now count down the days until next year’s mid-terms.


Brexit begins

Britain’s brutal encounter with reality

Time to be honest about the trade-offs ahead

NINE tumultuous months after Britons voted to leave the European Union, the real Brexit process is at last under way. Theresa May’s dispatch of a letter to the European Council on March 29th, invoking Article 50 of the EU treaty, marked the point at which Britain’s withdrawal from the union became all but inevitable. For half the country’s population this was a moment to celebrate; for the other half, including this newspaper, it marked a bleak day. The future of both camps—and of the EU itself—now depends on what Mrs May does next.

The negotiations are sure to be difficult. Time is short, since Article 50 comes with a two-year deadline. The task of unwinding Britain’s membership of the club is fearsomely complex.

Neither side is well prepared. In Britain, where Brexit increasingly resembles a faith-based initiative, voters have been given wildly unrealistic expectations of the Utopia ahead. Their first contact with the reality of losing preferential access to their main market will be traumatic.

Unless Mrs May can persuade the Brexiteers on her own side that they must accept concessions, Britain may end up flouncing out of Europe without any deal at all.

Cruising for a bruising
 
The timetable is tighter even than it looks. The sides may spend weeks arguing over process.

The EU wants to fix the terms of the Article 50 divorce, covering such matters as the rights of citizens resident in other countries and Britain’s multi-billion-euro exit bill, before starting work on a future trade deal; Mrs May wants to negotiate on everything at once. Nothing much will be agreed on before the German election in September. At the end of it all, ratifying the deal will take six months. That leaves little more than a year for the talks themselves.

Mrs May’s priority is to fulfil the Leave campaign’s promise to “take back control” by ending the free movement of EU citizens to Britain and the jurisdiction of the European Court of Justice (ECJ). She has acknowledged that this means leaving the EU’s single market. But leaving would be a mistake. Even if it takes control of immigration, Britain will not be able to cut the numbers much without damaging the economy, as ministers are slowly realising. And the government is wrong to claim that there exists some relationship with the single market that has all the benefits of membership with none of the costs.

It is true that many Britons backed Brexit because they wanted to cut immigration and regain sovereignty, but they did not vote to make themselves poorer—as Mrs May’s “hard Brexit” will. Her government has been characterised by U-turns and her letter this week was more emollient than some of her earlier statements. Even so, in thrall to Brexiteering backbenchers and the Eurosceptic press, she is unlikely to change course now.

Mrs May is not just making the wrong choices, but also downplaying awkward trade-offs. By promising barrier-free access to the single market while stopping EU migrants and ending the ECJ’s jurisdiction, she is still telling Britons they can have their cake and eat it. Although she concedes that exporters to the EU will have to obey EU rules, the more Mrs May insists on controlling EU migration and escaping the ECJ, the less barrier-free will be Britain’s overall access to the single market. This is not just because free movement of people is a condition for the EU, nor because it will be hard to secure tariff-free access for trade in goods, something both sides can readily agree on.

It is because the biggest obstacles swept away by the single market are not tariffs or customs checks, but non-tariff barriers such as standards, regulations and state-aid rules. Unless Britain accepts these, which implies a role for the system’s referee, the ECJ, it cannot operate freely in the single market—as even American firms trading in the EU have found.

Boxed into a corner
 
The most dangerous of Mrs May’s illusions has been her claim that no deal is better than a bad deal.

Her letter this week steps back from this notion, but only a pace. To revert to trading with the EU only on World Trade Organisation (WTO) terms would cause serious harm to Britain’s economy. It would mean the EU imposing tariffs plus a full panoply of non-tariff barriers on almost half Britain’s exports. No big country trades with the EU only on WTO terms. An acrimonious break-up would make it harder to co-operate in such areas as foreign policy and defence. And it would surely increase the risk of Brexit triggering Scotland’s exit from the United Kingdom.

Mrs May needs not merely to soften her tone, as she has started to do this week, but to lower expectations. Instead of threatening to undercut her European partners by building an unregulated Singapore-on-Thames (something that, despite its appeal to free-traders, would horrify most Brexit voters), or hinting that Britain might co-operate less fully on security, or claiming that the EU needs Britain more than the other way round, she should accept that in these negotiations she holds the weaker hand. She should hence be more flexible over payments into the EU budget, a subject her letter skates over.

Because negotiating a full free-trade deal is certain to take more than two years—no country has concluded one with the EU in so short a time—she should accept another consequence: that transitional arrangements will be needed to avoid “falling off a cliff” in March 2019. Her letter talks airily of “implementation periods”, but does not acknowledge how hard these may be to sort out. A proper, time-limited transition might mean prolonging free movement of people and the rule of the ECJ, but that price would be worth paying for a better Brexit.

The softer tone of Mrs May’s letter might, with luck, encourage her EU partners to be more accommodating. So far they have reacted to threats from London in kind, talking up the exit bill, insisting that Britain ends up being worse off outside the club than inside and digging in over terms for co-operating in foreign and security policies. There is a possibility of a deal between Britain and the EU that minimises Brexit’s harm. Unfortunately, in a negotiation against the clock where both sides start so far apart, there is also a big risk of one that maximises harm instead.


The Risks to America’s Booming Economy

Martin Feldstein
 .
USA factory worker manufacturing



CAMBRIDGE – After a long and slow recovery from the recession that began a decade ago, the United States economy is now booming. The labor market is at full employment, the inflation rate is rising, and households are optimistic. Manufacturing firms and homebuilders are benefiting from increasing activity. The economy is poised for stronger growth in the year ahead. We no longer hear worries about secular stagnation.
 
The overall unemployment rate is just 4.7%, while unemployment among college graduates is only 2.4%. Average hourly earnings are 2.8% higher than they were a year ago. The tight labor market and rising wages are inducing some individuals who had stopped looking for work to return to the labor force, boosting the participation rate.
 
A clear indication that the economy is at full employment is that the rate of inflation is increasing.
 
The “core” consumer price index (which omits volatile energy and food prices) has reached an annual rate of 2.2%, substantially higher than the 1.8% average during the previous three years. During the most recent three months, core inflation rose at a 2.8% annual rate.
 
Household wealth is also increasing. The price of homes, the most important asset for US households, rose by 5% during the most recent 12 months. The rising stock market has caused the broader measure of net worth to increase even faster.
 
Surveys of consumer attitudes point to strong positive feelings. The University of Michigan Consumer Sentiment Index recently reached a 17-year high. Likewise, the Conference Board Consumer Confidence Index hit a 15-year high in February.
 
Manufacturing firms have increased output in each of the last six months. Homebuilders are racing to keep up with demand, reflected in an increase of more than 6% in the number of new single-family houses in the past 12 months.
 
All of this suggests that real (inflation-adjusted) GDP will rise more quickly in 2017 than it did in the recent past. While volatile trade and inventory numbers have depressed the recent GDP figures, the more fundamental measure of final sales to private purchasers has been rising in real terms at an annual rate of about 2.5%. Overall GDP is likely to increase at a similar rate for 2017 as a whole.
 
But, although the economy currently is healthy, it is also fragile. The US has experienced a decade of excessively low interest rates, which have caused investors and lenders to seek higher yields by bidding up the prices of all types of assets and making risky loans. The danger is that overpriced assets and high-risk loans could lose value and cause an economic downturn.
 
The price-earnings ratio of the Standard & Poor’s 500 Index is now nearly 70% above its historic average. A return of the price-earnings ratio to its historic average would cause share prices to decline by 40%, implying a loss of more than $9 trillion, an amount equal to nearly half of total GDP.
 
Ten-year Treasury bonds now yield just 2.5%. With the current inflation rate of more than 2% and markets anticipating a similar inflation rate over the longer term (as measured by five-year five-year-forward inflation expectations), the yield on ten-year Treasury bonds should be above 4%. A rise of the ten-year yield to 4% would reduce the value of those bonds substantially. Other long-term bonds – both government bonds and corporate bonds – would suffer similar declines.
 
Reaching for yield has also narrowed credit spreads between high-grade bonds and riskier domestic and emerging-market bonds. And commercial real-estate prices have been bid up to levels that are probably not sustainable.
 
At the same time, banks and other lenders have extended loans bearing interest rates that do not reflect the riskiness of the borrowers. And, because these covenant-light loans impose fewer conditions on the borrowers, they are more susceptible to default if economic conditions deteriorate.
 
But a bad outcome is not inevitable. None of the risks I have described may materialize. Interest rates may return to normal levels, and asset prices may gradually correct. But there is a clear risk that a decade of excessively low interest rates will cause a collapse of asset prices and an economic downturn. This will be a major challenge to the US Federal Reserve and the Trump administration in the year ahead.
 
 


Is It Time To Take Money Off The Table In Gold? Here Is What We Think

by: Hebba Investments
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Summary
 
- Gold speculators increased their bullish bets on the metal for the fourth consecutive week.

- Silver speculators raised their own bullish bets to the highest in the COT data history.

- Despite big speculative purchases of gold the price didn't react very strongly over the past week which signals weak demand elsewhere.

- Despite bullish long-term fundamentals (weak USD policy and geopolitical concerns) there is too much positive sentiment in gold and silver and investors should expect a pullback.

 
The latest Commitment of Traders (COT) report showed another increase in the net speculative long positions as speculators continued to increase gold and silver for the fourth consecutive week. What is surprising here is that this COT report closed before US President Trump's comments on his desire for a weaker US dollar - which pushed gold up close to $1290 per ounce. That means the COT positioning is much more bullish than even this report shows, which gets us quite uneasy from a contrarian perspective.
 
Though it is not surprise that traders are bullish on gold as geopolitical uncertainty reigns large across the world, with this week's hot spot North Korea as both China and US beat the drums of war there. Europe is no cup of tea either, as French elections still have quite a bit of uncertainty as a potential anti-Euro candidate may be elected.
 
We will get more into some of these details but before that let us give investors a quick overview into the COT report for those who are not familiar with it.
 
About the COT Report

 The COT report is issued by the CFTC every Friday, to provide market participants a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. In plain English, this is a report that shows what positions major traders are taking in a number of financial and commodity markets.
 
Though there is never one report or tool that can give you certainty about where prices are headed in the future, the COT report does allow the small investors a way to see what larger traders are doing and to possibly position their positions accordingly. For example, if there is a large managed money short interest in gold, that is often an indicator that a rally may be coming because the market is overly pessimistic and saturated with shorts - so you may want to take a long position.

The big disadvantage to the COT report is that it is issued on Friday but only contains Tuesday's data - so there is a three-day lag between the report and the actual positioning of traders. This is an eternity by short-term investing standards, and by the time the new report is issued it has already missed a large amount of trading activity.
 
There are many ways to read the COT report, and there are many analysts that focus specifically on this report (we are not one of them) so we won't claim to be the exports on it.
 
What we focus on in this report is the "Managed Money" positions and total open interest as it gives us an idea of how much interest there is in the gold market and how the short-term players are positioned.
 
This Week's Gold COT Report
 
 
 
This week's report showed a fourth consecutive week of increases in speculative gold positions as longs added 15,827 contracts during the COT week while shorts decreased by 8,975 contracts.
 
Despite this bullish increase in long positioning, gold closed the COT week down about $5 ($1258 last week and $1253 this week) - which is not a good sign as it suggests that despite bullish traders, gold is not moving up as strong as it used to with the same increase in longs (i.e. weak demand elsewhere). The fact that we are currently at around $1288 per ounce, means that traders are probably much more bullish than shown in the COT report.
 
The last time we saw five consecutive weeks of increases in net gold positions, was early July of 2016 - which signified gold's peak for the year. While that obviously is a negative, on the positive side, the net long position for that period was double what we are currently at (July 2016: 286,000 net long contracts vs. 4/15/2017: 140,000 net long contracts), so from that perspective we still have some room to move up further.

Moving on, the net position of all gold traders can be seen below:
 
Source: GoldChartsRUS
 
 
The red-line represents the net speculative gold positions of money managers (the biggest category of speculative trader), and as investors can see, we saw the net position of speculative traders increase by 24,000 contracts to 140,000 net speculative long contracts.
 
As for silver, the action week's action looked like the following:
 
Source: GoldChartsRUS
 
 
The red line which represents the net speculative positions of money managers, showed an increase in bullish silver speculators as their total net position jumped by around 5,000 contracts to a net speculative long position of 99,000 contracts.
 
This is the highest speculative positioning that we have seen in all our data on silver positions - even higher than the 2016 peak. That is saying a lot because silver still remains under $19 per ounce, while in 2011 it reached close to $50 per ounce with much lower speculative positioning.
 
This is a big red flag unless there is strong physical demand outside of paper trading. Looking at US Mint sales (the largest seller worldwide of physical silver bullion), 2017 silver sales are fairly low.
 
Source: GoldChartsRUS
 
 
US Mint silver bullion sales are running well below last year's pace, with 8 million ounces sold through March. That calculates to around 32 million annualized for 2017, which is close to 20% lower than 2016's sales of 39 million ounces.
 
We realize that the US Mint doesn't represent the whole silver market, but it is the biggest seller of silver bullion to investors and the weak sales in 2017 track most of the other mints across the world, so it represents a good proxy.
 
Silver seems a bit dangerous here as it rockets past previous speculative positioning records, investors need to be VERY careful in silver.
 
The Dollar is Getting Too Strong
 
By far the biggest event of the week for the gold market was the interview by US President Trump with the Wall Street Journal where we said he thought the US dollar was "getting too strong."
Predictably the US dollar fell and gold jumped:
 
Source: Zerohedge
 
 
Not only did Trump want to see a weaker US dollar, he also mentioned that he liked low US interest rate policy:

President Donald Trump said Wednesday the U.S. dollar "is getting too strong" and he would prefer the Federal Reserve keep interest rates low. Mr. Trump, in an interview with The Wall Street Journal, also said his administration won't label China a currency manipulator in a report due this week. 
He left open the possibility of renominating Federal Reserve Chairwoman Janet Yellen once her tenure is up next year, a shift from his position during the campaign that he would "most likely" not appoint her to another term. 
"I do like a low-interest rate policy, I must be honest with you," Mr. Trump said at the White House, when asked about Ms. Yellen. "I think our dollar is getting too strong, and partially that's my fault because people have confidence in me. But that's hurting-that will hurt ultimately," he added. "Look, there's some very good things about a strong dollar, but usually speaking the best thing about it is that it sounds good."
We will save our detailed commentary for a future piece, but investors need to remember two things about these comments.
 
First, traditionally presidents RARELY comment on US dollar policy, preferring to leave that to the Federal Reserve. As CNN's Ivana Kottasova comments:
For decades, U.S. presidents have observed a couple rules about the dollar: 
1) Try to avoid talking about the dollar. 2) If you must comment, say you support a strong dollar and leave it at that. Not President Trump.
 
Now, we are not taking sides on whether or not a strong US dollar is better for the United States, but what we will say is that Trump's deliberate talking down of the dollar is certainly not a positive thing for the currency.
 
Secondly, for those that argue that Trump can do very little to the US dollar other than this type of jawboning, we remind them that in two years President Trump's nominees could make up the majority of Fed appointees. Not only that, Janet Yellen's term as the board's chair ends February 3rd, 2018, while Stanley Fischer's term as vice chair ends June 12, 2018.
 
Add in the fact that a sitting Fed chair would probably be hesitant to do moves that go against what a new Fed chair would espouse (i.e. an outgoing USD hawk pushing strong-dollar moves into an incoming weak-USD Fed), and we see it being difficult for the existing Fed to push against what the current president wants.
 
Point being, if President Trump wants to see a weak US dollar he has the ability through policy AND Fed nominees (and the future Fed chair) to push that policy.
 
Our Take and What This Means for Investors
 
It seems that not only do financial markets have geopolitical concerns (bordering on potential war) to buoy precious metals, but now we have a US president that has broken accepted presidential norms to push for a WEAKER US dollar.
 
If he gets what he wants, the medium and long-term picture for gold remains very bright.
 
Having said that we will take the crazy position of being a bit bearish in the short-term as sentiment seems very bullish in gold and EXTREMELY bullish in silver - the bullish silver speculative position is at the highest levels across our multi-decade dataset.
 
 
The geopolitical concerns and potential weak USD policy has been buoying precious metals, but we see a very high probability of a short-term pullback in gold and silver.
 
Of course, this position is based on expectations of now major war breaking out in Syria or North Korea. When it comes to the short-term picture, an investor must look at expected events and not Black Swan type events (whose probability is rare over months let alone a week or two).
 
That means for short-term speculators the strategy would be to reduce precious metals exposure in the short-term by either selling gold and silver positions (SPDR Gold Trust ETF (NYSEARCA:GLD), iShares Silver Trust (NYSEARCA:SLV), and ETFS Physical Swiss Gold Trust ETF, etc). Or reducing risk by trading for less risky positions (switching miners to ETFs or from silver to gold). Of course this is only in the short term. The medium-term to longer-term position remains very bright (and bullish) for precious metals.


Reflation Meets Stagflation In The Asymmetric Dot Plots

By: Adam Whitehead


Summary
 
- The Fed is predicting and accepting a period of "mild" Stagflation.

- Neel Kashkari has more in common with Janet Yellen than she has with her other colleagues.

- The San Francisco Fed has tried to frame the FOMC as being ahead of the curve.

- James Bullard has introduced the word overkill into the debate over FOMC policy.

- President Trump is stacking his political capital chips on tax reform.
 
(Source: Business Insider)
 

The last report discussed Janet Yellen's targeting of a yield curve steeper at the recent FOMC meeting and press conference. This steepening is driven by her willingness to tolerate an overshooting of inflation from the 2% target. Yellen's indication of this tolerance for inflation may be a response to new wording in the FOMC statement itself. The FOMC added the word "symmetric" to its explanation of its understanding of its 2% inflation target. A "symmetric" interpretation implies that the Fed will be equally as aggressive in responding to undershooting and overshooting inflation data.

Yellen however immediately made the interpretation asymmetrical with her overriding comment about tolerating inflation overshooting. For the FOMC, the target may be "symmetric," but for Yellen it is clearly asymmetric and implies her greater concern for undershooting. Yellen has therefore framed perceptions of what "symmetric" really means in practice, which is something different from the wording.
 
The FOMC is therefore fooling observers into believing that it is tough on inflation by using the word "symmetric" when in fact Yellen has no intention of delivering on this commitment.

Evidently, she wishes the yield curve to steepen, but not to get out of control to levels that will hit economic growth. An alleged official FOMC "symmetric" posture may be just enough to raise inflation expectations to steepen the curve to where she wants it without being called upon to actually do anything radical with interest rate increases.

Further study of the Dot Plots from the last FOMC meeting puts Yellen's curve steepener comments into perspective. The Dots very clearly show that the FOMC does not yet see the positive impact from President Trump's expected economic stimulus. Yellen to some extent framed the Dots when she said that she remains overwhelmingly in wait-and-see mode in relation to the expected Trump stimulus. Following her reasoning, the Dot Plotters should therefore have declined to forecast GDP out into 2019 and qualified this refusal by admitting that they are in wait-and-see mode.
 
(Source: Bloomberg)

 
GDP Dot Plots should come with a large disclaimer, given their dispersion. The gap between the New York Fed and the Atlanta Fed over the current state of GDP clearly shows this divergence and the lack of utility in the measures. Yellen herself has cast significant aspersions over what she calls the "noisy" GDP data. Her own guide to GDP, however, is not what could be termed robust. In her words:
"I would describe our economy as one that has been growing around 2 percent per year ….. That's something we expect to continue over the next couple of years.''
Evidently she has already discounted President Trump's campaign promise of 4% GDP, which has now been revised down to 3% by Secretary Mnuchin. Her own underwhelming view confirms and converges upon the median Dot Plot assumptions with alarming precision. It should also be noted that this median trajectory is downward sloping.
 
Much has been made of the way that the markets are no longer calling out the Fed for being too aggressive on rate increases. Whilst the forward curve has converged on the Fed's signal of three rate hikes this year, it is also reasonable to say that the FOMC's GDP plots are converging on the market's own pessimistic baseline. This general meeting of the minds has been viewed as the Fed asserting control of the narrative and the situation. Whilst this may be the case, care should be taken over interpreting the narrative as a sign of a vigorous economy.

The Fed's pervading view is just less bad than that originally foreseen by the markets.

Given the wide dispersion of the current GDP Dots and their uniformly lower convergence trajectory over time, along with Yellen's disclaimer, the lone dissenting voice of FOMC member Neel Kashkari perhaps does not look like an isolated maverick call after all. Indeed, when Kashkari recently spoke to provide context to his dissent, his explanation sounded very consistent with the "noisy" downward sloping GDP dots. He opined that the Fed in fact does not adhere to a "symmetric" inflation target, and also treats its 2 percent goal as a ceiling. This position does not conflict with Yellen's inflation overshooting tolerance; it rather seems to support her own recent waiver clause for tolerating an inflation overshoot. Kashkari also rejected the conventional wisdom of his FOMC colleagues that gradual, preemptive increases are more effective than swifter hikes in response to actual inflation data. Once again, he is consistent with the overshooting inflation prediction of Yellen, and also has a tactical policy tool of deliberate tolerance to address it.
 
Kashkari's comments on the labour market then painted a picture consistent with Stagflation conditions. He believes that slack persists in the labor market despite low unemployment. An overshooting of inflation with no pre-tightening moves by the FOMC would then be acceptable based on the perceptions of labor market slack. If the inflation did not drop back, the slack in the labour market would still give the FOMC time to react with remedial rate hikes without falling behind the curve. Thus far, Kashkari's comments are much closer to Yellen's than the 9 to 1 FOMC vote against him initially suggests. By logical inference therefore, one should not rule out Yellen's potential to pull a Kashkari on her colleagues, especially after she has said that their GDP plots are "noisy."
 
Kashkari may therefore come in very handy for Yellen this year as a new FOMC member.

Even his position on balance sheet exit has its utility. Officially he has now stated that he is in favor of the Fed publishing a plan with a timetable for balance sheet reduction before it raises rates again and "once data support tightening monetary policy." He also says that this move in and of itself will tighten liquidity conditions in advance of the scheduled exit. In the unfolding debate about the balance sheet, he has therefore served a purpose to anchor expectations of balance sheet reduction on a baseline that is not aggressive.

What the FOMC has done is to fill in the Dots in such a broad manner that implies that its members either doubt that the Trump stimulus will occur or that it will be ineffective.

Furthermore, the plotters may be assuming negative impacts from the president's trade agenda and the rise of populism in Europe. Treasury Secretary Mnuchin has already dialed back President Trump's campaign promise of 4% GDP to 3% GDP. The stimulus details have yet to be debated and legislated into existence by Congress, and it is unlikely that the president could get them through by decree given the very evident checks and balances on his policy making ability of late. Thus far, there has been an allegedly deficit neutral mix of spending proposals that redirect resources away from welfare and foreign aid to defence spending. Republican Congressmen and women are already baulking at these.
 
A pattern is emerging of presidential policy stimulus inertia combined with growing Fed skepticism of the Trump stimulus plans. Yellen's tolerance for an inflation overshoot hints that she is seeing a mild Stagflation as an elevated probability. More interestingly she is willing to tolerate it, which implies that she does not see strong economic growth in the future, and that also any inflation may actually take away from economic growth by sapping consumption power. The toleration of an inflation overshoot is therefore a neat way to arriving at the place of sub-optimal economic growth implicit in the Dot Plots. Arrival at this point will then be an acceptance of the requirement for greater fiscal and monetary policy stimulus.
 
The experience with central bankers this year is that they have been swift to discount the rise of headline inflation on the back of oil prices coming off a low base. The inflation component of any Stagflation will thus be subdued in their opinion. The real driver of the Stagflation is therefore the weak growth dynamic, hence Yellen's asymmetric prioritising of it over the inflation overshoot.

There are therefore conflicting forces at work on the yield curve. The worsening inflation picture and the Fed's tolerance of it will steepen the curve. On the other hand, the Fed's prediction of weak economic growth will tend to flatten it. Such conflicting forces make any attempts by the Fed to target the yield curve in order to manage the process of shrinking its balance sheet very tricky to pull off successfully. The Fed may thus find it practically impossible to attempt to shrink its balance sheet meaningfully over the period between now and 2019.
 
The recent comments from Fed policy makers since the last FOMC meeting neatly demonstrate this balance of risks.
 
Philadelphia Fed President Patrick T. Harker was the first Fed speaker to try and paint over the widening cracks between the GDP Dots and case for rising interest rates. In an interview on CNBC, he moved perceptions back to a baseline on which the FOMC still does not have visibility on the Trump stimulus plans, so that it must by necessity remain gradualist.
 
Harker was followed by Dallas Fed President Robert Kaplan, who took up the orthodox position of articulating another two rate increases for the year. This should be expedited "patiently and gradually" in order to avoid jolting capital markets. On shrinking the balance sheet, he believes that discussion about how this will be done should continue over the course of the year even while interest rates are rising. Even when the decision on when and how to shrink the balance sheet is made and published, he is in favor of a tactical execution which is incremental and does not have a major impact on the bond markets. He would also be in favour of selling both the MBS and Treasuries that the Fed owns.
 
Dove-turned-Hawk Boston Fed President Eric Rosengren gritted his teeth in relation to the fallout from the tightening process, and signalled that the Fed's job is not to save the casualties who will get hurt through their greed. Flagging the commercial real estate sector as a clear bubble, he opined that managing a soft landing in this sector was beyond the FOMC's monetary policy remit. Macroprudential rules would be best served to address this problem in his opinion, which suggests capital adequacy hikes for those institutions exposed to this sector.

As President Trump pushes back on bank regulation, this dog will struggle to hunt. With this ugly inevitable real estate market outcome in mind, he then pushed his own base case scenario of four rate hikes this year, justified in his own words because:

"My (his) own view is that an increase at every other FOMC meeting over the course of this year could and should be the committee's default."
Cleveland Fed President Loretta Mester was swift to downplay any economic weakness in Q1 as transient and is confident to continue to raise interest rates this year on multiple occasions, although not sequentially at each FOMC meeting. Interestingly, she is also ready to begin shrinking down the Fed's balance sheet this year.
 
Mester's continued Hawkish stance is now contrasted by the weakening Hawkish stance of her colleague Kansas Fed President Esther George. George has been a perennial Hawk, which makes her softening attitude stand out. Whilst she remains committed to tightening this year, she has now changed her rhetoric to become less insistent. In her opinion:
"The Federal Reserve is moving into what I consider a very critical time" and "It's going to require a lot of conversation and analysis".
Evidently, George is not seeing the kind of economic momentum that her previous Hawkish stance was based upon. This may have something to do with her view of fiscal policy. George has yet to factor in the Trump stimulus to her own baseline case for interest rate increases. Her view was recently supported by Fed Governor Jerome Powell, who noted that the recent healthcare reform failure has clouded the Fed's perceptions further.
 
New York Fed President Bill Dudley, often viewed as a good market signal, is also comfortable with two more rate increases this year, recently opining that the economy will cope "just fine."

It would appear that Dudley is motivated to portray the Fed as engineering a soft landing, as it emerges from the end of QE.
 
Dove-turned-Hawk Chicago Fed President Charles Evans is also in favour of the median consensus for two more rate hikes this year, although his logic seems slightly conflicted with his own growth forecasts. He has pushed his expectations for the impact of the Trump stimulus out into 2018, hence his median positioning for this year. His raised expectations for 2018 however do not fit the trajectory of the GDP dots.

Fed Vice Chairman Stanley Fischer also supports the current median consensus for two more rate hikes this year. Fischer is however visibly shaken by the threat to globalism that President Trump represents, so his embrace of the median forecast for interest rates is loaded with a big get-out-of-jail clause should global trade relations deteriorate from here.
 
The Fed may therefore be struggling to keep up with real-time developments. There is however a school of thought which says that it is in fact ahead of the game.
 
(Source: Business Insider)

 
A research piece by the San Francisco Fed neatly put the Fed's dilemma on how far to press on with rate increases given the paucity of details on the Trump fiscal plan into context. The article noted that the labour force remains artificially shrunk by those who would like a job, but who have given up looking since the Credit Crunch. Thus far, this unskilled reserve has not been called upon to participate. Maybe it lacks the skills to get the jobs on offer, and maybe the jobs for which it has skills have gone abroad. Perhaps this cohort was what tipped the balance for President Trump's victory. It has still to be repaid by the president for its kindness and support. The true unemployment rate according to the San Francisco Fed is therefore nearly half a percentage point higher, which, although significant, is much less than President Trump has estimated it to be. There is some slack there, but the Fed is already anticipating that it will be swiftly taken out and is raising rates accordingly.
 
The Sand Francisco Fed's report implies that the Fed is actually being somewhat preemptive, if admittedly gradually so, by raising interest rates in anticipation of the cushion in the labour force being taken out swiftly. The Fed is then actually ahead of the curve following the logic of report's authors. The growing risk is therefore that the Fed is actually way ahead of the political gridlock and fun and games in Washington that is frustrating President Trump's abilities to create jobs for the labor force slack that put him in office. The rise in bond yields and the US dollar until recently were further headwinds blowing alongside the political gridlock.

San Francisco Fed President John Williams, although not an FOMC voting member this year, is generally accepted to be a good median FOMC consensus indicator. His recent comments suggest that two more rate hikes and possibly more data permitting are expected this year, which will then put the Fed where it needs to be to start shrinking the balance sheet. 2017 can therefore be seen as the year that preparation is being made for balance sheet reduction in 2018.
 
The median consensus signaled by Williams and the signal that this is preemptive by his colleagues at the San Francisco Fed are ideas that are strongly refuted by St. Louis Fed President James Bullard. Bullard has been hotly contesting the views of his colleagues of late.

In a recent report he was observed to call them out for adopting a yield curve targeting strategy without officially debating or communicating it.
 
(Source: Seeking Alpha)


The source of Bullard's latest dissenting rhetoric can be traced back to an earlier report in which it was suggested that the FOMC may be creating monetary policy "overkill" by following through on its expected path of tightening this year. The rhetoric and behavior of the Fed "rate setters" on the FOMC was seen as widely divergent from the "staffers" who provide their data inputs. Indeed, the "rate setters" were observed to subjectively place their own estimates of economic performance above those of the "staffer" inputs. This situation can be seen again in the latest GDP Dots which show an economic growth pessimism that contradicts the verbal signals from the FOMC about the rising path of interest rates.
 
(Source: Seeking Alpha)


A negative feedback loop was then discerned in a later report, which noted that market observers and FOMC members were mutually reinforcing each others' perceptions about the need for further monetary policy tightening.
 
Evidently, Bullard has been watching the situation closely and has decided that it has reached a dangerously unstable tipping point which needs addressing. Perhaps the appearance of Eric Rosengren's new base case of four rate hikes this year has tipped the balance. The word "overkill" has now been officially introduced by Bullard into the debate over FOMC policy going forward. In his recent comments, in relation to the median consensus indicated by John Williams he said that: "I think it is potentially overkill." Moving on to dispute the San Francisco Fed's report about the FOMC being in preemptive mode, Bullard then opined that: "We do not need to be preemptive in this situation," and that "Some of my colleagues seem to think you really have to get out in front with a faster pace of rate increases in order to keep inflation and unemployment where they are. I don't think you have to do that. I think you can take much more of a wait-and-see posture." As with Neel Kashkari, Bullard articulates a good case for caution that supports his one rate hike and done in 2017 position eloquently.
 
(Source: Bloomberg)

 
A curious discounting mechanism has come about as a consequence of converging Fed and market expectations. Whilst a great noise was being made about the Fed winning over the doubters about future interest rate increases, this victory has been pyrrhic. Market observers have accepted a swifter pace of rate hikes in 2017, yet they remain skeptical that this will continue into 2018 and beyond. The Fed's GDP Dots therefore seem to be converging upon the market expectations after all. The corollary effect has been interpreted as a thumbs-down to the Trump stimulus impact. A larger question mark is developing over the whole Trump business agenda after the failure of his recent attempts to repeal Obamacare in collaboration with Paul Ryan. Consequently, the bid for American risk assets is predicated upon and sustained by the weaker US dollar outlook that a weak fiscal stimulus and benign FOMC response beget.
(Source: Bloomberg)

 
Combined with the drop in the risk bid is a growing consensus that the reflation trade is over for now.

The failure of oil prices to sustain any upside has underlined this feeling. The FOMC will therefore need to proceed with caution to avoid tightening into a deteriorating market and an economic backdrop where inflation expectations are becoming subdued. By the same token however, the FOMC must be mindful of President Trump's reaction to his early failures. The passing of his Keystone Pipeline bill, sans many of his promises to get a better deal for US construction interests, was little consolation, and on the contrary was a further example of his legislating impotence.
 
(Source: Business Insider)
 
 
The president will now have to pin his hopes and his reputation on enacting his tax reform policy. He will thus have to overcompensate and also to gamble on this outcome. In anticipation of the switch to this new political and economic centre of gravity, Treasury Secretary Mnuchin opined that the president's tax-code plan would face smoother sailing than the push to replace Affordable Care Act.
 
The stacking of all the president's political and economic chips on this one policy initiative will now frame perceptions of and also reactions to it. Thus far, positive market expectations are still way ahead of the current reality. One will have to catch up with the other. This vector dynamics of this convergence will be driven by what the president is capable of executing.

The last report noted the shift in American trade policy towards a Neo-Mercantilist model. This shift was evident at the recent G20 meeting, where the final communique omitted the traditional commitment to avoid protectionism by all members. The optimists have put this omission down to the fact that the Trump administration is in its youth and has not formulated a concrete trade position. This optimistic view overlooks the fact that the new administration has signaled what it stands against even if it has not articulated what it stands for in detail. This stance was clearly articulated by President Trump to Chancellor Angela Merkel when the two met for the first time in Washington, as the clouds of trade war gathered at G20 in Baden-Baden. After denying his guest a customary handshake, the president publicly rebuked the Germans for getting the better of trade negotiations and vowed to level the score. He then went on to demand reparations from Germany for America's vast expenditure on its historical defence. America clearly is no longer in favor of free trade, but is in favor of controlled and negotiated trade which puts America First.
 
The IMF was noted in the last report falling into line with American policy by highlighting the problems that the trade imbalances concentrated within a few large nations are creating. The nomination of the institution's biggest critic Adam Lerrick as Treasury Under-Secretary signals that further chastising and policy influencing is on the cards. Christine Lagarde was recently chastened enough to avoid opining on the lack of a free trade commitment at G20.

Instead she indicated obliquely her aversion to protectionism by saying that the current global recovery is at risk from the "wrong" policies without elaborating on what these are. She then committed the IMF to its original narrow remit from when it was established as an extension of US foreign policy rather than the globalist one that it has morphed into when she stated that it will operate "vigorous exchange rate surveillance and analysis of global imbalances." In the future, the IMF may be less of a champion of free trade and more a platform through which to negotiate managed trade.