September 20, 2019
By Steve Blumenthal
“I’m not saying that the past is prologue in an identical way. What I am saying that the basic cause/effect relationships are analogous:
a) approaching the ends of the short-term and long-term debt cycles, while
b) the internal politics is driven by large wealth and political gaps, which are producing large internal conflicts between the rich and the poor and between capitalists and socialists, and
c) the external political conflict that is driven by the rising of an emerging power to challenge the existing world power, leading to significant external conflict that eventually leads to a change in the world order.
As a result, there is a lot to be learned by understanding the mechanics of what happened then (and in other analogous times before then) in order to understand the mechanics of what is happening now. It is also worth understanding how paradigm shifts work and how to diversify well to protect oneself against them.”
– Ray Dalio, The Three Big Issues and the 1930s Analogue
If you haven’t yet read Dalio’s Three Big Issues and how they are analogous to the end of the last long-term debt cycle peak in the 1930s, you should. It is a road map of sorts for how the economy and markets work and will help you understand what to watch for and how to position your assets. Ray sees a paradigm shift ahead. A short summary from last week’s OMR post:
There are strong deflationary forces at work as productive capacity has increased greatly. These forces are creating the need for extremely loose monetary policies that are forcing central banks to drive interest rates to such low levels and will lead to enormous deficits that are monetized, which is creating the blow-off in bonds that is the reciprocal of the 1980–82 blow-off in gold.
The most important things that are happening now (which last happened in the late 1930s) are:
a) we are approaching the ends of both the short-term and long-term debt cycles in the world’s three major reserve currencies, while
b) the debt and non-debt obligations (e.g. healthcare and pensions) that are coming at us are larger than the incomes that are required to fund them,
c) large wealth and political gaps are producing political conflicts within countries that are characterized by larger and more extreme levels of internal conflicts between the rich and the poor and between capitalists and socialists,
d) external politics is driven by the rising of an emerging power (China) to challenge the existing world power (the US), which is leading to a more extreme external conflict and will eventually lead to a change in the world order, and
e) the excess expected returns of bonds is compressing relative to the returns on the cash rates central banks are providing.
This is happening at a time when investors are fully invested in equities, margin debt is higher relative to GDP than the last two bubble peaks, interest rates are very low (and negative in much of the developed world) and equity market valuations are near record highs.
What is happening now has happened before. The most notable period occurred at the end of the last long-term debt cycle peak in the late 1930s through much of the 1940s.
Bottom line: We sit at the end of a long-term debt accumulation cycle, zero interest rates will not convince overleveraged borrowers to borrow, and the Fed (and other central bankers) are pushing on a string. As Dalio said, “Their power to ease in order to reverse an economic downturn is coming to an end.” Play more defense than offense, it’s going to get bumpy.
Unintended Consequences in a Complex System
As expected this week, recent economic concerns prompted the Fed to lower rates for the second time this year, by 0.25 percentage points, to a target of 1.75-2%. But surprising, the big news was the turmoil in money markets.
Imagine your doctor prescribes you medicine to cure an illness. Read the back of the label and you see that there are risks of common side effects. Sometimes the side effects can be quite severe. Central bankers are the doctors within the economic system. Administer too much medicine for too long a period of time and the medicine may become ineffective. There are “Unintended Consequences in a Complex System” and one happened this week that last happened in 2008 (then, a harbinger of what we all know followed). I’m not saying another Great Financial Crisis is ahead. I’m saying the patient is obese with debt, he’s sick and the current form of medicine is no longer working.
Grab that coffee and find your favorite chair. Click on the orange On My Radar button to continue reading. I’ll walk you through the shock that occurred in the money markets last week but before you dive deep into the money market muck, I share with you T. Boone Pickens’ farewell letter. T. Boone passed last week and the open letter he wrote lifted me and I hope it lifts you. Please share it with your children. You’ll also find the latest Trade Signals post. Of note, the Zweig Bond Model moved to a sell signal suggesting shortening your duration exposure from longer-term maturities to shorter-term Treasury Notes or Bills. It’s not perfect nor guaranteed (nothing is) but it has a high percentage win rate. I find it very useful in risk managing my high quality bond exposure. My fundamental view is that we will make one more push lower in yields into the next recession but for now, the Zweig Bond Model is saying otherwise. I believe stop-loss risk management tools, like the ZBM, are important given where interest rates (near 5,000 year lows and a never seen before negative in much of the world) and equity market valuations (extremely high in most equities) sit today.
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Included in this week’s On My Radar:
- T. Boone Pickens’ Farewell Letter
- The Turmoil in Money Markets
- Trade Signals – Fed Approves Cut, Divided on Further Action; Equity Signals Remain Green; Zweig Bond Model Flashing Red
- Personal Note – Old Friends and the Statue of Liberty
T. Boone Pickens’ Farewell Letter
If you are reading this, I have passed on from this world — not as big a deal for you as it was for me.
In my final months, I came to the sad reality that my life really did have a fourth quarter and the clock really would run out on me. I took the time to convey some thoughts that reflect back on my rich and full life.
I was able to amass 1.9 million Linkedin followers. On Twitter, more than 145,000 (thanks, Drake). This is my goodbye to each of you.
One question I was asked time and again: What is it that you will leave behind?
That’s at the heart of one of my favorite poems, “Indispensable Man,” which Saxon White Kessinger wrote in 1959. Here are a few stanzas that get to the heart of the matter:
Sometime when you feel that you’re going
Would leave an unfillable hole,
Just follow these simple instructions
And see how they humble your soul;
Take a bucket and fill it with water,
Put your hand in it up to the wrist,
Pull it out and the hole that’s remaining
Is a measure of how you’ll be missed.
You can splash all you wish when you enter,
You may stir up the water galore,
But stop and you’ll find that in no time
It looks quite the same as before.
You be the judge of how long the bucket remembers me.
I’ve long recognized the power of effective communication. That’s why in my later years I began to reflect on the many life lessons I learned along the way, and shared them with all who would listen.
Fortunately, I found the young have a thirst for this message. Many times over the years, I was fortunate enough to speak at student commencement ceremonies, and that gave me the chance to look out into a sea of the future and share some of these thoughts with young minds. My favorite of these speeches included my grandchildren in the audience.
What I would tell them was this Depression-era baby from tiny Holdenville, Oklahoma — that wide expanse where the pavement ends, the West begins, and the Rock Island crosses the Frisco — lived a pretty good life.
In those speeches, I’d always offer these future leaders a deal: I would trade them my wealth and success, my 68,000-acre ranch and private jet, in exchange for their seat in the audience. That way, I told them, I’d get the opportunity to start over, experience every opportunity America has to offer.
It’s your shot now.
If I had to single out one piece of advice that’s guided me through life, most likely it would be from my grandmother, Nellie Molonson. She always made a point of making sure I understood that on the road to success, there’s no point in blaming others when you fail.
Here’s how she put it:
“Sonny, I don’t care who you are. Someday you’re going to have to sit on your own bottom.”
After more than half a century in the energy business, her advice has proven itself to be spot-on time and time again. My failures? I never have any doubt whom they can be traced back to. My successes? Most likely the same guy.
Never forget where you come from. I was fortunate to receive the right kind of direction, leadership, and work ethic — first in Holdenville, then as a teen in Amarillo, Texas, and continuing in college at what became Oklahoma State University. I honored the values my family instilled in me, and was honored many times over by the success they allowed me to achieve.
I also long practiced what my mother preached to me throughout her life — be generous. Those values came into play throughout my career, but especially so as my philanthropic giving exceeded my substantial net worth in recent years.
For most of my adult life, I’ve believed that I was put on Earth to make money and be generous with it. I’ve never been a fan of inherited wealth. My family is taken care of, but I was far down this philanthropic road when, in 2010, Warren Buffet and Bill Gates asked me to take their Giving Pledge, a commitment by the world’s wealthiest to dedicate the majority of their wealth to philanthropy. I agreed immediately.
I liked knowing that I helped a lot of people. I received letters every day thanking me for what I did, the change I fostered in other people’s lives. Those people should know that I appreciated their letters.
My wealth was built through some key principles, including:
A good work ethic is critical.
Don’t think competition is bad, but play by the rules. I loved to compete and win. I never wanted the other guy to do badly; I just wanted to do a little better than he did.
Learn to analyze well. Assess the risks and the prospective rewards, and keep it simple.
Be willing to make decisions. That’s the most important quality in a good leader: Avoid the “Ready-aim-aim-aim-aim” syndrome. You have to be willing to fire.
Learn from mistakes. That’s not just a cliché. I sure made my share. Remember the doors that smashed your fingers the first time and be more careful the next trip through.
Be humble. I always believed the higher a monkey climbs in the tree, the more people below can see his ass. You don’t have to be that monkey.
Don’t look to government to solve problems — the strength of this country is in its people.
Stay fit. You don’t want to get old and feel bad. You’ll also get a lot more accomplished and feel better about yourself if you stay fit. I didn’t make it to 91 by neglecting my health.
Embrace change. Although older people are generally threatened by change, young people loved me because I embraced change rather than running from it. Change creates opportunity.
Have faith, both in spiritual matters and in humanity, and in yourself. That faith will see you through the dark times we all navigate.
Over the years, my staff got used to hearing me in a meeting or on the phone asking, “Whaddya got?” That’s probably what my Maker is asking me about now.
Here’s my best answer.
I left an undying love for America, and the hope it presents for all. I left a passion for entrepreneurship, and the promise it sustains. I left the belief that future generations can and will do better than my own.
Thank you. It’s time we all move on.
The Turmoil in Money Markets
From the Economist:
“Why the Fed was forced to intervene in short-term money markets”
The repo rate spiked in an alarming echo of the financial crisis.
The Federal Reserve had plenty to fret about as it prepared to discuss policy interest rates on September 17th and 18th. Trade tensions and wilting global growth have seen businesses cut back investment in the second quarter of the year. In manufacturing, production and capacity utilization have been falling since the end of 2018. Though the Fed has described jobs growth as “solid”, some analysts worry that the labor market is wobbling. As expected, these concerns prompted the central bank to lower rates for the second time this year, by 0.25 percentage points, to a target of 1.75-2%. But the meeting was overshadowed by turmoil in money markets.
On September 17th, for the first time in a decade, the Fed injected cash into the short-term money market. The intervention was needed after the federal funds rate, at which banks can borrow from each other, climbed above the Fed’s target. It rose as the “repo” rate—the price at which high-quality securities such as American government bonds can be temporarily swapped for cash—hit an intra-day peak of over 10%. On September 17th the Fed offered $75bn-worth of overnight funding, of which banks took up $53bn. The following two days it again offered $75bn-worth. Banks gobbled it up.
That sent shivers down spines. A spiking repo rate was an early warning sign before the financial crisis. In 2007, as market participants began to doubt the quality of collateral backed by mortgage lending, repo rates jumped as lenders hoarded cash.
The latest jump was unlikely to have been caused by such doubts. Most collateral is now high-quality American Treasury bonds or bills. Even so, there are reasons to worry. America’s banks and companies seem to be short of cash. And during the turmoil the repo rate stopped tracking the federal funds rate. This link is the main way monetary policy influences the economy. A gap opening between the two deprives the Fed of its most important policy tool.
Fortunately, the Fed’s interventions seemed to work. The repo rate returned to its usual level, close to the federal funds rate, which in turn is within the range targeted by the Fed. Even so, the turmoil raised questions about how it plans to handle future cash shortages. The mere prospect of them marks an important shift for America’s financial system. Before the financial crisis the Fed controlled the federal funds rate using a “corridor”, with a ceiling and a floor. Banks with too little cash could borrow at the ceiling rate. But there was no compensation for extra cash held at the Fed (the floor interest rate was zero). To keep interest rates precisely on target the Fed used “open market operations”, swapping Treasuries and cash to control liquidity in the banking system.
Six years of quantitative easing changed all that. To push down long-term interest rates, the Fed bought vast quantities of long-dated Treasury bonds. Its balance-sheet ballooned to $4.5trn. The holders—mainly banks—ended up with mountains of cash. To keep market interest rates at or above the policy rate, the Fed was authorized by Congress to raise the floor from zero, compensating banks for their cash that it held. The ceiling became redundant, as did open market operations. Only the floor mattered.
But banks’ cash piles have dwindled of late. Since late 2017 the Fed has been reducing its balance-sheet by not reinvesting all the proceeds when its assets mature. The balance-sheet shrank from $4.5trn in 2017 to $3.8trn in June this year. Moreover, a wider budget deficit means the Treasury has had to issue more bills and bonds. So far this year it has issued an average of $63.9bn-worth per month, net of repayments. During the same period in 2017 the monthly figure was just $19.6bn. As banks buy Treasuries, their cash piles fall. The surplus reserves banks hold in their deposit accounts at the Fed fell from $2.2trn in 2017 to $1.4trn now.
No one knows how much surplus cash banks need to feel comfortable. That depends partly on regulations, which have increased the amount of cash banks must hold as a buffer, but also on business sentiment. Banks’ near-death experience in 2008-09 has left them with a strong desire to hold plenty of extra cash. Economists have attempted to estimate the level at which banks would start to squirm, most coming up with estimates of $1.2trn-1.5trn.
Usually banks have at least this much on hand. But they may not have had on September 16th, for quite benign reasons. That was the deadline for quarterly corporate-tax payments, meaning companies asked banks for more cash than usual. The Treasury had issued $77bn-worth of bills the previous week. The buyers, mostly banks, also had to pay on September 16th. The Fed expected these events, said Jerome Powell, its chairman, but not such an extreme reaction. As banks’ cash piles shrank, they grew reluctant to lend to companies and other counterparties. The repo rate spiked. Some banks stepped in, lending to companies at elevated rates. But then those banks tried to borrow from other banks in the federal funds market, pushing up the rate. This prompted the Fed to intervene.
Cash would have become scarce sooner or later, says Bill English of Yale University. In a growing economy—especially one with a rising government deficit—the demand for bank cash increases over time.
The Fed now faces a choice. It could return to conducting frequent open market operations to pin down interest rates, as before the crisis. Or it could keep the current system and avert future cash shortages by expanding its balance-sheet enough to keep the banking system permanently saturated with liquidity, even as demand for cash grows. On September 18th Mr. Powell suggested that the Fed would opt for the latter, saying it wanted reserves to be ample enough to avoid operations of the sort carried out in recent days. He also announced technical tweaks that will mean banks are compensated a little less handsomely for cash deposited at the Fed, which might encourage them to lend a little more in the repo market instead.
It is unclear how quickly balance-sheet expansion might be resumed. This week’s events suggest it may be soon. As Mr. Powell said after the Fed’s meeting, “I think we’ll learn quite a lot in the next six weeks.”
This article appeared in the Finance and Economics section of the print edition under the headline “Hitting the Ceiling.”
You can access the full article here.
My additional two cents:
What the Economist article did not say, and I believe is worth noting, is something few are focusing on – the Treasury is required, as mandated by the Treasury Borrowing Advisory Committee in 2015, to keep a cash balance of $400 billion on deposit at the Fed in case of a government shutdown. Think of it as emergency money to pay bills. Later, the Treasury is required to get their account balance back up to $400 billion. The current balance is just $194 billion so the Treasury needs to issue more than $200 billion in Treasury Bills, Notes and Bonds to get back to $400 billion. Investor cash from somewhere is buying the Treasury debt so that is an additional drain on system-wide cash.
The Treasury Borrowing Advisory Committee also said that whenever deficit is higher, the cash balance should also be higher than $400 billion. Well, the government is currently running a budget deficit of more than $1.2 trillion annually (spending more than the tax revenue it takes in). So, the need requirement is higher than the $400 billion requirement but I’m not sure of what the ratio to budget deficit is but it has to be higher. And does anyone see the budget deficit getting better any time soon? I don’t.
When the Treasury draws from the cash kitty, they are injecting money into the system. Think of it as another form of quantitative easing (QE). They are currently pulling money out of the system by issuing more debt. Think of the $200+ billion that is required to get back to $400 billion as quantitative tightening (QT). Last week’s turmoil in money market funds is a warning sign. It is an “Unintended Consequence in a Complex System.”
My guess is that within three months or so the Treasury should be back at the target level. Unless this week’s shock slows the pace. Ultimately, the more liquidity you drain from the system, the more it hits equities. I also believe the recent bond market sell-off is partly caused by the Treasury’s need to issue more debt. I expect a slowdown in earnings, a slowdown in the U.S. economy and a short-term top in the equity markets. Risk remains high.
Trade Signals – Fed Approves Cut, Divided on Further Action; Equity Signals Remain Green; Zweig Bond Model Flashing Red
September 18, 2019
S&P 500 Index — 2,984
Notable this week:
Market Commentary & Trends: Fed Day. The Fed approved a quarter point rate cut today but is divided on taking further action this year. This follows the European Central Bank’s decision last week to cut rates by 10 bps to -0.50% and launch a new QE bond buying program (20 billion Euros per month). “In view of the weakening economic outlook and the continued prominence of downside risk, governments with fiscal space should act in an effective and timely manner,” ECB President Mario Draghi said.
All of the equity market trade signals remain bullish. Helped by the market’s two-week rally, investor sentiment indicators have moved from “extreme pessimism” to “neutral.” The idea is to be wary of markets when sentiment reaches extreme optimism and get interested in the markets when investor pessimism is extremely high. “Don’t Fight the Tape or the Fed” indicator remains at a bullish +1 reading. The equity market uptrend remains intact.
The biggest signal change for the week is the Zweig Bond Model (“ZBM”), which moved from a buy signal to a sell signal. The buy signal has been in place for much of the past year. Years ago I worked with Ned Davis Research to resurrect an old model that Ned and the great Marty Zweig utilized in the mid-1980s. Long-time readers know the ZBM has been posted diligently each week in Trade Signals. The signal is a pure trend-following process that looks at price as well as the yield curve. It is my favorite trend indicator for the direction of high quality bond prices and interest rates. It is suggesting to trade to shorter-term Treasury Bills vs. longer-term Treasury Bonds (or LT high grade corporate bonds). The rules are spelled out in the upper left-hand section of the following chart. Not all trades are winners, yet that is the case with a fundamental trading decision and all other rules-based systematic process such as the Zweig Bond Model. It is best to find a process you believe in so that you can stick to the process. ZBM is my go-to indicator for the direction in longer-term interest rates and Treasury bond prices. Bottom line: Sell the rallies and shorten duration exposures.
Finally, the trend in the High Yield bond market is bullish and the trend in Gold remains bullish.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
Personal Note – Old Friends and the Statue of Liberty
“Be humble. I always believed the higher a monkey climbs in the tree, the more people below can see his ass. You don’t have to be that monkey.”
– T. Boone Pickens (1928 to 2019)
T. Boone said, “I left an undying love for America, and the hope it presents for all. I left a passion for entrepreneurship, and the promise it sustains. I left the belief that future generations can and will do better than my own.” Last Monday evening, I joined the team from Syntax on a sailboat ride from lower Manhattan to the Statue of Liberty and back. I was in awe as we sailed next to one of our most important monuments to freedom. I wondered what my great grandparents must have felt as they sailed to Ellis Island. “An undying love for America.” Love that. A big hat tip to the Syntax team. Grateful! Here are a few pictures from Monday evening’s event. I have never before been this close to the Statue of Liberty. Amazing… and the NYC skyline was fantastic. Pictured with daughter, Brianna, and good friend, Rory Riggs.
Last weekend’s Penn State vs. Pitt game was great fun. The tailgate with my fraternity brothers was priceless. It seems like just yesterday we were growing up together. And the Penn State win was a bonus. Boy was the Pitt quarterback fantastic. Too exciting of a game but a W is a W.
Son, Matt, pictured on the far right in the next photo. Yes, that’s a “shot ski.” Dad’s not particularly happy.
I’m heading to St Louis for meetings Tuesday – Thursday and LA and San Francisco meetings follow in early October. Busy but enjoying the ride. I hope you are as well. Wishing you the very best.
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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