The Macro Compass

‘‘We have made substantial progress in removing monetary policy accommodation, and we have to recognize there are clear signs of an economic slowdown in the Eurozone.’’

Christine Lagarde - ECB October press conference

Hi all, and welcome back to The Macro Compass!

Over the last two weeks, several G10 Central Banks came across as ready-to-pivot.

Australia, Canada and now Europe are starting to weigh pros and cons of calibrating monetary policy with a single objective: bringing inflation down to 2%, as soon as possible.Instead, they are beginning to consider a slowdown in the pace of hikes and most likely a complete pause relatively soon.

Why such a sudden change of heart?

Because all these jurisdictions have something in common: inherent fragilities.

Be it private sector debt (Canada), the domestic housing market (Australia), upcoming recession fears or a very suboptimal architecture for a ‘‘monetary/fiscal union’’ (Europe) it’s become increasingly clear that relentless monetary policy tightening will end up breaking something.And hence, all of a sudden pros and cons need to be weighed against each others.

Today’s ECB decisions and press conference went exactly into that direction, with a lot of interesting decisions and nuances.

In this short article, we will:

* Briefly discuss the ECB meeting, and focus on its most interesting nuances;

* Summarize the main implications for portfolio allocations & tactical trade ideas.

A Ready-To-Pivot ECB?

Actually, before we jump right in.

Nowadays, time is our scarcest resource and sharing insights in an effective way through charts and visual infographics is a great tool to have in your arsenal.On my social channels, I must have used Chartr visual insights countless times for this very reason - these guys are very skilled at conveying macro, business and market insights in a visual and easy-to-remember fashion.I strongly recommend signing up for their 5-minutes read newsletter which is packed with these very useful and information dense visual insights.It’s free - here is the link.

Back to it: let’s unpack this ECB meeting together.

#1: We Are Serious About Inflation, But…

The ECB hiked by 75 bps hence bringing the Deposit Rate to 1.50%, and acknowledged inflation is likely to stay high and hence that further interest rate increases will be necessary.

So, where is the ‘‘ready-to-pivot’’ stance?In the language used to communicate whatever is left of the ECB’s forward guidance.

A) The press release indicates the Governing Council doesn’t expect ‘‘to raise interest rates over the next several meetings’’ but only ‘‘to raise interest rates further’’: a much less specific reference to the hike sequencing being prolonged over time;

B) The press release now reflects an ECB assessing today’s stance as reasonably tight and moving there quickly: ‘‘With this third major policy rate increase in a row, the Governing Council has made substantial progress in withdrawing monetary policy accommodation.’’

C) Lagarde being very vocal in her press conference about recession risks, and the need to weigh pros and cons when moving monetary policy much tighter from here.

A quick snapshot of today’s market reaction - we will cover this in much more details later: investors immediately repriced the ECB terminal rate down by 30+ bps!

For now, the most important question I want to answer is: with inflation running at around 10% (!) in Europe, why would the ECB deliver such a sudden change of heart?

Because of its inherent fragilities.

An overleveraged and unproductive private sector, weak potential growth due to poor demographics and a very suboptimal monetary/fiscal union architecture chronically expose Europe to systemic risks.Sum up a brand-new and not necessarily Europe-friendly Italian government and geopolitical risks, and you see where I am going.

With such a backdrop, once you tightened by 200 bps in a few months the pros and cons of further aggressive tightening become more ‘‘balanced’’.The Bank of Canada is delivering the exact same message - notice any similarities in the presence of inherent fragilities and the sudden change of heart?

In other words, the ECB is ‘‘hoping’’ that markets are right about inflation falling off a cliff (spot European CPI at 10%, and 1y1y inflation swaps are pricing in 2.7%) and most importantly that a mild tightening of their monetary policy stance above neutral rates will be enough to engineer such a sharp drop in inflation.

While this ideal outcome might unfold, history suggests baby steps are not enough to slay the inflation dragon.Given my estimate of today’s EUR nominal neutral rate at around 1.5% (exactly where ECB depo is today), the market-implied terminal rate of 2.6% imply an ECB monetary policy stance ~100 bps above neutral.In the 1990s, in order to restore price stability France had to go 300+ bps above neutral for over two years.

Will 100 bps be enough?Maybe, but the ECB (& Co) are taking quite the leap of faith here.

#2: Dear Banks, The Free-Carry Party Is Over

The ECB also drastically changed the remuneration mechanism for TLTROs, the cheap funding mechanism that allowed European banks to borrow roughly EUR 2 trillion at very advantageous rates during the pandemic.

The idea there is simple: incentivize banks to repay these TLTRO loans as soon as possible, hence shrinking the ECB balance sheet and at the same time easing some of the collateral scarcity in Europe.

As the ECB balance sheet has ballooned to over EUR 4.5 trillion and this gigantic amount of excess reserves is at odds with a tightening monetary policy stance, the ECB is looking for ways to shrink its size.The two obvious candidates are QT and a sharp reduction in outstanding TLTROs.

The ECB is well aware of the dangers of QT in the Eurozone (Italy, Greece…?), and hence incentivizing banks to repay TLTRO loans early seems like a more viable option - the hope is also that correcting the imbalance between a very abundant level of excess reserves and a scarce amount of good quality collateral (AAA German bonds) will ease the collateral scarcity in Europe.

The chart below shows how 2-year German govies are trading 80 bps through 2-year Euribor swap rates (and roughly 50 bps through 2y ESTR swap rates, which track ECB deposit rates).

Will they succeed in getting European banks to repay early?

Yes, I think so.But less excess reserves and more bond issuance to fund energy subsidies and other fiscal maneuvers might also end up requiring wider risk premia in Europe.

So, how did markets respond to the ECB meeting and what about implications for portfolio allocations and trade ideas?

Conclusions & Portfolio Implications

The best way to grasp (the bond) market reaction to the ECB meeting is through a visual snapshot of the Rates & Credits section of my Volatility-Adjusted Market Dashboard (VAMD).Daily changes are color-coded to reflect the magnitude of the move: the darker the color, the bigger the volatility-adjusted move in that particular instrument.

EUR OIS rates dropped materially, and front-end volatility (3-month expiries for 2-year yields) also came down pretty materially.

But the biggest volatility-adjusted movers were curve steepeners and real yields dropping: and it makes a lot of sense.

If you are telling me you will be more reluctant to tighten monetary policy further even if inflation is still running at 10%, I have to:A) Price that in via lower short-end bond yields, but assign a bigger risk (term) premia to inflation persisting over time = steeper curves;B) Assume forward real yields will be lower, as your commitment to have a tighter monetary stance prolonged over time has materially dropped.

Now, what does this mean for portfolio allocations - especially if other Central Banks (Fed?!) experience a similar change of heart?

Using the Macro Compass quadrant framework, that would materially increase the probability of a move from Quadrant 4 to Quadrant 1 - at least on the margin.

A flatlining rate of change of the monetary policy stance (i.e. the next step being less aggr…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘We want to perceive ourselves as winners, but successful investors are always focusing on their losses.’’

Peter Borish - Founding Partner of Tudor Investment Corporation

Hi all, and welcome back to The Macro Compass!

This week felt like the good old days.

I was in London for some conferences, but most importantly for the Indian food…kidding: I meant to meet clients and friends working for the top macro hedge funds in the world.

These are amongst the most sophisticated macro investors out there - they deploy a great deal of analysis and tools to come up and correctly size macro trade ideas, and yet this is not their top skill.

They excel because they are humble about markets - always wondering whether there is really good risk/reward in that trade and where their macro thesis could go wrong.

The Macro Compass has always been about sharing my never-ending macro learning journey with you guys.

Today, I want to have a peek over the shoulders of the top macro hedge fund managers.Together with you!

In this article, we will:

* Unpack the main thinking and market musings of three influential macro hedge fund managers;

* Summarize the main implications for portfolio allocations & tactical trade ideas.

Welcome to the Dark Side of Derivatives

Actually, before we jump right in.

If you are reading The Macro Compass, you’ll probably be interested in other good quality newsletters.The guys at The Daily Upside are doing a great job at sifting through the clickbait-y headlines traditional financial media poses.Instead, their team of investment bankers, scholars, and journalists condense the latest financial stories in a clear, concise, and occasionally witty daily newsletter - it is read by over 750,000 people every day and by the way…it’s free!I definitely recommend checking them out: here is the link.

Back to it: I will not reveal the identity or the hedge fund these PMs are CIOs or work for, but I will give you some background color to best contextualize their takes.|Ready? Let’s go.

#1: Macro Rates & Credits Hedge Fund CIO

This crispy European gentleman is somebody with a long history in global fixed income strategy and fund management who now runs a rates & credits focused macro hedge fund.

‘‘Alf, where is the trade?’’

I love this - you can chat macro narratives all you want, but where is that good risk/reward trade we all look for?

He sees the world healing from inflationary pressures: the global supply chain is easing, core goods inventories abound while new orders remain weak, a big deleveraging in China is likely to keep that demand engine at bay etc.All very disinflationary, he argues.

But I showed him this chart and asked: isn’t this priced in already?The chart below shows how markets expect a 5%+ drop (!) in US CPI over the next few quarters already - to find a similar market-implied CPI drop over a 12 months period you have to go back to 2008.

He agrees: his point is indeed that investing isn’t like painting on a white canvas.We must always compare our subjective assessment of scenarios ahead against what markets are discounting - and right now, if your investment thesis solely relies on a sharp slowdown in inflation…well, it’s kinda priced in.

But here is where he disagrees with markets: the labor market will take a bigger hit than priced in, and earlier than expected.

The ‘‘bull case’’ for the housing market ahead is a total freeze: new marginal buyers are priced out due to the combination of today’s prices and mortgage rates, and sellers will hold on for as long as they can to avoid hitting a lower bid on their planned sales.But this means (plenty of) pain for housing-related job creation.

The math is simple: given its demographics and labor force growth, the US needs to add roughly 90k jobs per month to keep unemployment rate stable.Housing related activity (brokers, construction, furniture shops etc) accounts for almost 20% of US GDP and ~12 million jobs.If all the other sectors merely slow towards trend job creation and only 10% of real estate related jobs are lost, US Non-Farm Payrolls could soon carry a negative (!) sign.

We agree here - the housing market IS the business cycle.The sharp decline in the NAHB Housing Index (orange line, inverted) suggests US unemployment rate should quickly head towards 7% in 2023: such a vicious and powerful deterioration in the US job market is not market consensus yet.

So, what’s the trade?

He likes downside in homebuilders, REITS and credits linked to the real estate market.

Time to thank him, drink an espresso (oh gosh, the UK version…) and on to the next macro hedge fund!

#2: The Family Office Macro PM

This extremely smart lady works for a prominent macro hedge fund that has turned into a family office, allowing her more flexibility to take medium term risks.

All she wants to talk about is the US Dollar and monetary plumbing.

‘‘Alf: death by a thousand cuts or a sharp systemic risk event?’’

She sees the world through the lens of our USD-centric credit and economic system.Despite the US and USD accounting for only ~10% of world trades and ~20% of global GDP, the US Dollar takes the lion share of global trade invoicing, payments and most importantly non-US based credit creation (loans and international debt issuance).

At the end of 2021, the BIS reported an outstanding amount of roughly 12 trillion of USD denominated credit (bonds and loans) sitting on the balance sheet of entities outside the US - a 6-fold increase in only 20 years.

As long as US Dollars are organically flowing towards these USD-leveraged foreign entities, the system thrives.But for the last 6-9 months, global trade growth has slowed down and access to cheap USD funding has come to a halt.

She also thinks the US economy is in a much better shape than many people believe, and that for several reasons consumers will be able to withstand much higher rates.This in turn will force the Fed to keep pushing.

In such a $-centric system, that means something will break.Where and what - that matters the most for her macro thesis.

Unless the US repo or Treasury market seriously breaks, the path of least resistance seems to be the ‘‘death by a thousand cuts’’: idiosyncratic events happening at the fringes first (e.g. Turkey) and slowly moving towards the core (e.g. UK pension funds).But that’s definitely not enough for the Fed to pivot with core inflation north of 6%.

A breakdown of the repo or Treasury market would warrant an immediate turnaround, but she argues there is nothing really broken in the UST market yet - and I strongly agree.Wider bid-ask spreads are merely a function of much higher volatility which forces regulation-crippled market makers to be more conservative when onboarding risks, and the repo market is still functioning okay.

So if we’re looking into a ‘‘death by a thousand cuts’’ scenario, where is the next cut?She thinks China will be forced to aggressively devalue.

Now, one last chat before heading for pizza - 50 Kalo’ in London is like eating it in Naples. Seriously.

#3: The Cross-Asset Relative Value PM

This must be one of the smartest macro investors I know - always thinking in probability terms and truly ‘‘macro-fluent’’ in all major asset classes.He works for a large cross-asset global macro hedge fund.

‘‘Alf, everybody is still using the last 10-year framework - and they are wrong’’.

Wow, this was quite the opening line from him.He tells me many investors are underestimasting the power of fixed income volatility and also mispricing the tails, and this matters.

Bond volatility is very important for market makers and asset allocators: if the deepest, most liquid market in the world is moving by +/-10 bps per day, it’s going to be very hard to convincigly allocate into risk assets.

But what happens if none of the tails realize, and we instead stabilize around 4.50% Fed Funds for several quarters in a row?Bond volatility would likely move down, and here is what it does to risk asset valuations - bullish (!), on the margin.

Now to the tails.

If I ask you what’s your subjective prob…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.’’

Hyman Minsky

Hi all, and welcome back to The Macro Compass!

Recently, there have been crucial developments in the (global) pension fund industry.And to give you some context, we are talking about a $40+ trillion industry here.

Years and years of lower rates and subdued cross-asset volatility led pension funds to make a more aggressive use of derivatives (mostly but not only for hedging purposes).As derivatives require very little cash investment upfront, this freed up additional capacity to invest in higher-yielding and often illiquid assets to generate better returns - after all if volatility is so low, why not?

As the perfect storm hits markets, we are now finding out about the ‘‘why not’’ part.

In this article, we will:

* Break down the dynamics behind the UK pension fund drama;

* Discuss whether a similar episode could hit the European or US pension fund industry, and what the implications for markets and portfolios could be.

Welcome to the Dark Side of Derivatives

Actually, before we jump right in.On October 17-18 I will be a speaker at the Digital Asset Summit in London - it’s an excellent conference that combines the worlds of macro and digital assets and it features high-quality speakers and attendees (macro/crypto funds, family offices, banks and many more).If you want to grab a ticket, you can get a 20% discount using the code ‘‘TMC’’ - here is the link.

Now, back to it.

Let’s start with some context first.The size of the global pension fund industry is estimated to be in the $35-40 trn area. It's a very large and systematically important industry not only because of its size, but also because of its social impact - most of us look forward to retirement after decades of hard work.

We recently got some scary headlines coming from the UK: pension funds were about to blow up, and the Bank of England had to backstop them by limiting the relentless rise in 30-year yields.

Let’s look into the very dynamics behind such episodes of acute stress.

1. How Does It Exactly Work?

Pension funds are in the business of accumulating premiums today and investing them (assets) such that they will be able to pay out pensions (liabilities) in the future.Pension funds' liabilities are hence a promise to pay a stream of retirement cash flows in the far future (~20-30y), which organically exposes them to interest rate risks: the discounted value of these liabilities increases if rates go down, and vice versa.

To guarantee solvency, these risks need to be hedged at least to a certain extent.But funds must generate returns, too.

Here is how a stylized pension fund balance sheet looks like:

Let’s talk about the hedging part first.

20-30 year government bonds would be an obvious candidate as an asset to buy in order to hedge the interest rate risk of a 20-30 year pension liability, right?Indeed, that’s correct.But as yields kept moving lower for a decade, that also meant pension funds were locking in all their cash in low-yielding products.

Hence, a more ‘‘convenient’’ instrument became increasingly popular: swaps.

A receiver interest rate swap is nothing else than an agreement to receive cash flows at a fixed rate against the obligation to pay cash flows at the prevailing floating rate over time - ok, but where is the trick?

The beauty of a swap is that there is basically no principal investment up front. These derivatives are mostly cleared through a Clearing House, which requires an initial margin (often paid by posting bonds as collateral) and variation margins (mostly settled in cash every day).

Most importantly, that means the cash that would have been invested in long dated safe bonds can now been deployed in higher yielding investments - which in a low-return environment were vital for pension funds to be able to deliver the return necessary to service pension payouts in the future.Together with other factors, this led swaps to become so popular as a hedging tool that they now trade at a premium to government bonds (!).

Ok, so pension funds are sitting on a very large amount of 30-year receiver swaps to hedge long-dated liabilities.And as this requires very little upfront investments, cash can instead be directed towards higher expected return assets like stocks, EMs, credits etc.

Then, this happens.

Now, institutional investors’ risk models (trust me: first-hand experience) are mostly based on 5-10 years historical volatility and hence unprepared to deal with such moves.The amount of cash required to meet margin calls when the move in interest rates is 6-8x standard deviations is very large.

And remember where this cash has been invested?Mostly in riskier assets that Clearing Houses won’t accept as collateral.Pension funds also don’t have direct access to the Central Bank, which makes it impossible for them to post collateral and receive funds to meet margin calls this way.

All of a sudden, the most typical liquidity problem arises.The only way out is to liquidate assets (bonds, stocks, all!) and meet margin calls to avoid a liquidity problem morphing into a solvency issue.

Government bonds - the most liquid assets - are first in line, and large sales only compound the problem: rates keep rising, and market makers whose risk warehousing capacity has been crippled by regulation are unable and unwilling to help.A domino-like, vicious circle unfolds.The Central Bank is forced to step in and stop the bleeding by effectively purchasing as many long-end bonds as necessary to limit the cascading risks.

A huge, systemically important sector like the pension fund industry was effectively experiencing an acute liquidity crisis on the verge of morphing into a solvency crisis.

Serious stuff.

Now, how likely is this to happen in Europe or the US?

2. Yes, It Can Happen Elsewhere Too, But…

Is this only a UK pension fund industry problem?

Well, the UK certainly has a lot of idiosyncratic features that compounded the issue, and in particular:

* ~1.8 trillion worth (!) of Defined Benefit pension schemes, which require pension funds to make more extensive use of a liability-driven investment (LDI) approach and hence more derivatives and return-seeking strategies;

* Most importantly, a gigantic pension fund industry both compared to the size of its economy (119% of GDP as per 2020) and to the size of its high-quality bond market.

Here is how pension fund asset as % of GDP rank amongst OECD countries.

As you can see, there are many more jurisdiction with a humongous pension fund industry - but the devil is sometimes in the details.Take The Netherlands, for instance - at >200% of GDP, should Dutch (and Europeans) be worried?

Yes, and no.

Yes: because a sharp move in 30-year European rates could spark very similar dynamics amongst Dutch pension funds too.And yes, also because there are many more non-rates derivatives involved here: FX forwards used to hedge foreign bonds and equity investments, commodity derivatives, futures and so on. Volatility is picking up everywhere, and margin calls could pop up where you least expect them.

No: mainly because the size of the European pension fund industry as a % of the (decently rated) European bond and repo markets is much smaller than in the UK, and hence the magnitude of such an episode could be more contained.

Conclusions & Portfolio Update

Finally, a quick word about how this pension fund drama and today’s US inflation print will impact markets and portfolios over the next few weeks/months.

Stability breeds instability.Instability brings volatility.Volatility breeds more volatility.

When the most liquid and deep market (= fixed income) in the world experiences daily swings which are at least 3-5x bigger than the last decade average, it is mechanically impossible for large institutional investors to allocate capital in riskier assets.A hyper-financialized and leveraged system can only become more unstable when the very base of …

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘History doesn’t repeat itself, but it often rhymes.’’

Mark Twain

Hi all, and welcome back to The Macro Compass - we are now 100,000+ strong, wow!

Looking at historical parallels to assess prevailing macro conditions can be a useful exercise - also in markets, one can argue that in the end history doesn’t perfectly repeat itself but if often rhymes.

In December 2021, carrying a similar analysis I found out that 2022 had a high potential of being ‘‘2018 on steroids’’ and hence delivering negative returns across asset classes: what about today?

Refreshing my macro framework and digging into 50+ years of history, the evidence is pretty compelling: the next 6 months might well resemble the Q4 2000 - Q1 2001 period.

Leading to that period, we experienced excessive animal spirits and risk-taking activities mostly exemplified by the Dot-Com bubble.In late 2000 and early 2001, as financial conditions became tighter we instead experienced a marked slowdown in earnings and weakness in the labor market but inflation remained stubbornly above 2% hence delaying and limiting the Fed’s ability to accommodate.

Sounds familiar, right?

In this piece, we will:

* Update The Macro Compass framework, exploring the latest development in forward-looking macro indicators and gauges of monetary policy stance;

* Discuss the parallels with Q4 2000 - Q1 2001, and have a look at the performance of several asset classes during this period to learn some lessons about how to position our portfolios today.

Refreshing The Macro Framework

Actually, before we jump right in.

Over the last months, many of you asked for a deep dive into my macro framework - I thought a lot about this, and decided that a (free!) workshop was the way to go!On October 15th, I will join my friends at the global macro prop trading firm Axia in London to deliver a Macro Masterclass that will unpack my entire framework.The event will be live and there will be a long interactive Q&A session, but don’t worry if you can’t make it that day - a recorded version will be sent to your email too.This interactive Masterclass is FREE - you just need to register here.I hope to (virtually) see you on Saturday, October 15th! :)

Now, back to it.The Macro Compass framework revolves around forward-looking macro indicators and gauges of the relative monetary policy stance to assess where we stand in the economic cycle and hence what the most appropriate asset allocation could be.

While my analysis keeps firmly pointing towards Quadrant 4, quite a lot of things are brewing under the surface.To reflect upon those, let’s refresh some of my main indicators.

1. Forward-Looking Macro Indicators Are Pointing DOWN

The x-axis of the TMC Quadrant model informs us on the rate of change in economic growth: will economic activity be accelerating or decelerating?

Statistically significant forward-looking macro indicators are very useful to get an idea of what’s ahead for the global economy.Let’s focus on two of these.

The chart below shows the YoY changes in US ISM New Orders/Inventories ratio (blue) against YoY changes in S&P500 EPS growth (orange, lagged by 3-4 quarters).If companies are reporting a sluggish pace of new orders and at the same time quickly building up large inventories, a few quarters later earnings growth is likely to start disappointing.

Notice how this forward-looking macro indicator does particularly well at predicting turning points in EPS growth, and it’s now pointing towards negative earnings growth in 2023.

A robust framework doesn’t rely on a single indicator, so let’s refresh whether my flagship Global Credit Impulse metric suggests a similar slowdown ahead for nominal growth (here proxied with YoY S&P 500 earnings growth).

This indicator measures the rate of change of money creation for the real economy (mostly the non-financial private sector = households and corporates).Think about it: the faster your bank deposits (i.e. real-economy money) grow, the more likely you are to increase nominal spending and boost economic activity.

And vice versa.

In July 2022 (latest available data), the G5 Credit Impulse printed at 20y lows as the result of the combination of a gigantic post C-19 fiscal drag + Chinese de-leveraging + insufficient pickup in global bank lending.

While analysts expect earnings to grow by 8% in 2023 (green dot), such a drop in the Global Credit Impulse is instead consistent with an EPS contraction well in the double-digit area.

The message seems consistent: going forward earnings are likely to disappoint.And disappoint very hard.

In late 2000/early 2001, economic growth and earnings were on the verge of a serious slowdown: check.

2. The Relative Monetary Policy Stance Remains VERY TIGHT

The y-axis of the TMC Quadrant model instead captures the relative monetary policy stance - while many investors judge the Fed to be tight or loose based on the absolute level of Fed Funds, my framework suggests the pace of change in monetary policy and the Central Bank’s stance relative to equilibrium (r*) are much more important for economic growth and the performance of asset classes.In other words considering the much weaker demographics, sluggish labor supply growth and larger amounts of unproductive leverage…today’s equilibrium rates are much lower than 20 or 30 years ago, and hence a 5% risk-free rate today is much tighter than in the ‘90s - it’s all relative.

The sharp pivot from an accommodative stance and forward guidance in Oct-21 to a restrictive approach in H1 2022 was truly impressive, but most investors haven’t still realized how tight and for how long Central Banks will be against estimates of neutral real rates (r*).

Right now, US 5y real yields are trading >150 bps above neutral: wow!

Some observations about this very tight stance from the table above:

* Every time the Fed kept real rates ~50+ bps above equilibrium for longer than a few months, something broke (2000, 2007, 2018, 2022-2023…);

* After such a restrictive policy is enforced, 12m forward returns in the S&P500 are generally very negative and high-yield credit spreads are much wider; the exception being 2019, when the Fed’s massive pivot limited losses somehow;

* In 2022, we have now been tight for 113 days already and the latest levels of real yields are really, really high relative to equilibrium: ouch.

The reason why the Fed’s stance is so tight is credibility.The Fed has been so wrong for so long and their price stability mandate is far from their reach, and hence Powell’s credibility is seriously at stake.But J-Pow knows this, and his Jackson Hole speech was unambiguously clear: the Fed will be as tight as needed until the job (inflation back at 2%) is done.

And Powell can’t let markets challenge his credibility further.

This is why I built the Powell Credibility Indicator (PCI): it measures the market-implied real Fed Funds in one year from now.Given how bad the inflation setup is, to preserve his credibility Powell needs to convince markets that real Fed Funds will sit in the +1% area (very tight).

So far so good for Powell’s attempt to restore his credibility with markets.But this means that the Fed’s relative monetary policy stance will have to remain tight for longer.

In late 2000/early 2001, Fed Funds were at 6.50% (50+ bps above my estimates of neutral rate) and as inflation was in the 4% area for many quarters in a row the Fed was hesitant in cutting rates even as the economy was rolling over: check.

Let’s now discuss a bit further the similarities with the Q42000-Q12001 period and how asset classes performed back then.

Early 2001 Is Here, Again!

The Macro Compass framework calls for a period of slowing real growth, possibly peaking inflationary pressures but still a tight monetary policy stance ahead.

When looking for historical parallels though, controlling for the above variables isn’t enough - we also need to think about a period when inflation was running above Central Banks’ targets for long, the labor market was showing the first preliminary signs of weakness and animal s…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.’’

George Soros - The Man Who Broke The Bank of England

Hi all, and welcome back to The Macro Compass!

The FX vigilantes are back - and that’s an important news.

Global FX markets are on fire, with wild moves involving several currencies around the world and mostly having one common denominator: weakness against the US Dollar.

Why such dramatic moves?

For the last 20+ years, developed markets’ economic models were based on a two-tier system of cheaply available leverage:

* Low-cost economic inputs underpinned by just-in-time global supply chains (leverage used to generate non-inflationary growth);

* Relentless public and private credit creation at lower and lower borrowing costs (leveraged used to feed the wealth effect).

Such an economic model can work wonders…as long as there is no exogenous shock to the system - and right now, there is no shortage of external shocks (e.g. energy inputs, supply chains, inflation, borrowing costs etc).

Once you apply stress to a complex system, the resulting pressure will look for a release valve - currencies being one of the obvious candidates.But this scary pickup in FX volatility also brings a lot of potential opportunities, as not all countries sit in the very same boat.

All of a sudden, fundamentals matter.

In this article, we will:

* Provide you with a framework to assess relative FX vulnerabilities around the world, and investigate the moves and potential developments ahead for 3 major currencies (JPY, GBP, CHF);

* Assess the implications and provide portfolio allocation guidelines and trade ideas for both long-only and tactical long/short macro portfolios.

FX Fundamentals Are Back With A Vengeance

Actually, before we jump right in.

On October 17-18 I will be a speaker at the Digital Asset Summit conference in London - it’s a very well-organized event attended by large investors and companies situated at the crossroads between macro and the digital asset space.You can listen to a large amount of good quality content and meet macro and crypto funds, family offices, banks…or even me :)

If you are interested to attend, as a reader of The Macro Compass you can get tickers with a 20% discount using the code ‘‘TMC’’ - the link is here.

Now, back to it.

An easy way to think about global FX vulnerabilities is to ask yourself: where was the two-tier leverage system applied most extensively, and are policymakers now credibly able to stop the bleeding caused by exogenous shocks?

By quantitatively and qualitatively assessing the following variables per each country, we should be able to get a good snapshot of the situation.

* Vulnerabilities: debt and deficits.

If the value of your goods and services imports exceeds your exports (Current Account deficit), and if the value of your external debt is much higher than the foreign assets you own (net debtor country under the Net International Investment Position) you are not in a great position to handle external shocks - if you also plan to make a large use of Fiscal Deficits, that’s even worse - hello, UK?Additionally, if Private Sector Debt is very high you are likely not well-equipped to sustainably tighten fiscal and monetary policy to offset this shock.

* Strengths: Central Bank/policymakers’ credibility = net FX reserves & the ability and willingness to tighten policy.

Successfully overcoming exogenous shocks requires a wide array of credible policymaking (higher real rates, FX management, long-term strategic decisions): the amount of Net FX Reserves and the extent of Policymakers’ Credibility in their ability and willingness to tighten are important.

Here is a quick visual snapshot of how different currencies are ranking according to this framework:

The framework looks at quantitative measurements for each category, focusing not only on spot levels but also on trends and future base case.But it also overlays qualitative assessments - for instance on the willingness and ability of policymakers to deliver ‘‘friendly’’ FX policies (hello, Japan?).Finally, it color-codes variables for each country on an absolute basis: green tonalities for a healthy, FX-supportive element while orange/brown tonalities otherwise.

Let’s now cover the 3 interesting currencies in more details.

1. Japan: Is The YCC Ever Going To Stop?

Japan has been running QE forever, and few years ago the BoJ decided to focus on ‘‘quality’’ rather than quantity by shifting their focus on pinning 10y rates at 0.25% rather than on a certain amount of QE envelope - effectively kickstarting a Yield Curve Control (YCC) policy.

Japan’s current account and fiscal balances aren’t particularly healthy, and its private plus public sector leverage is very large. Lately, as interest rate differentials between Japan and the rest of the world widened aggressively markets are loudly asking one question - when will the YCC end?

The answer is in this chart.

Japanese core inflation has averaged minus (!) 0.2% over the last 2 decades, and 5-year forward, 5-year inflation expectations have only rarely managed to trade above 1%.Incentive schemes are important here: Kuroda’s term will end in Spring 2023, and he won’t easily give up on an easy monetary policy especially if he’s getting one last chance to declare ‘‘victory’’ and leave a ‘‘better’’ legacy behind.

But given the Japanese vulnerabilities to exogenous shocks highlighted in the table above, if markets can’t use bonds as a release valve…they’ll be testing the JPY.So, is the Ministry of Finance ammunition and credibility enough to (temporarily) defend the JPY?

Yes.

Japan owns $1.3 trillion in gross foreign exchange reserves, with the net amount (e.g. accounting for foreign currency liabilities like repo or FX derivatives) in the $1 trillion area - that’s 20% of GDP and it would cover for >1.5 years (!) worth of imports.

Does this mean Japan will sell US Treasuries and European bonds?Not immediately, at least - the first step is to deploy the 135+ billion sitting in deposits at foreign Central Banks.

Bottom line: Japan is definitely vulnerable to external shocks, but its policymakers’ incentive schemes and its large amount of FX reserves could frustrate JPY and JGB shorts for quite some time.

2. Switzerland: Strong and Orthodox

Switzerland scores pretty well on the FX framework dashboard due to its healthy current account and fiscal position, but most importantly due to the very large amounts of FX reserves accumulated since 2008: a whopping 120% (!) of GDP.

The idea was to ‘‘import inflationary pressures’’ by weakening the CHF - sell CHF to buy foreign currency (assets, actually) mostly denominated in EUR and USD.The Swiss National Bank ended up with almost $1 trillion (!) in reserves, with a very interesting portfolio composition - yes, they own 25% in equities.

The SNB doesn’t embark in much repo or FX derivatives operations, so gross basically = net reserves and also they mostly own securities rather than cash at foreign Central Banks - keep the last point in mind.

Now, inflation has been picking up in Switzerland too and the SNB is a very coherent Central Bank: as their orthodox approach led them to accumulate a gigantic amount of FX reserves and even invest them in equities, the same orthodox approach will now lead them to be very credible in mechanically hiking rates until CPI falls back in line.

Most importantly, they now wish for a stronger CHF and they have all the ammunition in the world: policymakers’ credibility in tightening conditions and a gargantuan amount of FX reserves to use - and if/when they do use them, German/French/US bonds and also equities could feel the heat of these large flows.

Bottom line: the Swiss Franc is a very palatable currency to use as long leg in FX trades given its unique position - policymakers willingness and credibility in hiking ra…

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‘‘Within our mandate, the ECB is ready to do whatever it takes to preserve the EUR. And believe me, it will be enough.”

Mario Draghi, July 2012

''We will keep at it until inflation is down to 2%. And our monetary policy tightening will be enough. It will be enough to restore price stability.''

Jerome Powell, September 2022

Hi all, and welcome back to The Macro Compass!

Yesterday’s Fed meeting was exceptionally important.

But not only because the Fed hiked by 75 bps - once again, the devil is in the details.

For instance: did you notice the uncanny similarity between Powell’s parting words at the FOMC press conference and Draghi’s famous ‘‘whatever it takes’’ speech in 2012?

And did you realize that the yield curve inversion is becoming so relentless and powerful that on a day when the Fed hikes by 75 bps, $TLT actually rallies?!

After Jackson Hole, Powell and his colleagues wanted to cement a clear message we have highlighted a month ago already: Fed Pivot My A*S.

But this time the nuances in the communication, Summary of Economic Projections (SEP) and the Dot Plot coupled with the impressive cross-asset market reaction really make for an interesting set of macro developments and portfolio implications.

So, let’s get to it!

In this article, we will:

* Provide a deep dive into the Fed meeting, paying particular attention to the nuances in communication, SEP/Dot Plot and cross-asset market reactions;

* Assess the implications and provide portfolio/trade ideas for both long-only and tactical macro portfolios.

In Case You Didn’t Get It: Don’t Fight The Fed

Actually, before we jump right in.

Nowadays I am lucky enough to be often invited as a guest in TV shows, podcast and conferences - but mostly to talk about today’s market environment.This time though the guys at Pepperstone (led by my friend and host Chris Weston, who was absolutely excellent) asked me to deliver something different: a 45 minutes deep dive into my macro framework, trade/portfolio construction process and risk management approach.This unique interview is available here - for free.

Now, back to it: one of the most interesting nuances in Powell’s communication actually came very late in the press conference - basically at the very end.

With a very similar choice of words vis-à-vis Draghi in 2012, Powell said the Fed tightening ‘‘will be enough; it will be enough to restore price stability’’.If in 2012 Draghi was trying to save the EUR, today Powell is trying to save the Fed’s credibility by winning this inflation fight.

The Fed made sure to convey this message further via the Dot Plot, the SEP and during the press conference - and markets reacted in a very interesting way.

Let’s go through it.

1. The Dot Plot - No Room For Nuances Anymore

The Dot Plot has a very poor track record in predicting exactly what the Fed will end up doing, and FOMC members themselves have been clear about it too - this is not a prediction of what they will end up doing, but rather a guidance based on today’s set of information.

Well, the change in ‘‘guidance’’ since June is very eloquent.

Based on today’s set of data and information, 12 out of 19 FOMC members expect Fed Funds to have to set between 4.50% and 5.00% (!) by December 2023.Let me translate: much tighter for much longer - this is the new guidance.

Let me stress out something: when it comes to financial conditions, markets first care about the shock - which is best represented by the rate of change in US Dollar, interest rates, credit spreads etc.And while this is widely understood, investors often underappreciate the second dimension: after the shock, markets care about the time persistence of loose/tight financial conditions.

A highly leveraged corporate which took opportunity of the historically attractive funding window in 2021 can kick the can down the road and find shelter from the ‘‘shock’’ in financial conditions, but it can hardly escape it if the shock persists over time - and this is what the new Fed Dot Plot tends to signal.

The other interesting point was that the neutral nominal Fed Fund rate is still seen in the 2.50% area: the Fed doesn’t think we are in a structural regime change for nominal growth.

So: 200+ bps above neutral (tighter) for 15-18 months (for longer).What else did we learn?

2. Channeling The Inner Volcker?

Another subtle historical reference Powell was very keen in using was the late ‘70s inflation fight Chair Volcker had to go through.

No room for ‘‘premature relaxation’’ when restoring price stability: history teaches us that it can be a very expensive exercise - the Fed knows it’s going to cause pain to the private sector (reflected in weaker GDP and higher unemployment forecasts in their updated SEP), but it deems this solution to be preferable to the risk of unanchored inflation expectations as elevated CPI persists over time.

This chart straight from the Volcker era is very telling.

Soon after Volcker became Chair, month-on-month core inflation was almost 1.5% (!) and the Fed’s response was swift: to deal with it, Fed Funds were pushed as high as 17%. But as soon as inflation slowed down, rates were swiftly cut (first red circle).This expensive mistake was repeated a couple of times and it ended up taking as long as 3-4 years to finally get inflation back to more acceptable (yet still high) levels.

Powell is well aware of this, and he doesn’t want to fall into the same trap.

To get there, he told us very clearly that real Fed Funds rates must be positive (well above estimates of r*, hence in the 1% area) for a convincingly long period of time.

Markets are taking him seriously: 1-year forward, 1y real Fed Funds rates have been pushed up to…1% indeed.

We know the Fed has a very strong influence on the front-end of the bond market.The real question is: how are other asset classes reacting?

3. It’s Getting Real

Think about this: in a day when the Fed hikes 75 bps and comes up with clear references to Volcker and a super aggressive Dot Plot…$TLT rallies?!

To understand this, allow me to propose a theoretical exercise that ignores term premium and some other technicalities: please think of 30-year rates as a strip of all the future 1-month Fed Fund rates for the next 30 years. Done?

The first 20, 30 monthly Fed Fund data points are likely to be in the 3.50-4.50% area……but what about the other 300+ data points?!

That’s exactly what the bond market is thinking: the more the Fed tightens, the more it inflicts long-lasting damage to future nominal growth.And it’s not only a US story.

Risk assets took a hit across the board, but I’d like to point out as so far this is just a mechanical adjustment to the new level of risk-free real rates.Expected defaults (credit), earnings (equities) and risk premia in general haven’t really widened much yet.

The chart below shows how even without downgrading EPS or expecting higher risk premia (left graph), the S&P 500 should already sit in the 3650-3750 area.My proxy for equity risk premium (right chart) trades in line with its 10-year average, which is somehow contained given the current uncertain macro environment.

So, what about asset allocation and trade ideas?

Portfolio Update

Big picture first.

Forward-looking growth indicators point to further deceleration in economic activity and upcoming weakness in the labor market too.Central Banks are as committed as ever in keeping conditions tighter for longer, and they are setting policy looking in the rearview mirror (core CPI is one of the most lagging indicators for the economic cycle) which virtually ensures they’ll be compounding recessionary forces.

My Long-Term ETF portfolio is constructed to deliver better risk-adjusted return vs a 60-40 benchmark portfolio (YTD: +2% vs benchmark -17%).It remains positioned as follows:

* Long (USD) Cash

* Large Underweight in Equities and all other risk assets

* Accumulating 10y+ Bonds

I didn’t yet add to the TLT and IBGL positions on this 2-4% drawdown we experienced since I started accumulating long bonds (h…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

''The economy of imaginary wealth is being inevitably replaced by the economy of real and hard assets''.

Vladimir Putin, September 2022

Hi all, and welcome back to The Macro Compass!

Last week, Vladimir Putin released a massive speech that clearly outlined his strategy to bring Europe to its knees.

For decades, Europe’s business model has been largely structured around cheap energy and input costs used to produce good-quality manufactured goods to export around the world - Germany being a prime example of such business model.

Due to globalization, ageing demographics and technological advances real output growth wasn’t necessarily spectacular and most importantly interest rates headed lower and lower over time.This led to another important development: a massive build-up in public and private sector leverage and the hyper-financialization of the West - including Europe.

Putin’s strategy is clear: take away the cheap energy inputs from the equation, and a domino of negative consequences will unfold - economic output will materially suffer, but at the same time energy-driven inflation will roar its ugly head too.That means that both the real economy and financial markets get squeezed hard: consumers and corporates suffer from negative real wage growth and much weaker profitability, while the highly leveraged ‘‘imaginary wealth’’ economy gets hit by the ECB being forced to tighten financial conditions.

The main question is: will this strategy work, and how will Europe respond?

In this article, we will:

* Explore Putin’s strategy in more details: how did Europe get here, and how much leverage does Putin really have?

* Summarize the likely European policymakers’ response starting from today’s ECB decision, and conclude with portfolio implications.

Cheap Energy & Imaginary Wealth

''The economy of imaginary wealth is being inevitably replaced by the economy of real and hard assets''.

This single sentence summarizes Putin’s entire strategy designed to try and bring Europe to its knees.

It consists of 3 main points: let’s walk through them.

1. Cheap Energy, Competitive Production, Strong Exports

Once you can get your hands around cheap input costs, manufacture good quality stuff and export it to countries around the world - well, you are looking good.

Germany is the European poster child using this economic model, but many other countries around the world (e.g. Korea) have flourished in the 2000s by relying on it.

The key question is: how important is the ‘‘cheap energy’’ component?Or in other words: how big is Russia’s economic leverage were they to drastically change this parameter in the equation?

Zoltan Poszar from Credit Suisse calculates that roughly EUR 1.9 trillion of German manufacturing output (red circle in the middle of the chart) relies on only EUR 27 billion equivalent of Russian energy inputs (bottom-left red circle).

That’s quite some embedded leverage.

And what happens to a highly-leveraged environment when the cost or the availability of this leverage (Russian energy in this case) drastically changes?

The system becomes unstable, and because of the embedded leverage the negative reactions are not linear but rather convex.

The chart of the momentum in the German current account balance speaks loud.

Clearly, this strategy aggressively damages Russia too: energy sales to Europe represent a large portion of Russian income, and the second round effect of effectively cutting ties with one of your biggest trading partners are very negative for your domestic economy.

But Putin is planning to go after another important source of leverage, too.

2. Leverage Here, Leverage There, Leverage Everywhere

Putin referred to the ‘‘economy of imaginary wealth’’.

He is talking about the enormous wealth generated through the combination of credit creation and low (real) interest rates Europe has experienced over the last 20 years.

An example?

Extend more mortgages at lower and lower borrowing rates and even if salaries are unchanged, people will be able to ‘‘afford’’ more expensive houses.

Think about it this way: the very same EUR 2k monthly mortgage installment only buys you a house worth EUR 350k at 4% mortgage rates, but if you borrow at 1% you can suddenly ‘‘afford’’ a EUR 500k home - you can quickly become ‘‘wealthier’’ even though your salary or ability to generate long-term cash flows hasn’t changed!

The most common misconception here is that only certain European countries make excessive use of debt.

That’s misleading.

Summing private and public debt, all major European jurisdictions easily exceed 200% of GDP and leading the pack you find France and The Netherlands - not Italy.

And this doesn’t even account for contingent liabilities: those are government guarantees or liabilities of public corporations which aren’t considered in official debt calculations - Germany’s contingent liabilities exceed 100% of GDP (!).

This aggressive credit creation coupled with lower borrowing costs has generated a large amount of financial asset gains - what Putin refers to as ‘‘imaginary wealth’’.

How does he plan to go after this additional source of leverage?

Easy: higher energy costs generate higher inflation, hence forcing the ECB to raise borrowing costs and apply tighter financial conditions - and again what happens in a highly-leveraged environment when the cost or the availability of this leverage (borrowing rates, in this case) drastically changes?

Yep, you get it :)

3. The Release Valves

Now, of course you can’t expect European policymakers to sit back and do nothing.

But do what?

To answer this question, you need to think of this saga like an Emerging Market external shock: EMs business models often depend on certain external inputs to function - a regular flow of USDs, supply of certain goods etc.

Once this input chain is subject to a sharp exogenous shock, the business model breaks and policymakers are faced with challenging short-term decisions that often lead to suboptimal outcomes.

This type of pressure always finds its way to a release valve.

Let’s see where Europe stands: the short-term options are the following.

1) Tighten things up and go through some pain: don’t use government balance sheets (don’t print EUR) to rescue the private sector and convincingly increase real rates (strong ECB hiking cycle) to protect your currency

Release valve: economic growth, highly leveraged sectors and peripheral debt.

The chart below shows an appetizer of what could happen: European high-yield borrowing rates have already doubled (8% now) from their 2014-2021 average (4%) as a result of the foreseen ECB hiking cycle and widening credit spreads.

2) Try to shield the private sector: offset losses by using the government balance sheet (print EUR) while somehow (?!) retain credibility on the inflation-fight front.

Release valve = the currency.

In an EM-like external shock, unfortunately there is no optimal short-term response strategy.

The latest UK and European policymakers’ announcements and today’s ECB meeting clearly signal politicians are going for the second option.

Why, and what does it imply?

The European Policymakers’ Response & Portfolio Implications

Today’s most important ECB announcement was not the 75 bps hike.

Instead, it was the sneaky wink to European excess liquidity and the banking sector.

In 2020-2021, European banks borrowed more than EUR 2 trillion from the ECB via the so-called TLTRO operations.The borrowing conditions were extremely advantageous with interest rates as low as -1% for the Jun20-Jun22 period and after that equivalent to the average ECB deposit rate throughout the lifetime of the TLTRO operation.

Please notice: that’s the average between -50 bps (ECB depo until Jun22) and the new prevailing ECB depo from now onwards.

Now, there are roughly 2 more years to go before these TLTRO loans mature but banks could in principle opt to repay early - hence reducing the ECB balance sheet.

Today, the ECB gave a nice incentive to banks NOT to repay these loans though:

* The funding costs are low:…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘If you can’t stand the heat, get out of the kitchen’’

US President Harry Truman, 1942

Hi all, and welcome back on The Macro Compass!

Global markets are at important crossroads.

Central Bankers around the world are showing an ever increasing commitment to fight inflation: Powell’s speech at Jackson Hole is being fully digested by bond markets, and the upside surprise in European core inflation has sparked a debate about a 75 bps hike by the ECB (!) and resulted in inverted European yield curves too.

At the same time, we are getting more evidence of cooling economic activity and geopolitical developments keep complicating the picture - China has just locked Chengdu (21 million people) down, hence further pressuring supply chains and hitting global demand.

The heat in the kitchen is increasing fast: can markets stand it?

In this article, we will:

* Deep dive into the important European and US fixed income markets reaction to the latest macro developments;

* Summarize implications for the bond and the stock market, and reflect on portfolio allocations going forward.

Bond Markets at Important Crossroads

Understanding what the bond market is pricing across its many dimensions is not useful because it tells us what’s going to happen - actually, its predictive abilities aren’t always great.Exactly one year ago, fixed income markets were expecting the Fed to hike by 25 bps in 2022 - instead, only 8 months in the Fed has already delivered 225 bps worth of hikes and another 100+ bps are highly likely.

It’s instead a very useful exercise because the bond market is the biggest and most liquid building block of the ‘‘global markets pyramid’’, and as such fully grasping its multi-dimensional signals is crucial to understand where consensus lies.What matters for portfolio returns is not our absolute macro and market views, but how and why those differ relative to market-implied consensus.

So, let’s dive into the European and US fixed income markets: 7 charts in total, and market implications for the bond and stock market after.

1. Will The ECB Really Dare To Hammer Inflation Down?

The drivers behind the European and US inflationary pressures are not exactly the same - several recent studies (one example here) attribute only 15-20% of the pickup in European inflation to pressures coming from aggregate demand.Energy and supply bottlenecks are responsible for most of the EU CPI increases.

So, should the ECB follow the ‘‘hammer inflation down, wherever it comes from’’ strategy and aggressively hike rates?

The key word here is should.With the momentum of European core services CPI at the highest level in 25+ years, the time for nuances at the ECB is over - regaining credibility is all that matters.

Yes: the drivers behind the strong inflationary pressures have been mostly supply and energy driven so far. But as inflation is broadening towards core services and the momentum isn’t slowing down, it’s not about what the ECB should do.

It’s about what the ECB has to do.

European fixed income markets are getting the memo, and real yields offer undisputable evidence that’s the case.

Before the Great Financial Crisis (orange box), risk-free European real yields consistently traded in positive territory - low levels of debt, decent demographics, no evident signs (yet) of capital misallocation etc.But after the GFC and the European debt crisis (green box), EU real yields found a new equilibrium in negative territory and traded between 0% and -2%.

Now, for the first time in almost a decade EU long-term risk-free real yields are back in positive territory: markets understand the ECB has to set tighter monetary policy.

That’s a massive change of scenery for over-indebted, low-quality balance sheet European borrowers which have enjoyed very friendly real borrowing costs for years.The party is over.

Another striking evidence of bond markets appreciating the forced ECB reaction function lies in the slope of the EUR OIS swap curve.As a reminder, the Overnight Index Swap (OIS) solely reflects market-implied expectations for the future path of the overnight Central Bank rate.

Well, the 5s30s EUR OIS swap curve just inverted for the first time since 2008.

As the ECB hikes to the priced-in terminal rate of 2%, markets expect this will somehow compound downside pressures on economic growth and hence start reflecting that via an inverted yield curve.I believe this trend will intensify.

Finally, a word on Italy.Elections are looming and BTP/Bund spreads are trading in the 230 bps area.

As the right-wing coalition could secure the majority in Parliament, a niche corner of the fixed income market (CDS spreads) is getting a bit more concerned about Italian Lira redenomination risks.

The chart below shows the delta between the old and new Italy CDS contracts: they both hedge against an Italian government default, but only the 2014 version also protects against redenomination risk while the 2003 doesn’t as that risk wasn’t considered material when the Euro was introduced.

A 85 bps delta between the 2014 and 2003 Italian CDS contracts is not negligible, and for good reasons: the potential new PM Giorgia Meloni has taken a loud anti-European stance throughout her political career, and the recent ‘‘softening’’ of this stance seems more like a temporary political maneuver than anything else.

Let’s have a look at the US bond markets now.

2. Ok JPOW, We Kinda Get It Now

Powell will be pleased with the US bond market behavior we have observed since his Jackson Hole speech, and let’s see why.

First of all: US real yields now trade in positive territory across the curve, which is something Fed members have clearly expressed preference for in recent months.

This is important because it means markets are understanding and transmitting a tighter Fed stance to real economy borrowers: getting credit and leverage is not cheap anymore in real terms, regardless of the tenor.If you can’t stand the heat, get out of the kitchen.

Something else the Fed was very keen on is conveying the message that the hurdle to cut rates in 2023 is very, very high.

But here, markets are much more reluctant to fully price this in as a base case: 5 quarters (to December 2023) of challenging economic conditions are quite a long time to go, and while the Fed’s control on the very short end of the yield curve is significant…5 quarters isn’t a very short time in this macro cycle.

The market-implied probability of 4% (or higher) Fed Funds by December 2023 moved back to 32% but it’s not yet the market's base case.

But the most important macro question to answer right now remains this.Let’s assume bond markets are right: over the next 18 months, US inflation will move down to 3% (orange) and Fed Funds will be in the 3.5% area (blue).

Will the Fed be ok with a new regime of inflation in the 3%+ area?

I really don’t think so: the first step to regain credibility is to achieve your targets, not to move the goalpost at your convenience.

In Short

European bond markets understand the ECB has no room for nuances anymore: they have to intervene and regain credibility on their price stability mandate.This will increase real yields and widen credit spreads much beyond what over-indebted European borrowers can afford, especially as the economy keeps weakening.

US bond markets have gotten the Jackson Hole memo, and they are now almost fully pricing in the Fed’s preferred monetary policy transmission mechanism: positive real yields across the curve, and (almost) no cuts throughout 2023.From here onwards, as the Fed basically pins front-end bond yields economic data will drive the long-end and the shape of the curve.

Let’s now quickly sum up what this means for portfolios and asset allocations.

Markets & Portfolio Implications

Forward-looking macro indicators and global credit impulse sinking while Central Banks are forced to aggressively tighten monetary policy and send real yields higher to regain credibility on the price stability mandate.This is the most challenging environment for investors across …

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘We will keep at it until we are confident the job (i.e. killing inflation) is done.’’

Jerome Powell, Jackson Hole speech

Hi all, and welcome back on The Macro Compass!

Economic data continues to disappoint with some pretty impressive downside surprises in leading, interest-rate sensitive sectors like housing.

QT is about to accelerate and the friendly dynamics behind the Fed balance sheet composition which helped risk assets stage a comeback rally in July are likely to fade away in Q4.

Nevertheless, we just heard Powell deliver a very decisive speech in Jackson Hole where he stressed out that the Fed won’t be making another mistake: after underestimating inflation in 2021 and delaying the tightening cycle, they will not prematurely stop now.On the other hand, they will keep at it until they are confident the job is done.

And getting the job done will come at a great cost for the economy and markets.

In this article, we will:

* Discuss recent economic data, the impact QT is likely to have from now onwards and how the markets are responding to this very interesting set of macro and monetary policy variables;

* Summarize implications for long-term and tactical portfolio allocations.

Don’t Fight The Fed

Actually, before we jump right in.

As you know I am a supporter of rule-based investing and risk management practices, as they are proven to reduce our innate bias towards emotional decision making.Very often though this approach requires quantitative skills and complicated coding infrastructure which makes popular and successful strategies (e.g. momentum, minimum volatility, risk parity, inflation hedge etc) accessible only to sophisticated investors.The guys at Composer are doing a very good job in democratizing this rule-based investment approach: they empower you to build and backtest your own strategy (at no cost!) and of course to also directly invest in these systematic strategies that minimize emotional decision making.I definitely recommend checking them out - here is the link.

Now, back to it: let’s look at the latest set of economic data, the dynamics affecting the Fed balance sheet and how markets are interpreting Powell’s Jackson Hole speech.

1. Housing IS The Business Cycle, And It Doesn’t Look Good

Housing activity is slowing down very fast, and it matters.

If we also consider the second round spending/activity around the housing market, it accounts for almost 20% of GDP in many countries and its highly leveraged, interest-rate sensitive nature makes it prone to move first when financial conditions and economic cycles are changing - this is why housing is so crucial to the business cycle.

The chart below shows the US NAHB Housing Index (orange, inverted on the LHS) against the Unemployment Rate (blue, on the RHS).Big changes in the National Association of Home Builders Index lead turns in unemployment rate by roughly 12 months - with the notable exception being the 2020 pandemic where the global economy was shut down so fast that the housing market couldn't lead the process.

With the momentum of US home sales slowing faster than in 2007 (!) due to the terrible affordability of real estate at the moment, the NAHB index just lost 30+ points.Historically, such a drop precedes a 3% jump in Unemployment Rate.If the correlation would hold, that implies US Unemployment Rate above 6% in 2023.

Soft landing, you said? :)

Aside from housing, also other leading economic indicators keep deteriorating.

The US Conference Board ranks the top 10 economic leading indicators and wraps them in a very convenient diffusion index depicted in the chart below.

Every time the index prints two or more times below 0, we are already in a full recession - you know, not only a technical one but one that also leads to protracted weakness in the labor market.Once this criteria was met, the index correctly forecasted 5/5 recessions since the ‘80s.

The recent trend is clear and the last print was 0: let’s monitor what happens next.

In short: tighter monetary and financial conditions take a few months to be fully reflect in leading indicators, and a few quarters to affect hard coincident indicators like the labor market and real consumer spending.It seems we are getting there, and the path after that doesn’t look great either.

2. Central Banks’ Balance Sheets DO Matter For Markets

Have we forgotten about QT?

As I explained in this primer, QT matters for markets as it generally reduces the amount of interbank liquidity (bank reserves) while adding net collateral (bonds) the private sector needs to absorb at the same time - this has major implication for repo rates and risk taking, more in the article above.

But over the past few weeks a very interesting phenomenon occurred: despite ongoing QT, bank reserves actually grew (!).What the heck?

When the asset side of the Fed balance sheet shrinks (QT), liabilities must shrink too: but bank reserves aren’t the only liability there - the Treasury General Account (TGA) and Reverse Repos (RRP) are also Fed liabilities.

After a very strong tax season in April, the TGA (green) almost hit $1 trillion.The US government just took some of that TGA money from the Fed accounts and spent it in the real economy - as they did that and the RRP outstanding was virtually unchanged, it was the drop in TGA which took the hit for QT rather than bank reserves (red).

This supported risk assets on the margin, but this trend isn’t likely to continue in Q4.As the TGA is almost down to standard levels and money stuck in the Reverse Repo facility likely struggles to get out given the absence of T-Bills issuance, bank reserves are going to bear the brunt - and when they do, risk assets tend to suffer and the yield curve flattens further.

That's because while Central Banks can greatly affect front-end yields, long-end yields are mostly driven by expectations about future growth and inflation.QE helps boosting those expectations, while QT kills them and hence flatter curves.

In short: Central Bank balance sheet dynamics matter for markets, and as QT accelerates and bank reserves bear the brunt of it in Q4 => ceteris paribus risk assets tend to suffer and yield curves flatten further.

3. Markets Are Taking Powell’s Jackson Hole Speech Seriously

Powell’s Jackson Hole speech was unambiguous: short, direct, crystal clear.The Fed won’t make the mistake of stopping too early or allowing financial conditions to unnecessarily ease before the job is done.

In other words: Fed pivot my a*s.

In the past, the Fed never stopped hiking before real Fed Funds (nominal Fed Funds minus YoY PCE) turned positive and this time won’t be different - actually they might want to tighten the screws further given the dangerous inflationary pressures.

Hence, the real battlefield for markets lies in pricing the path of Fed Funds and inflation in 2023 and 2024 - this is how it looks like today.

Bond markets smell a sharp economic slowdown and hence have a strong opinion inflation will quickly decelerate to 3%.Given the Fed’s clear message they will ‘‘keep at it until the job is done’’, they are pricing Fed Funds in the 3.4% area by Q423 - Q124.

The medium term important implication of Powell’s Jackson Hole speech lies in its unambiguous commitment to kill inflation even if it means a ‘‘sustained period of below-trend growth and softness in the labor market as these are the unfortunate costs of reducing inflation’’.

He is telling you to prepare for sluggish long-term growth and inflation expectations while financial conditions will have to remain tight despite that.

This is relevant for long-term and tactical asset allocation.

Markets & Portfolio Implications

It’s time to be defensive: over the next 6-12 months, long-end bonds should deliver a much better performance than (especially cyclical) equities.

My main tilts in the Long-Term ETF Portfolio are unchanged: underweight equities, overweight cash, and accumulating long-end EUR and USD bonds.

After the crazy ‘‘Fed will pivot hence let’s leverage up again and buy…

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Global macro and markets are a gigantic puzzle that will always fascinate investors and lure most to believe that in the end we can put all the pieces in the right place and find the Holy Grail of Investing.
The reality is different: we will always miss some pieces, and we will often be wrong.

The common trait of the best investors and hedge fund managers I can call friends is not having a macro crystal ball, but embracing and living by this simple principle: maximizing the odds (and not the ephemeral feeling of infallibility) of achieving good returns while taking predictable amounts of risk.

This is generally achieved via a combination of solid macro skills and by mastering the art of portfolio/trade construction.

In this article, we will:

Discuss the foundations of how to maximize your odds of success in both strategic asset allocation and tactical trade construction;

Look at how some trades sitting in my long-term and tactical portfolios try to reflect these principles given the current macro and market backdrop.

How To Maximize The Odds

As we know we will be wrong plenty of times: so how do we structure portfolios to be able to manage risks around these inevitable bumps?

There are at least 3 things we need to care about during portfolio/trade construction to maximize our odds of success in this highly unpredictable game called investing.

1. Build unbiased & data-driven macro models (and don’t blindly trust them…)

Let’s start by postulating that global macro and markets are not a 0-1 binary environment but rather resemble a probabilistic setup with multiple potential outcomes whose odds of materializing vary across time.
Every investor has its own subjective probabilistic macro setup that must be weighted against market consensus.

My approach to generate one is to craft unbiased, data-driven macro models…and after all the hard work, to not blindly rely on them for investment decisions.

For instance, The Macro Compass models use forward-looking macro indicators (e.g. G5 Credit Impulse, and many more) and a prop gauge of the monetary policy stance against neutral (e.g. real rates vs r*, liquidity proxies and others) to grasp the subjective base case macro environment we currently sit in.
This is how it looks like today.

My model-driven assessment is that the current base case macro environment is a Quadrant 4 setup: economic growth is poised to decelerate further while Central Banks are likely to keep monetary policy and liquidity tighter than equilibrium levels.

This has historically been a very poor setup for risk-adjusted real returns across asset classes.

And yet, I am overweight long-end bonds in my structural long-term portfolio and I am not indiscriminately max short everything in my tactical book: why?
Because to maximize our odds we can’t build portfolios solely relying on our own subjective assessment - we need to consider at least 2 more things.

2. Find your opponent’s (i.e. the market’s) weak spots

Many investors forget this is a relative, not an absolute exercise.
Your aim should be to find the best risk/reward setups in the relative discrepancies in cross-asset valuations between what your assessment suggests and what markets are discounting.

For instance: if your subjective assessment suggests there is a high probability the Fed will have to cut rates to 0% and the market is already discounting the very same probabilistic setup, you wouldn’t be maximizing your odds by adding that trade to your book.

For a strategic, long-term investor this relative assessment can be performed by looking at valuations and probability distributions.

On June 23rd, I bought 10y+ European and US Treasury bonds (see here) for my structural portfolio even though The Macro Compass model would not suggest the best possible setup for this investment yet: why?

Because as the chart above shows, markets were pricing the ECB to remain in restrictive territory (above my estimate of neutral rate) for more than a decade to come although the economy is already weakening very hard: even accounting for an error band in my estimate of EUR neutral rate, this very large discrepancy was hard to ignore.

Another way to think about this is to look at probability distributions: if you are able to identify an overly distorted one and anticipate how/when markets are going to normalize it, you have an edge.

The picture above shows the premium and payoff of a CADJPY 1-year digital option.
Don’t worry, it’s really simple - bear with me.

The option requires you to pay CAD 80k upfront to get a final payoff worth CAD 1 million if CADJPY drops 20% or more and hence trades at or below 80.526 (spot = 104.77) in 1 year from now or otherwise you’ll lose your premium.
The strike has been chosen to be 20% out of the money as this roughly compares with a 2 standard deviation move in one year - a theoretical 5% probability.
Given that you pay CAD 80k upfront and your final potential payoff is worth CAD 1 million, this means markets are pricing in a 8% probability instead.
Using digital options, you can derive market-implied probability distributions for almost any asset class you want and constantly compare it with your own subjective assessment: cool, right?
P.S. We are working to develop a tool that will interactively allow you to do just that!

Now the question is: what’s your subjective probability?
Mine is in the 20% area - hence I shorted CADJPY (and AUDJPY for similar reasons).

And here is why.

The Canadian private sector is more indebted than the Japanese one at the peak of the real estate bubble in the ‘90s - when the Imperial Palace was ‘‘worth’’ more than the State of California.
At the same time, the Bank of Canada is forced to tighten monetary policy way above neutral levels to tame inflation and hence it will compound the pain for a highly leveraged economy - there are already signs of a slowdown in the housing market.
On the other hand, as global economies slow down and yield differentials decline I expect money to flow marginally towards safe-haven and stable currencies like JPY.
While I don’t know whether CADJPY will trade 20% lower in one year, I expect markets to adjust their probability distribution my way going forward.

3. Remember: correlations aren’t stable and internals matter

The true Holy Grail of Investing is return-additive, yet poorly correlated assets to add to your portfolio - but there is one problem: correlations aren’t always stable.

The chart above proves the point: the 90-days rolling correlation of SPX and TLT returns over the last 20 years was mostly negative, with the most observed correlation being a healthy -0.52.
Nevertheless, this correlation can quickly become unstable: recently it has turned positive in two instances already as Central Banks won’t be able to ease policy during market drawdowns because of high and persistent inflation.

Studying how cross-asset correlations behave during different market regimes is very important to limit drawdowns - and also here, we are working on interactive tools for you to be able to do just that!

Finally, if you are running a more tactical portfolio you have a keen interest in comparing the recent volatility-adjusted moves across asset class against their theoretical expected behavior in the macro regime you have identified.

Last month, the sectors of the stock market which delivered solid volatility-adjusted returns were US Industrials and Retail stocks and certain EM countries like Turkey.
Against that, the laggards were Staples and Healthcare.

Does this fit in your macro picture?
If not, why? And is there a good risk/reward tactical opportunity?

Observing the recent vol-adjusted behavior of stock market internals and asset classes in general can be a very helpful tool for portfolio/trade construction.

Conclusions

Mastering the Art of Macro Portfolio Construction requires you to live by the principle for which the true wisdom is knowing that you don’t know - global macro investing is a giant puzzle filled with uncertainty.

To maximize the odds of success, there are at least three things you can do:

Build unbiased & data-driven macro models (and don’t blindly trust them…)

Find your opponent’s (the market’s) weak spots

Remember that correlations aren’t stable and internals/cross-asset moves matter

Embracing our data-driven models and trying to reflect the principles above, this is how our Long-Term ETF Portfolio remains positioned today:

A good chunk of (USD) Cash

Low exposure to risk-assets (preference for high-quality growth names and non-cyclical, low-beta industries: good tech, utilities, healthcare)

Higher than usual exposure to 10y+ Government Bonds

And this is how Tactical Portfolio is positioned (updates posted here and here: as always, maximum transparency).

And this was all for today, thanks for reading!

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The content provided on The Macro Compass newsletter is for general information purposes only. No information, materials, services, and other content provided in this post constitute solicitation, recommendation, endorsement or any financial, investment, or other advice. Seek independent professional consultation in the form of legal, financial, and fiscal advice before making any investment decision. Always perform your own due diligence.

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com