The Macro Compass

A ‘‘very strong’’ labor market report coupled with the first preliminary signs of inflation slowing down have brought back 2021-like euphoria in risk assets: junk credit spreads are tightening fast, meme stocks are going through the roof and even Turkey (!) is now priced as a much safer investment despite front-end real interest rates as low as -60%.

In the investment world, when markets are behaving as if the economy is delivering decent growth and inflation is predictably low we call that ‘‘Goldilocks’’ - as in the story of Goldilocks and The Three Bears, markets are not hot or cold but just right.

There is one problem: the Goldilocks or Soft Landing market interpretation seems very misplaced at this stage.

In this article, we will:

Discuss the latest CPI and labor market reports, and show how they do not necessarily imply high odds of a Soft Landing;

Look at the behavior of different asset classes and discuss implications for long-term and tactical portfolio allocations.

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

‘‘Almost every financial blow up is because of excessive leverage.’’

Seth Klarman - Hedge Fund Manager

Hi all, and welcome back on The Macro Compass!

I find August to be a great month to focus on the big picture and thoroughly enjoy the never-ending learning journey in global macro - no Central Bank meetings, (often) quiet markets and perhaps a bit of well-deserved relax.

Hence it seems like the perfect time to revive our Bond Market 101 Series with an educational piece on the most important market in the world: the Repo Market.

It’s a very relevant corner of the fixed income market which is often overlooked but given its role in underpinning the smooth functioning of government bond markets and the broad range of different players involved, its importance can’t be overstated.

In this article, we will:

* Unpack the repo market, including its different players and how/why they use repo and reverse repo;

* Explore previous stress episodes and relate them to today’s pricing and structure of the repo market: how likely again?

The Repo Market Explained

Before we start, a big ‘‘thank you!’’ to this wonderful community which keeps growing at a very rapid pace - we are now the biggest Finance newsletter on Substack: wow!

Delivering free educational material is a key objective of The Macro Compass - and as this is an article of my Bond Market 101 Series, for those who are not familiar yet that is my best effort at demystifying the bond market and providing you with the tools to analyze such an important and yet very deceptive market.

In case you want to explore it further, here are my previous pieces of the Bond Market 101 Series:- Helicopter View of The Bond Market- Real Yields and Inflation Expectations- The Yield Curve- Credit Spreads

Now, back to it: let’s explore the Repo Market.

A repurchase agreement (repo) is nothing else than a form of collateralized loan, where the cash borrower posts collateral (i.e. a security, for instance a bond) against its loan but he also agrees to repurchase the security back at the end of the agreement.The collateral “posted” by the cash borrower is basically a form of protection for the cash lender in the event that the borrower becomes insolvent - hence, repo is a secured or collateralized form of lending.The biggest repo markets in the world use bonds as collateral.Also worth noticing that the cash lender who receives the security as collateral can further redeploy that security in other repo transactions (!).

Essentially, we are looking at a low-risk (collateralized) financing mechanism underpinning the largest and most liquid markets in the world (bonds) with a built-in feature to enhance leverage and redeploy the same security over and over again as collateral (re-pledging).

I guess you can already understand how systematically important is the Repo Market.

Two important things to notice before we dig deeper.

* The global repo market is huge, with an estimated size of $15 trillion and a turnover of $3-4 trillion worth of repo transactions per day!

* Repo transactions require a cash borrower (security-rich agent) and a cash lender to interact. Notice how the balance sheet expands for the cash borrower.

Ok, but now: who are the players involved and what’s their incentive scheme?

A) Commercial banks: low-risk solution to monetize their liquid assets.

Since after the Great Financial Crisis, regulators have forced commercial banks to own very large amount of liquid assets (e.g. HQLA = mostly bonds). As natural buyers of these securities, commercial banks often engage in the repo market as a cash borrower (lends securities, receives cash) to monetize some of their liquid assets.

B) Insurers, pension funds, MMF and corporates: deploying cash in a safer way.

These large institutional investors do not have accounts at their domestic Central Bank. This means their ‘‘cash’’ is nothing else than an unsecured bank deposit at a commercial bank - very little reward, quite some risk.Participating in the repo market as cash lenders (reverse repo: lends cash, receives securities) allows them to deploy cash in a secured, collateralized way.

C) Hedge funds and dealers: exploit market opportunities via leverage and provide liquidity through financing large inventories.

Due to their high-quality and low-volatility, using bonds as collateral in repo transactions requires small haircuts and initial margins: a convenient way for hedge funds to amplify leverage when arbitraging away small pricing inconsistencies in bond markets (little capital required to magnify the size of your trade).For dealers, repos are important to finance large bond inventories required to accommodate flows and provide secondary market liquidity for their clients.Given their tactical and opportunistic nature, hedge funds and dealers are often both cash lenders and borrowers in the repo market.

In short: the repo market is a gigantic machine underpinning the most liquid asset class in the world, and able to unlock leverage and investment opportunities for a bunch of crucial players in the bond market arena.

How should you think of repo rates and episode of repo market stress, then?

Let’s have a look at it together.

P.S. I know this is a relatively complex topic; feel free to leave a comment and/or ask questions below - I’ll try to answer them all!

It’s All About Demand And Supply

Postulate: repo rates on Treasuries should be very close to the most risk-free rate available in the market.

Why?Because absent large balance sheet constraints or liquidity shocks, a Treasury repo is nothing else than a short-term fully securitized loan using the most risk-free and liquid asset in the world as collateral.And indeed, here is a chart showing how in normal times (e.g. today) repo rates (orange) trade very close to Fed Funds rates (blue).

This implies the repo market is functioning smoothly: the demand and supply of cash and securities in the market results in reasonable and realistic repo rates.

Curious to see an example of ‘‘distorted’’ repo rates?Look no further than Europe (in particular: Germany).

As a result of a long-lasting imbalance between supply (very limited) of good, AAA-rated and liquid collateral issued by the German government and the demand (big) for it, here is how the situation looks like today:

German repo rates are still below the ECB deposit rate, and in 2016/2017 we reached quite some impressive levels - the chart above shows repo rates for an average German bond, but certain ‘‘special’’ bonds traded 70/100 bps through the ECB depo!

As Germany wasn’t keen in issuing large amount of bonds but a huge QE program was ongoing, the financial sector was starved of good German collateral while flushed with bank reserves (cash for banks) at the same time.As banks had already abundant reserves and engaging in repo would further lengthen their balance sheet while all other participants were looking to lend cash and get good collateral in exchange (reverse repo), the marginal repo rate at which this transaction could occur had to dramatically change - it’s all about supply and demand, after all.

A similar (but opposite) dynamic was also one of the reasons behind the famous 2019 US repo market stress episode: as QT was forcing banks to absorb more collateral while draining their bank reserves (liquidity for banks) away, their willingness to engage in repo market transactions rapidly dwindled exactly at the point when hedge funds’ leverage had dramatically increased and required more - not less - repo funding.Mayhem in repo markets.

Regulation plays an important role, too: as you probably noted before, engaging in a repo transactions extends your balance sheet.Balance sheet constraints can impact the incentives to undertake repo intermediation, which is typically a low-risk but also a low-margin activity and this means a greater balance 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

‘‘We are now at levels broadly in line with our estimates of neutral interest rates, and after front-loading our hiking cycle until now we will be much more data dependent going forward.’’

Jerome Powell, July 2022 FOMC press conference

Hi all, and welcome back on The Macro Compass!

Despite admitting that economic growth is clearly slowing down, the Fed just hiked by another 75 basis points and reiterated the path of least resistance from here is well represented by the Dot Plot: more hikes ahead - all the way to Fed Funds at 3.75%!

And yet, markets have staged a humongous rally led by the most valuation intensive and risk sentiment driven asset classes: Nasdaq and Crypto.

So, what the heck?!

It all boils down to how one single sentence Powell pronounced was able to affect the probability distributions investors were projecting for different asset classes.Does it sound complicated? Bear with me: it’s not!

In this article, we will:

* Break down the FOMC meeting, and in particular discuss why that ‘‘one single sentence’’ spurred such a crazy rally;

* Assess where this leaves us now: is the music changing?

Why Such a Humongous Rally?

When the FOMC meeting press release was out, it all looked like business as usual: a well telegraphed 75 bps hike with the only small surprise represented by an unanimous vote (George did not dissent) despite a clear acknowledgment that economic growth is softening.

But not even 15 minutes into the press conference, the fireworks went off!And particularly when Powell said:‘‘We are now at levels broadly in line with our estimates of neutral interest rates, and after front-loading our hiking cycle until now we will be much more data dependent going forward’’.

This is very important for several reasons.

The neutral rate is the prevailing rate at which the economy delivers its potential GDP growth rate - without overheating or excessively cooling down.With this 75 bps hike, Powell told us the Fed just reached its estimate of neutral rate and hence from here they aren't contributing to economic overheating anymore.But that also means any hikes from here are going to put the Fed in an actively restrictive territory.

And the bond market knows that every time the Fed became restrictive in the past, they ended up breaking something.

Until yesterday, you could be completely sure the Fed would have just pressed on the accelerator - inflation must come down: no space for nuances.

So journalists went on and asked questions to find out something more about the ‘‘new’’ forward guidance. It went roughly like this:

Journalist: ‘‘Mr. Powell, the bond market is pricing you to cut rates starting in early 2023 already: what are your comments?’’Powell: ‘‘Hard to predict rates 6 months from now. We will be fully data dependent’’

Journalist: ‘‘Mr. Powell, due to the recent bond and equity market rally financial conditions have eased quite a lot: what’s your take?’’Powell: ‘‘The appropriate level of financial conditions will be reflected in the economy with a lag and it’s hard to predict. We will be fully data dependent’’

He did it.He totally ditched forward guidance.

And what happens when you do so?You give markets the green light to freely design their probability distributions across all asset classes without any anchor - and that explains the gigantic risk rally.Let’s see why.

If the Fed is so data dependent and there is basically one data they care about, it all boils down to how inflation will evolve in the near future - and the bond market has a very, very strong opinion about that.

Using CPI inflation swaps, I calculated the 1y forward, 1y inflation break-evens (CPI) in the US - basically the expected inflation between July 2023 and July 2024 which is represented in the chart above and sits at 2.9%.

Remember the Fed targets (core) PCE, which tends to historically be 30-40 bps below (core) CPI: basically, the bond markets expects inflation to slow down very aggressively and roughly hit the Fed target in the second half of 2023 already!

So if the Fed is not nearly on autopilot anymore, and markets have a strong opinion on inflation and growth collapsing then they can also price all other asset classes around this base case scenario: it starts to be more clear now, right?

This is what my Volatility Adjusted Market Dashboard (VAMD, here a short explainer) showed soon after Powell pronounced that one single sentence.

Reminder: the darker the color, the bigger the move in volatility-adjusted terms.Notice how I highlighted three movers, but let’s start from US real rates.

If the Fed isn’t gonna blindly keep hiking but be more data-dependent, contingent on their view that CPI will quickly come down traders have a green light to price a more nuanced tightening cycle and hence still restrictive real yields but less so than before.

And indeed 5y forward, 5y US real yields rallied 11 bps and hit their lowest level in over two months.

When real yields decline, valuation intensive and risk sentiment driven asset classes generally tend to outperform.

That's because the marginal inflation-adjusted return for owning cash USDs (risk-free real yields) becomes less attractive and the (real) discounting rate for long-term cash flows becomes much less punitive.Hence, the incentive to chase risk assets is larger - actually, following this narrative one could argue ‘‘the riskier the better’’.

Here is a chart showing the very tight relationship between real yields and equity market valuations.

So guess who were the two main characters of the Crazy Market Rally?The most valuation intensive and risk sentiment driven asset classes of them all: US Tech and Crypto.

But let’s now answer the real question: in this giant puzzle called global macro, are all the pieces falling into the right place to fully support this narrative?

Hold Your Crazy Horses

In short, the Crazy Market Rally was spurred by Powell ditching its forward guidance and kickstarting ‘‘full data dependency’’ season - given the bond market’s strong opinion on inflation going forward and no autopilot Fed tightening anymore on the horizon, investors went ahead and repriced all other asset classes accordingly.

If the Fed isn’t gonna blindly hike us into a recession and contingent to inflation slowing down aggressively as priced in (?), then:

* Less hikes now, less cuts later (curve steepening)

* Lower real yields (Fed won’t keep policy ultra-tight for too long)

* Multiple-intensive, risk sentiment driven asset classes can rally

So, does the new narrative pass the global macro consistency test?

Not really. Not yet.

And for two main reasons.

1. This is the most important inflation fight Central Bankers have engaged in over 35 years, and history suggests a ‘‘mildly’’ restrictive stance won’t be enough.

Slaying the inflation dragon is generally not done with baby steps, and that’s been true across different jurisdictions and historical circumstances.For instance: last time inflation was stubbornly high in France, the Central Bank had to bring nominal yields (orange) all the way to 8% and keep them there for years to slow CPI down - way above my estimate of the prevailing neutral rate (blue) at 4.5%.

Assuming the Fed will be able to engineer significantly lower inflation while already taking the foot off the gas pedal seems very optimistic.

2. Ditching forward guidance increases volatility in bond markets even further, and a volatile bond market is an enemy for risk assets.

Let’s assume the next inflation print is worse than expected in absolute terms, momentum and composition.A fully data-dependent Fed will have to consider a 100 bps hike in September: very likely to generate mayhem in markets all over again.

While ditc…

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

‘‘I've lived through enough bear markets that if you get aggressive on the short side, you can get your head ripped off in rallies.’’

Stanley Druckenmiller, June 2022

Hi all, and welcome back on The Macro Compass!

In an interview released last month, legendary investor Stanley Druckenmiller reminded everybody how bear market rallies can be a challenging experience for people comfortably sitting on the short side.Due to their fast and furious nature, they seem to be somehow designed to mine the confidence of the short side.

‘‘What if I am wrong on the big picture macro thesis?’’’’What if I find myself big times under-allocated in equities and we keep rallying?’’

Over the years running large institutional books I learnt that markets can be humbling, and that continuously challenging your own core thesis is a wise exercise to keep practicing - echo chambers are counterproductive.

Hence, in this article we will:

* Look at the current stock market rally in perspective, and try to assess whether we are looking at a bear market rally or witnessing a turning point in risk sentiment that will push equity indexes meaningfully higher;

* Refresh our portfolios accordingly.

Is The Music Changing?

Actually, before we jump right in.

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Every Sunday Andreas Steno and I interview the best worldwide macro strategists and risk takers for a discussion on their current thesis, but after we’ve unpacked their macro big picture we ask them to deliver one actionable macro investment idea!By the end of the show, Andreas and I also debate how to implement the trade (for both professional and retail investors) and whether we like the trade or not.We aim at producing a very educational and actionable macro podcast but most importantly also a show full of banter - expect plenty of jokes along the way!

After only 13 episodes, our show is already listened by over 50,000 macro enthusiasts every Sunday - if you are not amongst them yet, why not paying us a visit?(Apple podcast, Google podcast, Spotify, Blockworks YouTube channel).

Now, back to it: bear market rally or turning point?

Let’s first assess the magnitude of this rally in historical context - our friend Mr. Blonde has put together quite the dataset in his exceptional, outstanding free macro newsletter (must subscribe: link here).

Over the last 50 years, there have been 5 major and sustained bear markets which saw 40 episodes in total of 5%+ rallies from the 1-month lows.Bear market rallies, indeed.They lasted on average 3 weeks and delivered a fast and furious 7-8% return.The 8% rally we just experienced from the June 16th lows would hence be of average size, with its length (> 4 weeks) being above average - notice though most of the returns were achieved already after one single week.

Now that we know more about the size and length of this rally from a historical perspective and keeping in mind that equity market returns are mostly driven by changes in valuations and earnings growth, let’s look at what global macro indicators are telling us about its nature: bear market rally or turning point?

1. Real Rates, Valuations and Risk Premia

Changes in equity valuations are closely linked to changes in (long-end) risk-free real interest rates.

That’s because:A) Large, multi-asset investors don’t look at asset classes in a vacuum and their starting point isn’t ‘‘cash under the mattress’’ - it’s the real return of the most liquid, risk-free investment they can make: Treasuries. When that prospective return changes, the marginal appetite to buy more or less risky assets changes too.B) Stock prices are the net present value of all future (inflation-adjusted) cash flows whose value is discounted to today - change the real discounting factor, and ceteris paribus the stock price will change too.

After a very aggressive (+150 bps!) move up from the lows in Nov-2021 (-90 bps) to their highs in June (+60 bps), US 30y real yields (chart: orange, LHS) have slightly dropped and stabilized around 50 bps.As you can see, this has helped the 12-month forward S&P 500 earnings yield (chart: blue, RHS) drop from 6.1% to 5.8% - that’s the equivalent of 1 full point higher in forward P/Es from 16.4x to 17.3x and explains most of the rally seen so far.

Could real yields drop further and spur another valuation-led rally?

The Fed has been very vocal: as they want to keep conditions tight to tame inflation and they estimate the US equilibrium rate sits around 25 bps, they are keen to keep the entire US real yield curve above this level until they see meaningful progress.

Moreover, do equity valuations always blindly follow real yields?Not really: it depends on the Equity Risk Premium.

When real yields increase or drop but valuations don’t adjust accordingly, it means the perception of risk amongst investors is changing.My simplified version of the Equity Risk Premium sits into its 8-years average: equities can hardly be defined ‘‘cheap’’ given the challenging macro context.

In short: the real rates / multiple expansion side of the rally could go a bit further, but its upside is limited by both the Fed’s willingness to keep real rates into restrictive territory and the already contained Equity Risk Premium vis-à-vis challenging macro conditions.

2. The US Dollar

The US Dollar plays a pivotal role in determining whether this rally has legs to morph into a sustainable turning point for risk assets.

A stronger US Dollar as the global economy slows down hurts foreign entities which have borrowed in USD and need strong trade and economic growth to service their Dollar liabilities.

Moreover, it also affects US corporate profits.Over the last 20 years, US companies have expanded the volume of sales and corresponding profits they generate abroad: a stronger USD hurts this non-negligible source of income for American corporations.

Lower real yields in the US (even better if validated by a Fed dovish pivot) would make the US Dollar immediately less attractive against other currencies, and this would help risk assets rally further.

At this stage though, the Fed doesn’t seem ready to endorse lower real rates and a subsequently weaker US Dollar and the global de-leveraging process is keeping the USD overall quite still bid.

In short: The USD is still way too strong to provide any sustainable tailwinds to this risk asset rally as it will act as a drag on both foreign corporate profits and suppress the broad risk sentiment in markets.

3. The Yield Curve

When it comes to future economic growth and hence the prospect for earnings, the shape of the yield curve can be a very powerful guide.A steepening yield curve signals confidence towards future strong economic growth which is going to allow for sustainably higher interest rates; on the opposite, a flattening (and inverted) yield curve signals financing conditions in the foreseeable future are likely to be too tight and damage economic growth to the point Central Banks will be forced to cut rates.

Curves are inverted and flattening further in the US, but also worth looking at what the bond market is pricing the Fed to do against what the Fed told us they will do.

Some of the rally we have seen is also due to equity markets ‘‘cheering’’ on bond markets pricing 100 bps (!) worth of Fed cuts in the period between Q123 and Q124.This is the result of a probability distribution that assumes a 50%+ chance of Powell pivoting dovish essentially by year-end already - and that probability is already priced in risk assets too.

The question is: as time goes by, will Powell try to move that probability rather towards 0% or 100%?When it comes to future earnings instead, inverted yield curves are as loud as a noise can be: it’s not looking good.

In short:

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

‘‘Trust I seek and I find in you (global macro)Every day for us something new (right, J-Pow?)Open mind for a different view (always)And nothing else (except macro) matters’’

Metallica after reading The Macro Compass

Ehy guys, welcome back on The Macro Compass!Hopefully the Metallica are fine with me borrowing one of their most famous songs, but it’s really true: nothing else except macro matters here!

There were 3 important pieces of economic data released over the last week: a leading (NFIB survey), a coincident (Jobs Report) and a lagging indicator (CPI).

The picture couldn’t be any clearer:

* Inflation (lagging indicator) showing the most acceleration on the upside;

* The labor market (coincident/slightly lagging) holding on okay-sh for now;

* The NFIB survey (leading indicator) flashing red.

In this article, we will quickly cover those 3 reports and then analyze investment opportunities by breaking down each big macro asset class and answering the same question for each of them: is it time to go long, to go short or to go fishing?

The Lagging, The Coincident, The Leading

Actually, before we jump right in.

I’d like to take a second and thank you all.The Macro Compass is now a community of 70,000+ macro enthusiasts and investors, and sharing this journey with you nice people has been such a blessing.I am working on delivering even more for you: interactive tools for screening markets and sizing positions, ETF-only portfolios backed by my macro models and courses that will cover global macro, monetary mechanics and portfolio management - effectively, a Global Macro University.Expect plenty of fireworks in Q4!In the meantime: if you like TMC and you’re excited about what’s next…feel free to tell a friend or colleague!

Now, back to it: let’s quickly look at the latest piece of US economic data.

1. The CPI report: once again, the inflation momentum is accelerating and inflationary pressures are broadening.

While mainstream headlines would focus on the 9.1% YoY print, I’d like to highlight two more relevant statistics that would worry the Fed further here.

A) MoM headline and core inflation are the highest in 20+ years: the inflation momentum is not only failing to decelerate, but it’s even picking up!

B) Inflationary pressures are really broad now: roughly 75% of the components of the CPI basket have seen prices increase by more than 4% over the last 12 months. It’s not only used cars or energy prices anymore: it’s everywhere.

The Fed will be very uncomfortable with both developments, and we can’t discard a 100 bps hike in a few weeks now.But they’ll be adding fuel to the recession fire by setting their monetary policy stance based on CPI which is a lagging indicator: over the last 50 years, every sharp economic slowdown has always managed to substantially reduce inflation and commodity prices are already dropping like a stone.

But the Fed won’t take a more nuanced stance anytime soon, and who are we to fight the Fed…

2. The labor market report: holding on okay, but…

A) After accounting for negative revisions to prior NFP reports, the pace of job creation over the last 3 months is much less impressive than it would seem by reading headlines;

B) The labor force shrank (!) by 350,000+ people: the number of total employed people in the US divided by its total population in the 25-54y age bracket dropped below 80%.

Over the last 30 years, at the peak of each economic cycle this ratio was over 80%.Once we got there and some weakness started to emerge (Mar 2000, Feb 2007 and Feb 2020) the next 12-18 months weren’t particularly pretty for the global economy.

This time around we failed to even get there and we might be receiving some preliminary signals of unease in the labor market.Also, Google announced they are going to materially slow down hiring over the next 6 months - kind of a polite way to progress towards a hiring freeze?

The labor market is a coincident/slightly lagging indicator, and hence it would make sense to see some material weakness emerge over the next few months already.

3. The National Federation of Independent Businesses (NFIB) survey: bad, really bad.

The NFIB survey is a comprehensive set of questions addressed to roughly 800 US small companies across the country.

A) Small companies hold their worst future outlook on the expected volume of sales since 2009: in a high-inflation environment, it’s good to look at volumes and real numbers to avoid distorting the picture with nominal figures.

B) The diffusion index built with answers to a question addressing the outlook companies have for general business conditions ahead looks like this:

The NFIB survey is a very decent leading indicator for both economic activity and employment with a lead time of a few quarters.Ain’t looking pretty…

But now: what does this mean for each of the big macro asset class out there?

An Overview of Macro Asset Classes

Four big macro asset classes, and for each:

* Three main points

* One chart to rule them all

* A Long/Short/Fishing call with investable ideas through ETFs and futures.

Ready?

Bonds (Long 10y+)- ETF: US = TLT; Europe = MTH- Tactical/Pro: US 2s10s flattener, Schatz/BOBL flattener

* Long-end bond yields reflect expectations for future growth, inflation and a term premium to compensate owners for the interest rate risk they’re running.

* As it focuses on a lagging indicator (inflation), the Fed will be keeping a very tight stance and extend the duration and magnitude of the economic slowdown. This will compound expectations that future growth and inflation will remain low for a while, and increase the probability that such an outcome realizes.

* While short-term bond yields will be pinned close to where the Fed ‘‘commands’’ with their forward guidance, long-end bond yields will reflect what mentioned above (= yield curves to invert further).Yesterday’s rally in TLT after a 9.1% CPI tells you everything you need to know.

Equities (Short)- ETF: US = RWM, EU = BSX- Tactical/Pro: Short 2x Russell 2000, Long 1x Nasdaq

* Total returns in equities are mostly explained by changes in valuations and in earnings. As monetary policy became tighter and tighter while the economy started rolling over, valuations have taken quite a hit.

* Earnings instead are nowhere near pricing the economic slowdown predicted by my forward-looking models: way too much optimism still out there.

* Hence, I remain short cyclical indexes (Russell, EuroStoxx) that are highly dependent on strong earnings while also implementing a relative value trade (long Nasdaq, short Russell) to capture some relative tailwinds tech stocks might get from lower long-end real yields.

Commodities (leaning Short, but mostly Time to Go Fishing)

* Gold is finally experiencing a sustained drawdown as its negative correlation with moves higher in real yields would have implied; tough call from here as front-end real yields are likely going up, but long-end not really so?Time to go fishing.

* Supply-impaired commodities (Crude Oil, NatGas, some Agriculturals) have also been hit hard by the demand slowdown narrative being priced in, but geopolitical developments will be responsible for the bulk of the moves going forward - not much visibility there.Time to go fishing.

* Industrial commodities (Base Metals, Copper) are the cleanest expression of global demand destruction as their short-term supply chain is more functional and geopolitics plays a smaller role.One could consider shorting them but it’s basically another derivative of a long bond trade with the presence of other undesired risk factors. The 27% drawdown in Copper observed over the last 6 months (blue) generally precedes total returns over +10% for long bonds in the following quarters.Just buy those?

FX (Keep Leaning Long USD & Short Commodity Exporters: BRL, AUD, COP)

* Energy importers have been highly penalized so far even if their Central Bank has attempted to tighten policy in order to support their currency (EUR); a typical Emerging Market external shock situation where Terms of Trades worsen materially an…

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 are at the early stages of the U.S. economic expansion’’James Bullard - June 24, 2022

Hey guys! Back from my holiday, and happy to be writing a piece of The Macro Compass again.

While I was out, the Fed kept talking the US economy up but economic data showed clear signs of slowdown and we witnessed big moves in markets that seem to compound that thesis.

‘‘Global R’’ calls even are making the rounds.

That begs two questions:

* Will we actually see a global recession?

* And if so: when, and how bad?

Is A Global Recession Coming?

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 500,000 people every day and by the way…it’s free!I definitely recommend checking them out: here is the link.

Now, back to it: how likely is a global recession? And when is it going to hit?

Amongst the many forward-looking economic indicators I focus on, you will know by now that one of my preferred metrics is my G5 Credit Impulse series: it measures the pace of change of credit creation in the 5 largest economies worldwide and it serves as a very reliable leading indicator (6-15 months lead time) for economic growth and the performance of several asset classes.

Why?

Because as our structural ability to deliver economic growth is impaired by weak demographics and stagnant productivity, we learnt that printing money out of thin air works as a (temporary) substitute: the more money we inject in the private sector, the more likely we’ll get a cyclical boost to economic growth.Slow down that process, and growth will cyclically slow down too.

Notice two things:

* Printing money = printing bank deposits held by the non-financial private sector (us), not bank reserves printed by Central Banks. The former represents the ‘‘real economy’’ money printing, and the printers sit within commercial banks and governments - not Central Banks.More about that in these pieces (here, here and here).

* The pace of change (acceleration or deceleration) in real-economy money creation matters more than the mere direction.That’s because our system is based on the continuous expansion of credit and leverage, and hence while the direction is generally set in stone (up, apart from rare global de-leveraging episodes) the pace of change is more relevant.

So, how is the G5 Credit Impulse looking like today?I am in the process of updating the series, but these are the preliminary indications.

Sharp changes of direction in the Credit Impulse series have historically predicted aggressive acceleration or deceleration in the S&P 500 YoY earnings per share by a few quarters.

Courtesy of the massive fiscal drags and tepid refinancing activity in the private sector, we are now witnessing a contraction in credit creation which is even faster than the one we experienced during the Great Financial Crisis.As a result, we shouldn’t discard an earnings recession in late 2022/early 2023 already - for reference, analysts are still expecting earnings to grow by almost 10% this year and next year.

But what actually defines a recession?While I discussed above a potential earnings recession, the historical NBER definition implies two consecutive quarters of negative real GDP growth.

The truth is a proper recession involves the labor market: after all, US consumer spending accounts for almost 70% of GDP and as long as the labor market holds consumers might hold too.

The labor market is a coincident indicator: when it materially weakens above certain threshold, you are already in a recession.Keeping that in mind, let’s have a look at one of the most forward looking labor market indicator out there - US Initial Jobless Claims.

The 1990, 2001 and 2008 recessions all happened when the % change in the 3-months moving average in US Initial Jobless Claims exceeded 7% for at least 3 of the last 4 observations.The last two prints for the 4th week of May and June 2022 were +18% and +14%.

A print in the 220k area at the end of July would add fuel to the fire, confirming the US labor market is indeed weakening and contributing further to the recessionary narrative.

Markets are beginning to validate this narrative, too.Copper is considered the bellwether for global industrial activity due to its multiple end-uses and applications in the real economy.Its recent -25% monthly drawdown only occurred 0.45% of the times since 1992 (32 times in over 7500 rolling monthly return observations).If you exclude the idiosyncratic Sumitomo Copper affair (cool story, read here) such a magnitude of Copper drawdowns was only experienced around the GFC period.

Additionally, Mr. Bond Market is now pricing the Fed to convincingly cut rates immediately after the terminal rate has been reached in its brief but intense hiking cycle - almost 100 bps cuts are priced between Jan23 and Dec24.Over the last 15 years, the Fed was never ever priced to cut rates so aggressively in the 6-32 months period immediately following a hiking cycle.

The bond market has a strong opinion here.

As you have read here on The Macro Compass since December 2021, I have long been expecting a sharp economic slowdown as signaled by my models.And while more people seem to be in that camp by now, I believe the analysts’ consensus doesn’t entirely appreciate the speed and magnitude of such slowdown.

In other words: the chances of an imminent and non-negligible recession keep increasing month after month.

Conclusions

Summing up:

* The global credit impulse keeps plummeting, and its latest readings are consistent with an earnings recession in 2022 already;

* Even the labor market is showing preliminary signs of weakness, with changes in the 3m moving average in US Jobless Claims accelerating rapidly;

* Cyclical industrial commodities experienced a very severe drawdown consistent with sharply lower economic growth, and the bond market is pricing the Fed to aggressively cut rates immediately after completing its hiking cycle in early 2023.

When it comes to the broader asset allocation choices, The Macro Compass remains in Quadrant 4 but the transition towards Quadrant 1 is slowly ongoing.

As Central Banks remain focused on the month-on-month changes in inflation, their relative monetary policy stance is likely to be too tight to allow for a full transition towards Quadrant 1, but the bond market will be doing some early heavy-lifting by flattening curves and lowering long-end real rates to facilitate the transition.

Broadly speaking that means long-term portfolios should continue to stay away from highly speculative assets, own USD cash and start allocating towards 5-10y+ government bonds (as suggested already 2 weeks ago: see here).

My tactical portfolio (1-3 months horizon) instead remains net short equities and credit spreads while holding some opportunistic early Quadrant 1 trades (bond flatteners and long 1x QQQ vs short 1x IWM):

* 2s10s flatteners

* Long 1x QQQ, Short 1x IWM

* Short IWM

* Short LQDH

And I will be soon adding long JPY/AUD and Euribor flatteners.YTD P&L: +21%; maximum drawdown: -7%.

If you want to know more about how I’m thinking about portfolio construction and my view on each asset class, don’t worry: next week’s article will focus just on that!What would you like me to specifically cover in that piece?

And this was all for today, thanks for reading!

Last but not least: if you are interested in any kind of partnership, sponsorship, or in bespoke consulting services feel free to reach out at [email protected] I ask you to be so kind and click on the like button and share this article around, so that we can spread the w…

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I don’t see recession chances as particularly elevated now, as consumers have a very substantial cushion of savings. 100 bps hikes are not off the table.Jerome Powell - Senate Banking Committee hearing, June 22nd 2022

In yesterday’s Senate Banking Committee hearing, Powell brought his hawkish stance to new highs: a strong economy underpinned by healthy levels of consumers’ savings, 100 bps hikes not off the table, and to top it off a good likelihood the Fed will actively sell (!) mortgage-backed securities from their balance sheet.

Ok, so just more of the same?

Well, there is a big news: for the first time in 8 months, the bond market isn’t compounding Powell’s hawkish rhetoric. Actually, it isn’t even aligning with his stance in the first place.

Instead, fixed income investors have become loud enough we can almost hear them ask one big question: a recession is becoming increasingly likely, so what are you going to do about it J-Pow?

In this article, we will:

* Discuss the cross-asset evidence that demand destruction might be intensifying to more worrisome levels;

* Look at the whether the conditions to buy bonds are finally fulfilled;

* Update our portfolios accordingly.

Wen Bonds, Alf?

Actually, before we jump right in.

There are so many good macro newsletters out there, and there is always so much going on in global markets - and honestly it’s hard to keep track of everything!I personally find Harkster’s free newsletter extremely useful: every morning, you get your global macro and news highlights in a concise and to-the-point format.It only takes 5 minutes to parse through and you also get an overview of the top 5 trending macro articles on their fantastic free newsletter aggregator platform.Such a useful (and free) service: I definitely recommend to check it out (link here)!

Now, back to it: is it time to buy bonds?

For decades, bonds have been a beautiful asset to own in a diversified portfolio: a positive carry, return generating asset class with the ability to dampen equity market drawdowns. Wow.

But does this hold true in every macro regime?

The chart above shows a 20-year history for the US 5y inflation expectations (swaps, orange) against the 3-months rolling correlation between bonds and stocks returns (TLT vs SPX 90d rolling correlation, bottom part of the chart).

The interpretation is very clear: keep inflation expectations comfortably around/below the 2% area instead and bonds are going to be negatively correlated to stocks on a consistent basis.Instead, once you cross the 2.5% threshold in 5y inflation expectations the negative correlation property quickly disappears.But why?

That’s because once inflation expectations meaningfully surpass the Central Bank’s stated objective (2%), when equity markets experience a drawdown policymakers are faced with a hard choice: either accommodate conditions to stop the market bleeding or stay the course and preserve credibility about their inflation mandate.

For the time being, Powell has chosen to stay the (tightening) course.Can you guess what that meant for markets?

As the equity market experienced a severe drawdown and bonds couldn’t serve as a portfolio hedge in this environment, we just witnessed the largest ever ‘‘financial wealth’’ destruction in history.Ouch!

Even without factoring in crypto and other asset classes, US bonds and equities markets combined have experienced a drawdown from previous peak of about $15.5 trillion (or 60% of GDP). Just. Huge.

So: when will bonds regain their magic property of return-generating, drawdown dampening asset for your portfolio?

In other words: when can we buy bonds again?Let’s have a look at my 3-points checklist and see where we stand.

1. Is the momentum of growth slowing? Yes.

The PMI New Orders / Inventory ratio is one of the many forward looking indicators I incorporate in my macro investment process, and it’s been on a never-ending downward path for 14 months now. Check.And not only the momentum, but also the outright level is quite telling: prints < 1 in this ratio have last been seen in 2019 (0% earnings growth that year), 2012, 2009, 2001…you get it.

2. Is the momentum of inflation slowing? Meh, not really…but.

In a previous article (here), we have explained how inflationary pressures have been broadening from food and commodity-related prices to the stickier categories like core services.Nevertheless, commodity prices across the board (in the chart: blue/orange/green) still contribute for a good portion towards the high US CPI prints.

We also discussed how for bonds to regain their magic portfolio properties, we need 5y inflation expectations to drop below 2.5%.And do you know what correlates well with inflation expectations?Yep, you guessed it: commodities.

And while we will have to wait to get any evidence of a slowdown in the inflation momentum, my Volatility-Adjusted Market Dashboard (VAMD) shows some interesting patterns this week.

* Industrial/cyclical commodities: down.

* Commodity exporters (Brazil) underperforming importers (India, Japan).

* Fixed income in Europe (whose hiking cycle will be inevitably influenced by the evolution of commodity prices): big rally.

Have Central Banks engineered enough demand destruction already to sustainably hit even the supply-constrained commodity complex, and hence lower inflation and inflation expectations?Can’t tick the box with full conviction yet, but time is an important factor here.Which brings us to…

3. Are Central Banks (directly or indirectly) giving us the green light to buy bonds?Indirectly: basically, yes.

As my good friend and legendary investor Jim Leitner would say: always carefully listen to the Game Masters (= Central Bankers).Have they sent us a direct or indirect green light signal yet?

A. Direct green light: the first phase of monetary policy accommodation. When they explicitly pivot dovish vis-à-vis market consensus or they engage in QE, they are giving us a direct green light to lift bonds. Easy to follow, right?But they definitely haven’t sent us this signal. Actually, quite the opposite.

B. Indirect green light: they have tightened policy hard enough for long enough to basically guarantee a sharp economic slowdown. In that case, as they are enhancing the probability of nominal growth reverting to weak structural trends they are also increasing the appeal of long-term bonds.An indirect green light signal to buy bonds.

But how do we quantify that signal?

Focus on the red arrows and red box on the chart above.

In the late ‘90s, the Fed forced real yields (blue) to trade above my estimate for equilibrium real rates r* (orange) for a prolonged period of time (red box).

In 2007 and 2013, the Fed pivoted hawkish fast and furious (red arrows). That meant real yields quickly moved from below to above equilibrium levels.

In both cases, the indirect green light signal was evidently sent and a sharp and sustained bond rally ensued.But why?

Because when monetary policy becomes restrictive for long enough (red box) or sharply moves from very accommodative to tight (red arrows), our credit-addicted private sector suffers big times.Once cheap credit dries up, leveraged business models take a large hit and the subsequent demand destruction cripples economic growth for a while to come.

In other words, the distribution of outcomes for future nominal growth becomes more predictable: once enough short-term damage is done, long-term growth is almost guaranteed to disappoint.And in turn that means long-term bonds are more attractive.

You see that red dot? That’s where we are.The indirect green light has been turned on.

And as we are ticking almost all boxes, it’s time to look at what does it mean for our portfolios and tactical trades.

Portfolio Update

Summing up: in the Senate Banking Committee hearing, Powell told us he is…

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We won’t declare victory until we see a series of consecutive, sharp declines in the monthly rate of inflation. Jerome Powell - FOMC press conference, June 15th 2022

Heading into yesterday’s Fed meeting, the bond market asked a tough question to Powell: do you mean business?

Powell took a ‘’Bad Cop, Good Cop’’ stance: he answered with a firm ‘’Yes’’ at first, and then tried to soften the message during the press conference.

This spurred a relief rally in risk assets, but it won’t last.Bond markets hate half-hearted stances, and they will keep testing the Fed and risk assets until they get what they want: clarity.

In this article, we will:

* Unpack the Fed meeting by looking beyond the mainstream media headlines, and instead focusing on the nuances that really matter;

* Analyze the market reaction across asset classes, and assess the likely path ahead;

* Recap what does that all mean for your portfolios.

Bad Cop, Good Cop

Actually, before we jump right in.

We are now 58,000+ strong here on The Macro Compass!Being very grateful for this beautiful community of macro enthusiasts and investors, I am wondering how can I help you further? What’s that very thing you’d really want me to deliver, so that you can enjoy The Macro Compass even more?All topics, tools, formats, ideas: anything is fair game.Let me know in the comments!

Now, back to it: Powell played Bad Cop, Good Cop yesterday.Let’s start from the Bad Cop part - an opera in three acts.

1. The ‘‘growth is strong’’ mantra is unchanged, and that reinforces the Fed’s commitment to take aggressive steps to tame inflation.

Despite forward-looking growth indicators showing rapid signs of deterioration, the actual Q1 real GDP growth print in negative (!) territory and the Atlanta’s Fed GDP Nowcast pointing to 0% real GDP growth in Q2……Powell told us there are no signs of economic growth slowdown.The economic growth mantra is unchanged.

But if the Fed’s assessment is that the economy can take it, they will feel more confident about delivering a more aggressive hiking cycle.

And indeed this was reflected in the updated Summary of Economic Projections (SEP), which also contained some more interesting piece of information.Let’s have a look.

A) The FOMC’s estimate of ‘‘longer run’’ (i.e. neutral) rate moved slightly up to 2.5%, and they intend to hike rates all the way to 3.8%. That’s 130 bps above neutral. A pretty decent amount of tightening!

B) In 2022, unemployment rate is going to be 3.7%. In 2023, it is going to inch up to 3.9%. Nevertheless, in 2023 the Fed will keep hiking 40 bps according to their projections: a bit of collateral damage doesn’t seem to scare them at all.This was also reflected in the introductory statement where ‘‘The Committee expects inflation to return to its 2 percent objective and the labor market to remain strong’’ has been replaced by ‘‘The FOMC is strongly committed to returning inflation to its 2 percent objective’’.No mention of a persistently strong labor market anymore.

C) Even with all this tightening and some collateral damage to the real economy, core PCE is expected to revert back to only 2.7% in 2023 and 2.3% in 2024. A strong signal that even more might be needed.

When it comes to the hiking cycle, the Dot Plot allows us to evaluate the distribution of opinions within FOMC members.While in March only Bullard was voting for Fed Funds at 3% or higher by December, today no FOMC member (!) expects rates to be below 3% by year-end.Nobody.

2. Powell went to great lengths to explain they are seriously concerned about inflation and inflation expectations. And he means: seriously.

One chart to rule them all: the University of Michigan consumer survey for long-term inflation expectations.

We can talk about inflation swaps or TIPS all we want, but ultimately long-term consumers’ inflation expectations matter the most for Central Bankers.Based on those, consumers decide whether to borrow/spend more and whether it’s time to push for a stronger nominal wage increase to offset inflationary pressures.

As a Central Banker, you really don’t want these long-term consumer inflation expectations to get de-anchored and we just printed the highest figure since 2008…

And that’s why to top it off, Powell said ‘‘we are not going to declare victory until we achieve a series of consecutive, sharp drops in MoM inflation prints’’.

3. To achieve that, Powell is going to keep pushing until (more than) enough damage has been done.

He sent two very clear messages on that front.

1. ’’Interest rates, yield curve shape, credit spreads and equities are going to tell us how restrictive we are and how successful we are likely to be in slowing inflation down’’.

The Fed will take the foot off the gas pedal only if inflation markedly slows down.There is NO Fed Put until then. At any level.

2. ‘‘We’d like to see positive real interest rates across the entire curve. That will make us more comfortable inflation will be slowing down’’.

This is a big statement.Why?

This is the US real yield curve: nominal yields minus inflation expectations.Despite Fed Funds rate priced to average about 3.5% for the next 2 years, real yields are still deeply negative in the front-end.That’s because inflation expectations are north of 4.5% there!

Powell is basically telling us that either his tight monetary policy stance translates into lower inflation expectations quick, or he will have to bring Fed Funds rate above levels of realized inflation to mechanically achieve positive real interest rates in the shorter end of the curve.

In short: he’s going to achieve higher real yields one way or another.

So with all of this, why the heck did the market rally?And can it continue?

The Good Cop & The (Fake) Relief Rally

In my opinion: no, it can’t continue.Why?

The relief rally started when Powell hinted that:- 75 bps hikes are not expected to be common practice going forward;- The Fed will be at neutral (2.5%) later in summer, and from there they lean towards taking a more prudent (read: 25 bps?) hiking approach towards restrictive territory.

Remember: bond traders rarely approach events as black-or-white, binary outcomes. The bond market is rather a probabilistic, consensus-weighting machine and what you see on the screen is nothing else than the resulting base-case priced in.And Powell had just told bond traders to meaningfully cut their probability the Fed is going to raise by 75 bps multiple times, and to assume once they reach 2.5% Fed Funds they will be more conservative with the pace of hikes.

So the path to reach the terminal rate gets repriced: it will take longer.Which means 2y Treasuries can rally…but what about inflation swaps?

2-year Treasury yields tanked 25 bps in a few hours (!) while 2-year inflation swaps rose by 5 bps, hence causing a sharp rally in front-end real yields.As real yields became suddenly lower, a mechanical rally in multiple-intensive equities and credit spreads ensued.

But wait a second: Powell just told us he wants positive real rates across the curve?

On top of that, there are two main things that make this rally unsustainable.

1. Unless inflation markedly slows down, the bond market can’t reasonably price a terminal rate below 3.8% now that the Fed told us we’ll get there.

The chart below shows how the SPX (blue) party-rally was over once the bond market realized it could not meaningfully reprice terminal rates below the red line (3.8%).And that’s likely to hold true until MoM inflation really slows down.

2. The implied (and realized) volatility in bond markets is too big, and such a high level of uncertainty in the worldwide biggest and most liquid market cripples any meaningful ability to take risks elsewhere.

The chart above represents the level of implied (a…

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Pelley: “Where does it come from? Do you just print it?”Powell: “We print it digitally. So as a Central Bank, we have the ability to create money digitally.’’.

Jerome Powell - ‘‘60 Minutes’’ interview, May 2020

In a famous interview released on May 2020, Jerome Powell stated Central Banks can print money in digital format.And he is right, they indeed do that when they embark in policies such as QE.

But he forgot to mention that what they print is bank reserves, which is money only for commercial banks and not for us common people.And that these bank reserves don’t have legal tender, they can’t be used to transact in the real economy and most importantly they never reach the private sector. Never.

Running a large fixed income book for a big European bank for years, I have personally been on the ‘‘receiving end’’ of the QE trade - I am very excited to try and convey some of the experience and knowledge accumulated throughout that period!

In this article, we will answer the following questions:

* If Central Banks only print digital bank reserves and not real economy money, why do they engage in QE in the first place?

* If bank reserves are not money for the common people, what are they useful for then? What can commercial banks do with bank reserves?

The ‘‘Portfolio Rebalancing Effect’’ Explained

Actually, before we jump right in.

If you are a macro enthusiast based in the US, pay particular attention here!Being aware of how complicated it can be to translate a macro view in action as often you need complex derivatives contracts, I wanted to flag that a company named Kalshi is offering a neat solution to that problem.

Kalshi offers event contracts, which are "Yes" or "No" shares tied to specific future events — think of the May CPI report released on Friday: if you have a macro view on inflation, you can directly translate it into action!They have markets on various strikes for what the MoM inflation rate will be, ranging from 0.1% to 1.2%. If you have a view that inflation will surprise on the upside or on the downside, you can buy ‘‘Yes’’ or ‘‘No’’ shares directly tied to that outcome.

I definitely recommend to check them out (link here).

Now, back to it: Central Banks create bank reserves when they perform QE.But if bank reserves are just money for banks stuck in the financial system, why would they bother to do that in the first place?

Mainly because of the many channels through which QE helps generating the so-called Portfolio Rebalancing Effect.

To understand this, let’s start from what QE does to the balance sheet of a commercial bank.

When a Central Bank performs QE and directly buys bonds from a commercial bank, they merely change the composition of the commercial bank asset side by reducing the amount of bonds they own and instead increasing the amount of reserves.

No new spendable money for the private sector has been created in the process, as commercial banks don’t use reserves to make new loans.So why the heck would Central Banks embark in QE and forcefully change the portfolio composition of commercial banks in the first place?

In short: to encourage them to rebalance their portfolios towards riskier assets.How does this work? Let’s go through it together.

Historically, commercial banks own a portfolio of bonds because:

A) Regulators incentivize them to do that;

B) Bonds are interest-bearing and liquid instruments which are also widely accepted as collateral: all very desirable features for a bank;

C) They serve as a hedging tool for the interest rate risk of their liabilities.

Now, QE is taking away these bonds and flooding banks with reserves instead.

Let me show you why reserves are a sub-optimal asset to own for a bank, and hence why they’ll instead tend to rebalance their portfolio towards (riskier) bonds.There are 3 main reasons.

* #1: Regulators have made bonds (almost) as ‘‘regulatory-friendly’’ as reserves.

After the Great Financial Crisis, regulators realized that commercial banks weren’t always owning enough liquid assets to survive a sudden spike in deposit outflows and therefore implemented a new regulatory constraint: the Liquidity Coverage Ratio (LCR).

It basically forces banks to own enough High Quality Liquid Assets (HQLA) to be able to meet an avalanche of deposit outflows during a stressful period (e.g. bank runs).European and US banks are now forced to own about $12 trillion (!!!) of cumulative HQLA assets at any point in time.

Sounds huge, it is huge.Curious to know what’s eligible as High Quality Liquid Assets (HQLA)?

In yellow, our usual suspects: bank reserves and government bonds.But the orange boxes contain some interesting information, too.Subject to a maximum of 15% of the total HQLA portfolio, BBB corporate bonds, mortgage backed securities and even certain stocks (!) are HQLA eligible.

By making bank reserves and (riskier) bonds virtually inter-exchangeable from a regulatory standpoint, regulators have vastly increased the marginal appetite banks have for ‘‘regulatory-friendly’’ HQLA bonds.

After all, if for regulators these bonds are as good as reserves and they offer a higher yield on top…why not?

* #2: HQLA-eligible bonds carry higher yields than bank reserves.

The chart above shows the 2 to 10 years yield curve for bank reserves at the Fed (orange) against two forms of regulatory-friendly bonds: US Treasuries (blue) and US BBB-rated corporate bonds (green).

US Treasuries already yield more than bank reserves and they have a very liquid secondary market, a deep repo market and they are considered as the best collateral available out there - quite a no brainer!BBB Corporate Bonds offer an even higher yield, but there are some trade-offs there: the higher yield must be measured against the additional credit risk, some small regulatory haircut, a less liquid secondary market and a less deep repo market.

From a risk and liquidity-adjusted return perspective though, one can argue HQLA bonds are generally attractive vis-à-vis bank reserves.

* #3: Bonds can be used to hedge interest rate risk, while bank reserves can’t.

Finally, let’s quickly cover interest rate hedging.The liability side of commercial banks balance sheet is mostly composed by customer deposits, and generally these customers can decide to walk away with their money whenever they prefer.

Risk departments within banks are tasked to calculate the average tenor of customer deposits and other liabilities sitting on the bank’s balance sheet such that duration mismatches can be mitigated from the asset side - for instance, purchasing bonds with a certain offsetting duration.On the other hand, bank reserves are an overnight instrument with no duration and hence they are not useful to hedge interest rate risks.

The important bottom line is that while preserving many useful features, bank reserves are a zero-duration and low-yielding instrument which can be suboptimal to own in big sizes especially as regulation (HQLA) has become very friendly towards certain bonds.Here is a useful table to compare bank reserves and HQLA-eligible bonds.

Now that we have established how undesirable it is for commercial banks to own large amounts of inert bank reserves rather than regulatory-friendly HQLA bonds, let’s revisit our QE example to understand how the Portfolio Rebalancing Effect really works.

In our stylized example, the commercial bank HQLA portfolio will consist of a bunch of inert bank reserves which don’t generate much returns and can’t be used to hedge interest rate risk: quite a suboptimal composition, wouldn’t you agree?

Hence, they will be looking to rebalance their portfolio towards a better composition of regulatory-friendly bonds and reserves: they will go and buy Treasuries, MBS, Corporate Bonds and so on and so forth.

But wait a second: the Central Bank is already (!) buying these exact same bonds with QE, isn’t it? Yes, exactly.

Summarizing, here is the virtuou…

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‘‘Before you invest, you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong’’.

Benjamin Graham - The Intelligent Investor

Investing is all about probabilities: all you need to do is assess the chances markets are assigning to different scenarios today and anticipate how this probability distribution will move over time.In other words, you don’t need to be necessarily right on what happens next but just be able to grasp how market consensus will move from here.

Ignoring this simple principle has been a very expensive exercise for European fixed income investors over the last few weeks: the-ECB-will-never-really-hike mantra is melting under the eyes of bond investors married to a dovish narrative which has been successful for a decade but offers a very bad risk-reward today.

In this article, we will:

* Discuss the biggest volatility-adjusted moves seen in global macro last week;

* Explain why Europe is in a tight spot, which will lead us to…

* …assess where the best tactical risk-reward investment opportunities might lie.

What? European Rates Are Actually Moving?!

Actually, before we jump right in.

There are so many good macro newsletters out there, and there is always so much going on in global markets - and honestly it’s hard to keep track of everything!I personally find Harkster’s free newsletter extremely useful: every morning, you get your global macro and news highlights in a concise and to-the-point format.It only takes 5 minutes to parse through and you also get an overview of the top 5 trending macro articles on their fantastic free newsletter aggregator platform.Such a useful (and free) service: I definitely recommend to check it out (link here)!

Now, back to it.Here is what the Volatility Adjusted Market Dashboard (VAMD) is showing for the last 7 days: as the legend points out, the darker the color tonality the more significant was the move in standard deviation terms.

Most of the action happened in rates, and specifically in the Eurozone front-end of the yield curve with some 3+ weekly standard deviation moves: wow!

So, what’s going on there?

Inflation keeps surprising on the upside, and price pressures are broadening: core CPI is running at almost 4% annualized and the stickier components of the inflation basket (ex-energy services) are getting hit too.If it sounds familiar, it’s because a similar dynamic started unfolding in the US a few quarters ago already.

Not only that, but the momentum of the latest European inflation pickup has been impressive - if you annualize the 3-months change in CPI, you realize such a concentrated inflationary impulse has been last experienced in…the ‘80s?!

So obviously the European bond market had to react, and it did.But let’s look together under the hood and appreciate a few macro nuances.

In particular:

A) What’s the market pricing now, and is it enough - what’s the neutral rate in Europe anyway?

B) How does this square with the ECB ‘‘hidden dual mandate’’, i.e. prevent the hugely important geopolitical project (aka Eurozone and the EUR) to disintegrate?

After the sharp sell-off in front-end European yields, the EUR Overnight Index Swap curve (see here why I prefer OIS to look at yield curves) is pricing the following:

110 bps worth of hikes being priced by December 2022: 4x25 bps with a 50% chance the ECB will hike by 50 bps in one of the 4 meetings between July and December.After that, roughly another 100 bps hiking cycle in 2023 and after that…Ladies and gentlemen, your next and final stop: the market-implied ECB terminal rate, which currently sits at around 1.70%.

But as I explained in this article, when a Central Banker is faced with a prolonged period of high, broadening and stickier inflation the reaction function can quickly become very aggressive as the need to preserve credibility dwarfs anything else.And an aggressively tighter monetary policy stance is not reflected in an absolute level of interest rates, but in how much higher these rates are versus the neutral rate.So, the question is: what’s the neutral rate in Europe?

My model-estimate for the European nominal neutral rate is pictured in blue: it has been unsurprisingly trending down over the last 30 years due to poor demographics, higher and higher loads of unproductive debt, capital misallocations and so on.It now stands at around 1.40% (roughly -0.60% in real terms).

As the current market pricing for the ECB terminal rate stands at 1.70%, one might argue the ECB reaction function is correctly priced: a swift tightening of monetary policy to levels above neutral rates (30 bps above) to fight inflation.

Well, not really.

I went back and looked at the latest episode of prolonged price pressures which pushed European inflation meaningfully above 2% for a while: it happened in the early ‘90s - and as the EUR didn’t exist back then, I used France as the barometer for the Eurozone in my analysis.

As you can see in the red box, in order to tame the sticky 4%-ish French CPI and avoid the un-anchoring of inflation expectations, the Banque De France pushed 5y French government bond yields way above (not 30 bps, but 350+!) any reasonable estimate for the prevailing levels of neutral nominal rates. And they succeeded in their mission: 18 months later, inflation was back around 2%.

In other words, Central Banks can rarely slay the inflation dragon with baby steps: hence, the path of least resistance is for European bond markets to keep pushing the ECB towards a more aggressive hiking cycle.

But that also means higher interest rates while:

* Europe gets squeezed as a net commodity importer amidst big supply chain bottlenecks;

* Real income growth is deeply in negative territory as inflation outstrips nominal wage increases;

* By construction, the ECB has to set the same monetary policy for Germany and Italy which implies an overly punitive stance for the latter.

Which leads me to the true European conundrum: how can this more hawkish monetary policy stance be conciliated with the ECB ‘‘hidden dual mandate’’, i.e. to prevent the hugely important EUR geopolitical project to disintegrate under the pressure of widening cross-country spreads?

In my opinion, it can’t: right now, it’s all about getting a grip on inflation and also avoiding EUR/USD from flirting with parity.

And the BTP/Bund spread represents the proverbial sacrificial lamb on the altar…

Macro Investment Ideas

So, what about our macro portfolios?

For the long-term oriented readers: while I work through systematizing all the macro models into a long-only ETF portfolio, my broad prescriptions remain the same I have been highlighting since December 2021.Keep a healthy cash allocation and stay away from (especially speculative and valuation-intensive) risk assets: this is the time to preserve our capital and play defense, not offense.

For the nimbler investors, here is my current long/short tactical book.I added an explanatory note on the strategy of this book at the end of the article, in case you are interested.

The book reflects my bearish stance on risk assets, and especially on credit (BTP/Bund and US Investment Grade Corporate Spreads) and equities (SPX).

It is often updated on Twitter but from now onwards you will receive more regular updates on The Macro Compass newsletter too.

I see 3 main scenarios ahead of us with the respective subjective probabilities assigned:

A) Inflation slows down very aggressively, and Central Banks can afford to tighten much less: the bond market rallies, and even though the economy is weak we witness a big compression in risk premia - 10% chance, and I get stopped out everywhere.

B) Inflation ‘‘peaks’’ and slows down but less than implied by inflation forwards and Central Banks projections: reaction functions must be priced more aggressively and/or the tightening cycle has to last longer while the economy weakens - 65% chance, and my positions are ok.

C) Inflation momentum doesn’t really decelerate: ag…

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