The Macro Compass

‘‘When people begin anticipating inflation, it doesn’t do you any good anymore.’’Paul Volcker

We are at important global macro crossroads: Central Banks are trying to remove accommodation from markets to tame inflationary pressures right at a point when the impulse of global growth has lost momentum and we are witnessing a military escalation in Ukraine.

This piece will try to unpack for you:

* How Central Banks, the bond and the stock market are reacting and are likely to react further in such a macro backdrop;

* How I am approaching this environment with my tactical global macro portfolio.

Without further ado, let’s jump right in!

The Good, The Bad and The Ugly

Actually, before we jump right in.If you are interested in any kind of partnership or in bespoke consulting services, feel free to reach out at [email protected].

Back to it: markets are all over the place, what’s going on?

Let’s start from the master of them all: the fixed income market.

Over the last few weeks, bond yields have dropped and yield curves continued to flatten across the board. But the most interesting moves are visible once you decompose nominal yields into inflation break-evens and real yields, and focus on forward looking metrics and probability distributions.

The 35 bps move down in 10y Treasuries over the last 10 trading sessions can be decomposed in:

* A 20 bps move up in 10y inflation swaps;

* A 55 bps move down in 10y real yields.

The decomposition is even more impressive for 10y European rates: the 20 bps move down in 10y European swap rates is due to a 65 bps increase (!) in inflation expectations versus a 85 bps drop (!) in real interest rates in only two weeks.

Let’s look at inflation swaps (a proxy for market-implied inflation expectations) first.

As markets are forward looking, so should we: instead of focusing on spot inflation swaps, why don’t we have a look at what markets are pricing in down the road and what is the market-implied probability distribution for future outcomes?

The chart above shows how the spike in 10y US CPI expectations (blue) is largely not reflected in 5y forward, 5y CPI expectations (in orange, average inflation prints expected by market participants between 2027 and 2032).

This means that the bulk of the upward inflationary pressures are still expected in the first 5 years, or to be precise: very high CPI in 2022, still high in 2023, declining after.

Good news for Central Banks: long-term inflation expectations have not become unanchored on the upside yet.

Now, let’s move to the bad news.

The Minneapolis Fed database is a fantastic tool to quickly grasp market-implied probability distribution: they have data for US inflation (chart above), but also for S&P, bond yields, commodities and more.

The chart above shows the probability distribution for US inflation over the next 5 years priced in by markets today (in blue) versus roughly one year ago (in red).

The distribution has not only meaningfully shifted to the right (mean from 2.60% to 3.40%), but it has become leptokurtic: don’t worry, it sounds difficult but it’s not.

It means market participants are expecting a higher likelihood of non-standard inflationary events, and they are skewed to foresee them realizing in the form of very high CPI prints rather than very low (see here for more on kurtosis).

Average inflation expectations >3% for 5 years and a probability distribution with a fat right tail: bad news for Central Banks with a target of 2%.

Now, to the ugly.

Real yields are dropping like a stone - but not for good reasons.

The impulse of global growth started decelerating in the second half of 2021, and judging by the cliff in my G5 Credit Impulse metric experienced in H121 the downward trend in earnings is likely to persist for few quarters.That’s because the G5 credit impulse leads earnings by roughly 15 months.

The chart above shows how the global credit impulse leads worldwide YoY changes in equity earnings by 15 months on average.

The direction of travel is clear: downward revisions are coming to a place near you.

Actually, you might argue some of them are already happening.

The chart above shows the 3-months average of the MSCI World net earnings revisions: essentially, this metric measures the difference between the number of companies revisiting their forward earnings estimate up versus down.

Last time companies were revising their forward earnings estimates down on a net basis while Central Banks were attempting to tighten monetary policy was mid-2018: do you remember what happened few months later?

A 20% equity drawdown: the ugly.

Now to Central Banks: March is going to be a paramount important month for policymakers around the world.

If you are the Fed or the ECB, do you look at the good, the bad or the ugly?

As always, the answer lies in the incentive scheme: at this juncture, as a Central Banker you want to manage the worst tail risk for yourself - a loss in credibility.

Powell has already declared inflation to be his enemy #1, #2, and #3; and while long-term inflation expectations have not yet become de-anchored on the upside, the balance of risks is dangerously skewed the wrong way for Central Bankers.

Hence, hiking to neutral rates in an assertive manner is the path of least resistance.

The Chicago Fed President Evans is amongst the most dovish FOMC members, and last week he came up with similar statements (sure, he doesn’t vote on monetary policy in 2022 but if this is the stance of a dovish FOMC member…think about where the consensus will land at the Fed).

But what does this mean, concretely?

The path of least resistance is for the Fed to hike rates from 0% to at least 2% relatively quickly.2% is where the most conservative estimates for the US neutral rate stand right now.

The chart above shows the fixed income market is today pricing in just shy of 150 bps cumulative hikes: traders seem to have re-assessed the Fed reaction function as credit spreads have widened and equities have started retracing.

In other words, financial conditions are tightening and the bond market senses the Fed will be somehow receptive to that - an early version of the Fed put.

This time though I argue the incentive scheme for Central Banks is different: they hope not to be forced to choose, but gun to their head they will likely be forced to tighten even in the face of a stock market drawdown to preserve credibility on their price stability mandate.

The strike of the Fed put is still far from today’s levels.

An example of how far might the strike of the Fed put be is shown above.

Credit default swaps on 5-year US Investment Grade Corporate Bonds are trading at 76 bps at the time of writing: Fed puts (or pivots) became more visible in the past when this measure of credit spreads approached 100 bps.

In other words, the Fed’s focus is all on containing inflationary pressures and providing support to risk assets will only become an agenda point if the pain is big enough to seriously interfere with economic growth.

The bears are knocking at the door, but Central Banks can’t hear them (yet).

So, how do we position for such an environment?

The tactical portfolio approach

In a nutshell: we use the weak growth impulse and macro backdrop to chase Central Banks until one of these three outcomes realizes.

* Policymakers tell us where is the line in the sand (roughly where is the point when financial conditions have tightened enough for them to feel the pain?);

* Policymakers tell us there is no line in the sand: it’s literally only about bringing inflationary pressures down;

* Risk premia have repriced to levels where the …

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Hey everybody, welcome back to The Macro Compass!

‘‘Long ago, Ben Graham taught me that price is what you pay but value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.’’Warren Buffett

This is a special edition. We have the pleasure to host a discussion with a great macro analyst: Lyn Alden!

I sat down with her for a fireside Q&A session on a stock market sector she believes is primed for outperformance.

Without further ado, let’s jump right in!

Alf: ‘‘Such a pleasure to have you here on The Macro Compass, Lyn! Let’s not waste time and dive right into it: what’s the equity sector you like here?’’

Lyn: ‘‘My pleasure, Alf! I am talking about the Healthcare sector.

Healthcare stocks tend to do better than the broad S&P 500 in risk-off environments and periods of slowing economic growth. The majority of economic indicators look much weaker for 2022 than they did for 2021.

This following chart shows the ratio of healthcare stocks to the broad S&P 500, and you can see that the spikes are generally associated with recessions and risk-off periods.

These spikes include the Savings and Loan crisis (early 1990s), the Asian Financial Crisis (1997-1998), the aftermath of the dotcom bubble (early 2000s), the aftermath of the subprime bubble (2009), the oil crash and global economic slowdown (2015/2016), the liquidity issues that resulted in the Powell Pivot (late 2018), and the COVID-19 crash (early 2020).

I wouldn’t be surprised to see another leg up for that ratio in the coming years, and quite possibly within 2022.’’

Alf: ‘‘So, from a cyclical macro perspective it seems you believe we are entering a cyclical economic slowdown and perhaps leaning risk-off here?’’

Lyn: ‘‘Yes: an economic slowdown is in the cards. Further fiscal stimulus has been on hold due to Senate gridlock, high energy prices are eating into consumer pockets, and the economy is coming down from somewhat of a sugar high. The flattening yield curve suggests future economic weakness, and so does the Atlanta Fed’s GDPNow indicator, which currently models 1.3% annualized real GDP growth for Q1 2022 based on a wide array of economic data points.

The purchasing managers’ index and various leading indicators continue to suggest economic deceleration is in store for 2022

Alf: ‘‘Alright, but the impulse to economic growth has started to slowdown in the second half of 2021 already: why have healthcare stocks struggled in that period, too?’’

Lyn: ‘‘For the second half of 2021, many healthcare stocks, especially pharmaceutical companies, were held down by the possibility of legislation that would control their prices. Democrats in the House of Representatives passed legislation to limit their price increases in line with inflation, and allow for more negotiation by Medicare. When it came time for inclusion in the Build Back Better bill, which had to get through a tightly-divided Senate if it was going to pass, the legislation was watered down. Even then, however, the entire Build Back Better bill stalled, and healthcare price reform remains in limbo.

With a divided US Senate, there doesn’t seem to be any major healthcare reform on the horizon that would disrupt healthcare stock profitability in a major way. Polling currently suggests that the government will be even more divided after the 2022 mid-term elections, which further pushes away the horizon for serious reform.

Meanwhile, healthcare stocks generally have attractive valuations. They’ve not been piled into by hedge funds or meme traders, and have generally been unloved in a risk-on environment while drug pricing reform added an extra layer of uncertainty.

Alf: ‘‘Fair points! Do you have a couple of names investors could look into?’’

Lyn: ‘‘Yes, two names within a sector that remains overall attractive.

Cigna (CI), a health insurer and pharmaceutical benefits manager, is trading at under 11x earnings with solid growth. It initiated a dividend in early 2021, and then raised that dividend by 12% in early 2022. The credit rating is A- by S&P.

At a deeper value but with less growth is Bristol Myers Squibb (BMY). It trades at 9x earnings and has a dividend yield of over 3%. The company is reliant on a few blockbuster drugs, but due to its 2019 acquisition of Celgene, it also has a decent long-term pipeline of new drugs. The credit rating is A+ by S&P.

While I wouldn’t bet too big on any one stock, the sector seems attractive. A diverse collection of healthcare stocks seems primed to outperform Treasuries over a 5-year view, with better yields and then some growth on top. Unlike many other areas of the stock market, there are no significant signs of overvaluation in the healthcare sector.

Since healthcare stocks trade away most of their cyclical risk in exchange for having more regulatory risk, but with regulatory risk held back for the moment, they are well-positioned for 2022 in my view.’’

Thanks to Lyn for this good piece and macro chat with us on The Macro Compass: in case you are not following her, you should do that on Twitter and subscribe to her newsletter here.Lyn Alden is one of the most intelligent and well-grounded macro people out there, and she conveys complex macro topics in a very concise and clear way: a must follow!

I agree with Lyn’s 2022 cyclical macro slowdown thesis: the credit impulse has quickly faded away since early 2021, and Central Banks intend to tighten fast back to (at least) neutral interest rate levels while inflation expectations have likely topped.

This would continue pushing real yields and credit spreads up in an unfriendly way, and flatten yield curves all the way towards inversion.In such an environment, risk assets tend to struggle and it’s best to find ‘‘healthy’’ sectors to invest in if you really want to keep your exposure to equities: low-beta, high-quality companies tend to outperform the broad market returns during these periods.

The healthcare sector (IYH for US, IXJ for global healthcare) reflects most of the features described above.

Last famous words.If you enjoy my work, please consider clicking on the like button at the end of the piece and share the article.It would cost you literally nothing, but it would really make my day!

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See you soon here for another article of The Macro Compass, a community of 28.000+ worldwide investors and macro enthusiasts!

I will be off next week, hence the next piece will be released on March, 7th.Stay tuned!

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

‘‘Buy land, they’re not making it anymore.”Mark Twain

The real estate market is likely to experience a short-term slowdown in 2022 amidst its intact long-term bullish trend.

While its dynamics seem to be somewhat unpredictable, in this piece I will argue that both the short-term and long-term path for house prices depend on some clearly identifiable drivers: inflation-adjusted mortgage rates, real wages, supply/demand imbalances, and demographics amongst others.

The idea is to provide you with the tools to understand and navigate the biggest asset class by market cap in the entire world: the real estate market.

Without further ado, let’s jump right in!

The Drivers Behind the Most Systemic Market in the World

Actually, before we jump right in. If you are struggling to keep up with all the good macro newsletters out there, I get you. But the guys at Harkster.com have a handy solution: they created a fantastic newsletter aggregator that allows you to keep track of the ones you like, and find brand new ones to read.I am using Harkster myself, and you can also check out which macro newsletters I am reading!

Back to it: do you know what’s the biggest market cap asset class in the world?Equities? No.Bonds? No, try again.

The real estate market is by far the biggest asset class in the world: summing up residential and commercial real estate with agricultural land, at the end of 2020 the estimated market value of the global real estate market was at $326 trillion or about 40% bigger than the global bond and equities markets combined!

Ok, now that I have your attention let’s talk about the drivers of the most systematic asset class in the world.

House prices can be essentially thought of as the price of a long term inflation-adjusted bond, whose coupons depend on inflation-adjusted long term mortgage rates and the ability to service those depends on the trajectory of real wages.

Additionally, other factors like regulation, demographics and temporary supply/demand imbalances can affect house prices but we’ll cover them later.

About 70% of real estate transactions across the world are backed by mortgages: this percentage fluctuates depending on the ‘‘health’’ of the market - in a bear market like 2009, there were virtually no cash buyers while in a long bull run you’ll find more.

Mortgage origination is nothing else than the commercial banking sector printing new money (see here on how it works) and crediting your account with the funds necessary to buy the house: the trick is that you as a private individual can’t print money, so you need to be able to service this debt with your wage over time.Inflation eats away your liabilities but also your wage, hence we will look at long term inflation-adjusted mortgage rates and real wages.

First: real mortgage rates.

The chart above shows US 30y mortgage rates adjusted for consumer inflation expectations (right-hand side and inverted, in orange) versus US house price YoY change, lagged by 12 months (left-hand side, in blue).

Changes in real borrowing costs for the private sector affect YoY changes in house prices with a lag: a more expensive mortgage (2018) slows down the house price appreciation process, while a cheaper mortgage (2021) gives a boost to the long-term structural bullish trend in real-estate.

Inflation-adjusted 30y mortgage rates abruptly became more expensive by about 1 percentage point over the last few months as nominal mortgage rates increased from 3% to 4% while consumer inflation expectations remained unchanged around 3%: this alone would justify a short-term slowdown in house price YoY changes in 2022.

The short-term unfriendly trend is compounded by weak developments in real wages.After all, if your real mortgage costs increase but your inflation-adjusted salaries are increasing too…you can still afford purchasing the same house at the same price.

Unfortunately, real wages are down -3% on a YoY basis while the monthly mortgage payment required to be the US median house spiked up as both mortgage rates and house prices increased at the same time over the last 6-12 months.

Finally, a word on the supply/demand imbalance.

Plenty of attention is paid to houses under construction as an indicator for upcoming supply, but I believe the correct way to look at supply is housing starts adjusted for population. Plenty of houses are labelled as ‘‘under construction’’ due to shortages in components and tight labor supply, but have most likely already found a buyer before the recent spike in 30y mortgage rates.Housing starts adjusted for population are a less polluted metric of upcoming real estate inventory coming to the market, in my opinion.

On this front, we are still way below the 2006 housing starts mania when adjusted for population size but the housing starts per capita are increasing.

As a recap:

* House prices can be proxied as the price of long term inflation-adjusted bond, whose coupons depend on inflation-adjusted long term mortgage rates and the ability to service those depends on the trajectory of real wages;

* Short-term: inflation-adjusted mortgage rates spiked up and real wages are contracting;

* On top, housing starts/capita are not crazy-like-2006, but they are picking up.

In 2022, the real estate market is likely to experience a short-term slowdown.But its long-term bullish trend remains intact: let’s quickly see why.

Long-term, Long Real Estate

Remember: house prices can be essentially thought of as the price of long term inflation-adjusted bond, whose coupons depend on inflation-adjusted long term mortgage rates and the ability to service those depends on the trajectory of real wages.

As argued in my most-read piece The Macro EndGame, lower real interest rates are not a bug but rather a feature of the current monetary system in place for 50 years.

Our economic system produces poorer and poorer long-term economic growth due to low population growth and stagnant productivity, and this is socially and politically unacceptable. Hence, we continue to leverage up: by creating new money (credit), we bring forward future consumption and boost a wealth illusion effect.

Equilibrium real interest rates to service this increasing leverage and keep the system afloat are lower, and lower, and lower at each cycle.

The cheaper the borrowing costs for the marginal buyer, the easier it will be for the asset price / wealth illusion cycle to continue: previous asset owners feel ‘‘richer’’ and new asset buyers feel they can ‘‘afford’’ more expensive houses.Their real wages are moving up very slowly, but incremental leverage is accessible at super cheap real borrowing costs!

The housing market sits at the epicenter of the wealth illusion mechanism representing >50% of the global aggregate market cap, and it also feeds important second-round effects when it comes to consumer sentiment and spending: if the market value of your personal balance sheet increases, you are likely to feel more comfortable about spending and perhaps investing too and vice versa.

As the structural tailwinds behind the long-term downward trend in real interest rates remain, real wages moderately increase over time and the incentive scheme for policymakers not to derail but rather feed the steady long-term wealth illusion mechanism remains in place…

…the bullish long-term trend for real estate is likely to extend further, with the first major structural hiccups once real mortgage rates can’t markedly drop anymore.

Conclusion

In 2022, the real estate market is likely to experience a short-term slowdown in its long-term bullish trend.While the analysis focuses on the US market, you can easily extend it to your domestic housing market applying the same principles.

House prices can be proxied as the price of a long term inflat…

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‘‘When you combine ignorance and leverage, you get some pretty interesting results’’Warren Buffett

Real interest rates were in a secular declining trend centuries before the Federal Reserve or other central banks were established.That’s because the most important drivers of long-term real yields are to be found more in demographics and productivity trends than in monetary policy decisions.

But why are real interest rates so important?

Leverage is the very backbone of our credit-based monetary system.

Real interest rates determine how cheap or expensive economic agents find the access to new credit to be, and what matters the most is their level relative to the equilibrium real interest rate.

In this piece, we are going to discuss the importance of real interest rates, their long-term drivers and trends and the interaction between monetary policy and the equilibrium real rate r*.

Without further ado, let’s jump right in!

It’s Going Down, For Real

In the introductory piece of my Bond Market 101 Series, we discussed how the first way to deconstruct bond yields such that you really understand what’s going on under the hood is:

Real yields are the barometer of how cheap or expensive is the inflation-adjusted cost for the marginal economic agent to incur into more leverage.

Now, the first thing I want to clarify is that you cannot calculate real yields as 10-year nominal yields minus today’s YoY inflation figures.

Long-term nominal yields incorporate long-run expectations (and risk premium) for inflationary pressures, so comparing them to the latest YoY CPI figure makes very little financial sense.

If you have one, think about your own 10y+ fixed-rate mortgage: what you really care about is for inflation-adjusted servicing cost over the lifetime of the mortgage.

When it comes to assessing how cheap or expensive incremental borrowing will turn out to be, it’s all about assessing future CPI: hence, inflation expectations matter much more than today’s CPI print.

Ok, but why are real yields so important in the first place?

We operate in a fully elastic credit system that allows governments and commercial banks to create new resources for the private sector (e.g. ‘‘money’’) out of thin air and without an explicit hard peg.

For instance, when commercial banks lend they increase their balance sheet by extending a new loan (white stack with orange borders up) and crediting the consumer’s account with a new bank deposit (red stack with orange borders up).

The private sector now has more spendable ‘‘money’’ (bank deposits) and can hence contribute to a pick-up in cyclical economic growth.

Government deficits work in a similar way: the government pumps net resources into the private sector (think of stimulus checks) by expanding its balance sheet and it doesn’t plan to tax them back. More spending capacity for the private sector, again.Cool, right?

Wait a second: the flipside of credit creation is debt, though. And we have been pretty good at this game across the world over the last 40 years.

The private sector balance sheet also has liabilities (debt) and private economic agents must be able to service these obligations with their long-term cash flow and earnings generating abilities.

It’s all about balance: real yields measure the inflation-adjusted cost for the marginal economic agent to access this newly created credit, which must then be serviced with the long-term ability to generate earnings.

A quick look at 700 years of history of real interest rates reveals that the declining trend started way before Central Banks were even a thing.

So, what are the drivers behind the secular decline in real yields?

Poor demographics and stable but low productivity growth.

Except for the the post-WWII period between 1950 and 2000 when the world’s population grew at about 1% per year, we historically grow our population at yearly rates < 0.5% and the latest United Nations forecast point to 0% world’s population growth by 2050-2070.

As world’s population numbers struggle to go meaningfully up and our society ages too, the labor force tends to stagnate or even shrink in some jurisdictions.

The productivity of capital and labor force has hovered around 0-2% for centuries: we become more productive year after year, but at a relative slow pace when we consider the aggregate economy.

Central Banks are not the cause of structurally low and declining real yields: they merely calibrate monetary policy to achieve their goals in such a secular environment.

It’s All About the Equilibrium

As the structural drivers of the economic growth needed to service an increasingly high leverage remain poor, real yields tend to decline to allow the marginal economic agent to access new credit at affordable costs.

It’s all about equilibrium, really.

In order to ensure economic growth and price stability, Central Banks are very attentive to this balance and monitor a metric called equilibrium real interest rate or R-star.

R-star measures the (unobservable) real interest rate at which an economy runs at its own potential growth rate without overheating or unduly cooling down.

Here are the R-star drivers and future trends in Europe according to the ECB.

The most important drivers are related to demographics:

* Growth rate in labor supply (blue): lower birth rates and ageing population lead to a shrinking number of people in the labor force

* Savers/dis-savers composition (red): an ageing population with a longer life expectancy will tend to save more

Mainly due to demographics, the ECB expects the natural (or equilibrium) interest rate to drop by another full percentage point over the next decade or so.

Central Banks calibrate their monetary policy to facilitate economic growth, employment and price stability.

As R-star secularly declines, Central Banks have no other option rather than cutting policy rates in an attempt to keep monetary policy from becoming restrictive.

This bring us to the interconnection between monetary policy and real rates.

To truly grasp is monetary policy is accommodative or restrictive, you shouldn’t look at prevailing real yields in a silo.Instead, you should compare those short/medium term real yields to the equilibrium real interest rate (R-star).

If real yields are sufficiently lower than r*, the marginal economic agent will find the access to credit cheap enough: she will more easily lever up, boosting cyclical economic growth and hence earnings.If real yields are higher than the equilibrium r*, the private sector will find it prohibitively expensive to access new credit and likely behave more defensively: cyclical growth and hence earnings will slow down, and so will risk assets.

The chart above shows US 5y real yields minus R* (blue) and the S&P500 YoY performance lagged by 6 months (orange).

Every time 5y real yields approach or increase above the equilibrium rate r* (blue line crosses the zero threshold on the upside), with 6 months lag risk assets performance tends to disappoint.Monetary policy had become too restrictive relative to the equilibrium rates the economy could take: less access to credit, less cyclical earnings, more defensive behavior from the private sector = hit to risk assets.

For the record, my estimate for R* in the US sits around 0%.

Conclusion

Our credit-based monetary system relies on ever increasing leverage to generate politically and socially acceptable rates of economic growth.

Real interest rates determine how cheap or expensive economic agents find the access to new credit to be, and therefore are a key variable to understand when approaching bond markets.

Real interest rates were in a secular declining trend centuries before the Federal Reserve or other central banks were established.That’s because the most important drivers of long-t…

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

‘‘As a rule, any loan that had been turned into an acronym or abbreviation could more clearly be called a subprime loan, but the bond market didn't want to be clear.’’Michael Lewis in The Big Short.

Let’s face it: the bond market can be deceptive for many.

Plenty of incomprehensible jargon and technicalities, which often lead to the opposite outcome: over-simplified narratives, easy to grasp but…outright wrong.

This article will provide you with the tools to approach the fixed income market like a seasoned professional investor. In plain English.Ok, perhaps with my funny Al-Pacino accent…but you get what I mean.

We will decompose bonds into their basic components, discuss the importance of the repo market, and touch upon regulation constraints for the biggest whales in this market - e.g. banks, pension funds, and Central Bank reserve managers.

A helicopter view of how to approach one of the biggest and most misinterpreted markets in the world.Ah, and at the end of the article…two surprises, too!

Without further ado, let’s jump right in!

Piece By Piece

Before we start, a quick shoutout to Andreas Steno Larsen’s new Substack - his content is always fantastic, go and check him out!There are two important ways to deconstruct bond yields such that you really understand what’s going on under the hood.

The first one is:

(Risk-free) real yields represent the barometer of how cheap/expensive is the inflation-adjusted cost for incurring into more leverage.Borrowing at 2% nominal yields with inflation reducing the real amount of your due liabilities by 3% per year sounds good for borrowers, but bad for lenders/investors.

As our monetary system relies on ever-increasing leverage to bring forward future consumption and oil the ‘‘wealth illusion’’ mechanism, keeping a close eye on the real borrowing costs is paramount important.

Not only in absolute terms, but especially in relative terms. Relative to R-star.

R-star represents the equilibrium risk-free real yields at which the economy runs at potential growth rate: with those prevailing real yields, the economy doesn’t overheat or excessively slows down.

The chart below shows US 5y forward, 5y real yields against my estimate for equilibrium real yields: every time observed real yields approach or cross the equilibrium levels…ouch for risk assets and the economy.

Inflation expectations play an important role, too: Central Bankers often have a mandate to keep inflation around 2%, and hence they pay close attention to the fixed income market expectations for medium-term inflationary pressures.

Why the obsession with 2%? Simple: incentive schemes.

As we rely on increasing debt to produce some decent cyclical growth, deflation is very scary: the real value of your liabilities would increase over time, making debt-servicing costs unaffordable and leading to a toxic deleveraging exercise.

On the other hand, high level of inflation potentially de-anchoring expectations on the upside are tricky, too: the private sector might reprice their perceived inflation risk premium and demand higher wages to compensate for that, which in turn might boost aggregate demand and lead to a vicious spiral.

Policymakers love the status quo, so guess where they set their targets?Far enough from each scary tail scenario.

So, when you see 10y Treasury yields moving up or down always ask yourself: is it real yields, or inflation expectations moving?

Are they moving in the same or opposite directions, and why? Are real yields above or below r-star, and how fast are they moving in which direction?Don’t worry: I’ll help you answering all these questions in one of my next pieces here on The Macro Compass!

The second way to decompose bond yields is the following:

I promised plain English with an Italian accent, so let’s get in there.

In our monetary system, the purest proxy for a risk-free investment is an overnight deposit at the domestic Central Bank - after all, that’s the clearing house for all commercial banks and an entity fully backed by the government.

For instance, if you have access to a Fed account you’re lucky enough to get this risk-free investment outlet and ‘‘earn’’ around 0% per year at this stage.

But bonds have a maturity longer than overnight, and the fixed income market is very much forward looking: the long-term expectations for the overnight Central Bank deposit rate are captured by OIS swaps, which tell you where the fixed income market consensus expects Central Bank deposit rates to move over a fixed period of time.

If you want to grasp what the market expects Federal Funds rate to be in the future, don’t look at Treasury yields: focus on OIS swaps (for more, see here).

Cool, now let’s move to credit spreads.

What the heck is an Asset Swap Spread (ASW)?

That’s the difference between Treasury yields and OIS swap rates.

Wow, a positive ASW spread: Treasury yields (blue) are above OIS swap rates (green).

Does this mean that long-end Treasury bonds have some sort of embedded credit risk that makes them riskier than depositing money at the Fed over time (OIS swaps)?

No, not really.

Asset swap spreads on safe government bonds are mostly driven by regulation, balance sheet constraints, the repo market and (in the short-term) flows.ASW spreads are important as they are tightly connected with the functioning of the repo market, and because they influence the investment allocation and risk taking attitude of large fixed income investors (e.g. banks, pension funds) - I’ll cover the Asset Swap Spread market in depth soon on The Macro Compass.

Ok, so Treasury yields = OIS swap rates + ASW spread.

The private sector financing costs are unfortunately higher than Treasury yields though, and hence we need to overlay credit spreads over Treasuries.

Credit spreads are a very important component of the Financial Conditions index: if they widen quick enough, the private sector starts facing higher and higher costs to refinance their large debt loads and hence faces restrictive conditions. If credit spreads widen too much, the access to credit becomes prohibitively expensive and the private sector moves into a painful and forceful deleveraging.

Here is how High Yield credit spreads are trading:

We learnt how to decompose bond yields into real yields + inflation expectations, but also into risk-free rates + ASW + credit spreads and why those decompositions are relevant. Now, time to talk repo and regulation.

Repo & Regulation: Boring, but Important

The repo market and regulatory developments are by far the most overlooked (yet super important) aspects of the bond market.

A repurchase agreement (repo) is a short-term secured loan: one party borrow cash from another and lends bonds in exchange, with the agreement to repurchase them later once the secured loan expires.The bond serves as collateral for the transaction.

The repo market is huge: trillions of securities are exchanged in repo every single day.

This market allows cash-rich (e.g. money market funds) and bond-rich counterparts (e.g. banks, pension funds) to exchange cash for securities (and vice versa), but most importantly it allows hedge funds to run leveraged trades at a relatively cheap cost.

When a hedge fund manager “shorts” a security, she receives cash for selling a security she…doesn’t own. Wait, what?The hedge fund just borrowed (reverse repo) that security from another counterparty promising to buy it back at a later stage, and sold it to the market.On the other hand, hedge funds can also post the securities they own as collateral (repo) transaction whereby they borrow cash.

Basically, a leverage machine: with little capital, repo allows for large positions.

When the repo market functions smoothly, repo rates are very close to the Central Bank deposit rate: af…

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Clinton’s political adviser Carville once said: ‘‘I used to think that if there was reincarnation, I wanted to come back as the president or the pope. But now I would like to come back as the bond market. You can intimidate everybody.’’

At the end of 1994, 10-year Treasury yields climbed over 8% in response to increasing US fiscal deficits. The Clinton administration made an effort to reduce deficit spending, and yields dropped to around 4% by November 1998.

Around that time, Carville went public with the iconic statement you read above.

But if outright yield levels can intimidate everybody, yield curve inversions can literally terrify entire economies and financial markets.

An inverted yield curve not only predicts, but it directly contributes to sharp economic slowdowns: as refinancing credit short-term becomes prohibitively expensive while markets already price in poor expectations for long-term growth, the economic engine actually slows down and a vicious circle unfolds.

Today, we will talk about which yield curve to look at, why it’s very likely to invert and what does this mean for markets and the economy.

Without further ado, let’s jump right in!

Why The Yield Curve Will Invert

Let’s start from why I think the yield curve will invert.

Upward sloping yield curves are generally associated with markets expecting a healthy expansion down the road: why?

An upward slope implies that short-term borrowing costs are low enough to ensure decent long-term nominal growth.

Also, in this macro backdrop investors demand a higher compensation for holding riskier long-term bonds rather than simply rolling over the ownership of short-term bills - that compensation is called term premium (more here).

Today though, the macro environment doesn’t fit the picture above - quite the opposite actually: I argue the yield curve is likely to invert soon.

Starting in summer 2021, the yield curve has been flattening at a quick pace reflecting a slowdown in growth impulse and the Fed marginally tightening their stance.

The slowdown in growth impulse is well captured in this chart from the excellent Eric Basmajian, which shows the 6m annualized growth rate of a basket of four relevant US economic indicators.

The peak in growth impulse was in May 2021.

At the January FOMC press conference though, Chair Powell went a step further: he didn’t do anything to remove the most hawkish Fed tail risks (e.g. 50 bps hike in March, hiking at every meeting etc) despite the slowdown in economic data being even more evident than before.

The chart above shows how the probability distribution for Fed’s monetary policy actions in 2022 has not only shifted to the right after Powell’s press conference, but it also has a fatter right (hawkish) tail compared to the end of 2021.

The fixed income market now prices a cumulative 30% chance the Fed will hike 6 or more times (!) in 2022 - as Powell validated this as a non-remote possibility.

By saying ‘‘there is quite a bit of room to raise rates without hurting the labor market’’ and ‘‘tighter financial conditions don’t matter until they threaten our dual mandate’’, Chair Powell gave markets the green light to price a more aggressive tightening stance and hence higher front-end bond yields.

For the curve to invert though, long-end yields also matter: what about them?

Long-end bond yields = long-term nominal growth + term premium.

Poor demographics and stagnant productivity trends already weigh on long-term nominal growth prospects. On top, since summer 2021 we are witnessing a cyclical slowdown in growth impulse and now the Fed is on a mission to tighten financial conditions and increase short-term borrowing costs for the private sector: prospects for future nominal growth aren’t looking great.

Also, term premium is unlikely to increase: the uncertainty around future growth outcomes is not that high (it will suck) and hence the marginal compensation investors require to own long-term bonds in such a macro backdrop is pretty low.

Basically, long-end bond yields are going nowhere (or lower) while short-end bond yields shoot up to reprice an incrementally more aggressive Fed tightening cycle.

Up to the point when the yield curve inverts.

Ok, But What Yield Curve?

Yes, but what yield curve exactly?

The OIS swap curve - I like to look at the 5y-30y slope in this curve.

I know, it sounds complicated but it’s not: bear with me.

Most financial commentators look at various slopes in the Treasury yield curve to determine whether it’s inverted or not, but that’s not the correct way to do this.

Investors buying bonds are compensated with a bond yield that should cover both interest rate risk and credit risk.

A common mistake is to include the credit spread component in the assessment of yield curve slopes - it unnecessarily pollutes the analysis.Instead, our focus should be on what market participants expect for the short-term and long-term path of the purest risk-free rates instrument: Fed Funds rates.

OIS stands for overnight index swaps and they are are perfect for that. For instance: in a 5y US OIS swap, you receive a fixed 5y rate in exchange for paying the overnight Fed Funds rate on a daily basis over the next 5 years. Basically, OIS swaps tell you where the fixed income market consensus expects Fed Funds rates to move over a fixed period of time (more here).

And yes, I am telling you Treasury bonds trade at a (credit) spread to OIS swaps - I will cover this and other topics in depth in a Bond Market 101 article.

I use the 5y-30y slope: the average length of a Fed tightening cycle tends to be historically around 3-5 years, while 30y yields reflect long-term expectations for nominal growth and term premium.

Here is how it looks like.

It’s now at 16 bps only (spoiler: the same slope on the Treasury yield curve would say we are ‘‘still’’ at 46 bps, quite a ‘‘healthy buffer’’ if you don’t look at the right curve).

OIS swap rates are not easy to find online unless you have an expensive Bloomberg terminal - but don’t worry: you can follow me on Twitter for regular updates.

By The Way, Who Cares?

Cool, now you know why I expect what yield curve to invert.

But who cares about yield curve inversions? Well, you should.

Inverted yield curves not only predict sharp economic slowdowns, but they also actively contribute to them.

Unfortunately, my OIS swap data goes back only to 2011.

For a more historical overview, we need to use the ‘‘credit spread polluted’’ Treasury yields, and the best way to reduce this pollution is to use the 2y-10y slope as long-end Treasury credit spreads tend to be the heaviest across the curve.

The Chicago Fed shows a very famous relationship: inversions in the 2y-10y slope of the Treasury yield curve is a solid indicator of sharp economic slowdowns ahead.

I am going to go a step further here and briefly explain why an inverted yield curve actually contributes to the slowdown, rather than only predicting it.

As explained here, we often overlay cyclical growth to the poor structural growth trends using leverage - this ‘‘kick-the-can-down-the-road’’ system is sustainable only if (real) borrowing costs are cheaper and cheaper to facilitate refinancing and marginal access to new credit.

When the yield curve is inverted, the marginal cost of refinancing and accessing new credit short-term increases and often breaches the equilibrium levels required to keep the system afloat - this increases the hurdle for the private sector to access credit.As long-term growth prospects are poor, an already indebted private sector looking at more expensive borrowing costs might even think of the ‘‘true evil’’ - deleveraging.

A vicious circle therefore unfolds: restricted/more expensive access to credit in an already slowing and poor long-term growth environment leads the private sector to be more defensive, which compounds on the already ongoing cyclical slowdown.

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

One of the best European government bond traders (and a good friend) on the street has his alarm set to ring at 6.15am every morning.

Every morning, the alarm rings and asks him ‘’How consensus are my trades?’’

Markets have moved sharply year-to-date, and in one clear direction: short Cathie Wood and Bitcoin, long cyclicals (banks & oil).

This relative stance has now likely become consensus.

While there are good macro reasons for the first leg of the move, the second leg seems less justified at this stage.

What are the macro drivers for this move, and how do we trade it?

Let me share my thoughts with you.

Without further ado, let’s jump right in!

A Peak Behind the Macro Curtains

On Dec 6, I argued the risk/reward for Central Banks at this juncture in the macro cycle was definitely skewed towards engineering a ‘‘gentle’’ tightening.

As the labor market heals and we enter the mature phase of the cyclical recovery, financial and monetary conditions can be gradually and gently tightened in an effort to reduce inflationary pressures.

There are two main drivers Central Banks often look at while attempting to deliver a mild tightening in financial conditions: real interest rates and credit spreads.

Why?

Because the private sector borrowing costs are nothing else than the sum of real yields and credit spreads, and those financing costs can mildly rise as far as real wages and output are growing at a decent pace too.

Mess up with this chemistry, and you have a problem.

‘‘Abrupt’’ is the key word here.

An abrupt move in real yields and credit spreads relative to real wages and earnings causes a repricing in risk premia: in that case, the chemistry has not been respected.

In order to define ‘‘abrupt’’, I looked at the 10-year history of bi-weekly moves in 5y forward, 5y US real yields.

The Jan 3-17 move ranked like this:

It was the 7th worst rolling bi-weekly move up in 5y5y US real yields (+40 bps) over the last 10 years, ranking in the worst 2% percentile of the distribution!

Wow. That’s abrupt.

Such a sharp move in real yields weighed on risk sentiment, and the highest P/E & highest beta assets were hit the most - it makes sense, as those assets are highly dependent on risk premium and their cash flows (if any) are to be seen far away in the future.

On the other hand though, the move in high-yield credit spreads (only +20 bps during the same period) didn’t rank at all as an abrupt outlier and analysts consensus for S&P500 earnings growth in 2022 moved from 9% to…8.5%.

Basically, the market told us the real economy can handle this.

See below the outperformance European Banks staged over High-Beta stocks.

As explained, there are good macro reasons for the downside move in high-beta, high-multiples but much less so for the long cyclical move to continue its upside move.

In my opinion, there are three underlying reasons why:

* My credit impulse metric suggests earnings and inflation are going to disappoint consensus;

* The tailwind from higher real yields without a substantial negative EPS repricing is likely over, as we get dangerously close to the magnetic cap represented by the 0% level for 30y US real yields;

* It’s becoming pretty crowded.

Point 1: Mr. Credit Impulse is telling us the earnings bonanza is over.

Point 2: 30y US real yields traded close to 0% at some point last week. With a 300%+ world economy debt/GDP, the equilibrium levels for real yields are ever lower. We could try to temporarily break higher, but this is going to weigh on the private sector ability to hold together.

Point 3: everybody and their mother moved to chase long cyclicals and short tech.

Alright, so what are the trades here?

The Trades

Sharing my macro knowledge and framework and being fully transparent are the backbones of my work at The Macro Compass (I highly recommend Jon Turek as a fellow macro investment strategist: his Substack is worth the money, big times).

So, before we jump into the trade ideas I believe I should provide clarity on my investment approach (it’s described here in details, but there are some minor tweaks so I’ll summarize it again below).

I have two portfolios: a long-term secular portfolio where I invest 90% of my savings and a short/medium-term tactical global macro portfolio where I invest 10% of my savings. Plus, I own some real estate and some liquidity of course.

The long-term secular portfolio is invested 70% in global stocks (IWDE), 20% in US Treasuries (TLT) and 8% in Gold (PHAU) and 2% in Bitcoin.

This is primarily a secular risk-premium and earnings growth harvesting portfolio. TLT and Gold benefit from the secular move lower in real yields while reducing my drawdowns and/or serving as a tail risk hedge for a monetary reset. Bitcoin is a highly leveraged call option on risk sentiment with some marginal potential to play a role in the Macro EndGame too.

I hardly touch this portfolio apart from yearly rebalancing.

The tactical global macro portfolio aims at generating >10% total return regardless of market conditions, and the time horizon here is 1-3 months (it can be longer though).

Every trade has a skewed stop loss/initial profit target: hard stop at -2% of remaining capital and initial profit target >3%. This way I can be right 50% of the times and still make money at year-end if I am thoroughly disciplined.

The stop-losses are generally placed at 1 standard deviation distance from entry price calculated using 4y rolling monthly returns. The trade size is adjusted such that I can lose max 2% of my capital if that 1-sigma move hits me.

I will always cut my losses and let my profits run. The former is easy to understand. The latter means that if I hit my first profit target, I move the target up and my new stop loss too (now hitting the stop actually makes money).

Profits keep on running until I hit my new stop (now a profit).

Yes, but…show me the money now!

So, here are the trades and how the portfolio looks like today:

Compared to the investment ideas published at the end of 2021 here, I have applied the following changes.

* On Jan 18th: went long 10y Treasuries (publicly announced here)

* Today: opened a short in Oil (rationale explained here)

* Today: closed shorts on MSCI China and Gold (at a small loss) and on TIPS (at a good gain): rationale below

* Today: opened a long position in Chinese Real Estate: rationale below

Closing the shorts in TIPS rather than letting the profits run is actually contrary to my baseline approach, but I felt compelled to do so as the YTD move in real yields was ferocious.

On top, I had turned bullish nominal yields and short oil hence the book was at risk of becoming way too exposed to the same macro principal component.

Similar story for gold, which was contributing to that short real rates positioning but it hadn’t delivered much despite the big move in real yields.

Finally, the newly opened position: long Chinese Real Estate (CHIR ETF), which also involved closing the short MSCI China I was running.

China has opened the credit taps again, and they have the unique possibility to direct credit when they want and where they want it.

The 2022 CCP Politburo is coming, and the private sector deleveraging has been big and lasted for long enough – the latest PBOC action and the clear guidance given to state-owned banks should be sufficient to allow for a decent rebound in Chinese Real Estate from the large drawdown we have experienced over the last 3 quarters.

A trade to own for few months (or quarters, who knows), hence the sizing is smaller than usual to allow for stops and profit targets to be placed a bit wider than usual (stop loss at 2-standard deviations instead of 1-sigma).

In a nutshell: the abrupt rise in real yields has hurt risk assets, with the highest beta sectors hit the most while cyclicals…

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15’ reading time

A good friend and hedge fund portfolio manager once told me:

‘‘You see that guy? He likes chasing screens. Once the news is already out, any information asymmetry you perhaps had it’s gone. You can’t successfully trade old news. Don’t chase the screens’’.

Yes, QT matters. No, QT ≠ mayhem.

Quantitative Tightening is now old news: everybody and their mother are talking about it, and headlines about QT are everywhere.

So, instead of chasing the screens and trading on the news of QT…

Why don’t we have a look at what QT really is and what should you pay attention to?

Without further ado, let’s jump right in!

The QT explainer you were looking for (I hope)

As anticipated here, Central Banks will tighten.

They will try to do it in a gentle way, yes. But they will tighten.

The best definition of ‘‘gentle tightening’’ I can find comes from a speech former ECB president Mario Draghi gave in summer 2017.

If you remember, in 2017 the global economy staged a strong and concerted cyclical recovery - mostly due to the lagged effect of a huge 2016 Chinese credit expansion and some fiscal stimulus in the US.

‘‘As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged.’’

Jokes aside, the prospect of 4 hikes plus QT at the same time sounds all but gentle.

So, where is the trick?

The devil is in QT’s details.

Quantitative Tightening is the opposite of QE: Central Banks reduce their balance sheets by eliminating reserves from the system and they force the private sector to rebalance their asset composition from zero-risk, zero-duration reserves (banks) or bank deposits (non-banks) into credit and duration-intensive bonds.

Analysts now expect the Fed to shrink its balance sheet by about $1.5 trillion between mid-2022 and the end of 2023.

Here is what analysts were expecting in Q2-19 (orange) and what really happened (red).

Why is it so complicated to engineer a successful QT, and will Central Banks manage this time around?

Let’s look at the mechanics for a second - I was inspired by this post from The Fed Guy (Joseph Wang): check him out, he’s great!

In the example above:

A) The Fed has reduced its balance sheet with a couple of keystrokes; just as it created reserves out of thin air to run QE, now it doesn’t reinvest maturing bonds from its QE portfolio (= performs QT) and therefore destroys reserves;

B) We assumed the government would just roll-over its funding needs: as the Fed isn’t rolling over its bond holdings, the private sector now needs to step up and absorb more of the newly issued securities;

C) The private sector (identified with commercial banks here) has to forcefully change its asset side portfolio composition into owning more bonds and less bank reserves. For a non-bank private entity, the conclusion is similar: it would need to own more bonds, and less bank deposits.

So, what makes running QT so hard?

There are two reasons: the ‘‘cash’’/collateral positive imbalance gets reversed and the QE-driven incentive to move down the risk curve gets incrementally reduced.

To understand why that’s really hard to do, let’s look at what QE does first.

After all, QT is the opposite of QE.

Say you are a pension fund in the Eurozone.

On the asset side of your balance sheet you need bonds to a) offset the duration risk of your long liabilities, b) generate some yield, c) because the regulators say so.

Now, with QE the ECB has been forcefully changing the composition of your portfolio by removing bonds from the system and injecting inert bank deposits.

Here is a stylized example:

Notice: pension funds don’t have access to the ECB, and therefore their default choice would be to deposit money overnight at European commercial banks.

Yes. Unsecured, non-collateralized bank deposits at -58 bps (banks swimming in excess reserves will obviously charge rates below the -50 bps ECB deposit rate for additional deposits, such that they can generate returns able to compensate for balance sheet and leverage ratio costs).

Not a nice proposition.

So, what do they do instead? Reverse repos.

Pension funds would lend away their ‘‘cash’’ (i.e. inert bank deposits) and get back ‘‘collateral’’ (i.e. bonds) in exchange - this way, their overnight unsecured deposit at a commercial bank has turned into a secured, collateralized reverse repo transaction.

As the ECB drains collateral from the market and continuously injects ‘‘cash’’ (bank reserves and inert bank deposits), the positive ‘‘cash’’/ negative collateral imbalance becomes bigger and repo levels become incrementally more expensive - sometimes even returning way less than a risk-free overnight deposit at the Central Bank.

So: more ‘‘cash’’ chasing less and less ‘‘collateral’’ = more expensive repo levels.

Why does it matter?

Repos are used by primary dealers, hedge funds and about any other financial institution to borrow and lend money and securities to each other’s.

When repo rates turn very expensive, borrowing scarce securities to sell them short becomes a pretty expensive exercise - on the other hand, she who owns the shrinking amount of collateral and decides to lend it out gets a nice compensation in return.

This bring us to the QE-driven incentive to move down the risk curve.

The ‘‘abundant cash / scarce collateral’’ imbalance leads to more expensive repo levels, which makes short-selling government bonds more punitive ceteris paribus.

Generally speaking, this new incentive scheme leads to lower volatility: an increasing amount of ‘‘cash’’ chasing a shrinking pool of collateral makes sell-off look like a palatable opportunity to buy. A gravitational force, basically.

On top of that, the private sector now sits on a portfolio much more skewed to zero-yielding, zero-duration reserves than to much needed coupon and risk-bearing bonds.

Time for carry trades.

Below, the % of high-quality liquid assets major American banks chose to allocate to reserves (blue), Treasuries (green) and higher-yielding yet still regulatory-friendly liquid assets (orange and white).

The common trend is for a lower HQLA percentage held in reserves or Treasuries, and more allocated to higher-yielding assets: mortgage backed securities (MBS) and other bonds treated as HQLA under the Liquidity Coverage Ratio (LCR) regulation.

Hint: that’s mostly highly-rated Corporate Bonds.

Carry trades, indeed: less collateral versus more ‘‘cash’’, more expensive repo levels, less volatility = investors move down the risk curve and buy riskier securities.

All clear, so far?

Now, just think that QT delivers the exact opposite effects of QE.

Reserves get removed from the system while the collateral previously bought by Central Banks does not get repurchased once it matures: the ‘‘cash/collateral’’ imbalance starts to revert.

As the private sector is called to marginally absorb more collateral while owning less reserves and inert bank deposits, their marginal appetite to increasingly move down the risk curve reduces ceteris paribus.

Here is a look at what happened in September 2019, when the Fed had reduced its balance sheet from $4.5 trillion to $3.8 trillion in 2 years.

Conclusion: shall we freak out?

No.

While QT sets the direction of travel to be very different from QE, there are four main pillows the US will be using to engineer a softer landing.

* The starting point and the pace of QT: although nobody knows ex-ante what’s the amount of excess liquidity which holds the system comfortably together, reducing the balance sheet from $9 trillion to $7 trillion in a couple of years is unlikely to make everyt…

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12’ reading time

Hey everybody, welcome back to The Macro Compass!

This is a special edition. We have the pleasure to welcome back a great macro strategist and friend: Andreas Steno Larsen.

I sat down with him for a fireside Q&A session on his global macro and asset allocation views - enjoy!

We are in the late ‘80s.

Ross Johnson, the CEO of the massive food and tobacco corporation RJR Nabisco, attempts to buy the company. Before long, other major players become involved, most notably Kravis and Forstmann. It all quickly turns into a ruthless bidding war.

Forstmann argues that to stop raiders like Kravis: "We need to push the barbarians back from the city gates’’.

In the end, the ‘‘barbarian’’ Kravis wins the bidding war.

You can try to push them away, but Vikings always come back at the gate.

Without further ado, let’s jump right in!

Alf: ‘‘Welcome back to the Macro World, mate! Hot topic first: what do you make of the latest C-19 pandemic developments?’’

Andreas: ‘‘Thanks! Several people have already tried calling the “end of the pandemic” with limited luck, but it seems as if the data we receive on the severity of Omicron brings about an increasingly compelling case for this pandemic to be close to ending.

Right about every expert agrees that Omicron is substantially milder but also more transmissible than Delta. This is textbook virology. A virus mutates in a milder but more transmittable direction and soon lethality times transmissibility will prove benign enough for this to be treated as just yet another endemic virus.

Enough bodega-virology for now.. .’’

Alf: ‘‘I see. Well, shall we expect a crack-up boom in economic growth if you are right on the pandemic coming to an end?’’

Andreas: ‘‘Not really. The power of the rate of change of things is very important here. Look at money creation for example.The extreme volatility in credit creation is a result of Covid-policies since the first round of lockdowns did bring about the most bizarre short-term credit expansion in history as 1) governments ran humongous unfunded deficits and 2) everyone and their mother started utilizing idle revolving credit facilities at commercial banks.

This expansion led to a massive yearly increase in actual money creation (and here we are not talking about QE, but private/public sector credit creation), but it also leads to a so-called credit cliff as soon as the pandemic dissipates.

No more public credit schemes to SMEs while larger corporates start to bring down revolving credit facilities again as liquidity improves due to the increase in economic activity. All in all, a material tightening of the so-called credit impulse.

What comes up, must ultimately come down in rate of change terms and besides the GFC in 2008/2009, such a material change of the credit environment from a rate of change perspective has not been seen in modern history.

If you pair that with the Federal Reserve contemplating an outright shrinkage of the balance sheet, we may be in for a 2019-like contraction in USD reserves in the financial system already before year-end.

Alf: ‘‘So: the rate of change of both credit creation (mostly deficits and bank lending) and reserves creation (QE/QT) is moving in the wrong direction: what does this mean for bond yields?’’

Andreas: ‘‘Interestingly, the rate of change of credit means a lot to asset allocation as a credit boost equals an activity boost with a time-lag. A massive credit expansion in 2020 hence meant booming energy and industrial commodities, higher long bond yields and a decent performance in value-stocks in 2021.

We are now standing at those exact cross-roads again, as the rate of change in credit has come down materially through 2021 and will come down much further through 2022, in particular if the recent Federal Reserve rhetoric is any guide. Interestingly, we have had a peak in long bond yields exactly when the Fed ended QE1, QE2 and QE3, which makes the current end to QE4 an exciting empirical experiment.Right about everyone expects bond yields to skyrocket again alongside the end of asset purchases: we are not so sure even if inflation is running hot and unemployment is running low, and it has to do with both the power of rate of change and the end of the pandemic.

When the credit creation in rate of change terms has been running hot (measured by a rapid increase in dollar reserves), we have also seen a tendency towards higher long bond yields, not lower, which is in sharp contrast to the supply/demand picture through such period. As a consequence of tapering, the consensus this time around again - as it was when QE1, QE2 and QE3 ended – that fewer purchases of longer-dated bonds must lead to a higher long bond yield.

The thing is that consensus around higher bond yields and booming commodities is always extremely uniform when the rate of change in credit creation peaks, and it makes sense as actual creation of money in the real economy leads to an increase in activity.

Alf: ‘‘And what does this mean for inflation and other asset classes in 2022?’’

Andreas: ‘‘Thankfully, we can actually forecast on the credit impulse (impulse is a word invented by macro guys such as Alf, when they want to sound extra esoteric without any purpose), and furthermore the credit impulse actually often leads the market developments by quite a while.

In other words, we have seen long bond yields, commodities and inflation expectations peaking exactly when the rate of change effect is the most material, which is what we see just now again. The headwinds from a rate of change perspective will become bigger and bigger through 2022, and already in Q2 inflation will face rate of change headwinds in the used cars category and in Q4 the inflation growth will face almost every possible gust of base effects at the same time, which may lead the overall inflation into negative territory even if underlying fundamentals point in the other direction. Growth will face rate of change headwinds already now, which is before the headwinds will arrive in inflation from a momentum perspective. If the history of rate of changes is any guide, both inflation and growth are likely to surprise negatively by the end of this year.

Positioning is once again, as per usual by the end of a QE program, very loaded towards higher bond yields and cyclical assets such as industrial metals and this also coincides with a material positive rate of change effect in credit during 2020. Now that we are faced with the opposite – a material negative rate of change momentum in credit – it ought to lead positioning in the other direction over the coming 2-4 quarters once both growth, inflation and ultimately wage growth starts surprising to the downside.

As the pandemic dissipates, we should expect the workforce to increase (as boomers return), supply chain issues due to a bizarre purchase volume of goods to fade and stimulus measures to disappear. The result is a negative impulse, which will likely lead to one of the most material negative rate of change events in recent decades – and we argue that it makes sense to start positioning accordingly already now. Yes, the Fed is likely to hike. Yes, the Fed is likely to try and start tightening the balance sheet again. Yes, other G10 central banks ought to try and be hawkish… What happens when you tighten into a massive slowdown in the rate of change of credit, is that you flatten the curve materially... And I am even tempted to say that you should both buy the USD and duration (in most currencies) with an arm and a leg already now.. And equities overall.. Hmmm.. see below!Happy hunting in 2022 😊

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A small present for The Macro Compass subscribers: the interview I did with David Rosenberg. It’s a really interestin…

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15’ reading time

Hey everybody, welcome back to The Macro Compass!

What’s the Macro End Game?

In short, another great reset of our monetary system.

We often talk about what markets are going to do next month, or this year. We like the feeling of being in control of asset class performances: after all, achieving consistent alpha year after year is has remained an elusive task for many. Hence, we must try.

This obsession about short-term market performance puts investors at great risk of missing the forest for the trees - this article will zoom out and focus on the forest.

Specifically, we will cover:

* How did we get here (our current monetary system)

* The options ahead

* The Macro End Game

Without further ado, let’s jump right in!

Cheap credit is cheap money from the future

In 1971, the Gold Standard effectively came to an end.

President Nixon ended the convertibility of USD into gold at a fixed price, and effectively introduced the fully elastic fiat system we have been living with since then.

That’s how it works: commercial banks and governments can now create credit out of thin air and add net worth to the private sector without having to worry about the intrinsic value of the newly created money - the peg to gold is gone.

For more insights on how commercial banks (via lending) and governments (via deficits) create money out of thin air, check out our evergreen article on this topic.

The main drivers of long-term economic growth peaked in the ‘80s, and politicians find it unpalatable to have the economy grow at a slower pace.

Especially when they are sitting on a monetary system that allows fully elastic credit creation: so, let’s leverage it up guys!

The main drivers of economic growth in the long run are working-age population growth and productivity growth: both peaked in the ‘80s.

Here is a 2000-years chart of the growth rate of world population.

I guess the trend is clear, right?

And here is a 250-years chart of UK productivity growth.

I added a red arrow, which probably wasn’t necessary to prove the point.

Alright, so long-run potential growth after the ‘80s started moving inexorably south, and what did we do? As any company looking to boost earnings and activity…

World Inc. started to use leverage.

Healthy private sector balance sheets allowed for private sector debt expansion, and governments across the world started running more fiscal deficits too.

The chart below shows private and public debt as % of GDP - the party starts in the mid-80s in the US. Also notice as every jurisdiction in the world is doing the same, perhaps with a different mix between private and public sector leverage.

But everybody has leveraged up, big times.

Cool, but servicing a mountain of (often unproductive) leverage is expensive.

Inflation-adjusted servicing costs are relevant for borrowers: while you pay nominal interest rates to service your debt, inflation reduces the real amount of your due future liability. Hence, real interest rates are the relevant metric to look at.

The trick here is simple, but genius: lower real interest rates.

Here, it’s important for you to understand that the downward trend in (real) interest rates since the ‘80s is a feature of our monetary system, rather than merely the result of monetary policy actions.

True, Central Banks have gone the extra mile in cutting short-term nominal interest rates and embarked in once-considered unorthodox monetary policy (e.g. QE) but the equilibrium real interest rates would be very low anyway.

Equilibrium is the key word here.

Short recap:

* Our economic system produces poorer and poorer long-term economic growth due to low population growth and stagnant productivity

* To achieve politically and socially acceptable growth rates in the short-term, we continue to leverage up both in the private and public sector

* Real interest rates drop further and further to keep the system afloat: Central Banks accommodate this process with monetary policy actions.

The chart below shows how 30-year US real interest rates (blue) must drop to lower and lower levels as debt/GDP (orange, inverted) grows larger and larger.

The real genius feature of this system is what I call the ‘‘wealth illusion’’ effect.

Let’s go through this theoretical exercise to understand what I mean.

Say you bought a house in the US during the early ‘90s and let’s assume the bank lent you 100% of the purchase value (100% LTV). Just an assumption, bear with me.

You wanted to spend about $1.000 per month in mortgage installments and given 30-year mortgage rates at 10%, that meant you could buy a house worth approximately $120.000.

Now, fast forward to today.

You still want to spend $1.000 per month in mortgage installments, but now your 30-year mortgage rate is 3%.

You can now ‘‘afford’’ a house worth $240.000: double the initial price.

The previous owner who paid $140.000 for the house now feels ‘‘richer’’.

To further back the wealth illusion point, consider that the US Case-Shiller Home Price index has gone up by 258% (!) since 1990 but once you adjust it for inflation and the drop in mortgage rates, here is what you get.

You can apply this methodology to ‘‘rationalize’’ how our economy system works and also why asset classes valuations keep soaring. Of course, there will be pockets of over/undervalued asset classes - I am not here to argue that Rivian is cheap, but just to provide you with the tools to understand how the wealth illusion effect works.

Credit creation + lower real yields = the wealth illusion effect.

Nice, but we have a problem.

The problem, the options, and The EndGame

Many people believe the problem with this system lies in the debt/GDP ratio.

Not really, especially when it comes to the public sector.

The government balance sheet does not work like a household’s: governments are the monopoly issuers of currency, and hence they can always refinance as long as the broad public has trust and credibility in their means to ensure the stability of the currency they are issuing.

The real problem here is that for the current system to thrive, incremental leverage must be accessible at ever lower real interest rates.

This ensures both the ‘‘affordability’’ of incrementally higher debt levels and the continuation of the ‘‘wealth illusion’’ paradigm.

Now, how do we ensure real yields fall more and more? Either via lower nominal yields or via higher inflation (expectations). Or both, combined.

Nominal yields can’t fall much further due to the proximity to the lower bound - if nominal yields fall way below -1%, storing physical cash in a vault becomes a somehow viable alternative despite insurance and transferability issues.

In certain jurisdictions (Japan, and arguably the US) there is also quite some political opposition to negative nominal interest rates in the first place.

Inflation expectations are already around 1-2% in most developed countries, and trying to engineer those higher might a) prove to be very difficult, and b) at some point dangerous, as a de-anchoring on the upside of inflation expectations is not palatable for the price stability mandate of Central Banks.

Japan leads the way in this experiment, with the EU lagging by 8 years and the US by 15 years approximately.

Real yields have struggled to fall further in Japan.

So, what are the options ahead?

* Deleveraging: politically unviable. If creating credit is the equivalent of printing money, deleveraging = destroying money. An extremely painful process that inflicts large losses to 2 generations of people that have lived and prospered through the wealth illusion effect. The establishment is never going to volunteer for this political hara-kiri.

* Kick the can down the road: favored by the establishment, but it will fail. As a former G10 Prime Minister once told me, the establishment loves the status quo and wants to be re-elected. The wealth illusion paradigm can run a bit further, but income inequality is growing …

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