The Macro Compass

When the yield curve flattens and eventually inverts, you worry.But it’s when a recession hits, the Fed cuts rates and the curve steepens that you become s**t scared.

Yield curve dynamics represent a crucial macro variable, as they inform us on today’s borrowing conditions and on the market future expectations for growth and inflation.

An inverted yield curve often leads towards a recession because it chokes real-economy agents off with tight credit conditions (high front-end yields) which are reflected in weak future growth and inflation expectations (lower long-dated yields).A steep yield curve instead signals accessible borrowing costs (low front-end yields) feeding into expectations for solid growth and inflation down the road (high long-dated yields).

Rapid changes in the shape of the yield curve at different stages of the cycle are a key macro variable to understand and incorporate in your portfolio allocation process.

Hence, in this piece we will:

* Quickly walk you through the different yield curve regimes (i.e. bull steepening, bear flattening etc);

* Assess these curve regimes within the growth environment, and derive important cross-asset macro signals;

* Take a look at today’s yield curve regime.

There are 4 main yield curve regimes to consider:

* Bull Flattening = lower front-end yields, flatter curves.

Think of 2016: Fed Funds already basically at 0% and weak global growth. Yields stay put at the front-end and could meaningfully move lower only at the long-end, hence bull-flattening the curve.

* Bull Steepening = lower front-end yields, steeper curves.

Late 2020, early 2021: the Fed was keeping rates pinned at 0% and stimulating via QE but the economy was flooded with fiscal stimulus and ready for reopening. The friendly borrowing conditions and the massive upcoming growth boost could mostly be reflected through higher long-end yields, while 2-year interest rates were pinned at 0% by the Fed. Bull-steepening of the curve.

* Bear Flattening = higher front-end yields, flatter curves.

2022 was the bear flattening year: Powell raised rates aggressively to fight inflation, but he ended up choking the economy off. This was reflected in lower future growth and inflation expectations at the long-end of the curve. Front-end rates went higher, but the curve bear-flattened.

* Bear Steepening = higher front-end yields, steeper curves.

Do you remember 2009? The worst of the GFC was behind us and (monetary-mechanics-illiterate) investors were afraid that QE would lead to runaway inflation and the Fed would be forced to start acting on it. Front-end yields moved a bit higher, but long-end yields took most of the hit as investors (mistakenly) bumped the inflation risk premium up = the curve bear-steepened.

Rapid changes in the shape of the yield curve when growth is at turning points are a key variable to consider for a successful asset allocation process.

Here is a Yield Curve Cheat Sheet you can use:

Let’s see some quick examples.

In 2024 the yield curve has mostly bear flattened while economists were busy revising growth prospects higher.👉 Take a look at ''Growth Up + Bear Flattening''.What does that imply, and what asset classes benefit the most from this combination?1️⃣ Cyclical stocks 2️⃣ CommoditiesIn an environment where growth is moving higher and the market is busy repricing away cuts (= the curve bear flattens as rates move up mostly at the front-end), the ''Old Economy'' does well: value, cyclical, energy-related stocks deliver solid performance as the growth cycle is re-rating higher.And these sectors don't need lower rates to thrive: they just need strong economic activity.But now let's take another example: what if growth slows down, and the Fed is forced to cut rates faster?👉 Take a look at ''Growth Down + Bull Steepening''.Well, in that case cyclical stocks and commodities actually do poorly.The yield curve bull steepens as the Fed is called to urgently cut interest rates because economic conditions are deteriorating.

As you can see, understand yield curve dynamics in the context of the growth setup can provide with important cross-asset macro signals.

But where are we today?

The chart below shows the trend in US private job creation (blue) in the months following a persistent yield curve inversion. The red colored area is consistent with the onset of recessionary conditions, and the green dotted line signals a dis-inversion of the curve.

See the pattern:

1) Every recession since the 1970s was preceeded by a yield curve inversion

2) The timing between the initial inversion and the start of a recession varies: in the early 80s or 2000s recession it was as little as 12 months, while in 2008 it took 27 months (!) for the macro lags to appear

3) Today the yield curve has been inverted for over 20 months and counting, and private sector job creation has slowed down a lot.

A potential dis-inversion right here (green dotted line) would be the last step in the historical recessionary sequence.The US economy has proven to be way stronger and stubborn than many expected, but the jury is still out.

‘‘Is this time different’’?

Thanks for reading!

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Hey, this is Alf - welcome back to The Macro Compass!

Last week was big for macro and markets.

Today’s piece is going to cover:

* The Fed’s dovish announcement: a sizeable tapering of their Quantitative Tightening program;

* A potential upcoming shift in market dynamics: for the first time in a while the reflation thesis was challenged by a weaker suite of data clashing versus the very optimistic 5% economist expectation for 2024 US nominal GDP growth;

''Beginning in June, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion.''

With this sentence, the Fed announced the tapering of their QT program last week.The Federal Reserve has been running QT (Quantitative Tightening) since mid-2022: this process is aimed at unwinding the multi-trillion Fed bond holdings accumulated during previous QE episodes.The Fed doesn't sell bonds back to the market, but it merely allows them to roll over its balance sheet without reinvesting the full maturing notional.

Summing up Treasuries and other bonds, the Fed was allowing $95 billion of bonds (60bn USTs + 35bn MBS) to roll-over its balance sheet each month.

To be more accurate though, QT was actually running at about ~75bn/month.That’s because the loans underneath the Mortgage Backed Securities (MBS) sitting on the Fed balance sheet are being repaid slowly due to high interest rates hampering mortgage refinancing activities, and so MBS maturities are only ~15bn/month.

See this excellent chart from Michael Gray:

In any case, after Wednesday’s announcement QT will be running at roughly half (!) its previous pace: from ~75bn/month to about ~40/bn month.

Why does it matter?

This is a positive surprise for markets because it means the Fed will be doing more work to absorb the Treasury bond issuance planned over the next quarters to match the approved deficit spending.

It means pension funds, asset managers, banks and other institutions are required to absorb this heavy-duration bond issuance to a much more limited extent.And the portfolio rebalancing theory suggests that private investors with more balance sheet and risk-taking capacity will reallocate some of that towards riskier assets like credit or stock markets.

Also, a more measured QT pace implies an even slower drainage of reserves (aka ''liquidity'') from the interbank system.

But since mid-2022, despite QT shrinking the Fed’s bond holdings by $1.6 trillion and counting the amount of bank reserves (‘‘liquidity’’) is literally unchanged:

This is because we are witnessing QT Sterilization.

The $1.6trn of bank reserves (''liquidity'') QT was supposed to drain were sterilized by a liquidity injection elsewhere.That elsewhere is due to Money Market Funds (MMF) draining down the Reverse Repo (RRP) Facility to buy the avalanche of T-Bills issued by the US government.As a result, US banks were not asked to step in and buy bond issuance amidst QT - the standard mechanics by which QT reduces reserves.Instead, QT has been effectively sterilized via T-Bill issuance absorbed by MMF draining the RRP.

The Fed is being very prudent and risk-adverse with this early and aggressive move in reducing the pace of QT as they are scared of a 2019 repeat when a low amount of reserves in the system caused a blow-up of repo markets.

But interbank liquidity isn’t low, and reserves aren’t nearly getting scarce.The Fed just went ahead with a proactively dovish monetary policy announcement.

Which begs the following question.

Will they also replicate such a proactively dovish stance when it comes to interest rate cuts and start their cutting cycle in summer despite the inflation comeback we witnessed in the first quarter?

Basically: is the Fed Put back?

A Fed Put refers to the setup where Powell virtually sells put options on the S&P500 – effectively putting a floor under risky assets. The Fed would achieve that by signaling a very dovishly skewed Forward Guidance: ready to proactively ease at the first signs of weakness, while not tightening if growth or inflation pick up.

This dovish reaction function was prevailing for most of the 2013-2019 period.

The Fed would ''have the markets' back'' and investors would know that at any sign of economic weakness, a big easing would be around the corner.But when the economy or inflation accelerated, the Fed won't react hawkishly but rather ''let the economy run hot''.

Now, picture the US economy running at a 5.8% nominal GDP growth with economists expecting growth to remain at or above 5% for quarters ahead.The last time this happened was in 1996-1998 and 2004-2006:

And now picture Powell refusing to talk about hikes at the press conference, but only focusing on potential downsides ahead to discuss when (not if) the Fed is going to cut.

Doesn’t that look like a Fed Put?And why would the Fed risk such a proactively dovish reaction function - are they not afraid growth and inflation might pick up further as a result?

Well: maybe it’s because they are hearing a few cracking noises…

The labor market is still doing ok, but a few cracks are showing up under the surface.

Unemployment rate is gently picking up, cyclical industries like construction and manufacturing are seeing less and less job openings, and small businesses (orange) hiring plans are disappearing - which historically correlates with a broadly weaker US job market.

The reflation narrative is being challenged hard.And the Fed is listening…

Thanks for reading!

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Here is a trillion (dollar) reasons why the US economy is likely to hold up until elections: between now and then, Yellen is likely to drain the Treasury General Account (TGA) and unleash a wave of almost $1 trillion liquidity on markets and the economy.

In a second, I am going to walk you through the mechanics of the TGA drainage and its impact on markets.

But before we do that, it’s important to take a step back and reflect on this: mastering the mechanics of the various monetary plumbing operations like QE, QT, fiscal deficits, RRP and TGA refill/drainage will provide you with a sizeable edge as a macro investor over the next decade.

And that’s why today I am proud to announce the TMC Monetary Mechanics Course!

3+ hours packed with monetary plumbing examples explained step-by-step so you can become a master at understanding how monetary mechanics works.

The pitch is simple:

* Once you buy the course, you can watch the lessons and download the material whenever you want;

* You should buy it NOW, because I am offering a fat 50% off which is only valid until Sunday 28th!

Use the discount code ‘’MONEY50OFF’’ at checkout and become a monetary plumbing master for only € 249.5.

You can take advantage of the discount and buy the course HERE.

And now, back to the piece.

Nominal incomes are growing at 6%, and real GDP is crusing nicely around 2%.The labor market still holds okay, and there are no clear signs of broad economic weakness.

How can we square this with one of the most aggressive hiking cycle in history which brought Fed Funds above 5% for almost a year and counting?!

The answer lies in private sector balance sheets and fiscal stimulus.

Higher interest rates generally slow down economic activity: corporates and households face higher debt servicing costs and therefore they must cut capex/hiring/spending to allocate more resources to debt servicing.

Lower spending = the economy slows down.

In other words: higher rates tend to negatively affect the liability side of private sector balance sheets. But what if this time that’s going to take much longer, and in the meantime the opposite is happening?

Here is a very simple, stylized households balance sheet: bank deposits, stocks and T-Bills on the asset side and loans or mortgages plus net worth (equity) on the liabilities side.

What’s been happening lately?

* Continued fiscal stimulus: cheques and lower taxes increased the private sector net worth;

* Higher rates provide an additional income boost: households and corporates can park money at 5% T-Bill yields and harvest the benefits of higher rates;

* Higher rates are not affecting debt servicing: Fed Funds at 5% are less scary if households run on 30-year fixed mortgages and corporates have termed out their debt.

Here is how the US Private Sector Debt Service Ratio looks like today: yes it’s going up but slowly if you compare it to the fast and vicious Fed hiking cycle.

The main reasons for this slow pass-through are:

A) Long-dated mortgages and corporate borrowing, meaning very slow refinancing cliffs hitting households and corporates so far;

B) A low share of floating rate mortgages and corporate loans which limit the pass-through from higher Fed Funds;

So, if the private sector is temporarily shielded from higher borrowing costs but enjoying the benefits of higher interest rates and continued fiscal injections…

…one could make the funny argument that higher rates are stimulative?!

Such ‘’creative’’ arguments are generally heard at local tops in market and economic euphoria: soft landing headlines were popular in the second half of 2007, and with 5% 10-year yields in October 2023 we had a CNBC special on why yields were headed to 13%.

But it’s hard to fight back against the private sector balance sheet plus fiscal argument presented above.

In particular, while you can make the counter-argument that sooner or later the refinancing cliffs will start to bite and debt servicing costs will ultimately increase it’s much harder to fight against the fiscal largesse point.

And that’s why today I’ll present a trillion (dollar) reasons why this economic and market regime might continue for another 6 months until the US election kicks in.

Over the next 6 months, we might experience (another) huge liquidity injection in markets and the economy! How?

By having Yellen drain the Treasury General Account (TGA).

You can think of the Treasury General Account (TGA) as the checking account the US Government holds at its bank - which is the Federal Reserve. Every time the US government has accumulated excess money through taxes or bond issuance that it doesn't intend to immediately channel into spending, they will park it at the TGA account at the Fed.

As you can see from the chart above, the TGA generally sits around 250-350 USD billions and it occasionally increases towards USD 1 trillion only to be subsequently drained back to its standard size. After the ongoing tax season, Yellen will soon have around USD 1 trillion in the TGA - that's quite high, and hence we should expect a drainage to follow.

On top of it, the US debt ceiling suspension only lasts until the end of 2024 and at some point the US will ''run out of room'' to issue new bonds which means the only way to facilitate spending will be through using the money sitting in the TGA – great political cover to move ahead with a TGA drainage.

But why does draining the TGA matter that much for markets and the US economy?

That's because draining the TGA is akin to throwing fresh money at the economy (similar to deficit spending) and also adding new liquidity to the interbank system (similar to QE).

Borrowing a slide from the TMC Monetary Mechanics Course, we can follow the process step by step:

Step 1: the government drains down its TGA at the Fed, hence lowering its equity position but injecting this fresh new money in the real economy (= households’ net worth goes up!)

Step 2: households now have more money in the form of bank deposits, which end up in the banking system and hence banks also sit on a larger amount of reserves; the Fed’s balance sheet squares with less TGA perfectly offset by a higher amount of reserves (= interbank liquidity goes up!)

So now you see how powerful this monetary mechanics combination is?

The US will be simultaneously printing real-economy money and financial money at the same time, and it will be doing so while real GDP is at 2%+ and core inflation at 3%.

And what happens when you throw fuel on the fire?

Conclusions

The US economy is still running at a robust nominal growth pace because its private sector is temporarily shielded from higher borrowing costs while it’s enjoying the benefits of higher interest rates and continued fiscal injections.

‘‘Temporarily’’ remains the key word here, because ultimately the negative effect of higher borrowing costs will bite once the refinancing cliffs become more real.But Secretary Yellen might be planning to extend the ‘‘temporary’’ window until the elections through a crucial monetary plumbing exercise.

Draining the Treasury General Account and hence throwing almost $1 trillion of liquidity and stimulus into markets and the real economy!

So, all eyes on the upcoming Quarterly Refunding Announcement at the end of April to get to know what Yellen is up to.

This is a clear example of how mastering the mechanics of the various monetary plumbing operations like QE, QT, fiscal deficits, RRP and TGA refill/drainage will provide you with a sizeable edge as a macro investor over the next decade.

Don’t forget to get your time-limited 50% off on my new Monetary Mechanics Course (here), so you can become a monetary plumbing master too!

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

If you have been around for the last 10 years as a global macro investor you have experienced a situation where the US stock market was pretty much the only game in town. Since 2010 US stock markets largely overperformed Emerging Markets:

In the investment world, recency bias is strong and people assume this has always been the case. Yet taking a 70+ years historical perspective the evidence is much more mixed: for instance, the chart above shows the impressive EM outperformance in the 70s-80s or the early 2000s.

The next decade is likely to see a multi-polar world with geopolitical fragmentation, a bigger role for commodities, ongoing demographics and political shifts and increased US inflation and growth volatility. All these factors point to same conclusion: owning Emerging Market exposure in a long-term macro portfolio is a sensible thing to do.

Yet Emerging markets were (and still are) seen only as an exotic addition to portfolios: a 2020 survey by Morningstar shows only 7% of global portfolio allocations are dedicated to Emerging Markets. For reference, EMs represent about 15% of the MSCI All Country World Index (ACWI) and account for almost 40% of global GDP!

In other words: suffering from recency bias, global investors are largely under-allocated to EMs despite reasonable valuations and macro conditions in place for solid returns over the next decade.

Ok, but which Emerging Markets to invest in and why? This article provides you with a framework to approach long-term EM investing, and it points to three of my favorite Emerging Markets to own for the next decade.

We assess the most palatable Emerging Markets to invest in through fundamentals and valuations: countries with the best fundamental score and cheapest valuations make it to the shortlist. The focus is on EMs where sufficiently accurate data is available.

The scoring model on fundamentals is based on 4 main pillars:

* Economic growth (25% weight)

* Institutional credibility (25% weight)

* Leverage (25% weight)

* External vulnerabilities (25% weight)

Here is the summary table on fundamentals:

Structural growth is a function of productivity and labor force growth – both are used in our analysis. We also look at the last 10-year average realized GDP per capita as a concrete measure (not a forecast) of recent economic performance in each EM – remember take the Chinese number with a pinch of salt.

Eastern Europe (Poland, Hungary) and some Asian countries look good, while an ageing population and uneven allocation of resources in Brazil and South Africa don’t look promising for growth.

Countries can grow organically but they can also make productive use of leverage to boost growth: for this reason private and public debt are both part of our assessment.China is pretty much tapped out on leverage, and some other Asian countries (Thailand, Malaysia) also score poorly – recency bias again as the 1997 crisis seems to have been quickly forgotten? On the other hand Indonesia, Mexico, Poland and Turkey have leverage space to boost growth going forward.

Now a crucial point: investors hate volatility and unpredictability.

Organic or credit-driven growth matters, but institutional credibility is key for investors: a 2015 paper from Lehkonen shows how political instability is negatively correlated with long-term EM returns. To assess institutional credibility we have blended four relevant World Bank indicators (government effectiveness, regulatory quality, rule of law, and political stability) into one index and ranked EM countries.

Additionally, we reckon investors also assess policymakers’ credibility by their ability to keep inflation in predictable ranges – countries with the highest inflation volatility tend to be penalized by investors. We have therefore also ranked countries by their 10-year average standard deviation of CPI prints.

Combining these two metrics the worst performing countries are (unsurprisingly) Turkey and Argentina, while ex-China Asian countries rank well – particularly Malaysia and Indonesia given their predictable inflation ranges and good institutional frameworks.

Finally, it’s important to recognize that most EM countries have external vulnerabilities: either they owe to the rest of the world through a negative current account or through a net negative investment position (NIIP). Against this backdrop, EM countries will own a buffer of foreign exchange reserves (mostly USD and EUR) they can use to balance out their external vulnerabilities: we measure how many months of imports can be covered by the amount of net FX reserves each country has.

Turkey is notoriously vulnerable to external shocks, while China has amassed a gigantic amount of net FX reserves – actually even more than publicly disclosed.

It’s now time to blend together the fundamentals and valuations so we can derive actionable conclusions.

The x-axis represents the country fundamental score: right is good, left less so. The y-axis looks at equity market valuations: up means cheaper valuations, down = more expensive. The top-right quadrant is the place where to look for bargains.

Remember: the EM complex is under-owned and it’s overall a cheap and sensible exposure to have.

From a relative perspective, EMs look fairly priced against our fundamental models yet the blue circle highlights some interesting opportunities in this universe.

My final shortlist includes 3 countries: Poland, Malaysia, and Indonesia.

Indonesia is home to over 20% of global nickel reserves (essential in the EV-making process) and it has effectively banned the unprocessed export of nickel hence trying to force companies to set up plants locally and boost the country’s long-term growth perspectives. Even if this protectionist tactic could somehow backfire, it goes to show how Indonesia could attract more investments going forward.

Malaysia is also a net commodity exporter and the new government is keen on applying structural reforms too. We are talking about a country with 10 years of positive current account balance and a credible policymaking mix which has now lured Tesla to engage in business relationships.

Finally my darling Emerging Market: Poland.

Over the last 5 years Poland has managed to beat most of its European peers in GDP per capita growth, and its potential long-term growth has also been boosted by a large influx of Ukrainian immigrants. Poland is a productive economy with a long-standing and specialised manufacturing sector which will be increasingly targeted for ‘’friend-shoring’’. The country has also emerged as the 5th world largest producer of EV batteries.

The cherry on the cake is a newly elected coalition government led by Donald Tusk (former President of the European Council) which will replace the former European-critic government: a more friendly stance towards Europe will unlock further inflows of direct and portfolio investments towards Poland.

Turkey also is a high-potential investment trading at super cheap valuations and with strong demographics fundamentals, but policymakers credibility remains too low.

Concluding: investors suffering from recency bias can’t see beyond US equity markets but macro conditions and cheap valuations favor a long-term allocation to EMs. The entire space is interesting with Poland, Indonesia and Malaysia the most compelling countries.

This week, I am also sharing with you a global macro presentation I gave for institutional clients where I covered the Fed, China, Japan, bond markets and more.Click Here to watch it.

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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

Animal spirits are running loose.

* Bitcoin just hit all-time highs;

* NFTs of penguins and monkeys selling for over $500k;

* Virtually bankrupt stocks like Carvana rallying to the moon;

Investors aren’t thinking macro at all recently.

They aren’t overweighting assets with better balance sheets or higher profitability, or going after companies because of their earnings growth profile. Instead they are busy sending Bitcoin, Gold, and other non-cash flow producing assets to the moon despite risk-free rates sitting at 5.25%.

Is this so unusual as it sounds?Not really.

In 1999 and in 2007 animal spirits were running loose as well.

Do you want to guess where risk-free rates were back then?Yup: north of 5%.And it didn’t end well.

But animal spirits are hard to defeat.Yes - you can have a healthy 4-5% drawdown in stock indexes but if you really want the tide to turn you need proper macro volatility events.

So let’s take a look at the big macro events looming large ahead of us.

US Macro Data and the Fed Reaction Function

Next week we’ll have the new US CPI data for February, and that will be a crucial data point to shed light on the disinflation process.Was January a statistical aberration due to seasonal price resets, or is the disinflationary path stalling?

In the meantime, we got quite an interest US job market report on Friday.

On the surface, the Non-Farm Payroll report produced another friendly outcome for the Fed and markets.

* 223k private sector jobs created

* Only 0.1% MoM wage growth

* Downward revisions to what seemed to be a super hot January

Here is the key chart which shows the most important elements of the NFP report:

The 3-month average print for private sector job creation (blue, RHS) is a nice +204k, slightly up from the late 2023 lows.

Wage growth seems to be headed towards the 3.5% underlying trend which was consistent with 2% inflation before the pandemic.The 6-month annualized trend in wage growth (orange, LHS) printed below 4%.

This is all the Fed wants to see: an okay amount of new jobs created, and wage growth moderating to help them achieve the 2% target.

But there are a couple of worrying things going on under the surface.See that red line?

That’s the U6 unemployment rate - also known as the broad underemployment rate.

The U6 rate is a broader definition of unemployment.It includes not only the unemployed but also those who are working part-time for economic reasons and those who are marginally attached to the labor force.

It’s steadily ticking higher.

Additionally, cyclical industries hiring trends are very weak.

Full-time hiring in manufacturing, trading, transportation, construction and similar sectors is the weakest since 2011.

Softer (as long as not recessionary) job market conditions can even be positive for market sentiment…as long as the Fed accomodates accordingly.

And this is where I think a potential risk ahead might lie.We are hearing the first rumors: some Fed officials think ‘‘this time is different’’.

When you start hearing FOMC members discussing the potential for ‘‘higher neutral rates’’ it means they think something structural has changed in the US economy.They start to believe the US economy can bear much higher interest rates without harming its potential to sustainably generate 1.5-2.0% real GDP growth.

A very recent BIS paper blended 4 models to estimate where r* (the real equilibrium rate for the economy) sits in the US.

The Fed thinks it’s at +0.5%.The BIS models disagree: they point to a higher +1/+2% range.

If more Fed officials marry the idea that neutral US rates are higher, this means that the cutting cycle will be shallow and short.

A bit like in 1995.

Back then, the Fed cut interest rates only 3 times and it took a multi-year pause after.

Today, animal spirits are also fed by a more friendly bond market pricing.Markets are pricing 3-4 cuts this year, 4 more next year, and some more after that in 2026 and 2027.

What if the Fed decides to go 1995-style hence disappointing markets right when the underlying weakness in the job market is starting to show up?

Europe Playing With Fire

Eurozone’s GDP growth printed at another meagre 0.0% in Q4 2023.

The European economy is flat like a pancake, and some countries are basically in a recession already - especially the ones which are highly exposed to China, manufacturing (Germany) or the real estate market (Finland).

Yet, the ECB keeps telling us it’s too early to proceed with interest rate cuts.Lagarde won’t admit it publicly, but like many other colleagues she’s looking at Powell to give his green light for cutting rates.

And while she waits, growth and inflation keep trading lower while ECB rates remain prohibitively high - policy keeps tightening for the real economy.

An ECB deposit rate of 4% while core inflation is already trending at 2% for quarters effectively imposes a policy rate of +2% in real terms (!) on a very fragile European economy.

Last time ECB rates (orange) were above the underlying trend of core inflation (blu) for a sustained period of time was 1999 or 2007.

It didn’t end well as Europe isn’t equipped to handle largely positive real policy rates for too long.

Japan Matters

Finally, a few words on Japan.

We are getting more and more headlines: it seems the time is ripe for Japanese authorities to try and exit from negative interest rates.

Japan is one of the largest capital exporters in the world.

It owns over $2 trillion of foreign bonds.Over $1 trillion in US bonds, and about ~400 billion in EUR bonds too.

Were the BoJ to put down a credible and prolonged normalization plan for domestic interest rates, Japanese investors’ incentive schemes would change.Starved from decent yields at home, Japanese insurers and pension funds have flooded foreign bond markets with buying flows.

But with 30-year JGB yields already at +1.75% and potentially headed higher the risk of capital repatriation into domestic government bonds is not small.

This would be a tectonic shift for global bond and FX markets.

Conclusion

Animal spirits are running loose.Investors aren’t thinking macro, and going after assets with no cash flows despite risk-free rates are north of 5% - exactly like in 1999 or 2007.

And while animal spirits are hard to kill, several macro volatility events loom large.

The Fed’s shift to a 1995 short cutting cycle, the ECB stubborness, and potential tectonic shifts brought by a Bank of Japan hawkish tilt are only some of the volatility events ahead of us.

Stay vigilant.

A new episode of The Macro Trading Floor is out!Listen on your favorite podcast app, and don’t forget to subscribe/follow the show so you’ll get notified every time a new episode is out.

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Welcome back to The Macro Compass.

Let me cut to the chase: The Macro Trading Floor is back!

TMTF was one of the most popular macro podcasts out there - I launched it with my friend Andreas Steno in 2022 and it quickly became very popular.I’d like to thank him for the great ride together.By mid-June 2023 I realized I had to focus on other urgent commitments, and hence we decided to suspend it.

I am happy to announce that after a 9-month pause The Macro Trading Floor is back……and with some HUGE news.

The show has a new co-host!

Profile: former trader for large hedge funds and banks in the US, amazing writer and macro analyst, macro expertise with a focus on FX markets…did you make your guess?

Want to find out who he is and listen to the comeback episode?Here you go:

Apple Podcast

Spotify

Google Podcast

The show goes out every Friday - subscribe in your favorite podcast app, and make sure you tune in every week!

Macro Is Everywhere

In the podcast, we covered several global macro themes and investment opportunities.Macro is back, and it’s impacting markets everywhere you look.

We discussed the chart above: it shows the market-implied probability distribution for where Fed Funds will end in December.

I derive that market-implied distribution and table of scenarios from options on the SOFR December 2024 contract - in other words, I am looking at what fixed income option traders are willing to pay or get paid for different scenarios this year.

The distribution is quite interesting.

The modal outcome (the most observed in the distribution = the highest bar) is 475 bps or only 2 cuts! That’s even less than the 3 cuts the Fed projects in their Dot Plot.The recession tail is thin (11% probability only) but it still exists, and therefore it pushes the mean outcome towards 3 cuts - in line with the Fed.

Markets aren’t assigning a meaningful recession premium anymore to bond market pricing, and have fully converged with the Fed Dot Plot here.

‘‘Buy insurance when you can, not when you must’’ applies here?

All Central Banks in the world have followed the Fed in a sharp hiking cycle.But not all economies are equipped the same way to handle the effect that higher interest rates bring.

In this episode, we discussed a few of them including Canada.

The chart above shows how the Canadian private debt as a % of GDP is larger (!) today than it was in Japan at the peak of the real estate bubble.

Nevertheless, the Bank of Canada has raised rates aggressively and it’s now planning to only ease marginally - again, following the footsteps of the Fed.

Is that credible?

We also looked at China.

China recently cut the 5-year Loan Prime Rate which is the reference rate used for mortgages, and so the idea was to reduce household borrowing costs for Chinese people.As other policy decisions have failed, authorities now hope that cutting mortgage costs will do the trick.

But that’s unlikely to work.

In the early 1990s the Japanese real estate bubble burst and the world’s most famous balance sheet recession unfolded – the Bank of Japan lowered and kept rates to 0% for decades after and…nothing happened.

Look at this chart: Japan 10-year bond yields (orange) dropped from 8% to 1% and yet Japanese house prices (blue) kept falling! When you hit balance sheets hard through a deleveraging process, asking people to take on more credit isn’t going to work even if rates are low.

We also discussed a few trade ideas on the back of global Central Banks trying to imitate the Fed even if domestic economies appear much more fragile.

The comeback episode of The Macro Trading Floor is here.I discussed a lot of interesting macro topics, actionable investment ideas and had a ton of fun with my new co-host.

Tune in here:

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Next week is huge: revisions to 2023 CPI, US labor market print, the Fed, and most importantly the Quarterly Refunding Announcement (QRA) everyone talks about.

So I thought I’d share an initial framework for you to understand why everybody seems to care about the details of the US bond supply announced in the QRA.

The key is to think of bond supply within the context of the US monetary plumbing.

The first thing to understand is the tectonic shift happening at the policymaking level when it comes to the use of fiscal deficits.

The chart shows how until 2016 US politicians applied fiscal policy in a counter-cyclical fashion.

When unemployment rate (blue) was low like in 2006-2007, they proceeded with a conservative fiscal stance (orange) and reduced deficits.Instead when a big crisis hit like in 2008 and the unemployment rate moved higher, they tried to support the economy with more fiscal deficits.

This is a textbook counter-cyclical application of fiscal policy: support the economy by injecting fresh money when it needs, and withdraw support when it's running hot by itself.

But in 2016 something changed.

Trump became the new US president, and despite unemployment rates dipping below 5% the US budget deficit started expanding anyway.A bit like crocodile jaws opening, for the first time in decades fiscal stimulus was not used to support a weak economy but instead ON TOP of an economy which was already strenghtening.

As a result, in 2017-2018 the US economy was quite hot - the Fed raised rates, the stock market puked, and in 2019 Powell had to pivot.But as Biden got in office, he recently showed he learnt the same trick too!

In the 2023 fiscal year, Biden rapidly expanded fiscal deficits despite a tight job market - hence the crocodile jaws were opened again.

The result?A prolonged cycle for the US economy, with inflation which perhaps took a bit longer than expected to start slowing down.

As Trump is gaining ground in his race to become the next US president, I wonder whether he's going to continue with this new crocodile jaw paradigm - and my hunch is that he will.

US politicians are becoming familiar with the power of fiscal stimulus (but not with the dangers of its excessive use). And by 2028 the majority of voters isn’t going to be Boomers & Co anymore, but instead Millennials and Gen-Z looking for a change in wealth distribution.

Therefore, we can expect a robust use of fiscal stimulus in a semi-permanent way.

Now, back to 2024: the Fed is doing QT while Yellen marches ahead with deficits.These are the monetary plumbing mechanics of this exercise - visualized:

1-2) The US government proceeds with deficit spending, households and/or corporates get an injection of new money, and (potentially inflationary) bank deposits go up together with reserves in the system;

3-4) Simultaneously, bond issuance takes place: Yellen issues bonds, and banks (primary dealers) use reserves to buy bonds at auctions;

5-6-7) The Fed runs down its balance sheet through QT, and that works like a net drain of reserves from the financial system.

An excessive reduction in bank reserves can become problematic for the smooth functioning of the repo market: banks use reserves to settle repo transactions with each other, and if there is too much collateral (bonds) floating around and too little reserves the repo market can suffer (e.g. 2019).

But there is a way around this problem: Yellen issuing T-Bills instead of bonds.This is one of the reasons why everyone is watching the QRA next week:

In this case, QT does not drain bank reserves but it’s instead ‘‘sterilized’’.

The bottom set of T-Accounts explains why: when the government issues T-Bills and money market funds buy them by draining their existing balances at the RRP facility, bank reserves don’t need to take the hit for QT.

It’s basically sterilized QT.

The other incredibly important dynamic is that issuing T-Bills or long bonds has a very different impact on market participants.T-Bills have very little interest rate risk, while long bonds are much heavier to absorb because of their big duration risk.

I will be talking about the QRA in details next week, and analyze its direct impact on bond and equity markets.

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The Fed has been running QT for a while and yet there is still abundant liquidity in the financial system.

Fed’s bond holdings are down $1.3 trillion from their peak (due to QT), yet only half of this supposed tightening has actually impacted bank reserves (aka ‘’liquidity’’) which are down a meagre $0.7 trillion.

This ongoing ‘’money mystery’’ has caught many off-guard, and it has helped fuel several bullish narratives: the most famous one being that higher ‘’liquidity’’ has supported stock markets in 2023.

2024 is shaping to be another year where monetary plumbing will matter a great deal.

To understand the mechanics behind this money mystery, let’s start from QT. Here are 5 simple steps to understand how Quantitative Tightening works:

Step 1-2: the Fed doesn’t reinvest maturing bonds (1) from its QE portfolio (= performs passive QT) and therefore destroys reserves (2) - also known as ‘‘liquidity’’’;

Step 3-5: the government needs to roll-over its funding, but the Fed isn’t rolling over its bond holdings (3). Banks now needs to step up and absorb more of the newly issued securities (4-5).

The resulting balance sheet changes are summarized in the bottom tables: the Fed reduces its balance sheet by 100 which sees a 1:1 reduction in reserves (aka ‘’liquidity’’) as banks must step up to absorb bond issuance.

This is how QT normally works.Yet something different is happening this time.

Back in 2021 the Fed had an issue: rates were at 0%, and there was too much money in the system. Money Market Funds (MMF) were bidding up T-Bills so much that yields were testing negative levels (!), and so to stabilize money market rates the Fed proposed a friendly alternative: the Reverse Repo Facility (RRP).

This encouraged MMF to park money at the Fed, and they did in huge size: the RRP reached $2.5 trillion. You can think of this like pent-up ‘’liquidity’’ stored in a corner of our financial system.

Here is the thing.

In 2023 MMF have unleashed this pent-up force: the RRP usage has dropped materially, and this wave of supportive ‘’liquidity’’ has been thrown at markets.

And this is likely to continue in 2024.

How does this work? As always, let’s check our stylized balance sheets to find the answers:

MMFs drain down their huge RRP balances (orange) and they buy T-Bills (green).

The government has to roll-over debt while the Fed does QT (red), but this time the slack is picked up by money market funds and not by banks.

The result is that QT doesn’t drain ‘’liquidity’’ but the RRP takes the hit (blue circle).

Effectively, we are running a sterilized version of QT:

In other words, the Fed is actually reducing its balance sheet but not draining the ‘‘excess liquidity’’ (bank reserves) from the system.

A liquidity conundrum.So, what happens next?

The RRP facility is down from $2+ trillion to $600 billion, so this ‘‘sterilization’’ mechanism can work for a bit longer in 2024 but it will ultimately come to an end.And dwindling liquidity can cause a lot of trouble in the biggest monetary plumbing machine in the world.

The repo market.

Claiming that the amount of reserves (‘‘liquidity’’) in the banking system somehow affects asset prices is outright wrong: banks don’t use reserves to buy stocks, and that’s why the supposedly direct relationship between changes in liquidity and stock market returns doesn’t exist.

But banks do use reserves to engage in repo market activities with each others.And that matters!

As the chart above shows, the requested premium to lend money in repo markets against simply depositing at the Fed is slowly increasing - levels aren’t worrying yet, but there seems to be a trend in place.

The red circles in the chart show how unhinged repo markets became in 2019.

Here are the 7 steps to the real monetary plumbing risk ahead for 2024:

* The Fed continues QT but MMF stop immunizing the negative effect on liquidity;

* Bank reserves take a serious hit, and banks’ appetite to engage in repo markets declines;

* The US Treasury continues to issue large amounts of bonds;

* The imbalance between collateral (bonds) to absorb and available liquidity (reserves) grows;

* Repo rates steadily increase signaling more strains in the monetary plumbing arena;

* Leveraged players relying on steady repo rates blow up;

* Deleveraging occurs.

In short: the money trick which made QT look like a walk in the park in 2023 might as well disappear later in 2024.

And this is a very underestimated risk which almost nobody has on its radar.

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

Macro investing without deeply understanding bond markets is like eating soup with a fork.You can still somehow make it, but it’s cumbersome and unproductive.

We are at a crucial juncture for macro and monetary policy, which means getting a grip on bond markets is even more important.This piece will help you with that, and most importantly provide you with the right framework to use.

Everyone is talking about this chart all the time:

It shows the market-implied Fed cuts (in bps) over the next 12 months, and it says -165 bps.

165 bps of cuts in 12 months is quite aggressive by historical standards.Even in early 2008 with Fed Funds at 4.50% and the US economy on the verge of a huge recession, markets were pricing only 128 bps of cuts for the consecutive 12 months.

Why would bond markets be so aggressive now?In a nutshell, there are two main reasons:

The first reason has to do with the Fed’s mandate – one could argue the job is done.

The labor market is back in balance (glass half full) and judging from the trend in private job creation at only 115k/month and steadily declining one could argue there are risks it’s weakening too much (glass half empty).The labor market isn’t remotely hot anymore: job done?

Core PCE (the preferred Fed’s inflation measure) is already annualizing at 1.9% which is below Fed targets.Further disinflationary tailwinds from the delayed pass-through of weaker rent inflation and a softer job market should corroborate the trend in H1 2024.The underlying trend of core inflation is already consistent with 2%: job done?

The second argument for so many cuts priced in is tightly connected to the first.

If the Fed’s job is done, what’s the appropriate level of Fed Funds?Back to neutral over the next 12-18 months.

And if anything markets are more sanguine on where neutral Fed Funds are than the Fed is:

The pandemic hasn’t changed the Fed’s mind on what’s a neutral stance: 2.50% nominal Fed Funds (orange) are still considered the rate which doesn’t overly stimulate or cool down the US economy.Markets have a different and more sanguine opinion right now.

Prior to the pandemic, bond markets (blue) were always more pessimistic than the Fed about the neutral rate and they were proven right: the US couldn’t generate meaningful growth and inflation with Fed Funds often below 2%, let alone higher.The Fed was saying neutral was ~3%, and facts were showing this wasn’t the case.

Today, bond markets disagree again but for the opposite reasons: neutral Fed Funds are seen >3.25% hence quite a bit higher than the 2.50% the Fed is stuck on.

Let’s pause here for a second and recap.

Markets are pricing 165 bps of cuts over the next 12 months which is aggressive by historical standards, yet this might be partially justified as judging from labor and inflation data the Fed’s job seems done.

If the Fed’s job is done, policy should return to neutral over time – but here markets are more hawkish.They see neutral Fed Funds at 3.25% while the Fed thinks neutral is 2.50%.

Ok, this is interesting: but here comes the real banger.Once you understand this, the bond market will make a lot more sense to you…

Eager to read the remaining part of this macro report?

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Welcome back to The Macro Compass - may 2024 be your best macro year ever!

Let me get straight to the point: our models show inflation is on its way to undershoot (!) Central Banks targets in 2024.

Inflation is often a monetary phenomenon: print real-economy money too quickly for the supply side of the economy to adjust, give it enough time and the only release valve will be higher prices (inflation).Abruptly stop or reverse this process, and inflation will moderate rapidly.

In plain words: the speed of real economy money creation leads inflation trends by roughly 18 months.

The money creation boom of 2020-2021 led to the strong inflationary pressures we saw in 2022.Since then though mortgage applications and corporate borrowing collapsed as a result of higher rates.The TMC Credit Impulse series captured that, hence it has well anticipated the disinflationary trend in 2023.

But there is more to come: the model now predicts these disinflationary lags to kick in further in 2024.

US Core Inflation could annualize at or below 1.5% (!) by early summer.

Inflation undershooting Central Bank targets is a big deal for macro investing in 2024.Which brings me to our improved Quadrant Asset Allocation Model (QAAM).

The TMC asset allocation starting point is the Forever Portfolio which distributes a similar amount of risk budget to internationally diversified equities, bonds, commodities, and the US Dollar.

In other words: a portfolio prepared for different macro outcomes.

The next step is to look at our TMC macro models: they dictate the direction ahead for growth, inflation, and the monetary policy stance so that we end up in one of the Quadrants represented above.

Based on the quadrant we land in, Macro Tilts are applied to the portfolio (e.g. more stocks, less bonds etc).

Judging from the above snapshot, one should strongly overweight TLT + QQQ and go to sleep.

Well: not so fast.

Let’s dig deep into the full TMC macro investment process which leads us to the construction of our 2024 macro portfolio…

Eager to read the remaining part of this macro report?

Come join The Macro Compass premium platform to get access to Alf’s full-length timely pieces, actionable investment strategy and much more!

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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