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Imagine you are about to pause a hiking cycle and in the run-up to the event you have stock markets pushing higher and animal spirits running loose: what do you do?

You still deliver the pause you promised, but you sound as hawkish as you can - in other words: jawboning.

Powell’s press conference and the Dot Plot (the most overhyped and useless Fed tool, more on this later) were designed as hawkish as possible to try and deter a melt-up bid in SPX in response to the actual pause.

Cutting through the noise, the reality is that the Fed is pausing as they are more confident in a soft landing and don’t want to run the risk of overtightening and be blamed for causing an avoidable recession.

It reminds me of late 2006: pause, dream of soft landing in 2007, recession in 2008.History doesn’t repeat but it often rhymes?

The Summary of Economic Projections (SEP) says a lot about the Fed’s high confidence in a soft landing:

Contrary to March (red boxes), there are now a whopping zero FOMC members expecting a recession in 2023 (and in 2024 too).Also, less and less FOMC members see downside risks to their 1% GDP growth projection this year.

Not only the base case for GDP growth has been revised higher, but also unemployment rate is expected to remain lower while core inflation will trend down but more slowly.

The Fed is predicting the mother of all soft landings.

The two additional hikes in 2023 (blue box) are there as a posturing exercise: we think the economy is doing ok and the labor market is still tight and while inflation is moving in the right direction, we feel confident we can nudge rates a bit higher if needed to be – after all, the economy can handle it in case, right?

I think the Fed would highly prefer not to find out.

If a year ago you’d tell Powell that jacking up rates to 5% and doing $95 billion/month in QT would have resulted in below-trend growth (no recession yet) and inflation convincingly moving towards the 3% area he would have jumped out of joy.At this point, you don’t want to risk ruining this apparent soft landing miracle.

Under the surface though, overlooked but crucial corners of the markets are calling the Fed bluff…

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The pace of the upcoming disinflationary impulse is likely to surprise many: most of our TMC models and leading indicators confirm our call for US core CPI to be in the 3% area by December, and to drop at or below Fed target in early 2024 already.

We believe markets are far from fully appreciating this major disinflationary impulse which brings important implications for macro portfolios.

Let’s review the evidence first.

1.    No, disinflation isn’t only in commodities and goods: services sector inflationary pressures are abating too

The subcomponents that measure expected services’ sector price pressures in the ISM Services and the NFIB Small Business survey (orange and yellow, LHS) tend to lead trends in YoY US Core CPI by 6 months (blue on RHS, lagged by 6 months).

Both indicators widely and correctly anticipated the rapid surge in core inflation in 2022, but they are now somehow ‘’overlooked’’ as delivering false signals on the downside – that’s called recency bias.Core (services) inflation is the most lagging macro variable in each cycle, and as the growth impulse and hiring trends have peaked in 2022 and slowed down ever since it makes sense core CPI would cool off too.

These leading indicators suggest US Core CPI should be in the 3% area by December already, and judging by their downward trend a 2%-handle in 2024 is not out of the question.

That would mean the Fed having effectively achieved their goal: that would be a massive change for macro investors out there.

2. Don’t forget rent of shelter: the disinflationary lags are about to kick in!

Rent of shelter represents about 40% of Core CPI, and as negotiated on-the-ground rent inflation has massively cooled off (blue, LHS) since mid-last year we should start getting some serious disinflationary impulse in the official Rent of Shelter component (orange, RHS) about…now.

This is quite a known unknown amongst Fed members and market practitioners, but let me ask you this: what happens when we start actually getting consecutive 0.2% MoM Core CPI prints?

Even as a decline in rent of shelter inflation is expected, do you think the market is ready? I doubt it, so bear in mind this known unknown for the next few months.

3. Inflation is always a monetary phenomenon (you just need to know how to measure money…)

This is one of the most important macro charts out there, and a powerful force behind the next big macro trade we believe lies just around the corner…

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Assuming no last minute surprises, it seems like we might be getting a debt ceiling deal in the US which means you should be prepared to get overwhelmed with financial commentators’ takes about ‘’liquidity’’.

The very unnuanced story goes like: the government needs to rebuild its Treasury General Account (TGA) buffer at the Fed so it issues bonds and it drains ‘’liquidity’’ from the ‘’system’’.

And here I can picture you guys thinking: what the heck does that mean? And is it true?

In this piece, we will:

* Show the monetary mechanics that underpin a post-debt-ceiling-deal TGA rebuild;

* Analyze if and how well ‘’liquidity’’ (e.g. bank reserves) predicts stock market returns;

* Explain the role liquidity plays in our models to shape our Macro ETF Portfolio, and discuss our investment strategy accordingly.

Monetary mechanics are best understood through the use of good old T-accounting.In our stylized model, we will assume 5 players (government, Fed, commercial banks, money market funds and households) and mimic each monetary transaction – colors will help you ‘’follow the flow of money’’.

Before we go to the post-debt-ceiling TGA rebuild, let’s start from bond issuance to fund deficit spending.

BLUE: the government spends $100 (deficit spending) and it injects net worth into the private sector (household’s equity) and so households now have $100 more bank deposits. These bank deposits end up as a liability for banks, and the corresponding increase in asset is a boost of $100 in bank reserves.

GREEN: the government ‘’has’’ to issue $100 in bonds to ‘’fund’’ its deficit spending, and banks use some of their increased reserves to buy $100 in bonds.

There is no reduction in bank reserves when the government issues bonds to ‘’fund’’ deficit spending.

But what happens instead if the government issues bonds solely to refill its Treasury General Account as in a typical post-debt-ceiling-deal period?

RED: the government issues $100 in bonds without spending anything in the real economy, and banks have to absorb the new bond issuance by depleting existing bank reserves ($ -100).

GREEN: the government refills its Treasury General Account (TGA), and that is reflected in the composition of the Fed liabilities: TGA up $100, bank reserves down $100.

This is how a TGA rebuild drains ‘’liquidity’’ (e.g. reserves) from the financial system.If the government issues bonds without spending real economy money and banks/private sector must absorb the new issuance without any fresh new resources, bank reserves take the brunt.

But why are bank reserves referred to as ‘’liquidity’’ in the first place?

Bank reserves are money for banks: they use reserves to transact against each other and with the Fed, and you can think of them as the lubricant of the monetary mechanics pipes – the more reserves out there, ceteris paribus the easier for banks to engage in repo markets and provide liquidity to market participants.

Reserves are also part of banks’ high-quality liquid assets (HQLA), and hence a bigger reserve balance might encourage banks to take more risks in their liquidity portfolio for instance by buying corporate bonds – this compresses credit spreads and enacts a more favorable environment for equity investors.

On the contrary, less reserves are often associated with banks taking a more defensive investment stance and in providing markets with less liquidity.

So, is it as easy as saying that the TGA rebuild will for sure drain liquidity from the financial system?

How to best track global liquidity, what’s its direction ahead and what does that really mean for investors in the second half of the year?

Let’s dig in with some deep and actionable macro analysis…

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Hey everybody! Before we start, a quick announcement.

I just launched The Macro Compass YouTube channel!

Every week I will release a 10-minute video that breaks down the most important macroeconomic and market developments - no jargon, in plain English and with the use of plenty of charts!

It’s of course free, so what’s your excuse for not subscribing? :)This is the link to the channel.

The FX market is one of the biggest and most liquid in the world.

Fluctuations in currency valuations also greatly affect investors’ portfolios: for instance, a US investor buying Japanese equities will be inherently exposed to the Japanese Yen too.

So, how to make sense of FX moves and valuations?

Let’s get into this edition of the TMC Macro Education series where we are going to cover the most important fundamentals and drivers of currency valuations.

Now, picture we are walking into an energy crisis with a tight Fed policy and a roaring USD like in 2022 and you want to rank global currencies (using the USD as denominator).

The table above did just that based on current account, fiscal balance, net international investment position (NIIP), an index that measures debt vulnerabilities, net foreign exchange reserves and a measure of policymakers’ credibility.

Let’s see why these indicators matter for the value of currencies.

The current account balance measures whether the value of goods and services exported by a country exceeds (surplus) or is lower (deficit) than the value of its imports.

Due to higher energy prices, dysfunctional supply chains and a de-globalization push currencies that heavily relied on cheap imported energy and strong exports suffered the most: EUR, GBP, JPY for instance.Countries with a stable current account surplus (e.g. Switzerland) export more than they import, and that means they accumulate more FX reserves they can use to stabilize their own currency.

A good indicator to keep track of these developments is Terms of Trade (TOT), which is the ratio between the price of exports and the price of imports (higher = better for the currency).

You can find current account balance and terms of trade data here and here.

Net foreign exchange reserves represent the country’s war chest to stabilize their domestic currency against sharp devaluations – the larger the war chest, the easier to stop the bleeding.

When the Japanese Yen was under pressure and trying to breach 150 versus the US Dollar, it was aggressive sales of USD from the Japanese net FX reserves war chest that discouraged sellers to proceed further.

If Japan exports more than it imports, the country accumulates FX reserves which it invests in safe and liquid securities like US Treasuries – so far, so good.

When running this analysis, watch out for the ‘’net’’ though: Japan can also borrow (!) US Dollars through the FX derivatives or the repo market and these borrowed USD offset the available FX reserves.

In general, the bigger the net FX reserves war chest the more positive for the domestic currency.

The best way to tally up foreign exchange reserves is by comparing them to months’ worth of imports: back in September when speculators were attacking the JPY, Japan could cover 1.5 years (!) worth of imports by selling its net FX reserves down.

Data on FX reserves can be found here. For the net numbers, you have to dig into each Central Bank website.

So far we talked about goods and services, imports and exports.

But our world is highly financialized, and so the flow of financial assets and liabilities matters a lot: that’s what the Net International Investment Position (NIIP) tracks.

Can you find the outlier? :-)

Be careful extrapolating too much from this metric alone: as the provider of the reserve currency of the world, the US will always have foreign countries investing in US assets (Treasuries, US equities etc) to a larger extent than US investors export capital abroad.

As ~70% of global trades are denominated in USD, these hard-earned Dollars are then recycled back into US asset markets contributing to a negative NIIP.

Nevertheless, it’s important to remember that countries with a negative NIIP are net financial debtors towards the rest of the world and hence their domestic currencies are more vulnerable to financial shocks.

You can find NIIP data here.

What about domestic fiscal policy and external debt?

When it comes to currency fundamentals, a key concept to understand is that despite getting a lot of mediatic attention government debt denominated in domestic currency is much less of an issue than private debt or foreign currency denominated debt.

It’s much easier for a sovereign country to service a big amount of its own government debt denominated in local currency (Japan has been doing that for decades) than servicing foreign-currency denominated debt (China can’t print US Dollars) or for households to handle mortgage debt during a housing crisis.

Therefore, look for external debt vulnerabilities and trends in private sector debt: guess where the most indebted households are?

You can find data on external debt and private sector debt here.

Policymakers’ credibility is another important driver of FX valuations.

If politicians and Central Bankers do not set credible policy objectives and show commitment to reach them, investors are going to be reluctant to invest in their countries.

This is why the Fed isn’t going to change the inflation target from 2% to 3% anytime soon.Before actually achieving 2% inflation and retaining credibility, that’s not an option.

Credibility is the biggest asset of a policymaker, so best to invest in FX whose policymakers are highly credible.

The reason why I didn’t mention interest rate differentials so far is that they tend to matter more for short-term FX moves than as a structural fundamental of currency valuations.

But yes: rapid changes in rate differentials can have a relevant impact on short-term FX fluctuations.

This was it for today’s TMC Macro Education Series!

And remember the best trade out there: stay long macro education.

If you enjoyed this piece, I have to warn you are missing out on a lot more! :)

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The US is dangerously close to triggering its debt ceiling limit, and yet markets seem very relaxed.

The 2011 episode shows us how political incentive schemes can instead drag negotiations until the very last minute, and force investors to price in a more meaningful probability of an actual bad outcome.

So, let’s have a look at:

* The actual mechanics of government spending and the meaning of a debt ceiling;

* The potential x-date and what happens if we cross that without a deal;

* The impact on bonds, equities, and the US Dollar under a no-deal scenario.

In our monetary system, the government doesn’t need money to spend money.

As the very issuer of the currency we use, with deficit spending the government actually increases our net wealth – for instance, tax cuts imply we have more spendable money without incurring in any direct liability.

The real limitation to uncontrolled deficit spending is not ‘’where is the government going to find money’’, but inflation: excessive deficits may lead to (unproductive) excess demand which often can’t be met by a rapid increase in supply or resources – and the release valve is then an ugly inflationary spiral.

In any case, we also have another self-imposed accounting rule which dictates the government can’t run with negative equity and hence must issue bonds to ‘’fund’’ its deficit spending – see the table below.

This is when the US debt ceiling becomes a problem: another self-imposed limitation which prevents the US from incurring in debt above a certain threshold to ‘’fund’’ its deficit spending.

If the government can’t issue bonds anymore, to maintain its current level of (deficit) spending it will spend down its Treasury General Account at the Fed – but we are running out of fuel there too.

The TGA has been rapidly drawn down from $600 billion in January to less than $70 billion as per last week.

A key question is – when do we actually hit the zero lower bound?

John Comiskey (here) has been doing a great job in tracking and estimating government cash flows to project the famous ‘’x-date’’ when the US government is going to empty its TGA completely.

His latest analysis shows that between Jun 2nd and Jun 9th we are going to be dangerously, dangerously close to the zero lower bound – and as Yellen already warned us, we might actually hit it around these dates.

It’s worth remembering that past these dangerous dates, by Jun 12th new tax receipts would be coming in hence providing a much needed TGA boost to the government.But let’s assume the TGA hits zero and the debt ceiling prevents the US government from issuing bonds to fund (deficit) spending.

Would the US government default then?What would be the impact on bonds, stocks, the US Dollar and Gold and are markets preparing for such an outcome or would they be surprised?How to prepare a portfolio for such an outcome?

Let’s dig in…

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Our economic system is ultra-financialized and dependent on leverage.That’s why understanding the incentive scheme for both investors and borrowers is an important step to piece the global macro puzzle together.

Real yields play a crucial role in that puzzle.

Rule #1: you can’t calculate real yields by subtracting today’s inflation from long-term interest rates!

The right formula to calculate real yields is the following:

From a borrower’s perspective, real yields represent the expected inflation-adjusted borrowing costs to take on more debt and leverage.Why do real borrowing rate matter more than nominals?That’s because as a borrower if you pay 3% nominal interest rate on your debt but you expect inflation and your cash flows to grow by 4% per year, servicing your debt burden won’t seem that scary.It’s about future inflation, not today’s - and that explains the formula above.

Real interest rates matter for borrowers because they inform them on the expected inflation-adjusted cost they will face when taking on more debt and leverage.

From an investor’s perspective, (risk-free) real yields represent the safest layer of inflation-adjusted returns they can make and hence set the bar for everything else.If you can make 5% real risk-free return per year, your appetite to go and YOLO into some unprofitable tech name will be much lower.If real yields are negative, you will be looking for alternatives to deploy your cash much more aggressively.

Real yields play a big role in influencing investor’s asset allocation preferences.

Here is a stunning chart: the US real yield curve today (orange) against 2 years ago (blue) - the curve is derived using Treasury Inflation Protected Securities (TIPS) for different maturities.

In 2021, US real yields were deeply negative and projected to remain so for the next decade (!).Borrowers had the best time of their life as they could lock in extremely cheap inflation-adjusted borrowing costs, and investors were charged with negative real yields for the ‘‘luxury’’ to own risk-free government bonds.

Back then, it was all about TINA (there is no alternative): you have to get involved in risk assets at whatever valuations, and you have to go a step further before the herd does so - buy altcoins and unprofitable tech stocks, sell it to the next guy coming.

The absolute level and the rate of change in real yields are important drivers of stock market valuations.

As the chart below shows, if long-dated real yields are negative (blue, LHS) for a prolonged period of time people will at some point be happy to pay 30x forward P/E (!) to pile up in the S&P 500.We used 5-year forward 5-year real yields to isolate market expectations in 2021 for where US real yields would have been between 2026 and 2031.

In 2022 the Fed changed its mind, and Powell started to worry about inflation and hiked rates aggressively - he even explicitly mentioned real rates multiple times as he wanted to see them in positive territory.

A sharp increase in real yields (blue, LHS) led to a rapid drop in stock market valuations (orange, RHS) in 2022.As soon as investors were actually given an alternative through positive real rates on risk-free Treasury bonds, they understood there was no reason to pay frothy multiples for equities.

A rapid change in real yields affects markets behavior, and a persistently positive or negative level of real yields slowly affects investors’ preferences over time (positive real yields = less appetite for risk assets and vice versa).

But real yields also matter a great deal for economic growth.

Because real yields are so important for borrowers and providers of capital and our economy functions smoothly when there is balance between the two, let’s define a crucial macro concept: equilibrium real yields (r*).

R-star is the equilibrium real rate at which our economy functions smoothly and delivers its potential GDP growth without overheating or falling into a recession.The younger, more productive and less indebted our economy is the higher r* is.Unfortunately weaker demographics, stagnant productivity and a big burden of debt have lowered the equilibrium real rate at which our economies can smoothly function.

Today, estimated r* is at 0.00% - 0.25% in the US and at -0.50% to -0.75% in Europe.

R-star is a theoretical equilibrium real rate, but we can observe where real yields are actually trading in markets - and hence we can estimate whether markets are forcing the economy to work with real yields which are higher or lower than equilibrium.

The chart above shows a 20+ year history of US 5-year real yields minus equilibrium real rate r*: if the series records a negative level Fed policy was loose (real yields < equilibrium) and if the series moves in positive territory the economy was forced to function with real yields > equilibrium.

Notice how every time real yields were sitting above equilibrium, something broke in the economy and in markets (2001 recession, 2008 GFC, 2018 stock market).To the contrary, periods when real yields were below equilibrium were generally good for growth and markets (2004-2007, 2012-2017).

Real yields are the lubricant of our credit-based economic system, being the balancing mechanism that drives decisions for borrowers and providers of capital.They are therefore also an important driver of investors’ asset allocation preferences and economic growth.

Enjoyed this educational macro piece?Well, you are going to love what comes next :)

In my upcoming TMC Macro Course I will unpack the bond market like it’s never been done before - in plain English, and from a practical perspective.I will share my knowledge and data sources with you so that you can master this complex but systemically important market.

The course will be launched in a few weeks, and subscribers to The Macro Compass get hefty discounts (from 25 all the way to 50%!) - what are you waiting for?

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Investors have been asking themselves when and if are we going to see a real credit crunch.

I think that’s the wrong way to phrase the question.

Data shows we are already in a credit crunch.

The real questions to ask are how badly and when is it going to affect the economy and markets.

Let’s try to answer both questions together.

Why so much attention on credit creation in the first place?

A fiat system with weakening demographics and stagnant productivity trends can only achieve acceptable growth levels through the use of leverage: ample and cheaply available credit to the private sector.

When you want to engineer cyclical growth, providing the private sector with cheap credit works like magic.

Even as wages and earnings are unchanged, through cheap and readily available mortgages people can bid up the housing market and through lower borrowing rates companies can more easily finance their businesses and engage in more sales.With a lag, this drives up economic activity and a virtuous cycle begins: cheap credit, strong activity and earnings, buoyant markets, more robust hiring trends and higher wages.

And the opposite happens when the flow of credit dries up and lending conditions tighten.

This black-and-white chart from the St. Louis Fed shows how this has always been the case, even 60+ years ago: stop the credit flow and you get a recession (shaded areas).

This is why credit data and things like the Senior Loan Officer Opinion Survey (SLOOS) get plenty of attention in the late stages of the macro cycle – but let’s clear some stuff before we dive into this data.

The SLOOS mostly looks at bank lending and demand for bank loans: and while banks are an important driver of credit creation they are not the only one.In our highly financialized system credit creation also happens through capital markets, shadow banks, governments (and gov’t sponsored entities) and through more channels.

In the US, bank lending accounts for only ~40% of total credit creation for the private sector.In order to get the holistic look, we developed the TMC Credit Impulse index – a refresh on that metric later.

So, you are not looking at the full credit creation picture – but at roughly 40% of it.

The second important point to remember is that the SLOOS asks banks and borrowers whether credit conditions and loan demand have changed relative to last quarter.

If the net % of banks tightening their credit standards moves from 45% to 40% it doesn’t mean things are getting better: it means a net 40% of US banks have tightened (again) credit standards this quarter.0% means banks are applying the same (tight or loose) credit standards as last quarter.

With this in mind, let’s look at the credit data and the SLOOS together.

How tight are credit conditions today?Are they likely to get worse, and when will the economy and markets feel the heat?How do asset classes historically behave in similar conditions?

Let’s dig in!

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Most likely, this was the last Fed hike of this tightening cycle.

Even before the press conference, the omission of the key sentence ‘’some additional policy firming may be warranted’’ from the statement release was a clear signal.Moreover, the statement about what comes next was eerily similar to the one used in June 2006 when the Fed paused its hiking cycle for 13 months.

At this point, the base case is that Powell feels he is done: after raising rates by 500 bps in 15 months and considering the ongoing Quantitative Tightening on top…wouldn’t you feel like pausing, too?Sitting with rates at 5% and watching how ‘‘The cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments’’ play out is exactly what the Fed wants to do here.

But after months spent underestimating how hot and persistent inflation would be, what gives the Fed enough confidence that 5% Fed Funds are restrictive enough to sit and watch how they cool inflation off?

History.

Over the last 30+ years, every time Fed Funds (blue) were raised above the levels of core sticky inflation (orange), policy turned out to be restrictive enough to cool inflationary pressures back to 2% or below.By summer, core sticky inflation should be trending in the 4% annualized area while Fed Funds will be sitting at 5% - and history suggests that means the Fed has tightened enough.

Now the real questions are: how long does a pause last, how did markets historically perform in this period and how are they likely to perform this time?

This excellent chart shows how the median Fed pause at the peak of the hiking cycle lasts only for about 5 months, and it is followed by pretty marked easing cycles.The dispersion around the duration of these pauses is big: in the 80s we could only pause for a month, while in 2000 or 2018 we paused for 7-8 months before seeing Fed cuts.Back in summer 2006, the pause was as long as 15 months…and it led us to the Great Financial Crisis.

This time, the bar for the Fed to both raise and cut interest rates is very high.

As Powell himself said, 5% Fed Funds plus ongoing QT are an undoubtedly restrictive policy tool and if you sum up the banking stress and tighter credit conditions you are looking at quite the cocktail.

Why would you volunteer to tighten even further unless really forced to?

On the other hand until inflation trends back to 2% you are obliged to look through the various alarm bells: banking stress, credit tightening, housing market dysfunctionalities – the hurdle to cut rates is very high, too.

Which brings us to markets: if this pause is going to last for a while, what should we expect?

In a nutshell: something to break.

Let’s dig in together…

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Welcome back to another episode of our TMC Macro Education Series.

Before we dive into it, a quick reminder: if you enjoy these educational pieces and you haven’t subscribed yet to The Macro Compass premium platform……well, what are you waiting for?

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Now, back to this educational piece!

Recently, US House Speaker McCarthy tweeted this:

And although it sounds like common sense, it’s dead wrong.

The government doesn’t need money to spend money.

The government creates money for the private sector when it goes for deficit spending.

Let’s explain this with the use of some simple T-accounts and a stylized example involving the government, the Central Bank, commercial banks and the private sector (us).

Before government deficit spending, here is the stylized situation:

1)     The government has liabilities (bonds issued, purchased by commercial banks and the Fed) and assets in the form of student loans for example and money parked at the Fed (Treasury General Account);

2)     The Central Bank takes deposits in from the government (TGA) and issues bank reserves on the liabilities’ side, and it owns government bonds and other assets (say foreign exchange reserves);

3)     Commercial banks have deposits on the liabilities side, and an asset base composed of reserves at the Central Bank +  government bonds + loans to the private sector;

4)     The private sector has deposits at commercial banks on the asset side, and debts and capital on the liabilities side.

What happens when the government goes for the so-demonized deficit spending?

The government blows a hole in its balance sheet, effectively creating negative equity through deficit spending – public opinion would say it spent money it didn’t have, and hence it must borrow (issue bonds).

But have a look at what the government really did.

The government spent $100 by sending cheques home to people (private sector), which all of a sudden find their bank deposits have gone up by the same $100 without any liability (!) immediately attached to it.

In other words, the government blew a hole in its balance sheet but increased people’s net worth!

Now, as private sector with an increased net worth (cheques sent to us) we might decide to immediately spend that money or keep it in a commercial bank.If we’d spend this newly created money on buying a car, the car seller would now own the new bank deposit.In any case, this new money will end up as a deposit in the commercial banking system.

Hence, commercial banks now have more deposits (+$100).Given how balance sheets work, this also means they must have more assets right?The standard is that as deposits go up, commercial banks have more reserves to deposit at the Fed.

We could literally stop here.

Merely accepting the fact the government issues the very money the private sector uses, and it does not ‘’need’’ to save or find money before it spends it as McCarthy and many others believe.

Another way to visualize this is by understanding that government deficits = private sector surpluses!The government doesn’t ‘’need’’ money from us, but instead it increases (deficit spending) or decreases (austerity) the private sector net wealth through its fiscal decisions.

Back to the T-accounts for one last step.

In our system, we have several self-imposed rules: one of them is that the government can’t run negative equity positions, but instead it issues bonds – it doesn’t ‘’need’’ to, but accounting standards dictate it does.

Remember where we stood: the government does deficit spending, the private sector has more net worth and more bank deposits and commercial banks receive these deposits and increase their reserves at the Fed.

When the government issues bonds to ‘’fund’’ deficit spending, commercial banks use reserves to buy them: after all, bonds often provide with higher yields than reserves and banks are in the business of making money.

Now you can square all the process through the T-accounts above, and get it right: government deficit spending adds net worth to the private sector, and commercial banks use reserves to buy bonds issued to ‘’fund’’ deficits due to our accounting standards.

The government doesn’t need money to spend money.The government creates money for the private sector when it goes for deficit spending.

Does this mean the government can proceed with limitless deficit spending without consequences?

No.

The limits to government deficit and debt are inflation and real resources.Excessive deficit spending creates too much money for the private sector, and if the supply of labor and real resources can’t expand rapidly enough we get sharp bouts of inflation.This is exactly what happened after the US spent $5 trillion (!) in 2020-2021, and inflation ran hot after.

The main point is that government deficit spending is not bad per se – actually, it’s the obsession with zero deficits and ‘’paying off government debt’’ which is quite toxic.

To close this educational piece, let’s play a short game: pick any government with limited debt and very conservative fiscal policies – what came to mind?

Switzerland, Sweden, Canada, the Netherlands, Australia or even China with low public debt levels?

Well, their obsession with no deficit spending and low government debt levels led to large levels of private sector debt – all these ‘’virtuous’’ countries run 200-300% private sector debt as % of GDP.

Private sector debt is inherently more unstable than government debt.

That’s because the private sector doesn’t print money, but it needs real cash flows to finance their big debt burdens – and when a recession hits, these cash flows disappear rapidly leading to de-leveraging and economic instability.

All in all, these are the main takeaways.

The government doesn’t need money to spend money.The government creates money for the private sector when it goes for deficit spending.This doesn’t mean there are no limits to deficits: excessive deficit spending creates too much money for the private sector, and if the supply of labor and real resources can’t expand rapidly enough we get sharp bouts of inflation like in 2022.But the obsession with no deficits and low government debt is much more toxic, as it leads to high levels of private debt and more financial instability.

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The S&P 500 has recently tested the 4,200 area after rallying all the way from the lows seen in late 2022.

With the Fed probably delivering its last rate hike in May and the US economy staying clear from a recession so far, investors are grappling with a key question.

Are we looking at a new bull market or is this just another (looong) bear market rally?

In this piece, we will:

* Discuss the prospects for earnings growth and valuations;

* Assess the current stage of risk premia for equity markets around the world;

* Present some historical parallels and conclude with our assessment on the stock market for 2023.

We are often fascinated with the S&P 500 price as a barometer of short-term risk sentiment.

As a macro investor though, buying stocks means taking a view on the stream of future cash flows (earnings) the company will deliver and the price (valuation) you find reasonable to pay for them.

So, let’s start from earnings per share (EPS) prospects in 2023 and beyond.

As the table from Earnings Whispers shows, this week companies worth over $10 trillion will report earnings.The big bang is late next week with Apple’s earnings on Thursday followed by Friday labor market data.

So far, ~25% of S&P 500 companies reported earnings with 68% beating consensus: strong, right?

My career in banking taught me to take analyst consensus with a pinch of salt and rather focus on what really matters: are earnings rising, at what pace and how broad is the positive/negative momentum?

Equities have been a negative carry trade since summer 2022, and they will likely continue to be one.

Let me explain what I mean.

The chart on the left shows the realized S&P 500 annual earnings per share: it currently sits at $223.Since mid-2022 though the momentum of earnings growth has clearly stalled around the $220 area, and the expectations for future 12-month EPS growth has collapsed from the $240 to the $225 area.

In other words, investors that were buying equities since mid-2022 were:

* ‘’Promised’’ a 8-10% EPS growth over a 12-month period ($238 expected EPS in 12 months versus $220 spot earnings), and saw these expectations being slashed back to almost 0%;

* Delivered no actual earnings per share growth in almost one year.

When deploying capital, stock investors expect a future stream of above-consensus growing earnings.When actual cash flows are strong and above market consensus, equities are a ‘’positive carry’’ trade as investors are handsomely paid to sit in the stock market.

Since last year, the inverse scenario unfolded: realized earnings were weak, and future EPS growth expectations have been slashed.

As risk-free rates are now in the 5% area, equities are a negative carry trade.

Nevertheless, negative carry trades can still make money – how?Valuations expansion, or simply people willing to pay more to be in the trade.

The S&P 500 rally from the late 2022 lows has been almost completely driven by multiples expansion: as the green arrow shows, the 12-months forward P/E moved from 16x to 18.5x pretty rapidly as the disinflationary trend started and the Fed removed some of the ‘’Volckeresque’’ uncertainty from markets.

The question now is: what about future earnings, valuations and risk premia?In other words: is this a new bull market or just another bear market rally?

Let’s dig in!

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