John Ahearn

966

Be careful about people trying to solicit you to contact them off-platform.  This is a common phishing tactic to trick people into doing things against their own best interest.  In general, this is a forum for exchanging ideas.  Anyone offering you some magic opportunity that they want to talk about in private is more than likely a scam.  

Honest people advertise their services openly.  Don't fall for social engineering scams.  I've received private messages and seen open phishing attempts.  I guess people are starting to notice the real vision audience and we are attracting the douchebag scammers now.

So something I have been kicking around as an amateur at charting that I think I have a bit of a pulse on is the general direction that yields need to go in before it starts to become a problem in markets.

As always, consider me an idiot and do your own work, don't take my thoughts as gospel.  I am feeling in the dark for an answer, and while I think I'm fairly good at solving problems, I am outside of my core competency here.  

What I am about to write below is likely flawed, which is why I am sharing it for peer review and criticism.  It fits TOO well with my view and I want to see if anyone cares to punch holes in my work.

The Theory before I started all of this: US10Y can't grow much above 2% before problems start to show up in equities and other risk-on trades.

I have believed for a while now that 2018 Q4 taught us that there is a cap on yields that is preventing them from being able to go up without causing a collapse in the system.  What I have been trying to figure out is where that cap might be.

In 2018, the Fed was tightening policy and both raising rates as well as tapering their QE operations.  The markets tolerated this for a while before a sudden shock in equity markets forced the Fed to pivot back to easing.

You can see a clear pattern of yields moving down since Regan took office and debt started to increase at an accelerated pace.
 

Every time the Fed wanted to promote growth, they would have to tinker with rates and manipulate the market lower.  Meanwhile, the debt load got larger and larger, necessitating lower rates in order for the public debt levels to not act as an anchor.  As we approached the lower bound, debt grew faster and the Fed had to do more to keep the system working.

If we simply look closely at this chart, and we assume that this trend continues, we see that the 10Y can't really get much higher than 2% before we are in a similar spot that we were back in Q4 2018.  Plus, back in 2018 we got that high because the Fed pushed rates there.  Other than some off the cuff commentary from Bosic recently, there is little to no evidence that the Fed is going to force rates up before 2022 at the earliest.

So without doing any further work, I see three possible levels assuming everything today remains static:

• 1.63
• 2.135
• 2.63

But that assumes debt grows at a constant rate in line with GDP, and that inflation remains more or less in check.  We already know that debt has grown while GDP has lagged, and inflation is either non-existent or set for hyperinflation depending on who you listen to, so these numbers are more or less guesstimates.

So I wanted to see if there is any potential deeper dive I can look into, and I figured I would start with taking a look at the service cost of public debt (FRED:GFDEBTN * TVC:US10Y) assuming we were financing it at the 10Y rate.  The goal is to see if we can find a pattern that maybe gives us a more granular view of where the upper-end yield is and also to see if that number is in the same ballpark.
 

One thing that I noticed is that the finance cost sort of looks like a sound wave that is being amplified.  This makes sense to me, as debt grows, the same change to the interest rate has a much larger effect.  There also seems to be some sort of midpoint we can draw here which seems to be a sort of inflection point.  I theorized that this inflection point is Debt/GDP + CPI after playing around for a bit with some other ideas that didn't pan out.  Normalizing all of these to their starting point back in April of 1980 and seeing how they interact produced the following.
 

This was interesting to me.  Prior to 2000, the financing of debt (blue line) sort of stayed above the Debt/GDP + inflation.  After 2000, it has a really hard time getting back to that point.  This sort of fits the narrative that the Fed has been doing more and more post-2000, and especially post 2008 to try to keep the system stable.

The downside to this is that rates are now more sensitive than ever to any sort of move, and absent the Fed being dragged into NIRP, have very little room to ease further.

So using this chart and setting the yield to a constant rate, we should be able to graph (using my guesstimate yields and setting them to be constant relative to debt) to approximate what the purple line represents in terms of the top end of the US10Y rate.  Taking my three yields from above and plugging them into the formula shows what the debt carry cost would have been over time at a constant rate.

The three yields really fit in nicely with where I think the top end of the range is.  Now granted, this methodology is flawed and I am not capable of putting it into a formula that would make me be able to live and die by, but I think it gets us into the correct ballpark.

Interestingly enough, I had some further thoughts and observations off of this (assuming I am not 100% off base here).  I already held most of these views, but doing this exercise helped me to reinforce my thinking.

• ~2.6% seems to be a breaking point where the yield return is more attractive than owning risk, assuming inflation and debt/gdp growth remain constant.
• I believe GDP growth outpacing debt growth without also causing runaway inflation is the goal of the Fed, and their hail mary pass to get us out of this mess.  I don't see it as being the likely scenario, but it fits with the chart.
• Something is missing from this chart, because debt growth isn't guaranteed to be offset by GDP growth or by CPI.  The CPI is likely flawed, and a lot of that is hidden in education, home prices, and medical costs.  But potentially there is a USD fx weakness not factored into this chart that needs to be considered.  I'm just not sure how to factor it into the chart at this time.
• If the inflationists are right, the yield could go higher, but I don't think the Fed will allow that.  My gut tells me that they know that they can't allow the yields to rise past a certain point, they are just waiting till they have no choice but to interfere with the market to do anything about it.
• Without debt growth, this whole thing falls apart.  Debt reduction seems like a pipe dream right now, but if they could raise taxes and pay down the debt level, yields would all of a sudden have much more room to grow.  This would still cause a correction in markets, but it would probably be much more healthy for stability in the system overall long term as it would get us out of the lower bound.  We really have sacrificed everything to juice markets so that the 1% and boomers continue to enjoy the American Dream at the expense of future generations.
    

https://www.zerohedge.com/markets/cash-strapped-iraq-massively-devalues-dinar-fears-national-unrest-grow

Just some random thoughts I felt like sharing.  Not sure if I believe 100% what I'm going to write below, but I wanted to see how it looked later on and I wanted to see if there were any rebuttals.

As always, in the end, I am a trading idiot.  Don't look to me for advice =).

https://www.zerohedge.com/markets/make-dong-strong-again-us-treasury-finds-vietnam-switzerland-are-currency-manipulators

In a world where everyone tries to peg themselves to the dollar, it is hard to see the scenario where the US Dollar collapses.  Goes down?  Sure.  But collapse?  We still have a lot of fiscal spending to do before that occurs so long as other countries refuse to let their own currency appreciate against ours.  

This is sort of the problem with America's debt.  Even if you spend like a drunken sailor, the world enables you simply because they want a stable exchange rate.  The dollar reserve privilege is real.  If you pull back on spending, fewer dollars exist outside the domestic market, and global dollar-denominated debt becomes that much harder to service.  

It seems like the American taxpayer is stuck with the bill for allowing global growth to continue, yet that same growth is fueled by offshoring jobs from Americans.  And people wonder why our politics are so toxic?

https://www.zerohedge.com/geopolitical/foreigners-bought-record-amount-us-stocks-china-kept-dumping-treasuries

The narrative that Foreign Central Banks are dumping Treasuries seems to be one possible scenario out of many.  Another is that certain country's dollar reserves are being sold to offset the downturn in global trade in 2020.

People don't consider that the system can both be flooded with treasuries and at the same time those treasuries aren't getting to where they need to go.  The process of selling treasuries involves pulling dollars into the TGA from domestic and foreign buyers.  Perhaps the problem with foreign demand is simply that there aren't enough dollars floating around to soak up the supply?

It would also make sense to want better yield on your dollars in such a scenario.  Going out on the risk curve and getting a higher return helps offset constraints.  Risky?  Sure, but if you believe the Fed has everyone's back, it is one way to backdoor more dollars into global accounts without an act of Congress.  Sure, when the party stops it will be American pension funds and passive investing left holding the bag, but I guess the powers that be are tackling it one problem at a time?

I don't believe anyone really understands where the problems lie because we have no data on offshore dollars to point to that proves one theory over another.  But we do know that absent new debt being created by offshore banks or the US increasing its trade deficit, dollars will struggle to get out into the global markets to circulate.

I wonder if we will see some weird distortions eventually that make no damn sense?  Could we see bonds stuck in neutral because of YCC, eurodollars bid to the moon, and DXY falling?  Can't wait to hear CNBC explain that one haha.

Watching Markets today, and this looks like the early part of the March crash before things started really getting bad.  Possible reaction to EU stimulus and USD questionable stimulus?  This looks like a sudden drying up of liquidity to me.

Curious what you all think.

https://www.bloomberg.com/news/articles/2020-12-08/citadel-securities-backed-exchange-turns-treasuries-upside-down

Don't mind my tin foil hat ways.  😂

As always, keep in mind that I am an idiot, and should not be trusted for investment advice =).

So clearly the market has been front running Congress borrowing more dollars with the Fed backstopping it and taking on public debt.  Clearly, regardless of the reasons, the market says dollar weakness.  To hell with treasuries.  Bring me moar equities.

So if Congress follows thru and does massive QE, then the move is correct and the move stabilizes somewhere and we wait to see what the next shoe is to drop.  But will enough be done without a crisis?  I still don't see that as my base case.

There are some scenarios dancing around in my head that still makes me believe that everyone has it wrong.  And it has to do with bonds.  This is why I still own TLT in addition to bitcoin and gold right now.

It still feels like we are going to need a catastrophe to get stimulus moving in the size that justifies all of the dollar negative sentiment right now, and it needs to go into the hands of people who will spend it instead of keeping it locked up in the financial system.

• Everyone is so sure the world hates dollars

What doesn't compute for me is how certain the market is that everyone hates dollars.  Especially after we witnessed how volatile everything moved in March.  I'm not sure people realize that prior to and during the liquidity event, a lot of the things you wanted to own coming out of the liquidity event went down HARD.  Gold, Bitcoin, TLT (likely because of off the run holdings, not on the run bonds), even the FAANGS.  This also includes currency pairs like EURUSD.  

EURUSD went from ~1.08 to ~1.15 to ~1.06 to ~1.12 between the end of Feb to the end of March.  No one had a fucking clue what to expect.  The Fed jumped in with swap lines, but only to certain central banks.  The whole system was a mess.  I am more concerned about volatility in the currency pairs than I am with the direction right now.  Volatility to me = people are guessing left or right on a penalty kick right now.  

• Everyone is sure that foreigners hate treasuries.

Sure, we are issuing more treasuries than ever and the fed is buying more than ever.  And sure, foreign interest has not picked up with issuance.  But why is that exactly?  If everyone hates the dollar, then the smart thing to do is for everyone to toss their dollars out and buy something they don't hate.  Maybe that IS what the currency move is, swapping dollars for anything else.  It sure seems like China is doing that when looking at the Renminbi.

But last time I checked, US global imports and exports are both lower than they were pre-covid.  The dollar is falling, which means imports become more expensive relative to domestic production.  Politically, there are about 70 million people who want to see globalism end and will elect anyone who promises to do so.  That is not just going away overnight.  And everything commodity-wise is still priced in USD dollars, and a large percentage of global debt is dollar-denominated.

Why are we so sure that there is an overabundance of dollars coming when you can see more evidence for a slowdown in the availability of dollars right now?  Maybe, the lack of foreign interest has to do with a LACK of dollars, not a HATE of dollars.  Treasury issuance takes dollars out of the system, it doesn't add that money back unless it is appropriated by Congress or the Treasury at the direction of Congress.  At best, all we know about the Treasury is if Congess is in a stalemate, then it is going to have to use the TGA to buy back debt, which means less collateral in the system if that debt is of a short term nature.  Maybe we see some fun in Repo markets again next year if Congress doesn't so a stimulus deal by the end of Q2.

There is no market like the bond market when it comes to market cap, so it isn't like you have a sufficient number of places to hide if you need to move dollar reserves into other assets.  And if there is a lack of dollars, then someone is GOING to get hurt if the Fed doesn't come to their rescue with swap lines if things turn.

• Maybe I am an idiot, but are the banks idiots too?

My suspicions have to do with the fact that Primary dealers seem to be picking up the slack and taking the other side of the trade.  Sure, they have to buy the treasuries, but they seem to be buying government-backed debt to the exclusion of riskier debt, with some exception to a small bit of commercial real estate loans recently.  This makes me feel like they don't seem as optimistic.

And if you believe in reflation, then why the hell do you expect the Fed to suddenly let the long end of the curve blow out?  They literally proved in 2017 that the market can not take high-interest rates.  If rates can't be allowed to go up, and if conditions won't remain static, then there is only one place left for rates to go.  And one thing I am sure of is that the Fed is committed to manipulating the yield curve if it feels like it has to.

The market is wrong somewhere.  Maybe the currency move is correct, but I don't see how both reflation and the bond move can be correct at the same time.  If the Fed does nothing, reflation is killed by crippling debt with higher yields which leads to stagflation.  

If the Fed comes in, the whole signal is being read wrong and FAANG continues to trade like perpetual bonds.  And anyone who doesn't have access to credit markets is going to be crushed by deflationary forces as they run out of dollars.

• Conclusions

I just can't shake the feeling that we assume money created by Congress is going to fix everything when it has been proven that the current stimulus programs have not been very efficient at getting to where they need to go.

And if the US is not exporting dollars, and if SDR's aren't anointed as a replacement to USD or a whole bunch of bilateral trade deals doesn't show up in 2021 that fractures the world-wide dollar system, I don't see how you can hate the USD and yet love the Euro and Renminbi when both of those jurisdictions are dealing with their own problems.

I think people blame too much of what happened in 2020 on COVID, and don't consider that all COVID did was speed up the process we are seeing now.  COVID was a bomb that blew up small businesses because they don't have access to the credit markets large corporations do.  But half of all workers are employed by SMB, and they have had their finances destroyed.  This is where a lot of consumer demand is.  And it is currently sitting in their car on a food bank line because of how tough it is for them right now.

So long as we still make money as a goods and services economy, we need people who can afford to buy them.  If the demand side is broke and not getting enough money to go wild and spend our way into inflation, I don't see how we get long term structural inflation.  Supply shocks?  Sure.  COVID can do that on its own.  But you still need demand to be flush with cash for that to matter over the long term.  When COVID goes away, we run out of excuses for having 20 million people unemployed.  At the current job creation pace, it will take 2 years for that to be worked out of the system.  Unless we believe 10 million jobs are coming in one giant wave in the next 6 months, I don't get the optimism.

I need to see banks lending not just in the government-backed space, but taking actual risk before I start to believe reflation is real.  Right now, I just see a bunch of FOMO and front running.

We shall see, but I just don't see what the market sees right now, just what it hopes to see.  Maybe I lack faith in our central bank overlords that others believe in.  But I just think people are too optimistic and are being tricked into becoming bagholders by more savvy investors.

Well, I guess I know what I am shorting sometime after Dec 21st market open lol.

(note: I am an idiot, this is not advice.  I'm probably going to lose money.  Because equities make no sense.)  

But as a WTF flier, I'll probably short this a bit just to see what the price action looks like the week it enters the S&P.   If the VIX keeps going down, it might be worth a flier picking up a small number of calls on the VIX before then too.  If it turns against me though I am jumping out of this before it bites my head off.  But seriously, if this isn't the best opportunity to short TSLA absent Elon saying something profoundly stupid, I don't know what is.  Who the hell else is going to be left to buy it after Dec 21st?  

https://www.zerohedge.com/markets/tsla-surges-after-sp-announces-it-will-add-automaker-full-float