Market Analysis – Tuesday, January 15, 2019

Overview

This market analysis examines the performance of U.S. financial markets since the 2007-2008 Financial Crisis, delving into asset relationships in an attempt to identify risks lurking just below the surface. This report relies heavily on relative valuation to coax the hidden messages into the open. Keep your eye on the ball and don’t become distracted as it’s the activity (not rhetoric) emanating from the Fed and other major central banks that shall determine what happens next.

A Quick Review

The market anticipates Fed monetary actions to get a jump on investing. As the 2007-2008 Financial Crisis develops, a flight-to-safety drives bonds skyward as stocks tumble. Even ten target Fed fund rate decreases cannot prevent the bond-to-stock price ratio from going parabolic (Chart 1). Following Lehman Brother’s bankruptcy filing (Sep 15 2008), the Fed announces QE1, providing a reprieve to the markets. Bonds sell-off (yields rise) immediately, while stock investors digest what occurs; stocks eventually rebound strongly, after a final cleansing of weak holders, in March 2009. Going forward, each time bonds are heavily bid to catapult the bond-to-stock ratio up, the Fed rolls-out yet another unconventional monetary program. Astute investors trade ahead of the Fed, boosting stocks several months before a Fed announcement (Charts 1, 2 and Diagram 1).

Liquidity continues to drive the markets. Fed intervention keeps a constant bid on bonds as liquidity seeps (flows) into the financial markets, collapsing bond yields, while lifting stocks and bonds. Each time bond yields bounce off the down trendlines reinforces the uptrend in stocks (Chart 3). Other major central banks contribute to the liquidity influx, including the Bank of England’s four rounds of QE (Mar 2009, Oct 2011, Feb 2012, Jul 2012) and near zero-interest rate policy and Bank of Japan’s negative-interest rate policy and QE program (since the election of Prime Minister Shinzo Abe in December 2012, and subsequent appointment of Haruhiko Kuroda as BOJ governor).

The Deflation-Inflation Battle

Deflationary and inflationary forces struggle for control of the U.S. economy. Following the 2001 Dot-com Bubble burst, deflationary effects dominate monetary inflationary counter-action. Increasing positive correlation between stocks and bond yields represents a tell-tale sign of deflationary conditions (red shaded regions of Chart 4). By early 2014, after five years of unconventional monetary policy, stock prices and bond yields start to diverge (stock and bond prices re-couple) suggesting a return to normalcy ahead. But, in mid-2016 investors start factoring in the possibility of a Trump administration and the specter of deflation is awaken. From H2 2017, stock prices and bond yields firmly track each other. Glancing at the right-side of Charts 1 and 4, the eight Fed rate hikes since 2017 starts to take effect in 2018 when stocks capitulate in Q4 2018 – S&P 500 down 12%, Nasdaq Composite down 15%, and Russell 2000 down 17% from August/September highs. Combined with long-term declining commodity prices (Chart 4) and an analysis of inflationary stocks vs deflationary stocks (Chart 5) suggests deflationary conditions are back.

Reading the Tea Leaves

The Fed now expects only two rate hikes in 2019. At the recent FOMC meeting on Dec 18-19 the Fed revealed that it anticipates two rate hikes versus the three it expected back in Sept (Chart 6). The current target Fed funds rate stands at 2.25-2.50, yet Fed funds futures contracts indicate that the Fed is done with its hiking phase and the next move is likely to be a decrease (in 2021). So, what’s up?

Major Risks in 2019

The Mueller probe, more Trump investigations, Trump’s Wall, China trade spat, Brexit, Italian and European debt, China debt, U.S. debt, U.S. Syrian withdrawal, Nord Stream 2, U.S. government shutdown, Cloud-related snafu, slowing U.S. and global economic growth, the Oscars host, and the Kardashians all offer the potential to take one’s eyes off the ball. It’s still central banking liquidity that holds up the global economy and financial markets. Take that liquidity away and like a wrong move in Jenga…

Leveraged loans and high yield debt pose a major risk. Outstanding issuance of triple-B rated bonds have grown from $700 BN in 2007 to $2.7 TRN today as lower-rated companies have relied on a low-interest rate environment for financing during an improving economy. But, announced bankruptcies of Toys R Us, Sears, David’s Bridal, Mattress Firm, Brookstone, Claire’s, and Nine West and GE credit rating downgrade to BBB+ (or three levels above junk) in 2018 and recent down grading of PG&E Corp to B/B2 indicates that the credit cycle is turning over. According to Bloomberg, nearly one-half (49.2%) of investment grade U.S. corporate bonds are rated BBB, up from 21% in 1988, 34% in 1998 and 36% in 2008. Unfortunately for these borrowers, any significant hiccup in expected cash flows now could trigger a covenant breach, or, perhaps, even a default (otherwise, they wouldn’t be rated BBB). And, what more for the high yield credits (BB, B, CCC, CC, C)?  As the credit cycle rolls-over, once remaining credit lines are exhausted, access to new financing all but dries up for lower-rated credits, leaving DIP (debtor-in-possession) financing as the next likely recourse. While a detailed study will not be presented here, the search for yield has led many CLOs/CDOs to become filled with these high-yielding instruments and the leveraged loan market represents a risk to bank and other lending financial institutions loan portfolios. So, while many pundits have focused on the state of the equity markets, it’s the ginormous debt markets that should be scrutinized most. The upcoming Jan 29-30 FOMC meeting (and others to follow this year; Diagram 2) will be closely watched.

 

 

Market Analysis – Monday, February 13, 2017

Overview

This market analysis examines the recent performance of global financial markets, the role of liquidity in supporting financial markets, and the prospect of currency wars from the viewpoint of an analyst-trader that utilizes fundamental, technical, quantitative, and big data analyses.

It’s All About Liquidity

As discussed ad nauseam, governments relied on loose monetary policies in the aftermath of the 2007-2008 Financial Crises to prop up financial markets as exorbitant debt levels curtailed fiscal remedies and fear of political blame prevented necessary structural changes. Like passing the baton in a relay race (or a game of hot potato), monetary bodies took turns implementing different brands of QE. In approximate order: Fed (QE1, QE2, Op Twist, ZIRP, QE3), BoE (asset purchases), BOJ (asset purchases, ZIRP, NIRP), SNB (asset purchases), ECB (asset purchases, ZIRP, NIRP). But, despite the influx of paper money, developed and many developing economies failed to rise from the mat leading to the next phase of the Financial Crises: currency wars.

Currency Wars

Fear of a repeat of the 1989 Tiananmen Square protests, China unilaterally devalued the yuan twice in August (~2.9%) and December (~4.4%) 2015 in an effort to boost exports and jobs, resulting in a significant global sell-off each time (light blue boxes in Charts 1 and 2). Leaders from Washington to Brussels to Tokyo gasped and an undisclosed agreement was made at the Feb 2016 G20 finance ministers and central bankers meeting in Shanghai between the US, China, EU, and Japan (G4) to prevent a future financial market panic. As described by Jim Rickards, China would peg the renminbi to the USD (e.g. CNY6.50-6.30, Nov 2015 to Feb 2016 range) which would weaken, while the yen and euro would strengthen (Charts 2 and 3). But, a funny thing happened on the way to the pagoda. With the US presidential elections approaching and Donald Trump unseemingly holding steady, DXY drifted upwards starting in May 2016 as the markets factored in the remote possibility of a Trump win and a pro-growth platform. Not part of the agreement, China devalued in May-Jul (~3.4%) and again in Oct-Dec (~4.9%), contributing to a minor sell-off in stocks (green boxes in Charts 1 and 2). Now, with Trump in the White House, all bets are off as the greenback reached a 15-year high in Jan (black circle in Chart 2; DXY intraday high 103.82 on Jan 3).

Pushing an “America first agenda,” Pres Trump has threatened to institute import tariffs, declared China a currency manipulator, counteract China’s aggressive posture in the South China Sea, and has pivoted the US away from China and towards Russia. Many of his cabinet appointees support this view. Nevertheless, the Communist Party’s cling to power resides in its ability to provide jobs for the masses and keep the economy growing – no amount of antagonizing is going to change its stance. With problems of its own making, China must battle internal political unrest stemming from Pres Xi’s centralization of power, a massive credit bubble, and capital flight, to name a few. If push comes to shove, China may forego mini-devaluations and opt for a 20-30% maxi-devaluation, which some neocons would surely label as an act of war. The situation could go pear shape in the short future.

Coming Soon

My next post will examine the current state of financial markets in detail, discuss the role of complexity theory in analyzing the global financial markets, drawing reference to the Thai butterfly that caused the 1997 Asian Crisis (see Case Study: 1997 Asian Financial Crises, Parts I and II), and apply complexity theory and Bayesian statistics to today’s markets to determine the key drivers that could trigger a global market sell-off. My subsequent post will discuss the role of gold, SDRs, or eDollars in the event of a financial market meltdown that surpasses those of 1987, 1998, 2000, and 2007-2008 and the importance of China having a seat at the table of the next global financial system reset. Ultimately, I shall post on my results of using big data analysis, predictive analytics, and ensembles modeling techniques to produce leading drivers and their assigned probabilities of inducing a major market correction using the conclusions from my next post. Stay tuned!

Market Analysis – Tuesday, March 29, 2016

Overview

This market analysis examines recent actions by the Federal Reserve and its impact on financial markets, with a focus on emerging equity markets, and the outlook for Fed activity from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.

All Eyes On The Fed

Fed actions continue to act as the primary driver of developing economies and financial markets. The mere suggestion of liquidity tightening by Fed Chair Bernanke in May 2013 sets off the Taper Tantrum that sucks capital out of risky assets, propelling emerging equity and debt markets downward in weeks (far left, Chart 1). This leads directly to QE3 and a resurgence in risky assets, including emerging equities, which reaches a 3-year high to form the peak in a HS pattern (center, Chart 1). But, stoppage of US liquidity injections (end of QE3), results in emerging markets exit, despite liquidity infusions from BOJ, ECB, BOE, Riksbank, SNB, and DNB (right, Chart 1).

China’s credit-fueled investment expansion grinds to a halt that, combined with a strengthening USD, sends commodity prices plummeting (Chart 2).

In Dec 2015, the Fed finally raises the target Fed funds rate (and indicates a total increase of 300 bps over the next several years), after threatening to do so for two and half years, despite signs of a slowing US economy, shattering US energy companies, lackluster Europe, and imploding China, shoving emerging equity (and debt) markets into freefall (first green down leg, Chart 3). By mid-Feb 2016, the Fed, once again, reverses course to deliver a dovish spin, halting the equity correction in a near perfect “W” bottom reversal. At the widely anticipated Mar 15-16 FOMC meeting, the Fed confirms no raise and then Chair Yellen, at a speech at the Economic Club of New York on Mar 29, implies that not only would the Fed not be implementing its original three hikes this year but, perhaps, none at all, depending on the “data” (Chart 3).  What the heck is happening?

Set-Up for NIRP

The BIS and major CBs coordinate monetary actions since the 2007-2008 Financial Crisis to prevent a meltdown in global financial markets. Eight years later, and after rounds of traditional monetary policy, quantitative easing, qualitative easing, and ZIRP, global financial systems remain on life support. Now, European CBs and BOJ are employing NIRP to support the Fed’s effort to strengthen the greenback and normalize interest rates as official US national debt soars over $19.2 trn, or 102% of GDP. But, with the US economy teetering on recession, energy companies facing bankruptcy, at-risk banks and financial institutions confronting massive write-downs, and US presidential elections just seven months away, the likelihood of a rate hike diminishes by the day. The pretend wealth effect must continue for a little while longer.

By early 2017, once the energy sector has completed its current round of capital raisings, lenders off-loaded much of their exposed risk, and the new president sworn in, the Fed and banks may likely stand aside and let markets re-price. Would this be the ultimate cleansing discussed in earlier reports? Unlikely. More probably, similar to the 2008-2009 equity sell-off, after a 50%, or so, drop, the Fed would enact NIRP and, even, QE4, in a final (hopefully) effort to let the new administration and Congress find a solution to the financial morass.

Obviously, monetary actions have proven ineffective, so political leadership and regulatory, legislative, and structural changes are required to normalize the banking and financial systems and labor markets so that the real economy can grow, once again. If the actual problem of excess debt is not directly addressed, the US faces lost decades of fudged numbers and economic decline, just like Japan. But, under NIRP (see Market Analysis for Mar 11 2016), the unraveling may come much sooner. Throughout, of course, savers suffer and receive the blame for the ineptitude of borrowers.

Market Analysis – Friday, March 11, 2016

Overview

This market analysis examines the current economic environment, global monetary policy, and the outlook for global financial markets from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses.

Aftermath of QE3

Anticipation of the “official” ending of QE3 in Oct 2014, monetary easing at the BOJ, and easing rumors at ECB and Riksbank propels USD higher, starting in July 2014 (circle in Chart 1). Correspondingly, commodities plunge, dragging emerging markets along two months later (dashed vertical line in Chart1 and circle in Chart 2). Meanwhile, US equities, partially thanks to brethren central bank liquidity injections (see Market Analysis for July 27 2015), remain resilient, albeit volatile (first half of Chart 3). But, by mid-2015, Fed Chair Yellen’s talk about a rate hike finally takes hold as US equities breakdown through uptrend support (circle in Chart 3). Chair Yellen promises three rate hikes in 2016 and to raise Fed funds rate 300 bps by 2017. Despite intermittent rallies, equities face a decidedly downward journey…or, do they?

Energy Sector Gets Decimated

If a stronger dollar wasn’t bad enough, a slowing Chinese economy, prospect of new energy supplies from Iran, and highly-levered shale oil companies makes shorting energy a trade of a lifetime as crude oil trades below $30/bbl. With bank loans in dire straits (Citigroup $58bn, BoA $43bn, JPMorgan Chase $42bn, Wells Fargo $42bn exposures), energy companies manage to unload new equity offerings despite collapsing oil and share prices. According to Bloomberg, another $9.2bn share offerings have been announced YTD (as of Mar 1). With this as background, beware of bear market rallies…that knife is still falling! But…

The Fed to the Rescue

Despite the rhetoric out of the Eccles Building and deeply-massaged and contorted official unemployment figures, the facts are that oil prices are under $40/bbl. (not good for Russia nor US banks), US equities are trending down and volatile, and a lot of angry American voters are attending Trump rallies. At a 0.25%-0.50% target rate, the Fed is out of traditional ammunition to fight the next economic downturn, which is imminent. Any delay in a rate rise now means that the eventual hike arrives during a weaker economy, thereby triggering recession. With remaining FOMC meetings slated for Apr, Jun, Jul, Sep, and Nov 1 prior to the Nov 8 elections, perhaps, as NY Fed Pres Dudley’s speech on Jan 15 suggests, it’s too late to raise them at all. Like Pavlov’s dog sensing a free meal, financial markets make a swing-low in early Feb as the S&P 500 bounces from 1864 and WTI Futures Apr 16 from around 29.00. So, what next?

Alice in Wonderland Time

Picking up the QE mantle from the Fed, the BOJ (see Market Analysis for Jan 12 and Jul 27 2015), following the election of Prime Minister Shinzo Abe in 2012, unleases its own version of liquidity infusion, triggering the Yen Carry Trade. ..and, just to be sure, officially enacts NIRP on excess bank reserves last month. The ECB, for its part, announces in early 2015 an “expanded asset purchase program” of Euro 60 bn per month, expected to total at least Euro 1.1 trn. On Mar 10, the ECB increases monthly purchases to Euro 80bn, cuts interest rates (including the deposit rate to -0.40%), re-declares inflation target of 2% (despite ECB projections showing sub-2% inflation for next 5 years), and announces a scheme to pay banks to lend. On the latter, don’t be surprised if European banks use this opportunity (gift seems more like it) to generate some lending and broking fees to help eurozone corporates engage in some good ol’ American-style share buybacks to give European equities a boost. Remarkably, in his speech, Pres Draghi all but rules out further interest rate cuts…er, get it while it’s hot?  With traditional monetary policy, Quantitative Easing, Qualitative Easing, and ZIRP all failures, global CB focus now rests on NIRP to inflate government and bank debt away. And into the rabbit hole we go…

NIRP: What Could Possibly Go Wrong?

By taking the NIRP route, CBs gamble that banks can withstand the hit on their income as lending rates move below deposit rates. For US banks, not as much a problem as not as relient on deposits for funding, but elsewhere it could cause major dislocations. Judging by collapsing European bank share prices, the gamble is not paying off (Chart 6). Making less money, weak banks cut-back on lending, weakening economies and driving CBs to take rates even lower, thereby inducing a self-inflicted death spiral. A WSJ diagram succinctly sums up the situation (Diagram 1).

Deflation-Led Implosion

As discussed in the previous report, economies currently running into strong deflationary headwinds. To be sure, these headwinds stem from underlying problems from the 2007-2008 Financial Crisis and before (see Case Study: US Bear Market of 2007-2009, Case Study: Dot-Com Bubble, and Case Studies: 1997 Asian Financial Crisis, Part I and Part II)*, which never went away: Too much sovereign, corporate, and mortgage-related/asset-backed debt. Keeping debt off-balance sheet, changing accounting rules, or re-classifying debt did not make the debt disappear. Unable to create gentle, steady inflation with the blunt tools at hand, CBs seem determined to pursue NIRP. But, as shown, secondary and tertiary effects can wreck havoc on NIRP.

Again, as discussed in an earlier report, the markets show early signs of deflation in Sep 2014 (Chart 7), while many pundits and economists focus on lagging indicators that suggest all-is-well. In Jul 2015, markets give another emphatic shout that deflation is now a significant problem. Further incongruous actions of monetary officials and politicians perpetuates extremely loose money policies that will likely push economies past the event horizon and into a deflationary-spiral with a nasty terminus: Hyperinflation. Thus, economies and financial markets find themselves today.

Probability of Hyperinflation?

So, assuming NIRP is enacted on a global scale (BOJ, ECB, Riksbank, DNB, SNB, and, possibly, Fed), the chance that monetary and political authorities can withdraw monies from the banking system before inflation takes-off is exactly nil. Hence, expect double-digit inflation as a result of NIRP. As for hyperinflation (+50% general rise in prices), those economies unable to remove liquidity in rapid order would be staring directly at a Zimbabwe or Weimar Republic hyperinflationary environment. How long do global economies have until the SHTF?

Epilogue

As suspected, this story does not have a happy ending. The CBs, led by the Fed, determine the duration and magnitude of the outcome. Out of traditional bullets, fanciful methods are tried to inject liquidity into economies that simply, like gigantic and tiny Alice, effectively inflate financial market prices temporarily before prices deflate once again, thereby inducing another round of the latest monetary potion – NIRP for now. So, how long does this go on for? Japan has managed to remain whole for two and half decades, while caught in its deflationary spiral. But, as explained, NIRP may change this.

If “The Doom Loop” proves to be moderately accurate, NIRP shall likely be the last kick-of-the-can and weak banks and financial institutions (e.g. insurers and pensions with 6-8% real long-term actuarial investment return assumptions are deluding themselves) will eventually be taken-over by relatively stronger ones, while the weakest, facing bankruptcy, split into “good” and “bad” entities, with “good” ones acquired by the strong and “bad” ones run-off. Of course, major unhinging in economies and financial markets occur, including forceful inflation and, possibly, hyperinflation. But, economists already know the solution: Stop printing money. Hopefully, politicians force the purging of putrid debt, letting several major financial institutions and corporates to go the way of the dodo bird, and, with any luck, setting an example for others, before declaring any moratorium on the painful cleansing.  Once again, that barbarous relic gold (silver as well) will prove its usefulness, as it has done, time after time throughout history, as the ultimate safe haven store of value.

*  Forthcoming Case Study: 1971-1973 End of Bretton Woods System examines, among others, the role that a reserve currency plays in abetting an economy and local borrowing and the massive build-up of debt (sovereign, corporate, mortgage-related/asset-backed, and personal debt) in the US after the US transitioned to a pure fiat monetary system.

Market Analysis – Monday, July 27, 2015

Overview
This market analysis examines the current economic environment, the recent performance of U.S. financial markets in relation to the 2007-2008 Financial Crisis, and the scenario for hyperinflation from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. With U.S. presidential elections less than 16 months away, will the government (The Fed) really raise short-term interest rates before then, the occurrence of which, many market participants agree, would lead to a major, and possible historical, sell-off in the financial markets?

Inflation or Deflation: The Market has Already Spoken


The market prices in deflation. The battle between inflationary and deflationary forces following the 2007-2008 Financial Crisis, at an initial glance, appears to be nearing a climax. Each time an equity market meltdown seemed imminent, causing investor flight to safety that boosted US bonds relative to stocks, the Fed rolled out, yet, another unconventional monetary program to inject money and credit into the economy, leading to a recovery in stock prices and a fall in the US bond-stock ratio (Chart 1; also, Market Analysis for January 12).

Despite the “official” ending of QE in October 2014, the S&P 500 has risen 6.7% (as of July 20) since the end of January, all while Fed Chairwomen Yellen insists that she would raise rates soon. Worrisomely, US bond yields have recoupled with stock prices, signaling that deflation shall dominate the economy in the foreseeable future (Charts 2 and 3). A re-examination of the relative strength of inflation-sensitive stocks (comprised of mining & metals ETF, oil & gas ETF, oil & gas equipment and services ETF, TIPs ETF) and deflation stocks (comprised of financials ETF, utilities ETF, 1/TIPs ETF) reveals that deflationary effects emphatically took control of the economy starting in September 2014 as a major support line was broken (circle in Chart 4). Again, while many economists will wait until lagging economic data become available to cast judgement, the market has spoken: deflation is back. So, where’s the liquidity that continues to drive US equities higher coming from?

The Yen Carry Trade

The monetary liquidity baton has passed to the Bank of Japan. As discussed in the previous edition of Market Analysis (January 12 2015), the BOJ has initiated its own version of QE that dwarfs that of the Fed in relative terms. The Yen Carry Trade, running since rumors first surfaced that Shinzo Abe would vie for the prime minister role of Japan back in September 2012, kicked into high gear as the yen depreciated over 20% against US dollar during the last ten months (Chart 5). Since mid-October 2014, the S&P 500 has tracked USDJPY nearly step-for-step (Chart 6).

The ECB and SNB Quantitative Easing
On January 22, ECB President Mario Draghi announced a dramatic boost in ECB asset purchases to Euro 60 billion per month of euro-area bonds from central governments, agencies and European institutions, totaling at least Euro 1.1 trillion by September 2016. Several weeks later, the Riksbank launched its own bond purchase program (roughly $10 billion in total) in hopes of driving Swedish yields and the krona lower. While the krona has depreciated 4.3% against the greenback and remains virtually unchanged against the euro since the beginning of February, Swedish 10-year bond yields have actually risen slightly (up 2 bps to 0.72%), not what officials expected.

Hypothetical Scenario for Hyperinflation
For hyperinflation to occur requires a fiat monetary system and a large and growing budget deficit. In his book The Monetary Dynamics of Hyperinflation (1956), Columbia University economics professor Phillip Cagan defined hyperinflation as a price-level increase of at least 50% per month. A study by John Hopkins University economics professor Steve Hanke and economics researcher Nicholas Krus, World Hyperinflations (2012), discusses 56 episodes of hyperinflation, dating back to France 1795-1796. Some people argue that Hanke and Krus’s strict adherence to Cagan’s definition (e.g. if the price-level falls below 50% after twelve months, only to rise back above the next month would be considered a new episode) overstates the number of cases. Thus, Peter Bernholz, Professor Emeritus of Economics at the University of Basle, puts the number of bouts of hyperinflation over the same time frame at 30 (Monetary Regimes and Inflation (2003)).

So, what causes hyperinflation? Hanke and Krus name war, political mismanagement, and transition from a command to a market-based economy as some reasons. The debasement of currency traces back to antiquity. For example, Roman emperors to pay for their wars and global expansion would reduce the size of coins or lower the amount of silver contained within denarius coins, thereby increasing the supply of money relative to the supply of available goods and services; inflation, but not hyperinflation, soon followed. Today, fiat monetary regimes resort to the virtual printing press to digitally expand the monetary base, while the corresponding governments issue more debt for which it exchanges with the monetary bodies. Thanks to modern financial-banking systems, the money supply expands as the velocity of money multiplies the effect of each economic transaction. For now, the multiplier effect has been muted by a sluggish economy, but should expectations return to normal and the monetary base remain at its historical lofty level ($3.9 trillion as of June 30, 2015, Board of Governors of the Federal Reserve System) inflation would likely take-off in short order. As long as existing holders of government debt and beneficiaries of government obligations (public pensioners, social security, medicare/medicaid, food stamp, and unemployment benefit recipients, etc.) remain confident that they will be paid in full and that others will accept the currency, the system holds. As the level of public debt and future obligations rises relative to collected taxes (not GDP), investors and government obligation recipients start to get nervous.

As of July 24, 2015, total U.S. public debt outstanding stood at $18.1 trillion; federal tax revenue $3.1 trillion; federal spending $3.6 trillion; and federal budget deficit $497 billion (TreasuryDirect and U.S. National Debt Clock). According to Bernholz, all cases of recorded hyperinflation experienced government borrowing as a percent of government spending of over 40% at one time. Even, if an attempted recovery managed to push borrowing back below 40%, hyperinflation eventually overwhelmed the economy. When a government needs to borrow to pay back its interest and principal, it enters a debt spiral from which escape is difficult. Inasmuch as a deficit remains, new debt continues to be added on which interest must be paid. Thus, the U.S. finds itself today.

Epilogue
As deflation takes hold, and, probably, spreads abroad (Case Study: 1997 Asian Financial Crisis: Parts I and II), government officials are likely to aggressively step-up quantitative easing efforts to generate counter-balancing inflation. To be sure, deflation is not necessarily a pernicious phenomenon; during the gold standard, monetary authorities kept prices stable by routinely allowing slight deflation following a burst of inflationary, economic euphoria. Unfortunately, recent history is littered with examples of countries that tried to deliberately inflate their way out of a financial problem. In 2009, the U.S. government borrowed 40.2 cents for every dollar it spent. The total U.S. public debt outstanding listed above excludes unfunded government liabilities; some put the total at over $60 trillion and, possibly, $100 trillion. With all that in mind, notwithstanding the effect on equity markets, would the Fed really hike interest rates before elections?

Market Analysis – Monday, January 12, 2015

Overview
This market analysis examines the performance of U.S. financial markets since the 2007-2008 Financial Crisis to provide an outlook for economic conditions from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. Central bank activity carries on to drive the markets. Meanwhile, the tug-o’-war between deflation and inflation continues for supremacy of the U.S. economy. Altogether, this impacts the prospect for financial markets over the next 18 months.

Trading Ahead of the Fed

The market anticipates Fed monetary actions to get a jump on investing. As the 2007-2008 Financial Crisis develops, a flight-to-safety drives bonds skyward as stocks tumble, sending the bond-to-stock price ratio parabolic. Following Lehman Brother’s bankruptcy filing (Sep 15 2008), the Fed announces QE1, providing a reprieve to the markets. Bonds sell-off (yields rise) immediately, while stock investors digest what occurs; stocks eventually rebound strongly, after a final cleansing of weak holders, in March 2009. Going forward, each time bonds are heavily bid to catapult the bond-to-stock ratio up, the Fed rolls-out yet another unconventional monetary program. Astute investors trade ahead of the Fed, boosting stocks several months before a Fed announcement (Charts 1, 2).

Liquidity, Liquidity, Liquidity

Liquidity continues to drive the markets. Fed intervention keeps a constant bid on bonds as liquidity seeps (flows) into the financial markets, collapsing bond yields, while lifting stocks and bonds. Each time bond yields bounce off the down trendlines reinforces the uptrend in stocks (Chart 3).

Other major central banks contribute to the liquidity influx. To combat the UK’s economic crisis, the Bank of England undertakes four rounds of QE (Mar 2009, Oct 2011, Feb 2012, Jul 2012) and maintains a near zero-interest rate policy. In Japan, suffering a long recession-depression since 1989, the government relies primarily on fiscal stimulus and ZIRP, with miniscule QE efforts. But, with the election of Prime Minister Shinzo Abe in December 2012, and subsequent appointment of Haruhiko Kuroda as governor of the Bank of Japan, the BOJ pledges a money-printing program that is, relative to the size of the US economy, twice the size of the Fed’s QE3. Some of this foreign money flow finds its way into the US financial markets, helping to drive up stocks and bonds.

The Deflation-Inflation Battle

Deflationary and inflationary forces struggle for control of the U.S. economy. Following the 2001 Dot-com Bubble burst, deflationary effects dominate monetary inflationary counter-action. Increasing positive correlation between stocks and bond yields represents a tell-tale sign of deflationary conditions (red shaded region of Chart 4 and first arrow in Chart 5). Then, starting in 2012, the link between stocks and bond yields starts to weaken, turning negative in Q4 2013, hinting that deflation may finally be whipped. But, after bottoming in May 2014, positive correlation comes back with a vengeance as the market shouts deflation (second arrow in Chart 5).

From an economic analysis perspective, the Personal Consumer Expenditure inflation rate (Trimmed Mean version, which excludes high and low data points), the Fed’s preferred measure of inflation, shows 6-month and 12-month annualized inflation stabilizing between 1.25% and 2.00% over the last 3 years (Chart 6). But, with 1-year certificate of deposit rates at around 1.15%, savers continue to suffer drops in spending power, as banks and financial institutions leverage up on near zero financing while assuming riskier bets in a low-yield environment. Next, several scenarios for deflation-inflation are examined.

Three Hypothetical Scenarios for Deflation-Inflation
Scenario 1 (Deflationary Escape): Since December 2013, stocks and bonds appear to have re-coupled, returning to an inflationary / disinflationary relationship (arrows in Chart 4). Under this scenario, the U.S. economy has reached break-away velocity and escapes deflation’s crippling grip. Nevertheless, with U.S. government total debt at $17.8 trillion (as of September 30, 2014), or 101.3% of GDP, an inflation-bias will dominate for years to come. But, even moderate interest rate hikes in 2015 would surely spell the doom for the current stock and bond bull (bubble) market. With banks and financial institutions leveraged up, a rush to the exit would not be unexpected.

Scenario 2 (Return to Deflation): Should economic conditions continue to deteriorate, and/or another major financial institution run into trouble following the official ending of QE in October 2014, new liquidity injections (QE4?) could alter the financial market landscape, yet, once again. In which case, falling bond yields since December 2013, act as an early signal of a flight-to-safety and continued deflation, leading, most probably, to a major sell-off in stocks and clearing of the decks, before new Fed monetary easing re-ignites parts of the financial markets.

Scenario 3 (Keynesian Deflation Paradise): Similar to Scenario 2, except that the Fed announces a new round of QE before any panic selling occurs (perhaps, preempting a major bank failure). Thus, no major sell-off in equities takes place and prices actually jump upwards from today’s lofty level. Of course, this only delays the inevitable correction, which would occur from a greater height, producing a more pernicious psychological effect over all, perhaps, leading to the dreaded deflation spiral. How long politicians continue to kick the can down the road would, likely, be determined by the financial markets willingness to hold government debt.

Economic Outlook
So, what is the most likely outcome for the economy? From an intermarket analysis perspective, returning to Chart 1, the bond-to-stock ratio forms a large right triangle dating back to the start of the 2007-2008 Financial Crisis. As the ratio approaches the apex, a break below support, where the relative strength of stocks overwhelms that of bonds, would suggest a return to normalcy – inflation/ disinflation. However, the more likely bet is for a break above resistance, with bond relative strength dominating, to deflation, and the requisite Fed monetary easing (QE4?).

Equity markets give a strong deflationary signal. An examination of the relative strength of inflation-sensitive stocks (comprised of mining & metals ETF, oil & gas ETF, oil & gas equipment and services ETF, TIPs ETF) and deflation stocks (comprised of financials ETF, utilities ETF, 1/TIPs ETF) reveals that deflationary effects emphatically took control of the economy starting in September 2014 as a major support line was broken (circle in Chart 7). While many economists will wait until lagging economic data become available to cast judgement, the market has spoken: deflation is back.

Epilogue
The underlying causes of deflation never actually went away. Banks and financial institutions still hold huge amounts of non-performing property loans and other credit-related assets and associated derivatives via off-balance sheet vehicles. Accounting and legal gimmicks to hide these do not make them go-away. Furthermore, China, India, and the rest of the developing world possess a plethora of untapped labor that continues to exert downward pressure on prices. As advanced technology and processes roll-out in developing countries (albeit, requiring education and training of the workforce, and additional capital), prices would be suppressed even further. Also, the energy revolution in deep-sea drilling for oil and gas, shale oil, fracking, long distance pipelines, and LNG terminals and tankers raises energy supplies. For the developed world, aging demographics in Japan, Western Europe, and, to a lesser degree, in the U.S., lessens demand over time, depressing prices. To combat ongoing deflationary pressures and high government and corporate debt levels, developed countries would, most probably, continue to try to inflate via money printing and loose monetary policies and increased spending programs. The alternative, of course, would be to restructure the entire financial system, representing enormous losses and layoffs, and even a sharp recession. But, once a bottom is found, investors would return with capital, as they have throughout history, to enable economies to grow once again.