The Breakdown - Is the Problem That Not Enough Is Breaking?

Starting point is 00:00:00 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and FTCS, and produced and distributed by CoinDesk. What's going on, guys? It is Thursday, September 29th, and today we're exploring the possibility that the problem right now might be that things aren't breaking enough. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. It's where you can debate silly assertions,

Starting point is 00:00:44 like the problem is that things aren't breaking, or just generally talk about crypto, markets, or whatever you want. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always. In addition to them being a sponsor of the show, I also work with FTX. All right, folks, so today we are looking at something interesting and perhaps a little bit countering intuitive. And I'm actually recording this show just after I did the show about the Bank of England's intervention in markets on Wednesday, because it's a show that I had been planning and I feel like they're a pretty good back-to-back pair. But I'm telling you when I'm recording it in case something crazy happens between about 2 p.m. on Wednesday and when you're hearing this

Starting point is 00:01:24 that I don't talk about, now you know why. Anyway, what we're exploring today is the idea that the problem might be that things aren't breaking enough. As you well know, the Federal Reserve is engaged in the most aggressive monetary policy tightening in decades. The Fed is determined to break the back of inflation, and if that determination isn't at any cost, it's certainly willing at the cost so far of trillions of dollars of lost wealth in asset prices. As we've been discussing for now months, Powell's Fed is terrified of falling into the trap of the 1970s, when the Arthur Burns led Fed dithered on their commitment to beating back inflation, a scenario which eventually led to the need for Volker's famous tenure as Fed chair, which cranked the interest rate up to

Starting point is 00:02:04 the 20% and caused a deep multi-year depression. The Fed truly does not want a repeat of that mistake. They don't want inflation expectations to become entrenched, and they don't want to see a wage price spiral. For months then, the markets have been trying to figure out what will signal to them that the Fed has reached peacockishness, and frankly, the markets keep being rebuffed in that attempt. The summer saw a bit of rallying on the narrative of peacockishness, which was rebuffed a little when August's inflation data came in hotter than expected, and which was rebuffed a lot after the FOMC meeting when the Fed painted a tighter for longer view of interest rates that suggested that even at the end of next year, the federal funds rate would be around 4.6%. Also at this last meeting,

Starting point is 00:02:47 the Fed made clear that one of the things they're watching most closely is the employment market. The Fed believes that the tightness in the labor market reflects a huge risk to continued inflation, creating upward pressure on wages which could be passed on to the consumer in the form of higher prices. Indeed, at the last meeting, the tone shifted from the Fed being willing to see some pain in the labor market, to the Fed needing to see pain in the labor market. Now, in the absence of that pain in the labor market, the conventional wisdom is that the Fed would have to see something breaking in the financial plumbing to shift course from the path that they're on. And this has created much speculation about what will happen first, unemployment rising or financial markets breaking in some way. With all the chaos in global currency markets, some are starting to chatter that the breaking seems to now be happening. However, the topic of today's episode was inspired by the counterpoint perspective, led most

Starting point is 00:03:37 notably by Jim Bianco. On Friday, September 23rd, he tweeted, I think the interpretation of what is happening in markets is backward. The problem is not that things are breaking. The problem is that they are not. Without serious signs of real trouble, yields are free to soar higher which they are doing. This is crushing risk-on markets. Why is the pound getting crushed in UK rate soaring?

Starting point is 00:03:58 Trust announced massive tax cuts today. The fear is it will work, stimulate the UK economy, meaning higher inflation and opens the door to raising rates which they did today. Good news is bad news. So what ends the cycle? The answer is stuff actually breaking. How will stuff break? A few more weeks of the stock market diving like the last few weeks should do it. It will break inflation and a lot more things, aka collateral damage. On Monday, he revisited this, saying, the problem is the economy is not breaking yet, so rates can keep going higher, not remotely close to the Fed. put. This is killing equity markets. Jim then quote tweeted Elizabeth Warren from September 25th when

Starting point is 00:04:36 she said, Fed Chair Powell seems determined to push the economy over a cliff, even after he admitted rate hikes won't lower key prices. Destroying jobs and crushing wages of millions of workers is reckless and dangerous. Recession is not the solution to inflation. Bianco's quote tweet said everyone wants to believe this tweet, as it means the Fed put will be exercised. Just like they believed inflation was transitory, oil was going to 200, the Fed would pivot, and the sentiment was so bad in early September, the market was a buy down 11%. He then tweeted payroll and jobless claims charts and said, these are not the charts of things breaking. Every month this year, payrolls were more than 300K. Claims are trending lower. The problem isn't that the economy is falling apart. The problem is it is

Starting point is 00:05:14 not. So there is nothing to stop hawkish central banks. A lack of breaking is causing the dollar to surge, and U.S. 10-year yields rose 24 bibs today, tied for the second biggest one-day rise since the financial crisis. Today was historically bad for the bond market. This kills equities. Restated, financial markets are tanking because the labor markets are not. Or, what will break the economy, breaking the financial markets. So where is the Fed put? Much lower.

Starting point is 00:05:41 And if claims trend lower again, the strike keeps falling. So let's explore this. First, let's talk about what breaking really means. The most important thing is that the idea of markets breaking is not just about numbers going down. It's not even about markets going down quickly or in large amounts. It's about markets failing to clear when there aren't enough buyers or sellers willing to step in at any price. Breaking is about things like illiquidity.

Starting point is 00:06:06 So far, this year, we've had precipitous falls in various markets. The S&P 500 is down over 23%. The NASDAQ composite is down more than 30%. Housing is quickly cooling off. But nothing has looked like a crash. Nothing is dramatically broken. Looking over the recent history of the Fed, a market breakage has always been the signal for a Fed policy reversal. In 2019, there was serious weirdness in the repo markets, with rates for short-term lending of

Starting point is 00:06:30 Treasury spiking above 5%, more than double the Fed policy rate. This led to the Fed to cut rates at the following two meetings. In September 2007, as subprime defaults began triggering off what would become the global financial crisis, the Fed began cutting rates. By January 2001, when the Fed started to cut rates, the dot-com bubble had already burst, with internet stocks down 75%, wiping out more than $1.7 trillion in notational value. The notion that a part of the Fed's job is to support markets comes out of the Greenspan Fed of the late 90s and early 2000s. At the time, Chair Greenspan was notoriously plugged into stock market

Starting point is 00:07:01 movements, and the theory developed that any prolonged fall in the S&P 500 of more than 20% would trigger the Greenspan Fed to cut rates and support the stock market. This belief that the Fed would step in to end-bear markets and stocks has prevailed until today, which is part of what makes current markets so uneasy. There is a tension and sentiment relating to waiting for the Fed to intervene, but what if this time is different? The Powell Fed has been very forthright about needing tighter financial conditions and a drop in asset prices to cool inflation. We even had Minneapolis Fed President Neil Kashgari mentioned that he was, quote, happy to see a market sell-off following Chairman Powell's Jackson Hole speech. The notion that the Fed has your back or that the Fed is here to backstop equity prices has completely disappeared this year with the return of inflation.

Starting point is 00:07:42 It's quite clear at this point that the Fed is not interested in intervening in orderly markets just because they're dropping. And so, that begs the question, what are the things that could break? There's a few ways to look for signs of stress in markets that could break. We could look at things that have proved to be systemic weak points in the past, like subprime housing loans, repo or interbank lending markets, credit markets, which seized up completely in 2020, or even the stock market has been a cause for concern in the past. Alternatively, we can look past the obvious. We could assume that these markets have been significantly strengthened from previous breakages

Starting point is 00:08:13 with additional systems and regulatory requirements, which make them unlikely to break in the same way again. Instead, it might make sense to turn to more niche markets that may not be as well protected. In a Twitter poll last week, Callum Thomas, the head of research at Top-Down charts, asked Finn Twit what they thought was most likely to break first. The results of the survey were less interesting than the categories he chose, which were extremely broad. Emerging markets consisting of sovereign bonds, equities and currencies, developed market bonds and currencies, credit in general, and something else. Now, I think that this poll really captured something that's in the air at the moment. The first is the idea that this situation is more about

Starting point is 00:08:48 sovereigns and currencies, the building blocks of national economies, than it is about individual markets. The second is the lack of a distinct thing to point to as the current weak point, as the results were all over the board and the something else category garnered more than 12% of the vote. While there's a whole slew of markets that are falling in value, historic evaluations and currencies, and volatile commodity pricing, there's a real absence of a definitive market that you could point to and make the case that it's broken and that the Fed needs to step into for the sake of financial stability. U.S. housing has been a great example of this. There are numerous concerns with mortgage rates now getting up above 7%, the highest level in 20 years, which is locking

Starting point is 00:09:24 new buyers out of the market, and also creating a serious disincentive for people who have cheaper mortgages in the 2% and 3% range to ever sell, housing price declines of more than 3% per month in the hottest markets, 7 straight months of lower sales numbers, etc., etc., etc. Despite this, existing home sales are at a comparable level to 2014. Not great. and it's been a fairly rapid decline. But it's not broken. The market is still functioning, sales are still happening. It could break, but at this moment it's not broken yet. And this feels like where almost every market seems to be, at least in the United States. We could, in fact, dig deeper and look at what's proving more resilient than expected. The S&P 500 has dropped

Starting point is 00:10:03 more than 23% since its peak in January, but there hasn't been one single big dramatic day in that period. Of the 20 largest daily changes in the S&P, none of them occurred this year. Three occurred in 2020 and four occurred in 2008. In other words, what we're seeing in the stock market is not illiquid and panic sell-offs, just the slow and steady march downwards of a prolonged bare market. U.S. credit has also been fairly robust. Junk bonds, credit for low-quality corporations are trading at a 5% rate premium, a similar level to April 2020. What's different, however, about this period compared to 2020, is that the rate premiums have been slowly ticking up over the course of the last nine months, rather than breaking. In 2020, the rate premium

Starting point is 00:10:42 tripled in just five weeks, eventually leading to a total seizure with zero-bound issuance and the Fed proposing to directly intervene in the market. When it comes to treasuries, arguably the only market that truly matters to the Fed, there are signs of stress for sure. Bloomberg's liquidity index is at its worst level for 12 years, excluding the pandemic spike, and Bank of America's global financial stress indicator is showing a reading only seen twice in recent history in 2020 and 2009. None of that is good, but the market is still trading and treasury auctions are still being successfully completed. In other words, what you're seeing over and over is the crack showing, but breakage is not yet happening. And then, of course, there's the labor market,

Starting point is 00:11:18 whose not-breakingness is the biggest not-breakingness when it comes to dictating Fed policy. Unemployment remains at 50-year lows. Week after week of unemployment claims has shown little change in fresh layoffs. Nexto is a security-first platform built for the long run with everything you need for your crypto. Five key fundamentals, including real-time auditing and insurance on custodial assets, safeguard your funds, making Nexo the right place for you to buy, exchange, and borrow against your assets safely. Learn more about Nexo's reliable business model and start your crypto journey at nexo.io. That's nexo.io. Eager to make more

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Starting point is 00:12:50 There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCS, you pay no gas fees. Download the FTCX app today and use referral code Breakdown to support the show. Now, why aren't things breaking, if we really think that they're not? Why might they be holding up? One thing to pay attention to is the Fed itself.

Starting point is 00:13:24 In 2008, the Fed had very few tools to deal with financial crises. This led to Chairman Bernanke famously requesting the bazooka of infinite swap lines and later massive quantitative easing. This time around, the Fed is armed with much more delicate and precise tools. Although the Fed did use QE and swap lines during the 2020 crisis, they also greatly enhanced domestic liquidity provisions to financial institutions. including standing repo and reverse repo operations. This provides banks with as many treasuries and as much cash as they need for overnight liquidity without needing to rely on the open market.

Starting point is 00:13:55 They've also eased reserve requirements for banks, making sure they didn't swamp markets with excessive demand for collateral. The reverse repo facility in particular continues to be heavily used, with more than $2.3 trillion worth of treasuries currently loaned out by the Fed. That is still at an all-time high in dwarfing typical pre-2020 levels of around $100 billion. The next potential breakage point that has been dramatically short up is bank capital. Following 2008, the Dodd-Frank Act was passed, which, among other things, dramatically increased the capital requirements for banks. At the recent congressional hearing on oversight of megabanks, J.P. Morgan's CEO Jamie Diamond

Starting point is 00:14:26 made light of the idea that large U.S. banks would run into problems, suggesting that the problem was more likely that capital regulations requiring banks to hold too much capital, limiting their ability to assist with market liquidity during a crisis. Now, here it's important to note that we are talking specifically about the U.S. and that the picture isn't necessarily the same around the world. A core pillar of the strategy for previous crises was to provide dollar swap lines to allied central banks so that dollar shortages could be addressed and international markets could ease. So far, this year, there has been no hint that dollar swap lines would be open to rescue the world from a strong dollar. If anything, we've seen the opposite. During this month's FOMC press

Starting point is 00:15:02 conference, Chair Powell answered a question about global instability with mild indifference, saying, we are very aware of what's going on in other economies around the world and what that means for us and vice versa. I think Tracy Alloway co-host of Oddlots probably put it best in her reaction to the last FOMC meeting. Going to have to start caveating hike until something breaks with hike until something American breaks. So what are the candidates for something that might break? And again, I'll remind you here that this show is entirely speculative. One dark horse candidate is U.S. corporate foreign revenue. While the de-globalization trend is definitely happening, the largest U.S. companies are multinational conglomerates, who gain a significant portion of their revenue from overseas

Starting point is 00:15:39 markets. Weakening global currencies mean that those international companies are less able to maintain their profit margin overseas. And while that earnings reduction might not reach the point of a crisis, it is a clear demonstration of how ongoing dollar strength could ultimately bounce back as a U.S. problem. Another threat on the horizon that could return home to the U.S. is the ongoing European energy crisis. If things in Europe get as dire as some forecasters are warning, we could see significant industrial shutdowns in Europe over the winter. That could crimp supply chains and lower demand for U.S. imports on the continent. While oil has been down significant, significantly over the last few months, the threat lingers for another price spike. While the Biden

Starting point is 00:16:13 administration has been successful in shielding the U.S. economy from the worst of the oil shock, using the special petroleum reserve releases, that program is set to finish in October, with reserves now at their lowest level since 1984. And then there are bonds. Raoul Paul recently wrote, the bond market is now as broken as it was at the peak of the pandemic. Back then, 10-year futures moved 10 handles in 12 days. Right now, it's 10 handles in 36 days. Liquidity is equally as bad, Valls are as high, it is totally decoupled from the business cycle and from inflation expectations and from debt to GDP, and it's going to break everything. Add this to the dollar-recking ball, and the market may end up forcing the Fed's hand to put liquidity back in the system. We aren't

Starting point is 00:16:49 there yet. In this market, things can get crazy squared, but the fire has been ignited. And that, of course, brings us back to the UK this week. Zero Hedge wrote, 927. Yellen says markets functioning well, conditions not disorderly. 928. B.O.E. resumes QE due to significant dysfunction in guilt markets, material risk to UK financial stability. The question is, one, can the U.S. stay isolated from the rest of the world for long, as the problems of a strong dollar and global challenges in financial markets get more and more pronounced? And two, whether even if we try to, all of these cracks in various markets that we're seeing eventually just become the aforementioned breaks.

Starting point is 00:17:29 Now, the problem is also what happens if it does? John Turrick, who articulated the dollar doom loop, where a stronger dollar means lower global manufacturing, means lower commodity prices, means lower global trade, which means worries about global growth, which leads to a stronger dollar in an ever-ending loop. Odlotz recently had John Turich back on, who's the author of the dollar doom loop. This is the idea that a stronger dollar creates the conditions for it to get ever stronger, creating global challenges along the way. Turik said, in terms of where we are, I think we're in the things break stage.

Starting point is 00:17:59 Typically, when we enter the things breakstage, the Fed is able to get dovish and arrest the move. However, inflation is at 8%. And the Fed won't have confidence it is sustainably falling until the unemployment rate rises a bit. So this is the problem now and why this rendition of the doom loop is more severe. The Fed doesn't have its usual off-ramp because they are in panic mode over U.S. inflation. The whole global economy is basically waiting for the U.S. unemployment rate to tick up to 4%. Ultimately, it may be the case that the problem, for markets at least, is that the problem, is that things aren't breaking yet, meaning the Fed will continue to tighten.

Starting point is 00:18:33 But the challenge with breaks is that they happen gradually, then suddenly. And once the suddenly happens, they can be very, very hard to tame. For now, I want to say thanks again to my sponsors, nexus.com. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. I want to tell you about CoinDesk's new event, the investing in digital enterprises and asset summit or ideas.

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The Breakdown - Is the Problem That Not Enough Is Breaking?

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