wknd notes: A New Approach To Policy (MMT)

“She got it right,” said White House economic advisor Larry Kudlow, marking the first time a senior member of Trump’s team has had anything nice to say about Alexandria Ocasio-Cortez (AOC). “She said the Phillips curve is no longer describing what is happening in today’s economy,” continued Kudlow, “And Powell largely agreed. He confirmed that the Phillips Curve is dead, the Fed is going to lower interest rates.” For two years, the only thing Republicans and Democrats could agree on was that China is America’s adversary. “I hope to sit down soon with Ms. AOC to discuss supply-side economics,” said Kudlow. But of course, AOC would rather discuss a Green New Deal, made possible by Modern Monetary Theory.

Overall: “In early 2014, the Federal Reserve believed the long-term neutral unemployment rate was 5.4%,” said Alexandria Ocasio-Cortez to Fed Chairman Powell, gently placing a hunk of cheese on the trigger plate. “In 2018, it was estimated at around 5.4% and now your estimate is 4.2%,” continued AOC, pulling back the killing bar. “What is the current rate?” she asked, delicately positioning the holding rod so that even the slightest nibble by the Fed Chairman would activate the mousetrap. “3.7% unemployment,” answered Powell. “And inflation is no higher today than it was five years ago when you thought the neutral rate was 5.4%,” she said, sounding surprised, after all, the seven-member Fed Governing Board includes the nation’s leading economists, and has at its disposal the most comprehensive data available on the US economy. “Given the facts, do you think it’s possible that the Fed’s estimates of the lowest sustainable unemployment rate may have been too high?” asked AOC, stepping back slowly, as Powell drew closer to the cheese, incapable of wandering away. You see, the Fed’s record has been so utterly wrong in so many ways, over so many years that even the simplest line of questioning presents an inescapable death trap. “Absolutely. It’s substantially lower than we thought,” answered Powell, doing his best to sound upbeat to the executioner. “So the idea of a Phillips Curve is no longer describing what is happening in today’s economy?” asked AOC, smiling. “Very much so. The connection between slack in the economy or level of unemployment and inflation was very strong 50yrs ago. But it has gotten weaker to the point where it’s a faint heartbeat,” said Powell, nibbling the cheese. The killing bar swung down, snapping with a crack. As Alexandria Ocasio-Cortez publicly undermined the authority of the world’s most powerful central bank. Paving the way for a new approach to policy. Modern Monetary Theory. MMT.

Week-in-Review (expressed in YoY terms): Mon: Japan machine orders -6.2 to -3.7%, Iran considers plan to enrich uranium at higher purity level, Erdogan fires central bank chief, Greek center-right wins in landslide election, German industrial output -3.7%, Deutsche Bank to lay off 20k employees in restructuring, S&P -0.5%; Tue: Taiwan buys $2.2bln in arms from US, HK’s Lam stops short of meeting protesters demands, Australia dilutes capital buffer requirements for banks, Germany’s BASF (world’s largest chemical company) issues profit warning on slowing global economy & trade conflicts, Italy issues 50yr bonds at 2.9% (6x oversubscribed), Mexican Finance Minister resigns abruptly, US announces anti-subsidy duties on Canadian/Mexican steel, S&P +0.1%; Wed: China PPI -0.3 to 0.00% (first flat reading after 3yrs of price gains), China CPI unch at +2.7% (food prices +8.3% on surge in pork prices), Ramaphosa reappoints South Africa’s central bank chief, UK ambassador to US resigns following Trump’s outrage, Merkel seen shaking for 3rd time, Germany issues 10yr Bund with 0% coupon and -0.26% yield, EU Carbon Allowance prices hit 11yr high, France passes 3% digital services tax on sales by US tech giants (Facebook, Google, Amazon, Apple, Microsoft), Powell “uncertainties to the outlook have increased in recent months,” Fed minutes indicate “near term” rate cut, S&P +0.5%; Thur: Iranian boats attempt to intercept UK oil tanker, ECB meeting minutes show they’re ready to ease policy (swap markets price 80% probability that ECB will cut rates in July or Sept), BOE warns of rising risks of no-deal Brexit and material risks of economic disruption and volatility, US unemployment claims -13k to 209k, CPI -0.2 to +1.6% (core +0.1 to +2.1%), Trump drops fight for citizenship question on census, S&P +0.2%; Fri: China exports -1.3%, Turkey takes delivery of Russian S-400 missile system defying US warnings, Fitch cuts Turkey rating one notch, EU industrial production +0.4%, US PPI -0.1 to +1.7% (core unch at +2.3%), Trump tweets opposition to Facebook’s Libra and Bitcoin, Labor Secretary Acosta resigns over Epstein case, Mnuchin urges Congress to raise debt ceiling before August recess (treasury could run out of cash in Sept), Tropical Storm Barry slams New Orleans, S&P +0.5% (record high); Sat/Sun: Hong Kong protesters clash with police, ICE raids seek to deport thousands of unregistered immigrants, earnings season to kick off with expectations of earnings recession (Q2 S&P 500 earnings expected -2.8% YoY following Q1 -0.3% YoY).

Weekly Close: S&P 500 +0.8% and VIX -0.89 at +12.39. Nikkei -0.3%, Shanghai -2.7%, Euro Stoxx -0.8%, Bovespa -0.2%, MSCI World -0.0%, and MSCI Emerging -0.5%. USD rose +3.5% vs Ethereum, +1.6% vs Turkey, and +0.4% vs India. USD fell -7.3% vs Bitcoin, -2.2% vs Brazil, -1.5% vs South Africa, -1.3% vs Russia, -0.8% vs Sweden, -0.6% vs Chile, -0.6% vs Australia, -0.5% vs Indonesia, -0.5% vs Yen, -0.4% vs Sterling, -0.4% vs Euro, -0.4% vs Canada, -0.2% vs China, and -0.1% vs Mexico. Gold +1.1%, Silver +1.5%, Oil +4.5%, Copper +1.1%, Iron Ore +5.0%, Corn +4.1%. 5y5y inflation swaps (EU +9bps at 1.29%, US +9bps at 2.11%, JP flat at 0.11%, and UK -2bps at 3.58%). 2yr Notes -2bps at 1.85% and 10yr Notes +9bps at 2.12%.

YTD Equity Index Returns: Greece +37.7% priced in US dollars (+40% priced in euros), Russia +29.5% priced in dollars (+17.2% in rubles), Argentina +27.6% (+41.1%), NASDAQ +24.2%, Brazil +22.5% (+18.2%), New Zealand +21.1% (+21.5%), Canada +20.4% (+15.1%), S&P 500 +20.2%, Colombia +19.3% (+16.9%), Italy +19.2% (+21.1%), Australia +18.2% (+18.6%), Israel +17.7% (+11.6%), China +17.5% (+17.5%), Thailand +16.6% (+10.7%), Russell +16.4%, France +15.9% (+17.8%), Switzerland +15.9% (+15.8%), Germany +14.9% (+16.7%), Euro Stoxx 50 +14.7% (+16.5%), Saudi Arabia +14.6% (+14.6%), Netherlands +14.4% (+16.3%), Portugal +13.7% (+15.5%), Ireland +13% (+14.9%), South Africa +12.9% (+9.6%), Norway +12.7% (+10.2%), Philippines +12.1% (+9.1%), Japan +10.8% (+8.3%), Sweden +10.4% (+15.4%), HK +10.3% (+10.2%), UK +10% (+11.6%), Singapore +9.8% (+9.4%), Denmark +9.7% (+11.4%), Taiwan +9.4% (+11.3%), Belgium +8.5% (+10.3%), India +8.1% (+6.4%), Austria +7.7% (+9.3%), Spain +7.1% (+8.8%), Indonesia +6.7% (+2.9%), Finland +6.2% (+7.9%), Mexico +6% (+2.4%), Czech Republic +6% (+7%), Poland +3.9% (+4.7%), UAE +2.8% (+2.8%), Chile +1.3% (-0.7%), Hungary +1% (+4%), Malaysia -0.7% (-1.2%), Turkey -1.3% (+6.4%), and Korea -3.2% (+2.2%).

Beep Beep: “That sell-off in Q4 of last year was real,” said Roadrunner, the market largest trader of S&P 500 volatility. “It was an engineered move, driven by the Fed and the Chinese trade conflict,” he added, looking left, right, up. “It got the Fed to cut rates despite the economy’s strength.” The market is priced for a 25bp cut July 31st, and there’s roughly a 1-in-4 chance of 50bps. “Most investors are underweight risk assets even with stocks at new highs. And now I’m starting to see the kind of activity that you see before big rallies, not after them.”

Beep Beep II: “On Friday’s close, someone bought 23,000 Facebook calls and pushed their price from $0.60 to $2.10 without the stock moving,” continued Roadrunner. “And when the S&P grinds higher, more people are buying puts than calls,” he said. “When vol gets bid up as the market rallies, I get comfortable going short the market.” But that’s not happening. “Grain prices are rallying. Farmers are feeling better. Everyone else is flush. It’s a booming economy. And this is before rate cuts kick in, before we get a China deal, and Trump destroys the dollar.”

Beep Beep III: “He’ll sell his China deal as the greatest thing ever. But it’s all smoke and mirrors with him. All he wants is stocks higher heading into the election,” said Roadrunner. “And when the dollar falls, stocks go up, gold, Bitcoin too,” he said. “Doesn’t feel like this is over. I feel myself getting bullish which is the opposite of how I usually feel after a big rally,” said Roadrunner, looking around for a trap. “It just appears we’re headed into a FOMO period. Every day it gets harder to buy the S&P. Everyone is underperforming. Yet it drifts up and up.”

Private Sector: In 1974, Rubik’s Cube’s inventor took 3wks to solve his puzzle. The 3x3x3 cube has 43 quintillion configurations. Solving it never requires more than 20 moves. In 2018 China’s champion accomplished the feat in 3.47 seconds. A robot has now done it in 0.38 seconds. 2,598,960 possible 5-card hands can be drawn in Poker. Facebook announced it developed an artificial intelligence bot that beats professional Texas hold ’em players. “It’s safe to say we’re at a superhuman level,” said Facebook. These are problems fit for the private sector.

Public Sector: In 1974, when Rubik invented his cube, global CO2 emissions were 16.8bln tons. They doubled to 37bln tons in 2018, rising inexorably. Of course, the carbon accumulates, its impact appears to accelerate. The scale of the problem requires public sector solutions. Global clean energy investment fell to 5yr lows in the first half of 2019 to $118bln (driven by a pullback in China). Hurricane Katrina cost between $180bln-$250bln. And as Tropical Storm Barry hit New Orleans, the US Gov’t budgeted just $1.5bln for 2020 nuclear and renewable research. 

Election Math: A Presidential term is 1,461 days. That leaves just 478 until the election. Betting sites give Dems a 55% probability of winning, Trump 45%. Everyone runs calculations, charting policy accordingly. China is slow-pedaling US farm goods purchases. Beijing threatened sanctions on US companies selling arms to Taiwan. Turkey took delivery of Russia’s S-400 missiles defying US sanction threats. France imposed taxes on US tech giants. And the House voted to deny Trump the authority to wage war with Iran without congressional approval.  

Anecdote: “Imagine Congress appropriates $1bln to refurbish Air Force One,” said Warren Mosler, pioneer of Modern Monetary Theory (MMT). We were discussing the financial architecture that allows the Fed to create money. “The Department of Defense (DoD) hires General Dynamics to upgrade the airplane. The US Treasury instructs the Fed to credit General Dynamic’s account at JP Morgan with +$1bln. The Fed simultaneously debits the US Treasury account with -$1bln and the books are balanced.” Notice, the government did not need to collect taxes or issue bonds. “The US Treasury basically now has a -$1bln overdraft at the Fed. There’s no practical limit to how high the US Treasury overdraft at the Fed could become, but politicians don’t want the Treasury balance to be negative, so the Treasury issues $1bln in bonds, and deposits those proceeds at the Fed to eliminate its -$1bln overdraft.” The $1bln the Fed created is trapped in the banking system and finds its way to purchase the $1bln in bonds the Treasury issued to balance its Fed account. “Even if General Dynamics chooses to move the $1bln into Euros, it will do so by instructing JP Morgan to buy Euros from Deutsche Bank, which also has a Fed account. The Fed will debit JP Morgan’s account by -$1bln and credit Deutsche Bank’s account by +$1bln. The ECB will debit Deutsche Bank’s Euro account by -$1bln and credit JP Morgan’s.” The dollar’s exchange rate may fall, but that’s what Washington wants. “People misunderstand debt and money. Government debt is simply money the government has spent that hasn’t yet been used to pay taxes. Holders of that debt prefer saving over consuming or they wouldn’t own bonds. At some point, these people may choose to spend more than they save, and if that sparks excess demand and inflation (in Warren’s experience, large inflations are caused by other factors), then that’s easily dealt with. The government simply raises taxes or cuts spending.”

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.