How did the Fed get Inflation so Wrong?

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Lawrence McDonald is the New York Times Bestselling Author of “A Colossal Failure of Common Sense”  – The Lehman Brothers Inside Story  – one of the best-selling business books in the world, now published in 12 languages – ranked a top 20 all-time at the CFA Institute.

“By their fruits, you will know them. Do men gather grapes of thorns or figs of thistles?” —Jesus Christ, in his Sermon on the Mount as related in Matthew, a warning against false prophets.

Up More than 10% Year to Date, 33% from Omicron Fears on Dec1
A Large Tax on the middle class – energy prices. Goldman is now calling for $100 crude by August. Large implications on inflation looking forward.

The Shock

For the last available data week, money borrowed via reverse repo increased $66.4 billion while the Fed’s balance sheet increased another $22.6 billion. Back in Volcker’s day, that would have been considered a massive liquidity injection, and quite inflationary. You see, back in 1980, there was this thing called “the Volcker Shock” which involved increasing the Federal Funds Rate to the highest it has ever been. Such a dramatic move convinced everyone that he had the courage to kill inflation. He drained money from the system. He didn’t inject money into it! Volcker believed once inflation oozes into a million corners of the economy, it cannot be stopped with small – incremental rate hikes – you MUST go big to kill it. 

Killing Inflation Comes with a Price
Killing inflation comes with a high price, on a cumulative basis – Nasdaq’s new lows are epic.

Just as false prophets do not produce good fruits, so too do false inflation fighters fail to use a Volcker Shock. One should not judge prophets, and Central Banks, only by their words.

*Paul Adolph Volcker Jr. – He served two terms as the 12th Chair of the Federal Reserve from 1979 to 1987. He was nominated to position by President Jimmy Carter and renominated by President Ronald Reagan. He was widely credited with having ended the high levels of inflation seen in the United States during the 1970s and early 1980s. 

Markets Pricing Four Moves in 2022 – Now What?

The continued strong inflation has led to both a Fed pivot on inflation and markets now pricing in four 25bp moves this year, 160bp by December of 2023, and only 10bp more by December of 2024. With “transitory” officially retired at Powell’s September FOMC press conference, the main issue for investors is whether the Fed will meet the priced targets, undershoot or overshoot. In the 2015-2016 rate hiking cycle kickoff, they promised 8 moves to start and only delivered two over 24 months.

The Inflation Pivot

When we were on the trading floor at Lehman in Q4 2006. At that point, as the clock struck midnight on a frosty evening in December, we gathered the courage to pitch a colossal short on the US housing sector (Beazer, Countrywide, New Century – credit and equities). We pitched the trade into Mike Gelband (Global Head of Fixed Income) and Alex Kirk (COO of Fixed Income). Both approved the SIZE short – but said. “Make sure you run it by our economics team.” Before breakfast, the academic brain trusts – NONE of whom had EVER actually sat in a risk-taking seat – refused to endorse the trade. “Every model we believe in tells us housing will NOT decline on a national level with unemployment at these levels, it´s just NOT possible (historically, more people were working than ever before).” Gelband and Kirk approved the trade anyway, they said – “make sure you double it – 2x the size proposed.” Legends.

(This story is laid out in our New York Times Bestselling book – “A Colossal Failure of Common Sense”  – The Lehman Brothers Inside Story  – one of the best-selling business reads in the world, now published in 12 languages – ranked a top 20 all-time at the CFA Institute.)

The Fiscal and Monetary Response

Covid Crisis

$2.2T CARES Act, Q2 2020
$0.9T Aid package, Q4 2020
$1.9T American Rescue Plan, Q1 2021
$1.0T Infrastructure, Q4 2021
$4.0T Fed asset purchases


Post Lehman´s Failure

$0.7T Tarp Relief
$1.1T Fed asset purchases


FAILED Fed Economic Models Come with a High Price – Even in the face of this fiscal and monetary response differential – this cycle vs. last, the Fed models saw NO RISK OF SUSTAINED inflation six months ago. Economic models were focused on premature deaths, reduced immigration, forgone capital investment, the economic costs of lockdowns on unemployment, pandemic induced exits from the labor force. The Fed was too focused on demand, NOT supply. For example, ESG’s impact on oil, coal, and gas exploration – a $1T + hit to capex –  has had a colossal impact on the cost of energy. 

Back To Powell´s Change of Heart

Whether it was the continued release of strong inflation data or the realization of his reappointment, Chairman Powell exhibited a definite shift towards controlling inflation following the November 22 reappointment announcement. In Congressional testimony on November 30, he said it is a “good time to retire the term transitory.” At the press conference following the December 15 meeting, he stated “There’s a real risk now, I believe, that inflation may be more persistent and…the risk of higher inflation becoming entrenched has increased” … “That’s part of the reason behind our move today, is to put ourselves in a position to be able to deal with that risk.” This past week he stated, “If we have to raise interest rates more over time, we will.” He also said, “we need to focus on inflation a little bit more at the moment than the maximum employment goal.” With the unemployment rate back under 4%, that seems a good bet. While the past two nonfarm employment figures have been less than expected, the Household survey, which feeds into the unemployment rate, showed increases of 651 thousand and 1.09 million respectively.

US 30 Year Treasury Bond Yield vs. the Data

Up from 167bps to 212bps since early December

ISM Man 58.7 vs 60.0 exp Jan 4 (miss)
ISM Svs 62.0 vs 67.0 exp Jan 6 (miss)
Jobs NFP 199k vs 450k exp Jan 7 (miss)
AHE 4.7% vs 4.2 YOY exp Jan 7**
CPI 0.5% vs 0.4% exp MoM on Jan 12**
Retail sales -1.9% vs -0.1% MoM exp on Jan 14 (misss)
Industrial Production -0.1% vs +0.2% MoM exp Jan 14 (miss)
UMich 68.8 vs 70.0 exp on Jan 14 (miss)

**hot wage – inflation data

Rates and Economic Data
Economic data in the USA is rolling over, meaningfully. Inflation is already hiking rates for the Fed – very aggressively – where is the trade?  Reach out to

“It really depends on any crisis signal from stocks. A 25% one-day crash in US equities would halt the Fed in its tracks. A 25% decline of 2-ish percent a month over 12 months or so may not alter Fed behavior. Just because the Fed doesn’t like crashes doesn’t mean it can’t deal with slow grind declines. It is all about financial conditions” – Hedge Fund CIO in our Live Chat on Bloomberg.

Fed pricing reflects a steady tightening path in 2022 and 2023 with a terminal fed funds rate of around 1.75%. Note this is lower than the previous peak in fed funds of 2.50% in 2018/2019 and may prove to be low, indeed. By comparison, CPI was just 1.9% at the end of 2018 vs 7.0% today.

A number of Fed Presidents (Bullard, Mester, Harker, Bostic, Daly, George) have mentioned the possible need to raise rates in March and the possibility of four rate increases this year is also becoming more prevalent, matching market pricing. The surprise would be if the Fed tightens by 50bp or skips moving at a quarterly meeting. With Mester, George, and Bullard voting this year, the FOMC will have a more hawkish slant.

Balance sheet adjustment is also a discussion point, with some estimates it could come as early as June and certainly this year. A reduction in the balance sheet could potentially also be implemented in lieu of one tightening.

What Can Delay a Tightening?

At this point, with the Fed widely viewed as behind the curve, it will be difficult to delay the path. Two potential causes would be – 1. a continued uptick in Covid cases or a new, more deadly strain; and 2. a sharp correction in risk assets. With inflation gaining traction, the Fed is in a tricky spot, as they may have to continue tightening even though they don’t want to. As mentioned above, balance sheet reduction may help in this case.

Markets have had a dramatic move so far this year, and the GAMMA Alert (sent to clients) we had at the start of the year worked well. Green March Eurodollars are down 42bp and TYH is down almost three points the past two weeks. Special thanks to Arthur Bass, at Wedbush for his weekly insights.

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Institutional investors can join our live chat on Bloomberg, a groundbreaking venue, just email – Thank you.

Lawrence McDonald is the New York Times Bestselling Author of “A Colossal Failure of Common Sense”  – The Lehman Brothers Inside Story  – one of the best-selling business books in the world, now published in 12 languages – ranked a top 20 all-time at the CFA Institute.



A Colossal Theft in Pain Sight

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Institutional investors can join our live chat on Bloomberg, a groundbreaking venue, just email – Thank you.

Lawrence McDonald is the New York Times Bestselling Author of “A Colossal Failure of Common Sense”  – The Lehman Brothers Inside Story  – one of the best-selling business books in the world, now published in 12 languages – ranked a top 20 all-time at the CFA Institute.


What have we done with the $11 Trillion?

We have clients in 23 different countries, but most reside within the continental United States – in recent weeks, we keep hearing countless stories of self-proclaimed 24-hour turnaround testing centers to do a PCR test, then taking more than 80 hours to get the results back. Friends in New Jersey tell us not one pharmacy or walk-in clinic in a 100-mile radius has appointments available in the next week. Home testing has improved but for those traveling overseas – it is a PCR test that is needed.

The question that haunts us now is that, almost two years into this crisis and an $11 Trillion U.S. Fiscal and Monetary spending deluge, we still don’t have an adequate testing infrastructure? It blows us away –  we are still dealing with endless waiting lines, no availability of testing appointments, shortages of at-home tests and overwhelmed testing labs scrambling to process vials.  Where did all that money go?

State and Federal Debts Add Up

In the US, the corona crisis started on January 29, 2020, when the White House initiated its coronavirus task force. Since then, the US has gone from crisis to crisis and the media and our politicians have been obsessed with this epidemic and its consequences ever since. Amidst all the turmoil, the US government has left no stone unturned to throw money at this disaster. The Fed kicked off in early March by lowering interest rates to zero and shortly after began rolled out an alphabet soup of emergency programs. From buying high yield debt to bankrolling bailout checks (PPP loans), nothing was left on the table for our adroit stewards at the Fed. The byzantine maze of fiscal stimuli has left everyone confused. Nevertheless, the total amount of support the Fed has pumped into the economy is best measured by the expansion of its balance sheet. When the Fed finishes its asset tapering program in March of 2022, its balance sheet will have expanded by $5 Trillion. In less than two years the Fed deployed more money than during, and in the 10 years after, the great financial crisis ($3.5TR). This monetary support alone is also more than that of the entire GDP of Japan, the third-largest economy in the world.

Not to be outdone, the Federal government opened the floodgates by quickly passing spending bill after spending bill. After less than two years, the total amount of fiscal stimulus, as measured by the fiscal deficit spending, has reached a mind-blowing $6 Trillion. U.S. Federal debt has reached $29 Trillion and $32 Trillion if you add State and Local debt. At this point, US debt is a whopping 134% of GDP, giving the U.S. the dubious honor of being among top ten most indebted countries worldwide. This is a spot the erstwhile creditor to the world shares with the likes of Italy and Venezuela.
Where did all the money go?

And what did we, the American people, get for this colossal $11 Trillion in a monetary and fiscal deluge? As we find ourselves in the midst of yet another massive outbreak is case count, this seems like a valid question. You would think that the priority for these funds is to bolster essential healthcare needs to address this medical crisis. But even now, the US is still woefully ill-equipped with testing capabilities, almost two years into this crisis.  Our friends in Europe tell us testing is quickly done there. They live in urban areas such as Paris where testing is still readily available. France is also in the midst of another outbreak but seems to have no problem providing its citizens with ample testing facilities.

In hospitals, there has apparently been no improvement in available capacity in the critical ICUs, judged by the Johns Hopkins weekly hospitalization trends.


Incredulously, ICU beds-in-use compared to overall availability is almost higher now than it was a year ago.

So Where did the Money Go?

According to the Congressional Research Service, $25 Billion was appropriated for “selected domestic COVID-19 vaccine-related activities”. That sounds like a lot, but it’s a mere 0.5% of the federal emergency spending in the last two years. It turns out that the department of health and human services wasn’t even the biggest recipient of all the emergency spending. It was fourth on the list, which was topped by the Treasury Department, the small business administration, and the department of labor. Other major recipients were the department of education and the agriculture department. Why farmers needed a $160 Billion windfall during the pandemic is incomprehensible, especially since most crop commodities have been at record highs for a year now.

Reasonable people can agree that small businesses needed support during this crisis, especially during the lockdown. But the Fed’s Term Asset-Backed security Loan Facility (TALF), Primary and Secondary Market Corporate Credit Facilities ((P/S) MCCF), and Municipal Liquidity Facility (MLF) had absolutely nothing to do with small business assistance. These programs, together with the $5 Trillion purchases of Treasuries and agency debt, helped to foster an explosion in debt issuance by big business. Fueling stock buybacks – Investment-grade debt issued in this year and last year was a total of $3.1 Trillion, almost half the size of the total IG market. High yield issuance was even more baffling, setting issuance records two years in a row amidst a debilitating epidemic.

Junk Bond Bonanza Fueling Stock Buybacks

The effect of all this government largesse has had a profound impact on the stock market. The total market value of all stocks has risen from $34 Trillion to $53 Trillion; a whopping $19 Trillion (50%) increase from pre-pandemic levels. The IPO market has been red hot this year, with 1000 deals for the first time in history. Rock bottom interest rates and epic multiple expansion have driven investors into IPOs, as they clamor for excess returns in the most unsavory deals. U.S. junk bonds, we see new supply to plunge as much as 30% in 2022 as refinancings, the driver for almost 60% of issuance this year, will shrink because companies already capitalized on low yields and lengthened maturities. Likewise, a Fed in a hiking cycle should tighten financial conditions – shrink issuance.

Buybacks Driving S&P and Nasdaq Higher – On Leverage

Congress wants to tax stock buybacks – the implications are sky-high as a colossal equity market bid comes from Fed-induced corporate bond sales- See above with @SamRo – he notes just 20 companies are responsible for half the stock buybacks – this is one enormous – central bank fueled – leveraged Ponzi is driving stock indexes (S&P 500 and Nasdaq) higher. Of course in Q1 – Q2 2020 when stocks were on sale – few companies were buying back stock. Per Fitch – U.S. dollar-denominated, investment-grade (IG), corporate bond volume, excluding financial institutions, supranationals, sovereigns, and agencies, tallied $705 billion through Dec. 16, 2021. We saw the second-highest issuance through the first 10 months of the year and are up 27% and 13%, from 2018’s and 2019’s respective levels. Volume is down 36% versus the record 2020 amount; though that gap could shrink by year’s end as the final two months of 2020’s issuance was well below 2021’s monthly average. The volume disparity between 2020 and 2021 relates to deal size. Last year, there were double the number of transactions done for $4 billion or more compared with this year (60 in 2020 versus 29 in 2021). Both years featured at least two $20 billion issuances, with AT&T Inc. and The Boeing Company driving 2020 while Verizon Communications Inc. and AT&T led 2021. Several prominent companies tapped the IG market in 2021, including Verizon, AT&T, Inc., Oracle Corp., Comcast Corp. and Apple Inc. These six issuers comprised 21% of the year’s total volume, with all completing bond transactions of $15 billion or more. In fact, the 10 largest issuers make up 29% of 2021’s volume, highlighting the market’s concentration.

The problem is – central banks are fueling unsustainable inequality.

Share of Total Net Worth held by the Top 1%

2021: 32.5%
2010s: 31.2%
2000s: 27.2%
1990s: 26.7%
1980s: 23.2%

*Since 2003, the Bottom 50% total net worth held has plunged from 39% to 30%. Federal Reserve data. For 20 years 1990-2010, the top 1% net worth held was range-bound 26-27% – since central bank aggression in balance sheet expansion in 2009, inequality has exploded higher. 

The Great Heist at the Taxpayers Expense

This is all great if you own stocks, or when you are a Fortune 500 company issuing debt to repurchase your own stock, but neither the deluge in debt nor the record number of buybacks (at a run-rate of $1 Trillion this year) have done anything to bolster our country’s medical care or Americans’ health. More troubling even is reports showing outright theft of funds earmarked for pandemic emergency spending. The Wall Street Journal quoted the U.S. Secret Service who said that “some $100 billion has potentially been stolen from Covid-19 relief programs designed to help individuals and businesses harmed by the pandemic.” The main culprits are worldwide organized crime networks, who defrauded primarily the pandemic unemployment insurance program. On top of that, as much as 15% of the PPP loans ($76 billion out of $800 billion total) may have been fraudulent, according to the New York Times.

The Middle Class is in Pain

After $11 Trillion of emergency spending and support, the US healthcare system is just as inadequate as it was before the crisis, violent crime is rampant, drug overdoses have never been higher and the economy is showing signs of stagflation, as illustrated by the record spread between Treasury breakevens and TIPS yields¹.  What these bond market metrics suggest is that the potential growth rate of the US economy has structurally declined since the pandemic (it already declined a lot since the “great financial crisis”) and that any growth future growth is coming from price increases. The bond market is telling us – a significant portion of future GDP growth is coming from price increases, but there is little real growth in the economy, which is why TIPS yields are -1.00%.

Consumers in Pain
Since August – we have had THREE sub-80 readings from the University of Michigan Consumer Economic Confidence Data.  Looking back over the last 30 years – it is HIGHLY unusual for the Fed to hike rates with consumers in this kind of pain. Inflation´s taxing powers over the consumer have already hiked rates 100bps for the Fed in our view – colossal demand destruction has taken place. These stagflationary conditions erode people’s real disposable income, making them worse off. Ultimately, most of the $11 Trillion ended up benefiting the top wealthiest Americans, by inflating the prices of assets such as bonds and stocks and lowering interest rates for borrowers with the highest credit rating. For the average citizen, this has been a very raw deal.

Loud Covid Narrative Hides Inconvenient Truths     

We must look at the big picture. There is a high price from lockdowns and Covid human suppression / OUTSIDE of cases. The number one killer of Americans aged 18 to 45 is now fentanyl overdoses, with nearly 79,000 victims in the age range dying to them between 2020 and 2021.

Inflation is a Regressive Tax on the Middle Class
TIPS: Treasury Inflation-Protected Securities: The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. Breakeven yield is calculated by deducting TIPS yields from real yields. Breakeven rates derive the rate of inflation priced in by the bond market for applicable maturity (such as 10-year breakevens express the implied rate of inflation in the next 10 years).

Trillions of Fiscal and Monetary Support

What is so painful is that not only is there no discernable improvement in the healthcare infrastructure to deal with the corona crisis, but other facets of America’s healthcare are now even worse off. The CDC reported this week that fentanyl is now the leading cause of death among teenagers. These drugs have killed more people between the ages of 18 to 45 than corona, car accidents, and suicides. Data from Families Against Fentanyl suggests that now one person dies from an overdose every 8.5 minutes. The pandemic has pushed drug abuse into overdrive as “the stress of the pandemic has led more people to use these types of drugs, according to experts.”  The Census Bureau this week reported that America’s population grew at the lowest rate in history. In the year that ended July 1, the U.S. recorded only 148,000 more births than deaths, with the balance coming from net immigration. America’s life expectancy last year declined by an unprecedented 1.8 years to 77 years. Besides corona, increases in mortality from drug overdoses, heart disease, homicide and diabetes also decreased life expectancy. Violent crime especially has seen a dramatic increase in the last two years. CDC’s National Center for Health Statistics reported that homicide rates rose 30% between 2019 and 2020 and they continue to go up this year.  At least 12 major U.S. cities have broken annual homicide records in 2021 — and there’s still three weeks to go in the year.

US Annual Population Growth

2021: 0.1%
2011: 0.8%
2001: 1.0%
1991: 1.2%

*America is dying – and it’s NOT just a Covid narrative. From 1999–2019, nearly 500,000 people died from an overdose involving any opioid, including prescription and illicit opioids -CDC data. 

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Institutional investors can join our live chat on Bloomberg, a groundbreaking venue, just email – Thank you.

Lawrence McDonald is the New York Times Bestselling Author of “A Colossal Failure of Common Sense”  – The Lehman Brothers Inside Story  – one of the best-selling business books in the world, now published in 12 languages – top 20 all-time at the CFA Institute.



Garbage Floating to the Top

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Institutional investors can join our live chat on Bloomberg, a groundbreaking venue, just email – Thank you.

Lawrence McDonald is the New York Times Bestselling Author of “A Colossal Failure of Common Sense”  – The Lehman Brothers Inside Story  – one of the best-selling business books in the world, now published in 12 languages – top 20 all-time at the CFA Institute.

If the Fed’s gravy train had been this aggressive in 2008, Bernie Madoff would still be sipping mint juleps in the Hamptons. Lehman NEVER would’ve failed. Central bank largess is protecting Enron’s out there – as accommodation is withdrawn – garbage will float to the top. The toxicity is off the charts this cycle – Dozens of Madoffs and Enrons – it is sickening.

All you need to know is one important fact – there is $30T more debt on earth today sub 2% in yield – than there was in the last two hiking cycles. The below 2% part is important because it speaks to colossal convexity in today´s bond market.  Everyone knows – with interest rates UP, bond prices go DOWN.  The problem is – with trillions more debt on earth BELOW 2% – just ONE little 25bps rate hike carries the destructive forces of 4 hikes 15 years ago!!! The bond market is telling us this, screaming at us. The U.S. 30 year bond yield is 1.87% – while the 20-year is yielding 1.91%. Eurodollar futures have recently started to price in rate cuts in 2024-2026, NOT hikes.  The last two rate-hiking syles were FOUR years-long – NOT this time.

Rate Hiking Cycles
The bond market is telling us, the Fed´s ability to pull back accommodation over an extended period of time is HIGHLY limited. Nearly 71% of the U.S. Federal budget is interest spending and entitlement spending vs. 30% thirty years ago.  Close to 14% of Americans are on Food Stamps today vs. near 3% in 2000.  There are bills to pay, the Fed´s hands are tied.

The Secret

The dirtiest secret in economics is that it provides no coherent, provable, and universally accepted theory of recession. The reality is, economists, don’t actually know what causes recessions. The reality is, there may be no single cause. It’s even hard to wrap your brain around how you are supposed to approach the data. For example, if you look at rate hikes and when recessions occur, it’s not clear that rate hikes cause recessions. Certainly, about 75% of the time quick rate hike sequences were followed by recessions. But then, 25% of the time they weren’t.

Well, a cause is something that works 100% of the time. Certain predictable chemical reactions work 100%. Entire industries and thus economies are built on these industries and their 100% certain causalities. They wouldn’t exist if the criterion for a cause = 75%. As traders, we are delighted if we find something that works 75% of the time and so too readily falls into the trap of confounding probability with causality.

So, we can accept that rate hikes are probably followed by recessions. We think the explanation, perhaps, is that a withdrawal of lending by banks causes recessions. And they stop making loans when they feel, sometimes rationally, sometimes irrationally, that if they make loans they will lose money. Sometimes this feeling happens when interest rates rise. Sometimes it doesn’t. 75% of the time in a rising interest rate environment, banks get the feeling making loans isn’t a grand idea.

Well, why does that happen? There are lots of reasons unique to each cycle, unfortunately, which is why there is no grand unified theory of recession. But clearly, if interest rate hikes go too far, somehow the lending proposition becomes less viable. Again, how do we know when the hikes are too far? We don’t, until after the fact. However, we can say that if a bank’s model is to create money by borrowing short term and lending long term, a negative sloping yield curve will kill loan creation. And what causes a yield curve to invert?

The belief that the demand for money will steadily decline i.e. the belief that there will be a recession. So it’s circular, far from rational. Or it could simply be that a yield curve inverts because traders think inflation will be lower later, causing the curve to invert, thereby causing banks to restrain lending, thereby, in turn, causing a recession. In which case traders’ opinions about distant inflation trigger recessions, which seems a tad bizarre but the world is a crazy place so perhaps it’s true. But yield curves aren’t perfect predictors either. And they change. We do know that if growth is greater than the cost of capital that is less likely to cause a recession than if growth is less than the cost of capital. That does seem logical. So if rates rise less quickly than growth, it seems reasonable that there will be no recession. But growth rates can be a moving target, so a rate hike that is appropriate now may be inappropriate two months later. So we don’t know. But we have the odds: 75% of the time rate hike sequences lead to recessions.

We would only add that when rate hikes are accompanied by an increase in bank reserves then recessions happen for sure. This is why we are so impressed by China’s recent lowering of reserve requirements for its banks. To us, that is a buy signal. Certainly in the US when bank reserve requirements are lowered, equity bull markets follow.

Value vs. Growth – Late Stage
Value vs. Growth the Epic Final Days of this Battle – TSLA is Through key support – 20% off sale – Tesla TSLA is going through the recent lows pre-market – observation of the week – the 25-30x sales LARGE caps (NVDA – TSLA) – are playing CATCH UP with the COUNTLESS 40-100x sales garbage that is now trading 10-20x (ARKK names). So we have a washout in the Nasdaq with 300+ companies moving from 40-100x sales to 10-20x sales and NVDA still sits unched at 30x sales?? – Large-cap stretched names are playing catch up this week.

Value vs. Growth – Early Stage
Close to 20% off their highs – hot software names are in pain. The Nasdaq Composite Index is up roughly 15% year-to-date. However, when removing the 5 largest equities, the index is down close to -20% on the year! This shows how large the tail-risk to US equity markets is if the largest names are to see a significant pullback. This is one of the most top-heavy markets in history.  As we stressed in January on Real Vision and CNBC – the net present value of FUTURE cash flows is worth A LOT MORE with certain deflation and worth ALOT LESS with certain sustainable inflation. 

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The Week that Changed the World – 13 Years, Just Wow

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“‘China’s Lehman Brothers moment’: Evergrande crisis rattles economy” – The Guardian

“The crisis engulfing Evergrande, China’s second-biggest property company, is the greatest test yet of President Xi Jinping’s effort to reform the debt-ridden behemoths of the Chinese economy. As angry protesters occupied the headquarters of the troubled property developer in recent weeks, some analysts have described the Evergrande crisis as “China’s Lehman Brothers moment”. Only this time it’s a credit-fuelled housebuilder that suddenly can’t pay its $300bn debts, rather than a blue-chip (Lehman) investment bank that many assumed was too big to fail but was instead thrown to the wolves 13 years ago.” They took Lehman´s head underwater and they watched for the bubbles – but why?

Credit Leads Equities – Our 21 Lehman Systemic Risk Indicators

My name is Larry McDonald, that’s our UK book cover above. In the years before the failure of Lehman Brothers, I ran a successful distressed credit business at what was the 4th largest investment bank in the U.S. – becoming one of the most consistently profitable traders in the fixed income division. In late 2008, early 2009 – with Patrick Robinson, we penned “A Colossal Failure of Common Sense” – the Lehman Brothers inside story. At least once a month, I tell my wife while wearing a hopeful smile —“if we sell a million books — we´ll break even on our Lehman stock.” On September 15, 2008 – it all came crashing down in the largest bankruptcy in U.S. history. Known as, “the week that changed the world,” a very painful experience indeed. I was down on the mat looking up at the referee as he delivered the count. It was one of those fateful moments most of us face. Staring into the abyss, drenched in blood-curdling uncertainty, there are times in life when we must get up. Even when it looks like all is lost in a valley of no hope.  Ultimately, the lucky ones learn there are valuable lessons in re-invention. The last 13 years have been a breath of fresh air. Our New York Times bestseller has been published in 12 different languages, the “page-turner” is in the CFA Institute’s top 20 all-time (finance books), and was featured in the Academy Award-winning movie with actor Matt Damon, “Inside Job.” It’s an absolute must-read filled with countless lessons, especially for someone under 35 years of age. Over the last decade, I have been told more than a thousand times – it´s one of the most readable books in finance, ever written. Anyone can enjoy it.

Today – we run one of the largest institutional client chat rooms across the Bloomberg terminal. Since 2010, more than 600 buy-side investors participate, now from 23 different countries. Please reach out to for more details.

Life´s Lessons

One of the important lessons in our book comes down to – how to use leading credit risk indicators? In the 2007-2010 period, the global credit risk epicenter was obviously inside the US.  In the 2011-2013 period, Europe´s banks were the focus during the Grexit panic. In recent years, Asia has become far more interesting, a new epicenter has been formed.

Credit Risk, the US Epicenter 2007-2010

As far back as the spring of 2007, U.S. banks began to underperform financial institutions in Asia. By now, everyone knows most of the subprime mortgage credit risk was inside the USA with domestic banks more exposed than other banks around the world. Notice above, Goldman Sachs (green above) 5 year CDS (the cost of default protection on the bank), began to meaningfully divergence from Standard Chartered. Standard Chartered PLC is an international banking group operating principally in Asia, Africa, and the Middle East. The company has far more credit risk exposure to China – Asia than U.S. banks. It is clear above, more than 12 months prior to Lehman´s failure, banks in the USA were dramatically underperforming from a credit risk perspective. In other words, in 2007 – the cost of purchasing credit default protection on Goldman Sachs was far more expensive than the bank´s Asian peers. Indeed, elephants leave footprints – when large hedge funds see credit risk – they start placing bets months if NOT years before a credit event. The credit market sniffed out Lehman´s demise months BEFORE equity investors got the joke.

CNH China Currency Volatility
During the 2015-2016 China currency devaluation crisis, CNH volatility was a solid leading indicator while China was hemorrhaging foreign currency reserves. In recent weeks, all has been calm, but in recent days a lot has changed. If an asset manager wants to buy some cheap protection against a credit event in China, one can place a bet against the CNH – Yuan. As capital flows into these kinds of wagers, the cost of currency hedging surges. Hence, CNH vol is on the rise. If there is truly a credit crisis in China, the currency should be a lot lower and the cost of CNH vol should be MUCH higher.

Lessons of 2015-2016

Now, let us think of Asia in the summer of 2015.  The Fed was attempting “liftoff” – their first rate hike since 2004. Finally, in December of 2015, the Fed hiked rates 25bps for the first time in eleven years. In the process, as the central bank prepared the world for the now-infamous rate hike. In just six months the dollar ripped from 80 (July 2014) to 100 (March 2015). Emerging markets were in flames, the Fed had triggered a global dollar crisis. More than $1T left China (the country´s fx reserves were on the run). The world was in a real currency devaluation panic, with Asia wearing the epicenter title this time around.

Credit Risk, the Asia Epicenter 2015-2021

During 2015, the China currency devaluation crisis picked up steam in September and came to risk climax in Q3. But months before, the cost of default protection on Asia´s Standard Chartered began to sharply diverge (blue above) from Goldman Sachs in the U.S. Once again, credit risk was screaming “there is a problem” in May 2015, by September the S&P 500 lost 16%. In 2007, Goldman’s credit risk was so telling. Then, eight years later – banks in Asia would wear the credit risk epicenter title. Fast forward to 2021, Evergrande headlines are all the media rage, especially with the Lehman, the lucky 13th anniversary this week. But, what are credit markets telling us this time? As you can see above – far right. Credit risk is calm on Asia banks with exposure to China, no difference to speak of. Central bank liquidity is so abundant, there is NO way Lehman would have failed today. Free markets no more. Adam Smith has one (invisible) hand tied behind his back. We have unintended consequences as far as the eye can see with Uncle Sam’s fingerprints on every street corner.

The Trillion Dollar a Day Gravy Train

The flood of cash in U.S. interest-rate markets pushed the amount of money that investors are parking at a major central bank facility to yet another all-time high – every day a new high indeed. In recent weeks, EVERY DAY more than Eighty participants have been lining up for nearly $1.2 trillion at the Federal Reserve’s overnight reverse repurchase agreement facility. Large counterparties like money-market funds can place cash with the central bank. This easy money gravy train is hiding the next Lehman Brothers, all embraced in deception. In terms of bond yields, let’s look around the planet. In the U.S., close to 90% of the junk bond market is trading below CPI inflation of 5.3% (highest since the early 90s). Over the last 50 years, the highest this number ever reached was 7%. China’s high yield credit market is just 8-10% away from its March 2020 lows in bond prices – highs in yields. All of which begs the question – How can the U.S.-centric JNK Junk Bond ETF yield 4.4% while China´s junk bonds are offering 10-12% cash flows?! Always with an important lens – our friend, Jens Nordvig reminds us – “foreign involvement is small in China. It is true that the high-yield bond market has a sizable USD component (mostly foreign). But relative to the US, where subprime exposure was sold around the world, it is a much more local (controllable) system.” It has been clear for months, there is Evergrande credit contagion – it’s just inside China at the moment.

An Unsustainable Reach for Yield Comes with a Price – It is NOT FREE

Each year that goes by while central banks force investors to reach for yield – any paltry plus return on capital will do these days – complacency builds over time to an extreme – dangerous level.  Mark my words – there were dozens of Bernie Madoffs, Al Dunlaps, and Jeff Skillings sipping mint juleps in the Hamptons and the beaches of the south of France this summer. Central bankers are these guys’ best friends, that is the reality no one wants to admit. As long as central banks do NOT allow the cleansing process of the business cycle to function over longer and longer periods of time – credit risk will continue to build under the surface. Each month, week, and year we allow this charade to move forth – the corners capital flows into are deeper and deeper soaked with moral hazard toxicity. Today´s players on the field make “Dick Fuld” – former Lehman CEO –  look like a choir boy walking out of Sunday mass. The coming event will dwarf what was – “A Colossal Failure of Common Sense.”



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Amazon and The Power of Labor – Secular Change


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The winds of secular change are howling, but is anyone listening? We see a colossal impact on asset prices in the months ahead. The clues do litter the field with one of the most telling coming from our planet´s largest online retailer.  Case in point – Amazon’s productivity continues to improve across its roughly 1.4 million employees. As a result, the company can pay them more and still gush cash. Looking at real impact – for its next 125,000 workers, minimum pay has been set at $18 an hour. This means that any business competing with Amazon for workers will have to pay up. We call this wage inflation. So while productivity enhancements by Amazon are disinflationary considered in and of themselves, they are inflationary in their knock-on effects on wage-price pressures on other businesses. And there is an even broader psychological impact. When workers see a minimum pay at $18 away, they will be more vocal about wanting a higher wage for the job they already have. This is how labor strikes get lit. The power of labor is getting a big boost from Amazon. Strikes by Amazon workers in Italy, Germany, and India are bubbling into an international struggle against the world’s fourth-most valuable company – now they are paying attention. International efforts against Amazon have been building for some time. The UNI Global Union helped mobilize thousands of Amazon workers in four European countries to strike in recent years. Momentum is on the rise.

Average hourly earnings climbed by 0.6% from July to August, more than the 0.3% that economists in a Bloomberg survey had forecast. Over the past year, they were up 4.3%, exceeding the expected 3.9%. Pay has been climbing strongly in recent months as job openings have exceeded the number of people actively looking for work. Why is this important? We count $100T of global wealth shoe-horned into deflation assets (growth stocks, negative-yielding bonds, bonds below 2% in yield). This is a COLOSSAL bet on transitory inflation.

Hot AHE – Secular Change in the Power of Labor

For decades, the foundation of “transitory inflation” has been found in the power of labor. The less powerful the labor force the more transitory inflation has become. Since the 1980s, the power of labor has been in secular decline. The kick-off came when the Reagan administration fired the 11,345 striking air traffic controllers, and banned them from federal service for life. In recent years, these tables have turned powered by the Covid-pandemic and a back-to-back fire hose of $3T deficits coming out of Washington (2020 and 2021, $6T deficit spending in total). In recent years, Amazon was criticized for paying workers $12-$14 an hour, now they are up at $18-$19. Everyone knows there are 5.5 million fewer workers in the U.S. labor force (per BLS data) today vs. 2019. At the same time – U.S. JOLTS data, jobs openings are 50% greater than 2019 levels. That is at least two standard deviations above the ten-year mean number of available jobs. So, next time someone tries to sell you on “transitory inflation” – look at the data, labor has more power today in terms of influence on wages than they have had in 20 years. 

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Ida Impact, Crack Spreads and Refiners

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Hurricane Ida made landfall Sunday evening and hit New Orleans and Baton Rouge on Monday morning. The National Hurricane center currently identifies Ida as a “dangerous Category 4 hurricane” with wind speeds up to 150 mph. To compare, hurricane Katrina in 2005 had a maximum wind speed of 175 mph and hurricane Laura (2020) had a maximum wind speed of 150 mph. The storm could damage as many as 1ml homes (think insurers), with a possible reconstruction cost that exceeds $200bl. For the oil and gas industry already battered from Covid-19 disruptions, the impact could be significant in the short term.

As of right now, 1.65ml bpd of crude production is shut in due to the hurricane, equal to 91% of Gulf crude production, 85% of natural gas production is shut in as well. On top of that, 1.9ml bpd of refining capacity, or about 10% of total US refining capacity is shut down or brought to a reduced rate. Refiners that have shut down or reduced production include Marathon’s Garyville (578K bpd), Exxon’s 520K bpd Baton Rouge refinery (50% shut), Phillips 66 Alliance (255K bpd) and Shell’s Norco (230K bpd) facility.

Where is the Trade?

From 2011-2020, cheap natural gas was a colossal headwind for Nuclear power plays like NorthShore Global Uranium Mining ETF (URNM), with prices up 20% since mid-August and 100% since December – natural gas has become a substantial tailwind for the nuclear power sector.

Refining and Chemicals

The total operating refining capacity in the Gulf Coast (a.k.a. PADD III) is currently about 9.6ml bpd. This means that as much as 20% of PADD III refining capacity is shut down. The Gulf coast oil refining industry is also responsible for about 20% of global ethylene production.

In a worst-case scenario, refining capacity could be offline for multiple weeks. This could put further upward pressure on prices of petrochemicals such as polypropylene and PVC (used for bottles, pipelines etc). Dow (Chemical) DOW equity surged to $65.42 Friday from as low as $58.50 in July. Prices for these chemicals are already near all-time highs as a result of the February freeze that caused supply disruptions in the industry. For gasoline, having refiners offline for multiple weeks could also lead to a surge in gasoline prices, as supply is impaired. We see an additional inflation impact here.

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Gasoline Supply Picture Heading into Ida

When hurricane Laura hit Louisiana around this time last year, oil and refined product demand was still depressed because of lockdowns and other corona-related demand constraints. U.S. Gasoline demand was then around 8.6ml bpd, which was 12% below normal levels. Today, gasoline demand is back to pre-corona quantities, which is 9.5ml barrels p/d. To add insult to injury, gasoline inventories are currently well below their 5-year average (chart above). This means that any supply disruption that lasts several days or weeks could have a significant impact on gasoline prices. When hurricane Harvey hit the Texas refining industry around Corpus Christi in August 2017, the nationwide refining utilization rate dropped from 96% to 78%. The disruption lasted about one month before refining capacity was fully back online. Gasoline prices spiked 30% in the days after the natural disaster that hit Texas.

Today, refining utilization is at 92%, meaning that any unplanned outages will cut supply even further. Ironically, during these types of disasters, the stocks of refining and petrochemical companies tend to benefit, as the pricing power more than offsets any loss of sales due to local capacity taken offline. For the petrochemical industry, companies like DOW and LYB are the dominant players and could benefit if the chemical industry capacity around New Orleans is taken offline for several weeks.

Valero VLO Seasonals, Outperformance in Q3, Q4
Refiners such as VLO, PSX and MPC benefit if gasoline prices rise more than oil prices. While oil platforms in the Gulf have been shut down ahead of Hurricane Ida, the offshore infrastructure is much more resilient and quicker to come back online than refiners. As a result, oil prices tend to rally less than gasoline prices in the aftermath of these hurricanes.

Refiners, Crack Spreads – VLO Seasonals Performance
Crack spreads, which are the difference between gasoline and crude oil prices, tend to expand. Rising crack spread means higher profit margins for refiners. In 2017 crack spreads jumped from $18 to 27 following the devastation of Harvey on the refining industry, and in 2005 crack spreads doubled from $14 to $28 after Katrina.

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China vs. USA – The Big Tech Great Divergence, What is Underneath the Surface?

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Breaking July 9:

Biden Administration to Give Technology Mergers Greater Scrutiny

Many of the large platforms’ business models have depended on the accumulation of extraordinary amounts of sensitive personal information and related data.

In the Order, the President:

Encourages the FTC to establish rules on surveillance and the accumulation of data.

Big Tech platforms unfairly competing with small businesses: The large platforms’ power gives them unfair opportunities to get a leg up on the small businesses that rely on them to reach customers. For example, companies that run dominant online retail marketplaces can see how small businesses’ products sell and then use the data to launch their own competing products. Because they run the platform, they can also display their own copycat products more prominently than the small businesses’ products. BN

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Thank you. LGM.

An Important Message from Jason Hsu and Larry McDonald

30% off sale – “Didi Extends Drop to Fresh Lows as China Weighs Rule Changes – Ride-hailing company has lost $17 billion in value this week – China plans changes to block firms from listing overseas” – Bloomberg

The future of Chinese Tech and ADRs: What can we learn from DiDi and Ant?

Much has happened this week in the Chinese tech and ADR space. Below are our thoughts in response to some of the questions I’ve been receiving from investors and others.

“The US IPO conveyor belt needs to slow down. US banks MUST do more due diligence. With 30 more China-based IPOs in the pipeline, look for the SEC to put the breaks on any day now.”

Larry McDonald, Founder of the Bear Traps Report

China Internet KWEB vs. Nasdaq 100 NDX
Equity markets have been pricing in pain for weeks in China big tech.

Is DiDi Ant Financial redux?

On July 6th, DiDi plunged 20% following the news of (1) a formal investigation by the Chinese Cyber Security Administration and (2) a temporary removal of its app from all app stores in China. Many western investors viewed this the same as Ant Financial’s scuttled IPO last year. Their analysis started and ended with, “What did DiDi say to piss off Beijing?!”

This is far from the correct interpretation; Didi is not Ant Financial Redux. Let us explain why these two are not even close.

“The SEC should rescind the DIDI offering and protect US investors from China’s shenanigans. It’s time to protect US investors from Xi Jingping. Yet another example as to why China’s companies should BE FORCED TO ADHERE to the same standards as US companies.”

Kyle Bass, CIO Hayman Capital Management

An obvious indicator of the difference between these two is that the Chinese regulator halted the Ant Financial IPO in its tracks. By contrast, it politely waited until one week after the DiDi IPO before announcing a formal investigation. If the Chinese regulator believed DiDi’s deficiencies could not be resolved to its satisfaction or would jeopardize DiDi’s operations in mainland China, it would have asked DiDi to pull its U.S. IPO – and DiDi would have complied. The fact that it allowed DiDi’s IPO to proceed is significant.

Some have suggested Beijing has exercised enforcement unevenly against DiDi and Ant Financial, unfairly targeting Jack Ma for harsher treatment. Again, this is not the correct interpretation. For starters, Ant and DiDi are both incredibly plugged-in and aided by the most connected powerbrokers in China. Rounds of informal but deliberate conversations will have occurred and agreements reached in both cases before anything formal is announced in the press. The key difference is that for Ant Financial, the regulatory deficiency was too great to be remedied under the existing model. To the extent there is reasonable dissatisfaction with Beijing’s handling of Ant Financial, it is that the regulator waited too long to act.

Didi’s IPO was allowed to proceed precisely because, unlike Ant Financial, Beijing believed the company’s deficiencies can be remedied. The concerns regarding data privacy are easily addressable and the punishment—temporary removal of the DiDi hailing app from app stores—insignificant in the long-term. DiDi’s hailing app is, after all, already on every smartphone in China through WeChat.

There is no doubt that Beijing intended to make a point with by announcing the formal investigation. Sending a signal to other industry players is often a primary objective when there are public sanctions against the clear industry leader for industry-wide infractions. However, the issue at hand is relatively minor. The regulator was apathetic enough to be willing to agree to a delay in the formal investigation until after the IPO, and that tells you everything you need to know about the difference between DiDi and Ant Financial.

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Is Beijing going after Chinese tech firms listed in the U.S.?

Some of the issues the China regulator is investigating regarding DiDi are industry-wide, which means the government action has broader implications. This was on display when major indexes tracking Chinese tech ADRs took a major nosedive on July 6 – even though most of them had not yet added DiDi!

This is One, Unsustainable – Yet Impressive Divergence
In the USA, close to 92% of corporate profits sit in the hands of the largest 100 companies, up from 57% in the 1990s, per the Wall St. Journal. Monopoly power is on the rise as Washington is on the sidelines, for now.

Clearly, the market is reading something much bigger into DiDi’s cybersecurity investigation. Investors are now concerned about all tech firms that store massive amounts of data and perform analyses on Chinese citizens and businesses. The Chinese government, like the U.S. government, does not want those servers to run on foreign hardware and software, which could make them vulnerable to foreign spyware. Tech firms are squarely in the regulator’s bullseye.

Meanwhile, the government’s claim against many of the same tech giants for anti-competitive business practices also looms large. The Ant Financial action served to signal zero-tolerance for innovations the regulator feels may circumvent financial stability regulations. This has caused tech players to abandon one of their core business strategies—taking a slice of the massive Chinese consumer finance market while avoiding the high compliance cost of distributing financial products. This was a valuable business. So yes, it appears a revaluation might indeed be warranted for all Chinese consumer tech giants. But that is hardly due to Beijing turning anti-tech or even anti-capitalism— it is just Beijing discharging its duty as the steward of China, Inc.

It may appear to some outsiders that China is targeting the firms that have chosen to list in the U.S.. After all, many of the most highly scrutinized firms –like Alibaba, JD.Com, Meitun and now DiDi – are widely held ADRs. But this is far from the truth, and it is a matter of correlation rather than causation. Stated differently, these firms are not being targeted because they are listed in the U.S.

Most of the U.S.-listed consumer-tech firms pursued listing in the U.S. not because they were “defecting” from China in pursuit of a better venue. These Chinese firms listed in the U.S. because they could not receive approval for listing back home. Alibaba, for example, could not gain approval for listing in mainland China or Hong Kong because of its corporate governance deficiencies, where Jack Ma as a small shareholder could always out-vote everyone. DiDi also actively explored listing on the mainland exchanges in addition to HKEX before it decided those paths were nearly impossible due to their various unresolved compliance issues related to China’s labor laws and tax codes (think Uber in the U.S.). The growing concern around DiDi’s ability to generate positive cashflow and reach profitability also made local regulators queasy about approving the company for listing, especially given the recent froth in tech shares. For DiDi, the quickest path to unlock liquidity for its founding core and its PE backers before the global tech euphoria recedes was to dash for the U.S. From filing to listing, DiDi took only 20 days, and priced at the top of the range. Heck, if Lyft can list successfully while stating in its prospectus that it has no business model toward eventual profitability, then surely DiDi can make a fine listed company on the NYSE.

When you consider that many firms listed in the U.S. are tech firms that listed here precisely because there were facing domestic regulatory concerns, it should be no surprise to find that a disproportionate number of the firms facing investigation are those listed in the U.S.

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Understanding Chinese Regulators

Those seeking to understand Ant Financial, DiDi, or other regulatory actions in China should start their analysis by understanding the differences between the U.S. and Chinese regulatory approaches.

Chinese regulators are interventionist. They so this, in part, because their financial markets are dominated by unsophisticated retail investors. Appealing to the wise invisible hand of an efficient market is a luxury that Beijing does not have. Thus Chinese regulators have to set P/E caps for IPO pricing to avoid irrational retail investors bidding prices to astronomical ranges during the subscription period. Thus Chinese regulators chose to take time to vet company financials and business model independently before approving listings. There is real personal career risk for the regulator who approves a firm that turns out to be a fraud or that craters in price due to its inability to execute on the promised business plan.

What Is An Investor To Do?

Foreign investors wishing to invest in Chinese firms must also accept a higher frequency of government intervention at the market, industry, and firm level. They should also understand that this intervention is not driven by senseless bureaucracy or a desire to punish success. The China’s regulator intervenes because it has a foundational (and sensible) lack of trust in its own inefficient capital markets. In China, the invisible hand wears a red glove.

About our Associate Jason Hsu

Jason Hsu is the founder and chairman of Rayliant Global Advisors. Throughout his accomplished career, Jason’s commitment to academic rigor and investor advocacy have led him to research, develop, and bring to market investment strategies that create significant value for investors. At Rayliant, Jason is continuing that commitment by educating investors and offering products to transform the investment ecosystem in Asia and beyond. Prior to his current role, Jason was the co-founder and vice chairman of Research Affiliates.

Jason is at the forefront of the smart beta revolution and is one the world’s most recognized thought leaders in that space. Building on his pioneering work on the RAFI™ Fundamental Index™ approach to investing with Rob Arnott in 2005, he has published numerous articles on the topic, notably his articles “A Survey of Alternative Equity Index Strategies,” which won a 2011 Graham and Dodd Scroll Award and the Readers’ Choice Award from CFA Institute; and “The Surprising Alpha from Malkiel’s Monkey and Upside-Down Strategies,” which won the 2013 Bernstein Fabozzi/Jacobs Levy Award for Outstanding Paper in the Journal of Portfolio Management. In 2015, Jason received the Bernstein Fabozzi/Jacobs Levy Outstanding Article Award for “A Study of Low-Volatility Portfolio Construction Methods” published in the Journal of Portfolio Management. He has twice received the William F. Sharpe Award for Best New Index Research (2005 and 2013), which is awarded by Institutional Investor Journals.

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