Power of Labor vs. EPS

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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.

Economic Signposts

Classic economic bellwether – UNP is close to 9% lower in two days – this is an extremely important leading indicator.

“US railroad workers prepare for a strike as rail companies see record profits – As Biden’s recommendations fall flat, negotiations between management and unions are at an impasse – and workers are prepared to walk.” The Guardian

September 15 Update – File Under NOT Deflationary Freight – Rail Labor “Deal” includes – a 24% wage increase over 5 years, including a 14.1% effective immediately, as well as five annual bonus payments – National Carriers Conference Committee.

*Inflation is juicing labor bargaining power, and demands.

Secular Trends – Headwinds for Equities
A large bear reversal in the classic economic bellwether, UNP – major technical fail. Some would say labor threatened national strike risk is high, which is true and obvious, but the larger picture is the power of labor, back to 1960s era strength. Many equities are NOT priced for a secular change in the power of labor, indeed.  This week, street research is picking up on macro crosswinds, a pending reset in the rails and trucking market, and stubbornly high labor inflation juices the risk of top-line growth and margin expansion into 2023.

What makes inflation sustainable? Inflation has a traditional pattern: an exogenous shock (war, pandemic, an oil embargo, what have you); followed by the rise of the power of labor in the form of wage inflation; followed by the government mucking things up.  An example of the latter, to pick one among many, is that not only are there not enough trucks and truckers but there are not enough parking spaces for the truckers to park their vehicles. Why? Because of restrictions on how close trucks can park to highways (where, naturally, there is plenty of space for them to park!).” Bear Traps Report, January 2022.

Labor Power vs. Profit Margins
Bernstein notes – “labor cost inflation for agreement workers will at best be the worst we have seen since de-regulation.” The Street is still looking for $244 (down from $258) in S&P 500 eps next year. The SPX is at 3950 ish, that´s a PE of 16.2x — a very pollyannish 2023 earnings outlook. Sure nominal earnings are helped by inflation but, real bottom line earnings get hammered in an inflation-enhanced “power of labor” world. 

A Look Back at Labor

While Covid is nowhere near as bad as the Black Death of the mid-14th century, precisely because the latter was more extreme, its ramifications are easier to see and learn from. In 1348 the plague crossed into England and wiped out half the population. With fewer peasants and serfs, labor was in scant supply and the peasants, and those serfs that could escape the manorial estate or had fulfilled their obligations to their lord, charged much more for their labor. Landowners’ profits plummeted. This in turn destroyed commerce in the towns, with dire financial consequences. Chaos ensued. Various laws were enacted in an attempt to hold wages to pre-plague levels. Never before had the royal government allied itself with the landowners against the workers in such an obvious and heavy handed way. This proved extremely unpopular. Nonetheless, wages continued to rise and many peasants were able to join guilds from which they had priorly been barred and learn trades, moving up the socio-economic ladder.

The off-again-on-again Hundred Years War against France heated up again and taxes were raised in 1379 and again in early 1380. The taxes were innovative, extensive, and unpopular because they were poll taxes, levied on every eligible individual regardless of rank or income. A third poll tax was instituted at the end of 1380, the most unpopular of all. Poll tax collectors interefered with life in every town and London seethed in unrest. Furthermore, political partisanship was extreme and the ruling class divided.

Finally, when investigations into failure to pay the poll tax in villages in Essex occurred at the end of May 1381, outright revolt ensued and spread like fire across the country, an uprising historians now call The Peasants’ revolt. Eventually the Tower of London was sacked and many royal officials murdered. The revolt was finally suppressed. 1,500 people were killed in the process. The population had not revovered from the plague and is estimated at 1.8 million at the time. It would be like over 300,000 US citizens being killed today.

 

In any event, there was a clear relationship between the plague and the ensuing power of labor and wage inflation. Furthermore, while the poll tax was thorough-going, our inflation today is more so. Geopolitical risks abound and if war ensues, inflation will take another leg up. We’ve had revolts in our own history, not to mention civil war. So a risk for civil strife exists now and over the near term. We may see more riots, and more violent ones, in the coming years.

 

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Powell Playing Tough Guy with the Math Stacked Against Him

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Institutional investors can join our live chat on Bloomberg, a groundbreaking venue since 2010 – now with clients in 20+ countries, just email tatiana@thebeartrapsreport.com – 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.

No One is Doing the Math

There is nearly $200T more debt on earth today relative to the days of Paul Volcker – so why does much of Wall St. constantly compare Fed Chair Jay Powell to central bankers from an entirely less levered era?

The Fed and their collection of well-placed pawns keep lecturing us on their policy path filled with endless rate hikes to fight inflation  – but the math tells us the sales pitch is all bs.

Three Things You Need to Know

1. The income that the Federal reserve generates comes almost exclusively from their $8.8Tr portfolio of Treasuries and agency MBS. The Fed transfers that interest income to the Federal government, and this has been a nice source of income that supports Washington DC deficit spending. However, the interest income the Fed generates is reduced by the interest it pays the commercial banks for their excess reserves. The Fed likes to call these “interest to depository institutions”. Last year this interest rate was still a paltry 0.15% but as it is directly linked to the Fed funds rate, it has since risen to 2.4%. So the interest income the Fed earns is the sum of the money it makes on the QE assets minus the money it pays the banks for their $3Tr in excess reserves.

The Backstory goes all the Way to Lehman Brothers

Fourteen years ago this week – Lehman Brothers failed. How is this colossal financial collapse, tied into the road ahead? After the Great Financial Crisis – our brain trusts in Washington wanted to make sure the U.S. financial system would never again succumb to the double-edged sword of excess leverage. Regulators forced U.S. banks to “reserve up” and so – for the last 14 years – Wall St.’s financial epicenter stored an ever-enormous dollar number of reserves – mostly found in U.S. Treasuries.  Today, as promised the Fed must pay these banks MORE and MORE interest on these reserves. As the central bank hikes rates – the unintended consequences are MOUNTING along with a political backlash – potentially louder than a Donald Trump appearance on “The View.” This time next year, the Federal Government is looking at a near $400B negative swing; a) from profit to a loss on the Fed´s transfer of net interest income – triggered by a surge in interest payments to banks on reserves, b) plus $200B additional interest on their $31T debt load. Dollar headwinds are mounting from; emerging market credit risk, China currency devaluation, the Eurozone energy crisis, a weaker U.S. consumer (see Capital One CDS, the cost of default protection is on the rise), and one-year inflation expectations crashing at the fastest pace since the fall of Lehman Brothers. Sit back, think of taking the Fed Funds rate from 25bps in March to 325bps this month, that´s three years of accommodation withdrawal in just six months. The Fed is very close to table max, the risks that they have over-cooked the goose are sky high.

2. Keep in mind, that the Federal government pays interest on its now $31Tr  in debt. This interest is going up, as low-yielding securities are maturing and the newly issued paper has a higher interest rate. So while the Fed’s interest income is going down, as the portfolio shrinks (QT) the interest they pay (IOER) is going up. Sometime in the next year, the Fed will start generating losses, as IOER starts to exceed QE income. Meanwhile, Washington DC is spending more money servicing its debt as interest rates increase.

Interest on Debt will Explode Higher if the Fed Keeps Hiking Rates
In the chart, we show how this works. The blue line shows the income from the Fed’s QE portfolio and compares it to the cumulative increase in interest expenses, from both higher interest on the government’s debt and the Fed’s payments of interest on excess reserves (IOER). This shows the $400bl negative swing next year in government income due to the deterioration in net interest income.

3. The data demonstrates how the government will incur a negative swing of more than $400bl in the next year just from interest payments and income.

 

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Institutional investors can join our live chat on Bloomberg, a groundbreaking venue since 2010 – now with clients in 20+ countries, just email tatiana@thebeartrapsreport.com – 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.

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Lies, Damned Lies and QT

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Institutional investors can join our live chat on Bloomberg, a groundbreaking venue since 2010 – now with clients in 20+ countries, just email tatiana@thebeartrapsreport.com – 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.

“The Fed Guy” https://fedguy.com/the-reserve-gap/

QT – The Federal Reserve Promises $1T in 12 Months?
We have a Federal Reserve promising to take their overnight rate to 4.5% (in March, just six months ago – the lending rate was 0.25%) and reduce this balance sheet by $1 trillion over 12 months – we were born at night, just NOT last night. Why is this important? The speed – in the balance sheet reduction process has a colossal impact on liquidity inside the market – all with a significant impact on asset prices. In Q4 2018, when the Fed ramped up its balance sheet reduction fantasy – equities crashed.  Never – ever forget, that the Fed and their Wall St. pawns were promising $2T of QT last cycle. That was BEFORE the beast inside the market – stopped them in their tracks near a $685B balance sheet reduction. After all the bogus promises – they actually restarted QE, rebuilding their balance sheet in Q3 2019. 

The Fed Guy

The “Fed Guy” says Quantitative Tightening may be more difficult than the Fed hopes. What a revelation!!! Moses has come out of the desert. Why? Because along with its QT aspirations, the Fed would like total bank reserves to be about ~$2 trillion, about 8% of GDP. They have NO clue whether or not that’s the appropriate number – but they want us all to believe they have a clue. The Fed believes that is the requisite amount to keep the financial system running smoothly. In Q4 2018, they proved — beyond a shadow of a doubt — that they have ZERO clue whether or NOT that’s enough liquidity. Now, the Fed wants us all to believe they control liquidity with precision – hilarious!!! And YES, the largest central bank on the planet is reducing liquidity like a blind man reaching into darkness.

2022

Bitcoin: -55%
Nasdaq: -23%
Russell 2000: -15%
S&P: -14%
Dow:  -11%
Gold: -5%
US Dollar: +14%
Oil: +18%
Uranium: +22%

Finger Sandwiches

Of course – the Fed does not control where that liquidity is drained from. If liquidity drains from banks’ reserves, it is possible reserves could go below the Fed’s pain threshold, in which case, QT would stop. Tim Duy is a nice guy, a real talent – but a constant Fed lap dog, God bless him. Of course, guys like Tim want to make sure they still get those finger sandwiches at the sucking-up cocktail parties complete with Fed Governors and ex-central bank farm hands. For more than a decade – we have seen this charade up close and personal in Manhattan. This is as critical as you will EVER see the “Fed Guy” – this fact, in itself means a lot. Likewise, if Treasury issuance was also to be funded mainly by cash investors, and not by hedge funds buying through leverage accessed from the Repo market  — You know those “relative value” clowns that blew up the financial system heading into Covid with 8-1 leverage – see the penny – insert steamroller, insert face plant crowd — that would also drain cash from the banks, hurting reserves. It will take some time. Bank reserves now are at about $3 trillion. Indeed, the Fed may like to see excess reserves decline, reducing the amount it has to pay on reserves thereby.

The $300B Hole Treasury Must Fill

As macro maven – Ben Melkman points out – the higher the Fed pushes up Fed funds near 4% – the higher the probability they are going to be short $250B to $500B annually (interest on reserves owed to Jamie Dimon and the rest of the big banks). Complete with hat in hand looking up into the eyes of Senator Elizabeth Warren next summer at the Humphrey Hawkins sit down with Powell on Capitol Hill. You see – the side effects of the collapse of Lehman Brothers and the financial crisis are on stage here.  Regulators forced US banks to “reserve up” and so – for the last 14 years – Wall St.’s financial epicenter stored an enormous amount of reserves – US Treasuries.  Today, the Fed must pay these banks interest on reserves as promised. But as the central bank hikes rates – the unintended consequences are MOUNTING along with a  political backlash bigger than a Trump appearance on “The View.”

Massive USD Credit Risk

With nearly $13T of dollar-denominated debts oozing through the smallest countries on earth – there are significant side effects as the Fed tries to conduct monetary policy. Emerging markets are blowing up as the Fed´s strong greenback exports inflation to our planet´s poorest countries. Inflation-driven, political instability is at multi-decade highs and U.S. dollar headwinds are picking up with intensity.  People do NOT understand – it’s GAME OVER for the US dollar – the MOST crowded trade on earth. Over the next 24-48 months – the Fed´s ability to support asset prices is highly limited without significant USD decay (Modern Monetary Theory). It is a COLOSSAL maturity – cash flow mismatch – your U.S. front-end rates are extremely high (borrowing 350bps) – and the yield on the average weighted maturity on their bond portfolio is low (trillions paying 75bps or less). For the last 20 years – this WAS NOT the case. Foreigners own $20T MORE U.S. Treasuries than U.S. investors own foreign debts. Furthermore, there are those who think banks don’t need as many reserves as even $2 trillion.

“Across what Zoltan would call the ‘Outer Rim’ of USD funding. The banks are flush, and UST repo demand is low (thanks in part to the Fed itself) so the cash is deployed into more profitable funding silos like FXswaps and AAA ABS. Read the OFR report on bilateral repo, it’s 2Tn! The Fed will begin ‘selling UST at 100Bn, while Treasury increases issuance 100Bn. That will spike demand for UST funding, which can be met with RRP cash. But that balance sheet must be held PRIVATELY. MMFs (money market funds) cant buy coupons, only repo. A dealer must offer that repo.” via @Stimpyz1.

We think they do, but we recognize estimates as low as $900 billion. Nobody really has a clue, that is a fact. This lower theoretical level is based on the fact that banks can increase reserves at will when the financial system is operating normally. However, we note that reserves aren’t even needed at $900 billion when the financial system is operating normally. Reserves don’t exist for normal times. They exist for abnormal times. The Fed itself can directly increase reserves by buying T-bills, as they did in 2019. The Supplementary Leverage Ratio (SLR) creates regulatory expenses for banks holding reserves. Apparently, these are not so onerous as to stop banks from having more reserves than they need. Nonetheless, the SLR could be relaxed if reserves fell towards $2 trillion. Thus, there are methods the Fed could use if Reserve levels were to fall too much. And, of course, they may not fall all that much. Net net, we think the Fed would indeed like to see Excess Reserves decline moderately without threatening the current mandated reserve levels.

“I don’t doubt Ben’s math for a second. and I can’t wait for the Elizabeth Warran – Powell shakedown in July 2023 – I am sure he is right. But given the Fed owns $8.2 trillion of stuff that yields on balance on average something, that income is subtracted from the $208B the Fed would pay out if rates jacked to 4% (AND reserves did not decline AND RRP assets did not decline after a QT of any kind at all – unlikely). This means there is some other line item that Ben is looking at besides interest to be paid on Reserve Balances and RRP. It would be nice to get a back of the envelope from him on how 4% leads to $250B to $500B net expense. Clearly, I am missing something.”  NY-based CIO in our live client chat.

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

Institutional investors can join our live chat on Bloomberg, a groundbreaking venue since 2010 – now with clients in 20+ countries, just email tatiana@thebeartrapsreport.com – 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.

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