All posts by NY Times Bestselling author Lawrence McDonald

Larry McDonald; founder of THE BEAR TRAPS REPORT investment letter, is a political policy risk consultant to hedge funds, family offices, asset managers and high net worth investors. As former Managing Director, Head US Macro Strategy at Societe Generale, he's a frequent guest contributor on Bloomberg TV, CNBC, Fox Business, and the BBC. Larry is a NY Times bestselling author, his book "Colossal Failure of Common Sense" is now translated into 12 languages. He ran a $500 million proprietary trading book at Lehman Brothers, made over $75 million betting against the subprime mortgage crisis and was consistently one of the most profitable traders in the firm. His "Bear Traps" letter is one of the most highly regarded on Wall St. He's participated in 3 major financial crisis documentaries: Sony Pictures, Academy Award winning documentary the "Inside Job," BBC‘s "The Love of Money" and CBC‘s "House of Cards." He's delivered over 72 keynote speeches in 17 different countries, at Banks, Investment Firms, Conferences, Law Firms, Insurance Companies and Universities.

Bitcoin Eating Gold Alive, for Now

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Correlation Breakdown

This week, we witnessed the largest breakdown in gold – rates (bonds) negative correlation in some time.  10s (US ten year Treasuries) – have rallied 2.39 to 2.31% with gold off 2.5%.  For a big change, its been rates DOWN, gold DOWN in recent days. In recent years, the negative correlation has been as high as 81%, but this week it’s positive.
A Powerful Negative Correlation is Reversing this Long Trend
For the last 24 months, the consistent trading pattern has been gold UP with bond yields DOWN (see the dark blue line above).  A very steadily high – negative correlation.   The latest developments are causing some disruption in the quant and macro hedge fund space, some participants are tinkering with their models to adjust for this possible regime change. 
Clients are Pointing to Bitcoin’s $250B mkt cap, Eating away at Gold
The total amount of gold above ground is 190K tonnes or $6Tr at current value. Half of that is in jewelry so left with $3Tr. Half of that is in reserves at central banks so that leaves a physical gold market size available to investors of $1.5tr (excl derivatives).  Today, total cryptos are remarkably 23% of gold liquid (physical) market capitalization.  The total value of all cryptocurrencies out is now $350bl of which bitcoin $250bl. So cryptos are 23% of physical gold available to investors now.
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Global Reflation Sparks more Rate Hikes

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Following the Federal Reserve, Bank of England, Bank of Canada – South Korea joins the rate hike party.

The Bank of Korea raised its benchmark interest rate for the first time since 2011, marking a likely turning point for Asian central banks.

Last Hiking Cycle Kicked off in 2010 in S Korea

Thursday’s decision to raise the seven-day repurchase rate to 1.5 percent was forecast by 18 of 24 analysts surveyed by Bloomberg. The rest expected the central bank to leave the rate at a record-low 1.25 percent, where it has been since June 2016.   As you can see above, markets widely anticipated this move – interest rates in China and S Korea have been on the rise for 15 months. 

 

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The Fastest Growth Economy on Earth is taking Leverage Down (Popping Asset Bubbles). What’s the Impact from China?

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De-leveraging in China kicked off this Week

They are trying to thread a very fine needle in China right now, credit risk is surging to two-year highs.

– After China’s 19th Congress meeting of political leaders in October – we’re seeing sweeping regulations focused on curbing financial risk.  New rules are appearing, many announced over the last week.   Most of the new restrictions cover China’s $15T asset management products landscape.  A colossal deleveraging is in the works.

– PBOC (China’s Central Bank)  is driving the bus through their Financial Stability Board.

Credit Risk on the Rise in China

2007-2017

This week’s fears pushed China government bond yields to a 3-year high, taking U.S.  two year Treasury bond yields north with them.

  • Very quietly, late this week the PBOC launched a $50B lifeline into their grossly leveraged banking system, the natives are growing more restless by the day.  This was the largest injection of emergency cash in the last year.

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Something Big is Brewing in the Bond Market

iShares 20+ Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.  Over the last decade, wedge breaks in the technical chart pattern of the TLT have led to large moves in interest rates.  Today. an important wedge is near a breach again, a true Bull – Bear battleground is forming (middle right above).  

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Ackman’s Positive Look over Fannie Mae $FNMA

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In cooperation with ACG Analytics in Washington, we advise institutional investors globally on the GSEs (Government Sponsored Entities) with a focus on Fannie Mae $FNMA.

In recent weeks, the Senate Banking Committee has been working on a regulatory relief bill, while Chairman Mike Crapo is optimistic that a deal on housing finance reform could be next on the agenda (2018).  African Americans make up 13% of U.S. Population, but received around 3% of 2014-15 conforming loans (HUD data) – the system is broken and fueling inequality.

Down from the Pre-Financial Crisis Highs

AIG $AIG -96.4%
Fannie $FNMA -96.3%*
Royal Bank Scotland $RBS -95.2%
Citi $C -87.2%
Deutsche Bank $DB -84.6%
Bank of Amer $BAC -51.6%
Morgan Stanley $MS -47.1%

*Over the years we’ve witnessed extreme risk and volatility in these Fannie Mae $FNMA shares – 2017 was no exception.  Bloomberg data above.

Below is a recap of Pershing Square’s view of the current investment landscape (risks and opportunities) facing the GSEs.

These “positive developments” are listed in Bill Ackman’s Q3 Letter to investors:

(1) a Republican National Committee resolution made public on September 13, 2017, that seeks to protect taxpayers by restoring safety and soundness to the GSEs, calls for Fannie and Freddie to be “permitted to rebuild equity capital,” and recognizes that Treasury can generate “an estimated $100 billion in additional cash profits by monetizing its warrants for 79.9% of each company’s common stock;”

(2) a September 13, 2017, letter from six Democratic Senators to the Treasury Secretary and FHFA Director “requesting that the GSEs be permitted to build capital” to prevent a future draw on Treasury’s line of credit;

(3) testimony from FHFA Director Mel Watt to the House Financial Services Committee on October 3, 2017, in which Director Watt outlined the extensive reforms that have taken place at the GSEs during their nine-plus year conservatorship, stated that required minimum capital levels for Fannie and Freddie should be “in the range of 2 to 3 percent,” and hinted at some form of initial capital retention in the coming months; and

(4) comments from Treasury Secretary Steve Mnuchin in mid-October that housing finance reform would be the next priority after tax reform, and that Fannie and Freddie would not be in conservatorship by the end of his initial four-year term. All of the above are broadly consistent with the key principles which we have been advocating since the inception of our investment in late 2013.

Senator Corker announced in late September that he will not seek re-election in 2018, and will leave the Senate upon expiry of his current term at the end of next year. Senator Corker has been one of the leading voices in Congress on housing finance reform for the last several years, and we believe that he would like to see this issue resolved before his retirement. He and his colleague Senator Warner have suggested that they will soon put forth new bipartisan legislation regarding housing finance reform, for which they should have the support of Secretary Mnuchin after the tax reform initiative concludes. In the meantime, the intrinsic earnings power of both entities continues to increase, driven by growth and improved credit quality in their core single-family guarantee businesses.

Fannie Mae $FNMA Equity, 38% Off this Year’s High

Bill Ackman’s Pershing Square Capital Management owns 44.7 million shares of FNMA, per the Bloomberg terminal.  The LIFO cost basis is listed at $3.37 acquired over the last two years. This week, shares closed below their 200-day moving average.  In the past five years, Fannie Mae crossed below this level 26 times and fell an average 1.7 percent in the next five days. It declined 17 times for an average loss of 3.9 percent, and advanced eight times for an average gain of 2.9 percent.

Nearly ten years after the financial crisis, Fannie and Freddie are still in “conservatorship.”  This is the question that has many investors globally scratching their heads.  Fannie and Freddie are still sweeping $25B a year to the U.S. Treasury, nearly $300B total (since heading the financial crisis).  Few Americans realize, how to spend funds is at the President’s complete discretion.  Boy did the Obama administration love this gravy train.

“Fannie Freddie will NOT be left in conservatorship” 

US Treasury Secretary Steven Mnuchin,  Bloomberg

Dodd-Frank has banks retaining capital at 20-year highs while Fannie and Freddie are retaining zero capital on $5T loan portfolio?  The risks to the U.S. taxpayers here is COLOSSAL.  There’s NO capital retention.

GSEs: “Fannie-Freddie Might Need $100B in the next Crisis”, FHFA Says

Policymakers also face a deadline of sorts. Fannie and Freddie are set to run out of capital early next year and would have to draw on Treasury if they suffered quarterly losses, a move that could spook the mortgage market. Lawmakers are hoping to cut a deal before that happens.

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A Surge in the Cost of Default Protection, Saudi Arabia

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In recent years there’s been a strong relationship between oil prices and the cost of Saudi Arabia credit default protection.  Lower oil prices have consistently been tied to higher default risk.  Today, we’re seeing an entirely different, disturbing picture – oil prices have surged with default risks.  This speaks to rising geopolitical credit risk.

A Surge in the Cost of Default Protection, Saudi Arabia
The cost of insuring Saudi Arabian debt from default is approaching two-year highs, even as oil prices globally are ripping upward.   On our Bloomberg terminal, five-year CDS soared another 20 basis points last week.  On the heels of a destabilizing “anti-corruption” purge in the kingdom, credit risk is on the rise. Increasing tensions with Hezbollah, an Iranian-backed militant group, have compounded investor concerns about rising political risks in the region. The last time the nation’s CDS jumped as much in a single week was in January 2016 at the height of the oil-market crash.  Back then, Brent was $27, compared to $64 last week.  The Kingdom’s debt profile has broadly expanded.  Public debt outstanding in 2014 was down at $44B, today she’s approaching $300B, per Bloomberg data.

 

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The Power of Drawdowns #Bitcoin #Amazon #FAANGS

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The immortal Jackie Gleason once said, “the only problem with losing 50% is… you need double to get it all back.”

Late this week, Bitcoin dropped under $7,000, to trade nearly 20% below Wednesday’s all-time high.  That shaved well over $1,000 off her sky-high price.

In a tweet in July, we called for a bounce – noted bitcoin’s support level down near its 100-day moving average.  Today, this level appears miles away at $4119 ($6581 Friday’s close), but as history’s lesson – she can be there in a New York minute.

Bitcoin dropped to $6,418 on the Luxembourg-based Bitstamp exchange by 1200 GMT Friday, before recovering a touch to trade at $6,664 only minutes later.  A violent week indeed.

Famous Asset Bubbles within 9 Yrs of Peak

Bitcoin 2011-2017: 66x
Tulip Mania 1617-1622: 53x
Nasdaq 1991-1999: 13x
Oil 2001-2008: 7x
Silver 2004-2013: 6x
Miami Condo Mkt 1998-2007: 6x
Nikkei 1982-1990: 5x
Nasdaq 100: 2009-2017 5x
US Stocks Dow 1921-1929: 5x

“But, but but… Bitcoin is the future” the young man screamed across the room.  The thing about manias comes down to measuring just how much goodwill is priced in?  The Amazon AMZN lesson is an investor classic. From June in 1997 to June in 1999 the stock was 7100% higher (yes 71x!) – only to lose 95% of its value by 2001. In took over a decade but Amazon was able to take out its 1999 high by early 2010. Eleven years of growth was priced into its first two years as a publicly traded company. Ultimately, the equity grew into its expected growth profile, but this lesson remains one for Bitcoin investors today. In determining your entry point into a once a decade secular trend, we must determine how much is priced in relative to the long-term upside. Bottom line: most investors DO NOT have the patience to capture long-term gains once a major drawdown takes hold.

Bitcoin’s $7882.10 perch was reached Wednesday after a software upgrade anticipated for next week  – would have split the cryptocurrency in two,  news of a suspension triggered a relief surge.

The Rocky Trading History of Bitcoin
A 2013 investment in bitcoin took nearly three years to get back to even after a nearly 80% loss.  Indeed, Bitcoin is not for the faint of heart. 

FAANG Equities

Netflix $NFLX 2008-2017: 78x
Amazon $AMZN 2008-2017: 31x
Apple $AAPL 2009-2017: 14x
Facebook $FB: 2012-2017: 9x
Google $GOOGL 2008-2017: 7x

FAANG equities are a POUNDING the table, screaming sell.  Since 2010, Amazon has had six drawdowns of 15 to 30%, three of which were thirdy percent.  Sit in the boat and buy fear in fangs.  

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Data Pointing to (further) Bond Yield Spike

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“In the coming weeks, we expect a super mean reversion. This summer’s weak inflation data (CPI, PPI, PCE, AHE) is unsustainable in our view.  U.S. economic data (Citi Economics Surprise Index), the level of expected Fed hawkishness (less accommodation), Washington policy (fiscal policy expectations) have all moved sharply lower with remarkable cohesion. They’re singing the same song.  At the same time, geopolitical risks have surged to their highest level of 2017 – suppressing bond yields.   The perfect storm of good news for bond bulls has run its course.   We are bond bears – looking for higher yields – out over the next 90 days.”

The Bear Traps Report, August 30, 2017

Friday we learned U.S. unemployment declined to 4.2% in September, from 4.4% the previous month – the lowest level since 2001.

AHE’s Move North

Average Hourly Earnings surged 12 cents in September to $26.55. That was the largest move higher since 2007.  For the 12 months that ended Sept. 30, wages were up 2.9%, well above the low inflation rate.

Sell Off in US Treasuries Meets Resistance

The U.S. 10-year treasury yield has surged up to an important Fibonacci resistance level near 2.39%.  As we examine treasury futures using the Bloomberg terminal,  TY1 has reached important lows recorded in July and May at 124-25+/124-23.  Lower bond prices meet higher yields indeed.   After the yield spike – since September 8, the Bloomberg Barclays Global-Aggregate Market Value of Bonds has lost nearly $1.5T.  

It’s clear, labor force participation is moving higher for the young and able – this development has wages heading north.  Bottom line, when measuring risks to higher bond yields, Average Hourly Earnings AHE is far more important today than the actual jobs number.

Rate Backup Victims Include Commercial Real Estate

Since September 8, the yield on the 10 year US Treasury bond has surged from 2.01% to 2.39%, while the Real Estate Select Sector SPDR Fund XLRE is nearly 5% lower.  In interest rate futures, the probability of a December Fed rate hike has surged from 21% to 80% – large cap REITS have been one of the big losers on the follow.  Technically, the XLRE is on a key level – a possible trend line violation (top right above) has longs nervous.

Yelvington’s AHE Revisions

An important observation from our associate Brian Yelvington, we must NOT overlook the July Average Hourly Earnings AHE revision (see the chart below – yellow line), the revisions’ IMPACT is impressive.

A Colossal Bounce in the Revised Data

Average Hourly Earnings AHE risk to higher bond yields is real.  Lost in all the noise this week are these meaningful developments.  Not only did September print at 0.5% but August was revised to 0.2% (from 0.1%) and July to 0.5% (from 0.3%). Inflation has finally arrived!

Fed’s Rosengren Saturday

“Already-tight labor markets are likely to tighten further as the economy continues to grow faster than its potential.”

Federal Reserve Bank of Boston President Eric Rosengren said on Saturday.

*ROSENGREN: ALREADY-TIGHT LABOR MKTS LIKELY TO TIGHTEN FURTHER – October 7, 2017
*ROSENGREN SEES RISKS IF FAIL TO RESPOND TO VERY TIGHT LABOR MKT – October 7, 2017

Rosengren is not a voting member of the rate-setting FOMC this year.

Data Pointing to (further) Bond Yield Spike

The relationship between 25-54-year-olds actually in the labor force to Average Hourly Earnings points to a coming problem for bond yields.   As labor force slack has been chewed up, AHE’s summer reversal (bounce) speaks to bad news for the crowded long duration trade.

Correlation US Treasury Bond Yields vs Gold*

2017: -0.81%
2016: -0.62%
2015: -0.45%
2014: -0.32%
2013: -0.23%
2012: +0.21%

*Rolling 1 Year, Bloomberg – Citi data

Investors in the gold trade are just starting to realize, they’re not trading gold they’re trading (interest) rates.  The negative correlation between higher bond yields and lower gold prices has exploded in recent years, north of 80%.  Gold prices are clearly rates driven – since the September 8 reversal higher in bond yields, gold prices (XAU) are 7.1% lower (gold miners GDX -10.1%).

Inflation Expectations

Low inflation expectations in the marketplace have been a trouble spot for the Fed.  Sure, inflation has remained tame throughout most of this year – but recent price action is getting attention.  Since August, the surge in breakeven rates, a gauge of US inflation expectations, is a foundation of hope for dollar bulls. The 5-year 5-year forward breakeven rate is near 1.90%, well above the June lows.  The possible wedge break (above in the purple circle) is a key technical level.  A break above into new real estate will put the Fed on notice that market participants are taking inflation far more seriously.  This is something which will draw more rate hikes (raise expectations) out of the FOMC in our view.  

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