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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for these guys to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

The 2.6 percent headline rate doesn’t do justice to fourth-quarter GDP where consumer spending rose a very strong 3.8 percent that reflects a 14.2 percent burst in durable spending.  Bloomberg noted Residential investment, which is another consumer-related component, rose at a very impressive 11.6 percent annualized rate. Turning to business spending, nonresidential fixed investment rose at a 6.8 percent rate which is the fourth straight mid-single digit result.

What does this mean for bonds?  We have an important note coming out, pick it up here.

Government purchases at a 3.0 percent rate, also added to GDP in the quarter.  What pulled down fourth-quarter GDP were net exports, at an annualized deficit of $652.6 billion, and inventories which rose at a slower rate than the third quarter. Looking at final sales to domestic buyers, which excludes inventories and exports, GDP comes in at a robust 4.3 percent.

Prices also showed some vigor in the quarter, with the index at 2.4 percent vs the third quarter’s 2.1 percent. This is a standout report led by the consumer that shows the economy accelerated into year-end 2017 with strong momentum going into 2018.

What are the key Takeaways?

There are both positive and negative views that can be extrapolated from today’s data.

• The consumer savings rate fell to its lowest since November 2007, down from 3.3% to 2.6%. If it had stayed the same, Real PCE would have been 0.8% (annualized) instead of 3.8% and GDP would have been 0.6% instead of 2.6%.  Clearly, business and consumer confidence levels are nearly 2 standard deviations higher than the 1010-16 mean, thus spenders seem to be more confident dipping into savings with visions of better times ahead.
•  The GDP came in lower than expectations, but net of hurricane-impacted inventories and exports, 4.3% is an objectively impressive number.

Pick up our latest report here:

Looking ahead into Q1, and Beyond

This adjusted 4.3% rate isn’t unprecedented growth, however, even in recent memory.  We saw 3% YoY in first half 2015. So, then, how sustainable is the growth? In the short term, a decreasing savings rate will boost demand. The near-term outlook is bond bearish, and it should be. Prices are rallying, savings are down, and over the next quarter or two we should see some legs on consumer demand; something that has been notably weak in recent memory. There is a reason to be optimistic into early 2018 from a consumer spending perspective, and perhaps even beyond, depending on the timeline for infrastructure spending.

Economic activity built on a foundation of lower savings, in the absence of wage growth, will eventually drag output lower.  Lower consumer savings is likely overstated; we regularly see upward revisions.

Cycle-low savings rates don’t stay low forever. Companies have shown a resilient hesitation toward raising wages. Americans are borrowing to finance their own spending and with any reasonable stall in consumer spending into 2018, our current annualized growth rate will be under significant pressure.

Pick up our latest report here:

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

Pick up our latest report here:

Correlation Breakdown

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.

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

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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. 

Pick up our latest report here:

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

Pick up our latest report here:

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.

Where’s the Trade?  Pick up our latest report here:

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).  

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

Pick up our latest report here:

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.

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

Pick up our latest report here:

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.