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This was not supposed to happen – everything is running so well, unemployment, ‘soft’ survey data, sentiment, Trump comments, the economy… so why the massive double top? And it must be a buying opportunity, right?

However, while this carnage comes as a shock to market participants used to low-vol-high-return environments under the central planning of global central banks, as Nomura’s Bilal Hafeez notes, this is actually returning stocks to the old “normal” – so get used to it…

While US stocks are now up a paltry 2% (before the US open) so far this year, on a 12-month basis they are up around 7%, which almost exactly the average return since 1960.

Now if we subtract by cash yields to arrive at excess returns and then adjust by volatility, we get to the Sharpe ratio. We find the current 12m Sharpe ratio to be 0.35 , which is similar to the historic average (see chart below, I exclude dividends).

Last year was shocking

So even though the recent drop in US equities has been eye-watering, the reality is that we are reverting back to historical averages. Instead, it was always the super-smooth ascent of US equities last year that was shocking. That ascent saw 12m returns reach over 20% by early January this year and the Sharpe ratio reaching a whopping 3.5 (see chart below). That’s a return Warren Buffett would be proud of, but anyone long an S&P500 ETF would have achieved. But with the recent drop, we can now see what separates Buffett from the rest of us.

Previous surges, see lower subsequent returns

The last time we saw a similarly high peak Sharpe ratio of 3.5 or higher was all the way back in late 1995. After that peak, returns fell, and volatility rose. The good news was that the Sharpe ratio stayed positive for a while. Over the subsequent 1y after the peak, the Sharpe ratio averaged 1.9, and the subsequent 3 years after the peak, it averaged 1.5 (see chart below).

That was of course the dot-com boom phase.

1960s also saw negative years after surges

Outside of that episode, we have to go back to the 1960s to see similarly high Sharpe ratios of 3.5 or higher being achieved. The most obvious difference to the 1995 phase was the large swings seen in  the Sharpe ratio from positive to negative over that decade. Indeed, we saw the worst loss in Sharpe ratio terms in that period. Naturally the subsequent 1y and 3y averages after the peaks were also much lower than what we saw after the 1995 peak.

Normalising expectations

The bottom line is that we need to re-centre our US stock return expectations – low vol/high returns like 2017 are unlikely to be seen again. US stocks normally only beat cash by 3%-5% and volatility is higher. And if the 1960s are anything to go by then negative years soon follow high peaks.

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After cooler-than-expected producer and consumer price inflation, import and export price growth also slowed markedly in September.

Export prices were unchanged in September (below expectations of a modest 0.2% MoM rise) and slowed notably YoY (+2.7% vs +2.9% exp and +3.5% YoY in August).

However, import prices rose more than expected (up 0.5% MoM vs +0.2% exp and up 3.5% YoY vs +3.1% exp).

This is the 3rd month of slowing trade inflation.

Import prices ex-food and fuel rose 1% YoY in September, but we note that, after PCPI showed Used Car prices slump, Auto prices were unchanged in September after no change in August. Additionally, consumer goods prices fell 0.1% after no change in August.

Import prices from China have resumed their downturn, exporting deflation modestly to the world…

So these are the 3rd and 4th inflation prints this week that offer The Fed an out on their hawkish path – will Powell take it?

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When we reported Wells Fargo’s Q1 earnings back in April, we drew readers’ attention to one specific line of business, the one we dubbed the bank’s “bread and butter“, namely mortgage lending, and which as we then reported was “the biggest alarm” because “as a result of rising rates, Wells’ residential mortgage applications and pipelines both tumbled, sliding just shy of the post-crisis lows recorded in late 2013.

Then, a quarter ago a glimmer of hope emerged for the America’s largest traditional mortgage lender (which has since lost the top spot to alternative mortgage originators), as both mortgage applications and the pipeline posted a surprising, if welcome to bulls, rebound.

However, it was not meant to last, because buried deep in its presentation accompanying otherwise unremarkable Q3 results (modest EPS and revenue beats), Wells just reported that its ‘bread and butter’ is once again missing, and in Q3 2018 the amount in the all-important Wells Fargo Mortgage Application pipeline shrank again, dropping to $22 billion, the lowest level since the financial crisis.

Yet while the mortgage pipeline has not been worse in a decade despite the so-called recovery, at least it has bottomed. What was more troubling is that it was Wells’ actual mortgage applications, a forward-looking indicator on the state of the broader housing market and how it is impacted by rising rates, that was even more dire, slumping from $67BN in Q2 to $57BN in Q3, down 22% Y/Y and the the lowest since the financial crisis (incidentally, a topic we covered recently in “Mortgage Refis Tumble To Lowest Since The Financial Crisis, Leaving Banks Scrambling“).

Meanwhile, Wells’ mortgage originations number, which usually trails the pipeline by 3-4 quarters, was nearly as bad, dropping  $4BN sequentially from $50 billion to just $46 billion. And since this number lags the mortgage applications, we expect it to continue posting fresh post-crisis lows in the coming quarter especially if rates continue to rise.

That said, it wasn’t all bad news for Wells, whose Net Interest Margin managed to post a modest increase for the second consecutive quarter, rising to $12.572 billion. This is what Wells said: “NIM of 2.94% was up 1 bp LQ driven by a reduction in the proportion of lower yielding assets, and a modest benefit from hedge ineffectiveness accounting.” On the other hand, if one reads the fine print, one finds that the number was higher by $80 million thanks to “one additional day in the quarter” (and $54 million from hedge ineffectiveness accounting), in other words, Wells’ NIM posted another decline in the quarter.

There was another problem facing Buffett’s favorite bank: while true NIM failed to increase, deposits costs are rising fast, and in Q3, the bank was charged an average deposit cost of 0.47% on $907MM in interest-bearing deposits, nearly double what its deposit costs were a year ago.

Just as concerning was the ongoing slide in the scandal-plagued bank’s deposits, which declined 3% or $40.1BN in Q3 Y/Y (down $2.3BN Q/Q) to $1.27 trillion. This was driven by consumer and small business banking deposits of $740.6 billion, down $13.7 billion, or 2%.

But even more concerning was the ongoing shrinkage in the company’s balance sheet, as average loans declined from $944.3BN to $939.5BN, the lowest in years, and down $12.8 billion YoY driven by “driven by lower commercial real
estate loans reflecting continued credit discipline” while period-end loans slipped by $9.6BN to $942.3BN, as a result of “declines in auto loans, legacy consumer real estate portfolios including Pick-a-Pay and junior lien mortgages, as well as lower commercial real estate loans.”  This is a problem as most other banks are growing their loan book, Wells Fargo’s keeps on shrinking.

And finally, there was the chart showing the bank’s overall consumer loan trends: these reveal that the troubling broad decline in credit demand continues, as consumer loans were down a total of $11.3BN Y/Y across most product groups.

What these numbers reveal, is that the average US consumer can barely afford to take out a new mortgage at a time when rates continued to rise – if not that much higher from recent all time lows. It also means that if the Fed is truly intent in engineering a parallel shift in the curve of 2-3%, the US can kiss its domestic housing market goodbye.

Source: Wells Fargo Earnings Supplement

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Authored by Tom Lewis via GoldTelegraph.com,

According to the Bank of America Merrill Lynch, gold is set to take a run over the next year due to the constant cloud of uncertainty with regards to the U.S budget deficit alongside concerns over trade wars.

The head of global commodities and derivatives research, Francisco Blanch has stated that gold could average $1,350 an ounce of 2019 due to the U.S fiscal balance.

“We’re still pretty constructive longer term on gold,” because of worries over the future of the U.S. economy even though it’s performing relatively well right now, said New York-based Blanch.

“In the short run, the effects of a strong dollar, higher rates dominate. But in the long run, a huge U.S. government budget deficit is pretty positive for gold,” he said.

The tax changes are lowering the revenue base, said Blanch.

“That means the Treasury has to borrow more so that puts pressure on rates, which in the short run has not been good for gold,” he said from Hong Kong.

“However, in the long run, it basically begs the question, can this go on for much longer? Can the U.S. borrow its way out of the next downturn and at what cost?”

“Eventually the trade wars are going to come back to bite the U.S.,” said Blanch.

“It could take longer, it could take shorter, eventually it’s going to happen, but maybe the Fed acknowledges it sooner, which is what people are going to be looking for in terms of getting more bullish on gold. We know that trade wars are not good for the economy.”

One of the world’s most successful hedge fund managers Ray Dalio has also gone on record to express his concern over the budget. Mr. Dalio has predicted that the US economy is nearly 2 years away from a downturn, which will result in the dollar plunging as the government prints money to fund the growing deficit.

Want to know why the USA will eventually be stripped as the reserve currency of the world?

Just take a look at this: pic.twitter.com/fu9iE6jZNx

— Gold Telegraph (@GoldTelegraph_) August 26, 2018

Goldman Sachs has also expressed their concern and has recently turned bullish on gold as they have forecasted a price target of $1,325 in 12 months.

With the US budget deficit set to swell to roughly $1 trillion by fiscal 2019, it’s worth noting that the interest owed by the government is set to exponentially increase as it set to triple over the next 10 years according to the Congressional Budget Office.

Whatever the case is, it’s only a matter of time before the short term trick of printing money doesn’t come back to haunt the United States economy.

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Oh how the mighty have fallen…

Seven months after he angrily quit the Trump Administration in protest over President Trump’s tariff plans, former Goldman Sachs President Gary Cohn has broken his silence to announce his first big career move since leaving the West Wing. As the Financial Times reports, Cohn has joined the advisory board of a…blockchain startup?

Somebody should tell Cohn that he’s about a year late: In 2017, joining a blockchain startup was the trend du jour for bankers looking for an entry point into the burgeoning fintech space who – despite the reality that many of them didn’t understand the underlying technology beyond the notion that it would someday “revolutionize” banking/commerce/logistics/supply chains). To be sure, Cohn is merely a member of the advisory board of Spring Labs. And we concede that the company has a tantalizing pitch: Its founder, Adam Jiwan, plans to leverage blockchain technology to build a secure “peer to peer” system that would allow banks to share customers’ credit data in a way that could render credit reporting agencies like Equifax and Experian obsolete. If last year’s Equifax data breach taught us anything, it was that the credit reporting bureaus have grossly represented their ability to protect our most sensitive personal data.

Under the current credit system, banks hand over customer data to credit reporting agencies such as Equifax and Experian, before buying back aggregated reports from those companies. Last year, Equifax disclosed that it had suffered a massive data hack in the US, affecting 143 million clients and raising concerns about the safety of customer information.

Adam Jiwan, Spring Labs’ chairman and chief executive, said his company was building blockchain-based applications that would allow such data to be shared directly between parties in a “highly secure” and “anonymous” way that complies with data privacy regulations.

He added this could “ultimately . . . replace the credit bureaus you see today”.

That sounds like a viable business strategy, but the one obstacle is the technology itself. Nobody – including Spring Labs’ engineers – has figured out how to scale blockchain technology to accomplish these tasks on the scale necessary to make this model viable. Even Cohn – who is also an investor – admits that “building the technology” is the company’s biggest obstacle.

“When you look at the two challenges Spring Labs has, one is building the technology. Once you’ve built the technology you’ve got to get it accepted and adopted,” Mr Cohn said, adding that he would use his experience in financial services to help the company tackle the latter.

Blockchain technology allows for information storage and transmission without a central control body. While it is best known for its role in underpinning the exchange of cryptocurrencies such as bitcoin, its decentralised functionality has made it popular with companies seeking to manage large flows of data. However, critics have questioned whether its usefulness has been overstated, and the technology has also been tainted by its association with the cryptocurrency world, which many have warned is vulnerable to fraud.

Still, we wish Cohn best of luck with this new venture. If it doesn’t work out, we hear there might be a few job openings in the West Wing early next year (though the former Goldman banker may have burned those bridges)…

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Authored by Lance Roberts via RealInvestmentAdvice.com,

The worse things seem, the better the opportunities are for profit.

Such is the very nature of investing.

Baron Rothschild, an 18th-century British nobleman and member of the Rothschild banking family, once said:

“The time to buy is when there’s blood in the streets.”

He should know. Rothschild made a fortune buying in the panic that followed the Battle of Waterloo against Napoleon.

Warren Buffett once said the same:

“Be fearful when others are greedy, and greedy when others are fearful.” 

In other words, going against the crowd often yields the most successful outcomes. 

This is the essence of contrarian investing.

Contrarian investors have historically made their best investments during times of market turmoil. During the crash of 1987 (also known as “Black Monday”), the Dow dropped 22% in one day in the U.S. In the 1973-74 bear market, the market lost 45% in about 22 months.  The “Great Financial Crisis” of 2008 saw asset values get cut in half. The list goes on and on, but those are times when contrarians found their best investments.

But being a contrarian is extremely difficult. As Howard Marks noted:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

Of course, behavioral analysis shows that investors always do the opposite of what they should do – they repeatedly “buy high” and “sell low.” 

This is why being a contrarian is both lonely and tough.

If you could buy the stock market today at a 50% discount – would you?

Well, there is currently a glaring “contrarian” opportunity in Treasury bonds as I noted last weekend:

“With bond traders more short than at any point in history, the ultimate “reversion to the mean” in Treasury’s will drive rates towards zero.”

“The chart below strips out all periods EXCEPT where net-short bond positions exceeded 100,000 contracts. In every case, interest rates turned lower.”

But yet, despite the massive “one-sided bet on bonds,” investors can’t wait to sell.

The Great Bond Bull Market Approaches

Eric Hickman recently made “the” key observation as to why rates will fall in the months ahead:

“With the economic expansion nine months from being the longest in U.S. history, the yield curve nearly flat and housing market indicators peaking earlier this year, it doesn’t take much imagination to see what’s next: a recession and falling interest rate cycle – i.e., a U.S. Treasury bull market.”

There is a very long precedent to back up his claim. The chart below, which tracks rates back to the late-1800’s, shows that rates not only fall during recessions, but they can, and do, remain low for extremely long periods of time.

The premise is fairly simple.

Rising interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time. There have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I, and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed. But that was just the start of it.

Beginning in the late 50’s, America embarked upon its greatest quest in history as man took his first steps into space. The space race that lasted nearly twenty years led to leaps in innovation and technology that paved the wave for the future of America. Combined with the industrial and manufacturing backdrop, America experienced high levels of economic growth and increased savings rates which fostered the required backdrop for higher interest rates.

Today, the ingredients to create that kind of economic growth no longer exists.

• The U.S. is no longer the manufacturing powerhouse it once was.

• Globalization has sent jobs to the cheapest sources of labor.

• Technological advances reduce the need for human labor and suppress wages as productivity increases.

• Labor force participation rates remain mired near their lowest levels since the 1970’s.

• Demographic trends in the U.S. continue to weigh on the sustainability of pension benefits and long-term economic growth.

• Massive debt levels divert capital from productive investment to debt service.

• Productivity growth, the engine for economic growth, has ground to a halt.

Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically, the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. (Currently, we do not have the type of inflation that leads to stronger economic growth, just inflation in the costs of living that saps consumer spending – Rent, Insurance, Health Care, Energy.)

This is shown in the chart below. The rise in rates during the 60-70’s was combined with rising inflationary pressures driven by a rising trend in economic growth and wages. Extremely low levels of household indebtedness allowed rates to rise without severely negative consequences.

With households, corporations, the government and investors more levered today than ever before in history, the rise in rates will have a more immediate and widespread economic consequence.

When rates start to increase, there is NOT an immediate negative consequence on economic growth, employment, or inflation. As the increase continues, early warning signs are dismissed as just a “lull” or “soft landing.” However, those early warning signs have previously been just that.

However, the problem with most of the forecasts for a continued rise in rates, along with a continued stock bull market, is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. The issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American the vast majority of whom have no stake in the markets. Interest rates, however, are an entirely different matter and has the greatest effect on the bottom 80% of the economy. Think student loans, auto loans, credit card debt and mortgages.

The chart below shows the composite economic indicator of inflation, wages, GDP, and savings as compared to interest rates and the S&P 500. Sharp upticks in rates have historically led to financial events, recessions, market corrections, or a combination of all three.

The irrationality of market participants, combined with globally accommodative central bankers, have continued to push asset values higher and concentrate investors into the ongoing “chase for yield.” 

Bull markets, low unemployment, elevated consumer and investor sentiment, economic growth, and inflation are near peaks at the end of the cycle. As Eric noted:

“Bull markets began far before their accompanying recession did. The bull markets started an average of 1.8 years before. This happens because the start of a recession is marked by a decline in real economic activity, yet long-term Treasury yields start to move lower from the mere hint of a slowdown in activity. This is important because many familiar commentators and banks (Ray Dalio, Ben Bernanke, Nouriel Roubini, Mark Zandi, Societe Generale, JP Morgan) are warning of a recession in 2020. This 1.8-year average combined with a mid-2020 recession would suggest a U.S. Treasury bull market beginning around now.”

The majority of the speculative bond “shorts,” shown in the chart above, were put on between 2.80% and 2.90% on the 10-year Treasury. When rates approach that level, shorts will likely aggressively buy to cover their shorts and prevent loses. Such a “short squeeze” will send rates lower very quickly.

There isn’t much guessing on how this will end, and history tells us that such things rarely end well.

But this is where the opportunity currently exists for a contrarian with a longer-term view:

“It is counterintuitive, but U.S. Treasury bull markets begin when the economic weather is the sunniest. It happens when the unemployment rate is the lowest and consumer and industrial confidence the highest. By the time a recession is obvious, a good chunk of the move lower in rates will have taken place. Of course, there are no hard and fast rules to make money in finance, but to the extent that ‘this time isn’t different,’ now is the time to get ready for a large opportunity in the U.S Treasury market.”

I agree.

The next recession will be much larger and deeper than most currently expect due to the massive amount of leverage built up during the current cycle. A loss of 45-50% on the S&P 500 will not be surprising as a mean-reverting event wipes out a big chunk of the gains made over the last decade. Efforts by the Fed will be restricted as the pension fund crisis expands and a “debt deleveraging” cycle takes hold.

The ideal investment to take advantage of the next cycle will be Treasury bonds.

You just want to buy them while they are still cheap because once they begin to move, the reversion to the mean will be much more rapid than you can imagine.

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JPMorgan has officially launched Q3 earnings season with earnings that were generally inline including a solid beat on earnings, despite an unexpected miss in FICC sales and trading and Investment banking.

JPM reported total managed revenue of $27.8BN (the sum of $14.1BN in net interest income and $13.8BN in non-interest revenue), above the $27.44BN estimate, resulting in $8.4BN in net income, a 24% increase Y/Y, translating in $2.34EPS, higher than the consensus estimate of $2.25. The number included net charge offs of $1 billion, offset by a $0.1BN reserve release, resulting in total credit costs of $0.9BN.

Commenting on the results, Jamie Dimon said that “the U.S. and the global economy continue to show strength, despite increasing economic and geopolitical uncertainties, which at some point in the future may have negative effects on the economy.”

Something else: as Bloomberg’s Max Abelson notes, “when I re-read Dimon’s comments this morning, I’m struck by just how much he seems to be trying to flatter Donald Trump.”

Not only does Dimon cite “smart regulatory policy” (a euphemism, in part, for a friendlier White House) and “a competitive corporate tax system” (lower taxes for big companies), he even touts the bank’s first branch in Washington. In other words, he’s still backtracking from his notorious Trump insult a few weeks ago. I’m wondering if he had a nudge from his board?

Helping the bottom line was JPM’s effective tax rate of only 21.6%, down sharply from 29.6% a year ago, which may explain why Jamie Dimon gave a shout out to corporate tax changes: “We are extremely excited to be expanding again, as smart regulatory policy and a competitive corporate tax system help us to deliver on our commitment to invest in our customers and communities.

For yet another quarter, JPM relied on old-fashioned lending, reporting average loans up 2% to $479.6BN from $469.8BN, while firmwide core loans rose +6% Y/Y. Average deposits rose from $673.8BN to $674.2BN. As a result, JPMorgan said net interest income jumped to a record $13.9 billion in the period, helped by rising interest rates and steady growth in what the bank considers core loans. Meanwhile, bond-trading revenue fell 10 percent (more below).

Some more top-line details via BBG:

• 3Q Basel III common equity Tier 1 ratio 12%, estimate 11.9
• 3Q return on equity +14%
• 3Q net yield on interest-earning assets 2.51%, estimate 2.50%
• Assets under management $2.1 trillion

On the cost side, compensations expenses were $8.11, in line with the $8.13 exp.

Of note, the provision for credit losses was down from the year-ago period and down from the second quarter, meaning they’re setting aside less money for potential loses on bad debt and is generally indicative of JPM’s optimism on the economy. Specifically, JPM reported only $948MM in provision for credit losses, sharply lower than the $1.46BN estimate and down from $1.452BN a year ago. The number included a $0.1 billion reserve release. The bank explained the drop in credit costs in its consumer banking division as follows:

• Home Lending: $250mm PCI reserve release; net recovery largely driven by a loan sale
• Card: reserve build of $150mm this quarter vs. a $300mm build in 3Q17

JPM also said that the current quarter included a reserve release of $250 million in the Home Lending purchased credit-impaired portfolio, “reflecting continued improvement in home prices and delinquencies”, offset by a reserve build of $150 million in Card driven by loan growth and higher loss rates. Net charge-offs were lower, predominantly due to a net recovery in Home Lending, which was largely driven by a loan sale.

There was also an improvement in JPM’s credit card charge offs, which declined for the 2nd quarter to $1.073TN after peaking in Q1.

There were some disappointing numbers too, mostly in the bank’s Investment Bank, where FICC Sales and Trading revenue declined by $320MM Y/Y to $2.84BN, below the $2.96BN estimate, a 4% miss to expectations. Investment Banking also missed, rising $1.73BN, unchanged from a year ago, and below the $1.82BN estimate.

The silver lining was the Equity Markets once again outperformed, with the bank reporting $1.595BN in equity market revenue, up $232MM on the year, and better than the $1.42BN consensus estimate.

In JPM’s Consumer & Community Banking (CCB), net rev. rose 18%, driven by higher net interest income due to higher deposit margins, balance growth. At the same time, home lending net revenue fell 16%, driven by lower net servicing revenue, as well as loan spread and production margin compression: this is where the rise in yields is hitting as household refi activity has crashed.

Card, Merchant Services & Auto net revenue was up 10%, driven by higher Card net interest income on margin expansion and loan growth; higher auto lease volumes, higher Card noninterest revenue, reflecting lower acquisition costs, which were offset by lower net interchange income.

Here is how Opimas CEO Octavio Marenzi summarized JPM’s results:

“Going into this earnings cycle, there were some concerns that interest margins would start to deteriorate, and that revenues from trading would suffer. Neither of these fears was borne out by JPMorgan’s earnings announcement. There was some weakness in home lending, but cards and consumer banking more than made up for this, as well as a decline in fixed income markets, but this was at least partially offset by gains in equities.” 

And so with 3Q revenue and EPS beating, but not by the usual blockbuster amount, and with some concerns about the bank’s sales and trading and i-Banking miss, investor excitement has been capped with shares paring gains, now unchanged after earlier jumping as much as 1.5%.

JPM’s earnings presentation is below:

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Nine months after initial headlines warned of China reducing its Treasury purchases (sparking a mini-panic), a senior Chinese policy advisor has once again raised the specter of China rotating away from USD in its reserves, and specifically reducing its UST purchases.

China’s Treasury holdings have been falling for much of the last 6 years, so this is nothing new per se…

And now, following last week’s ugliness in USTreasury markets (albeit with a bid back this week), Bloomberg reports that Zheng Xinli, senior adviser to policymakers, said in an interview with Market News, that China should look to switch future foreign exchange reserve investments away from U.S. Treasuries and into areas such as high tech research as trade dispute intensifies.

Zheng is former deputy-director of Policy Research Office of the CPC Central Committee and frequent participant in drafting annual central government working reports according to MNI.

While China turning away from the U.S. bond market would complicate Treasury’s financing needs, Jefferies economists Ward McCarthy and Thomas Simons noted in January, when the last China scare hit, that U.S. statistics suggest “that China has not been a major buyer of Treasuries for a while now.”

Some have argued that this should be interpreted as Beijing wanting to send a signal to the US that it is willing to use financial means to respond to any shifts in US policy on issues such as trade.

Furthermore, this ‘signal’ comes at a time when the yuan is depreciating (in a non-manipulated manner according to US Treasury) against the dollar and as the petroyuan continues to rise in popularity, we are reminded of the apparent ‘peg’ that has developed between Yuan and gold…

As a reminder, when the same headline hit in January, that “Officials reviewing China’s FX holdings have recommended slowing or halting purchases of US Treasuries, according to people familiar with the matter,” Treasury futures puked and gold spiked. Today the reaction so far is extremely muted.

Ironically, minutes after this headline hit, Treasury Secretary Mnuchin was interviewed on CNBC confirming that “there is plenty of demand for US Treasuries.”

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Authored by Chris Whalen via TheInstitutionalRiskAnalyst.com,

President Donald Trump has been criticizing the Federal Open Market Committee for raising interest rates.  The reaction of the US equity markets is self explanatory.  But while the economist love cult in the Big Media may take umbrage at President Trump’s critique of the central bank, in fact Trump is dead right.

First, the Fed’s actions in terms of buying $4 trillion in Treasury debt and mortgage paper has badly crippled the value of the fixed income market as a measure of risk.  The Treasury yield curve no longer accurately describes the term structure of interest rates or risk premiums. This means that the Treasury yield curve is useless as an indicator of or guide for policy.  Nobody at the Federal Reserve Board understands this issue or cares.

Second, Operation Twist further manipulated and distorted the Treasury market.  By selling short-term paper and buying long dated securities, the Fed suppressed long-term interest rates, again making indicators like the 10-year Treasury bond useless as an measure of risk. Without QE 2-3 and Operation Twist, the 10-Year Treasury would be well over 4% by now.  Instead it is 3% and change and will probably rally to test 3% between now and year end.

Third is the real issuing bothering President Trump, even if he cannot find the precise words, namely liquidity.  We have the illusion of liquidity in the financial markets today.  Sell Side firms are prohibited by Dodd-Frank and the Volcker Rule from deploying capital in the cash equity and debt markets.  All bank portfolios are now passive.  No trading, no market making.  There is nobody to catch the falling knife.

The only credit being extended today in the short-term markets is with collateral.  There is no longer any unsecured lending between banks and, especially, non-banks. As we noted in The Institutional Risk Analyst earlier this week, there are scores of nonbank lenders in mortgages, autos and consumer unsecured lending that are ready to go belly up.  Half of the non-bank mortgage lenders in the US are in default on their bank credit lines.  As in 2007, the model builders at the Fed in Washington have no idea nor do they care to hear outside opinions.

If you understand that the Fed’s previous “extraordinary” policy actions have the effect of understating LT interest rates by at least a percentage point, then you know why President Trump is howling like a wounded hound. Nobody understands the danger of leverage better than a real estate developer.  When you see the dislocation and distress visible to those with eyes wide open in the non-bank residential and, especially, multifamily mortgage sectors, then you know why President Trump is rebuking the Federal Reserve.

Bottom line: We fully expect to see some business failures in the residential lending and multifamily development sectors over the next 12 months.  The real estate markets are over-extended, asset prices are silly and the only way forward for debt and equity valuations is lower.  More important, if the “real” rate for the 10-year bond is over 4%, then where should the Dow and S&P be tomorrow at the opening?  By raising short-term interest rates instead of unwinding QE 2-3 and Operation Twist, the Fed is repeating the mistakes of 1928 and is creating the circumstances for a liquidity crisis.

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