No mysteries in finance…

While mystery has always been a great seller to the masses in terms of books, movies and TV shows, it’s unfortunately also a top seller in financial media. We can see this with all the frenzy surrounding the dreaded inverted yield curve and this past week’s repo market mania. Both were events presented as mysterious and nefarious in nature, but when analyzed with some technical knowledge and common sense, both become perfectly explainable and are not actually harbingers of the next recession or crisis. In reality, both events are just a result of supply and demand for different assets in their respective markets by participants conducting normal business. So, by working through these “mysteries” and having the FOMC meeting behind us, we can now focus on the positive economic data that was out last week which is what will ultimately drive this market higher.

Looking at the situation of the inverted yield curve, we can break this down into two basic parts. First, is the Fed pushing up short term rates through its policy decisions and second, is the bond market pushing down long-term rates from sheer demand for treasury securities.

A close up of a piece of paper Description automatically generatedThe front part of the curve is the easiest to explain with the Fed having embarked on its rate hiking cycle back in December 2015 and driving the Fed Funds rate from essentially zero all the way up to the 2.25-2.50 range In December 2018 and thus taking market based short-term rates with it. So, while the Fed was performing its economically justified policy adjustments on the front end of the curve, the rest of the curve was being held down by a confluence of forces:

As a result of the financial crisis, significant regulatory actions were taken on financial institutions in order to mitigate systemic risk. Regulatory actions like the Dodd-Frank Act and Basel 3 Accord have forced institutions to hold a larger proportion of their assets in high quality liquid assets (HQLA) so that in the event of another crisis, they could be more easily liquidated to raise capital and not become a tax payer burden again. As seen in the chart below, these higher quality holdings have nearly doubled since the crisis.

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Because treasuries are already considered a vital component by institutional asset managers due to the treasury market’s unparalleled liquidity, the additional regulatory demand has generated a significant source of downward pressure on rates.

Next, we have an interesting situation of persistently low inflation helping to keep rates low which is unique to this economic expansion. In the past, economic expansions that approached the length of our present one have always been associated with rising inflation and sometimes very strong inflation. However, thanks to recent technological advances ranging from fracking, smartphones and open source software, to name just a few, there has been an unprecedented increase in productivity without an equivalent increase in prices. With fracking allowing the US to go from being not just the world’s largest oil consumer to also being the world’s largest producer, the reduced energy costs have helped anchor inflation while providing significant benefits throughout the economy. These technological advances along with a consumer shift in preference towards experiences versus goods has also helped to keep prices in check. It is this persistent lack of inflation that has been an ongoing point of discussion at the Fed and also a stated reason for ending this hiking cycle at the January 2019 FOMC meeting.

Lastly, we have the concept of relative value which has been another source of downward pressure on rates. Relative value describes a bond investors preference to always seek the highest yielding (return) bond with the best credit (likelihood of receiving that return) in a related group of bonds. So, in the case of treasuries, the comparable (relative) bonds would be those of similar developed sovereigns, which is primarily the European Union. With some EU sovereign yield curves having gone mostly negative and even being less credit worthy than the US, it’s easy to see why the US is such a great relative value and why foreign holdings of treasuries have risen significantly since the end of the crisis.

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Thus, by taking the confluence of forces acting to keep long-term rates down along with Fed policy changes pushing short term rates up, we can see why the yield curve was literally pushed into inversion by various market participants and not by omniscient investors who had “divined” that a recession is imminent. Even research which concludes that yield curve inversions precede a recession by some amount of time are spuriously correlated at best because of the significant events that happen in that time span that do actually cause a recession. All of this is not to say that yield curves do not provide any information because they definitely do. Rate curves are the fundamental basis for valuation models across multiple asset classes and are an invaluable economic metric. However, thanks to global quantitative easing and low inflation, rates have been anchored in such a way that some of the curves’ descriptive ability has been muted.

Moving on to our next mystery, let’s look at the spike in overnight (REPO) funding rates that occurred last week. As a quick primer in its most basic form, the repo market is where investment banks and other leveraged participants secure funding for their trading and investing activity. The repo market allows institutions with excess cash, like money market funds, insurance companies, corporations, banks and sovereign wealth funds to lend that cash to institutions that need it on a daily basis. These cash loans are collateralized by high quality securities like treasuries and are grouped into a category called general collateral (GC). For this exercise we will only refer to the spike in GC rates even though there were spikes across the spectrum of money market rates. Here is a brief history of GC rates from before last week and through it:

With some definitions and history out of the way, we have an understanding as to what happened. Now, the question is why did it happen? Similar to the confluence of forces that helped drive the yield curve inversion, there were several issues that came together to drive the spike in GC which could have been avoided had the NY Fed been more in tune with the markets. It turns out that the immediate cash shortages were driven by corporations withdrawing cash from the market to pay for tax liabilities and newly auctioned treasury securities that had to be paid for by various investors. There was also speculation that Saudi Arabian related funds withdrew cash in light of the bombings over the weekend. Then, on a larger-time frame, cash has been regularly drained from the market as a result of Basel 3 regulations which went into full force in January and that essentially forced global systemically important banks (G-SIBs) to hold enough cash to be able to cover a 30-day period without any need for funding in the event of another crisis. As things unfolded on Monday, the NY Fed was able to get its processes running to add the needed liquidity to the market and the situation was eventually fixed. But before the NY Fed was able to remedy things, financial media had already begun speculating that this situation was a redux of the spike in funding rates that happened during the crisis and that a new crisis was upon us. However, the major difference is that the funding problems back then were driven by the sudden introduction of counterparty risk into a market where it was previously inconceivable that a major US investment bank would become insolvent and that some collateral might actually be worthless. All one had to do last week was look across different asset classes to realize that this funding issue was limited in scope because other markets were functioning with a risk-on tone to them as opposed to the total calamity that existed during the crisis. It’s funny how media always seems to fill in the knowledge gaps with fear.

Throughout all the wild swings last week that started with what looked to be a significant market drop due to the Saudi Arabian oil field bombings, there was still some good news delivered. We got a strong industrial production (IP) report for August which also supports the idea that the weak ISM manufacturing reading earlier this month was a one-off driven by Boeing related issues. The IP report saw strength in business equipment, construction supplies and mining output. Then we had a Philadelphia Fed manufacturing report that showed healthy readings in new orders, production, shipments and employment data. There was a jump in the prices paid / received data in both current and future expectations readings that could be reflecting tariff-related effects, so that will have to be monitored. Given the strong IP report and solid Philadelphia Fed data for September, a rebound in the national ISM and Markit manufacturing surveys could be in store for September. On top of the solid manufacturing data was a second month in a row of a pickup in existing home sales (EHS). EHS, which account for 90% of total home sales saw increased buyers taking advantage of lower rates. The continuing lack of inventory is still holding sales back though as the market awaits homebuilders to complete new projects. With mortgage lending standards significantly stricter than what they were back before the crisis, the economic health and sustainability of purchasers today is something to note as an additional tailwind for this expansion. Last, but certainly not least, we got another week of historically low unemployment claims. And unlike the inverted yield curve, weekly unemployment claims are a reliable recession indicator. This week’s claims came in at an historically low 208,000. We need to see that number get above 300,000 and stay there before we start taking the R-word seriously. Overall, the data from last week indicates that the soft spot the economy had throughout the summer is firming up as we head into fall.

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Having worked through the inverted yield curve and repo market madness we’re now ready to face a new week with earnings season right around the corner. We have plenty of A-list economic data to look forward to and what is certainly no mystery, more China trade war news to swing the market back and forth.

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG. Marco has no positions in Boeing.

An Economy Sustained

Sustainability is a popular word in today’s media and is a part of an abundance of freshly-coined terms which deal with climate change and how we can all be better stewards of the earth. And in the highly charged social environment we are in, some of the ways being proposed to achieve this environmental sustainability would be to end the use of fracking, fossil fuels and the partaking of our favorite bovine. While the merits of these proposals are outside the scope of this discussion, one thing is for sure, and that is that a hurried implementation of them would be an end to our economic sustainability. Now, putting aside the frightening thought of a meat-less football season, we can look at the strength and sustainability of our economy that was evidenced in this past week’s data. With financial media doing its best to keep pushing the recession narrative, which so many have predicted for so long and that it’s still right upon us, the actual data shows the contrary. In reality, what we are seeing is the resiliency and sustainability of our modern services and consumption based economy.

Unfortunately, the term services economy is usually thought of as being limited to the leisure and hospitality sectors when it actually includes technology, finance, education, healthcare and others. The primary reason why we have enjoyed such a long expansion is that our economy has moved away from a manufacturing / exports base towards a services / consumption one. By doing so, the economy has become more sustainable and less susceptible to exogenous economic shocks which makes for longer business cycles. The chart below shows the consistent growth and smoothness (sustainability) of services versus goods-producing employment throughout this transition.

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That said, if we group the existing NBER business cycles to reflect this transition, a transition which is supported by the dramatic growth in services employment, we can see how the average business cycle has significantly lengthened.

In addition to the dynamics which have supported a longer cycle, we are also seeing an evolution of the services labor force into an even higher skilled and sustainable one. For example, in the August employment report there was a loss of 14,800 General merchandise store jobs and an addition of 14,800 Professional and technical services jobs. This is not to say that people are simply switching positions but that there is an overall transition occurring in the labor force as a result of changes in business trends.

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Then, as the table below shows, in the top five employment growth areas, four of them are services sectors which also account for nearly 55% of private sector employment by themselves. This is all important to note because financial media tends to only point out the job losses.

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So, while some scoffed at Friday’s employment report as being weak, when the data is taken in the context of a labor market at full employment, job openings (JOLTS) still near all-time highs, unemployment claims near all-time lows, and with a 3.2% rise in average hourly earnings, the 130,000 jobs created is just fine. It’s the details and trends in the report where the true strength lies.A screenshot of a cell phone Description automatically generated

Since services account for just over 80% of total private employment, we see why the strong ISM Services (NMI) report we got last week is so important, especially versus its manufacturing counterpart. The August NMI came in with a solid headline reading of 56.4%, up 2.7% from last month and handily beat expectations. The new orders component came in at its best reading of the year at a very high 60.3% with various types of labor being reported in short supply.

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Even though some survey respondents expressed concerns about tariffs, the overall commentary was describing a positive and growing business environment. Taking this report along with the strong services employment data and low weekly unemployment claims, we see how healthy and resilient the US services / consumption based economy is. In the absence of trade war noise, it’s this data that can propel equities higher.

As for the ISM Manufacturing (ROB) report that spooked the market last Tuesday, we need to understand how ISM calculates its indices to see what could have driven the drop into contraction. Basically, ISM weights all the responses it gets by the sector’s contribution to GDP. In this month’s report, we see that the drop in the PMI was primarily driven by drops in new orders and employment. Within those two components, it was the Transportation Equipment sector that was the most heavily weighted sector with the most negative responses. Given the issues plaguing Boeing and its supply chain, it’s likely that it’s these idiosyncratic issues that are especially weighing on the indices. With August car sales having come in well so far, it makes Boeing related issues a heavy favorite to be the culprit for the ISM decline. With that said, we can see from other survey respondents that tariffs are an issue, but that businesses are still trudging along. The takeaway here is that it’s a given that the manufacturing side of the economy will always be especially susceptible to external forces but thanks to American product superiority in many of our exported goods, even that decline will be limited.

The question becomes, so now what? The S&P is trading 22x trailing earnings and 17.9x 2020 estimates which have already come down 5% since March due to trade ware fears. Those valuations are arguably low given the low rate and inflation outlook. We also have a Fed that is committed to cutting rates with Powell stating that he was concerned about low inflation in his remarks from Switzerland on Friday. With an easy Fed, the stage has been set for a strong market and potential multiple expansion. Now, the obvious worry left is China.

When we look at the deteriorating economic conditions in China, the known issues alone are clearly serious. The PBOC finds itself facing inflation as a result of its weakening currency along with a shortage of USD’s from reduced export revenues. The PBOC needs USD’s to pay for commodities, USD denominated debt and for other external funding needs like its One Belt One Road projects. From a purely financial perspective, it behooves China to reach a deal because without one, F/X issues could put them in dire straits. Then the job losses from supply chains leaving adds the additional threat of civil unrest from unemployment which is something we know Beijing has no appetite for.

Next, there are purely domestic issues like the African swine flu outbreak and the Hong Kong riots. China is the world’s largest consumer of pork and has seen its hog population reduced by at least 30% thanks to the ASF outbreak that has been out of control for over a year. Because of this, pork prices have spiked over 70% and food importers have had to import beef from Australia and South America. Given Beijing’s history of covering up issues, it’s most likely that the ASF outbreak is much worse than what has been reported. This issue is also made worse by a weaker Yuan.

Finally, we have the civil unrest in Hong Kong that could result in China losing its crown jewel developed market asset and its best connection to the financial world. Should there be military action that unofficially makes Hong Kong the same as China, then Hong Kong would no longer be trusted as a global marketplace and the loss would be devastating to China’s financial future. This is why we have not seen full scale military operations yet and why there is hope for a peaceful solution.

However, even with all of these issues, it could still be possible that China will stay true to its dictatorship history and crush any rebellion and let its people endure any hardships as long as they may last. The reality of all these issues may have been what led to Beijing’s willingness to reach out about a trade deal last week, which makes it seem that the moderates in Xi Jinping’s inner circle may be gaining some traction and cooler heads may prevail. We will have to wait and see what comes out of the planned October meetings. So, given current market valuations, a dovish Fed and a healthy economy, there’s plenty of justification for the market to sustain its upward path, but the ability to withstand the headwinds of a prolonged trade war remains to be seen.



Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG. Marco has no positions in Boeing.