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Good news on the housing front

If you have been looking to buy a house in the past year or so, there is great news on the horizon. The current environment is clearly a sellers market, as these super inflated prices persist, giving sellers the best prices they have been offered, ever. There is a massive shift happening in city ordinances though, and that can have a big effect on housing supply.

For the longest time, the argument for why housing prices have been so sticky in big cities, has been supply, supply, supply! Well, that’s about to change, at least in Dallas, starting in December!

After more than three years of master plans, committees, recommendations, briefings, complaints, delays, debates, campaigns and more than a bit of animosity, a question that had long been without an answer finally got one. In a 12-3 vote, the City Council decided that short-term rentals like those marketed on popular services Airbnb and VRBO will not be allowed in single-family residential neighborhoods in Dallas.

It is important to note that Dallas isnt the first city to do this, New York City has already done this…

New New York City rules on Airbnbs and short-term rentals went into effect on Tuesday, with tens of thousands of illegal short-term listings expected to be affected.

First, New York, and now Dallas, have both embarked on a bold new plan to resolve this problem, if not as a main cause, then by side effect. Both cities have decided to ban STRs. According to Chalet, there are currently 6945 active rentals in Dallas, TX. Almost 85% of all listings are 1 and 2 bedrooms. This should affect thousands more of listings/homes, registered and unregistered, which should in turn bring in listings for sale, or long term rentals, both positives for the populace as a whole.

Another reason why so few homes have been coming to market is the long term low rate mortgages that people locked in, in 2020/2021, which made the idea of Airbnbs very profitable. Low mortgage payments, and sky high rentals, allowing many people to just buy a few properties, and quit their jobs. Last year, new Airbnb hosts made over $170M, the third highest in the nation!

This ban will make that difficult to hold on, since longer term rentals are not as profitable, and the volume coming to market will further drop rental rates or simply force people to sell the extra houses that they have bought, regardless of mortgage rates.

The arguments for or against Airbnbs is irrelevant at this move, what matters is the result of these new laws. If this indeed does relieve some of the supply pressures, then you can rest assured that more cities will step up and ban STRs to alleviate some of the housing problems that we are currently facing, especially for new buyers.

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King Dollar is dead, or is it?

This past week, the headlines were dominated by how the death of the USD was upon us (A BRICS Currency Could Shake the Dollar’s Dominance
De-dollarization’s moment might finally be here.) and how the world was shifting away from the King of all currencies, the US Dollar.

The BRIC countries met this past week, in an attempt, as portrayed by the media, to distance themselves from the USD, and minimize the role of the world’s most widely used reserve currency, which has been the dominant force in international trade for the past few decades.

First off, where is this threat even coming from? The BRICS we are told, a group of countries (Brazil, China, Russia, India, and South Africa) who sound determined to move away from the hegemony of the USD. They recently expanded membership (to include Iran, Saudi Arabia, Egypt, Ethiopia, Argentina, and the UAE). Funny enough, Argentina itself is in the process of Dollarizing its own currency! While adding this entire list together would result in a big enough economy to be a challenge, both Russia and India have come out and said that a uniform currency between these nations is not a realistic goal in the near term.

Who is the next challenger? The Euro they say. Europe is in terrible shape, economically, a pseudo war has for all intents and purposes, shown the weakness of the European continent and its dependence on all things external for raw material (namely gas/energy) . The Euro has been in decline (much like the continent), and the continent as a whole has been incredibly weak in its recovery, ever since the recession of 2008.

Sadly, if the Euro was no threat in 2008 (it wasn’t), it definitely isn’t a threat today. A has been power with no natural resources trying to challenge the dominance of the USD is a non event.

The main premise then was that the amount of USD used in international trade was diminishing, as countries were on their way to trade with each other in their own currencies, to circumvent the use and relevance of the USD. This may indeed be what the countries in question would be projecting, however what they do and what they say, yet again, does not match reality, as Dollar usage in global payments in July rises to record! as shown below, this number has actually increased, yes, you read that right, the share of trade being done in USD, has increased. In fact, the USD’s role in global transactions just hit a new all time high of 46%, last month.

With the nonsense of the BRICS’s unified currency, and the now failed experiment of the Euro, who is left to challenge the USD’s dominance? the likes of Bitcoin, gold, and the Chinese Yuan are simply non events, since as a percentage of world trade, they are beyond negligible, if and when that changes, I would love to reconsider them.

The USD remains the world’s main reserve currency for many reasons, and the US empire is in no danger of losing that status, not anytime soon anyway.

I recently came across this video, and would like to recommend it to anyone who is skeptical of the advantages that the US has had, and has, to this day, over any other country, in its path to growth and prosperity;

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Markets vs the Economy

Ask anyone on main street how business is, and usually you will start hearing fear, slow downs, and worrying signs that the best of times might already be behind us. You can then pull up charts from the stock market, and since everyone believes that markets are forward leaning, you would get the exact opposite feeling, as equities rallied to new monthly highs (especially the Nasdaq). So what are we to glean from all this?

There are many factors that play into this outcome, but if we are to look at the current landscape, the talk on the street seems to be revolving around rates. Rates are rising, and they will continue to do so, the Federal reserve has said they don’t intend on cutting in 2023, yet a lot of market participants seem to think that they will pivot and drop rates soon. I clearly disagree, for the following reasons;

  • Unemployment at historic lows
  • Equity markets roaring higher
  • Real Estate markets are looking solid with no signs of easing
  • Inflation acting sticky, and no longer responding like it did initially
  • The fact that the Federal Reserve has literally said they continue to want to raise

It is also important to note that as stated numerous times, that the lag effect on rates are 12-18 months, meaning the economy is responding to what rates were set over a year ago, and that today’s rates will show up in 2024, at the earliest. This is specifically why I think the hardest times are ahead, and not behind us. We have a flurry of headwinds ahead. Not to mention that small things like the student forgiveness moratorium will come to an end this year, further squeezing the consumer (who has loans). As contentious as the loan forgiveness is, the economy needs it, as another tool to further cool off demand. Demand destruction is the Fed’s goal, as they are raising it by raising unemployment, which is why the student payments coming back further assists that cause.

“Markets can remain irrational longer than you can remain solvent”

John Maynard Keynes

It is important to not pay too much attention to equity prices, as a read. The greatest push in the latest equity market rally has come from the introduction of AI. This is very much like how things were in the .com bubble (for those of you old enough to remember that. I had just started trading back then, and lost a lot of money in that bubble).

Before we continue, please understand that I am the biggest fan of AI. I literally created the above picture with one command in less that 10 seconds (no revisions). This is just the beginning of what we can do with AI, and the future is glorious, but caution is warranted.

As you can see from the chart above, fewer and fewer stocks are driving up this market (mostly AI based). Which itself should be concerning. I am not saying that the markets should be shorted, far from it. It is important to note though, that things are not as healthy as they appear, and that based on the information at hand, one should be worried as to what is coming in the year(s) ahead. Plan accordingly.

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US stock valuations, and the everything bubble

This is in no way an attack on any stock, or even investing in the stock market, however this is a good piece on undervalued and overvalued assets. The real estate market is overvalued by metrics such as average income to house value among other metrics for instance, but undervalued by almost no metric. Based on the chart below, we haven’t even normalized mortgage rates, based on a 50 year average. We probably cant afford rates that high, but to say that rates are unfavorable, simply implies that one has to be very short sighted.

The US stock market has been on an absolute tear of a rise in the past decade, but more importantly for as long as rates have been dropping, and that can be measured in decades, not years (The chart above applies to the rates that apply to the stock market too since they are all based on the Federal Funds Rate). That rate has stopped dropping simply because you really cant sustain rates that close to zero for very long, as the Federal Reserve learned, inflation will come to haunt you and force your hand, which is exactly what is happening.

We do have an everything bubble now, and the only way to get out of this is either a crash (which I don’t see), or a very very long period of no growth, to allow all this liquidity to drain itself out, it has been our stance that this will play out for the past year and a half and so far so good.

This weekend, I spent sometime trying to understand how overvalued the stock market was, and tried to make a comparison that even I found shocking.

The largest stock in the US stock market by valuation, and market capitalization is Apple. Apple stock is now worth US $2.76 Trillion. This number/valuation is officially larger than the entire stock market value of the fourth largest GDP in the world, Germany. Think of all the German car companies, chemical and drug companies, mechanical companies, and when combined, they are worth less than a cell phone company in the US. Granted, Apple is more than just a cell phone company, but stay with me here, the valuation of US companies are so high, that finding true value is hard to come by, everything is simply overpriced in the US economy.

Investing is about buying undervalued assets, and holding them while they find their true value, and currently, there are very few, if any assets that are considered cheap. We are in a very unique investing environment where everything is expensive, with almost no cheap assets to be had. Too much money has created a problem for us, which the Fed is trying hard to correct, and based on their actions, they have decided to tackle this via unemployment.

The Fed intends to create demand destruction, via unemployment. As people lose their jobs, they will be forced to buy less (cooling inflation) and forced out of homes they can no longer afford (housing availability). Its cruel, but the only way we can tackle this problem.

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Rates and their trajectory for the rest of 2023

Today, lets talk about rates and where we believe they are headed for the remainder of the year. The Federal Reserve, who decides if rates should be higher or lower will be meeting 6 more times in 2023, on the following dates;

  • May 2-3.
  • June 13-14*
  • July 25-26.
  • September 19-20*
  • October 31-/November 1.
  • December 12-13*

With the next meeting fast approaching, and with the consensus predicting another 25 basis point hike, one has to wonder how much more they are willing to raise.

The Fed is limited in what they can do, they cant continue raising indefinitely. There are limits to this tool, and today we will explore what these limitations are;

  1. The federal deficit/debt is affected by this rate. The higher the rates go, the higher our national debt payments will become. We are close to the upper limits of what we can afford. As of 2022 we were paying close to 500 Billion dollars a year, just to service that debt.
  2. It usually takes a year for rates to actually show up in the economy, so there is a danger of going too far and then having to pivot hard, which would cause immeasurable pain and volatility. Rates have slowly started to show up in the economy, due to what they were a year ago (todays rates will show up a year from now) with a cooling off of real estate, an increase in company lay offs (it costs more for companies to borrow money so they have to cut costs/workforce), and stricter loan requirements by banks, specially in the car loan department.

The Fed, cant just back off the rate hikes and pivot either, they have the following reasons to keep rates high. However its important to note that even a pause here would do the job, they just cant pivot and drop rates.

  1. Unemployment is at historically low levels. We need unemployment to rise so we can create demand destruction, which will lead to lower inflation. The more people lose their jobs (this is a terrible thing to want, however its a price that needs to be paid), the less demand for goods, and thus a cooling off on inflationary pressures.
  2. Inflation. The current inflation is at 5%, but its a sticky inflation. The Fed’s target is, and has been 2%. They can’t pivot until we get closer to the target, otherwise a pivot would result in a spike yet again, one which would be much harder to drop.
  3. Equities, Real Estate, and most assets have hardly budged in price. A pivot here would be reckless, as we would go back to fueling the ever growing bubble in all assets. Real estate rose 40% nationally in 2 years, this will take 5+ years to digest, a pivot here would be destructive to that market and all other markets, fueling an inflation rise that would crush our currency.

So what should the Fed do? Its clear that the Fed is stuck. They cant raise much more, and they absolutely cant cut rates, which means they will try and control the market with language while keeping rates steady (up or close to where they are now, by within 100 basis points) for the remainder of the year.

This will result in what we had predicted at the beginning of the slowdown. Assets will not be allowed to grow as the economy slows down. There will be very little growth in most assets, and it is incredibly hard to see a Fed pivot in 2023, unless we have a complete meltdown, which is very unlikely. This is an important take away from all of this. The in no real strength in the economy, corporations, real estate, and most assets have peaked, and they only way to keep them going higher is by lowering rates, to artificially pull demand forward, which was reckless to begin with when we had such low rates for a decade. There is no free lunch, and now we simply need to digest the gains of the past decade.

The chart above displays how reckless and lazy the Federal Reserve has been with low rates recently. Over the past 70 years, low rates were always an emergency tool to help along the economy, they were never meant to be used the way we have had them stuck near zero for as long as we did.

We continue to expect range bound movement in all assets, so exact entry and exits in most assets will make the difference. The age of passive investing has come to an end, at least for the foreseeable future.

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Notoriously early, as usual

On Friday (03/17/2023), gold did something it has rarely accomplished in the past. Gold rose over 2% on Friday, closing the week with the biggest weekly rise in 3 years. Indeed, the last time gold was this favored was due to the outbreak of a global pandemic.

Suggesting a position in gold was made a while ago, since I am terrible with timing, but every now and then, the trend change is easier to spot that others. The trend change from equities to gold was predicted and spotted in this post, dated April of 2022.

Much has changed since then, but the hypothesis of of the risk off/risk on has stayed true and this should stick. These longer term trend changes aren’t an exact science, but when they come, they stick around for a while. Safety has left equities and it has been evident long before this past week.

Early to this call, but the trend has been spot on, and should continue for now, I see no reason, yet, for this trend to reverse. If anything, more events are aligning with the trend change that we were early to point out, and got lucky to catch the move with. The chart posted in that post, has only gotten stronger and bolder since then.

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Have too much cash? Store it safely, here’s how

With the latest bank drama in the US, first with SVB, and now with First Republic, there is no shortage of nonsensical fear mongering articles floating around in the media. You may simply have too much cash, and now you are worried. We all know that the FDIC will protect all your cash up to $250,000 at an accredited financial institution. However, lets assume you have more than that, and you want additional protection, with the convenience of checks etc. Well, luckily for you, there is a solution, and it involves moving your cash from your bank to a brokerage!

Before you start telling me, that you don’t understand stocks or don’t want to trade with your money, allow me to stop you right here. None of that is necessary. You can literally open a brokerage account, store your $250,000 in cash, and be able to store an additional $250,000 in short term (government) bonds (which have a solid yield these days), giving you a whopping $500,000 worth of protection under the SIPC.

Money Markets are also looking attractive these days, and keeping your cash in one, allows you to earn an interest, while having the cash available to you at any time, something you can’t usually get at your local bank.

As a bonus, if you have an IRA and a Roth account at the same firm, you get $500,000 worth of protection on each. This is a unique situation though, that only applies to these two types of accounts, other accounts would simply be combined for single protection of $500,000 worth.

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A quick note on SVB and how to prepare for what is next.

Silicon Valley Bank is pretty much toast, its all over the news, and there is little to cover in that area, since there is a plethora of articles, Youtubers, and news outlets covering it. What’s shocking to me, is the number of people concerned and who have lined up outside their banks. You want me to believe that all these people have more than $250K in their accounts as cash deposits (the maximum amount that the Federal Reserves covers per individual)? sadly that cant be true. In a country where over 50% of the population live paycheck to paycheck, this is nonsense, however people like sensationalist behavior, so be it.

All nonsense aside, SVB will be saved. Bigger banks will buy up what they can at discount, with the Federal Reserve ready to save what’s left. This is not 2008, and banks are well capitalized, with a very eager Fed ready to step in to save the big boys. The circumstances that resulted in the SVB mess is mostly due to rates. The rates are rising too fast and too many banks have been anticipating a peak or pivot, from the FED, hoping they can weather the slaughter that is poised to hit the economy. Unfortunately for them, that isn’t happening anytime soon. They simply own too many bonds at lower rates that they cant afford to sell for a loss.

More broadly speaking and what we have been preaching and expecting, the Federal Reserve wants unemployment to rise, but they will never admit to that. This is the only way to fight inflation. We either stay at full employment and have destructive inflation, or we tame inflation and sacrifice employment. These are the only two options we have, no matter what anyone else says. Demand destruction is needed to bring inflation down, and we cant have that with everyone employed and feeling rich from the bubble in Real Estate (what most people consider their wealth factor).

Rates will stay elevated, more cracks will appear, and we will end up with a slowing economy, even one with no growth for a while. There is much at play, but the last thing anyone should worry about is their money in the bank being lost. The Fed might even come out and raise the insurance on deposits next week to calm fears, but the fear is unfounded, at least as of now.

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Following the big money in Real Estate

There are patterns developing in the Real Estate market. Some are very clear and easy to see, others though are beginning to develop and need closer attention. With low rates having been around for so long and all the easy money available, the rate of building of new single family homes was clearly up. There will be a flood of new homes coming to market in the near future. This though is clearly tapering off, as interest rate hikes take a bite out of demand and affordability for most Americans. The money and demand is drying up, and there is already a notable drop in construction, as evidenced by the chart below.

This trend is very clear to see, and there is nothing new to ponder on. There is another trend though that needs our attention, and may be showing us what smart money is anticipating. Big money, is building multi family houses (5+ units) at the fastest pace in the history of the United States. Despite higher rates, they continue to break records month after month as they are predicting that most people will leave single family homes and go towards renting of a unit in this ever challenging environment/economy.

As you can see, there is no cooling off in the rate of building multi house construction, as there seems to be a shift developing in the housing sector. With close to 1 M of these under construction, the amount of choices that will be coming online (over 5 million units), offering a lot of competition, it makes sense that renting will soon be the more favorable option, as renting becomes a much better investment for people to consider versus buying a home, which is becoming less and less affordable, with a very rocky future (I’m predicting little to no growth for the next few years).

3 Years ago, the average price of a single family home in the US was $380K, with mortgage rates clocking in at 3.5%

Today, average home prices of a single family home in the US is $474K, with mortgage rates clocking in at 7.5%

The result is that the 20% down payment would see an increase of $18,800 today, along with an increase of 92% in the monthly mortgage, for the same house! ($1383 versus $2651). This doesn’t even take into account any taxes, insurance etc. which would all tick up.

The sustainability of this disconnect is hard to see holding, which explains why there is a massive shift in the direction of how things are going to look in a few years from now, and the smart money is fast adapting to this new environment.

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Real Estate Trajectories and Possibilities

Much like all other assets, real estate is currently very rich in its valuation. by very rich I actually mean ridiculously over priced. Another conclusion that can be reached is that upside growth in Real Estate is going to be a very labored trajectory in the years ahead.

We are clearly in a bubble in everything. The last housing bubble was in 2008. From the peak, in 2006, it took us close to 10 years to regain those prices. Real Estate prices simply don’t pop that hard back to back. The rise comes in small waves that should take years. The low which was achieved in 2012, took close to 6 years to reach.

This is clearly not 2008 and the situation is different. The variables are also very different. I’m not expecting a crash, simply because we don’t have a leverage problem. There is no oversupply of Housing either. Employment is at its highest level, and rates were so low a year ago that no one wants to sell. That’s the good news. Despite this being nothing like 2008, the similarity lies in the froth in the sector. We have to burn through that, and it has to be done via time, price, or both.

The bad news is that employment is at its highest, so any uptick in unemployment (something that the Fed is intent on doing in order to create demand destruction to fight inflation), along with the fact that (over 50% of Americans earning over $100K are living paycheck to paycheck), and the fact that savings are yet again at generational lows, means we are walking on super thin ice. The supply issue will easily be overcome as soon as people cant make their payments, regardless of what their rates are locked in at. The American consumer has the keys to this puzzle, and they are stretched thin.

It is important to remind everyone that Housing is very location sensitive. The East Coast and the West Coast will definitely see the biggest drops, while the Midwest will probably fare better since they had less of a crazy rise. The numbers that I am using are nationwide. Also houses at different price points will behave differently too. There will always be pockets of exception to that rule. I’m not interested in exceptions, since they don’t matter when we discuss generational shifts and macroeconomics.

Under no circumstance though, does a 40% increase in Real Estate in 2 years make any sense, and the outcome will be a painful 10 year slog, or a crash. I just cant see the crash scenario playing out, so this will be a long painful drag. The fact that we had a record number of Real Estate agents (over 1.5M) at the end of 2022 is a good indication of a super frothy Real Estate market. Real Estate was sure bet for many. The times of easy flips, easy gains, and annual withdrawals based on home equity loans has come to a screeching halt, and this will have a big effect on the consumer, and their spending habits. It is very difficult to make a case that real estate is anything but dead money for the next decade. Those who have a good eye, and a great location, will be in great shape if they can keep up with inflation. This is especially important since inflation is always underreported, and the numbers coming out are proving that this battle is long from over.

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2023 and what is in store

Two weeks into the new year and we have enough data to predict what we can expect for the year ahead. Unemployment is low, real estate is holding strong, and equities are holding the fort, absorbing the new norm, in preparation for the new Fed’s Fund rate of 5%. This is the story we are told. How much of this is true?

Lets start with Real Estate. One of the reasons why real estate was out performing so strongly the past few years, was because big money, via hedge funds, were buying them at any price, looking for any kind of return in a low interest environment. With the change in the environment, big money wants out, and they want out fast. They want out so fast, that withdrawals had to be limited! In an illiquid asset class, you just can’t liquidate on demand. This is a problem. Do I think Real Estate is heading for a crash? I doubt it. Do I think real estate is a good place to grow in the next few years? Also very doubtful. Real estate, at best is a dead asset class for the next few years. The possibility of outsized returns simply cant be made here. Every Doctor, lawyer, and engineer entering this business to rebuilt and flip will be glad they kept their day jobs.

Next up, is equities. Equities will be range bound. They wont crash and they wont explode higher. As predicted in the last newsletter, they will be rangebound for the year, at minimum. This will give the Federal Reserve cover, to keep rates elevated. Equities simply aren’t priced for growth, they are rich, and they have to absorb that growth either with a correction (unlikely due to the amount of capital available from people buying dips), or with no growth over a very extended period of time. Its dead money at best. Again, it doesn’t take a genius to make money in a rising market, the time has come to separate the boys from the men in this field. Stock pickers are in for a rude awakening.

Inflation expectations are finally under control based on today’s release, but its important to look at breakdowns. Food is still rising, while oil is the main reason why we got a break. A rise in oil prices in the months ahead can easily reverse this. This is also why the Fed is unlikely to pivot. This brings us to the next point. A lot of pundits are beginning to believe that this economy can actually sustain these rates. I’m not exactly sure how these people got their jobs, but these rates are absolutely destructive to the economy, and the cracks will show up in the months ahead. Historically, it took 6 to 12 months for rates that are set by the Federal Reserve to actually show up in the economy. The effect of the latest hikes have yet to even show up. Is it possible that the Fed, for the first time ever, is able to engineer a soft landing? and improbable as that may seem, we have to believe that it is possible. Being open to any outcome is what allows us to be flexible and ready for any scenario. As of right now, as usual, I have been early, but still on point. Portfolio stays unchanged.

Ill leave you with one of my favorite tweets on rates, from Taleb himself;

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The opinion of the smartest guys in the room

When I first started trading, back in the 90s, one phrase that used to get thrown around a lot, was that the smartest guys in the room were always the bond traders, which made watching bonds, really important. It immediately stuck with me, and I have delved deep into bonds ever since. It is with that understand and bias that I present to you, this eye opening chart

The chart above is a worrying one, we see the 10 year minus the 2 year, and it is at a disparity not seen since the early 1980s. Bond traders are seeing something that rest of the population is unaware of.

This kind of positioning is usually reserved for long periods of no growth, with bouts of deflation baked in. Will they be wrong this time?

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The USD and its current trajectory

This week, I want to take a deep dive into the USD and how this can play out, longer term.

Above is a 20 year chart of the USD. Besides today, there were 4 other instances where the price was this stretched above its 200 DMA. The distance between the two on all occasions, in percentages, are listed below;

November 2008; 16%

March 2009; 11%

June 2010; 11%

March 2015; 15%

As of today, that number is 13%. We are definitely stretched, but it can always go on longer that anyone anticipates, but we are close to a peak of some kind. More importantly, I believe the correction from this top will be more like the one in 2015, where I have drawn a box on the chart. Instead of a massive drop the more likely outcome will be a consolidation.

More importantly the forces at play here are slow. With the USD being so strong the rest of the world is going through a world of pain of their own. Other central banks will soon need to step in to support their own currencies and will need to get USD for this. The Federal Reserve does have a system in place to allow them to get dollars without the need to sell treasuries (thus avoiding a bond crisis), but the USD will become a bigger and bigger problem.

The real problem for the US would start if the USD falls fast, that would immediately result in a drastic rise in assets and the inflation game will kick into high gear again. In a lot of ways, the strength in the USD is why oil is trading in the 70s, which was a huge problem in the 100s. I’m expecting a solid back and forth for the foreseeable future, but in a volatile climate like today, nothing is easy to foresee.

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King Dollar and the uncertainty it creates

As of Friday, the Yen is at 24 year lows, the Euro at 20 year lows, and the British Pound at 37 year lows.

What a week we have had in the markets! For better clarity, I decided to break things up;

Equities

Equities are having a super hard time as rates keep rising. The 2 year treasury note now gives you 4% guaranteed. Money will slowly leave the volatile stock market and slowly build a small home with bonds. The 60/40 (I would even settle for an 70/30) ratio of stocks to bonds, something that I last saw in the 90s, could make a comeback if this persists. This will only create more headwinds.

Interest Rates

This week, we had the FOMC, and they indeed raised by 75 basis points, no surprise there. The Fed funds rate now sits at 3.0%-3.25%. By historical standards that’s still very low, but compared to the last decade, its incredibly high. Why is this important you may ask? and here lies the problem that few discuss. How high can they realistically raise? If I had to guess, it would be in the 5-6% range, and the rate limiting factor would be the national debt. As of last month, to service the interest on our $30 Trillion debt, we are paying close to 400 billion dollars a year, yes you read that right, it costs us over a billion dollars a day to service our debt. More importantly, a doubling from here, we would be close to a Trillion dollars a year in payments alone, and that’s a massive chunk, specially when all tax collections in 2021, when we were flying at peak economic output (or at least that’s what we were told), was a mere $4 Trillion. I don’t think we can survive a situation where a quarter of all taxes collected are simply going towards national debt repayment. The standard of living in the US would take a massive beating.

So what does all this mean? The runway is short, and the Fed is limited in what it can do. Even at its current 3% Fed funds rate, we can already start to see some slowing in housing, and more importantly, these things take time to show up in the economy. The results of these hikes usually take 12 months on average to actually show up in the economy. I believe the worst of this will be a year from now, I’m expecting a very difficult 2023.

Commodities

I still believe that commodities are the cheapest assets out there, however the caveat is that with rising rates, bonds will steal the show from commodities too, due to their yield. A massive correction can lead to all assets being sold and money being rearranged to include bonds in the portfolio. It is hard to beat a guaranteed 2 year note of 4%, I can only imagine how much harder this becomes when it gets to 5% or 6%. Interest rates have to cool off, their current trajectory is unsustainable, despite what Powell keeps pushing for. This level of hawkishness hasn’t been seen since even before my time, the 70s, when Paul Volker did the unthinkable. Thanks to a massive national debt though, we can’t do what he did with a fast and furious rate hike cycle.

The USD

It is no surprise to us that the USD has been strong, I’ve talked about this at length here, and it has since simply gotten better and better. The USD is backed by the biggest economy in the world, with the biggest and mightiest military. I’m not a war monger, but world reserve currencies have always been backed by the strongest militaries in the world (the struggles of Russia in Ukraine, simply attest to this). I see no challengers, for decades. To add to this, the rest of the world is a lot worse off than we are. The USD index clocked in at over 113 on Friday, it’s highest level since 2002!

This past week, The Bank of Japan, intervened to support their currency for the first time since 1998! To do so, they will need to sell treasuries and that only increases the demand for the USD.

The Bank of England and the European Central Banks simply don’t matter any more at this point. They are behind the Fed and will simply follow, the Euro itself is a dead currency for now. The Australian Dollar is too commodity dependant, and as long as commodities are under pressure, so will the AUD.

The USD is simply the only game in town, but that can become dangerous if demand out strips what there is out there, specially with the Fed trying to drain liquidity. This could easily open the door to more QE if the rest of the world remains on this trajectory.  If and when that happens, I’d change course and buy any and all assets.

Conclusion

There are a lot of moving pieces now and more and more variables are becoming relevant. Extreme caution is warranted, something that I’ve warned about for a while. Keep your capital safe.

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Winds of change?

For the past few months, oil and equities have been inversely correlated. This is quite natural, since the more expensive oil got, the less profit companies make since a lot of costs involve plastics, transportation, or simply power generation which all use fossil fuels. Even the conversion to EVs wont help this much, since a lot of hydrocarbons are used in the mining of battery components, plastics used in the interiors, and even the electricity grid relies on them when charging the vehicles. There has been very little change in our reliance on fossil fuels.

The oil to equities ratio however isn’t always perfect, and in our current economic standstill, based on the last few months alone, it seems like oil below $90 makes equities happy and when it goes above $90 it becomes a sensitive topic.

Oil prices being so important to manufacturing, thus plays a huge role in inflation. The question of where we go from here in terms of CPI and inflation numbers in general is an unknown as this is a long battle, and we discussed this at length here. The price of oil has gone down considerably since its peak, and this allows all expenses to take a breather, but this has no forecasting value, we cant predict on where oil will be a few months from now, which is what makes this market incredibly hard to trade. Its hard to see CPI/inflation numbers staying high with oil in the $80-$90 range as of last week. Lower inflation will certainly embolden equities to rally since they will be predicting a dovish Fed.

To make things even more interesting, despite the large percentage of oil prices having been determined by supply and demand, we must never forget the importance of the USD. The USD is taking a breather here, which is probably why oil started finding its legs towards the end of the week, but how far the USD corrects will probably determine how far oil rises too, which in turn plays a role in the price of equities.

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Don’t fight the FED

This has been the mantra of most traders for over a decade now. What this really meant was that the Federal Reserve will do what ever it takes to create inflation, and they did. The market fell into a mindset that they would always be rescued by the Fed put. The Fed made sure they dropped interest rates, and allowed the easing to create growth and inflation, in turn creating a lot of geniuses with stock picking and bottom calling, as they always stepped in to save the markets and allow them to rise. A lot of the rise in the markets were a side effect of inflation though. The massive Quantitative Easing programs added to the numerous amounts of stimulus, played a huge role for any growth projections. During these high flying times, it made sense to always buy dips, and no matter what you bought, chances were high that you benefitted from the Fed’s plan.

Times have now changed, and the Fed is intent on fighting inflation, which has gotten out hand. After all, the Fed’s mandate is simply inflation and employment. Where the equity markets, real estate, or global carbon emissions initiative end up, is none of their concern. We literally now have a purist Fed, intent on bringing down inflation back to the 2% mark. This will be painful.

The Federal Reserve has stated time and time again, that they want to create demand destruction, and we have talked about this on numerous occasions, and yet I hardly see anyone discussing this issue. They are staying the course and will maintain that, however, for traders that have gotten used to the old Fed who was trying to create inflation for the past 14 years, they don’t really know how to adapt. This market shall humble a lot of traders, and will crush a lot of portfolios, I have no doubt about this.

On Friday, during his annual Jackson Hole meeting speech, Powell was very clear, yet again;

Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.

Jerome Powell at Jackson Hole speech on August 26th 2022

Do yourselves a huge favor and read that paragraph from his speech twice. Does this sound like a man who would sway on what we have discussed time and time again here? I think not. Powell basically reiterated what he has continued to preach the last few months, that demand destruction is still all he cares about and the only means that he believes we can cool off inflation is the path that he is on. The USD has been unstoppable, but unfortunately oil is not cooling off, so inflation is still persistent. There is no pivot in sight until that changes. What is worse is that if the USD does falter, then oil would explode higher and we would be in real trouble.

As always, listen to the Fed, and don’t fight them. They are intent on creating disinflation (very different from deflation), and they will get their way, my advice has been to not fight the Fed, just like everyone else, but you need to first listen to them, before you know what you are fighting. Their message has changed, and those who aren’t listening will learn a painful lesson.

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The state of the USD vs the Euro

The dynamics in play for the US dollar remain the same as they were a few years ago. I wrote this piece, King Dollar, in 2017, and most of that still remains the same despite all the fear mongering about the death of the USD. If anything, the case for the King of fiat currencies has gotten stronger as the alternatives have gotten weaker. Today I will try and dispel the danger that Europe (Euro currency) ever did or ever will have on the USD. To date, in 2022, the USD has strengthened against the Euro by 12%!

Most of the strength of the Euro is basically carried by Germany. Most of the southern European countries simply provide the labor when necessary and are usually in need of bailouts just to keep up with their northern brethren (think PIIGS- Portugal, Ireland, Italy, Greece, Spain). This all works out fine as long as Germany remains strong enough, economically, to carry the majority of the load. This however has been shifting, and was recently exacerbated by the invasion of Ukraine. The pressure on Germany is immense and they are feeling it. Germany actually had a foreign trade deficit of $1 billion for the month of May. The last time this happened, was in 1991.

The need to import energy, and the problem with worldwide inflation that we are having is that countries that don’t have their own resources, and thus net importers, end up paying a hefty price. Germany is a great example of this with their reliance on gas on Russia. The German populace is already feeling the squeeze, but if the war doesn’t come to a ceasefire by itself before winter, I strongly believe that out of survival, Germany will push for it, no matter the cost to Ukraine (via giving up some of their properties in the east). Putin is winning the economic war with Europe, and it will only get worse this winter, its really hard to see the war go past the winter with Germany and even France (rolling blackouts) preparing for the worst. The timeline for this war is running out, as Europe will be forced to cave in.

The uncertainty with Europe, only increases the shine on the USD. The king of all fiat currencies has been on a magnificent run lately, as the world awakens to a need for a safe currency from a safe country, where the Fed is raising rates and securing its leadership. As the Federal Reserve raises rates, not only are they achieving demand destruction, which is healthy for the economy despite the short term pain, they are also making the currency stronger so that when they do pivot, they do it from a position of power. This also allows us to fight the inflation problem.

Unless the world goes into a depression (this is extremely unlikely), the direction we are going in, is a less globalized world. A less globalized world, where the uncertainty of a lot of governments and their currencies will come into play as they suffer the negative impacts of nationalization movements. The biggest problem with this movement is that it increase their need for a safe currency, that others accept and that they would agree to trade with, and currently, the USD is making a case for why its the leading candidate.

South American countries are the first in line, and they will all gravitate to the USD before considering any other currencies simply because of the long term relationships and the vicinity to the US. The majority of the world will either have to peg to the USD or simply rely heavily on resources to back their own currencies, if they have it.

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Is the worst of inflation behind us?

We had some insanely great, granted somewhat doctored unemployment numbers release last Friday, and this week we had a drop in the CPI (read inflation) numbers. We are now at 8.5% compared to last month’s 9.1%.

This is indeed good news. The markets have rallied violently since the release of this data on Wednesday assuming that peak inflation is now behind us, and that as inflation comes down, the Fed pivots, stops raising rates and the good time of easy credit shall return.

Will they though? allow me to introduce a few flies in this ointment;

  • The Fed actually wants a rate of inflation closer to 2%, even if peak inflation is behind us, we are a long way from that number. That could take us a couple of months or maybe up to a year to attain. There is no telling when we reach 2% inflation, and until we do, the Fed will not pivot to easing.
  • The strong Unemployment numbers and the beasty move up in equities only allows the Fed more room to raise, without fear of negative impacts. If the economy is ‘strong’ they can justify raising rates, as long as we use equities and employment data to justify it, which seems to be the case this week.
  • Based on the S&P PE numbers, the market is currently rich. The higher interest rates go, the more the market will appear expensive, since it would result in slower corporate growth and spending. This isn’t an immediate threat, but its a cautionary aspect that is ignored by many.
  • A drop in inflation doesn’t necessarily mean that the worst is behind us. The chart below is a great example of that, as we could make new highs in the CPI.
Its a different environment, thanks to low unemployment today, but these trends can switch quickly.

I like to always look for the cheapest assets to own, because in the end, the cheapest assets have the best chance of putting on gains in the long run. Currently, equities, and real estate (which I covered here), are both very well priced, if not expensive.

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How expensive is housing?

We have heard many stories in the media lately telling us how well-priced housing is and how it can’t go lower based on demand. There just isn’t enough housing they say. The demand is too high and there isn’t enough supply to fill the void.

That might actually be true, but the price isn’t just supply and demand. There are other variables, such as interest rates, unemployment, and even incomes. Indeed housing compared to income used to be my favorite metric of housing prices, but lately, that number has just fallen off, and there are some very good reasons why that has happened and this might actually help us explain what might be coming straight ahead for us.

The common rule of thumb has always been that your mortgage should not cost more than 30% of your gross monthly income. Another rule is that a house should not cost more than 2-2.5 x your annual gross income. With that being said, where are we today?

As of 2021, average gross household income in the US is $80,000. The average house price therefore should be anywhere between $160,000 and $200,000. The average house price though, in 2022, in the US is closer to $400,000. Is housing twice as expensive as it should be? Not so fast. The housing market is all about location, and it varies from $108K in West Virginia to $640K in Hawaii. So what does this all mean? Just that some states wont see much of a correction, while others could be in for some pain ahead. Historically speaking, the graph of housing income to Housing price looks dangerously inflated. There are several ways this can correct itself, either housing stops rising, and allows wages to rise (this would require a massive infrastructure spending along with an expanding economy, but our economy has been shrinking lately), housing crashes to affordable rates based on income (crashes are rare), or we just halt the rise of real estate until inflation in all other assets makes this asset attractive again (most likely and least destructive option).

No mater how we look at this, gains in Real Estate from here on out becomes less and less sustainable. Never call for a crash, since those are once in a generation occurrences, however the fast and furious rise in real estate that we have witnessed the past decade may be coming to an end, and real estate either cools off, or starts to underperform, relative to other assets and specially underperforms relative to inflation.

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The markets versus the Fed, who is right?

This was a pivotal week. We were expecting a -0.4% GDP growth, and the numbers came in more that 100% worse, at -0.8%. While the data was screaming recession, the White House, Janet Yellen, and Powell himself don’t believe that it is recession worthy. The Wikipedia page was altered tons of times this week, just to change the definition. Wikipedia literally stopped allowing edits!

So what does it all mean? The Federal Reserve met this week, and on Wednesday decided to raise rates again, and did so by another 0.75% to the current Federal Funds Rate of 2.25%-2.50%. Expectations would be for mortgage rates to rise and equities to drop to account for the higher corporate borrowing costs. By Friday, the exact opposite had happened.

The equity markets have rallied furiously, and interestingly, mortgage rates have dropped. This is the exact opposite of the effect that Powell was anticipating. This is the economy calling Powell’s bluff and thinking that he won’t be raising much longer, and that he will back off raising rates, and that the good times of easy credit will return as the Federal Reserve in their infinite wisdom realizes the errors of their ways and brings back QE.

Now it is imperative to pay attention to Jerome Powell claiming that he will continue to raise rates to fight inflation, as he reiterated during his press conference. If equities rally back to new highs, this could only be due to one thing, that inflation remains hot (there certainly is no corporate growth right now), and that will give him enough fuel to keep raising rates, creating the scenario for a shocked market that could result in brutal volatility and corrections.

So who is right? The market, or the FED? Jerome Powell is thinking and playing the long game. Usually rates take 8-12 months to show up in the economy, much like how it took a year for the stimulus checks and QE to show up as inflation, the natural duration cycle of policies showing up in the economy is usually a year. Powell hopes that higher rates slow down corporate borrowing, thus slowing down corporate earnings, creating a bit of unemployment, which in turn would create organic demand destruction in every facet of the economy. He has claimed as much in many of his speeches, yet everyone seems to be fixated on housing and consumer spending, and neither has budged. 2023 is when we see the result of these rate hikes, not now.

We also don’t have a Fed meeting in August, so the next time the Fed meets will be in September, and if the markets and commodities are any tell (so far), he will raise yet again.

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Real Estate, Rates and what to expect

I’ve been asked a few times, based on my last few posts regarding my expectations on where I think Real Estate is headed and whether people should be selling on buying. The following is how I see this unfolding.

With the Federal Reserve raising rates lately, the real estate market has definitely cooled off, or at least stopped its rip roaring rise trajectory that it has been on the past few years. Its just not realistic to expect double digit returns year after year, but what is reasonable? Well, Fannie Mae now predicts a 3% return in 2023, which might sound disappointing when they are still predicting 11% for 2022. This continuous rise that we have witnessed the past 10 years, which seems to be accelerating isn’t healthy.

Most homebuyers use a mortgage to buy their homes, only 10% of homes are purchased in cash. For the minority cash buyers, a drop in RE prices is a great thing, and yes, they would benefit, since a drop in RE (provided we do end up dropping) will directly result in owning a bigger home. For the other 90% though, its not that simple.

As the Federal Reserve raises rates (they raised rates by 0.75% at their last meeting), and they wont be slowing down much since the CPI (read inflation) is still high, clocking in at 9.1% (they want it closer to 2%), things are not looking good.

To a mortgage homebuyer, their monthly payment is much bigger determinant of a home size they can afford than the actual price. Lets look at a quick example for clarity.

On a $500K loan, with an APR of 6.5%, you are looking at a monthly mortgage payment of $3160. Now if the Federal reserve raises rates by 0.75% which is what they did at their last meeting, that payment jumps to $3411. That’s a 7% increase on their payment for the same house. What this means, is that this same house would have to drop by 7% just so that they can afford the same house! So if RE does indeed correct by 7%, meaning the new price of this same house coming down to $465K, with the new rates, your payment would remain the same. Quite the downer for everyone who has been waiting to buy a home for cheaper during a slowdown.

I hope the above example made sense, it is where I stand on this subject. That even for people who have been waiting for a correction, if it were to come, due to rising rates, they wont necessarily be able to buy a bigger house for the same money. They will simply end up owning the same sized home for the same monthly payment, which is the rate limiting step in 90% of homebuyers looking to get a mortgage to buy a house.

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The Dollar Milkshake Theory

This week, the latest CPI numbers were reported, a whopping 9.1%, notching in another 40 year high reading. What’s interesting though is how the USD is now in a runaway move, and getting stronger and stronger every day. Its almost at parity with the Euro which is pretty incredible.

The Dollar Milkshake theory is an interesting one, and it offers a much better macro understanding of the entire picture, specially one which explains the USD’s strength along with inflation.

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Inflation pain, and who to blame it on…Russia, Biden, or the FED.

Before you put on your political party hat and start throwing accusations and random facts, allow me to present to you a case which might often be ignored simply because its boring, or which lacks exciting options as a solution.

Sometimes a graphic/chart is the best tool to display causation. I present to you the following graph;

According to the politicians and economists who have been in denial the past decade, the main cause of Inflation today is the Russian Invasion of Ukraine. Although this is partially true, for the most part, its nonsense. Allow me to explain;

As you can see from the chart, we had growing inflation and we were destined to have major issues, which is why I still believe that the Federal Reserve missed their opportunity to raise rates in 2019. By the time 2020 rolled around, we had Covid-19 to contend with (red arrow), and soon after we had to ‘save the economy’ with massive stimulus, which started (at the green arrow) promptly, and ended 2020 with a combined 12.7 Trillion USD.

  • 5.2 Trillion USD specifically earmarked for Covid-19
  • 4.5 Trillion USD in Quantitative Easing
  • 3 Trillion USD geared towards Infrastructure

Let that sink in for a minute…compare this to the entire cost of WWII in todays dollars, which cost us 4.7 Trillion!

To say that we were careless, is to put it lightly. We were on the path to disaster way before Russia invaded Ukraine (brown arrow), and that’s mostly due to oil, which has only made the situation worse.

The Federal Reserve has been incredibly careless with stimulus and easing metrics, and now that it has caught up with them, they like to blame it on Russia.

To make matters worse, the Federal Reserve was buying Mortgage Backed Securities (MBS) up until June of this year! a program they restarted in 2020, worth $40 Billion a month, and yet we wonder why housing is so expensive. Since March of 2020, the Fed has purchased over $700 Billion in MBS, which is purely added pricing pressure where none was needed. The Fed now owns a combined $2 Trillion in MBS on their balance sheets! There was absolutely no reason that we needed to artificially elevate prices in real estate. Granted, the Fed has decided to stop this madness starting this month, but like all things when it comes to the Fed, its too little, too late. When they start unloading these assets, if ever, it will be a painful exercise. Today, we are dealing with the aftermath of this very poor management of the economy, exacerbated by the Federal Reserve, and yet we like to point to Russia.

The problem with ‘printing’ (it’s actually created, not printed) all this money, is that you don’t get to pick and choose where it goes, like the Fed thinks it can. You can support Real Estate, allow for its price to double but it gets to a point where it just cant sustain its gains, and the excess flows into other assets. That includes the stock market, commodities or a host of other assets (crypto). Right now the money has flowed into commodities in the form of inflation. You cant have housing double, commodities to double, and expect to pay less at the pump, that’s simply not how things work in real world economics. This might be the biggest problem with a Federal Reserve which is occupied by presidents who are all academics with zero real world economics experience. Our president might be old, and out of touch, but he isn’t to blame for the inflation.

The slowing economy thesis persists, as people strategize their spending based on their home values and their 401Ks…If either one of these stops going up year after year, then there will be restrategizing in spending habits, and that has a compounding effect on the economy’s ability to recover. We live in very interesting times, as we all try to predict how this will play out.

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Dr. Copper

A well known metric that old timer economists usually refer to, is Dr. Copper. The reason why they call Copper, a Doctor, is because it is viewed as a diagnostic/predictive element in readings of the health of the economy. The price of copper has historically been a good gauge of economic demand, and thus the health of the economy. In bad times, there is no demand for copper, so price falls, which is indicative of a slowing economy, and over time, this is a leading indicator of a recession. In the chart below you can see a historic chart of copper going back to 1960, and in every case the price drop of copper has been indicative of an economic slowdown.​

Granted, not all copper drops result in recessions, but all recessions have come on the back of a copper sell off. Since Feb 28th, copper has fallen from a price of $4.94 to $3.74 on June 20th. This is a huge drop. A drop of 24% in copper, while we have had the highest inflation rate of the last 40 years, has to be alarming.  It’s predicting that a recession, or at least a global slowdown is well under way. Just confirmation, if and when the Fed announces that we are in a recession (could be as early as the first week of July when we get GDP numbers). ​

For the record, the economy and the stock market are two very different creatures. They can split and go in different directions for a significant amount of time. If the Fed backs off to a more cautionary stance and decides to start QE again, it could bolster the stock market, while the economy continues to slow down.

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What a week!

This was indeed a pivotal week. This post is rather long, I have decided to delve a little deeper so everyone understands what is actually happening. There is a lot to cover, so grab your coffee, get comfortable, we are going to have a class on macro economics!

History

This is vital to understand why we are where we are today. Debt is our problem. There are 3 kinds of debt that we need to consider. 

  • We have bank debt, which was responsible for the 2008 crisis. That sort of leverage was reeled in, and no matter what the media says, the banks have actually been behaving, and managing their leverages well (no more silly loans). 
  • The second type of debt is consumer debt, basically credit cards, mortgages, car loans etc. and those aren’t looking too good, but are still manageable in my opinion. This can backfire in a recession as the problems will compound, especially with unemployment. There are small signs of layoffs, which is the start of the domino effect that could kick in later, but this could still be salvaged.
  • The third type of debt is the biggest one, its government debt. This is a big problem, and all that stimulus from 2 years ago has made it infinitely worse. The Fed’s balance sheet has been too accommodative, buying Mortgage Backed Securities well into an inflated housing market has been careless to say the least. Rates have been so low for so long, and have encouraged a lot of debt and speculative behavior. This in turn results in inflation, our so-called problem today. Inflation is actually manageable if we have growth, something that isn’t happening today (we already had a negative GDP reading).

Central Banks

An argument can be made as to why we even need a Central Bank in a free market economy where the market can set the rates based on supply and demand, but this is a heated argument that needs to be shelved for now.

  • The Federal Reserve has decided that inflation is running so hot that they need to act immediately and raised 0.75% (they did so this past Wednesday). Mind you, they said that this was not even being considered a month ago. This kind of behavior does not instill confidence. Inflation is on a runaway course, and forcing their hand. The bond market is becoming volatile and that’s not good for anyone. A volatile bond market can bring the economy to a halt. Sadly, it takes 6-12 months for most rate hikes to actually show up in the economy, and as it stands right now, 2023 could be a difficult year.
  • The European Central Bank is in a worse situation. They announced that they were going to cut back on QE this week (they are a few months behind the US, and in a much weaker position to act), and just 2 days in, the rates to borrow on government bonds in southern europe (Greece, Italy, Spain, Portugal, Malta) has shot up by as much 400%. Yes that’s not a typo, 4 fold! They have since announced that Europe is in danger of ‘fragmentation’. In case that doesn’t ring a bell, it means the European Union splitting up, the death of the Euro…imagine how bad things must look for a bank to even consider that!
  • Bottom line, these banks have made easy money a requirement for growth, and thanks to a 40 year bear market in bonds (lower and lower rates), this has become a huge problem. If and that’s a big If, the bond bear has ended, we could be due for years of just slower growth.

The US equity markets are in turmoil, and down a minimum of 20% on all indexes. There is little doubt that we are in a recession now, but nothing goes down in a straight line. We are due for a rally soon. The Fed has printed too much money for everything to just tank so we will see money being sloshed around from asset class to asset class, leaving behind destruction and volatility. Trading in this environment will be downright impossible.

Expectation

It’s hard to predict what happens next, since these central banks hold all the cards. Restarting QE, a massive drop in inflation, or a host of other unforeseen events can change the course of all expectations, however there are a few indications of what is already happening.

  • The strength in the USD against the Euro is unpredictable. Too many variables are at play along with unprecedented actions of a rogue central bank at play. Predicting the direction of currencies is a gamble at this point. This could just become another summer of 2011 where we had a currency crisis, but we are not there yet.
  • Equities are weak, mainly due to the inflation (cost of input rising), and a weaker consumer who is now scared of a recession and thus not spending like they used to. A lot of people watch their 401K to determine expenditures, and with market corrections, they end up shelving purchases at times. This has a snowball effect. A more frugal consumer might be good for consumer debt, and the consumer itself, but it’s bad for a service economy like the US.
  • Commodities have fared very well. My expectation is to continue to see them doing well, I know that we were early to our call for gold to rise, but when compared to most assets out there, they are doing incredibly well. Sometimes, in a recessionary environment, when assets devalue, any kind of value add is golden (pun intended).
  • Precious Metals will gain some of the rotation that will seek commodities as a safe haven, again, when or how much remains to be seen. The safety haven angle of gold has shined lately, as bitcoin and bonds were being hammered due to the equity sell off, so we are on the right track.
  • Oil is what the Fed is worried about and they are on a mission to create demand destruction. The Fed is thinking that by higher rates, people will back off from buying as many things, driving, flying, which will in turn drive the demand for oil lower, and thus drop the price of oil. Demand destruction in a dangerous game though, it’s incredibly difficult to reverse or control. For now, it seems to be working, as oil has backed off, and could be in for longer term consolidation/drop. I think the drop in oil and oil services companies will have a meaningful impact on slowing down the sell off in equities, if it is to persist.

All in all, these are difficult times where knowledge can only help you make better decisions. I hope this piece helped you understand a bit more of why we are where we are and what can happen next.

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Crypto (Bitcoin) VS Equities (SPY)

Approximately 2 years ago, 2020, the correlation between Bitcoin (GBTC) and Equities (SPY) was roughly at 0.65. Meaning they weren’t very correlated. (a correlation of 1.00, means we have a 100% correlation). This was right around the time where everyone was discussing what Bitcoin should be categorized as, either a currency, an asset, a safety haven etc. There was confusion and everyone had a valid argument, along with the fact that it was trading to its own tune.

Fast forward to now, June of 2022, and the past 10 days, show a correlation of 0.94 between Equities and Bitcoin. Something changed drastically in the past 2 years. Bitcoin is trading just like equities, so what caused this? My understanding;

  • Crypto has become legitimized, is now traded by major brokers, was added to the CME (futures trading), and is accepted as an instrument to be traded. This means that it is now no longer immune to market forces, and is also vulnerable to margin calls and short squeezes.
  • It is no longer considered a currency, and thus being viewed as an asset by the majority of the industry. No one uses it to purchase anything, most people intend on holding it and hoping to gain through higher valuation in the future, like other assets. Its simply another asset in a portfolio.
  • The fact that it has become an asset, it can be used as collateral, thus being very fluid in times of uncertainty. Margin calls from equities have resulted in margin calls in Crypto, which is the main reason why it isn’t considered a safety haven. This is also why the correlation has grown over time to Equities.

This market sell off has proven that Bitcoin is just another risk asset that trades in lock step with equities (for now).

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Why Silver

I wanted to explain why one should or shouldn’t own Silver. As of today, Silver is trading in the very low 20s. Do you know when was the last time it did this? Below is the list of all dates that Silver has crossed this same area ($20ish).

January 1917

January 1918

June 1968

January 1974

April 1982

August 1984

July 1987

February 2007

August 2009

September 2014

April 2016

August 2017

August 2019

January 2020

May 2020

May 2022

This is very unusual, specially for an industrial metal. Granted, technology has had a deflationary effect on mining but industrial use has been increasing too.

Manipulation is a term that has been thrown around, but this is the case with any illiquid asset. Big trading firms see opportunities and they take it. This is precisely why I like gold over silver.

What does this tell us? That in over 100 years, silver has barely budged. This is terrible in terms of an inflation hedge, but it’s also incredibly stable. 

Personally, I like precious metals as insurance, and much prefer gold over silver.

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Understanding Bonds, the USD and the current state of them both

The USD has been on an absolute run lately, and despite what everyone is telling you, it is actually the king of all fiat currencies.

The idea that the USD is weak or losing its status has been floating around ever since the Federal Reserve started QE (Quantitative Easing) in 2008. The fact is that the demand for USD is incredibly strong. The negative nellies have been wrong this entire time and will continue to be wrong for many reasons. I wrote about this, 5 years ago, and little has changed since then.

This brings us to the fundamental reasons for this, today. The bond market has been tanking. I believe it is the biggest fall since we started 2022, on record. As countries have been squeezed around the world, and have needed to inject aid into their economies due to Covid shut downs (they can’t all just print like we did), they have been forced to sell their reserves (surplus from years past that they stored in US treasuries). As they sell their stores of value, the supply demand equation tilts and thus there is an over supply of bonds in the market and so they fall in value, as demonstrated in the the chart below.

As they sell bonds, they get USD back, and that drains the system of US Dollars, and the same supply demand equilibrium is yet again affected, since there is a demand for the USD as countries suck it out of the system, resulting in a huge demand for the greenback. This has caused a massive rally in the USD, as shown below.

The Federal Reserve likes this, as a tool to fight inflation, which is why they have been very hawkish and raising rates aggressively. Unfortunately for the Federal Reserve, the one asset they wanted to control was oil, and yet the one asset that has held on strongest to its gains, and still trades above the $100 dollar mark is oil. We either need inflation to have peaked, or the war in Ukraine needs to end soon, or else a recession is a 100% certainty, and the rising rates continue to wreck the economy via an equity market sell off, a rising rates environment that will bring real estate to a halt, and a domino effect of a US consumer who has less and less money to spend on what drives this economy, consumerism.

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Risk on/Risk off

Back in 2008 I got on the precious metals trade and it was a life changer for me. I got lucky and was able to ride that wave, all the way till my early exit in 2011.

A very similar set up could be forming here. The attached chart displays the gold to equities (stocks) ratio over the past 20 years. If this is the bottom and a major low just formed a few months ago, one should expect equities to underperform precious metals for the foreseeable future. This does not mean a bear market in equities is starting or that they wont go up, what it does predict is that gold and precious metals in general should outperform equities as a whole.

Strap in, because despite being early to the trade, we actually got it at a lower price. Its good to be lucky sometimes.

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Oil and its inflationary trajectory.

It’s early, and I’d like to send out an educational note on the current situation on oil and its ability to determine the future of our economy, before the madness of the trading week gets going.

Tonight, oil just traded at $130 USD!

It was sometime last year when I started getting bullish on oil, with the caveat that if it got out of hand it could become dangerous. The attack on Ukraine and the sanctions that have followed clearly have thrown a wrench into the theory, and inflation plays a role here. I’d like to take a minute and explain this phenomenon that we have here today.

The premise of the oil bull market is a healthy expectation. This however could easily be destructive if obtained in a destructive manner. Allow me to explain;

Economic theory dictates that supply and demand resolve all mispricings. Demand goes up, price rises, resulting in more supply coming to market, meanwhile allowing oil refiners and producers to make more money, so everyone wins. This is a healthy bull market.

On the other hand, if supply can not come to the markets, the rise in price will result in an eventual drop in demand, which is a slow down. This is what leads to a recession, and is a destructive bull market.

The reason why we were bullish on oil was a healthy bull market reading, however, with Russia who is responsible for 5 million barrels of oil a day of production being sanctioned, this creates a very unhealthy and destructive ‘bull market’. A resolution and a crash in the price of oil is needed quickly, or else, these high oil prices will put an end to the massive economic expansion that we have had for the past decade.

Inflation usually leads to deflation, and deflation is recessionary.  The price of oil will need to correct, be it via new supply, or demand destruction. Which path oil takes to lower pricing will determine the health of our economy.