Dropping Liv off at West Point tomorrow to start her great adventure. Making the most of our days before Beast (that’s what Cadets call summer boot camp). Then I head to Wyoming in July to climb mountains with Jackson and his brothers from Navy. Time is short. Presents an opportunity to hand wknd notes off to Marcel Kasumovich, our Head of Research, for the month of July. He’s a truly special human being, one of the top five minds I’ve encountered in all my travels, filled with wonderful market stories, life lessons, and sporting a few scars like all of us who dare reach. A wise soul. A talented communicator. And the former Chief Strategist for Soros, who helped George position for and successfully navigate the Global Financial Crisis. Like Mara has always been for me, she will be Marcel’s editor-in-chief. I’m so excited to see what they create together. Below is Marcel’s first edition:

Overall: “The Fed is “all in” on re-establishing price stability,” Fed Governor Waller pronounced in pleasantly direct language. “Experience has shown that markets need time to adjust to a turn from accommodation to tightening.” In response to questions, Waller spoke with blunt determination: “I don’t care what’s causing inflation, it’s too high, it’s my job to get it down. The higher rates and the path that we’re putting them on, it’s going to put downward pressure on demand across all sectors.” Powell offered his own sober message, “A soft landing is our goal. It is going to be very challenging. It has been made significantly more challenging by the events of the last few months – thinking of the war and of commodities prices and further problems with supply chains.” New York Fed economists provide a bit more precision, arguing that “the chances of a hard landing are about 80%,” starting in Q4 2022. Something will break. Something always does. Digital did and the regulatory landgrab has started in full force. Lagarde, with plenty of serious policy decisions ahead, observed that “crypto assets and DeFi have the potential to pose real risk to financial stability.” Spain’s Minister of Finance, Montero, announced digital asset owners would need to declare holdings and trading “in anticipation of regulations that would soon be carried out throughout the European Union.” The East-West divide is clear in policy focus. President Xi is focused on growth, vowing to “strengthen macro-policy adjustment and adopt more effective measures to strive to meet the social and economic development targets for 2022 and minimize the impacts of Covid-19.” Strains in emerging markets are being managed from within. Sri Lanka’s 22mm people are in the most severe economic crisis in nearly a century and India’s Foreign Secretary Kwatra underlined, “India stands ready to help Sri Lanka through promoting investments, connectivity and strengthening economic linkages,” beyond the $4bln aid already provided. The East-West center of gravity between global war and peace sits in Kaliningrad, a tiny Russian province pressed between NATO countries. Lithuanian President Nauseda offered that “Russia cannot be stopped by persuasion, cooperation, appeasement or concessions.” Elevated rhetoric continued when Russia’s Foreign Minister Lavrov drew comparison to Hitler’s war against the Soviet Union. “The EU and NATO are bringing together a contemporary coalition to fight and, to a large extent, wage war against Russia.”

One River Digital described the recent market panic in the context of pre-Fed history – they come fast and end faster [click here].

Week-in-Review (expressed in YoY terms): Mon: US holiday, Macron loses absolute majority of parliament after unexpected surge of far right support, Fed’s Walller confirms support for 75bp hike at July meeting, US rejects China’s claim that Taiwan Straight is not international waters, Yellen says some Trump-era Chinese tariffs serve no strategic purpose, S. Korea fin min says will act on FX market if necessary, ECB’s Centeno says committed to act on fragmentation risks, leftist Petro wins Colombian presidential election, China keeps 1y and 5y prime rates unch as exp, Germany PPI 33.6% (33.8%e), S&P closed; Tue: RBA gov Lowe dovishly tilted July meeting expectations to 25-50bp hikes (was 50-75bp hike), Biden says US recession isn’t “inevitable”, Fed’s Barkin says 50bp or 75bp should be on the table for July, Brazil CB signals that another hike is needed in August, Rehn says ECB is committed to containing unwanted fragmentation, Fed paper suggests greater than 50% odds of recession in next 12 months, Israel’s ruling coalition collapses – headed for 5th election in 4yrs, HK CPI 1.2% (1.6%e), Chicago Fed 0.01 (0.47e), US existing home sales -3.4% MoM (-3.7%e), S&P +2.5%; Wed: Germany triggers stage 2 (of 3) state of emergency gas plan (passing on higher prices to generate demand destruction), Biden asks congress for federal gas tax holiday for 3m, Fed’s Powell reinforced focus on tempering inflation rather than avoiding a recession, Czech CB hiked as exp (last meeting for outgoing hawkish gov), Fed’s Harker favors getting rates above 3% and then surveying outlook, Fed’s Evans says 75bp is very reasonable place for July discussion, UK CPI 9.1% as exp / Core CPI 5.9% (6%e) / RPI 11.7% (11.4%e), Canada CPI 7.7% (7.3%e) / Trimmed Mean CPI 5.4% as exp, EU cons conf -23.6 (-20.5e), Russia PPI 19.3% (34.9%e), S&P -0.1%; Thur: Norway CB hiked 50bp (25bp exp), Japan’s former FX head at finance ministry says intervention cannot be ruled out, soft European PMIs ignite recession fears / bond rally, German finance minister warns of “Lehman like moment” due to gas crisis, Turkey CB unch as exp, Indonesia CB unch as exp, Hungary CB unch as exp, Philippines CB hikes 25bp (as exp), Mexico CB hikes 75bp as exp, Fed’s Bowman supports 75bp hike in July, Fed’s stress tests show US banks continue to have strong capital levels, India CB meeting mins indicated further rate hikes, Ukraine granted candidate status to join EU, S. Korea PPI 9.7% (9.7%p), Singapore CPI 5.6% (5.5%e) / Core CPI 3.6% as exp, UK Public borrowing 14b (12b exp), Sweden PPI 24.4% (23.8%p), EU mfg PMI 52 (53.8e) / serv 52.8 (55.5e) / comp 51.9 (54e), US init claims 229k (226k exp), US mfg PMI 52.4 (56e) / serv 51.6 (53.3e) / comp 51.2 (53e), US KC Fed 12 (10e), S&P +1%; Fri: SCOTUS overturns Roe vs Wade, Fed’s Bullard sticks with hawkish stance and says too early to discuss recession probabilities, RBA gov Lowe says on a narrow path back to low inflation, US senate approved gun legislation, Lula leads presidential election polls, Japan CPI 2.5% as exp / ex Food 2.1% as exp / PPI services 1.8% (1.7%e), UK ret sales -4.7% (-4.5%e), Germany IFO exp 85.8 (87.4e), Brazil IPCA 12.04% (12.03%e), US UofM final 50.0 (50.2e) / 1y infl 5.3% (5.4%e) / 5-10y infl 3.1% (3.3%e), US new home sales 10.7% MoM (-0.2%e), S&P +3.1%.

Weekly Close: S&P 500 +6.4% and VIX -3.90 at +27.23. Nikkei +2.0%, Shanghai +1.0%, Euro Stoxx +2.4%, Bovespa -1.2%, MSCI World +2.5%, and MSCI Emerging -0.9%. USD rose +4.8% vs Chile, +1.7% vs Brazil, +0.3% vs India, +0.2% vs Yen, and +0.2% vs Indonesia. USD fell -10.7% vs Ethereum, -5.3% vs Russia, -3.3% vs Bitcoin, -2.3% vs Turkey, -2.3% vs Mexico, -1.3% vs South Africa, -1.1% vs Canada, -0.5% vs Euro, -0.4% vs Sweden, -0.4% vs China, -0.2% vs Sterling, and -0.2% vs Australia. Gold -0.7%, Silver -2.5%, Oil -1.7%, Copper -7.0%, Iron Ore -9.4%, Corn -8.1%. 5y5y inflation swaps (EU +11bps at 2.17%, US -5bps at 2.59%, JP -1bp at 0.80%, and UK +2bps at 3.81%). 2yr Notes -12bps at 3.07% and 10yr Notes -9bps at 3.14%.

YTD Equity Indexes (high-to-low): Turkey +10% priced in US dollars (+37.5% priced in lira), UAE +8.8% priced in dollars (+8.8% priced in dirham), Chile +8.2% priced in dollars (+15.7% in pesos), Indonesia +2.9% (+7%), Saudi Arabia +0.3% (+0.3%), Brazil 0% (-5.9%), Portugal -0.5% (+7.4%), Venezuela -1.4% (+15.2%), Singapore -3.2% (-0.4%), Colombia -4.7% (-3.2%), Mexico -7.6% (-10.4%), HK -7.8% (-7.2%), South Africa -9.7% (-10.5%), Thailand -11.1% (-5.4%), Norway -11.4% (-0.8%), UK -11.5% (-2.4%), Spain -11.8% (-5.4%), Canada -12% (-10.2%), China -12.6% (-8%), Russia -12.8% (-36.9%), Malaysia -13.3% (-8.3%), Greece -13.4% (-6.5%), India -13.9% (-9.5%), Czech Republic -15.4% (-9.7%), Australia -15.6% (-11.6%), Denmark -17.3% (-11.2%), Israel -17.8% (-8.6%), S&P 500 -17.9% in dollars, Argentina -18.2% (-1.1%), Philippines -18.8% (-12.7%), Switzerland -19.8% (-15.9%), Belgium -20.8% (-14.5%), MSCI World -21.1% in dollars, France -21.4% (-15.1%), Russell -21.4% in dollars, Japan -21.6% (-8%), Taiwan -21.8% (-16%), Germany -23% (-17.4%), Netherlands -23.3% (-17.2%), Euro Stoxx 50 -23.9% (-17.8%), New Zealand -24.1% (-17%), Italy -24.6% (-19.1%), NASDAQ -25.8% in dollars, Finland -26.2% (-20.6%), Korea -26.6% (-20.5%), Austria -28.3% (-23.1%), Ireland -28.9% (-23.3%), Poland -30.2% (-23.5%), Sweden -31% (-22.9%), Hungary -33.4% (-22.3%).

Liquidity Unknowns I: How much QT is too much QT? We don’t know. There is no tidy math formula, no general equilibrium model, no linear approximation that will tell you. The trouble is, in a world of false precision, everyone wants a number. And policymakers have a hard time saying, “we don’t know,” especially when it’s true. Through the week ending June 22, balances with Federal Reserve Banks – previously known as ‘excess reserves’ – stood at $3.115trln. Powell guided the market that the end point for the Fed balance sheet would shrink another $2.5trln to $3trln. How does that math work?

Unknowns II: Yet again new tools were needed in this cycle. To make sure rates didn’t fall below the Fed’s floor, they needed a broader mechanism to absorb excess liquidity. That mechanism was private sector access to the reverse repo facility. Remember the 2018 period of QT. Excess reserves were $1.9trln before liquidity conditions started to bite in September. Private sector reverse repos were basically zero. Today? $2.5trln. The Fed’s liabilities are acting as the riskless asset to private money funds in a way. The Fed clearly thinks reverse repos will decline. We don’t know. Behavior could drive it up if everyone wants liquidity and wants to face the Fed. As reverse repos rise, excess reserves decline. QT has more liquidity plumbing risk today – tools can turn into weapons.

Unknown III: The risks are different but the strategy with QT is the same – start small, increase gradually, and then let it run. It isn’t the obvious choice. Reducing the pace as liquidity is withdrawn is a more natural path – you typically slow as you approach a stop sign, after all. We will know when the tightening – both in liquidity and interest rates – has gone too far. Weak links will break. Digital plays the role of EM in this cycle – big enough to be noticed, not enough to get policy to stop. Asset deflation, a USD credit crunch, and risks from maturity transformation has led to capital controls with 11 digital intermediaries. As in the Asia Crisis, the ecosystem will respond to gain independence and resilience.

Unknown IV: Digital is the warning sign, not the circuit-breaker. Typical candidates – a rapid rise in the US dollar, EM currency and debt crisis, and banking strain – are just not applicable. After each crisis is a response, and those responses act like a vaccine against future ‘shocks.’ Emerging markets have insulated themselves with large holdings in the US dollar. Currency depreciation forced EM central banks into more orthodox positions well ahead of the Fed, ECB, and BOJ. Banks don’t have the space to make the mistakes of the GFC, with leverage financing pushed to capital markets. But markets have not been weaned from liquidity. To the contrary, each crisis has increased dependency on Fed liquidity.

Unknown V: The adjustment in broader markets is orderly. How else would it be? Disorder is how it ends, not how it starts. “It is like jumping from the 100th floor of a building and saying, ‘so far, so good’ halfway into the drop,” a prolific investor remarked when confronted with “contained” language head of the GFC. Liquidity transformation in traditional markets, the driver of digital weakness, is everywhere. And it is a so-far, so-good story. ETF discounts make the point emphatically. An illiquidity pocket means that ETFs would clear the way closed-end funds do – hunting for a price where a buyer is willing to absorb the liquidity risk. Mortgage ETFs are down 9.7% for the year and trade exactly on net asset value. So far, so good.

Unknown VI: What we can see is rarely the problem. The grandest mismatch resides in private markets. “Prior to the pandemic, many had already grown concerned about public market valuations and were exploring private capital markets in the hopes of addressing lower return projections for their traditional 60/40 portfolios.” Pronouncements like these became the norm. A generation of “J-curve” investors – the pattern of private investments to draw capital and then deliver rapid returns – was born. Everyone wants a liquidity buffer. Nobody has one. And in the everything bubble, to get one you are selling assets in the hole. You sell what you can. You promise never again, even if enticed by the Fed toolkit. Until it happens again.

Anecdote: The Ruffer Review 2022 brilliantly captured the unique state of the financial and economic cycles – ahead of the news. It is a reminder that the decisions confronting policy today are relatively easy. Unemployment is low and inflation is high. The solution is obvious and not met with political and electoral friction. Inflation will decline with recession. But then the hard choices arrive – long-term inflation control versus short-term growth. Politics will decide, policy will execute.

Winter is coming for liquidity, it’s coming for narcissism, it’s coming for retail punting, and it is definitely coming for businesses which depend on any of these things.

There are inflationary amplifiers in the system, too. Quantitative investors claim to have worked out which investments work in inflationary periods – apparently commodities and trend strategies are particularly reliable. Investor actions to preempt inflation can therefore bring forward both inflation and inflationary psychology.

The biggest of the new, inflationary supply side shocks is the transition to Net Zero. The Peterson Institute estimates that if carbon is priced at $100 [per metric ton], the resulting impact on GDP would be the equivalent to the 1974 oil shock, at 3.6% of GDP. While it’s dangerous to take this comparison at face value, it reveals the regime change implied by the Net Zero transition involves a deadweight loss with profound and potentially adverse macroeconomic consequences.

The system dynamic is biasing back towards heat pump mode [hot inflation]. But is faces a financial architecture which is intolerant of inflation. Financial market obstinance is multilayered. The list of intolerances extends to: rising interest rates and risk premia; declining flows (liquidity); and falling collateral values. The financial system wishes to believe in the narrative of lower interest rates forever.

So, when central banks assume that a 200bps rate rise from 0% to 2% is broadly the same as the one from 4% to 6%, they are not only wrong, but dangerously so. Convexity is rife in both prices and investor behavior.

Markets are unlikely to tolerate much tightening, of liquidity or interest rates. That’s why we should expect inflation volatility.

Good luck out there,

Marcel Kasumovich

Head of Research

One River Asset Management           

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.