“Today the enemy counts on popular demonstrations to strike the Islamic system,” declared Iran’s Supreme Leader, 83-years-old, in power since 1989, the year of the Tiananmen Square student slaughter and the fall of the Berlin Wall. Unrest tends to cluster. “The enemy hopes to turn the people against the Islamic Republic by psychological means, through the internet, money, and the mobilization of mercenaries,” continued Khamenei, seeking to quell Iranian protests over rising food prices, corruption, incompetence. Not all revolutions are sparked by food price inflation, but most are. Mass migrations too. “If, God forbid, these weapons are used against Russian territory then our armed forces will have no other choice but to strike decision-making centers,” warned Russia’s former President Medvedev, responding to Biden’s decision to supply Zelensky with M142 high-mobility rocket systems. Going to be a hot summer.

Overall: “My job as President is not to nominate highly - not only nominate highly - highly qualified individuals for that institution, but to give them the space they need to do their job,” announced America’s chief executive, ahead of a private meeting with Chairman Powell and Secretary Yellen. “I’m not going to interfere with their critically important work,” pledged the President, consumed by a desire to draw the clearest possible distinction between his own management style and that of his predecessor. Powell first hiked rates by 25bps to 1.75% in March of 2018. CPI was 2.36% that month, unemployment was 4.0%. Jerome’s final hike of that cycle came nine-months later, in December 2018, with CPI at 1.91% and unemployment at 3.9%. But Powell was also quantitatively tightening in late-2018, at a $50bln monthly pace, draining a pool of liquidity built up during a decade of bond buying. Trump was as unhappy as he was vocal. But those were simpler times. The secular stagnation years. Back when economists still thought every developed nation was turning Japanese. Robots were going to render blue color jobs redundant, white collar too, suppressing wages forever. Silicon Valley billionaires, haunted by visions of idle truckers, displaced by ubiquitous self-driving semis, raced to pen universal-basic-income whitepapers. In those years, the real reason our central bankers raised rates was so that they might have something to slash in the next economic downturn. It was certainly not to suppress CPI; inflation was barely an ember. Covid changed all that. Our politicians acquired the taste for extraordinary deficit spending, funded by the Federal Reserve. And where our central bankers once wondered what it would take to generate inflation, they now question what is required to contain it. “My plan is to address inflation and it starts with a simple proposition: Respect the Fed and respect the Fed’s independence, which I have done and will continue to do,” declared Biden, not yet halfway through his presidency, as deeply unpopular as was his predecessor, with inflation at 8.25%, unemployment 3.5%, overnight rates 0.75%, and a Fed Chairman only just now starting to quantitatively tighten.  

Paul Ebner, Portfolio Manager and Researcher for One River Digital published an interesting piece this week on the warp-speed nature of digital asset price adjustments and creative/destruction cycles [click here].

Week-in-Review (expressed in YoY terms): Mon: US Holiday, China continues to march toward reopening as covid concerns ease, Biden to hold Oval Office meeting with Powell, ECB’s Lane says 25bp in July and Sept are now benchmark pace of hiking, German impt prices 31.7% (31.8%e), Spain CPI 8.5% (8.3%e), Italy PPI 44.1% (46.6%p), EU economic conf 105 (104.9e), German CPI 8.7% (8.1%e), S&P closed; Tue: EU CPI 8.1% (7.8%e) / Core CPI 3.8% (3.6%e), EU agreed partial ban on most Russian oil imports – Hungary exempt, Hungary CB hikes 50bp as exp, US won’t send long range rocket systems capable of striking Russia to Ukraine, Biden announces 3 part plan to tackle inflation in rare op-ed ahead of meeting with Powell and Yellen, France CPI 5.8% as exp / PPI 27.8% (26.8%p), Italy CPI 7.3% (6.7%e), US Case Shiller Home prices 21.17% (20%e), US Chicago PMI 60.3 (55e), US cons conf 106.4 (103.6), US Dallas Fed -7.3 (1.5e), S&P -0.6%; Wed: BoC hikes 50bp as exp, BoJ deputy gov Wakatabe thinks BoJ should stick with its easing bias, Fed begins QT (runs off 30b UST / 17.5b agency MBS per month), JPM’s Dimon warns of an impending hurricane in markets, ECB’s Holzmann advocates for 50bp rate hike in light of record levels of inflation, China’s State Council mandates banks add 800b CNY in credit lines for infrastructure projects, Fed’s Daly advocates for 50bp at next two meetings, Fed’s Bullard supports the 50bp hiking path but reiterates desire for 3.5% by year end, EU unemp 6.8% as exp, US Job openings 11.4m (11.35m exp), US total vehicle sales 12.68m (13.7m exp), Russia ret sales -9.7% (-5.8%e) / unemp 4% (4.3%e) / real wages 3.6% (-4%e) / IP -1.6% (-1.1%e), S&P -0.8%; Thur: Fed’s Brainard says hard to see a case for a Sept pause and 50bps seems reasonable for June/July, early report that said Saudi is prepared to produce more crude to offset Russian output decline / OPEC then announces only 648k bpd increase in production – below the rumored increase, rumors that Biden will visit Saudi Arabia later this month, Hungary CB hiked depo rates by 30bp as exp, Hungary continues to make it difficult for EU to pass a ban on Russian oil as it adds to its list of demands, Indonesia CPI 3.55% (3.59%e) / core CPI 2.58% (2.7%e), Swiss CPI 2.9% (2.6%e) / Core CPI 1.7% (1.6%e), EU PPI 37.2% (38.2%e), US Unit Labor Costs 12.6% (11.6%e), US init claims 200k (210k exp), US factory orders 0.3% MoM (0.7%e), S&P +1.8%; Fri: US NFP 390k (318k exp) / US unemp 3.6% (3.5%e) / US AHE 5.2% as exp, BoJ gov Kuroda says looking for price rises and wage gains, Elon Musk stops all hiring and suggests Tesla needs to cut 10% of workforce as he has a “bad feeling about the economy”, Brainard shows support for 50bp hike in Sept if CPI and infl show no signs of cooling, McCormick concedes Pennsylvania’s US senate republican primary to Trump-backed Dr. Oz, Biden calls for ban on assault weapons and high capacity magazines, India reports biggest jump in covid cases in 3m, Turkey CPI 73.5% (74.7%e) / core CPI 56.04% (55.72%e) / PPI 132.16% (126.86%e), S&P -1.6%.

Manufacturing PMI (high-to-low): Switzerland 60 (previous 62.5), Netherlands 57.8 (previous 59.9), Canada 56.8 (prev 56.2), Austria 56.6/57.9, US 56.1/55.4, Sweden 55.2/54.9, Norway 54.94/59.9, Germany 54.8/54.6, Vietnam 54.7/51.7, UK 54.6/55.8, India 54.6/54.7, France 54.6/55.7, Brazil 54.2/51.8, Spain 53.8/53.3, Greece 53.8/54.8, Japan 53.3/53.5, Czech Republic 52.3/54.4, Italy 51.9/54.5, South Korea 51.8/52.1, Hungary 51.5/57.6, Indonesia 50.8/51.9, Russia 50.8/48.2, South Africa 50.7/50.3, Mexico 50.6/49.3, Singapore 50.4/50.3, Taiwan 50/51.7, Turkey 49.2/49.2, Poland 48.5/52.4, China 48.1/46. Services PMI: Sweden 68.2/68.2, Ireland 60.2/61.7, India 58.9/57.9, Brazil 58.6/60.6, France 58.3/58.9, Spain 56.5/57.1, Germany 55/57.6, Italy 53.7/55.7, US 53.4/55.6, Japan 52.6/50.7, UK 51.8/58.9, Russia 48.5/44.5.

Weekly Close: S&P 500 -1.2% and VIX -0.93 at +24.79. Nikkei +3.7%, Shanghai +2.1%, Euro Stoxx -0.9%, Bovespa -0.7%, MSCI World -0.8%, and MSCI Emerging +1.7%. USD rose +3.0% vs Yen, +1.7% vs Ethereum, +1.4% vs Turkey, +1.1% vs Sterling, +0.9% vs Brazil, +0.1% vs Euro, and +0.1% vs India. USD fell -8.2% vs Russia, -1.7% vs Chile, -1.6% vs Bitcoin, -1.0% vs Canada, -1.0% vs Indonesia, -0.6% vs Australia, -0.6% vs China, -0.4% vs Sweden, -0.3% vs South Africa, and -0.1% vs Mexico. Gold -0.4%, Silver -0.9%, Oil +3.3%, Copper +3.8%, Iron Ore -2.1%, Corn -6.5%. 5y5y inflation swaps (EU +17bps at 2.27%, US +13bps at 2.77%, JP +1bp at 0.76%, and UK -6bps at 3.88%). 2yr Notes +18bps at 2.66% and 10yr Notes +20bps at 2.94%.

May Mthly Close: S&P 500 flat and VIX -7.21 at +26.19. Nikkei +1.6%, Shanghai +4.6%, Euro Stoxx -1.6%, Bovespa +3.2%, MSCI World -0.2%, and MSCI Emerging +0.1%. USD rose +46.6% vs Ethereum, +23.8% vs Bitcoin, +10.4% vs Turkey, +1.6% vs India, +1.0% vs China, and +0.6% vs Indonesia. USD fell -12.9% vs Russia, -4.8% vs Brazil, -3.8% vs Mexico, -3.2% vs Chile, -1.8% vs Euro, -1.6% vs Australia, -1.6% vs Canada, -0.9% vs South Africa, -0.8% vs Yen, -0.7% vs Sweden, and -0.2% vs Sterling. Gold -3.7%, Silver -6.1%, Oil +11.4%, Copper -2.6%, Iron Ore +1.1%, Corn -7.4%. 5y5y inflation swaps (EU -27bps at 2.16%, US -9bps at 2.65%, JP +7bps at 0.80%, and UK -23bps at 3.88%). 2yr Notes -16bps at 2.56% and 10yr Notes -9bps at 2.85%.

YTD Equity Indexes (high-to-low): Chile +30.1% priced in US dollars (+24.2% priced in pesos), Colombia +23.3% priced in US dollars (+14.4% in pesos), Brazil +23.2% in dollars (+6% in reais), UAE +15.9% (+15.9%), Turkey +12.5% (+40%), Saudi Arabia +11.9% (+11.7%), Indonesia +7.9% (+9.1%), Portugal +3.3% (+9.6%), Singapore +1.4% (+3.5%), Norway +1.3% (+8.4%), Mexico -0.5% (-4.8%), Canada -1.5% (-2%), South Africa -1.6% (-4.1%), Thailand -3.3% (-0.6%), Australia -3.6% (-2.8%), Venezuela -4.9% (+4.7%), Spain -5.1% (+0.1%), Greece -5.4% (+0.4%), UK -6% (+2%), Argentina -6.4% (+9.9%), Malaysia -7.3% (-1.9%), India -8.3% (-4.4%), Philippines -8.7% (-5.4%), HK -10.4% (-9.9%), Israel -10.7% (-4.5%), Czech Republic -10.9% (-6.7%), Denmark -13.7% (-8.9%), Germany -13.7% (-9%), S&P 500 -13.8%, MSCI World -14%, Taiwan -14.3% (-9.1%), Korea -14.5% (-10.3%), France -14.6% (-9.3%), Switzerland -14.9% (-10.5%), Japan -15.1% (-3.6%), Belgium -15.1% (-9.9%), Russell -16.1%, Italy -16.2% (-11.6%), China -16.2% (-12.2%), New Zealand -16.7% (-12.4%), Euro Stoxx 50 -17.1% (-12%), Austria -17.2% (-12.7%), Netherlands -17.3% (-12.2%), Finland -18.4% (-14%), Ireland -20.2% (-15.3%), Sweden -20.6% (-14.5%), Poland -22.2% (-17.9%), NASDAQ -23.2%, Hungary -27.3% (-18.6%), Russia -28.8% (-39.1%).

Distortions: “Since 2010, Central Bankers became active market participants,” said Lindsay Politi, PM for One River’s inflation-strategy. “Uneconomic market participants with infinite balance sheets, seeking to distort market mechanisms for pricing of risk,” she added. “These distortions spread into all financial markets. Most people treat this tightening cycle like so many in the past. They tell us how equities behaved the last 5 times the Fed hiked. But this easing cycle has no precedent and undoing something so unique will not resemble previous cycles.”

Distortions II: “To grasp the differentiation, consider the most glaring QE distortion – negative yielding debt,” continued Lindsay. “At peak, there was $18.4trln negative yielding debt in public markets. For context, in Q1/2008 the total of the entire residential US mortgage market was $14.7trln, from 2004-2007 there were $1.4trln CDOs issued, and the size of Lehman Brothers’ balance sheet was $640bln at the peak,” she said. “There is still $2.5trln in negative yielding debt, and we’ve just experienced the worst first quarter for bond returns in history.”

Distortions III: “At the end of Q1 2022, global central bank balance sheets had shrunk slightly to just under $31trln,” said Lindsay, keeping close tabs. “This $31trln is made up of securities bought at uneconomic prices with the goal of smoothing activity and encouraging investment. It ended up just distorting financial market prices,” she said. “EU GDP is $15trln, global GDP is $84trln. To return balance sheets to where they were in 2010 at the beginning of QE would mean a sale of $20trln in assets, or roughly equivalent to selling the entire $24trln in US annual GDP.”

Distortions IV: “That wasn’t the intent of QE,” said Marcel Kasumovich, One River Head of Research, picking up where Lindsay left off. “Interest rates stuck at the zero lower boundary with downside economic risks left two options – break the glass on the lower boundary or use excess reserves to lower rates and encourage investment. It worked, just not in ways its architects expected. Investment surged in the longest duration assets – intellectual property where capital kept flowing. And investors extrapolated the benefits of IP far into the future.”

Distortions V: “Companies also borrowed aggressively in response to the decline in interest rates,” continued Marcel. “But the investment was financial, through share buyback programs – lifting US equity market values to more than 2x GDP, nearly twice the October 2007 highs. And while it is tempting to try and attribute this expansion in equity values to factors other than QE, it is not possible to know until we reverse the policy and observe how markets respond. That is clearly not to say we should adjust policy to get our answer, it is simply an observation.” 

Distortions VI: “A central bank balance sheet would ordinarily expand with demand for currency,” added Marcel. “What QE does is pull forward that expansion, distorting time. When QE stops, excess reserves decline with a rise in currency demand. In other words, QE front-loads expected future currency in circulation. With the Fed balance sheet now a mind-numbing 36% of GDP, it would take 17yrs at an average nominal growth rate of 4% to normalize the balance sheet to pre-pandemic levels without QT - another distortion embedded in financial markets.”

Anecdote: “Since central bankers are enacting monetary policy by acting like market participants, let’s analyze them like investors,” said Lindsay Politi, PM for One River’s inflation-strategy. “Central banks are the biggest whale in financial market history. And we’ve all seen what happens when a whale needs to exit. The catalyst is always an unaccounted risk, a surprise event, or an incorrect assumption,” said Lindsay. “Whether it’s a margin call that can’t be met, a risk officer shutting it down, or client redemptions; there’s a point where every ordinary investor is forced to liquidate.” If the position is big enough, a bubble bursts, and risks shift from being idiosyncratic to systemic. “While global central banks were building their $31trln portfolio, there was little concern about systemic risk because they don’t have the same limitations as others.” There is practically no limit to how much they can buy, no return target, no traditional pain threshold from market losses. “Because central banks don’t have stops like ordinary market participants it was assumed there was no stop at all. But central banks, explicitly or implicitly, have the same stop. They are required to respond to inflation,” said Lindsay. “And now they’re getting stopped out.” Because inflation is forcing the end of the QE trade, it will be the dominant driver of behavior for years, if not decades, as markets digest this unwind. “Central banks did not spend the 1960s deliberately inflating asset prices, so while inflation punished markets in the 1970s, it did not force a central bank position unwind. This is why analogs to the 1970s are tenuous,” explained Lindsay. “The full extent of the QE trade will be impossible to quantify except in hindsight because it almost certainly spread in ways that aren’t entirely clear yet but are surely staggering,” she said. “Sometimes in my role I’m asked to predict the future. But now, I think there’s more than enough value in being able to simply see the present clearly.”

Good luck out there,

Eric Peters

Chief Investment Officer

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.