Controlled Chaos

The summer is now over, kids are back in school, and the beach clubs are starting to take down the umbrellas. And what a summer it has been! Just 7 weeks ago the mood in the markets was downright apocalyptic. Stocks were meandering near their lows after a historically bad first half of the year. But as summer wore on the mood brightened and we witnessed the S&P 500 index bouncing nearly 13% off its lows, providing some breathing room for those who became fearful of opening their 401k statements. Using the 10-year note, Rates temporarily stabilized in the 2.50% – 3.0% range. And inflation tempered itself to some extent – but is still too high for those on tight budgets or fixed incomes and all those who still must overcome high food costs, medicine, and rents.

All those good summer vibes changed drastically however on the 26th when Chairman Powell delivered an 8-minute speech at Jackson Hole which essentially said, “we aren’t pivoting and are going to get inflation lower – regardless of the economic ramifications.”
The question repeatedly asked (especially daily on any financial news) is, was that just a temporary sugar high or the marked bottom of an ugly downturn and the resumption of another bull market that will carry us into 2023 and hopefully quell the stench that was most of 2022? If you spend three minutes on Twitter, you will be bombarded with charts or historical comparisons that either argues this is just a classic bear market bounce – sucking in buyers and will soon bash all hope against a rock wall, as has happened numerous times in the past, or it is truly different this time; is the sharp bounce that has occurred, followed by a sizeable pullback, more a reflection of a tight labor market, resilient consumers, and the notion that the Fed has already fired off their bazooka and will now resort to their pistol when determining further Fed policy?

Come September, the Fed’s balance sheet run-off will almost double to $95 billion per month. Which drains liquidity and is theoretically bad for assets. So the question on everyone’s mind is: How much if any of this is already priced into the various markets? Let’s keep in mind that the Fed issued its quantitative tightening schedule in early May and it has not, publicly at least, altered its intentions. We briefly touched on this in our mid-month note and want to reiterate it here due to what we feel is the top catalyst for the remainder of the year.

Again, we emphasize that the attempt to de-risk a nearly 9 trillion dollar balance sheet, while raising rates, with a wonky economic backdrop, has never been attempted in world history. It’s with that little piece of trivia that we would caution that anyone attempting to hypothesize what the future holds given the stated circumstances above, is literally guessing; sure, it’s likely an educated guess, but it’s still just a guess. The only thing that we would add is that the banks and dealers have known about the coming run-off of the Fed’s balance sheet for months now and we can only assume (hope) that they have taken the necessary steps to deal with it. Also, they have already gotten a smaller taste of the process seeing that there has already been a “phase 1” run-off underway, so would we assume the process won’t be too burdensome?

But that does not change the fact that liquidity is being withdrawn from the system. A lot of it, to be clear. We re-emphasize a) how much more there is to go to normalize (whatever that means) the balance sheet and b) just how little has been run off since the process started in June. Some will argue that the reverse repo market that is trading nearly $1.5 trillion per day will be the first to satiate a couple trillion of the runoff and will aid in the liquidity struggle. Guess we will wait and see if that does indeed come to fruition. The TINA trade (There Is No Alternative) was wildly popular during the quantitative easing portion of the show. And so far, at least judged by the first half of 2022, the quantitative tightening portion has been equally unpopular. But we would argue that equating both as equals would omit some obvious inputs. For starters, few are prepared to go to 100% cash at any time. Even with the recent jump in rates, the yields on savings accounts or even CDs locked up for 3+ years; CDs are barely 3% and still negative in real terms when factoring in inflation. Also, we live in a world that encourages risk, right or wrong. Free live quotes, instant access to mobile trading platforms, social media swagger, and 24-7 financial news, have all combined to morph financial markets into more of a sport than a place to park and hopefully
grow capital.

This was back on display briefly in August as the Meme traders returned with vengeance. The once left-for-dead group refreshed its online accounts and reengaged its battle with any small-cap stock that has a large short base. Some of the names included: Gamestop, AMC, Bed Bath and Beyond, Fubutv, and a handful of thinly traded Hong Kong tech stocks. This synopsis reinforces the theme that we, despite all the tough sledding in 2022, still have a penchant for risk. Sure, we aren’t all loading up on weekly call options in hopes of creating a gamma squeeze. But the bull market has left a lingering taste in our collective mouths and we aren’t ready to let it fully dissipate yet – despite the challenging macro backdrop. We fully embrace the risk-on mode, for it creates ample opportunities, increases volume, and stretches trading ranges. All positives for active traders who are willing to put in the time. Some may not like the gambling culture the Meme traders have created and find it reckless and financially irresponsible. And it is, for sure. But who are we to tell others how they should attack the markets? Why is one method more honorable than others? Just because it doesn’t fit your style or risk profile doesn’t make it wrong for others. The way we see it is if you pay your fare to get in, you can do whatever you please as long as you are willing to accept the consequences. We will let others debate the morality or integrity of the market discussion. That could go on forever, never coming to an agreed-upon conclusion. There are more profitable ways to spend one’s time. However…again, as we touched on in the mid-month note, the Fed cannot be happy seeing these pockets of unbridled speculation frenzy return to a market they had thought they tamped down with aggressive hikes in 2022. It was also interesting to see them parade various governors in the weeks following the meeting on the 27th in an attempt to convince the markets that the pivot narrative they took from the meeting was indeed misguided and the opposite of what they were saying. Well, the market listened, pondered it, and then decided to ignore the Fed for
a second time and continue to party on…until Chairman Powell re-dropped the hammer on the 26th.

So now we have a truly upset Fed that is in disbelief that the markets aren’t listening, or even more insulting, not believing them. We are fairly confident, especially after the Jackson Hole lecture that the tone in the press conference following the next rate decision on the 21st will be quite stern. Like a parent that is exasperated and grounds its child only to see the bad behavior carry on – or even worsen. Expect Chairman Powell to continue playing the angry dad role in September. To further add fuel to the Fed’s non-pivotal argument, the FOMC minutes released on the 17th provided some more clues as to what their current temperament is. For example, those who think the recent downturn in key commodity prices will aid the pivot claim should read below: (emphasis ours)

“Participants remarked that, although recent declines in gasoline prices would likely help produce lower headline inflation rates in the short term, declines in the prices of oil and some other commodities could not be relied on as providing a basis for sustained lower inflation, as these prices could quickly rebound. Participants also noted that the high cost of living was an especially great burden on low- and middle-income households. Participants agreed that there was little evidence to date that inflation pressures were subsiding” FOMC minutes, August 17th And then there was this little nugget that should at least give pause to those risking using the Fed pivot as their catalyst: “Officials judged that bulk of tightening effect yet to be felt.” FOMC minutes Now, to be fair, that’s not breaking news. Many economic studies have shown this to be true and it’s a widely held belief. So, it’s hard to believe that line caused any new thinking. But who
knows these days; with so much trading (70%+) being done via algorithmic programs anything is possible.

Some think the current inflation spike is due more to the after-effects of Covid supply-chain disruptions (and those still worsening thanks to China’s insane Covid practices) and to the Ukraine war that feels like it will drag on forever despite receiving less and less global
attention. But only if, and it’s huge if, these are one-off events that will eventually dissipate and lead us into a more normal environment (whatever that entails these days). So, if one is confident that high levels of inflation can be squashed quickly due to transient catalysts then a somewhat benign VIX makes sense here. And if the Fed agrees, which right now we would argue it doesn’t, then a 1970s Paul Volcker
jihad against inflation, the economy be damned, is not warranted. The Fed Funds Futures are now pricing in a 65% chance of a 75bps hike for the September 21st meeting.

The daily analysis of the economy is getting tiring, to be honest. Mounds of data, charts, yield curves, and historical comparisons are flung around the internet and financial news programs all day every day it seems. The yield curve inversion argument, which is very real on several metrics, the 2-10s garnering the most attention, has been in the markets for months now and has had little impact. But if you are in the camp that these inputs take 6-months to seep into the real economy then maybe the bear argument is still intact.
Regardless of opinion, the Fed will likely try and raise rates enough to create a buffer for future rate cuts if the economy does indeed concede to a hard landing.

Here are a few items to consider:
 The economy has contracted for 2 consecutive quarters – bad
 The unemployment rate is 3.7% and the last job two reports have exceeded expectations
– good. The participation rate is back to pre-Covid levels. – good.
 More companies are announcing layoffs – Wayfair and Snap being the latest saying they
will shed 5% and 20%of their workforce, respectively – bad.
 We’ve had warnings from Seagate, Snap, PVH, Dollar Tree, and Burlington-bad.
 Lululemon reported a blowout quarter and saw no weakening in consumer demand –
 Airlines, hotels, and Airbnb bookings have been and remain resilient. No recession in live
events. Live Nation has already sold more tickets for 2022 than it did throughout 2019.
Average ticket prices are up double digits on top of it. – good
 PMIs in Europe is weakening – bad. But the Manufacturing PMI here just came in at
52.8 – higher than expected and expansionary. Consumer confidence is much higher than
one would believe if they read the news – good.

There are numerous examples to cite on both sides of the coin. The point is it’s not as clear-cut, or dire, as some would like to make it. And we would argue that Fed policy remains the leading catalyst for markets, not the economy – as irrational as that seems. Bitcoin Update: This month one of the largest money managers in the world, Blackrock, disclosed that they were launching a private trust offering to institutional clients in the US looking for direct exposure to Bitcoin. “Despite the steep downturn in the digital asset market, we are still seeing substantial interest from some institutional clients in how to efficiently and cost-effectively access these assets using
our technology and product capabilities” -Blackrock press release, 8/14 That was the second bit of news this month concerning Blackrock, which has $8.5 trillion in assets, and cryptocurrency. On August 5th they announced their Aladdin investment the management system will partner with Coinbase to facilitate trading on their exchange – initially for Bitcoin with the plan to add other coins down the road. Again, in response to the customer demand to have access to these markets.

Blackrock has gone from being fully skeptical of Bitcoin, once referring to it as a convenient way to launder money, to now setting up vehicles for its clients to have exposure to it. That’s quite a turnaround for a firm that has a footprint in virtually every asset class in the world and deals with some of the largest, tuned-in players on the globe. Google, another rather big player, disclosed this month that they have invested $1.5 billion in crypto-related companies in just the past 9 months. Some of the names included Fireblocks,
Dapper Labs, Voltage, and Digital Currency Group. It was another month of solid news flow for cryptocurrency and it was met with another month of “blah” price action in response. Bitcoin had been holding steady above $21,500 – which was good. But also has not shown much enthusiasm for trading to $25,000 or above. This is an along-winded way of saying it’s in a tight trading range. There continues to be regulatory pressure on the cryptocurrency industry. This month the CFTC pushed to oversee most of the crypto spot markets and has bipartisan support for this action to eventually take effect. But there is still a wide swath of greyness when trying to determine which tokens may be considered commodities and which may not. We imagine that the argument will take quite a while to resolve itself – especially when factoring in that the government is involved.

It has been and will continue to be our position that the more regulation brought upon this industry, the better. Yes, that goes against the charter for which these digital currencies were created. But our stated reasons remain firm – the more regulation, the more acceptance, and adoption by larger institutions (i.e., Blackrock this month), and the more it will trade as a legitimate asset class and provide better liquidity, clearing options, eventually providing a new set of derivatives to trade. All good things for new asset classes looking for recognition. The two biggest stable coins by market cap, Tether, and Circle, disclosed this month that they now hold over $80 billion worth of short-term US Government debt and now account for almost 2% of the overall market. This is further proof that the stable coins have “considerable room to grow should stable coins become a form of digital payments” – according to JP Morgan Goldman Sachs and JP Morgan are quietly, but actively trying to convert Wall Street into the blockchain according to the Wall Street Journal this month. JP Morgan’s ONYX platform has processed over $350 billion in repo trades on the blockchain thus far, and Goldman traded over $100 million this month in European bonds over the blockchain, taking just one hour to settle versus the usual five days. Small potatoes in Wall Street parlance, but just another sign that despite the rough goings thus far in 2022 – innovation keeps moving forward. One of the biggest losers for us in 2022 has been silver and to a lesser extent gold. We have made repeated attempts to initiate a long position to hopefully catch a longer-term trend in a commodity that has been left for dead, it seems. So far, the biggest red flag in this paragraph is
the word “hopefully.”

Hope doesn’t belong in any trading or investing parlance. Hope is when you bet $50 on your favorite football team or get a potential date’s phone number. That is what hope is for. We know this and yet still have lost too much money this year “hoping” silver or gold would turn up and charge higher as it’s supposed to. under these macro conditions. It’s a classic trap that we allowed ourselves to enter even though in the back of our heads we knew it was indeed just that, a trap. Creating a narrative to fit your trade never works. It’s delusional on the highest level. The markets inform you quickly whether you are right or wrong; it’s then up to you to determine what to do next. But we aren’t going to quit looking at silver quotes. Just because one asset class doesn’t work well for a (long) time doesn’t mean we have to quit it. When looking at the macro-landscape, especially these days, it’s imperative that you use every input available to try and draw a picture that resembles any sense. Also, this bit of research that we came across from Data Trek this month was interesting and helped specify the extreme oversold nature of silver on a historical basis. The gold/silver ratio from 1985 to the present day is at extremes. The average over that time is 68:1, and the 2 standard deviations upper band is 93:1. The only 2 times the ratio has breached the +2- standard deviation levels were in early 1991 (at the start of the first Gulf War, 93:1 peak) and during the depths of the Pandemic Crisis (2020, 112:1 peak). The current geopolitical/economic environment, with Russia – Ukraine and inflation concerns, has taken the gold-silver ratio right to the brink of a statistical extreme. None of this means silver is finally ready to go on a mad upwards tear, but it does justify keeping it on the quote screen. Looking Forward and other Market Commentary: The “regular season” resumes in September. Vacations are over and skeleton staff at major trading desks and quant shops will be fully engaged now that the kids are all back in school. Seasonally, the next two months tend to be weak on average. September is statistically the weakest month of the year. But this year has already set some records regarding poor performance metrics on several assets (namely stocks and bonds), so let’s wait and see how much, if any, of the weakness has already transpired. September will be more of a macro month than a micro month. Earning season doesn’t start in earnest until mid-October. This month every single developed nation’s central bank will meet. The Fed meets on the 21st; but more importantly in our minds at least, is the ECB meeting slated for the 8th. Europe is a mess, to put it succinctly. Their real inflation rate is over 10% by most estimates. Energy prices have skyrocketed, mostly due to the Ukraine invasion and Germany’s heavy reliance on them for natural gas. Also, crop production is down all over Europe, also partly due to the invasion, and inclement weather.

Additionally, the ECB is woefully behind the tightening curve and the economies are contracting at alarming rates. Throw in the always difficult narrative that is the ECB -namely the 19 different countries that are members under one (unified?) umbrella. And to that point, when energy is expensive and scarce and inflation becomes an overwhelming concern amongst citizens, the ability of the ECB to unify its members for the “greater good,” as they say, becomes a much more ardent task. Currently, power in Europe is now equal to a $1,000 barrel of oil (per Bloomberg) and the rates across the EU are on the rise highlighted by the German Bund whose yield has gone from negative yields to +1.93% in just over a year. This stress has been reflected in the euro currency, which traded under parity with the dollar in August and shows no signs of putting in a meaningful bottom anytime soon. Maybe the announcement on the 8th will be the spark, although it’s hard to see any actions, aside from a massive rate hike (75bps is the rumor), that would satiate the dollar bulls. The recent unfortunate events in Europe and the continued inability of China to differentiate itself from an illiquid, mostly state-controlled nation have further dented the “dollar is dead” crowd chant that has resonated on mostly deaf ears for a sustained period now. And now with the Fed taking the global leader in responsible banking, the dollar has retained and strengthened so that it’s the cleanest shirt in albeit a dirty pile of laundry that has amassed over the last 10 years due to incredulous amounts of debt that have been layered on the globe. The death of the dollar camp is likely in for a long winter – as is Europe. As usual, the four biggest macro inputs for September will be the jobs report on the 2nd, the CPI on the 13th, the PPI on the 14th, and the PCE prices report on the 26th. There is no need to expound on these inputs. Everyone is laser-focused on inflation levels and these reports along with the daily monitoring of energy prices are front and center on everyone’s terminal or news feed. All we can say is that the current narrative is inflation has peaked and any data that refute this will not be looked upon kindly, especially in the bond markets. We came across an interesting chart this month that we wanted to share and briefly comment on because it serves two purposes. One, to take all the “bad” news that is pushed upon us with a grain of salt or, two, to just reiterate how much technology has helped the world advance on numerous fronts.

Crop production is down this year in various regions of the world, especially here in California. Europe is almost 50% drought-stricken and has real worries about meeting supply needs this winter and the recent annual Crop Tour completed in the last week of August showed some disturbing results, especially with corn. Water restrictions are increasing across the west and the levels at major lakes and dams are approaching truly frightening levels. With all that said, one would think prices of grains would be at or near all-time highs. But actually, they are anywhere from 10-25% off their highs. The graph below shows that we now can do more with less due to technology and the improvements in fertilizer and drought resistance seedlings. Companies like Bioceres are leading the revolution in farming and how we attack food production in this new climate-challenging world. This hardly means all is well and that we shouldn’t be concerned with the current circumstances around food security. We most definitely should. But technology and innovation are helping and are vastly underreported. Mostly because doom and gloom get more clicks than some story about an innovative fertilizer company.

Covid is over. Right? This month the CDC declared that quarantining after being infected with Covid-19 is now just “recommended,” as is social distancing. The Biden administration will stop purchasing vaccines and test kits coming this fall. Funding for $10 billion to fund continued pandemic response efforts in Congress have stalled and likely are dead until at least the midterms are over. Although, new Omicron vaccines have recently been approved for distribution. Southern California imposed mask mandates once again recently. Then they quickly rescinded the mandate and are back to normal. Here in San Francisco, masks are recommended but are rarely seen out despite most bars, restaurants, concert venues, and sporting events being packed. The share prices of Moderna, Pfizer, and Novax are all down 30% + from summer highs and look to have further to fall. Covid isn’t “over”; there are still cases reported daily and daily death counts are near 500 daily, and those unvaccinated or with comprising conditions are still at high at risk. But the point is that society and more importantly the economy has moved on. There was nary a word about Covid during the recent batch of corporate earnings conference calls. Supply chains have eased some this summer due to the lessening of restrictions on Covid protocols. But there is still one place where Covid is not over and that is China. Yes, China continues to promote its zero-Covid policy and is inexplicably locking down different cities, the latest being Chengdu, any time there is the slightest breakout, causing continued frustration amongst its citizens who are thoroughly fed up with living like prisoners. All this while their economy continues to contract, and their real estate bubble expands.
This month however China hit a new level of irrationality when they started testing local fish for Covid. At first, we assumed it was a headline from The Onion. But it wasn’t. It is just further evidence of how bizarre, and dare we say conspiratorial China continues to behave while the world attempts to heal and move on from the pandemic nightmare we have all had to endure.

Time for China to join the real world.