Wednesday, November 22, 2017

Tax Cuts and a Weaker Dollar

The institutions are throwing caution to the wind and diving into risk.  In both stocks AND bonds.  When you have this much complacency and fearlessness, you see buyers of stocks and buyers of long bonds.  They don't want the shorter duration stuff anymore in fixed income, because the Fed is going to raise rates a bunch more times, flattening the yield curve, according to the "experts".

With bond, stock, commodity, and FX volatility so low, it encourages bigger positions in stocks and bonds.  The best way to get a big position in bonds is to go for the 30 year bond, the biggest bang for your buck.  The best way to get a big position in stocks is to go for Nasdaq stocks, also the biggest bang for your buck.  The S&P is at 2600!  Who would have expected that with revenue growth at 5%? Of course, US corporate profit margins are at all time highs and those who said it was mean reverting are saying its different this time.  This is due to quasi monopolies in existence in the US, thanks to the big corporations lobbying on Capitol Hill to extend and expand patents, keep competition to a minimum, etc.

And now you have the big time corporate tax cuts coming down the pike, which seems to be unpopular among those who actually have seen the proposals, which is a small minority, of course.  This should help corporations expand their profit margins further, at expense of a weaker dollar.  Yes, a weaker dollar.  Fiscal stimulus that lead to higher deficits with limited economic impact are dollar negative, not positive.  And this tax cut will just be another way for corporations to expand their stock buyback programs.  With individuals getting very small tax cuts, it provides limited economic stimulus.

The Republicans have deftly crammed down a very business friendly bill, at the expense of the value of the dollar, because the Fed will end up printing the money to pay for the deficits anyway to keep the Treasury's interest rates low.  If Japan can do it, for sure the US can do it with the world's reserve currency and a Fed that is a slave to financial markets.

If you follow the most likely course of events over the next 5 years, it is as follows:   You will have massive budget deficits, thanks to an aging population which raises Medicare and Social Security spending, and of course, the Trump tax cuts.  The proposal appears to have a giant loophole for individuals to incorporate themselves in order to benefit from the lower business tax rates for S corps and LLCs.  So the deficit will likely go up a lot more than projected.  Of course, the deficits which will be funded by Treasuries, will eventually be financed by Fed QE, when there is the slightest downtick in the economy.  And when Fed starts cutting rates again, the dollar will get destroyed and you have 2010 to 2012 all over again, as the Eurozone can't handle a strong euro.

Back to the current market.  It is a pig of a stock market.  There is no value.  It is what it is.  I am looking at a possible small short for Friday, as CNBC Fast Money seemed wildly bullish.  And is usually a sign that upside is limited.

But during this time of year, you may get a slight pullback in late November, early December, but that is about it.  You almost never see weakness starting from mid December to year end.  So if you want to short, you want to keep it short term, and the pullbacks will be small.  Next year will be the time to get aggressive on shorts, not now.  Tops usually last a long time, so the opportunity to short at high prices will be there for a while.  No rush.

Wednesday, November 15, 2017

Questioning the Effect of QE

The ECB will reduce their QE to 30 billion euro starting next year, and there are rumblings about the potential effect of central banks pulling back stimulus in 2018.  Unlike other investors, what is more of a dark cloud on the equity market is the high valuations relative to the growth rates. This overvaluation is conveniently rationalized by low interest rates, which is easily debunked when you compare the valuations of Europe and Japan versus the US.  If low interest rates are the reason for a higher multiple, then how come NIRP Europe and ZIRP Japan are priced cheaper in all valuation metrics compared to PIRP US? 

The light blue line is the S&P 500, the dark blue line is Eurostoxx 50.  Since March 9, 2015, when ECB QE started, the S&P has outperformed the Eurostoxx, 25.2% to 8.4%.  While the US was tapering and tightening, the ECB was pumping out 60 billion euro per month, and Europe still can't outperform the US.  So maybe QE isn't the end all, be all for the stock market. 

When investors can't understand why stocks are going up, the most convenient rationale is the expanding balance sheet of the global central banks.  Not many people question this belief, even though the divergence in US and European equity performance since ECB QE simply doesn't support the case. 

This brings me back to the current market.  Europe has been getting pummeled in November.  I guess there is no positive seasonality in that market.  The US has tried hard to ignore the scarecrow European market, going up on gap down opens for 2 straight sessions.  Today will market another day of a healthy gap down thanks to Europe.  Europe has usually been a good forecaster of future US performance, so this European weakness should foreshadow future weakness in the US. 

Perhaps the long awaited 3% correction comes after Thanksgiving, since the US doesn't like to selloff ahead of that festive time period.  So expect the market to stabilize soon, as Europe is approaching strong support levels in the Eurostoxx made post French election and late September, just above 3500.  S&P should stay above 2550, but be capped under 2600 till Thanksgiving. 

Sentiment wise, it feels a lot like fall of 2014, after the market V bottomed in mid October, and went straight up till end of November.  That was the last time I have seen this kind of exuberance and complacency for equities.  Investors spent much of 2013 and 2014 getting max exposure to equities, as the market complacency finally kicked in the internal greed algo.  Same as post November 2016.  I can picture a 2018 that will be an even uglier version of 2015, purely due to the extent of the overvaluation.  Remember, the higher they go, the harder they fall. 

Monday, November 13, 2017

Bonds and Stocks Going Down Together

An interesting thing happened on Thursday and Friday last week, which hasn't been common this year.  Both the stock market and bond market sold off.  While the drop in stocks isn't that much, the VIX has gotten perkier, going above 11.  The selloff in bonds wasn't trivial, the 30 year sold off 11 bps in 2 days, which is a large move these days. 

Bonds and stocks going up together is quite common, and so are stocks going down and bonds going up, or stocks going up and bonds going down, but both stocks and bonds going down is pretty rare.  I don't have the numbers this year, but I don't recall bonds going down this hard while stocks were also down.  In 2015, both bonds and stocks going down together was more common, as stocks topped out ahead a vicious correction in August-September, and then again in January 2016. 

Just another straw on the camel's (bull's?) back. 

We have VIX trading higher again this morning, and with the S&P hardly down on the day.  The long side seems saturated and the VIX sellers are feeling some pressure.  There is subtle sell pressure across asset markets, and this is something new for this market. 

On a side note, with CME announcing they will be introducing bitcoin futures later this year, I have noticed the extreme volatility over the past few days.  It reminds me of the volatility in late 1999 of the dotcom bubble.  Also the talk on social media has changed from calling it an outright bubble this summer, to more of an acceptance/belief of blockchain as a revolutionary technology.  Seems like bitcoin too is nearing its final legs of a bull market, although I do believe it will top out after the S&P, not before it. 

Thursday, November 9, 2017

Don't Ask Don't Tell Gap Down

These are the most powerful gap downs.  When no one knows why it's going down.  And in premarket, of all times.  Usually you are getting the no news moves higher in premarket, not this.  Don't ask, don't tell.

For the first time in months, I am seeing signs of buyer exhaustion as the Russell 2000 continues lower while the S&P continues higher.  The Russell finally couldn't keep it together and cracked on Tuesday, going down 1%.  A 1% move in any US stock indices is considered a big move now.  We are in that kind of low volatility grind. 

This week, the calm in the S&P has masked a Eurostoxx that is starting to lag, even with a weaker euro, continued lagging breadth in the US indices, as the leadership is becoming thinner.  And now this, a gap down for no reason. 

By the way, isn't tax reform supposed to be that great catalyst for another move higher?  Well, clearly the market doesn't think that there will be any significant growth boost from the package, as bonds rallied after last week's announcement, even as the S&P was grinding higher.  The flattening yield curve, as the 5-30 spread has gone below 80 bps, shows skepticism about future growth, as well as the ample liquidity out there in fixed income.  The money has to go somewhere.  And usually its either stocks and bonds.  And with stocks at these levels, there is a lot of money that needs to go to bonds to make a more balanced asset allocation. 

The equity fund flows are also flashing a warning sign, as October had heavy inflows.  It is feeling like the topping process has begun, and we should have a hard time rallying much more from here.  The only fly in the ointment is seasonal positive time period of November and December, which is amplified by the incentives to postpone capital gains due to possible tax cuts for 2018.  So while the topping process has probably begun, it should take a few months before we go down the mountain.  The bear suit has gathered enough dust, I will have to dust it off and put it on soon.

Monday, November 6, 2017

Heavy into Equities

Retail is heavily overweight equities.  The Fed issues a quarterly review of the financial accounts of United States which includes flow of funds and the levels of financial assets and liabilities for households.  The numbers surprised me.  I bought into the belief that more money flowing into bond funds and out of stock funds since 2008 was a rebalancing by households as stocks went higher.  But it pales in comparison to the amount that equities have rallied compared to fixed income.  It really has been a TINA market, There Is No Alternative.

In essence, for retail, as of 2017 Q2, they are holding more in equities ($16.9 trillion ) than checking, savings and money market funds ($1.1 + $9.1 + $1 trillion) and bonds ($3.9 trillion) combined.  For reference, in 2009 Q4, they held $7.2 trillion in equities, $0.9 trillion in checking, $6.7 trillion in savings, and $1.4 trillion in money market funds, and $4.6 trillion in bonds.  Basically, households have more than doubled their allocation to equities while reducing their allocation to bonds over the past 8 years.

What is interesting is that even at the peak in the S&P in 2007, household equities holdings was still at $6.1 trillion, which is less than at the end of 2009 ($7.2 trillion), when the S&P was much lower.  So it has been a long term trend of households rebalancing towards more equities and less fixed income over the past 10 years, regardless of what the stock market has done.

This runs counter to the claim that this is the most hated bull market in history.  The flow of funds is speaking loudly, and it is overweight stocks.

We have hit another new high today.  It's another day, another new high.  VIX is below 10, so no need to start looking for a top.  I will not try to pick a top and go short unless I see more volatility.  This is a nightmare market for shorts, and a pretty bad market for traders.  It is heavenly for buy and hold investors.  The trader's time to shine will eventually come.  Make sure you are one of the traders left with sufficient capital to take advantage of the other side of the mountain.  That is why I am doing very little here, especially in S&P.  I see a few opportunities here and there in other markets, but nothing to get excited about.

Monday, October 30, 2017

Fed Chair

The market has been waiting for Trump's Fed chairman nomination and the suspense was building up until Friday, when a trial balloon seems to have made it almost a lock that Jerome Powell becomes the next Fed chair.  Trump got what he wanted with the Powell trial balloon.  The stock market rallied strongly as did the bond market.  I am sure Mnuchin will be in Trump's ear telling him Taylor as Fed chairman will tank the stock market. 

Powell is a low interest rate guy, someone who follows orders, and I am sure Trump has asked him for a pledge to keep interest rates low if he were to be Fed chairman.  Unlike Taylor, Powell seems more interested than Taylor in playing politics and strategically being dovish to increase his chances of getting future government and corporate gigs.  That's why he was basically a yes man to Bernanke and Yellen.  That is why Neel Kashkari has taken the strategy of being the dovish outlier, the crazy dove who thinks rates should be lower in the face of near consensus rate hikes, complaining about the lack of inflation.  That is how he is able to get himself into the conversation for Fed chair nominee even though he's only joined the Fed board recently. 

By the way, on inflation, and the Fed still looking for that 2% inflation rate.  Well, good luck with that, because it is clear as day that the CPI and PCE inflation numbers have been so manipulated to the point that it can really only spit out low inflation readings unless there is hyperinflation.  Hedonic pricing, substitution, and "new" valued added features compensating for higher prices of goods, etc.  It was comical in the middle of  2008 to see the government pump out low single digit % CPI numbers as the dollar weakened against everything, corn went from $3.50 to $7.50/bushel, and oil went from $50/barrel to $147/barrel from 2007 to mid 2008. 

Anyway, the Fed chairman job, if Trump is looking for someone who will obey his commands and keep interest rates low, Powell is his guy. 

On Friday, we took a page out of 1999 and got a huge surge in the high flying big cap Nasdaq names, while the rest of the market was doing nothing.  It is a bubble, but there are so few of those high growth stocks remaining in this market that the supply just can't meet the demand unless prices go higher.  Even at these levels. 

Hoping (however, not expecting it) we could maybe get a sustained VIX rise for once, but it petered out again after the Powell rumors and Nasdaq surge on Friday.  Back to the same old low VIX grind. Again.

Thursday, October 26, 2017

Worried About Rates

Now we see Fast Money bring up the bond market excuse for stock market weakness.  This often happens late in a down move for bonds, as those who usually don't care about that market suddenly get interested, almost like passers by who stare  at two people yelling and pushing each other, and about ready to start a fist fight.

You've got to have a long term fundamental basis for your trades if you really want to be able to hold on through the volatility and drawdowns.  The current levels for bonds are quite compelling from a long term view.  I don't believe the global economy can take much higher rates, which means that rates can't go up much before the stock market has a tantrum, and in a circular loop, that will keep rates low.

But we live in a short term driven hedge fund world, so the short term price action can run counter to your long term view, even though the view is still valid.  While you are seeing stronger economic data recently, a lot of it is based on rebound effects from the 2016 slowdown, and the extra confidence boost provided by a rising stock market.

You cannot rule out the bubble expanding, especially since volatility is still low and it doesn't appear like we have topped out.  But longer term, beyond the next few months, into the next few years, you are looking at future stock market weakness, that could persist for quite some time.  The valuation levels just are too high for this type of earnings growth.  You are looking at a demographic headwind of Japan, Europe, and U.S. getting older, with many retiring and reducing consumption.  That is a powerful headwind that could only be held back by massive amounts of global QE, and that was just to keep the developed economies growing at low single digits.

At an S&P of 2560+, you are pricing a continuation of the past 5 years of steady growth because of low interest rates.  Yes, the monetary policy will be easy in the future and interest rates will probably stay low, but the market has gotten used to low rates, and priced it in, so that's not a positive catalyst anymore going forward.  Monetary stimulus works because you are changing conditions by making them easier, not by keeping them easy.  So just keeping rates low will not stimulate anything.  You will have to have growth, for stocks to keep going higher from these levels, and that will be harder to come by in the future.

Short term, this a hard market to trade, although buying intraday dips like yesterday usually works, at least until the dips become more frequent, in which case, the dips become more dangerous to buy.  We are not at that point yet, but a few more intraday down days like yesterday in the near future, and you will likely see that weakness go all the way to the market close.

Thursday, October 19, 2017

Waves from China

The trigger for the gap down today is the late day selloff in Hong Kong.  It is no coincidence that the last time we had meaningful sustained selling was on worries about China.  Hong Kong is basically a proxy market for foreigners to trade China.  We are just back to levels of last week, so this is nothing meaningful, but it does show you that the weak point for global equities markets remains in China, so that is where you have to look for signs of weakness. 

The top is a while away, and you will have these "scary" gap down days, this just happens to be on the 30th anniversary of the Oct 19 1987 crash.  So it puts a look of extra psychological pressure on stock holders today.  If we bounce right back within a couple of days, which I expect, then this down day only confirms future strength.  However, if we can sustain selling for more than a couple of days, then this market is giving us something to think about, which could be significant or not. 

The positive seasonality is hard to fight with the lack of volatility and persistent strength.  November is historically a strong month, and it is also the heaviest time for corporate stock buybacks, so definitely a tailwind for this market after earnings season is over. 

Not only is the stock volatility really low, so is bond volatility.  The MOVE index is hugging the lows for the year, even though rates have been trending higher over the past several weeks.  Usually, bond volatility tends to rise with rates.  It seems the bond market isn't too scared of a Fed determined to hike in December or a more hawkish Fed chairman.  That is basically the story of the year.  No fear and no action.

Monday, October 16, 2017

Grind Can Last a While

It is not at all unusual for the market to grind higher like this for several weeks in row, or even several months in a row.  It happened for nearly 12 months straight, with one brief interruption (in late Feb 2007), from August 2006 to July 2007.  It was a regular feature of the powerful bull market in the mid 1990s.  It just hasn't really happened since 2008, even with an 8 year old bull market.  You had regular meaningful dips from 2009 to 2016, which would scare out those who had 2008 flashbacks, only to V bottom higher.  This year, you had a few shallow dips, almost as if the dip buyers were so thick that they stopped the dips from getting deep.

It is the triumph of the dip buyers.  They have won. They have been so successful that the dips are now so shallow and brief, that even a 3% correction looks like a monster buying opportunity. 

When does it end?  You want to see a VIX that is rising when the S&P is rising.  That is the first and biggest clue.  You want to see less inflows into bond funds and more inflows into stock funds.  And you want to see China's markets do worse, because they often foretell broader global stock market weakness. 

It is a grind these days, and there is not much new to add.  I don't want to repeat myself, but the top is months away, so either be long (if you can ride bubbles) or in cash.  Just don't be short. 

By the way, I will be writing fewer posts with the lack of action.  If things pick up, I will write more.

Wednesday, October 11, 2017

On their A-Game

They are on their A-game.  I am talking about fund managers.  It is easy to not make big mistakes when you are making money.  An equity market at all time highs and a bond market that is stable is about as ideal an investing environment for institutions.  They will not do anything rash under these conditions. 

While you can question their long term positioning, in the short term, they are not making the mistake of puking out positions on a short term dip, because they have learned their lesson.  They realize it is a loser's game to set tight stops and regularly get stopped out, only to see the market reverse right away and go higher. 

It is a lot like poker players, when they are making money, they play more optimally and make better bet, call, and fold decisions.  There is no feeling of desperation to make their money back, so they can play more calmly and without need.  Usually those that are losing money start to play more hands, try to win more pots, and go on tilt.

Right now, the players in the game are making money, and not making any short term mistakes.  To try to make short term money in this market is like trying to squeeze blood out of a rock.  I would rather just play high stakes poker.  At least that game is more interesting than trading this market.

Here is the thing about playing the money game.  You have to want it, but not need it.  Those that can trade without a need to make money can play the long game, looking out months and years ahead.  Getting caught up in the day to day market action can often prevent one from catching the longer term opportunities.  That is where the real money is. 

Friday, October 6, 2017

Finding Distractions

Dabbling a bit in stocks, anything to keep me occupied and away from making any big trades.  There isn't much of an edge trying to make a stand here against this type of momentum, with the VIX so low.  This type of calm upward, relentless momentum reminds me of late 2006, early 2007.  If you remember, the market didn't top till summer of 2007, so if this market follows that analog, then we've got about another 6 months of uptrend remaining. 

We are seeing a lot of speculation in small cap stocks, which is also similar to what you saw in 2006/2007, as well 2014/2015.  They proceeded tops by about 6 to 12 months. 

So there are couple of very early warning signs that the clock is ticking.  But lots of time left before we hit the apex.  If you can't ride the bubble higher, just stay away.

Wednesday, October 4, 2017

Hedge Funds and Risk Tolerance

With the low volatility, the day to day trading edges are very slim.  Sure, these days there are a few small cap speculative stocks where you have insane and irrational moves, but there are lots of trading frictions in those markets, the difficulty in finding borrows, exorbitant borrow fees, extreme tail risk, and lower liquidity.  The liquidity is the big thing.  You can't move large size easily in small cap stocks, which limits the scalability of a strategy.  So that pretty much leaves either large cap stocks or futures/options.  Since the large cap stocks provide little leverage, futures/options are a much more attractive area for speculative trading. 

I recently heard that hedge funds are making a comeback, with inflows over $80B this year.  I also noticed that their YTD returns are 5.1%.  The SPX is up 12% this year.  Bonds are also up.  Once again, a simple 60/40 stock/bond risk parity strategy which can be put on for near zero fees is beating the hedge funds again.  I recently saw that a hedge fund of funds manager, Mark Yusko, made a bet with Warren Buffett that he could beat a SPX index fund in 10 years, net of fees.  I think Yusko will lose that bet.  Just because of the fees.  Even with the SPX highly overvalued, hedge funds are basically a more costly, lower beta play on the stock market. Hedge funds don't really provide alpha anymore, just damped down beta covered in a thin veil of secrecy to protect their 2 and 20 business model. 

The reason I bring up hedge funds is because they are the main reason there are short term market dislocations.  If you take away hedge funds, that removes a lot of the speculation in the futures and options space.  Most of the money going into mutual funds and ETFs don't make big bets on FX, interest rates, and commodity prices.  The hedge funds are there to provide more fuel to the fire, making trends last longer, going to prices they probably shouldn't go to. 

Most hedge funds in the futures space are trend followers, so in general, they will blindly buy strength and sell weakness.  In the past, when trends lasted a long time, it was a good strategy.  Nowadays with so many following the same strategy, as well as low inflation and money printing central banks, you don't have as many long term trends in FX, interest rates, or commodities.  So they have been getting churned and burned since 2008. The returns of the Barclays Hedge CTA index (survivorship bias inflates these returns) is basically flat since 2008, while the S&P has gone up over 200% in the same time period. 

These CTAs built up a lot of their record when the futures markets tended to have long trends, and before their strategy got overpopulated, splitting what little edge they got from following the trend with other hedge funds.

Whether it is hedge funds liquidating positions that have gone bad all at the same time, or piling into a position with a herd mentality, there are opportunities created in their trading.  But the only real way to capture those opportunities is to extend your time frame beyond the hedge funds' time frame.  The hedge funds' time frame is constrained by their inability to accept big losses, since institutions don't want a lot of volatility in a fund's performance. 

This is their big handicap. Risk tolerance.  Hedge funds cannot withstand big drawdowns, which means they have to cut their losses before they get too big.  This creates opportunities during their liquidations, because often, they are liquidating not because they suddenly discovered a fundamental change in the market, but because they hit their loss limit on the position and they had to get rid of it.  That is where the opportunity lies.

On the other hand, the individual trader can trade more aggressively and trade more optimal size because they can weather big drawdowns and don't have to worry about redemptions.  They don't have to puke out their positions as much.  Yes, sometimes the individual gets a trade wrong and has to get rid of it, but it should be based on criteria of market behavior and price action, not a loss limit.  Remember, the fastest way to grow your account size is to follow the Kelly criterion.  This exposes your account to big drawdowns, because you are betting your edge, basically. A 10% edge on a 1 to 1 bet calls for a 10% bet. A 99% edge on a 1 to 1 bet calls for a 99% bet! 

Most hedge funds can't bet that way.  They are reluctant to lose more than 2% on any one trade.  That is a big disadvantage.  They follow a much, much less risky money management strategy, which while safer, offers much lower potential returns.  This is why I believe profitable traders are much better off accumulating their own capital and trading it aggressively, rather than try to gather assets and trade more capital, but in the process be pigeon-holed by their investors' lack of risk tolerance.  Plus, its a headache dealing with all the paperwork and regulations of managing a fund.

I expect the hedge funds to be the ones to push this equity market towards its ultimate top, taking prices too high.  I also expect them to be the ones who liquidate their positions en masse as the trend changes.  That is what you saw in 2015/2016, and I think you see that again in 2018. 

Monday, October 2, 2017

Long Way to Go

The S&P just won't quit.  It is going to surprise the mean reversion traders here, as this thing will grind them to dust, as they look for that 5% correction.  The problem is, the 5% correction will probably finally happen about 10% higher than here.  There is nothing worse than being an early short in a bull market.  And pretty much anything except for shorting within 2-3% of the top is too early.  Which leaves a LOT of time for being early as a short seller. 

I don't know why this thing is going up. I just know that with high probability, we are nowhere close to the top, in both time and price.  The driving force higher could be a few things:  animal spirits, bubble psychology, and momentum building on itself.  It certaintly isn't improving fundamentals, not with the Fed looking to continue to raise rates.  Those tax cuts aren't going to move the needle unless they get everything that they want, which is unlikely.  And even if they did pass those huge tax cuts, the pain in the bond market from higher deficits and more Treasury supply would temper any stock market gains off the euphoria. 

These are the type of markets that favor those who are expert bubble riders, riding it to the top, and getting out when they sense the volatility rising and signs of a top building.  It is not easy, and its something I definitely will not do, just from the inherent vulnerability of a market that is trading so high with no fundamental backing.  I don't think we crack, but it does feel like being long is the equivalent of selling cheap put options.  And I don't use a put selling strategy. 

The only real comfort I can take from this type of market is that it is building up potential energy for the market to get exciting again when the SPX does finally top out.  I think that happens in spring/summer of 2018.  In the meantime, I will focus more of my energy on other markets which have better opportunities, such as bonds, commodities, or individual stocks.

Thursday, September 28, 2017

Big Tax Cuts are Dollar Negative

FX traders tend to base every currency based on interest rate differentials, and the difference of the near term policy direction of the various central banks.  The generally accepted view is that big tax cuts which provide fiscal stimulus should strengthen the dollar, based on its effect on monetary policy.  It is assumed that you get tighter monetary policy with tax cuts.  But that overlooks recent history.  

One of the main reasons the Fed started QE in 2009 was because it wanted to lower the interest rate burden of the large budget deficits after the recession, because large Treasury supply was going to have to be taken down, and the only way that was going to happen was either by selling at higher yields or by having the Fed by a huge chunk of the supply.  If the market had to digest all that supply at higher yields, you would have had an absurdly steep yield curve, higher rates for corporations and small businesses to borrow at, and higher mortgage rates that would be a negative for the housing market.

With the rising trend in mandatory spending on Social Security and Medicare, the budget deficits are set to rise substantially anyway, without any tax cuts.  You add the proposed budget buster tax cuts to the mix, and you will see $2 trillion budget deficits within a few years.  That is why the market didn't skyrocket yesterday on the Trump tax cut plan.  Rising interest rates with low GDP growth don't mix.  And these tax cuts aren't going to do much for GDP growth, as it's mostly going to those who will pile it back into savings in the form of stocks and bonds, not consumption.  

So what will end up happening is the higher interest rates will more than offset any fiscal stimulus from lower taxes, and when you get the economy slowing down, the budget deficits will skyrocket and you will get huge amounts of Treasury supply coming down the pipe.  The Fed will react like they always do when the economy slows down in the face of rising interest rates due to excess debt:  they will lower them, and then do another QE.  

So these tax cuts will eventually lead to Fed rate cuts and then QE in a couple of years.  Which will lead to dollar weakness, not dollar strength.  Tax cuts are a long term negative for the dollar, due to the higher budget deficits and subsequent larger Treasury supply.  Just look at how the dollar performed in the years after Ronald Reagan's tax cuts in the 1980s and George W. Bush's tax cuts in 2001.  

So if you see any large tax cuts pass, keep this in mind when it comes to the dollar.

Dollar Index (43 year historical chart)



Wednesday, September 27, 2017

A Budget Buster

Based on Trump's tax plan, there is no way the Republicans can stay within their budget guidelines of $1.5 trillion more debt over 10 years.  Politically, most of those deductions have no shot of getting eliminated, with the power of Washington lobbyists behind them.

But the bond market thinks that there will be huge debt fueled tax cuts. For Treasuries, it seems like shoot first, ask questions later at the moment.  This is definitely a budget buster, and will increase Treasury supply enormously over the next 10 years. With the trend of higher mandatory spending for Medicare and Social Security as the baby boomers retire, you could see $2 trillion annual deficits.  Without a QE, that will roughly quadruple the size of the Treasury coupon auctions.  And there is no way that much supply is taken down at these yield levels without a recession.

That is based on the premise that Trump gets everything that he's asking for.  That's probably unlikely, even though the Republicans are desperate to pass anything to save their hides in 2018 elections.  Most likely, the tax cuts get watered down, with no deductions removed, and the corporate tax rate gets cut modestly and you get a little increase in the standard deduction.

But the bond market is hating the uncertainty of a possible whopper of a tax cut passing, and with ECB tapering coming up in late October, a suddenly hawkish Yellen, and VIX hovering around 10, it is fragile times for bond investors.  Once the dust settles, you should get to lower bond price levels which should hold up, but the question is how much lower.  Worst case scenario, if the SPX keeps making new highs till year end, we could revisit 2.60% 10 year yields.  More likely, I think we get up to 2.40-2.50% and find a top there.

In SPX land, the realized volatility is at 3 over the past 10 days, compared to a VIX around 10.  So even at a VIX of 10, vol is actually expensive here!  Just horrible for the ES day trader.