While all eyes are on the beach [Brexit], the great white shark from the movie Jaws has entered the pond [US NGDP]. I think that Brexit is not at all, from an American portfolio managers who has American assets, a serious issue. Contagion after 5 years of imposing stress tests on the US banking and financial industry and with Basel III implemented - while there may be globalization of investing, crisis going forward will be regional but for those which pose a threat to US national security.
Every week we publish a detailed report on the US Treasury curve (using 20s less 5s given the data availability as Fisher took a divot with shutting down the 30 years for a while) and derive the future growth in the US economy from that data. Right now it depicts an extraordinary situation.
While I think the over-all conclusion from this report is that the US Treasurys curve and rates are the results of one of the more entrenched long running policy error in Federal Reserve history, we have to respect the bizarre several sigma results it shows.
This Fed Reserve error is the continued low near ZLB rate despite the economy showing normal growth. And this is compounded by the large Fed balance sheet from QE II and III. The large amount of excess reserves shows that while the first $1 trillion of QE, concluded by 2010, was used in the system as excess reserves did not build, the second two tranches of QE II and III almost produced dollar for dollar change in the excess reserves. That resulted in about 2 ¾ trillion of the Fed’s QE having no effect in changing the output gap or dropping unemployment. Yet the Fed’s $4 trillion total balance sheet, most of increase being QE, has had impact on sector segmentation pricing and has induced “binding” which has the collateral value of the notes and bonds in QE being ever more important in pricing. https://research.stlouisfed.org/wp/2015/2015-002.pdf
But if the Fed is not in the midst of error then risky asset prices are very high now and the SP500 should trade at around 1400 area if the expected NGDP in the curve and forwards are forecasting the longest stretch of sub-par growth in the US in the nation’s history is our future.
Put simply, a 2 ¼% long bond is incompatible with a 2100 SP500 and it is pricing in periods of deflation.
Given the how fantastically grim these expected curves and NGDP are, I assume that it is monetary error ( I hope?) which given the clout and size of the Fed has been able to “paint the tape” to this date and could for a longer time. But given the size of the US economy it will sooner or later "roll over" the Fed, if the Fed does not correct. The error is sticky as now careers are attached in this very black view of the US, and if th US econ does roll over these monetary Malthusians, heads will roll. The first one to go would be Yellen. But I do not think the Fed is as strong as the BOJ was relative to the Japanese economy, where almost the same monetary policy resulted in 20 years of sub par growth to date.
For our portfolio this means we keep very close watch on the financials and we do not use the TLT or other long duration US Treasurys. This exposes us as the change to low negative correlation by US Treasurys during a business cycle downturn is a keystone for our portfolio. We are not alone - now the MetLifes and Bridgewater alike are finding it very difficult to use long duration US Treasurys which in the past were the keystone to either reaching excess return or provide an offset for business set backs. That is quite an issue for all nation's insurance, pensions, household savings, and banks.
This is a very severe monetary crisis - and hopefully just "monetary" and not a secular stagnation state that strikes to the core of the US economy.
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