“Davidson” submits:
Trade battles, algorithms and Modern Portfolio Theory coupled with traders who believe price trends reveal all they need to know makes a confusing investment environment when fundamentals differ widely from current market pessimism. The reliance on trading algorithms has come to dominate short-term market prices. 70yrs of Modern Portfolio Theory and massive computing power with traders believing that ‘markets repeat’ produces computer trading algorithms based on price-trends. It is the classic past-predicts-the-future thinking that drives this effort. The conflict occurs when events occur which have no precedent. Market perception by many is not aided by a myopic focus on simple relationships when global capital shifts the dominant theme away from ‘return-on-capital’ to ‘safety-of-capital’. The titanic battle between the US and China is rewriting decades of market history. Traders with their algorithms are caught in price tends signaling economic disruption and recession when economic indicators continue to signal economic expansion. History indicates that it is the economy which eventually dominates market prices given enough time. Those few investors who remain positive and disciplined should come though the current period as long as they are not spooked by media concerns.
The current environment can be explained in 7 charts. Short and long term histories of FedFunds and Treasuries explain the thinking of traders and the behavior of algorithms. The short and long term history of the Chinese Yuan/US Dollar exchange rate explains what traders and algorithms fail to understand. Lastly, several fundamental US economic indicators define how widely the current level of market pessimism differs from fundamentals. There is a significant investment opportunity for those who can visualize this difference.
The 1st three charts, one daily from 2012 and two monthly from 1954, explain the history of the Federal Reserve in setting FedFunds rates vs. T-Bill rates, 10yr Treasury rates and their rate spread. The Fed’s setting of FedFunds rates has a long history of following T-Bill rates by several weeks. The philosophy has been that FedFunds should be higher than the T-Bill rate to encourage borrowers to work out problems at market-determined rates rather than turn to the FedFunds Window for help. Economic experience set a pattern of the FedFunds following T-Bill rates after a lag. When rates were rising rapidly there were times T-Bills carried a higher rate than FedFunds and the Fed had to rush to catch up. The same occurred when markets feared recession driving rates lower faster than the Fed could adjust. Those who did not pay attention to this detail came to believe that it was the Fed which controlled rates. That the Fed controls rates is a fallacy that is widespread and persistent today. The facts shown by the data leaves no doubt that markets based on investor perceptions control rates. Not the Fed!
The rate spread between T-Bills and 10yr Treasuries (some use other maturities) has become an algorithm favorite for traders (think Hedge Funds). When the 10yr Treasury rate falls below that of the T-Bill is called an inverted yield curve. An inverted yield curve as the onset of recessions is well documented. Mechanically, the simple visualization is that banks lend and profit using the spread between short and long rates with the T-Bill/10yr Treasury a good proxy for these profits. A narrowed spread hurts profits forcing lending to decline after a period of economic expansion and a recession ensues. Algorithms were developed and began to incorporate this relationship as data sources became digitized and computer processing power soared. The actual thinking behind using the yield curve inversion comes from John Templeton who often said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” It was the ‘euphoria’ phase of the market cycle which drove T-Bill rates higher than 10yr Treasury rates indicating a high level of general optimism that resulted in unsupportable level of excessive economic activity that led to recessions. Algorithms have no means of factoring or interpreting euphoria. This time it has been pessimism not optimism that has been the driver.
This time it is different. The daily short and long term Yuan/US Dollar exchange rate histories are instructive. This part of the current investment cycle is experiencing a global capital shift as the US does battle with China over tariffs. The issue is much larger than most realize. Two decades ago as Western investors sought higher growth opportunities Emerging Markets became a key part of the equation. China, even with its Communist dictatorship, was believed to offer great opportunity. It was believed that by developing China as an investment market, higher performance could be realized and in the process China would submit to Western rule of law and be forced towards Democracy to participate. China appeared to be heading more towards a more open society as it participated in global trade and investment markets. Even though China remained relatively closed, the Yuan became stronger with foreign investment and investors thought they could see a shift towards democracy. Then Xi Jinping came to power Nov 2012. Shortly afterwards, under the ruse of an anti-corruption campaign, Xi consolidated his powerbase and the Yuan began to weaken. Some realized their capital was at risk and the capital shift out of China to Western markets began which began to drive Sovereign Debt and real estate yields in Western markets lower. Most have not recognized the magnitude of this shift to this day. Xi held a meeting of the Communist Party called the Third Plenum out of which a key document (“Document 9”), since verified, was smuggled outlining his approach:
“… many of (‘X’s) actions taken and techniques used under his year of leadership suggest a return to ideas and tactics that hark back to the days of Mao Zedong.”
“Document 9: A ChinaFile Translation” http://www.chinafile.com/document-9-chinafile-translation
China’s goal has been aimed at global dominance through any means necessary. Maintaining high tariffs against imports while ignoring property rights to intellectual property from trading partners was formalize in “Document 9”. The effort by the US to renegotiate lower tariffs and protections to intellectual property rights has been slow to evolve as Xi has firmed his control and lately attempted to take control of Hong Kong. Xi appears not to understand that Hong Kong is China’s ‘Golden Goose’ and the source of its financial strength and flexibility. That those in China do recognize this fact comes from the Yuan’s weakness as capital flows out of China and into the US. It is this capital shift which is driving US 10yr Treasury rates lower forcing an inverted yield curve during a period of strong market pessimism. Such sharp weakness in a country’s currency has always proven to herald the eventual demise of the leadership.
In my opinion, the current administration cannot accept China’s high tariffs and routine violation of US intellectual property rights to fund an increasingly autocratic government threatening international norms. It is too early to anticipate any outcome. My guess is we will continue to see capital leave China along with foreign manufacturing centers. Should China’s leadership persist, they will reap an impoverished nation having most of its cash flow derived from the US considerably diminished. That this trade dispute is not having much impact on the US can be seen in US economic Indicators.
The last two charts combine multiple economic indicators with the US$(US Dollar) for perspective. There has always been s a relationship between a stronger US$ and weakness in US Manufacturing. A stronger US$ makes US exporting of goods and services more expensive which slows US manufacturing activity and employment growth. While manufacturing is important, it does not dominate the US economy as can be seen in Real Personal Income and Real Retail and Food Service Sales. Even though today there is an inverted yield curve due to capital coming out of China, it has served to drive down rates but not depress broad economic activity which remains very much on trend. Note: the 2014-2016 period of US$ strength occurred during the past period of Yuan weakness and resulted in an Industrial Recession, however, the US economy continued to expand.
In summary, the economic trends in the US remain intact since 2009. The US trade dispute with China has had no discernable impact on the US economy. Inflation remains low, hiring remains high and US GDP continues to expand. The inverted yield curve represents China’s weakness and is not a sign of a pending recession. Every market cycle is different. One cannot predict where these differences will arise till we actually experience them. There is a long history of economic activity being the final arbiter of market prices even when temporary events and current perception are confusing. Each market requires consideration of the aspects of geopolitics with regards to Free Market activity. The Freer Markets always win over time even if it means simply severing trade with autocratic-command economies such as China.
Will the Fed cut FedFunds rate? Effective FedFunds rate is 2.12% while the T-Bill rate is 1.95%. To cut 0.25% brings FedFunds to the 1.87% range. The last cut had no impact on rates. A cut to 1.87% will not likely have any impact on market rates. Nonetheless, the Fed may think it should cut to meet the market’s perception that the Fed controls rates when it does not.
So…what will happen if the Fed cuts rates and nothing happens to market rates? Will the Fed’s status come into question as being in charge of rates? Will some investors panic thinking no one is in control? Will we eventually come to realize that the Fed has always followed not determined rates? Will we come to realize that markets determine rates and that perceptions have been wrong for 70yrs.?
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