Podcast Summary
Banks face competition from other financial instruments: Households may shift funds from bank deposits to money market funds or treasuries due to potential safety and higher yields, reducing deposits in banks and increasing their risk
That banks are facing increased competition from other financial instruments like money market funds, which could lead to a shift in the composition of money and potential risks for depositors. Alf explained that while bank deposits are the most commonly used form of money for households, they can also choose to invest in money market funds or directly in treasuries. The safety and liquidity of these options depend on whose liability the money represents. Money in a bank is the liability of the government up to a certain amount, while above that amount, it becomes the liability of the commercial bank. In contrast, money in a money market fund or treasuries represents the liability of the US government, making them potentially safer options. However, these alternatives may offer lower liquidity compared to bank deposits. The ongoing trend of low interest rates and the availability of higher yields in alternative investments could lead more households to consider these options, potentially reducing the amount of deposits in banks and increasing their risk.
Choice between risky bank deposits and safer alternatives: Households shifting funds from deposits to safer investments can decrease money velocity and real economy money, leading to economic slowdowns or liquidity events.
The current economic environment presents households with a choice between relatively risky bank deposits and safer alternatives like money market funds and treasuries. This shift in funds can lead to a decrease in the velocity of money and a reduction in real economy money, as deposits that could be used for spending are instead allocated to financial sector investments. Additionally, quantitative tightening is shrinking the amount of both real and financial economy money by reducing bank reserves and limiting fiscal stimulus. This dual decrease in money supply can lead to economic slowdowns or systemic liquidity events. The European Central Bank's recent rate hike is an acknowledgment of this trend towards higher interest rates and the potential for prolonged inflation.
Central Banks Beyond the Fed Adjusting Monetary Policies: ECB faces economic unity challenges, Canada and Australia deal with housing market and private debt fragilities, leading these central banks to be more cautious about raising interest rates compared to the Fed.
While the Federal Reserve remains steadfast in its monetary policy, other central banks, including the European Central Bank (ECB), Bank of Canada, and Reserve Bank of Australia, are becoming more nuanced due to inherent fragilities in their respective economies. The ECB, for instance, is grappling with the economic unity of 19 jurisdictions under one monetary policy but disparate fiscal policies. Canada and Australia face fragilities in their housing markets and private debt levels. These central banks are more cautious about raising interest rates due to financial risks and instability. In contrast, the US economy, bolstered by an unprecedented stimulus, is in a better shape, and the dollar's central role in the global economy makes it less vulnerable to early stress. As a result, central banks with inherent fragilities are more likely to pivot from their current monetary policies earlier than the Federal Reserve.
ECB's Inflation Mandate vs Financial Stability Risks: The ECB must balance its commitment to fighting inflation with financial stability risks to avoid worsening inflation or causing economic pain for households.
The European Central Bank (ECB) faces a challenging decision regarding its inflation mandate and financial stability risks. If the ECB focuses too much on financial stability risks and becomes less committed to fighting inflation, real interest rates may drop, leading to increased borrowing and economic activity. This could potentially worsen inflation, as seen in the 1970s. On the other hand, if the ECB takes a firm stance on inflation, it may cause economic pain for households through higher interest rates, a cooling housing market, and lower stock prices. Navigating this complex situation requires careful consideration and a balanced approach. Ultimately, the ECB must weigh the potential consequences of each decision and communicate its intentions clearly to the markets to avoid unwanted volatility.
Staying Informed About Financial Markets with Yahoo Finance: Investors use Yahoo Finance for company news, account tracking, and research. The Fed's upcoming meeting has market speculating potential interest rate changes and response to demands for a pivot. The ECB used TLTROs to maintain credit flow during the pandemic. Inflation remains a concern, and the Fed's credibility is at stake in bringing it down.
Staying informed about the financial markets is crucial for investors, and tools like Yahoo Finance provide valuable insights, such as company news, investment account tracking, and research. The upcoming Federal Reserve meeting is a significant event, with speculation around potential interest rate changes and the Fed's response to market demands for a pivot. The European Central Bank's approach to addressing the fragile European economy during the pandemic involved targeted longer-term refinancing operations (TLTROs), which allowed banks to borrow cheaply from the ECB and maintain the flow of credit to economic actors. Inflation remains a major concern, and the Fed's credibility is on the line as they work to bring it down.
European Central Bank's TLTRO and its impact on European banks' reserves: The European Central Bank's TLTRO led to an arbitrage strategy by European banks, but as borrowing conditions became less favorable, banks had to repay loans, causing a decrease in reserves and potential reduction in liquidity in the European financial system.
The European Central Bank implemented a Targeted Long Term Refinancing Operation (TLTRO) during the pandemic to encourage European banks to keep their lending books stable and maintain the flow of credit to the private sector. Banks took advantage of the negative borrowing rates and engaged in an arbitrage strategy by borrowing at negative interest rates and parking the reserves back at the central bank. However, as the post-pandemic period approached and the European Central Bank aimed to curb inflation, it announced that borrowing conditions would no longer be favorable. This forced European banks to repay the loans, leading to a shrinkage of the European Central Bank's balance sheet and a decrease in reserves in the banking system. This reduction in reserves may result in less liquidity in the European financial system and make banks more conservative in their risk-taking and asset allocation. Additionally, the 1-year, 1-year inflation swaps minus the US year-over-year CPI ratio indicates that the market expects a significant drop in US inflation. The speaker emphasizes the importance of considering market expectations when forming investment strategies.
Bond Market Expects Inflation Drop but Markets Don't Always Get it Right: Despite bond market predictions of significant inflation slowdown, factors like lingering credit injections and long-term trends could impact inflation trajectories, and monetary and fiscal policies will continue to shape inflation cycles.
While the bond market expects inflation to drop significantly in the next 16 to 18 months, it's important to remember that markets don't always get it right. The pace and extent of the inflation slowdown trade depend on various factors, and there are differing opinions among experts. One argument is that the massive amount of credit injected into the economy in 2020 and 2021, which leads inflation by roughly 18 months, is now at historically low levels. This means less money is reaching the private sector, leading to a potential slowdown in inflation. The speaker also suggests that while long-term trends like deglobalization and a shrinking labor force may contribute to inflation, these trends take time to unfold. In the meantime, cycles driven by monetary and fiscal policies will dictate inflation trajectories. The speaker's recent shift in stance from holding cash to going long on treasuries and potentially shorting equities may reflect this view.
Consider shifting to defensive assets as economic conditions change: Investors should consider allocating to bonds and gold as inflation may decline and earnings and economic growth disappoint, drawing parallels to market conditions in 2001.
As the economic landscape shifts and inflation may begin to decline, investors may want to consider shifting their asset allocation towards defensive assets like bonds and gold. This advice comes from Stavros McCurum, who draws parallels between the current market conditions and those of 2001, when inflation was high and the Fed's ability to intervene was limited. McCurum also notes that earnings and economic growth are expected to continue to disappoint, making defensive assets like bonds and gold potentially attractive. Additionally, McCurum points to similarities between the current market and the dotcom bubble of 2000, including excessive risk-taking and irrational behavior. As the labor market begins to slow down and earnings continue to deteriorate, McCurum expects some asset classes to start delivering positive performance, even as others continue to struggle. Overall, McCurum suggests that investors should be cautious and defensive in their investment strategies as the economic cycle shifts.
Central banks lowering interest rates during economic downturns make bonds more attractive: During economic downturns, bonds may outperform equities due to lower interest rates set by central banks, but pension funds face significant interest rate risk and use interest rate swaps to hedge against future rate changes
During economic downturns, bonds may outperform equities due to the actions of central banks like the Federal Reserve. In the early 2000s, the Fed lowered interest rates to help mitigate the effects of an economic slowdown, making bonds a more attractive investment. However, this pivot typically occurs when damage has already been done to the labor market and earnings, which can be a bearish sign for risk assets. Additionally, pension funds face significant interest rate risk due to their long-term liabilities. To hedge this risk, they often invest in government bonds, but with interest rates dropping rapidly over the last few decades, they have turned to interest rate swaps to lock in today's interest rates and hedge against future rate changes without requiring large upfront cash payments.
Hedging interest rate risk with swaps but risks during high volatility: Pension funds use swaps to hedge interest rate risk and invest in higher yielding assets, but during high volatility, large margin calls can force sales of bonds and equities, worsening market instability
Interest rate swaps can help hedge interest rate risk while potentially increasing returns by allowing cash to be invested in higher yielding assets. However, this strategy comes with risks, particularly during periods of high volatility when margin calls can require large amounts of cash, which may not be readily available. In such cases, pension funds may be forced to sell off their bond and equity portfolios to meet margin requirements, exacerbating market instability. This was seen in the UK when interest rate volatility surged, leading to large margin calls and a wave of selling by pension funds. The potential for systemic risks hidden in the financial system becomes apparent only when volatility picks up and market stress emerges.
Public.com offers a higher interest rate on cash accounts compared to various financial institutions: Public.com offers a 5.1% APY on cash accounts, higher than most other financial institutions
Public.com offers a higher interest rate on cash accounts compared to various other financial institutions, including Robinhood, SoFi, Marcus, Wealthfront, Betterment, Capital One, Ally, Barclays, Bank of America, Chase, Citi, Wells Fargo, Discover, and American Express. This 5.1% APY is subject to change and is available through a secondary brokerage account with Public Investing. While the Dutch pension fund industry is also substantial, it's important to note that the Netherlands is part of Europe and can access the Eurobond market, which limits the risk of collateral squeezes. However, similar risks could still unfold as pension funds, insurance companies, and asset managers use various derivatives, and volatility is increasing in financial markets. In the case of Italy, the risk of redenomination from the euro to the Italian lira and the climbing credit default swaps are still a concern with the recent election of a right-wing government.
Understanding European CDS Contracts and Their Spreads: Investors can compare the spreads of two types of European CDS contracts to gauge their willingness to pay for protection against sovereign default and redenomination risk. Current market concerns about Italy's redenomination risk and economic deleveraging in China are reflected in their respective CDS spreads.
During times of economic uncertainty, investors seek protection against potential risks through financial instruments like credit default swaps (CDS). In the case of Europe, there are two types of CDS contracts: those that protect against sovereign default and those that also protect against the risk of redenomination of debt in domestic currency. Before the Eurozone crisis in 2011, there was only the former type of contract, but as the possibility of a member country redenominating its debt became a real concern, a new contract was introduced. This means that there are now two types of CDS contracts in Europe, and comparing their spreads can help investors understand how much they are willing to pay for protection against redenomination risk. Currently, there is heightened concern about this risk in Italy, and the spread between the two types of CDS contracts reflects this. Additionally, there are other markets, such as China, where CDS spreads are increasing due to economic deleveraging and regulatory actions.
Credit stress in the financial sector and potential recession indicators: The 10-year, 2-year Treasury spread is inverted, indicating credit stress and potential recession. The Federal Reserve's tight monetary policy could worsen the situation, but staying patient and observing labor market and earnings data is crucial before making investment decisions.
The financial sector, particularly in the U.S., Europe, and China, is facing signs of credit stress due to regulatory constraints and exposure to the housing market and emerging markets. The 10-year, 2-year Treasury spread, which has been a predictor of recessions, is currently inverted and at levels last seen in the 2000s and 2007. The Federal Reserve's tight monetary policy could cause further inversion, but the entry point for investing in longer-term government bonds is less palatable than it was earlier in the year. The labor market and earnings data will be key indicators of an impending economic slowdown, and it's crucial to stay patient and observe these indicators closely before making investment decisions. The risk of being early and wrong in the market is significant, but the potential reward of buying 5-year or 10-year U.S. government bonds at higher yields when the economic data confirms the slowdown could be substantial.
Potential Housing Market Downturn Could Lead to Higher Unemployment: The housing sector's significant role in the economy and sensitivity to interest rates could cause a potential downturn to result in a 6% unemployment rate, job losses in housing sales, construction, and related industries, and a possible cascade effect of decreasing house prices and further unemployment.
The housing market's expected slowdown could lead to a significant increase in unemployment rate in the US beyond the median prediction. Elliott Bisnow expects the unemployment rate to reach 6% by the end of next year due to the housing sector's vital role in the economy, its sensitivity to interest rates, and its large contribution to GDP and employment. The potential housing market downturn could result in a decrease in transaction volume, leading to job losses in sectors like housing sales, construction, and related industries. Additionally, if homeowners are forced to sell due to job loss, it could trigger a cascade effect, causing house prices to drop and potentially leading to further unemployment. This scenario, while not the bull case, seems likely based on current trends.
Macroeconomic Expert Al Capello Educates and Informs Investors through Weekly Newsletter and Twitter: Stay informed about macroeconomic conditions through Al Capello's free weekly newsletter and Twitter updates for better investment decisions
Al Capello, a macroeconomic expert and bond market specialist, emphasizes the importance of financial education and staying informed about macroeconomic conditions for making informed investment decisions. He achieves this through his free weekly newsletter, the Macro Compass, which has over 110,000 readers and provides financial education, macroeconomic insights, and actionable investment ideas. Capello also shares more frequent updates and insights on Twitter at @macroalf. By following Capello's work, investors can gain a better understanding of macroeconomic conditions and make informed decisions for wealth preservation. Capello's mission is to help educate and inform individuals about macroeconomics and the bond market, and provide actual investment ideas and portfolio locations. His resources are easily accessible through Google or Substack, and he encourages listeners to follow him on Twitter for more frequent updates.
