Several lines below you can read an excerpt from my Weekly Market Letter available exclusively for subscribers. In this week issue:


-Market Recap and potential triggers ahead
-US labor market - digging into the numbers
-Understanding the Economic Surprise Index
-Coronavirus consequences
-Federal Reserve and other central banks
-The US corporate bond market and a little touch on the pension system

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Here is the text:

“True, governments can reduce the rate of interest in the short run. They can issue additional paper money. They can open the way to credit expansion by the banks. They can thus create an artificial boom and the appearance of prosperity. But such a boom is bound to collapse soon or late and to bring about a depression.” - Ludwig von Mises

This quote perfectly describes what we have experienced over the last several decades. In the next months, we will likely witness one of the most severe economic downturns of our lifetimes. Millions of people are already feeling the inevitable pain. I am talking about massive lay-offs, company closures, rent, and loan paying issues. How significant will be the impact? How do I position myself during this downturn? In my letters, I am trying to answer those and many other questions.


FEDERAL RESERVE KILLING THE LEFTOVERS OF PRICE DISCOVERY

After introducing a historically large bazooka over the last several weeks (explained in the previous report), the Fed seems to be calming down a bit and tries to maintain the current conditions of the markets stable. During this crisis, they’ve used the entire 2008 crisis playbook but in a much shorter period. It is not surprising then that the market has eased, for now. The problem is, however, that if the stock and credit markets start falling again, they will go all-in and will start buying everything including junk bonds and equities. All to prevent the full-blown financial crisis. After 2007-2009 they managed to somehow step back, raise interest rates, and shrink the balance sheet by almost $1 trillion. This time the exit might be much more difficult which will completely reduce the already broken market signal – or the so-called price discovery (the process of determining a proper price by studying market supply and demand). How to determine a true price when we have a buyer with a theoretically unlimited amount of electronic cash? Why theoretically?  Because if a central bank incurs losses, it can cover them through money printing, eventually leading to hyperinflation and killing the financial system. Examples of Venezuela, Argentina, Zimbabwe or Weimar. The other option is having TAXPAYERS back via Treasury and recapitalization. Therefore, as you can see that we have no free market in almost every type of asset anymore and the central banks are playing a very dangerous game.

This graph explains the engagement of the Fed in the US Treasury market. Goldman Sachs estimates that more than $2 trillion of new bonds issued by the US treasury will be absorbed by the Fed during this year. In comparison, roughly $700 billion by the money market funds (MMMFs). These numbers are unbelievable. We can say that the Federal Reserve is going to monetize (financing government operations) the vast majority of new United States debt. Monetization happens when the Federal Reserve or other central bank creates new credit (cash for banks) by buying the national debt and putting it on its balance sheet and holds it till maturity. As a result of the Fed’s recent activities, its balance sheet has reached a new all-time high, $5.81 trillion. Over the last two weeks, they’ve increased its assets by a whopping $1.14 trillion – the highest two-week change in history. Even though the Fed has announced that it will trim the daily pace of buying US treasuries from $60 billion to $50 billion next week. This amount is still enormous. When we add $25 billion of Mortgage-Backed Securities a day it turns out that its total value of assets will reach an astonishing $6.28 trillion at the end of the next week (four trading days).
As you can see, it is going exponentially. It has to be pointed out that it is not only the Fed expanding its balance sheet by massively buying assets. The same is done by Bank of Japan, Bank of England, European Central Bank, and the Swiss National Bank. In effect, a cumulative value of those central banks’ balance sheets has also reached a new record, $17.6 trillion which is an equivalent of 31.5% of the entire global bond market (24 developed and emerging markets), up from 27% one month ago. The record high from 2018 stands at 33%. This is truly unprecedented. If they would continue the pace of buying the number may reach even $30 trillion during the entire year which is more than US stock market capitalization. It has never happened before. If it does not create inflation in the medium-term (several months) then we can throw out economic books to the bin. How can we talk about real capitalism, the process of price discovery, and finding true fair value of assets when central banks own 1/3 of the government debt around the globe.

Another important development on the US central bank front is swap lines. I elaborated on the topic in my recent report including why do I think it will not help to ease dollar shortage pressures. Fed's Central bank liquidity swaps rose again, this time by $142 billion in the week ending April 1. Since February 26, those swaps have risen by almost $350 billion. And yet, the dollar index has increased.
Remember 58% weight of the index is euro which is a vast majority of the overall composition. Therefore it is worth looking at other indices such as the Trade-Weighted US Dollar Index or Bloomberg Dollar Index which both have also gained in value. If you would like to read a fantastic article about the dollar pressures from the macroeconomic perspective let me know, I’ll drop you a link. On this occasion, just keep in mind that $13 trillion borrowed by non-financial corporations outside the US. It will be troubling to fill that gap if insolvencies will rapidly increase.

In the other news, the Federal Reserve introduced a new facility which I believe is the seventh one during this downturn. It aims to combat the US dollar market stresses. This is a temporary FIMA (Foreign and International Monetary Authorities) Repo Facility where foreign central banks can swap US government bonds for greenbacks. Let’s see how that one’s gonna work. 

While the fight with dollars shortages continues at its best a new lending program for small and medium-sized US entities maybe another couple weeks away as it was said by the Fed’s Boston President Eric Rosengren. I wouldn’t be surprised if thousands of companies will go under until they ultimately set up this facility. I pointed out in one of my tweets that there are 30.7 million small firms in the US and they create 1.5 million jobs every year – 64% of all new jobs created. Over 90% of the entire business population is represented by small and medium-sized enterprises. To put it differently, this is the main driving force of the largest economy in the world. Fed is doing everything to avoid a financial crisis when at the same time the real source of benefits for the financial system is rapidly being destroyed. In both cases, the beneficiaries of these actions will be commercial banks.

That’s not everything. The Fed also announced on Wednesday that it temporarily eased leverage rules for large banks. They can exempt US Treasury debt and deposits held at the US central bank account from the calculations of the Supplementary Leverage Ratio (SLR), one of many restrictions imposed on large banks in the aftermath of the Great Financial Crisis. In effect, banks will be able to use more Treasuries for different kinds of operations which as a result should encourage them to continue/increase lending activities for businesses and institutions. The exemption will stay until March 31, 2021. Hopefully, this money will eventually go to those in the most need until it will be too late (look at the previous paragraph). With all those interventions the Fed has become the lender of the last resort for the entire economy, instead of being the lender of last resort for the banking system. Big banks, by the way, have somehow bounced back from the lows as the entire stock market two weeks ago and then has started falling again (chart on the previous page).

source: Thomson Reuters

BKX is the KBW Nasdaq Bank Index which includes 24 banking stocks in the United States such as JP Morgan Chase, Citigroup, and others.

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Stay Safe.

Seb