Tantalean Punishment
“Never regret thy fall, O Icarus of the fearless flight. For the greatest tragedy of them all is never to feel the burning light” - Oscar Wilde
While in our previous conversation we mused about the “reversal theory” and as such we turned more negative on the outlook for “high beta” in general and “duration exposed assets” in particular, as we stated in in our conversation “State of Ambivalence” we remain less convinced about the inflation receding narrative. As such, because of some conflicting macro data such as the most recent US CPI and PPI data and the elusive inflation target of 2% being actively discussed, when it came to choosing our title analogy we decided to go for a Greek mythology reference. Tantalus was a Greek mythological figure most famous for his punishment in Tartarus, the deep abyss that is used as a dungeon of torment and suffering for the wicked and as a prison for the Titans. Tartarus was made to stand in a pool of water beneath a fruit tree with low branches, with the fruit ever eluding his grasp, and the water always receding before he could take a drink. He was also called Atys. The Greek used the proverb “Tantalean punishment” in reference to those who have good things but are not permitted to enjoy them. As such the latest nonfarm payrolls significant rise is clearly a good thing but, unfortunately inflationary pressures are not permitting the Fed to enjoy this kind of data. It is to be noted that the English word “tantalize” means to torment with the sight of something desired but out of reach, tease by arousing expectations that are repeatedly disappointed. The 2% inflation level is therefore something desired but out of reach for the Fed as pointed out recently by Mohamed El-Erian, chief economic adviser at Allianz and Bloomberg Opinion columnist:
“You need a higher stable inflation rate. Call it 3 to 4%. “I don’t think they can get CPI to 2% without crushing the economy, but that’s because 2% is not the right target.” Mohamed El-Erian.
With US CPI rising by 0.5% in January, the most in the last 3 months with a higher than expected 6.4% level, the “Fed’s “Tantalean punishment” might indeed be pivoting, but the other way that is, meaning hiking higher for longer we think. Mohamed El-Erian also added:
“It’s right to take data into account but you’ve got to have a view of where you’re going. The problem now, is that the Fed is stuck chasing an elusive 2% goal.- Mohamed El-Erian
As such, again as in 2022, “convexity” is starting to bite again, particularly in long duration US Investment Grade:
- Graph source – Macronomics – KOYFIN
In previous musings in late 2022 we recommended the “Make Duration Great Again” (MDGA) trade which is in effect investing on the long end of Investment Grade Credit from a carry and roll down perspective which had seen US High Grade (Investment Grade) 15+ years “outperforming” US High Yield and now is only up by +2.47% (5.34% YTD in our previous conversation). “Convexity” being back, US Investment Grade is suffering.
As we pointed earlier on in our previous conversation, as per Lord John Maynard Keynes advice, we have changed our opinion merely because facts and circumstances have changed. The ones who do not change their opinion in the long run comes to grievous loss to paraphrase Lord Keynes or face the mythological “Tartarus” as such. We do not want to face the same fate.
In this conversation, we would like to discuss why it will be difficult in the current context to have a fast receding inflation towards the 2% level and as well an historical perspective on inflation and commodities. We also want to look at “the reversing pivot” narrative and what it entails.
· The “Tantalizing” 2% inflation target
After having seen US producer prices rebounded in January by more than expected, it is clear to us that persistent inflationary pressures will push the Fed to pursue further interest-rate increases in the months ahead, somewhat validating the “hiking higher for longer” Fed narrative:
- Graph source Bloomberg - Twitter
With the PPI (Producer Price Index) for final demand rising by 0.7% last month, the most since June due to higher energy costs, the PPI has climbed 6% from a year earlier.
When it comes to the unemployment level, we think that we have seen in the United States the lowest point in this cycle and agree with the below chart from Bloomberg:
- Graph source Bloomberg – Twitter
Another illustration of the proverb “Tantalean punishment” for the Fed, meaning have good things but not permitted to enjoy it, has been the rebound in retail sales at the start of the year:
- Graph source Bloomberg – Twitter
The most impressive was the jump in restaurant sales in January with a gain of 7.2%, the strongest level since March 2021.
In February 2021 in our conversation “Some Like It Hot”, we confided that we had switched allegiance from the “deflationista” camp towards the “inflationista” camp. We opined at the time:
“The Fed said they are happy with inflation ticking higher. The Fed follows the Phillips Curve. The current high rates of unemployment and low rates of inflation provide policy makers with ample motivation to embrace the tradeoffs suggested by the Phillips Curve, as modified by the natural rate and expectations augmented theories. The faster that the labor force adjusts its expectations in response to changes in inflation, the quicker the market will return to a normal unemployment rate. The quicker that the labor force is to adapt, the less effective monetary policy may become as a means of reducing unemployment. This is the essence of the “expectations-augmented” theory of the Phillips Curve. Easy monetary policy generally enhances economic activity and employment but increases inflation. The Fed would like to "overshoot" its inflation target of 2%. Let's be clear on this. The surge in US inflation expectations continues unabated, highest since March 2013 at 2.37%. And the bond market is starting to take note, with 30-year Treasury yield moving up to above 2%, highest since last February.” – Macronomics – March 2021
We also pointed out in this March 2021 conversation that many sell-side companies were talking the possibility of a new commodity super-cycle. We have seen this movie before. A trader friend of ours pointed out to us the following that in 1719, thanks to John Law, the French monetary base exploded higher leading to a boom in stocks followed by a boom in commodities.
This boom in commodities led to a surge inflation and wheat prices exploded higher and eventually led to the French Revolution as clearly explained by French economist Florin Aftalion in his 1987 book entitled "The French Revolution - An Economic Interpretation":
"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.
Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.
As we pointed out in our conversation “The Law of the Maximum” in 2016, “The Law of the Maximum” was a law created during the course of the French Revolution as an extension of the Law of Suspects on 29th September, 1793. It succeeded the 4th May, 1793, "loi du maximum", which had the same purpose: setting price limits, deterring price gouging, and allowing for the continued flow of food supply to the people of France. Numerous food crisis during the French Revolution which led to speculation on a grand scale were linked to the "inflationary" bias of the much-dreaded heavy issuance of "assignats" which lost rapidly their value:
- Source: Le marché des changes de Paris à la fin du XVIIIe siècle (1778-1800) -1937
According to Andrew Dickson White, Professor of History at Cornell, the ever-greater and ultimately uncontrolled issuance of paper money authorized by the National Assembly was at the root of France's economic failure and most certainly the cause of its increasingly rampant inflation. This is as well confirmed by French economist Florin Aftalion in his 1987 book. What we find of interest from a historical perspective, is that with the repeal of "The Law of The Maximum" in December of 1794 came inflation, mass economic strife and riots that ultimately lead to the rise of the Directory and the end of the Thermidorian period and the execution of French politician Robespierre.
The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788) as a reminder.
As well our trader friend pointed out the period of 1793 and 1821 were the rise in the monetary base was more contained. During the US civil war, there was a significant rise in the monetary base leading also to a boom in stock prices followed by a boom in commodities price due to embargo policies:
“The Nobel Laureate Milton Friedman once noted that wars have provided laboratories to examine the behavior of money, prices, and income (Friedman, 1952). The Confederate experience during the American Civil War is no exception. Between January 1861 and April 1865, the Lerner Commodity Price Index of leading cities in the Eastern Confederacy increased from 100 to over 9000. Price inflation in the South during the Civil War ranks second only to the American Revolution in U.S. history.”
- Graph source Lerner 1956 – EH.net – Money and Finance in the Confederate States of America.
On a side note and returning to the “Law of the Maximum” we find it interesting to find a similar policy geared towards Russian oil prices with “cap prices”. As pointed out by our smart trader friend “war commodities” are generally the ones that rises the most.
Since the war broke out between Russia and Ukraine, we found of great interest the widening in the spread between oil prices and jet fuel:
- Graph source IATA – S&P Global – Refinitiv Eikon
Competition is coming for Jet Fuel given Air India announced a 470-plane order with Airbus and Boeing in what stands to be the largest purchase in commercial aviation history. Does the world have enough “refining capacity” currently? The answer is simply no:
“Nearly 1mn b/d of new US refining capacity is under construction or planned for investment in the coming years, but many of those projects are unlikely to be completed on time or at all.”- source Argus Media – Crude Summit
Deglobalization, wars and sanctions are inflationary. That simple. As well as pointed out by our friend Zoltan Zselyes CFA, CAIA, ESG policies are inflationary:
- table source Zoltan Szelyes, CFA, CAIA - Macro Real Estate
ESG initiatives lead to higher costs. This was as well pointed out by Mish Shedlock on the 14th of February in his post “The EU Warns – There is no escape from its ESG Environment Madness”:
“The European Parliament’s environment committee last Thursday backed tougher legislation that will force firms with over 250 staff and annual worldwide turnover of more than €40 million (US$42.8 million), to check and report whether their suppliers within and outside Europe use slave or child labour, or pollute the environment.”
As well Mish pointed out an article that Hong Kong was going to pay 30% more for ESG jobs as companies fight for talent. Sustainability reporting as well as increased salaries are “inflationary” in our book. If you think Asian companies will not pass on the cost of regulatory burden to their European clients, think again.
Returning to the subject of rising “commodities” we found an historical interesting article from the 21st of February 1938 from the Time magazine archive:
“Since February 1933, the general U. S. price level has risen 32%, cost of living 24%, prices of farm products 118%, wholesale prices 45%, Moody's index of spot prices of basic commodities 140%, prices of copper 188%, lead 115%, eggs 73%, flour 69%. Listing these figures and many others in the December Atlantic Monthly, Princeton Professor Edwin Walter Kemmerer commented: "That is inflation." Economist Kemmerer expects commodity prices to rise some 69% more and the cost of living to double. Nor is this a lone-wolf stand. Harvard's Professor Melvin Thomas Copeland made similar predictions last fall (TIME, Oct. 4). And 82% of the 2,560 ranking U. S. economists in the American Economic Association are on record that the present U. S. trend is toward dangerous inflation of money and credit.
Back in 1933, in common with many another investor, a group of ultraconservative young men in Boston's Back Bay began to worry about possible inflation and how it would affect bond and stock values. After two years of quiet study, they decided that the only satisfactory hedge against inflation is commodities. Accordingly, in February 1935 they set up what they believe to be the first commodity investment trust in the world, called it Commodity Corp. Last week, after two years of "laboratory testing" in Boston, Commodity Corp. moved to Wall Street with assets of nearly half a million dollars in its coffers and big plans in its brief case.” – Source Time Magazine, 1938.
For those of you not familiar with the work of Professor Edwin Walter Kemmerer he was a professor of economics at Princeton University. He became famous as a "money doctor" or economic adviser to foreign governments all around the world, promoting plans based on strong currencies and balanced budgets. He also helped in the design of the US Federal Reserve System in 1911:
“A price is the value of a particular commodity in terms of the value of the monetary unit. It is an expression of the number of units of money for which a commodity is bought and sold. The price level represents a composite of individual prices. Prices fluctuate, therefore, with the changing value of goods and also with the changing value of money.” – Edwin Walter Kemmerer – The Prospect of Rising Prices from the Monetary Angle
If the only satisfactory hedge against inflation is commodities as thought by investors in 1933, we are not surprised to have seen such a significant rise in commodities related stock prices such as Glencore (2 years chart below) in the Diversified Miners space:
- Graph source Macronomics – Refinitiv - Eikon
This “commodities related” surge can also be ascertained in the oil tankers 2 years chart below:
- Graph source Macronomics – Refinitiv - Eikon
And in oil services as well:
- Graph source Macronomics – Refinitiv Eikon
As pointed out by an astute readers of ours (that goes by the nickname of “Salmo Trutta” in Seeking Alpha), Dr. Philip George told us the following:
“When interest rates go up, flows into savings and time deposits increase.” (thereby destroying money velocity).
What we have seen in recent years is that reducing interest rates towards the zero bound merely inflated asset bubbles (Cantillon effect) without really improving the real economy (CAPEX lagging also thanks to ESG pressure for Oil & Gas) regardless of the much vaunted “wealth effect”. The ongoing “Tantalean punishment” for the Fed means that it needs to “moderate” the number of its hikes in order not to “crash” the real economy.
Pivoting the other way?
Looking at the return of the “convexity” pain, one might wonder if indeed the risk reversal is coming from the Fed “pivoting the other way”.
As such, the recent rise in “real yields” has ensured a return of the “Gibson Paradox” and weighted on gold and gold miners:
- Graph source Bloomberg
In similar fashion to 2022, both the US Treasury Notes 10 year yield and the US dollar versus the Japanese yen have risen together:
- Graph souce Macronomics – Refinitiv Eikon
Given real rates are on the rise again, no wonder Japanese yen ETF YCS is experiencing a boost as it did in 2022:
- Graph source Macronomics – TradingView
As we pointed out in our previous conversation, the most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line. The quarterly Senior Loan Officer Opinion Surveys (SLOOs) published by the Fed does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Tightening in credit standards in conjunction with rate hikes will eventually weight on High Yield we pointed out:
- Graph source Macronomics – KOYFIN
As pointed out by Brian Wälchli in our LinkedIn feed:
“We better get that soft landing and re-anchoring of inflation - US Equity Risk Premium now at 175bps, a new 15 years low.” Brian Wälchli
- Graph source Brian Wächli – Bloomberg
We also agree with Boaz Weinstein in our Twitter feed, when it comes to assessing rising default risks from the Fed Quarterly SLOOs and the tightening financial conditions:
“Still think credit is the better short because of the asymmetry of High Yield at 400bps with defaults starting to rise.- Boaz Weinstein
He also added:
“High Yield managers touting double digit yielding debt as a once in 15 year opportunity without caveating that almost all of it is from TBills at 5.25 rather than 0.25.” – Boaz Weinstein
When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer:
- Graph source Bloomberg
Credit cycles generally die because “too much debt” has been raised.
Another great point was made by Joe Little the CIO from HSBC Asset Management:
« A new theme in macro markets is the so called “no landing” scenario - growth is stronger, recession can be avoided, but rates must rise more.
It’s a provocative idea. But we have to be careful: it contradicts the recession evidence (for later in the year) already coming from leading economic indicators (US, UK, EU)
And challenges the widely-held assumption that medium term growth and interest rates remain low.
Long-term interest rates have risen almost 50bp over the last month. That would normally mean a c10% fall in stocks. But markets, so far, remain very resilient.
It leaves a “valuation anomaly” at the heart of investment markets - rising real interest rates (red line), versus stock market earnings yields that continue to fall (black line).
How this “anomaly” corrects itself will be a key theme for the next phase in markets. » - Joe Little HSBC AM CIO
Another “macro friend” of ours commented on the above:
“The superposed chart is interesting. Since the y-axis is on the same scale (3.5), it shows that the real ERP (vs. Real yields as opposed to nominal yields) has remained rather constant during the past 5 years, except the past 8 months or so). The ERP used to be a healthy 5.5%. now only 4%. Something's gotta give.”
The “Tantalean Punishment” of the Fed is in motion, as such, we remain very doubtful on the “no landing” / soft landing scenarios playing out. This would be tantamount to the Fed avoiding a “policy mistake”, which in the past they haven’t been very good at avoiding. The Fed committed the obvious policy error after the 2000 recession when it kept the Federal Funds rate below the CPI inflation for a long period, which contributed to the housing bubble and caused the great financial crisis of 2008, also the commodity price bubbles (QE2), and a weaker US dollar. Is this time different? We do not think so.
"Others have seen what is and asked why. I have seen what could be and asked why not." – Pablo Picasso
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Martin - excellent as always, quoting Trutta even... the Fed is flailing in the wind, the interest rate is the price of credit, not the price of money.
As usual very thorough analysis! I particularly like your long term historical perspective