Anyone Have a Match?
Posted on Saturday, July 22nd, 2017
The debt ceiling is coming! The debt ceiling is coming! Not quite Paul Revere but the Treasury market is showing signs that investors are getting concerned about the debt ceiling being reached in mid October as the CBO has warned. If Republicans can’t get a bill through that they have been working on for seven years how will they get the debt ceiling passed through the most polarized congress in history? Months ago we were looking at sweeping changes with the Republicans controlling both houses. Now, instead of tax reform, we are looking at a government shutdown. For once, gridlock in DC may not be so good.
We have been postulating for years that the reason that the economy is not doing well is that interest rates are too low and that there was no threat that interest rates would go higher. Think about it. There has been no incentive to borrow and buy a car, a home or invest in plant and factory. We can “put it off until next year” because we aren’t sure about the economy and rates aren’t going anywhere. We came across this blog post from Epsilon Theory and Dr. Ben Hunt. It is not the common thinking but that is usually where the answer lies.
The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback?
(As the Fed slowly raises rates) It will force companies to take on more risk. It will force companies to invest more in plant and equipment and technology. It will force companies to pay up for the skilled workers they need.
In exactly the same way that QE was deflationary in practice when it was inflationary in theory, so will the end of QE be inflationary in practice when it is deflationary in theory.
My view: as the tide of QE goes out, the tide of inflation comes in. And the more that the QE tide recedes, the more inflation comes in.
–Dr. Ben Hunt Epsilon Theory
I agree with Dr Hunt that at some point central bankers may be asking – Why is inflation accelerating as we raise rates? How come we cannot contain inflation? In talking to business leaders over the last several years we have not seen many talking up their industry as “hitting on all cylinders”. Last month we spent some time with a leader in the medical device field which he says is booming. Industry players are borrowing for plant and equipment for the first time in years. Combine some tax reform with higher rates and BINGO! That joint is jumping. Central bankers have been pouring gasoline on the pyre for years with no effect. Pushing on a string. Higher rates may be the match and with too much gasoline on the fire inflation may be the result.
Markets have been quiet. A little too quiet. We have read story after story about the volatility trade and how volatility has to spike higher to flaunt this overcrowded trade. We agree but this year has been very quiet. How quiet? This year has seen its largest drawdown of only 2.8% on the S&P 500. That is a far cry from the 14% average. According to LPL, the S&P 500 has not had a drawdown of 5% or more in a calendar year only 5 times in the last 60 years and it has not happened in 30 years. NASDAQ was up 11 straight days until Friday. According to LPL’s Ryan Detrick this has happened 21 times since 1980. The next month on average for the NASDAQ is up 2.6% with 16 of those 21 being positive months.
The tapering of the Fed’s balance sheet looks to be still on schedule to start in September. The debt ceiling is scheduled to be hit in mid October. Short interest is back down to levels last seen in the second quarter of 2007 at the market peak. Equities are at the top of their new range on the S&P 500. For now we see support at 2400 on the S&P 500 with 2475 providing resistance. If they break through resistance then we are off to a new range of 2475-2550. The path of least resistance is higher for now but September looms large. The animal spirits are still in charge as long as the flow of the Fed’s balance sheet is neutral to positive.
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