Short-Term Headwinds Abound For Gold

Summary & Key Takeaways

  • Through rising real yields, a slowing economy and poor seasonality, short-term headwinds remain for gold and precious metals.
  • However, this move higher in real yields is unlikely to last, and will soon turn from a headwind to tailwind for gold.
  • In an environment of ongoing geopolitical tensions, fiscal dominance, sanctions on foreign exchange reserves and international trade, and the weaponization of the dollar, the long-term bull case for gold remains as strong as ever.

What is going on with gold?

One of the notoriously difficult asset classes to forecast are gold and precious metals. Touted as a safe haven, store of value and inflation hedge, the recent price action in gold has largely defied such classifications. This is particularly so within a risk-off environment that is currently sweeping through markets.

Unfortunately, the short-term outlook for gold remains decidedly unclear despite some of the conditions being in place that gold bugs have dreamed of for decades in inflation and geopolitical tension. What is evident is that precious metals and mining companies have been unable to escape the recent volatility encompassing nearly all financial assets.

However, given the recent moves higher in real yields, this pull-back is perhaps unsurprising as real yields tend to be the most reliable indicator for the yellow metal.

Negative real yields are of the consequence of financial repression, an environment that clearly favors gold’s store of value attributes. So, with the recent move higher in nominal yields (particular on the long-end of the curve) being of greater magnitude than inflation, real yields are now largely positive across the board and thus have dragged gold lower.

Right now, real yields are signaling further pain may be forthcoming for precious metals.

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Indeed, we can see this relationship between gold and real yields by also looking at the rate-of-change in TIPS (via the TIP ETF) compared to the gold price.

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And by the examining the relationship between gold and the total level negative yielding debt outstanding.

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Source: Variant Perception

As rates have been rising worldwide, the level of negative debt outstanding has plummeted. Clearly, rising real rates are a significant headwind for precious metals at present.

This swift (and historic) move higher in real rates shouldn’t necessarily be surprising to investors however. Historically, one can get a good idea of where real rates are headed simply by looking at the business cycle. We can observe this relationship between real rates and the business cycle below, using the ISM manufacturing PMI as a proxy for the business cycle.

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A growing economy should lead real rates higher and a slowing economy lead real rates lower.

An important observation we can ascertain from this relationship is how much the monetary policy actions at the Fed suppressed real rates through their historical levels of QE since early 2020, despite a growing economy. Now, with the Fed tightening monetary policy in response to their underestimation of inflation, we have finally seen the release valve for real rates turned and allowed them to catch up to the business cycle. A move that has happened in short order.

Whilst there is the likelihood real rates will continue to move meaningfully higher over the next few months, given the outlook for economic growth such a move will be short lived. Whilst this would be negative for gold in the short-term, such a scenario would present attractive entry points for those looking to allocate to gold, silver or precious metals miners long-term. Indeed, the long-term case for gold lies in this thesis that an over indebted economy simply cannot handle sustained positive real rates.

From a positioning perspective, we are beginning to see some constructive movements. Firstly, by looking at money manager positioning in the futures market, we have seen a significantly unwind in long position through this recent move. Remember, money managers consist of hedge funds and CTA’s, both of which are largely trend followers and tend to be long at the tops and short (or less long) at the lows.

A further unwind in managed money longs is something I am keeping a close eye on as a move to the 50-60% level in longs relative to total managed money positioning has been indicative of excellent contrarian buying opportunities in the past. Likewise, an unwind of speculative long positioning will help to put a floor on the gold price.

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More constructive for the present however is the futures market positioning of gold producers. Producers (i.e. the smart money) tend to be largely short the market as they are selling forward futures contracts as a means to hedge their production. They currently have on their smallest short positions since 2018, which as we know was an excellent time to buy.

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From a sentiment perspective, we have also seen a constructive unwind of bullishness of late, as measured here by the Bullish Percent Gold Miners Index. Again, I would like to see a little more pessimism towards precious metals before I become tactically bullish.

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If we look at sentiment through the lens of SentimenTrader’s Optic index, we can see a further washout generally aligns with the better buying opportunities in recent times.

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It is important to member too that sentiment is not necessary a great timing tool as it can remain elevated or depressed for long periods.

From a technical perspective, the picture is somewhat positive. As real yields have been repriced higher, gold has corrected back down to the $1,850 support area, with this test of support accompanied by a DeMark 9 sequential buy signal.

Depending on your time frame this may be a level worth slowly buying into a precious metal position. However, given my outlook for the economy, I could see a flush down to $1,750 or even $1,700 as a distinct possibility for the yellow metal, both of which would represent excellent points to add.

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In regards to the gold miners, given the $34 support area of GDX has been lost, I suspect a move down lower to $30 to be likely, an area I would look to slowly accumulate. Should gold correct further however it is important to remember that miners are largely high-beta versions of gold, so the downside risk is more prevalent with gold miners in a market wide risk-off event typically seen during growth cycle downturns.

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Indeed, given we are entering the worst seasonal period for precious metals in May and June, this ties in nicely to the idea that this correction has yet to run its course.

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Another significant headwind for precious metals at present is the dollar. Whilst the negative relationship between the dollar and gold has not been evident in recent months (a bullish sign for gold), it is important to remember that in a slowing growth environment the dollar will remain bid and is likely to continue higher. Dollar strength is not an ideal environment for precious metals.

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What is the catalyst for the next move higher?

Fortunately, these short-term headwinds for precious metals should provide investors an opportunity to accumulate at lower prices. The question then becomes; what will catalyze the next move higher?

To me, a dovish policy pivot by the Fed will likely be said catalyst. Given Chair Powell and his minions continue to hold steady in their attempts to tighten the economy to stave off inflation, the Fed put is certainly lower than what we have been accustomed to in recent times. However, I am of the belief that maybe it is not as low as some now believe it to be.

Given the poor outlook for the economy, one that risk assets look to be beginning to price in, tightening monetary policy into a slowdown was only ever going to be a recipe for disaster. We remain in a financialized economy and risk assets will continue to struggle whilst the Fed pursues this course. It is only a matter of time before something breaks. Should such a pivot occur later this year if equities correct meaningfully lower, injecting liquidity into an environment of higher inflation would be an environment wherein gold would likely thrive.

Furthermore, as I have touched on, slowing growth will eventually become a headwind for real rates themselves. As such, it seems as though this move higher in real rates is only temporary, and is one that will eventually turn from a headwind to a tailwind once more.

For now however, gold will not escape a market crash event, as correlations between all assets will rise to one. This is a distinct possibility.

The bull case for gold remains intact

Longer-term, the bull case for gold remains as strong as ever. All else equal, an environment of ongoing geopolitical tensions, fiscal dominance, coupled with a precedent for sanctions on foreign exchange reserves and international trade, and the weaponization of the dollar, these dynamics should provide more than enough fuel to warrant investors maintain an allocation to precious metals.

Indeed, the long-term technical picture for gold remains widely bullish, with the decade long cup-and-handle structure pointing to much higher prices in the years ahead, very much confirming the long-term fundamental case for gold.

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This is particularly true for miners, who have largely lagged gold in recent times.

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When the bull market for gold resumes, the miners should finally have their time in the sun.

Housing Market Set To Stall

Summary & Key Takeaways

  • Through higher mortgage rates, demand for US housing is beginning to wane.
  • This will have significant cyclical implications for house prices.
  • As house prices growth slows or rolls over and given housings cyclical importance to economic growth, the housing market will move from a tailwind of economic growth to a headwind.
  • However, the structural outlook for the housing market remains on solid footing, and as such any pull-back in house prices will not resemble anything like what occurred in the Great Financial Crisis. Structural undersupply, favourable demographics for first home buyers and solid consumer balance sheets will help provide a floor for the housing market in the years ahead.

The Importance Of The Housing Market

With house prices having increased in value by over 20% this past year, there is now mounting evidence to suggest this trend in housing appreciation is not only set to stall, buy may indeed roll over in the year ahead. Understanding the cyclical and structural standing of the US housing market is a critical component of assessing the business cycle, as any move lower in housing will have critical implications for the economy.

According to the National Association of Homebuilders, the activity in housing through the mechanisms of residential investments and housing related consumption spending contributes to around 15-18% of GDP. As such, real estate cycles should be monitored with in-depth consideration as housing is one of the most cyclical parts of the economy and thus one of the major cyclical drivers of economic growth and consumer welfare. After all, real estate is the biggest asset class on the planet.

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Source: Macro Alf

Due to housing’s sensitivity to interest rates and the close associated of housing and construction, a downturn in housing activity and housing-related spending is a warning sign that the tailwind to the economy that has been the US housing market of late may now be turning into a headwind.

Analyzing the housing market through the lens of demand and supply, mortgage rates, consumer balance sheets and demographics allows us to assess the outlook for US housing from both a cyclical and structural perspective, whilst providing an important insight into where the growth cycle is headed. As it stands, waning demand, rising mortgage rates and temporary increases in supply are all providing a clear cyclical headwind in the housing market that should push prices lower in the coming months, whilst the structural outlook for the housing market remains on solid footing thus providing some comfort that any pull back in house prices will not be akin to 2008.

Housing Market Set To Stall

Starting with housing demand, one of the most reliable longer-leading indicators of both housing activity and economic growth as a whole is building permits. Following the highest year-over-year spike in growth in April of 2021, building permits have been trending lower over the past 12 months.

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Given how building permits precede housing construction and are impacted by cyclical factors such as mortgage rates, the trend in permits provides important insight into the direction of housing growth and thus housing construction. This trend lower is clearly indicative of waning demand.

With both 15-year and 30-year fixed mortgage rates hitting their highest levels in over a decade (4.38% and 5.11% respectively) and thus crowding out potential buyers, it is hardly surprising to see demand rolling over. Although much of the outstanding mortgage in the US is fixed in nature, potential home buyers are not afforded this luxury and are subject to these higher mortgage rates.

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Therefore, it is hardly surprising that both the level and direction of mortgage rates provides a lead on house prices, given they represent the cost of borrowing. After all, this has been the quickest rise in mortgage rate since 1994.

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Source: Macrobond

As borrowing costs rise, we see a drag on demand which leads to a fall in mortgage applications and a headwind for house prices. As I have noted, whilst existing home owners are less impacted by this dynamic, any potential new home buyer is now subject to paying the highest mortgage rates in over a decade should they wish to purchases a home at a time whereby house prices are the most expensive they have ever been.

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Source: Macrobond

As such, real mortgage rates in particular tend to provide a long lead for house prices and are telling us the market have become overextended.

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Mortgage rates have a long history in impacting housing affordability and house prices. So long as mortgage rates continue to trend higher and remain elevated, house prices will struggle to move significantly higher in the near term as demand falters. As the chart by Macrobond below illustrates, higher mortgage rates equal less affordable housing.

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Source: Macrobond

With housing affordability where it stands today, the spread between consumer’s intentions to buy a home and consumer intentions to sell a home per the University of Michigan is at its widest in a decade. Indeed, buying intentions for housing have not been this low for over 20 years, whilst intentions to sell remain elevated. We are clearly amidst a sellers’ market, and, when there are more sellers than buyers, prices move down accordingly.

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On a shorter-term, we can see these trends beginning to show up via home sales, and more importantly, pending home sales. Pending home sales measures the contract activity in housing, and, because sales generally go under contract a few months prior to the actual sale, pending home sales provides us with a short lead on actual home sales. As we can see below, pending home sales have been trending lower on both a quarterly and six-monthly growth rate basis since the latter stages of 2021.

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Indeed, also confirming these trends in demand is the MBA Mortgage Purchase Index, which too has been trending lower through the turn of the year as mortgage rates have soared. As mentioned, mortgage applications activity tends to provide some insight into the direction of house prices as they impact both building permits and home sales. Clearly, demand for housing is waning.

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Source: EPB Macro Research

Interestingly, the yield curve has also historically been a leading indicator for building permits by around 12-18 months. Despite what you think of the yield curve predictive capabilities for the economy, this largely aligns with my own forward outlook for growth.

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This has important implications for housing construction. Given how construction within the housing sector provides a significant cyclical boost to the economy (as I will delve into later), waning demand will continue to flow through to construction activity.

Indeed, as we can see below, the trend in residential construction has rolled over and is another indicator suggesting house prices have peaked for now.

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What is also concerning for prices from a cyclical perspective is how housing supply has rebounded over the past 12 months. Though there still remains a structural undersupply of housing, we have seen the biggest year-over-year increase in supply in some time and are now at the average level of months’ supply of housing seen over the past decade.

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Such a rise in supply becomes problematic for house prices when met with falling demand, of which the data suggests is clearly evident as I have discussed. This demand and supply dynamic has now become a short-term headwind for house prices and too suggests a pull-back is on the cards.

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Implications Of A Stall In House Prices

Given the dynamics in housing demand, supply and mortgage rates I have discussed, not only are the implications evident for housing prices themselves over the ensuing months, but these dynamics will also have significant implications for both the economic growth and the performance of housing related homebuilder stocks.

Indeed, higher mortgage rates are still pointing to ongoing underperformance for homebuilders (per the ITB ETF) relative to the stock market.

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Whilst home sales are not supportive of any move higher in homebuilder stocks any time soon.

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From a purely technical perspective, homebuilders look vulnerable. Given the outlook for housing and the macro backdrop, I struggle to see any reasons why we do not at least test the $50 support level at some point this year. It is worth noting however that homebuilders do look somewhat oversold on the shorter-term charts, and could to with a bounce in the coming weeks.

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I suspect any relief rally to be short lived however. Indeed, as noted recently by SentimenTrader, “when homebuilders underperform equity markets to a significant degree, this has historically not bode well for both the future performance of homebuilders and broad equities going forward.”

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Source: SentimenTrader

We are also entering a seasonally unfavorable period for homebuilder stocks.

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This is important to note given housing’s importance to the economy. If homebuilders continue their relative underperformance, it suggests the stocks/bonds ratio is headed lower (which would most likely be through stocks falling further than bonds).

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Observing these market internals and their movements are incredibly valuable tools as they provide an insight not only to the prospects for asset markets, but for the economy as a whole. The great Stan Druckenmiller himself has discussed how the best economic predictor he has seen are the relative performance of the cyclical sectors within the stock market.

Homebuilders are certainly echoing this notion given how important housing is to the business cycle. Economic growth and construction are tightly linked, and the trends in housing will give us an indicator of the trends in construction. We can see this relationship below as housing starts tend to lead the growth cycle, as proxied here by the ISM manufacturing PMI. Housing starts are clearly suggestive of slowing growth.

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A similar relationship can be seen with housing investment and ISM manufacturing new orders, which too is suggesting slower growth and a sub-50 PMI.

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So too is the relationship of residential fixed investments as a percentage of total fixed private investment, one of the more reliable long-term leading indicators of the growth cycle. A slowing housing market is and will continue to be a drag on growth for the time being. Clear are the cyclical implications of the housing market.

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In almost every business cycle in the past 70 years, housing related investment generally starts to decline as a percentage of total GDP in advance of major economic downturns. When housing starts to decline as a percentage of overall GDP, the economy losses a cyclical tailwind.

We can perhaps find some solace in the fact that residential fixed investment as a percentage of GDP has yet to materially move lower in such a manner that has preceded past recessions, though as I have indicated this is likely to occur in the months ahead, and, depending on how material a decline is seen should help us assess the severity of the economic slowdown.

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For now, a slowing housing market will negatively impact employment in the residential building and construction sector. Though employment is very much a lagging economic indicator, the timeliness of employment as an indicator can be enhanced by looking at the trends in the more cyclical components of employment, such as residential construction. Residential building and construction related employment is trending lower.

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As are housing related retail sales.

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A pull back in house prices would also be a positive outcome for renters. If we do see rents begin to come down a little or at the very least stabilize for a period of time, this will certainly help alleviate some inflationary pressures in the year ahead, given the Owners’ Equivalent Rent component contributes around 30% of headline CPI.

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Median asking rents per the BLS is too suggesting such an outcome, as we can see below.

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Structural Tailwinds Remain For The US Housing Market

As the cyclical headwinds for the US housing market are apparent, this is lending credence to many market commentators signaling a bursting of a housing bubble akin to 2008. However, the data does not support this notion, and in fact suggest the structural outlook for US housing is on solid footing.

Indeed, it is important to remember there is a structural undersupply of housing. Despite the pick-up in supply in response to the recent boom in house prices, total housing starts relative to housing stock remains well below the previous cycle highs, whilst the long-term downtrend is clear.

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Unlike the housing boom of the early 2000s which was largely fueled by subpar lending standards and credit creation, the tailwind for housing looks to be one driven by an undersupply in housing inventory. This should indeed help to keep a higher floor on house prices relative to previous housing cycles.

The fact that housing supply per working age persons continues to trend lower is indeed supportive of this structural dynamic.

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Unless we see a material pick-up in supply over the coming years, this trend in supply relative to the working age population is only likely to worse as the largest expected population growth over the next five years is likely to be for 29-44 years, aka first home buyers. There is a clear demographic tailwind over the coming years as millennials look to enter the housing market.

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Source: Variant Perception

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Source: Variant Perception

Further supporting these structural tailwinds for housing is the current state of the consumer balance sheet. When analyzing the long-term outlook for the housing market, an ever important consideration is the state of consumers and households.

As it stands, household debt service capabilities are in good stead. Mortgage debt service payments as a percentage of disposable income for households remains near their lowest level in over 40 years.

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Given that the majority of currently outstanding mortgage debt is fixed and not variable in nature, the fact that inflation resides well above mortgage rates at present is actually a positive for fixed rate mortgage homeowners as the real cost of their repayments are decreasing.

Likewise, compared to the previous housing bubble, the housing loan to value ratio for households has continued to trend lower as households have de-levered post GFC.

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Meanwhile, household net worth as a percentage of GDP has climbed to significantly higher levels, for both households as an aggregative and for the bottom 50% of households, although a clear wealth gap remains.

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On paper, homeowners are effectively the best ever. These strong consumer balance sheets will help households whether the storm of rising mortgage rates and a cyclical downturn in housing.

Although house prices look set to pull-back in the ensuing months as a result of the significant cyclical headwinds facing the housing market at present, the evidence suggests that the structural bull market in housing remains intact.

For a look at all of today’s economic events, check out our economic calendar.

The Bull Case For Bonds

Central to my market and macro outlook at present is the likelihood we are amid a growth cycle downturn that is looking to decelerate meaningfully in the coming months. Whilst a potential recession was not part of this thesis, given the recent movements in the yield curve, geopolitical landscape, inflation pressures and deteriorating forward outlook for growth, the probabilities of such an outcome seem to be increasing by the day.

So, whilst having a macro framework and data driven outlook in mind, how to trade and profit from this scenario is key. It is all well and good analyzing markets, companies and the macro environment, but, profiting from this analysis is what we as investors strive to do. In a slowing growth environment, buying long-term treasuries has been the go-to macro trade over the past 40 years. Right now, this classic late cycle long-bond trade is more hated and contrarian than it has been in a generation.

This is perhaps rightfully so with inflation is at its highest level since the 1980s. Unsurprisingly, long-term treasuries have as a result suffered their worst peak-to-trough drawdown in over 20 years.

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Source: Bloomberg

This bond sell-off has seen 30-year yields once again test the upper range of their 40-year downtrend, a trend that has been colloquially termed ‘The Chart of Truth’.

Is the great bond bull market finally over and the Chart of Truth no more?

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We are indeed seeing endless calls for this to be the case, with any suggestions to the contrary being met with ridicule and contempt. However, some of the great contrarian trades eventuate when there is clear consensus. Right now, the consensus is very much of the opinion that yields are only going higher.

Such one-sided consensus can be headlined by one of the classic contrarian sentiment indicators in recent times in the cover of The Economist.

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Likewise, calls for higher rates by the likes of JPMorgan’s Jamie Dimon seemingly have an uncanny ability to occur at their peak.

Clearly, bonds are hated right now and people want to believe yields will only go higher from here.

Looking at bond market sentiment through the lens of SentimentTrader’s Optix index, we are witnessing a level of pessimism towards bonds seen only a handful of times over the past two decades, all of which formed the base of strong rallies in the long bond.

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On a shorter-term basis too, bond sentiment (per the 10-day Daily Sentiment Index) is nearing levels indicative of a reversal in recent years.

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Source: The Felder Report

Whilst being a contrarian can be profitable at times, it is important to not simply be a contrarian for the sake of being contrarian. But, when everybody in the world hates bonds and we are heading into a growth slowdown, the risk-reward setup for bonds begins to look attractive. To profit as a contrarian is to have variant perception.

So, what could lead yields lower?

Well, with all this talk of a shift to structural inflation, it is important to remember when yields rise this far this fast, things tend to break.

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Source: Jesse Felder – The Felder Report

The market can only sustain such a swift rise in yields for so long. Throw in a slowing economy and the potential peaking of inflation, and we the makings of a fundamental case for an allocation to bonds.

Growth, Inflation & Bonds

I have recently laid out my thesis for a slowing economy and peak in inflation in great length, so I will abstain from covering too much familiar territory regarding these matters here. But, in short, we are seeing a clear indication of a slowing economy and mounting headwinds for inflation.

There is now plenty of evidence to suggest we are entering the late stages of the economic cycle. Whether or not a recession will eventuate is not yet clear, but a material slowdown in growth is certainly what the leading indicators of the growth cycle are pointing to. We have a tight labor market, inverted yield curve, low unemployment, peak earnings, spiking oil prices, waning demand and plunging consumer confidence among many other late cycle indicators flashing risk-off.

Couple this with a monetary policy stance that is now a headwind for growth worldwide, and we have a clear deceleration in growth ahead of us.

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Source: Top Down Charts

And financial conditions are now tight, a situation that does not bode well for growth.

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Source: Andreas Steno Larsen

Indeed, inflation acts a tightening of financial conditions in its own right as it destroys demand and eats into real incomes.

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Source: Raoul Pal

You simply cannot raise prices on consumers at a faster pace than their income growth without a significant destruction in demand. This is why inflation will in itself sow the seeds of its own demise.

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Source: Gianluca

Again, as I have detailed in the past, though many inflation tailwinds are likely to persist for the years ahead, on a rate-of-change basis there is much evidence to suggest that inflation will deceleration throughout the second half of 2022 as the deceleration in growth becomes too much to bear. This dynamic should at some point provide a tailwind for bonds.

Even the Fed’s response of quantitative tightening to the current inflation pressures via the contraction of their balance sheet has ultimately resulted in yields falling over time. This is an important dynamic overlooked by many. The Fed implementing QT has historically resulted in yields falling over time as the economy cannot withstand higher yields in the face of slowing growth and tightening monetary policy.

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Even during the inflationary 1970s, the period so prevalent in investors minds at present, bonds outperformed equities and did a better job of offsetting inflation than equities as the Fed tightened, a dynamic recently noted by Verdad Capital.

“In hiking environments, the risk-reward for owning equities becomes worse, and investors should look to diversify away from an all-equity book to preserve their capital for a better time. As bad a hiking cycles were in the 1970s, preserving capital for easing cycles would have been a terrific strategy.”

Again, this ties into the idea that Fed tightening is a late cycle dynamic brought on by their dual mandate of stable prices and low unemployment, two of the most lagging business cycle indicators that exist.

Indeed, the unemployment rate has in recent times provided a good indication of where we are in the business cycle. Right now, it is clearly telling us we are nearing the latter stages, which in the past has marked the top in interest rates. Don’t get me wrong, the Fed will proceed to raise the Fed Funds Rate for the foreseeable future and proceed with reducing their balance sheet, but, as notes by Alex Gurevich, “When unemployment levels get very low there is less possibility and room for growth, coupled with the Fed getting aggressively tighter to avoid a “wage spiral” (and quell inflation overall), but, the reality is, it is through these actions that growth comes to die.”

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Again, this is where bonds could begin to provide some value as 2022 progresses. As noted by Teddy Vallee, whether or not bonds appreciate on an absolute basis as much as once would have remains to be seen, but relative to broad equities they are beginning to appear quite attractive.

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Source: Teddy Vallee

Indeed, slowing growth has long been a tailwind for bonds.

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Source: Andreas Steno Larsen

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Source: Julian Bittel

As the business cycle slows, yields will eventually follow suit.

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Source: Acheron Insights, FRED, 42 Macro

As will inflation. The evidence suggests this will likely be the story for the second half of 2022.

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Source: Mr. Blonde Macro

Indeed, the current inflation pressures won’t be able to escape the business cycle forever. Meanwhile, investors have seemingly priced in nearly every bearish outcome for bonds, whereas the market internals now seemingly confirming what the business cycle is telling us and are too beginning to diverge from consensus.

The divergence between bonds and utilities relative to regional banks is striking. What this could mean for yields is clear.

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Source: EPB Research

Represented differently, the performance of regional banks relative to the S&P 500, generally an excellent barometer for the direction of rates, have also diverged negatively.

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Likewise, the copper to gold ratio has not confirmed this latest move higher in yields. Ever the markets macro barometer, the copper to gold ratio has a fairly solid track record of the direction in yields and was calling for higher yields for much of 2021. This is a notable non-confirmation in the new high in yields.

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The performance of small caps relative to large caps is confirming this message.

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Likewise, the ratio of cyclical versus defensive stocks has also diverged bearishly from yields.

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The most economically sensitive sectors of the stockmarket as a whole are now pointing to lower yields.

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Source: The Felder Report

Clearly, the markets are pricing in slower growth. Eventually, bonds will follow suit.

Indeed, when yield rise this far this fast and the 12-month rate of change exceeds 25% in conjunction with the 14-month RSI exceeding 70, we tend to see yields fall or at the very least plateau over the ensuing months. Again, yields cannot rise this fast without causing damage.

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Though we are amid a bond market rout and inflation bonanza, bonds are starting to appear to offer a more attractive risk-reward profile over the next 12-months relative to broad equities. Again, as noted in the previously mentioned piece by Verdad Capital, we are amidst one of the worst drawdowns from treasuries in the past 70 years, with the subsequent six month returns in nearly all cases being positive and an average of 4.9%. Right now, bonds have a growth tailwind at their back, equities do not.

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Source: Verdad

From a technical perspective however things aren’t so rosy for bonds. On the weekly chart, the 30-year yield has clearly broken through an important resistance level around the 2.5% area, though this breakout comes accompanied by another weekly DeMark 9 sell signal and waning momentum. Whether or not this proves to be a false breakout or the 30-year yield can flip 2.5% into a new level of support will be telling.

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Should this breakout prove to be a head-fake and we break back below 2.5% in the coming months would for me be the trigger to go long bonds and prove my thesis correct. This is an important technical level to watch in the weeks and months ahead.

In regards to bonds themselves via TLT, we have clearly broken down from the important $130 support level. $115-$120 looks to the next key level of support to watch. If we break below $115, I suspect bonds will go much lower before they go higher, perhaps as low as $105. Such levels would appear attractive entry points given the growth and inflation dynamics highlighted above.

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Risks To The Bond Trade

Like any trade or investment, there are a number of risks to be considered that may prove to be a headwind for one’s thesis. For a potential bond trade, there remains a number of risks which must be addressed.

Stocks & Bonds Correlation

Firstly, with the latest headline inflation reading coming in at over 8%, the negative correlation between stocks and bonds that has existed during this great bond bull run will simply continue to be non-existent until the rate-of-change in inflation subsides.

At what point could this negative correlation reassert itself, this looks to be around the 2.5%-3% level for core-CPI.

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Source: Gerard Minack

Or, per the work of Darius Dale at 42 Macro, the negative correlation could seemingly reassert itself should headline-CPI fall back below 5%.

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Source: 42 Macro

Though supply chain and commodity issues remain, waning demand, slowing growth and unfavorable base effects for the growth rate in inflation should in all likelihood prove to be a headwind too strong for inflation to bear come the second half of 2022. As such, at some point later this year we should see bonds again behave as the traditional diversifier and safe-haven asset they have been in recent times. Remember, the US dollar and the US bond market are still the most risk averse assets in the world.

Oversupply Of Bonds

Another significant risk for bonds at present is the clear oversupply of treasuries set to flood the markets as the Fed accelerates their QT program and contract their balance sheet. Though I have discussed how previous attempts at QT has seen bond yields actually fall as result of the market simply breaking under the weight of tightening financial conditions, there is of course no guarantee such a scenario will play out during this tightening cycle.

This is a significant risk to bonds that has been highlighted recently by former Fed trader and financial plumbing expert Joseph Wang. Put simply, as a result of the Fed shrinking their balance sheet, a record amount of Treasury Securities will flood the markets over the coming months. Based on Fed Chair Powell’s QT guidelines of a balance sheet reduction of $1 trillion per year and with Treasury issuance by the Federal Government set to remain historically higher at around $1.5 trillion per year, Wang notes that:

“This implies that non-Fed investors will have to absorb ~$2t in issuance each year for 3 years in the context of rising inflation and rising financing costs from rate hikes. Even the most ardent bond bulls will not have enough money to absorb the flood of issuance, so prices must drop to draw new buyers. In this post we preview the coming QT, sketch out potential investor demand, and suggest a material steepening of the curve is likely.”

This is a significant risk of bonds. Were the Fed performing QT without the backdrop of a growth slowdown, the upward pressure of interest rates exerted by QT and Treasury issuance would be even greater. Though this may indeed by the case, it could well prove true than QT once again breaks the economy and ultimately leads to yields rolling over.

For now, I do suspect QT will exert further upward pressure on rates and downward pressure on bonds, at least until something breaks.

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Source: Joseph Wang

Have The Rules Of The Bond Market Changed?

Pondering whether the rules for the bond market have changed appears to be the culmination of the previous two points I have highlighted in inflation and an oversupply of bonds exacerbating the current sell-off. Indeed, as noted by Luke Gromen, despite the clear deteriorating growth environment bonds have yet to catch a bid.

Per Luke Gromen (via FFTT-LLC):

“In plain English, the potential rule change is this:

Post-Great Financial Crisis, when the Fed began removing QE, market participants shifted into long-dated USTs on the anticipation of the return of deflationary pressures in the absence of Fed QE.

This time, for the first time post-GFC, the US fiscal and debt situation has deteriorated to such a degree that in the ongoing absence of sufficient foreign buying of USTs seen since 2014, as the Fed pulls back on QE, UST yields are beginning to rise, potentially driven by supply and demand issues.

We are not completely convinced that the rules have changed… it is still theoretically possible that a massive global depression and stock market crash could drive risk assets into USTs, driving yields down.

However, we are increasingly leaning in the direction that there HAS been a rule change on this front, because of the lived experience of March 2020, when global stock markets crashed, and 12 days into that stock market crash, UST markets began crashing alongside stocks (i.e. UST yields up), due to insufficient UST buying in the face of massive foreign UST selling.”

This is a significant issue posed by Luke, and one in which we simply cannot yet know the answer. However, for a contrarian like myself, it seems as though Luke’s view is now becoming a little too consensus. I am not yet willing to fully write of bonds in the face of a slowing economy.

Still Too Early

So, given these risks, what could be the catalyst for a rally in bonds?

Firstly and most importantly, we would need the material deceleration in the growth cycle to commence, and, based on the short-term leading indicators of the growth cycle, such as ECRI’s Weekly Leading Index below, said deceleration may not materialize until the latter stages of Q2.

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Source: Economic Cycle Research Institute

If we intertwine this idea of an impending growth slowdown with 30-year treasury seasonality, we can see that long-term yield tend to bottom around the March to April period, with the May to August months being the most favourable for bonds historically. Seasonality is suggesting the bond sell-off may be nearing an end.

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Further weakness in equities over the coming months (a likely scenario when growth continues to roll over) would also do well to have investors reconsider their allocations to fixed income. It is important to remember that, as a function of the TINA trade, investors are currently the most underweight fixed income exposure they have been in the past decade. Everyone is record underweight bonds.

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This is a particularly important consideration for pension funds, as for the first time since 2008, their solvency ratio’s lie above 100% (as result of rising yields reducing the value of their liabilities and rising risk assets increasing the value of their assets). This observation was recently flagged by Alfonso Peccatiello, noting that pension funds “will need to lock-in some gains as they are still under-hedged when it comes to interest rate risk, and buying long-end bonds yielding close to 3% will reduce this interest rate risk and provide a hedge against drawdowns in risk assets.”

The longer-term bull market in bonds may no longer be the home-run trade it once was, but for now, the cyclical forces appear favourable for a rally over the next year or so. While the chart of truth breaking and the bond bull market ending is a very real risk, one that may yet occur in the next five years, I suspect we may be a tad early calling for the death of bonds.

Summary and key takeaways

  • Current consensus is that inflation is out of control, interest rates are going to the moon and the Chart of Truth is broken. When it has become a standard narrative to talk about structural inflation and rates need to be raised to 10 plus percent, maybe we should start looking at things differently.
  • This is the largest percentage increase in rates in all recorded history. There is simply so much priced into the rates market at present.
  • The bond trade may not be the home run it once was during a slowing growth environment, but it may still provide a good hedge in the event of a significant deceleration in growth.
  • Remember, the US dollar and the US bond market are still the most risk averse assets in the world. Increased geopolitical risks and slowing economy continue to make bonds look more attractive.
  • The ideal setup for bonds is not here yet, but it may come sooner than you think.

Does This S&P 500 Rally Have Legs?

As I have discussed much in recent months, we are unequivocally experiencing a growth cycle downturn that is only going to accelerate materially to the downside over the coming quarters. However, for now, it appears as though the stock market may have jumped the gun and as such could offer some respite over the coming weeks. Any such relief would undoubtedly be a gift to investors.

S&P 500 Technical Analysis

Following the 15% peak to trough fall in the S&P 500, we have since retaken the important 4,300-4,400 level after what appears to be a false breakdown below. From a technical perspective, having so easily retaken this level is certainly a positive outcome for now.

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Though I do not expect new all-time highs any time soon, should we be able to hold 4,300 in the S&P 500 and the price action make a higher low, this could help provide a solid base for a continuation of this bear market rally. However, should we rollover and lose 4,300, then the bullish short-term thesis presented herein is likely null and void.

Nasdaq Technical Analysis

For the Nasdaq, we have seen this rally also retake the important $350 level on the Q’s, which again if held could provide a solid foundation for at the very least a continued consolidation into Easter. I do believe this to be the highest probability outcome over the coming weeks.

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Seasonality

Indeed, it is important to remember we are entering the most seasonally favourable period for stocks over the month of April. This period of positive seasonality is particularly prevalent for those stocks and assets of a high-beta and pro-cyclical nature. And yes, whether you care to admit it or not, there are structural reasons in the market why seasonality does matter.

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Historical Analogs

If we look at historical analogs of years past whereby stocks performed in a similar manner to what we have experienced thus far in 2022, we can see how markets have historically rallied out of March through April. Though I am not necessarily a fan of using historical price analogs, it does help provide us with some historical guidance.

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What we have so far seen this year is investors seemingly positioning themselves a little too bearish too soon. Per the work of the excellent Darius Dale at 42 Macro, we can see below that when investors are flocking to defensive market sectors (i.e. those who perform best when economic growth is slowing, such as utilities) to such an extreme degree that the purple line enters the consensus fear zone and then exits this area as the market falls (as investors reallocate and buy dips in more pro-cyclical stocks), this has generally been a bullish outcome over the immediate term. Though it is difficult to see below, 42 Macro’s Cross-Asset Correction Risk Indicator has just left the consensus fear zone, a historically bullish short-term outcome in the majority of cases.

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Source: 42 Macro

Relative Performance

Indeed, we can illustrate this differently by comparing the relative performance of some of the most economically sensitive sectors in the stock market. The retail, transports, metals & mining, materials and industrials sectors were clear underperformers as the market topped in December and have since outperformed, as we can see below.

Encouragingly, all of these sectors barring retail appear to be outperforming to the upside amid the current rally. Watching out for relative underperformance of these economically sensitive sectors should the broad market rally continue will help provide us with an excellent indication of when the market may again roll over.

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Risk Appetite

In a similar manner, various risk appetitive measures of investors are too confirming strength to the upside. Again, watch for negative divergences among these investor risk appetite indicators for rally exhaustion.

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Liquidity

Also potentially supportive of the stock market for now is net liquidity (as measured below by the Fed balance sheet less the Treasury general account). Net liquidity will become a significant headwind for stocks once the Fed accelerates its monetary tightening and reduction of their balance sheet in May, but for now, stocks look to have gotten a little bit ahead of themselves in pricing in the pending reduction in liquidity.

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Given how closely the performance of the S&P 500 has tracked liquidity of late, we could see liquidity provide support to stocks over the coming months prior to when the Fed actually starts its taping program in May.

Volatility Analysis

What has also clearly supported (or perhaps more accurately was the direct culprit) of the recent rally was the fact that last Friday’s quarterly options expiry saw roughly 30% of S&P 500 Gamma being wiped from option dealers books. Given we were in negative Gamma territory pre-OPEX, this significant reduction in Gamma positioning resulted in dealers buying-back a significant amount of their short S&P 500 delta hedges, and coupled with bullish Vanna flows as implied volatility collapsed sharply last week helped squeeze the market higher. The tail continues to wag the stock market dog.

Whether or not we see any bullish Vanna flows from here remains to be seen. The VIX has already fallen to the low 20s and would likely need to go sub-20 to precede significant further Vanna flows. Seasonality certainly favors this outcome as we enter a very unfavorable seasonal period for the VIX. One would however expect implied volatility to remain somewhat heightened given the current geopolitical backdrop and poor economic growth outlook.

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As of now, we remain above the short-gamma volatility trigger (per the work of Spot Gamma below) and thus could see a more stable market over the next month, potentially providing the possibility of further positive Vanna and Charm flows into Easter.

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Source: Spot Gamma

However, as investors have given up much of their downside protection following March’s expiry and haven’t replaced this protection over, then if markets were to roll over and continue lower we could well see a significant pick-up in put buying as investors seek to protect their downside. This may reflexively then result in a continued move lower as dealers would need to delta hedge their books by selling the underlying against their short put positions, such is the power of the options markets on stocks these days. Should such a scenario unfold then the put wall around 4,100 looks to be the next major support level.

Dark Pool Activity

The fact that dark pool activity for the S&P 500 has seen its most bullish period over the past month since early 2020 certainly leaves me with a bullish bias over the next few weeks. Similar dark pool readings in the past have provided a tailwind for forward 30-60 day returns.

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Source: Squeeze Metrics

Corporate Buyback Authorizations

Likewise, there remains a record number of corporate buyback authorizations set to enter the market this year, a dynamic which could again help provide support to markets over the next month or two before the growing headwinds in slowing growth and monetary tightening drag down markets.

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Source: Goldman Sachs

Clearly, whilst I do believe we are amidst the beginnings of a bear market in stocks that could encompass much of 2022, there is evidence to suggest this current rally could continue or at the very least consolidate over the next few weeks. Whilst I am not championing for an opportunity to go tactically long, further strength in stocks presents an opportunity to take profits and accumulate cheaper hedges as implied volatility continues lower.

Summary and Key Takeaways

  • Barring a significant news event or external catalyst, stocks seemingly have the potential to continue to rally into Easter during what is a seasonally favourable period. The May FOMC meeting could be the negative catalyst that ushers in the next wave lower as the Fed becomes more aggressive with their tapering plans.
  • As a result, any prior continued rally would be a gift given the particularly bearish economic and fundamental outlook for the second half of 2022. Should implied volatility also continue lower over the coming weeks, this would allow investors a golden opportunity to add additional downside hedges.

Crypto Market Update: Tough Times Ahead, Part Deux

Through a combination of the disastrous geopolitical landscape, slowing economic growth and impending central bank tightening, the price swings in such high-beta risk assets as crypto have been extreme. It is a difficult environment out there.

Not a whole lot has changed in my crypto outlook over the next few quarters since my most recent post on the subject. Most notably due to the deteriorating macro environment, I remain bearish over the medium term. However, we are beginning to see some positive on-chain developments of a longer-term nature which should be encouraging for longer-term bulls. For the sake of positivity, such developments will hence be the focus of this article.

Starting with the technicals however, the daily chart for BTC shows just how volatile the market has been of late. We have now had multiple rejections at both the $45k resistance level, but also the $34k support area. Short-term, these are the levels investors should keep an eye on. Should we break below $34k, then $30k seems inevitable and should be bought, whilst conversely, a break above $45k would have me reconsider by bearish tilt and could be the impetus for crypto’s macro decoupling.

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For Ethereum, the price action is looking somewhat precarious and is seemingly readying to make a move one way or another. $2,350 remains support whilst $3,350 is the key resistance area to watch. Should we break below $2,350, $1,700 looks like a reasonable proposition and again would represent an excellent long-term buying opportunity. There is however more downside for ETH relative to BTC at present.

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Turning back to Bitcoin via the weekly chart, it is looking more and more likely that we at least test the $30k key support level at some point this year given the unfavorable macro backdrop. Again, as I have repeatedly stated in the past, $30k would be an absolute must buy opportunity for those bullish crypto long-term.

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What makes the $30k area of even more importance from a technical perspective is this level is roughly equal to the 61.8% Fibonacci retracement of the entire bull run off the March 2020 lows. Should we be unable to hold $30k, the 200-week moving average looks to be the next key area given there is no support between $30k and $20k. Though painful, such a move would be consistent with previous bear markets and would again represent an excellent long-term buying opportunity.

What makes me increasingly wary that the low is not yet in for 2022 is the fact that we are yet to see a capitulation style spike in volume that has occurred at all the recent lows in late 2019, early 2020 and mid-2021, as we can see in the chart above. Though not a prerequisite for a market bottom, such a capitulation-like spike in volume helps to give us confidence for when such a bottom may be near.

Given the incredibly unfavorable macro outlook set to weigh down crypto assets over the coming quarters, it is difficult to see Bitcoin, Ethereum or any other crypto assets making a sustained move higher in the immediate future. What we know during growth cycle downturns is that high-beta stocks underperform low-beta stocks, and, whether we like it or not, crypto has by and large traded in-line with high-beta risk assets for quite some time know.

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What we also know that occurs historically during a growth cycle downturn is the strength in the US dollar, which in times of stress becomes the ultimate safe haven asset, if only out of necessity and foreigners scramble for dollars. Whilst Bitcoin and crypto can clearly still appreciate in value when the dollar rallies, a strong dollar environment is a significant headwind for risk assets. What’s more, the geopolitical tension we are seeing today will only exacerbate this dynamic.

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Eventually, we will see crypto undergo a macro decoupling, but for now, the growth outlook remains a significant headwind.

Longer-term developments

Turning now to the aforementioned longer-term developments in the crypto space, we are most certainly beginning to see some constructive signs for those who are bullish crypto long-term, as I am.

Firstly, we can see sentiment is slowly but surely reaching levels of extreme fear. It is important to keep in mind however that sentiment can stay both euphoric and fearful for extended periods of time, hence why I prefer using a 20 or 50-period moving average of sentiment indicators such as the Crypto Fear & Greed Index below. Sub-20 readings for the 20-period moving average look to be excellent opportunities to slowly deploy ones capital.

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In terms of the derivatives space, open interest has reduced significantly since the November high to a level more indicative of a stable and less leveraged market, though open interest still remains at levels higher than we saw during the lows in the middle of 2021. It appears there is still some remaining speculation needing to be flushed out of the system before we can confidently say the low is in for now.

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Source: CryptoQuant

Funding rates however are now largely neutral, clearly showing signs that speculators have somewhat reigned in their leveraged positions.

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Source: CryptoQuant

From an on-chain perspective, the Market Value to Realised Value (MVRV) ratio below has too dropped significantly of late, exceeding the lows we saw during mid-2021. The MVRV ratio serves as a rough proxy for the average profit/loss position of BTC holders, and has been cited by many as an important long-term valuation indicator for crypto. Clearly however there is still room for this ratio to fall further to the downside, with readings below one generally considered to be excellent long-term buying opportunities. Such an outcome is possible this year and would be very opportunistic.

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Source: CryptoQuant

There is much positivity to be gleaned from the recent movements of long-term buyers. Firstly, buying activity of whales picked up significantly in January and February as the price has tanked to sub-$40k. Quite simply, if you are a long-term holder, you want to be buying when the whales (i.e. the smart money) are buying. The red and orange dots below indicate whale buying whilst the blue dots whale selling, courtesy of Ecoinometrics.

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Source: Ecoinometrics

Extending this observation through the distribution of ownership, we can see how long-term holders (represented by the blue to green colors below) are slowly starting to increase their ownership percentage of outstanding supply, a dynamic noted within a recent piece from IntoTheBlock:

“Bitcoin distribution cycle — Bitcoin holders tend to follow a pattern based on price activity and new vs old entrants dominating. It goes something like this:

1. Price rises attracts new entrants, which leads to further price increases

2. Speculation gets out off hand as short-term holders (pictured in red and orange above) rush in while long-term holders sell and create the top

3. Price crashes, with many of the new entrants exiting with losses

4. Long-term players buy in again and accumulate a larger share of holdings

Right now, we seem to be between step 3 and 4, with Bitcoin hitting an all-time high in November and short-term traders dropping as much as 32%. Simultaneously, long-term holders are starting to increase their share of supply as shown by the black arrows in the UTXO age indicator.”

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Source: IntoTheBlock

We can also see this same dynamic illustrated below (blue line), as the percentage ownership of outstanding coins by long-term holders is increasing, a trend historically associated with periods of crypto weakness but indicative of attractive buying opportunities for said long-term holders.

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Source: IntoTheBlock

Positive longer-term signals for the various on-chain data are seemingly beginning to pop-up all over the place. Indeed, the Reserve Risk indicator looks to be finally entering an area representative of favourable long-term buying opportunities, though I would like to see this metric fall a little further before I become too optimistic. Reserve Risk is a measure of the price relative to the HODL bank, and is used to assess the confidence of long-term holders.

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Source: Glassnode

Likewise, Dormancy Flows, measuring the ratio of market capitalization and the annualized dormancy value, is too nearing the long-term buy zone.

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Source: Glassnode

As is the percentage of transfer value in profit (as measured by the 90-day moving average), a development recently noted by Glassnode.

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Source: Glassnode

Long-term exchange movements continue to trend favorably, as there has been a clear continued increase in willingness for investors to hold BTC off-exchange (i.e. HODLing in cold storage).

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And finally, one other development I would like to point out that portends favorably for the crypto space as a whole is how the hash rate (which can be considered a proxy for the security of the Bitcoin network) has gone on to reach an all-time high, despite Bitcoin still being nearly 45% off the highs set back in November. This is certainly a healthy trend and one we didn’t necessarily witness during 2021.

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As we can see, despite the short-term macro headwinds at present, we are beginning to see some constructive signs longer-term and are nearing levels whereby investors can slowly but surely begin dipping their toes in the market once more.

Summary and key takeaways

  • Volatility has once again dominated the crypto markets of late.
  • Given the unfavorable macro outlook, expect this to continue for the coming quarters, particularly so as crypto is trading in-line with high-beta stocks.
  • Technically, a break below $34k for BTC and $2,350 for ETH could usher in further declines. Such outcomes would provide excellent long-term buying opportunities.
  • We are slowly seeing positive long-term developments from various on-chain indicators, as Bitcoin is slowly but surely reaching the buy zone.

 

Growth Cycle Outlook: Time Is Running Out For Risk Assets

Unsurprisingly, my growth outlook has not changed since I penned my most recent article detailing the subject.

Alas, we are coming ever closer to the inflection point whereby financial markets will succumb to the significant growth, liquidity and policy headwinds abound. Within this Growth Cycle Outlook I will rehash why I continue to believe a significant deceleration in growth is likely to rear its ugly head in the coming quarters, and whether we will see one last rally in risk assets before this change in trend.

Checking in on the forward-looking leading indicators of economic growth, the Chinese credit impulse peaked back early to mid-2021 and its impact is clearly starting to be felt in developed markets.

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Source: Julien Bittel

G5 central bank asset purchases are too signaling that global PMI’s are likely headed lower in the coming quarters.

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Source: Julien Bittel

Whilst the Economic Cycle Research Institute (ECRI) Weekly Leading Index continues to trend lower since peaking nearly 12 months ago.

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Source: Lakshman Achuthan

The housing market is all but confirming this message, pointing to a sub-50 ISM in the months ahead.

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Source: Julien Bittel

Accompanying the deceleration in fixed residential investment is building permits, which is flirting with near negative year-over-year growth.

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Given the housing sectors importance to the economy, the implications here for economic growth are clear and obvious.

Turning to the consumption and demand side of things, both Rail Carloads and Freight Shipments are looking very weak.

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Whilst the manufacturing sales to inventory ratio continue to decline (inverted below). When sales are rising at a greater pace than inventories and the ratio rises, then more inventory needs to be produced, thus putting upward pressure on prices as well as an increased need for workers and hours worked, thus positive for growth. When inventories rise at a greater pace then sales and the ratio falls, the inverse occurs. Clearly, demand continues to falter.

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If we source this ratio from the ISM Manufacturing Survey via the New Order to Inventory spread, the message is the same…

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Source: Mr Blonde Macro

Clearly, demand is waning and the economy is slowing. Inflation has completely destroyed real income growth.

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As a result, not only is consumer sentiment below where it was during the onset of the pandemic, but it is now at its lowest level in a decade.

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Throw in the fact that every 50% rise in oil prices in the past has preceded a recession…

It is not hard to see how inflation is destroying incomes, demand and consumer sentiment. We are clearly at the latter stages of the business cycle.

So, what’s the solution? Tighten financial conditions into an economic slowdown by raising borrowing cost…

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Source: Michael Kantrowitz, CFA

As we can see above, such actions will clearly reinforce the slowdown. The Fed of course have no choice in the matter as it is part of their mandate to achieve stable prices, and all they can do is use the tools available to them to attempt to achieve this. It just so happens the tools at their disposal have no ability to impact inflation. Such is the damage of inflation on the economy.

For risk assets, what matters in a large part to their performance is the direction of the rate-of-change in growth, as well as inflation. As I have discussed thus far, growth is slowing and looks set to materially decelerate throughout 2022.

What is more concerning is that inflation also looks set to decelerate on a rate-of-change basis come the second half of 2022 (I discussed this dynamic and its implications in detail here). Should both growth and inflation indeed decelerate in tandem as the year progresses then we have a clear signal to be cautious of pro-cyclical risk assets during such times. Couple these dynamics with tightening monetary policy and a fiscal situation which has swung from stimulus to fiscal drag, investors will do well to position themselves appropriately for the year ahead.

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Source: Bloomberg

These are the exact opposite dynamics that drove markets higher throughout the second half of 2020 and into 2021, during which we had accelerating growth and inflation, record quantitative easing, fiscal stimulus and excess liquidity. Expect the markets to behave accordingly as these factors now reverse course to the downside.

Now, having said all this, the question then becomes at which point will this slowing growth environment truly show up in asset markets. It is important to remember when discussing macro and forecasting the business cycle that you are attempting to live in the future. Macro is slow moving and quite difficult to time to perfection. So, despite the recent weakness in equities, could we see one last rally into mid-year before we see the real growth deceleration take place? This looks to be a distinct possibility.

Indeed, there are a number of signs suggesting that the low may be in for equities for the time being.

Firstly, as noted below, we can see that corporate buyback authorizations are running at a record high pace year to date, whilst sentiment has reached extreme levels of fear. Speculative leverage too has significantly reduced over the past couple of months.

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Source: Imran Lakha – Options Insight

Investors have been piling into hedges via put options, again indicative of extreme fear.

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Meanwhile, seasonality for discretionary and most pro-cyclical stocks is about to enter the most favourable months of year in March and April.

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As it is the stock market as a whole (and yes, due to market structure seasonality does matter).

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And finally, dark pools have seen a significant level of bullish activity of late, suggestive of positive market returns over the next one to two months.

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Source: Squeeze Metrics

As we can see, although we are amid a growth cycle downturn there are reasons to believe we may see a rally in equity markets over the next two to three months. However, given the poor macro backdrop there are no guarantees and investors ought to be sellers into strength and take such an outcome as an opportunity to raise cash and position portfolios to a more defensive nature.

Summary and key takeaways

  • The leading indicators of economic growth point to a material slowdown as 2022 progresses. This is not a favourable environment for pro-cyclical equities and risk assets.
  • The Fed is in a difficult position whereby they have no choice but to tighten monetary conditions into an economic slowdown. Given that lagging hard economic data (via a tight labor market and low levels of unemployment) continues to point a robust economy, coupled with persistent inflation, this will likely keep the Fed on their tightening path for the foreseeable future. The Fed put will likely be struck lower that what we have seen in the past.
  • Additionally, better economic data coming out is not necessarily bullish for equities, as this keeps pressure on the Fed for more aggressive tightening, so too with high inflation readings in the next few months.
  • If we see an equity market rally into the middle of the year in the face of a severe slowdown in growth, this would appear an opportune time to take profits and position portfolios on a more defensive nature.
  • Investors will do well to focus on capital preservation as opposed to capital appreciation in the year ahead. A growth slowdown is not the time to be a trading hero.

For a look at all of today’s economic events, check out our economic calendar.

Crypto Market Outlook: A Potential Bounce May Be Imminent

Several of the key support levels for both Bitcoin and Ethereum I highlighted in my initial crypto market outlook have since been breached and unsurprisingly ushered in further negative price action to the downside. Bitcoin now resides on what can only be described an incredibly important level of support at $40k-$42k. For dip-buyers and long-term holders alike this is almost a must buy level as its importance as both resistance and support throughout 2021 has been paramount and thus could well be a level Bitcoin consolidates and bounces from. However, as I will cover off within this article, not all of the signs are there for a meaningful market bottom.

Beginning with the long-term technicals for BTC per the weekly chart, what is of concern is the recent price action has taken us meaningfully below the 50-week moving average. This moving average has provided key support since the mid-2021 lows and any meaningful close below would be the first since March of the 2020. By simply examining the weekly chart it looks as if we could easily see the price fall back to the $30k area. If we do enter a sustained bear market for crypto in the latter parts of 2022 I would not be surprised if this level is reached. Such an outcome would not doubt provide an excellent long-term buying opportunity for those bullish digital assets.

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What also concerns me regarding the recent price action is we are yet to see a spike in downside volume that would usually accompany downside capitulation representative of a sustainable bottom. Although we have seen such volume spikes to the downside in all meaningful market bottoms over recent years, it must be said of course that bottoms can form without such movements in volume. This is certainly is something investors should keep an eye on nonetheless.

Shorter-term, BTC finally lost its 200-day moving average after back-and-forth price action in recent weeks, ushering in a swift move down to $41k. As I mentioned earlier, we can see below how important this level has been for over 12 months, flipping between support and resistance on a number of occasion. I have highlighted such points on the chart below for reference.

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Given its obvious importance from a technical perspective, this level provides a simple and attractive opportunity to structure a long trade with a clear stop below $40k. Should we indeed break meaningfully below $40k, $30k looks all but inevitable.

Turning now to Ethereum, the story is largely the same as Bitcoin, with $3k marking an excellent buy-the-dip opportunity but a break below opening the possibility of a fall down to as low as the $1,700 area.

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To become more bullish on Ethereum in the short-term, I would love to see the 200-day moving average retaken in short order similar to what occurred in late-June and early-July of last year.

That being said, the recent price action of the ETH/BTC spread does not look favourable to me for Ethereum in the short-term. Unless the 0.08 resistance level can be retaken, what we may have witnessed was a false break above this level in December and a reversal to the downside, pointing to further Bitcoin outperformance going forward. This would either playout with Bitcoin outperforming to the upside which would be constructive for the overall market, or Bitcoin outperformance to the downside, not an ideal outcome for altcoins and riskier digital assets.

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Though we currently reside at important levels that can easily be bought, not all the technical signs are there for a meaningful market bottom to be in place. Ideally, I would like to see a spike in downside volume along with bullish divergences in such indicators as the RSI and OBV (On Balance Volume) confirming the bottom is in, particularly so for the latter.

Turning now to investor sentiment, we are evidently nearing levels of extreme market fear. We can see this via the Crypto Fear & Green Index.

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And Bitcoin Optix.

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Whilst we are nearing levels indicative of buying opportunities in the past, the issue with sentiment measures for crypto markets is they have historically displayed a momentum effect, in that positive investor sentiment is indicative of positive price performance over the short-term and vice-versa. As such, though the Fear & Greed Index is low, it could well go lower or remain low for some time as price continues to fall. This is why I have used the 10-period moving average for the Optix index as it appears to provide a more accurate contrarian buy or sell signal.

We can also assess sentiment through the lens of the futures market positioning in both Bitcoin and Ethereum. In the crypto futures markets, hedge fund activity differs to that seen in traditional asset futures markets as have thus far acted as the smart money and thus tend to be short at the market tops and less-short at the market bottoms. The other and non-reported categories (representing the dumb money, i.e. small speculators) seem to be long at the tops and less-long at the bottoms.

Hedge-funds are still heavily net-short, although the Other and Non-Reported categories appear to be reaching more favourable levels.

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Source: TheBlockCrypto.com

In terms of open interest for all derivatives for Bitcoin and Ethereum, BTC open interest still remains elevated relative to the recent price action. We saw an excessive drop in leverage as open interest fell significantly in early December along with price. Since then, whilst the Bitcoin price has continued to make a new low, open interest has instead made a new high, positively diverging from price.

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As I have noted in the past, it is important to remember however this open interest data for Bitcoin is being influenced by the introduction of the Bitcoin futures ETFs in recent months. As the futures market is generally used for traders of a short-term time frame due to the excessive roll costs associated with holdings futures contracts for long time periods, buyers of the Bitcoin futures ETF who intend to hold for the long-term would cause the open interest data to be skewed to the upside. As a result, looking at Bitcoin open interest in isolation as means to asses speculative leverage within the system may be misleading.

However, the fact that Ethereum open interest remains elevated to its own history (though has fallen along with price unlike Bitcoin) indicates there is still a large amount of leverage within the market for crypto as a whole.

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This divergence in open interest for BTC could be indicative of a couple of things. Firstly, it may mean there is still further leverage to be washed out before we find a sustainable bottom, or, it could be suggestive of traders betting heavily against BTC on the short-side, thus selling futures. To get a better idea of whether this is indeed the case, we can examine long-liquidations relative to short-liquidations for BTC. Long-liquidations in the past couple of weeks have been significantly greater than short-liquidations in terms of notional value.

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This dynamic creates the possibility that we could be setting up for some form of short-squeeze to the upside in the near term. We saw a similar dynamic play out during the July/August bottom.

The leverage ratio for both Bitcoin could well be confirming the notion that investors are indeed betting heavily on the short-side, again indicating the potential for a short-squeeze in the near term.

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However, it is important to note that funding rates for both BTC and ETH are not necessarily confirming this theory as they remain positive (though marginally) for the time being. Negative funding rates indicate traders are paying extra to be short the market.

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Before I move on to the on-chain metrics I monitor, one final thing I would like to point out in regards to the derivatives space is how we have just entered negative Gamma territory (…what’s Gamma?), and how dealers are short a decent amount of Gamma below the $42k area.

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Source: Laevitas

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Source: Laevitas

The options market for crypto does not have the same impacts on price movements as it does in equity markets via Gamma, Vanna and Charm flows but it likely does have some influence and is worth paying attention to. Undoubtedly, its impact is one that is only going to grow and become increasingly important going forward as more and more institutions enter the space, particularly so when we see things like the rise of short-volatility and yield enhancing mechanisms in De-FI Options Vaults (DOVs).

Indeed, we did see the impact of dealer hedging influencing prices throughout the latter part of December as we approached the massive open interest options expiry at the end of the month. Given the significant level of out of the money (OTM) call option open interest that expired in December, this left dealers largely short calls. As we didn’t see any catalyst cause the market to move higher, the effects of Charm caused dealers to slowly reduce their long BTC hedges, keeping a cap on the market into expiry.

For now, what can be gleaned from the negative Gamma situation we find ourselves in at present is that volatility is likely to remain high in the short-term, whether to the upside or the downside.

From an on-chain perspective there is a couple of things worth pointing out. Firstly, the 0.5 net unrealised profit/loss area has been breached. As noted by Glassnode in recent weeks, this 50% unrealised profits area has acted as key support and resistance over the past 18 months, and seems to be an area that defines whether we are in a bull or bear market. We have now clearly broken below this key level which indicates we may need further consolidation or negative price action to materialise before the bottom is in.

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Likewise, the Short-Term Holder Market Value to Realised Value (MVRV) is sending a very similar message. This ratio measures Bitcoin’s market capitalisation relative to its realised capitalisation for short-term holders and can be thought of as a measure of their profitability. This metric has recently crossed below one, and when this has occurred in the past we have seen a period of sideways price action at the very least for some months. Again, this metric appears to be telling us a sustainable bottom may not yet be in place.

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Source: Glassnode

If we look at the buying activity of Whales (those who control more than 1 BTC and who can be thought of as the smart-money given their historical buying trends) relative to the Small Fish (those who control less than 1 BTC), we are again yet to see significant buying activity from the formed which would be indicative of a bottoming or up-trending market. Per Ecoinometrics, the blue dots on the below chart indicate Whales selling and the red/orange dots buying.

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Source: Ecoinometrics

Likewise, if we look at exchange outflows, which measure the amount of Bitcoin removed from exchanges per transaction, we are not seeing a spike that would represent Whales accumulating and moving their coins off-exchange to be held for the long-term. High readings would be indicative of Whale buying (i.e. smart-money buying) as they would be moving a significant amount of their holdings off-exchange per transaction, a trend that would also signify decreased selling pressure.

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Turning now to the macro outlook and in particular the growth cycle outlook, from a medium-term perspective I do believe crypto markets will find it very difficult come mid-to-late Q1 and beyond this year as we see a material pick-up in the deceleration of economic growth. I detailed this dynamic in depth within my recent Growth Cycle Outlook. Again, as I have pointed out previously, crypto markets do not perform well in macro regimes whereby growth and inflation decelerate in tandem. Unfortunately, slowing growth and inflation remains the highest probability outcome for much of 2022 at this point in time.

Indeed, we can see how much retail speculation has subsided in recent months as the business cycle began its slowing in Q2 2021 and how this has impacted crypto markets by looking at the number of active addresses. This metric peaked in early 2021 and has not recovered since.

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Given so much of crypto’s price action has been governed by discretionary spending and consumption trends over the past couple of years, it is unsurprising to see that as real income growth has fallen and demand subsided, we have seen a lull in crypto markets via a significant drop in retail participation.

For the next month or two moving forward, we are seeing equity markets again attempt to price in one last bounce in growth before liquidity conditions truly deteriorate. As such, a mini-reflation trade over this time frame would likely bode well for crypto assets, particularly if we see rates continue to rise and a blow-off top in equity markets eventuate.

Couple this with the institutional money ready to flow into crypto markets, we may well see constructive price action for crypto in the months. Indeed, if we look at how much cash has been raised by institutional focused custody firms in 2021, approximately $3.5b, we get an idea of how much cash on the sidelines from an institutional perspective there actually is.

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Source: The Block Research

In summary, we currently reside at important technical support levels for both Bitcoin and Ethereum that should be bought so long as investors employ proper risk management. Likewise, sentiment has by and large been washed out to a level indicative of buying opportunities in the past (though this could well go lower). Couple these factors with a potential short-squeeze and risk-on rally in equity markets, there are signs we could see constructive price action for crypto in the immediate term.

Once again, what remains a certainty is that risk management has never been as important in crypto markets as it is today.F

Growth Cycle Outlook: 2022 Will Not be 2021

Not much has changed in regards to my economic growth outlook going forward since my most recent growth cycle update. We continue to be on the precipice of a material decelerate in growth due to hit markets in the coming months as predicated by the leading indicators of the growth cycle. For now, growth did indeed rebound to some extent in Q4 of as many predicted it would.

The following chart highlights various coincident growth metrics, which give us an up-to-date view of where we are generally in the growth cycle and where we have been. These coincident metrics include real manufacturing and trade sales, non-farm employment, industrial production, real personal consumption and real incomes excluding-stimulus payments. On the whole these metrics give us a broad view of coincident economic growth and as we can see below, growth peaked around April 2021 which coincided with the peak of the reflation trade.

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Indeed, if we look at the market performance of some of the most pro-cyclical stock market sectors as a means to assess the reflation trade, we can see their relative performance compared to the S&P 500 peaked in and around Q2 2021. We did again see relative outperformance in late Q3 as these areas of the market began to price in the Q4 growth bounce, though this was short-lived relative to the reflation trade that look place from late 2020 and into 2021.

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Over recent months, we have seen a clear shift towards the defensive areas of the market, with utilities, health care, REITs and consumer staples all outperforming the broad market of late and seeing constructive technical action to the upside.

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It is worth noting however these defensive sectors have by-and-large become overbought relative to their cyclical counterparts, and as such has preceded a clear shift back to pro-cyclical and high-beta risk assets for the time being.

Turning now to the forward outlook for the growth cycle, the long leads have been telling us for some time growth is likely to inflect lower in 2022. The Chinese credit impulse leads the growth cycle by around twelve months, given China’s role as one of the primary drivers of world growth. The credit impulse metric measures the rate of change of newly created credit via commercial bank lending and government stimulus. This peaked in early 2021.

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Source: Julien Bittel – Stouff Capital

Likewise, liquidity measures continue to deteriorate. A continued slowdown in overall liquidity over the coming months is likely to begin to realise itself in asset prices, particularly so when the tapering of asset purchases by the Fed accelerates. The following chart is CrossBorder Capital’s measure of global liquidity and its implication for global wealth, to which it has historically been a solid long-term leading indicator. Liquidity is one of the primary drivers of asset markets and a deceleration in liquidity is cause for some concern.

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Source: CrossBoarder Capital

If we focus on the areas of liquidity most likely to impact the private sector and thus the real economy, the message is not much different. The following chart is the aggregate measure of the year-on-year rate of growth of the physical currency in circulation, household checkable deposits and currency, small time deposits, large time deposits and money market funds total assets.

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Paying closer attention to household sector, the growth rate of household net worth has historically been another excellent long lead for the growth cycle and leads consumption by around six months. Household net worth peaked in Q1 2021 and has since inflected lower.

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Likewise, building permits continue to decelerate lower. A reduction in building permits is indicative of slowing growth in housing and construction as building permits precede the construction of new housing and indicate lessening demand, as well as being impacted by various cyclical factors such as disposable income and interest rates. Given housing’s importance to the economy, building permits do a solid job forecasting the housing market and provide a long-lead for the growth cycle.

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From a consumer perspective, inflation continues to impact demand. The University of Michigan Consumer Buying Intentions Survey for vehicles, houses and household goods all continue to trend lower. Given how real incomes have been decelerating on a rate-of-change basis in the past year, this shouldn’t be a huge surprise.

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When real income is falling, that is, costs increase by more than incomes, consumption must then be maintained via new debt or drawing down from savings and investments. Unfortunately for consumers however is that savings have fallen back to trend and thus is indicative of falling future growth potential.

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As such, it is not surprising to see many of the shorter leads of the growth cycle starting to turn back downward after a brief respite of late. The Economic Cycle Research Institute (ECRI) Weekly Leading Index has once again turned lower. This metric peaked in early 2021.

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Source: Economic Cycle Research Institute (ERCI)

In addition to ECRI’s Weekly Leading Index above, of the several leading econometric forecasting models of economic growth which I monitor, almost all are decelerating.

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Sources: OECD, ECRI, Conference Board, Trading Economics, 42Macro

Digging further into the shorter leads within the manufacturing sector, several of the sub-components of the US ISM Survey help provide key insights into the direction of the manufacturing sector. We can see below the New Orders Index registered its second lowest reading in nearly 18 months. New orders provides a timely insight into the direction of demand. Likewise, we can see that pricing pressures are beginning to ease across the manufacturing sector.

Likewise, the Backlog of Orders index within the ISM Survey also continues to move downward, perhaps indicative of easing supply chain pressures. Such measures seem to indicate inflation will at some point in the near future begin to trend lower in rate-of-change terms. Though inflation will likely remain at much higher levels on a nominal basis, what matters primarily for asset prices is the direction of change in growth and inflation.

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Source: Institute of Supply Management

If we examine the spread between the ISM Manufacturing New Orders Index above and the ISM Inventories Index, have have historically been able to track the direction of the overall ISM Manufacturing Index itself by about three months. We can see this below courtesy of the great work by Stouff Capital’s Julien Bitel. As the new orders to inventory spread falls, this means inventories are increasing faster than sales, and less inventory then needs to be produced going forward. Less production means less workers and thus is indicative of falling demand.

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The growth in industrial commodities is confirming this message. Industrial commodities and metals such as aluminium, copper, nickel, zinc and lead are more likely to follow the growth cycle as increases or decreases in industrial production and manufacturing require the use of these commodities. To confirm the next move higher in the growth cycle we would ideally like to see a move higher in these type of industrial commodities.

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As we can see using the short and long leads of the growth cycle, it is relatively clear that a deceleration in growth and inflation is the highest probability outcome for 2022. What this means from an asset allocation perspective is relatively straight forward; investors will do well to underweight their pro-cyclical exposure and overweight their defensive exposures. An overweighting of defensive exposures allows investors to allocate to the asset classes and equity style factors which have historically done best during times of decelerating growth. The following chart provides an asset allocation guide given my current growth cycle outlook over the next six months or so.

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However, I say that to say this; a macro framework and outlook is only once piece of the puzzle. One’s macro outlook should not necessarily be cause to overlook a micro opportunity. I use my macro outlook to assist with my risk management and tactical exposures to my various holdings. Additionally, we cannot forget that macro is inherently slow moving by natures, so it becomes important to understand timeframes when one has a bearish macro view, as some of the biggest moves in markets occur during the late stages of the growth cycle.

It may well be the case that we do see a high-beta driven risk-on rally eventuate over the coming weeks and into the latter stages of Q1 2022 before the Fed accelerates its tapering. Likewise, we have largely seen the defensive equity sectors become somewhat overbought of late, and as such it appears some of the pro-cyclical areas of the market could well lead the market higher.

Indeed, we can see this by examining the various iterations of the yield curve. Whilst the longer yield spreads such as the 10s/2s, 30s/2s and 30s/5s remain in a downtrend overall as the bond market continues to price in slowing growth, we are seeing a minor steepening of late which would do well to favour pro-cyclical assets should this continue.

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Should the 10-year treasury yield break out of this range and hit 1.8%+, that would confirm this thesis and could be bullish short-term for pro-cyclical equities relative to their defensive counterparts, with small-caps and financials being two such beneficiaries.

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If we do see yields break higher I suspect a material move higher to be difficult given how commercial hedgers (i.e. the smart money) have on their longest 10-year treasury positions in the futures market in a number of years, whilst conversely, commercial hedgers (i.e. the dumb money) are heavily short 10-year treasuries. Should this level therefore reject, we would likely see any pro-cyclical rotation be short-lived.

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What’s more, the dollar wrecking ball is entering its most seasonally bullish month of the year in January.

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The dollar has consolidated nicely following its recent move higher and is looking like it wants to bounce off the 50-day moving average. This could well be the impetus for its next move higher.

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As I have mentioned in the past, Lacy Hunt refers to the currency markets as the most forward-looking of all markets, and a higher dollar indicative of a weakening economy.

Summary

In summary, the growth and liquidity impulse that drove the reflation trade throughout the past couple of years is now over, meaning the easy money has been made. As growth and inflation look to decelerate further in the coming quarters, investors will do well to continue to transition their portfolios to a more defensive nature.

With the nominal value of inflation higher than anything the market has experienced in recent times and likely to remain so (though on a decelerating basis), the dynamic of how the Fed will intervene within markets via the “Fed Put” may no longer be as supportive of asset prices going forward as it has been in the recent past. Whilst the Fed has implicitly supported asset markets up until now, their mandate is to maximise employment and achieve stable prices. Though it may be difficult to believe, the economy is their primary concern, it just so happens that due to the disinflationary trends holding down inflation up until now, this has allowed the Fed to remain easy and thus use the stock market as their conduit to supporting the economy. What is different in 2022 and beyond is the stock market and the economy no longer lay on the same path from the perspective of the Fed. Jerome Powell will now need to decide between combating inflation and stabilising prices into an economic slowdown (bad for stocks), or support the stock market which is likely going to struggle as the economy slows and the Fed tightens.

The “Fed Put” is likely to be much lower going forward than it has been in the past so long as the Fed now opts to help main street over wall street.

For a look at all of today’s economic events, check out our economic calendar.

Crypto Market Outlook: Nearing A Make Or Break Moment

Whilst the euphoric sentiment towards Bitcoin has been largely washed out amid this pullback and on-chain data is beginning to appear more favourable, we are nearing some very important key technical levels for both Bitcoin and Ethereum. Furthermore, the apparent slowing economy is unlikely to bode well for risk assets in 2022, especially crypto, and thus represents the big headwind facing the market for the foreseeable future. Though we could see positive price appreciation within the early months of 2022, for those betting on $100k bitcoin and $20k Ethereum in December 2021, it is time to reign in your expectations.

After what proved to be a false breakout attempt to new all-time highs in early November, BTC now lies right at the confluence of the 50-period moving average on the weekly chart and the ascending trendline that has held up well thus far since the March 2020 lows.

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This 50-period moving average on the weekly chart (blue line above) has been an incredibly important resistance level throughout 2022, and if broken, could see BTC retrace back down to the $30k level in short order, an area that appears to be the lower resistance level in what has been a large consolidation range.

On the daily chart, the 200-day moving average is the key area to watch. Should this level continue to hold, we could potentially see the psychological $50k level retaken and presage a nice bounce into January, though if the 200-day moving average does not hold, a further flush to the $40k-42k seems likely.

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Ethereum meanwhile has shown significant relative strength over recent months. Key support lies around the $3,600 area which the price has bounced off nicely in recent days. Below that, $2,900 looks to be the next key level along with the 200-day moving average; not a bad area to go long.

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What remains in ETH’s favor for now is the recent breakout of the ETH/BTC spread. This ratio looks to be trying to turn the key 0.08 level that was once resistance into support.

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If this level holds, we should expect ETH outperformance to continue. Should the market indeed bounce over the next month or two, ETH could well be the place to be relative to Bitcoin.

Turning now to investor sentiment, we have seen this recent correction wash out much of the bullish sentiment towards the crypto markets that was evident in November. The Bitcoin Fear & Greed Index has now fallen to levels reminiscent of decent long-term buying opportunities in the past.

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Confirming the wash-out in sentiment is the Bitcoin Optix, which too has reached levels supportive of a potential short-term bottom possibility forming.

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Positioning in the futures market is also beginning to look somewhat more constructive for BTC. If we look at the Other and Non-Reported categories below, representative of small speculators within the futures market (i.e. the dumb money), both have significantly reduced their net-long positions to a level similar to the May to July lows. Speculators in the futures market tend to be long at the tops and short and the bottoms.

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Source: Crypto Quant

Conversely, hedge funds, who in the BTC futures market tend to be long (or less short) at the bottoms and heavily short at the tops, have reduced their short positions to a certain extent amid this current pullback, though not nearly to the level seen at the July lows earlier this year.

Whilst not pictured, we are yet to see a washout in speculative positioning in the futures market for ETH, which is unsurprising given its recent relative strength. This does however lead me to believe ETH has more downside potential relative to BTC at present, and if this market were to continue lower then ETH could play catch up to downside. We are seeing similar messages for ETH relative to BTC in the futures open interest data and perpetual funding rates.

Indeed, we have seen a significant reduction in open interest in BTC futures of late, indicating a reduction in the excess leverage in the system, though the total open interest still remains at elevated levels relative to what we have seen during 2021. However, it is important to consider how this open interest data is being effected by the introduction of the Bitcoin futures ETFs in recent months. As the futures market is generally used for traders of a short-term time frame due to the excessive roll costs associated with holdings futures contracts for long time periods, buyers of the Bitcoin futures ETF who intend to hold for the long-term would cause the open interest data being skewed to the upside.

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Source: Crypto Quant

This does not mean we should dismiss the open interest data completely, particularly when ETH open interest remains at particularly excessive levels, as we can see below.

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Source: Crypto Quant

Perhaps a better measure of leverage within the system however are the futures funding rates. Funding rates are indicative of the directional bias of leveraged positioning. When positive, long traders pay premiums to shorts, and when negative, shorts pay premiums to longs. Positive spikes generally indicate extreme optimism whilst negative spikes often indicate extreme pessimism.

We saw BTC futures funding rates go heavily negative in early December and have since stabilized around neutral territory. This is certainly positive, clearly telling us that much of the leveraged long BTC positions have been wiped out, though this does not necessarily mean further downside is not a possibility.

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Source: Crypto Quant

Turning now to some of the On-Chain analytics, what is interesting is the precarious position we currently reside in for several of these metrics and how they are aligning with the important technical levels highlighted above.

As noted this week by Glassnode, the net unrealised profit/loss (NUPL) metric for BTC has established a clear level of resistance around the 0.5 area.

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Source: Glassnode

Should this level fail to hold, it would presumably coincide with a break of the 200-day moving average and would likely presage another move lower. Should it hold, then those who have bought this dip are likely to be rewarded.

Encouraging though from an on-chain perspective is that we are witnessing BTC holdings being transferring from on-exchanges to off-exchanges. Falling exchange balances could indicate accumulation by long-term holders, whereas transfers on-exchange are generally indicative of selling pressure.

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Source: Glassnode

To me, the signal form the on/off-exchange movement is twofold; first, long-term holders are buying this dip in earnest and locking away their holdings off-exchange without the intent to panic-sell; and second, we are yet to see a true capitulation from these long-term holders that would indicate a true market bottom, similar to what we saw during the July bottom. As such, I find difficultly in extrapolating a clear message from the exchange-flows activity, so take from it what you will.

From an aggregate on-chain risk perspective, the market is still far from overheated, but neither are we near an aggregate risk level seen at past long-term market bottoms, as per Ecoinometrics.

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Source: Ecoinometrics

Looking towards the macro and economic growth cycle and their implication on crypto; I believe the potential resumption of the deceleration of growth in early 2022 to be a significant headwind for all crypto markets over the medium-term, particularly given how retail driven and pro-cyclical crypto has become of late.

As I detailed within my most recent Growth Cycle Outlook, a deceleration in the rate of change of growth and inflation, monetary tightening into an economic slowdown, a fiscal cliff and diminishing liquidity conditions all have the potential to rear their ugly heads as early as Q1 2022. Throw in strong dollar and we have the ingredients for a lull in risk assets.

Indeed, what we do know certain is historically, BTC has not performed well in environments whereby both growth and inflation decelerate on a rate-of-change basis in tandem, courtesy of the great work by Darius Dale of 42Macro.

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Source: Darius Dale – Bitcoin historical performance vis-à-vis macro regime.

For reference, the above macro regimes as per the work of 42Macro are categorized by the direction of the rate-of-change of both growth and inflation. Goldilocks represents periods whereby growth accelerates and inflation decelerates, Reflation where both growth and inflation accelerate together, Inflation whereby growth decelerates and inflation accelerates, and Deflation whereby both growth and inflation decelerate. It is always important to remember, what primarily impacts asset prices and financial markets is the direction of the rate-of-change in growth and inflation.

Additionally, given how much discretionary spending has played a part in the crypto run-up of late 2020 and early 2021, we are entering a period whereby these conditions are no longer present. Inflation is eating into demand and real income growth is negative. Though we have witnessed a small bounce in growth throughout Q4 relative to Q3 and one that may even extend into early 2022, said bounce is running out of fumes and defensive assets are now leading the charge in traditional financial markets. Investors cannot assume 2022 will be the same as 2021.

However, if we see the dollar correct somewhat in the coming month or two (or even continue to consolidate), as the weekly DeMark 9 sell count is suggesting it may, this scenario may ease some of the pressure on risk assets and potentially allow crypto to rally into January.

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I do however expect to see the dollar to continue to move higher next year, potentially even as high as 103 on the dollar index. This is an area which has marked the top of what has largely been a rangebound market over the past half-decade.

In summary, both the bull case and the bear case have merit for crypto over the coming months. Investor sentiment has largely been washed and is beginning to look favourable, so too in regards to leverage within the futures market. Additionally, we are not seeing any major red flags from the on-chain data. However, the macro headwinds could cause some pain in the next quarter or two. Will we see the market rally into January and February? Quite possibly, particularly so if hedge funds and institutions enter the market as they reset their books for the new calendar year.

What is certain is risk management has never been so important as it is now.

Growth Cycle Outlook: Growth Bounce, Then Deflation

For 2022, the culmination of peaking inflation, peaking liquidity conditions and peak growth, brought on by rising prices, falling real incomes, the fiscal cliff, stronger dollar and rising rates could usher in a period of disinflation whereby both economic growth and inflation decelerate in tandem. A continued shift from cyclical to defensive assets and equity sectors ought to serve investors well over the medium term.

Beginning with the long leading indicators, they have for some time been telling us that 2022 will be very different from what we experienced during 2021. The Chinese credit impulse leads the growth cycle by around twelve months, given China’s role as one of the primary drivers of world growth. The credit impulse metric measures the rate of change of newly created credit via commercial bank lending and government stimulus. This peaked in early-to-mid 2021.

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Source: Julien Bittel, Stouff Capital

Such a deceleration in credit creation should begin to be reflected in realised growth and asset prices potentially as early as the first half of 2022. Prometheus Research, who forecast the growth cycle via systematic modelling and NowCasting are projecting the deceleration of growth to be pronounced in 2022, as we can see below.

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Source: Prometheus Research

Confirming this message are the liquidity conditions. Liquidity is another excellent long-term leading indicator for both the growth cycle and asset markets and is similar to the credit impulse. Whilst still accommodative for now, liquidity has well and truly peaked and should transition into realised growth and asset market performance sometime in the first half of 2022.

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Source: Prometheus Research

Another measure of liquidity and long leading indicator is the Marshallian K, which compares the ratio of the money supply (M2) relative to GDP. This metric peaked in early 2021 and again leads the growth cycle by around 12 months.

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An accelerated taping by the Fed brought forward due to continued inflationary pressures is likely to only worsen liquidity conditions in 2022. That however, remains a story for 2022.

Turning now to housing and construction, housing permits are well below their April 2021 peak on an annual growth rate perspective.

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A reduction in building permits is indicative of slowing growth in housing and construction as building permits precede the construction of new housing and indicate lessening demand, they are also impacted by various cyclical factors such as disposable income and interest rates. Given housing’s importance to the economy, building permits do a solid job forecasting the housing market.

From a consumer perspective, higher prices continue to impact both the demand for goods as well as real income. The University of Michigan Consumer Buying Intentions Survey for vehicles, houses and household goods all remain near their lowest levels in years. Though the survey data for housing and vehicles appears to have slightly ticked upward over the past couple of months, indicative of the small bounce in growth we have experienced during Q4.

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Source: Acheron Insights, University of Michigan

Indeed, looking at the growth of real disposable income per capita and real disposable income excluding transfer receipts (i.e. ex-stimulus), the former remains in negative territory in a year-over-year basis whilst the latter continues to decelerate.

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Disposable income is struggling to outpace inflation, particularly when government stimulus is removed from the equation. Indeed, on an absolute basis, real disposable income per capital is beginning to fall below the pre-COVID trend. As stimulus fades and the fiscal cliff approaches, it appears as though one of the primary drivers of real growth over the past 18 months is dissipating.

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This is particularly worrisome when assessing how far the labor force participation rate is from its pre-COVID levels. Though the labor market may be tight and wages on the rise, any positive growth impact from rising wages is being offset via a shrinking labor force.

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It is not just inflation that is eating away at incomes but interest costs too. Mortgage costs are over 30% higher than where they were 12 months ago.

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Higher interest costs and higher costs in general is damaging unless offset by rising real income. If real incomes continue to decline, demand will likely continue to follow suit and with it consumption.

From a shorter-term perspective, the short leading indicators did pick up the growth bounce seen in Q4. How long this continues remains to be seen, but, as I will detail below, the markets appear to no longer be pricing in much of a continued bounce through the outperformance of cyclical assets. Ideally, we would need to see the consensus of the short leads pick up materially to confirm this view. Whilst the long leads give as a guide of what could occur over the next six to twelve months, the short leads provide confirmation of cyclical turning points, particularly when used in conjunction with asset market data.

Firstly, the Economic Cycle Research Institute (ECRI) Weekly Leading Index did turn up in October. Should this index continue to accelerate on a rate of change basis, we could see this growth bounce continue to surprise to the upside throughout the next couple of months and into the first quarter of 2022.

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Source: Economic Cycle Research (ECRI)

Again, confirming the growth bounce was Citibank’s economic surprises index, which has picked up into positive territory over recent weeks, though perhaps somewhat of a function of Q3 growth being lower than expected.

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Source: SentimenTrader, Citigroup

The shorter leads of the manufacturing sector however appear to be confirming the notion of the longer leading indicators that a deceleration of growth is set to continue and the growth bounce is nearing exhaustion.

The US ISM survey’s Manufacturing New Orders index provides a timely insight as to the demand for manufacturing. This survey just reported its lowest reading in over a year.

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US ISM Manufacturing New Orders Index

Source: Institute of Supply Management, Investing.com

Confirming this is the US Census Bureau’s reporting of manufacturing new orders, both in consumer durables and total manufacturing. The Census Bureau data peaked in April 2021 on a growth basis and has been decelerating since.

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The manufacturing sales to inventory ratio too continues to decelerate, per the US Census Bureau manufacturing data. When sales are rising at a greater pace than sales and the ratio rises, then more inventory needs to be produced, thus putting upward pressure on prices, as well as an increased need for workers and hours worked, positive for growth. When inventories rise at a greater pace then sales and the ratio falls, the inverse occurs.

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After peaking in May on a growth basis and again spiking in October, industrial commodities and metals are decelerating, confirming the manufacturing data above. Industrial commodities are more closely linked to the growth cycle than energy and agricultural commodities. A continued decline in the acceleration of growth in industrial commodities is suggestive that a Q4 bounce in growth is only temporary.

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Forecasting growth from a data driven perspective is only half the story however, we must take heed of what financial markets are doing and whether they are pricing in continued growth or slowing growth.

Firstly, the various iterations of the yield curve are by and large trending lower. Clearly, the shorter curves (such as the 5s/3ms and 10s/3ms) are rising to reflect the impending monetary tightening. However, the longer iterations of the yield curve are continuing to trend lower, as the bond market continues to price in slowing growth and slowing inflation for 2022. We are not seeing any real form of curve steepening whereby longer-term rates rise faster than short-term rates, indicative of higher growth and inflation expectations. Particularly notable is the 10s/2s spread recently breaking down to new cyclical lows.

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After pricing in the growth bounce in late September to early October, the pro-growth sectors and style factors have largely underperformed during November.

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Meanwhile, the anti-inflation asset classes appear to be rebounding from their underperformance over recent months, whereby inflation continued to accelerate to the upside. This market shift could well be signaling peak inflation.

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The currency markets too are by and large indicating a continued slowdown in growth, as the pro-cyclical currencies are largely heading lower. This is particularly pronounced in emerging markets, whereby US dollar strength wreaks havoc as foreign debt costs rise with the dollar.

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The dollar itself has been on a tear lately, with the dollar index up nearly 9% over the past six or so months. Fortunately, it looks as though we may be in for a reprieve over the next month or two as a dollar correction or consolidation is well over due. Should this occur, such a scenario would be supportive of a Santa Claus rally in risk-assets and a potential continued growth bounce into early Q1 2022.

The dollar recently triggered a weekly DeMark 9 sell count, and is entering overbought territory.

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Dollar seasonality is supportive of this view, as December is historically the worst month for the dollar.

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Lacy Hunt refers to the currency markets as the most forward-looking of all markets, and a higher dollar indicative of a weakening economy. Should this hold true, we should expect to see a resumption in growth deceleration at some point during the first half of 2022.

The bond market is certainly conveying this message, with the 30-year yield at a critical point and threatening to break lower, though we could see a bounce off this resistance level and a retest of the descending trendline before a break lower, which would again be supportive of risk assets over the next couple of months.

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The bond market tends to get these things right; we saw yields peak in early Q2 this year as growth peaked before turning lower and again rebounding in late September/early October amid the recent bounce in growth. This is a chart investors should be keeping a close eye on.

What’s more, if we look at positioning in the futures market, speculators (i.e. the dumb money) have on their shortest bond positions since early 2020, whilst hedgers (i.e. the smart money) are currently net-long at a level not seen since early 2019 when long-term bonds rallied nearly 50% over the next 12 months. Historically, rates have struggled to move much higher in such circumstances.

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Additionally, the long-term chart of the stocks-to-bonds ratio is at the upper end of its decade long channel and is looking like bonds are ready to outperform. I don’t believe we will see such relative outperformance of bonds to the extent we reach the lower bound of this channel, but this chart is suggestive of some level of bond outperformance in the next year or so when interpreted in conjunction to that which I have detailed throughout this article.

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Summary

In summary, it appears as though we may be heading towards an inflection point in early 2022 whereby we begin to see the rate of growth continue its deceleration to the downside. Whether inflation follows suit remains to be seen, though my base case in the direction of change in inflation could surprise to the upside again in December and perhaps even January as the owners’ equivalent rent (roughly 25% of the CPI basket) continues its inflationary tailwind, before unfavorable base effects and the slowing of demand and consumption alleviates the persistent supply chain pressures in the first half of 2022.

Should we see both growth and inflation begin decelerate in tandem on a rate of change basis, risk assets will no longer be the place to have the majority of one’s capital. Until then, it may be prudent for investors to slowly transition from the high-beta, cyclical, short-duration asset classes and sectors that perform will in a pro-growth, pro-inflation environment, and rotate into their defensive counterparts over the coming months.

For a look at all of today’s economic events, check out our economic calendar.

Energy Is Breaking Out: Is It For Real?

With the bond market reacting to the announcement by selling off sharply, yields look to be trying to now price in inflation. A clear repricing of those assets who benefit from higher yields has been evident. Despite much of the leading data suggesting economic growth looks set to decelerate over the coming months, it’s important to remember that, when the bond market makes a move, it is generally the right move and investors ought to pay attention.

Indeed, on the back of rising yields and a steeping yield curve, one of the biggest beneficiaries of this shift has been the energy sector, namely oil and oil related equities. With crude oil leading the charge, the energy sector looks to be breaking out of an important technical resistance point, a potentially bullish outcome for the immediate future.

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The fundamental case for crude oil and energy-related equities, particularly in the exploration and production space, remains as bullish as ever. The sector has been starved of capital since 2014 and is a trend set to continue for the remainder of 2021 and 2022 at the very least. Ever-increasing ESG pressures will only exacerbate this dynamic over the coming years. The energy sector remains one of my favorite trades for the next few years.

Source: Goldman Sachs
Source: Goldman Sachs

Combined with attractive valuations on both a relative and absolute basis, the stage is set for a continuation of this bull market. Indeed, with the energy sector still only representing around 3% of the S&P 500 index, despite having appreciated roughly 150% since March 2020, plenty of upside potential remains.

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Thus, as long-term investors bullish the sector this begs the question; is this breakout the catalyst for the next move higher?

While breakouts above well-defined horizontal levels of resistance are inherently bullish and represent excellent opportunities to trade tactically, of the many indicators I monitor not just technical but from a sentiment, fundamental and macro perspective, the signals are mixed.

What is encouraging when looking at the market from a longer-term perspective is how commercial crude oil hedgers (i.e. the smart money), have reduced their short positions in the futures market to the lowest point since early 2020, as illustrated below. Producers themselves are now fully net long (not pictured), an encouraging development as the producer hedging position is most often short rather than long.

Producers use the futures markets primarily as a means to hedge downside risk against falling oil prices. In addition, the managed money futures positioning (not pictured), consisting primarily of hedge funds and CTA’s, also have their smallest net-long positions since March 2020. It pays to fade managed money as these market participants are effectively just trend-followers, and are thus routinely long at market tops and short at market bottoms.

Source: SentimenTrader
Source: SentimenTrader

However, as you will note above small speculators remain heavily net long, clearly illustrative of investors betting on a continuation of the reflation trade.

The futures curve itself remains in state of backwardation, a situation whereby the prices of the shorter-dated contracts exceed the longer-dated contracts. The futures term structure is by no means a predictor of future prices, but rather is reflective of supply and demand within the oil market. A state of backwardation as we are in currently is representative of a deficit, meaning demand for immediate delivery exceeds immediate supply. This has been the case for most of 2021.

Source: BarChart, Acheron Insights
Source: BarChart, Acheron Insights

The shape of the term structure is a very useful tool to assess the underlying fundamentals within the market. Backwardation implies a deficit, resulting in inventories needing to be drawn down to meet demand. This is the opposite of what occurred in March 2020, where the short-dated contracts went negative in a state of steep contango, reflecting the worldwide evaporation of demand induced by the initial COVID-19 lockdowns. The majority of gains within the energy markets come when the curve is in either backwardation or falling contango.

However, it is during times of falling contango whereby the most impressive returns in energy markets take place. In fact, as noted recently by SentimenTrader, backwardation is more closely associated with periods near market tops, with six to 12 month subsequent returns historically negative.

Source: SentimenTrader
Source: SentimenTrader

Although it must be said this analysis has very little bearing for the immediate future, as the curve will likely shift from backwardation to contango prior to such market pull-backs, hopefully providing a decent warning signal in advance. For now, the backwardation of the term structure in the futures market is supportive of this recent breakout.

Turning now to the technicals, as we can see below the breakout in crude has been accompanied by daily DeMark 9 and 13 sell signals, a sign of potential trend exhaustion.

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It’s hard to argue this clear breakout is not bullish from a pure technical perspective, though we are yet to see the broad energy stocks follow the path of crude. The XLE energy sector ETF is sitting right at a level of strong overhead resistance. A close above 56 would be a bullish outcome and a confirmation of the breakout in crude.

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The XOP ETF however, appears to be confirming the bullish breakout in oil. This in unsurprising, as XOP contains the oil and gas exploration and production companies whose price action resembles somewhat of a levered play on oil itself.

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Whilst the fundamentals are strong and the technicals potentially looking bullish, not every indicator is confirming this breakout. Firstly, we are on the precipice of the worst performing months for crude oil historically. Whilst I would never base my investment decisions off seasonality alone, as my preference is to utilize a holistic approach combining fundamentals, technicals, sentiment and macro, one thing is for certain, going long crude oil in Q4 is one fraught with danger historically.

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From a sentiment perspective, investors have gone from pessimistic to outright euphoric in a matter of weeks. We can see this by looking at the energy sector Bullish Percent Index ($BPENER), which is maxed out at 100.

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And by looking at the XLE Optimism Index (Optix).

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From a growth cycle and macro perspective, energy stocks and oil are best suited to environments of accelerating growth, ideally accompanied by accelerating inflation. Stagflation on the other hand is not an environment in which crude oil or energy equities have performed well historically, nor in one of disinflation.

Whilst inflation may well continue to accelerate on a rate of change basis throughout the remainder of this year, what is evident is the leading indicators of the economic growth cycle are still pointing towards a deceleration in growth over the near term. I discussed this in detail within a recent post. Confirming this message is the Atlanta Fed’s GDPNow forecast for real GDP growth for Q3. This estimate has again just been revised down to a 1.3% annualized quarter-over-quarter growth rate of real GDP from 3% only last week.

Source: Atlanta Fed
Source: Atlanta Fed

As a result, we are beginning to see divergences emerge between the performance of energy and several growth related market indicators that are not supportive of the recent positive price action. Firstly, the dollar has continued to rally despite bonds selling off over recent weeks. As the dollar and energy are very much negatively correlated, one will catch up with the other at some point.

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Could it be the dollar is confirming the message of slowing growth? Seasonality is suggesting this may be the case.

Source: SentimenTrader
Source: SentimenTrader

As is the copper-to-gold ratio, another historically good indicator for assessing the current macro environment. This ratio is yet to confirm the breakout in energy and has continued to make lower highs since May.

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While the bond market and various equity sectors are looking like they are trying to price in a resumption of the reflation trade, the leading growth cycle indicators are yet to follow suit. Given the bond market in particular generally gets things right, it may well be the case that we see energy prices continue to March upwards throughout the final months of 2021.

However, until we see a pickup in growth reflected in the leading data and with the potential macro headwinds and euphoric sentiment towards the energy sector at present, it’s hard to see this breakout as more than a potential trading opportunity from a tactical perspective for the time being.

Industrials: A Buy The Dip Opportunity For Long-Term Investors

Whilst the industrials sector has only fallen about 7% from its highs set in May of this year, as per the XLI ETF, the extreme washout of sentiment and breadth within the sector presents a potentially favorable buy-the-dip opportunity for long-term investors.

Beginning with sentiment, the SentimenTrader Optix measure of the pessimism and optimism of investors within the sector has fallen to extreme levels representative of decent buying opportunities over recent years. On the whole, investors are clearly pessimistic towards industrial stocks right now.

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Whilst not at the same level of pessimism as the Optix measure above, the Bullish Percent Index (BPINDY) for the sector has fallen to a sub-50 reading. Such a level in the past has generally been indicative of attractive buying opportunities for those with a time frame of at least 12 months.

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Meanwhile, the washout in breadth within the sector has too reached favorable levels for those looking to accumulate long-term holdings. The number of stocks within the XLI ETF trading above their 50-day moving fell to below 15%, if only briefly.

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Using another measure of market breadth, the McClellan Oscillator (which calculates breadth based on various measures of the number of advancing versus declining stocks), has also plunged to a level indicative of an excellent long-term buying opportunity historically. According to SentimenTrader, when we see a reading in this breadth measure whilst XLI continues to trade above its 200-day moving average, investors who were willing to deploy capital at such a time were rewarded with excellent returns over the proceeding six to 12 months.

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Corporate insiders are clearly taking note and are using this opportunity to add to their company holdings. The corporate insider sell-buy ratio for the industrials sector has fallen to its lowest level since March 2020.

Source: WhaleWisdom.com

Source: WhaleWisdom.com

From a technical perspective, the sector has been channel-bound for a number of months now, but has still managed to reach an oversold level in momentum (RSI) and money flow (MFI). Encouragingly, there appears to be a strong level of support around the $97-$98 area, which is the confluence of the lower trend-line of this channel and the 200-day moving average.

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However, as you have probably noticed thus far, I am emphasizing my view that this buying opportunity potentially presenting itself is geared towards long-term investors looking to add or commence positions in the industrials sector. Whilst the breadth and sentiment levels in the sector are indicative of favorable buy-the-dip opportunities historically, this is more so the case for those buying with a long-term/multi-year timeframe.

As with most cyclical stocks and assets classes at present, the current state of the business cycle and the apparent deceleration in growth does not present a favorable risk-reward set-up for the next few months at the very least. This is a topic I covered comprehensively in a recent post. Indeed, as we can see in the back-test above, the one to three month returns in such times historically were subpar. This is the likely scenario for the next few months in my view. Until the leading indicators of growth in the economy begin accelerating, the industrials sector is likely to continue to underperform the market, as has been the case since May. However, as we have experienced this past week, unfavorable macro conditions create the potential for additional buying opportunities for the long-term investor.

Finally, confirming this message of potentially imminent further weakness is seasonality, which indicates that historically, September and October are generally not favorable months for the sector, but have provided solid buying opportunities.

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In summary, whilst the macro headwinds are present for the industrials sector and are likely to remain present for the next few months, for long-term investors willing to look past the potential short-term volatility and underperformance, we may be experiencing a good buy-the-dip opportunity.

For a look at all of today’s economic events, check out our economic calendar.

Economic Growth Outlook: The Slowdown Continues

Furthermore, a continued slowdown in growth may precipitate a deceleration in the rate of change in inflation, indicating a transition from a stagflation macro regime to that of outright disinflation, whereby both inflation and growth decelerate together. As such, investors would do well to position their portfolios in a defensive nature and reduce risk, particularly with the notion of the likely tightening of monetary stimulus by the Federal Reserve on the horizon.

Leading Indicators: Credit Creation

Beginning with what is perhaps the best indicator of growth potential in the real economy, as opposed to just the financial economy, the G3 credit impulse is now firmly in negative territory after peaking in the latter stages of 2020.

Source: Nordea
Source: Nordea

Credit impulse is a measure of the rate of change of new credit creation as a percentage of GDP, with the G3 measure above incorporating this data from the US, China and Europe. Unlike pure monetary measures such as the M2 money supply, credit creation measures the rate of change of credit creation in the real economy, via commercial bank lending and fiscal deficit spending, and thus acts as a far better tool for predicting real economy growth. Credit impulse is effectively a leading indicator for just about everything, usually by about 10-12 months.

Confirming the message of the credit impulse is Chinese bond yields, which themselves are an excellent leading indicator of the world’s business cycle. China remains the world’s largest manufacturer and drives much of the world’s business cycle. Similar to their credit creation, Chinese yields have been trending lower since their short-term cyclical peak in December 2020.

Source: Trading Economics
Source: Trading Economics

Leading Indicators: Construction

Turning to manufacturing, building permits for new housing have been decelerating in a year-over-year rate of change basis at an alarming rate since April.

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A reduction in building permits is indicative of slowing growth in the housing and construction sector as building permits precede the construction of new housing and indicate lessening demand.

Leading Indicators: Manufacturing

So too confirming the deceleration in growth is the manufacturing sector. The US Census Bureau’s manufacturing inventories to sales ratio continues to trend upwards to nearly positive on year-over-year rate of change basis.

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When sales are rising at a greater pace than inventories and the ratio falls, then more inventory needs to be produced, thus putting upward pressure on prices, as well as an increased need for workers and hours worked. When inventories rise at a greater pace then sales, the inverse occurs.

We can extrapolate this further by focusing on the Census Bureau’s data of new manufacturing orders, which continues to decelerate after peaking in April this year. As new orders are very demand sensitive, a deceleration in the data clearly indicates a slowing of growth in the manufacturing sector.

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Again, we can extend this further to see both the growth rate of new orders of durable goods and capital good peaked in the March to April 2021 period and are decelerating. Both metrics provide a good lead on the short-term direction of the economy.

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Of the US ISM Manufacturing Index, supplier delivery times is another leading indicator with important consequences, as this measure gives us a good read on supply chain disruptions in the manufacturing sector. Like with the manufacturing data presented above, supplier delivery times according to the ISM Manufacturing Index participants have been trending lower since May.

US ISM Manufacturing Supplier Deliveries IndexSource: YCharts
US ISM Manufacturing Supplier Deliveries Index

Unsurprisingly, as manufacturing demand and delivery times begin to trend downward, we are seeing the ISM Manufacturing Prices Paid index too begin to trend downward. As supply constraints lessen and demand decelerates, it is unsurprising to see prices paid follow suit. As these ISM readings trend lower, it tells us that fewer executives in the manufacturing sector are facing supply constraints and price increases relative to the previous month.

US ISM Manufacturing Prices Paid IndexSource: YCharts
US ISM Manufacturing Prices Paid Index

Industrial commodities are too confirming this message. Although they remain elevated on a nominal basis, the growth in prices for industrials commodities is clearly decelerating.

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The same can be said for employment in the manufacturing and construction sectors. The aggregate data of both peaked in April on a year-over-year rate of change basis and have been decelerating since.

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Leading Indicators: Consumer Demand

From a consumer demand perspective, the University of Michigan Consumer Buying Intentions Survey for vehicles, houses and household goods all remain near their lowest levels in some time. The spike in inflation over the past number of months is clearly impacting consumer demand for goods. Evidently, demand is not only waning in the manufacturing and construction sectors but in households too.

Source: Acheron Insights, University of Michigan
Source: Acheron Insights, University of Michigan

Other Leading Indicators

Turning now to several broader leading indicators of economic growth, the growth rate of Economic Cycle Research Institute’s (ECRI) weekly leading index continues to decline following its April peak. As noted by ERCI, this composite index generally leads cyclical turning points in the economy by 2-3 quarters.

Source: Economic Cycle Research Institute (ECRI)
Source: Economic Cycle Research Institute (ECRI)

The Citibank Economic Surprise Index remains firmly in negative territory. This index measures the level of economic data coming out better or worse than expected, and thus, when in negative territory is indicative of more economic data releases disappointing to the downside rather than surprising to the upside.

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And finally, SentimenTrader’s Macro Index Model recently triggered a sell signal. This index combines 11 economic indicators to determine the current state of the US economy (with a focus on the housing market and labor market), of which the indicators are; new home sales, housing starts, building permits, initial claims, continued claims, heavy truck sales, the yield curve, the S&P 500 relative to its 10 month moving average, the ISM manufacturing PMI index, margin debt and year-over-year headline inflation.

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Coincident Indicators

Confirming the trends of the leading economic indicators I have detailed above are the coincident economic indicators. Whilst not necessarily useful in predicting changes in the business cycle, they are important data points that define and confirm the trends in economic growth.

We can see the growth in total non-farm employment confirming the cyclical growth peak in April.

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The same can be said for personal consumption of both goods and services.

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Whilst we would expect to see the growth rate of goods consumption slow as the lockdown induced spike in the consumption of goods was always going to be unsustainable once the economy began to reopen, a deceleration in goods consumption coupled with the decelerating growth in services consumption seemingly confirms the message of a slowdown in the business cycle.

Financial Market Performance

Turning now to financial markets, as I have noted previously, some of the most cyclically sensitive sectors of the stock market have very much confirmed the growth cycle story outlined above. The relative performance of the retail, transports, metals & mining, materials and industrials sectors compared to the S&P 500 all peaked during the first half of 2021 and have underperformed since.

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As growth accelerates, you would expect to see these cyclical sectors outperform, and conversely, when growth decelerates you would expect to see them underperform, as has been the case over the preceding few months.

In addition to the stock market sectors confirming the downward trend in growth, we can see other market performance data sending a similar message. Stocks relative to bonds, commodities relative to stocks, copper relative to gold and lumber relative to gold have all largely underperformed since the first half of the year. Should growth continue in its current downward trend over the coming months as the leading data suggest it might, we ought to expect these relative market performance trends continue.

Taking a closer look at the performance of stocks relative to bonds, we can see that aside from the Nasdaq and the mega-cap growth names, stocks have largely underperformed relative to bonds in recent months. Again, this is indicative of a slowing growth environment.

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And finally, the various iterations of the yield curve continue to remain well below their peaks in March earlier this year. The bond market continues to price in a slowdown of the economy as well as a deceleration in inflation.

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Portfolio Positioning & Asset Allocation

It is important to remember from an asset allocation and portfolio positioning point of view that it is the direction of the rate of change in growth that matters. As growth and credit creation accelerates, it is important to position your portfolio towards the business-cycle sensitive equity sectors and asset classes expected to benefit in such conditions. Similarly, as growth and credit creation decelerate, it is those business cycle sensitive equity sectors and asset classes who are likely to underperform.

As of right now, the leading economic data suggests we are now firmly in a period of decelerating growth, coupled with the likely cyclical peak in inflation. Although inflation pay persist at higher levels on a nominal basis for some time yet, from a rate of change perspective, we are likely to see a deceleration in CPI going forward.

Source: Acheron Insights, BIS, OECD
Source: Acheron Insights, BIS, OECD

As such, investors will do well to position their portfolios towards assets most likely to benefit from a deceleration in credit and growth, and underweight assets that are unlikely to benefit in such a scenario. Risk management is ever so important during such times.

Source: Acheron Insights
Source: Acheron Insights

With the probabilities indicating the slowdown in economic growth is likely to persist for the coming months, investors should do well to adjust their portfolio allocations accordingly in order to ensure their portfolio’s downside risk is limited, whilst also being prepared for what opportunities a potential continued slowdown in growth may provide.

Everything You Need To Know About Central Bank Digital Currencies

In almost any iteration, CBDCs could completely revamp the global financial system as we know it. They have the potential to change the face of finance, and ultimately, change the nature of money itself. Through CBDC’s, fiat money will become truly digitalised and finalise the merger between monetary and fiscal policy.

The development and implementation of digital government money is not necessarily a trend or development one might trade, but rather represents what could be the biggest change to how the financial system is constructed and operates, and is a development everyone must be aware of and would do well to educate themselves on. Should Central Bank Digital Currencies be developed and introduced in a certain permutation, then what money and currency actually are will be reinvented.

Everything from how credit is created, the role of central banks and governments in society, monetary and fiscal policy transmission mechanisms, how the banking system operates, how transactions are processed, the very nature of money itself and how it works, all these things have the potential to be redefined and reengineered entirely.

The problem is however, with these significant changes come even more significant implications. Brought on by temptation, necessity, wealth inequality and rise of populism, Central Bank Digital Currencies “might open a Pandora’s box of unintended consequences, fiscal as well as monetary, overwhelming our would-be masters of money.”

What are Central Bank Digital Currencies?

In their most powerful iteration, Central Bank Digital Currencies will allow individuals, businesses and almost everyone in the private sector to have a digital wallet or bank account directly with their central bank. This in itself is significant, as within our existing financial system it is only commercial banks who are able to account directly with central banks in the form of central bank reserves. In the United States, it is though this channel the Federal Reserve conducts its quantitative easing (QE); they purchase assets from the commercial banks in exchange for central bank reserves.

Without going too much into the dynamic of how QE works, it is via the commercial banking system where true money creation occurs for the real economy. Allowing individuals to have a direct CBDC account with the Fed would allow the central bank to stimulate and interact directly with the individuals, something that cannot be achieved in the present system.

This direct interaction with individuals is being purported as one of the main reasons behind the development of CBDCs. The bypassing of the commercial banking system offers policy makers a completely new toolkit in how they are able to conduct monetary policy. No longer will central bankers’ stimulative measures be constrained by the wills of commercial banks and private sector credit creation.

Rather than relying on bank profitability, regulation and demand for credit to influence the money supply in the real economy, the Fed would be able to inject liquidity directly to individual consumers and businesses themselves. Such a form of a Central Bank Digital Currency would truly transition the central banks from the lenders of last resort to the spenders of last (or first) resort. With such a potentially powerful tool comes great responsibility and equally great consequences, as I will endeavor to detail below.

Almost every central bank in the world has, at the very least, begun preliminary research into the development of their own form of government digital currency.

Source: EY - Tokenization of Assets
Source: EY – Tokenization of Assets

The fact that CBDCs are gaining prominence and entering developmental stages throughout the world at a time where traditional (and “emergency”) monetary policy tools among most developed nations are nearing their usefulness, along with the move of many nations, particularly the United States, to a program of fiscal dominance, Modern Monetary Theory (MMT) coupled with the rise of populism should come as no surprise.

Policy makers have made it clear their intentions are to support asset prices and attempt to generate economic growth at any cost, as they simply cannot afford not too; CBDCs and their inevitability appear to be the culmination of these trends. Debt, demographics and disinflation have put central bankers in a position where they will do anything and everything to avoid Japanification. Central Bank Digital Currencies are the next step down this path of monetary and economic intervention.

Types of CBDCs and how they work

Without going too deep into the potential technologies and infrastructure behind the Central Bank Digital Currencies being in development, it is important to have an understanding of how the various iterations of CBDCs will work and what form they may take. There are numerous different forms of CBDCs being developed, and as such, within this section I will attempt to best summarise these different proposals, along with the potential uses and utility of each.

Retail vs. wholesale

Firstly, CBDCs will either be in a retail or wholesale form. A retail CBDC would be designed for use by the wider population and consumers themselves. This would allow central banks the tools to directly interact with consumers, and thus provide policy makers the greatest amount of stimulative or restrictive measures and data gathering capabilities. A retail iteration of a CBDC represents the most significant change to the monetary system of today and it is through this iteration that money itself will be completely redefined.

A wholesale CBDC on the other hand would be introduced for use within the commercial bank interbank market and other selected institutional and shadow-bank participants. The goal of a wholesale CBDC would be to increase the efficiency and ease of transaction within these wholesale markets. However, compared to a retail CBDC where direct interaction with consumers provides the mechanisms of stimulus and intervention the central banks truly desire, the benefits of a wholesale CBDC do not appear overly significant.

Indeed, from a payments infrastructure perspective in the United States, “there appears to be no need for a CBDC in wholesale payments in the United States”, as the existing wholesale payments infrastructure allows efficient wholesale transactions to be processed with “infinitesimal operational costs and zero demands for collateral or liquidity”.

Direct vs. indirect

A direct model represents the likely iteration of a retail CBDC described above. A direct model would allow consumers to have a direct relationship with their central bank, who would then need to provide many, if not all, the banking and payment services whose responsibility currently falls to the commercial banking system.

For a CBDC to have any meaningful stimulative ability by central bankers, a direct model would be required as this would eliminate the need for intermediaries in the money creation process. Simply, a direct model would allow consumers to have a bank account directly with the Fed, in which they hold their Central Bank Digital Currencies. The central bank would then have complete autonomy over every CBDC held by the private sector within their CBDC account.

There are both significant benefits and consequences associated with a direct iteration of a CBDC. Most notably and meaningful is the role of commercial banks in a world of direct central bank money. Such an environment would completely alter the responsibilities and requirements of the central banks as well as the commercial banks.

Whilst costly for central banks and significant in scope, some permutations of CBDCs could result in the central bank completely intermediating the commercial banking system and taking complete control over the roles and responsibilities commercial banks provide. Everything from banking to lending. This is a significant development in which I go into further detail later.

An indirect (or two-tier model) of a CBDC would allow consumers to hold their CBDCs directly with a commercial bank, similar to how deposits are used today, with the commercial banks continuing to act as the intermediary between the central bank and consumers. The commercial banks would be required and obliged to provide the CBDC to consumers on demand, of which the commercial banks themselves will hold on reserve with the central banks. This is similar to how central bank reserves work today, and may not necessarily be a meaningful change to the financial plumbing currently in place.

Indeed, the central bankers utility of the two-tier model largely depends on the restrictions and regulations commercial banks are offered in relation to their ability to use their CBDC reserves. Whilst this model would remove the central banks from the significant operational requirements of a direct CDBC model, if the goal of a CBDC is to allow central banks to bypass the commercial banking sector and provide direct stimulus, a two-tier model may not necessarily provide any meaningful additions to how central banks can stimulate.

Token-based vs. account-based

A token-based CBDC would be akin to digital cash in a similar manner to the currencies of today, the difference being cash would be completely digital and a physical alternative redundant. A token-based CBDC would make all units of the CBDC fungible and would be a bearer instrument, fully transactable by the holder.

An account-based CBDC differs on the other hand, as it is through this version of a CBDC whereby the policy maker’s toolkit becomes immense. In an account-based CBDC system, ownership of a CBDC is demonstrated through ownership of an individual account that holds the CBDC. One would demonstrate ownership of a CBDC account and all of the currency within. The individual CBDCs themselves would not be fungible nor would they be a bearer instrument.

An account-based form of a CBDC is perhaps better categorised as an identity-based form of money. One’s identity would be imbed in their CBDC account, and thus their identify embedded within their money itself. By embedding ones identify within ones currency, an account-based or identify-based CBDC could be manipulated for both good and bad based on the individuals status in society or their spending habits as a means to implement monetary “stimulus”.

Associating an individual’s money with their identity is one of the most important and impactful considerations associated with Central Bank Digital Currencies; herein lies the association with money as digital surveillance and the dangerous path this can ultimately lead for society as a whole.

Infrastructure: Distributed ledger technology vs. existing banking technology

Whilst a CBDC could be introduced via the existing banking infrastructure or via distributed ledger technology, the use of either type of technological infrastructure will not likely have any meaningful impact on how a CBDC functions. Whilst discussions around CBDCs have generally associated them with distributed ledger and blockchain technology, there are variations of CBDCs that could be built using conventional centralised transaction technology.

Indeed, though true digital currencies of today (i.e. cryptocurrencies) are synonymously associated with decentralised distributed ledger technology, a CBDC utilising a centralised database would still be effectively digital, whilst retaining similar characteristics to today’s monetary payment systems. Distributed ledger technology on the other hand would be costly and difficult to operate for a CBDC to be used in a direct, retail iteration.

Will CBDCs be interest-bearing?

Whether a CBDC is interest bearing or not interest bearing is one of the most important considerations governments must decide upon developing their digital currency. The introduction of an interest bearing CBDC completely changes the fundamental nature of money itself. Whilst bank deposits and financial assets house the majority of the world’s currency, the distinguishing feature of money today lies in the fact that physical cash itself is a non-interest bearing instrument and has no associated interest rate.

The introduction of an account-based, direct, and interest bearing CBDC to replace digital cash would be a policy makers dream; opening the floodgates of liquidity and monetary intervention unlike anything we have yet seen. For example, if the central banker’s econometric models are telling them a negative 3% interest rate will stimulate the economy, an interest bearing CBDC would allow direct implementation of such monetary policy measures, instantly and selectively.

Such levels of direct stimulus are simply impossible today so long as the commercial banking system intermediates monetary policy and the real economy. The ability for central banks to attach an interest rate to a CBDC has significant ramifications for not only the functionality of monetary policy, but the way consumers and individuals view their currency. Such consequences are discussed in further detail in the following sections.

Regardless of the specific technology, infrastructure and type of CBDC ultimately introduced by central banks worldwide, it is important to understand that, at the end of the day, CBDCs are programmable money whereby the terms and conditions of that money are controlled by policy makers as a means to conduct monetary policy in a way that is simply impossible today.

Why Do We Need CBDCs?

As I have touched on above, there are a variety of reasons why Central Bank Digital Currencies are in development, most of which lies in the added power and broader range of monetary policy tools CBDCs would provide central bankers and policy makers.

In a world of interest bearing CBDCs, herein lies perhaps the greatest tool for the ever increasing manipulation and intervention in the economy. As with all stimulative measures available to policy makers, there will be both benefits and consequences. By directly controlling the interest rates of a CBDC, central bankers could charge different interest rates on their CBDC deposits to different people. This is where an account-based or identity-based CBDC becomes a powerful tool for central bankers.

By assessing the historic spending and savings habits of individuals and corporations, policy makers could offer a lower rate of interest or an outright negative rate of interest to whomever historically has saved more than they have spent, in the hope this will encourage consumption and generate economic growth. Political agenda could become the foremost determinant of interest rates and stimulus, along with ESG and populist considerations.

Indeed, as a means to counter the demographic problem facing the developed world, an interest bearing CBDC could be used by paying higher rates of interest to younger savers and lower rates of interest to wealthy retirees. This effectively becomes a tax for those who have been less inclined to spend and opens up a vast array of consequences.

An interest bearing and identify-based CBDC would indeed allow central bankers to target different outcomes for different people. What’s more, it is not just via interest rates a CBDC could undertake such targeted monetary policy measures. A direct CBDC allows policy makers to conduct true money printing. For businesses who have generally struggled to access credit in times of crisis as bank lending standards soar, the central bank could simply inject additional units of their CBDC directly into the business’s CBDC account.

This is direct stimulus in its truest form; afforded only by the introduced of CBDCs. In an economy where the structural drivers of growth such as demographics remain unfavourable and thus driving the disinflationary trends we have succumb to over the past 40 years, the types of stimulus offered by CBDCs will be far too tempting to ignore. As we issue more and more debt to try and stimulate, the productivity of debt and velocity of money remain at their lowest levels in over 70 years, central bankers are attempting to do whatever it takes to change this dynamic. To think they will not at the very least trial CBDCs seems folly, even in the more democratic countries like the United States.

Source: Hoisington Investment Management
Source: Hoisington Investment Management

A digital government money affords policy makers even more stimulus tools beyond just those mentioned above, however. Indeed, an extreme case could see expiration dates on people’s holdings of CBDCs as a means to encourage spending. CBDCs give policy makers and central banks the power to wipe out your savings. This is a powerful and scary tool.

Direct stimulus allows policy makers and central bankers the ability to conduct their policy decisions as a means to effect human behaviour and economic decision making in a way that traditional monetary and fiscal policies cannot.

Implications & Consequences Of CBDCs

What has become clear to me through my research on Central Bank Digital Currencies is how the negative implications of their introduction are more than likely to outweigh their benefits. From changing the nature of money itself, the potential for the direct injection of unlimited liquidity, to how a CBDC would impact the banking system, the implications for the dollar’s status as the global reserve currency, to the privacy concerns and the potential for abuse of power, the consequences of adopting CBDCs could be broad in scope and severe in nature.

As I have discussed, CBDCs provide policy makers with unprecedented tools for monetary intervention and economic influence to a point far beyond the monetary and fiscal tools of today. Whilst the now normal “unconventional” monetary policy we are seeing today has undoubtedly influenced asset prices via monetary debasement, CBDCs have the potential to create truly sustainable consumer price inflation. In doing so, central bankers would be altering the level of market functionality traditionally offered by a capitalist economy, all the while muting price signals for market participants entirely. Further inefficiencies, zombie corporations and lack to economic destruction would undoubtedly continue.

Whilst the benefits of a digital government money appear tempting at first glance, in reality, these purported benefits are likely illusory, and vastly outweighed by the consequences.

Potential for inflation

Central Bank Digital Currencies allow for limitless money creation in the truest sense. By removing the constrains of the banking sector, central banks can decide to increase the CBDC deposits on any or all individuals at their discretion, as I have discussed. The constraints on this ability of true money creation will ultimately befall to the inflationary repercussions.

In a recent podcast with Grant Williams conversing with the great Lacy Hunt, Lacy opined the following in regard to the potential introduction of CBDCs: “If a government digital currency is enforced, the government would be able to track and control everyone’s financial record, it would be a great intrusion on private freedom. A US CBDC would put the Fed in the money printing business and constitute a major break within out system.

Money would have no value as soon as the money illusion passed and Gresham’s Law would prevail. CBDCs are part of the view that financial transactions create income and wealth, not hard work, creativity and saving out of income, they would be a trump of the free lunch school of economics. The US at that point will have achieved banana republic status. To go along this path would lead to hyperinflation and widespread miserable conditions for the US household.”

For mine, this statement encapsulates the implications of CBDCs perfectly; inflation being front and centre. I have commented a number of times in my recent writings on inflation and deflation the implications of the introduction of CBDCs. With a CBDC fulfilling the role of money, the unit of account almost becomes redundant as money is created and given to individuals on the basis of wants and needs. Such a system is incredibly susceptible for abuse. Money would have far less value, and as a result consumers would be far more willing to spend rather than save. “CBDCs have the potential to become an inflation game changer, and may open Pandora’s box of unintended consequences.”

Implications for the banking sector

Whether CBDCs are introduced as an additional form of money alongside bank deposits or as a means to entirely replace existing fiat currency, and given how CBDCs are an avenue for central banks to provide direct stimulus – which by default circumvents the banking system – one would expect there to be significant implications for the banking sector itself.

The most significant impact on the commercial banking sector would be in the scenario whereby CBDCs are set to replace existing fiat money. If consumers are fully on boarded to a CBDC system, then much of the deposits and liquidity within the banking sector would cease to exist. The implications here are twofold, the commercial banks would lose their deposit base, and the role of lending would fall to the public sector over the private sector.

In the United States, whether it is from the lack of demand for new credit from the private sector or the unwillingness of commercial banks to lend to the broad public, commercial bank credit creation continues to be lacklustre. In the current system, private sector credit creation remains the truest and most impactful means of money creation for the real economy.

https://images.squarespace-cdn.com/content/v1/5edb072f48c9fd655031c59d/1629594548994-Q6S6KN0H89KQXYLN37YZ/Capture.PNG?format=1500w

Due to this lack of credit growth in the private sector, the commercial banking system is simply not in a position to contribute to economic growth at present and assist the Federal Reserve in stimulating the economy. We can see this trend by not only looking at the growth in commercial bank lending per the above chart, but also by looking at the commercial bank loan/deposit ratio, which has been in a decline for nearly two decades and with it the velocity of money.

Source: Hoisington Investment Management
Source: Hoisington Investment Management

This is an important point because the growth and supply of bank credit is the primary driver of productive economic growth today. If deposits flow out of the commercial banks and instead sit with the central banks under a CBDC system, it would be up the the central banks and policy makers to lend and create credit. As it stands today, central banks have no experience in lending nor are they designed to perform such functions.

However, by introducing a CBDC, it would be fully up to central bankers to reallocate liquidity, credit and money in a productive manner, which, ultimately leads us down the path toward a centrally planned economy. As well-meaning as they may attempt to be, policy makers in such a scenario would make their decisions via political agenda. For this to be a success, policy makers would need to be more efficient in their money creation and capital allocation than the private sector.

However, if CBDC’s were introduced to exist alongside the existing commercial bank system of today, these negative implications for the banking sector and money creation process would be lessened, though other implications would remain.

Firstly, an interest bearing CBDC would directly compete with bank deposits. Depending on the rate offered, this would effectively create a floor for bank deposit rates as banks would need to offer a higher rate to attract deposits. If banks were to offer a rate below that of its competing CBDC, then we could see bank runs whereby consumers withdraw their monies from the commercial banks and deposit these within their CBDC account, creating potential for liquidity issues within the banking sector.

For this to occur however, the CBDC and existing fiat money would need to be fungible, which as I have discussed is unlikely. If it were the case, this is where a cap on people’s CBDC accounts would be beneficial. Regardless, CBDCs have the potential to completely upend in the banking system as we know it. CBDCs could give governments virtually complete control over the entire monetary system.

Privacy concerns & government power

Two major concerns associated with Central Bank Digital Currencies, which are perhaps more so philosophical, are the effects their introduction would have on personal privacy and enhancing government power.

Beginning with privacy concerns, an account-based or identity-based CBDC inherently connects individuals to money and removes the fungibility of money in order to enhance governments control of said money. By default, such a form of money requires individuals to give up their freedom and ability to transact anonymously.

By removing the fungibility and token-based nature of conventional currency, a version of a CDBC which does not embody these characteristics creates a vast array of ethical and philosophical responsibilities for its issuer. We as a society must decide who we entrust with our personal data. An account-based CBDC would allow its issuer to gain access to all of our spending habits; what we buy, how much we spend, what we invest in and what we save.

Would we rather entrust this information to the government, a central authority who are notoriously successful at misallocating capital as political agenda is what drives decision making. Targeted stimulus based around such data would ultimately be conducted on a political basis, as it is done so today. With identity-based money, individuals and policy makers must consider how much monetary and personal information is attached to their CBDC, and, individuals must be able to trust their policy makers with such information and that it is used for the right reasons.

Under almost any CBDC design, the central bankers and policy makers would gain extraordinary power. Without these powers, the benefits of CBDCs for the economy in most developed nations are likely to be limited. To be beneficial, or at least attempt to be beneficial in democratic countries, CBDCs will place more and more responsibility in the hands of the state at the expense the private sector. As this would only serve to give more power to the central banks, their political “independence” would become more important than ever. I can’t imagine it wise to give entities such as the central banks whose independence is already in question greater responsibility.

This is particularly prevalent for the banking sector, as I have touched on. Depending on how much CBDCs were to disintermediate the commercial banking sector, the credit creation process would be at the discretion of policy makers. The money creation process will largely become a function of the state, reinforcing the central banks power over the economy. In this scenario, CBDCs effectively introduce state banking.

It is important to remember however these concerns over privacy and enhanced government power will vary for state to state. For example, the Chinese digital yuan (or “DCEP”) is likely being developed by the People’s Bank of China as a mean to further their authoritarian control over their people, whereas in more democratic states like the United States where there are far more checks and balances to contend with such issues, these concerns are likely to be less valid. However, if used incorrectly, the introduction of CBDCs could be a historic blow to personal liberty and privacy. Perhaps the biggest risk of CBDCs are they end up being surveillance disguised as currency, thus creating a link between money and social agenda.

Whilst there are societal benefits offered by Central Bank Digital Currencies, unfortunately, the privacy one would have to renounce will not likely be understood by the majority. The ease of use and “free-money” appeal will likely be welcomed at first. Think of smart phones tracking your viewing history and targeting advertising based on this information; people will be blinded by the purported benefits and not see the consequences until it is too late.

Chinese digital yuan

The worst case scenario for individual liberty is not hard to imagine. In fact, China’s version of a CBCD, known as the Digital Currency Electronic Payment (DCEP), or digital yuan, is exactly that. The PBOC is most likely doing exactly what a CBDC allows; leverage the power and individual data capabilities of a CBDC to further their political agenda.

The authoritarian ambitions of China’s digital yuan is likely to be one of the biggest changes to the financial system in some time. Out of all the governments and central banks who are beginning to realise the potential and power of fully digital currencies, China has thus far been the one taking it the most seriously in both development and implementation. For China, having the enormously powerful data associated with an identity-based CBDC can be used to further their dominance over their people. The following excerpt from a paper released by the Bank Policy Institute does an excellent job summarising a worst-case Chinese CBDC:

Source: Central Bank Digital Currencies: Costs, Benefits and Major Implications for the U.S. Economic System
Source: Central Bank Digital Currencies: Costs, Benefits and Major Implications for the U.S. Economic System

History tells us authoritarian governments tend not to want to shed power, but instead continue to accumulate it. Indeed, whilst the PBOC have stated their development of the digital yuan is to enhance monetary policy and illegal activity, officials have also said the DCEP will have value as a tool for enforcing party discipline, as per the above. The CCP can decide who gets punished for being a bad citizen, and who gets rewarded for being a good citizen via the creation and destruction of the money supply a CBDC would allow.

However, it is not just through the means of furthering their political agenda leading China to develop their digital yuan at a pace far quicker than any other central bank, but it is also through a desire to bypass the dollar dominance and its influence within the world’s financial system.

It is undoubtedly true that many of the central banks developing Central Bank Digital Currencies are doing so as a means to bypass the dollar hegemy and its role as the world’s global reserve currency. China’s digital yuan is absolutely case and point in this regard. CBDC’s could offer an avenue of escape for many countries, if designed and implemented in such a way whereby their reliance on the dollar is somehow reduced. It is no secret that many countries do not necessarily favour a dollar based financial system. Recently, the Bank of England’s Mark Carney spoke of this very thing.

China’s digital yuan is being designed in part as a viable alternative to the dollar for the world’s economies. For example, in order to entrench and promote adoption of their digital yuan, China could impose requirements on foreign businesses who wish to operate in China to do so solely in their digital yuan. This means opening a CBDC account with the Chinese central bank. Recently, financial plumbing expert James Aitken discussed how significant this development is, opining how the United States and other western government officials are shocked at how advanced China is in the development of their digital yuan.

The penny has certainly dropped for the powers at be as to how game-changing a digital yuan could be and the dangers associated with China being at the forefront of Central Bank Digital Currency adoption. However, it must be stated the authoritarian ambitions associated with China’s digital yuan are likely to reduce its viability as a global alternative to the dollar. Whilst it is unlikely to be the digital yuan that supplants the dollar hegemony, the entire dollar based system will eventually give way to a digital based currency system, of which CBDCs as a whole are likely to play a key role.

Conclusion & Final Thoughts

Central Bank Digital Currencies are clearly significant in scope and in consequence. People are yet to come to terms with how money itself is going to be reengineered. CBDCs have the potential to change the financial system and money as we know it. From digital surveillance to unlimited direct stimulus, the introduction CBDCs appear inevitable and game changing.

Whilst it is most likely the case the introduction of CBDCs would in the end be a negative outcome for the citizens of the countries who adopt them, these considerations of intrusion of privacy are most likely to be lost or unforeseen by individuals until it is too late.

Economic Growth Is Slowing & What This Means For Investors

Within this article, I intend to delve a little deeper into the various leading economic indicators to assess where we are in the current growth cycle and what this means for investors.

As I discuss below, my reading of the current environment is relatively clear; both the longer-term and shorter-term leading growth indicators are pointing toward the heightened possibility of slowing cyclical growth. As a result, these downward trends suggest investors ought to be rotating out of the reflation and cyclical trades and into the defensive counterparts, or reducing risk entirely.

Beginning with the longer-term leading data, almost all of the variables I monitor peaked earlier this year and are now rolling over or trending downward. My favorite of which is the China credit impulse. Credit impulse measures the rate of change of new credit creation by both commercial banks and fiscal budget deficits.

As it stands, credit creation is the truest measure of money creation and thus leads many economic variables by around 10-12 months. We can see the credit impulse from China peaked some months ago and has since turned negative. This is important as China remains the worlds largest manufacturer and drives much of the worlds business cycle.

Source: TopDownCharts
Source: TopDownCharts

Drilling deeper into the commercial bank credit creation process, we can see commercial bank lending on a year-over-year basis has been trending downward for the past 12 months and is now in negative territory.

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To me, despite the impending shift to fiscal dominance and central planning, credit growth in the private sector is still the best driver of the economy and is one of the more reliable indicators of long-term growth prospects. The fact that growth in private sector credit is now contracting is worrisome. We can extrapolate this further by analyzing the private sector loan-to-deposit ratio.

A falling ratio indicates money is not leaving the banking system and being spent in the real economy, but instead remains trapped within the banking system. This ratio can be thought of almost as a proxy for the velocity of money. The loan-to-deposit ratio has been in a downward spiral ever since the COVID-19 crisis began.

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Confirming this trend in credit creation is building permits year-over-year rate of growth, which looks to have peaked. Like most assets, the housing market has been hot of late and if building permits are any guide, may be slowing down.

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It is important to keep in mind however these long-term indicators are, by definition, long-term in nature, and thus for there to be any actionable asset allocation decisions to be made based on their readings, we need to see the shorter-term leading indicators confirming the trend.

Of the shorter-term leading indicators, ECRI’s weekly leading index peaked back in April and has since rolled over. ECRI’s Lakshman Achuthan recently appeared on the MacroVoices podcast to discuss the implications of the weakening in their leading indicators.

Source: Economic Cycle Research Institute
Source: Economic Cycle Research Institute

Citibank’s Economic Surprises Index, a measure of economic data coming out better or worse than expected has too recently turned negative, again signaling peak growth has passed and better than expected economic data is no more.

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The manufacturing new orders subcomponent of the ISM Purchasing Managers Index (PMI) has flattened over the last new months, clearly signaling a slowdown in manufacturing demand.

Source: YCharts
Source: YCharts

Meanwhile, the University of Michigan Consumer Buying Intentions Survey for vehicles, houses and household goods have all recently plummeted to their lowest levels in some time. Clearly, the spike in inflation over the past number of months is beginning to take its toll on consumers. Demand is waning not just in the manufacturing sector but in households too.

Source: Quandl, Acheron Insights
Source: Quandl, Acheron Insights

Turning now toward the financial markets, some of the most cyclically sensitive and economically sensitive stock market sectors have too been confirming this message of slowing growth. The retail, transports, metals and mining, materials and industrials sectors all peaked back in the March to April period and have been out of favour ever since. Investors appear to be pricing in this slower growth and taking profits in the reflation trade that has performed so well over the past 12 months.

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In addition to the stock market sectors confirming the downward trend in growth, we can see other market performance data is sending a similar message. Indeed, the performance of stocks relative to bonds, commodities relative to stocks, copper relative to gold and lumber relative to gold all peaked in the April to May period. Should growth continue in its current downward trend over the coming months as the leading data suggest it might, we should expect to see these relative market performance trends continue rolling over.

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So, what matters then is the investment implications of a slowing economy. Firstly, it is important to remember the macro environment is inherently slow moving. Just because the long-term leading indicators suggest growth may slow in the coming quarters, unless the shorter-term leading and market data too confirm this message it can be costly to act prematurely. However, as I have endeavored to illustrate above, it seems as though both the long-term and short-term economic data are aligning and suggest we are well and truly entering a period of slowing growth.

As such, the most obvious step for investors to take is to allocate a greater portion of their capital to defensive bets that appear likely to outperform in a slowing growth environment. For instance, we should expect to see equities underperform bonds.

Source: Julien Bittel
Source: Julien Bittel

Defensives stocks to outperform cyclical stocks:

Source: Julien Bittel
Source: Julien Bittel

As well as long-duration type assets and sectors to outperform short-duration type assets and sectors.

Source: Julien Bittel
Source: Julien Bittel

Utilities is one such example of a defensive, long-duration equity sector that looks attractive from a purely technical perspective, recently breaking out strongly to the upside.

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The performance of utilities companies is heavily linked to interest rates, as rates are a strong driver of their earnings power given the high debt to equity ratios of the sector. The outperformance of utilities is thus a good indicator of the markets expectation of falling interest rates and slowing growth.

In addition to utilities, another attractive opportunity at present on the defensive side is the Japanese yen. The yen is effectively the ultimate risk-off, safe-haven currency. Even more so than the dollar. From a sentiment perspective, commercial hedgers (i.e. the smart money) in the futures market remain net-long whilst speculators (i.e. the dumb money) are the shortest they have been in years.

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Optix, another measure of investor sentiment, is also showing a relatively bullish reading.

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What’s more, seasonality is quite encouraging for the next few months.

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And from a technical perspective, a break of the 108.5 area would seemingly confirm this thesis and potentially provide a good tactical trading entry point.

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In all, we can see economic growth is clearly slowing and is beginning to be priced into risk assets. What this means going forward is we are likely to see a continued outperformance of defensive, long-duration type assets and equities, with the reflation trade likely done for the time being. Investors would do well to position their portfolios accordingly, whether that be taking profits from the cyclical trades, accumulating cash or deploying capital in defensive type opportunities as I have detailed above.

The Stock Market Is At An Important Inflection Point

Within my latest piece discussing the merits of deflation, I briefly touched on how several leading economic indicators appear to be signally growth may have peaked for the time being. Whilst these business cycle and growth metrics are not necessarily useful on their own, when the price action of equities appear to be confirming the macro message; it may be time to pay attention. Such at time appears imminent.

Looking at two of my preferred leading macro indicators of the business cycle, the ERCI weekly leading index and global credit impulse, both are signaling peak growth may be in the rear view mirror.

Source:    Economic Cycle Research Institute

Source: Economic Cycle Research Institute

Source:    Alfonso Peccatiello - The Macro Compass

Source: Alfonso Peccatiello – The Macro Compass

Confirming this message are the most economically sensitive sectors of the stock market. Retail, transports, metals/mining, materials and the industrials sectors have all underperformed these last few months relative to the S&P 500. When the markets goes on the make a new high and all economically sensitive sectors such as these do not confirm the new high, it is a clear signal the new highs are not being supported by economic fundamentals.

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Indeed, these recent highs have seen a significant rotation out of the reflation and value type sectors back into the growth darlings. Market breadth, another excellent measure of market internals, has too not confirmed the recent highs. We are seeing significant bearish divergences in almost all measures of breadth, and the recent rally is almost solely being driven by the likes of Apple and Amazon.

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In the past, periods of poor breadth amid new highs in the major indices have generally lead to at least some form of correction or consolidation. It is perhaps unsurprising then to see that small-caps and emerging markets have gone nowhere over the past six months (in a similar manner to the economically sensitive sectors illustrated above) whilst the broad market has continued to march higher.

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The market is now almost entirely being driven by a rotation out of cyclical sectors and back into tech, FAANG and defensive stocks.

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Such periods of tech outperformance coinciding with the market cap weighted S&P 500 outperforming the equal weighted S&P 500 have been reminiscent of market tops in recent months.

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Continuing this theme of non-confirmation are investor risk-appetites. Firstly, the pro-cyclical currency pair of AUD/JPY and AUD/USD both appear to be rolling over. The strength of the Aussie dollar is generally a good proxy for risk-on and risk-off type environments.

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Extending this out to a longer-term perspective, another chart I referenced within my deflation article was the long-term AUD/JPY FX pair, which looks to have broken out of its bearish rising wedge pattern at the top of its near decade trading range.

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Continuing with risk appetites via the VIX, which is effectively investors expectations of volatility over the coming month, the VIX has not made new lows over recent months as the market has gone on to make new highs. Such divergences between the two have typically preceded periods of market turmoil in the past.

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Turning now to the technicals, they too are bear a similar message. On the weekly chart, we are seeing slight negative divergences in RSI and money flow, accompanied by a 9-13-9 weekly DeMark sequential sell signal.

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What’s more, we are amidst a seasonally weak period of stocks, almost indicative of what I have detailed above. Clearly, we can see on many different measures that stocks are seemingly at risk of some form of correction, or at the very least, a period of consolidation.

SPY Seasonality.jpeg

In isolation, these indicators and measures are not of much use, but, in the case where they align to tell a similar story at once, it is important to take heed. I personally tend to favor trades and investment opportunities whereby fundamentals, technicals, sentiment and macro all align. For the most part, now appears to potentially be such a time.

However, I shall stress I am by no means predicting a significant risk-off event is imminent. For fear of being labelled a “perma bear”, let met be clear I am merely presenting a number of important measures investors should take heed of as part of their own due diligence and risk management. The clear takeaway from what I have presented above is that the risk-reward set-up for equities is not overly favorable at present. Nevertheless, there does remain pockets of value and opportunity still to be found within these markets.

Those who have been readers of my previous writings will be well aware of how I have deemed there to be several decent buying opportunities in the gold and precious metals market of late. At the risk of repeating myself once more, dare I say it but today stands as another such opportunity for investors seeking to deploy capital. In terms of valuations and fundamentals, the gold miners are clear standouts.

Source:    Sprott via Ronnie Stoeferle

Source: Sprott via Ronnie Stoeferle

However, fundamentals in isolation may not necessarily be meaningful if they are already priced in. It does however appear this is not the case. We can see this by comparing the divergence between the gold price and real interest rates. This is an inverse relationship that has historically nearly always held up, and is a key driver of the gold price. Given how real rates remain deeply negative today, it seems only a matter of time before the gold price catches up to real rates. One way to view this is by using TIPs as a proxy for real rates relative to gold.

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Will gold follow real rates? Seasonality suggests it will.

deflation.jpeg

To conclude, the market appears to be running our of gas. I for one would use a potential pull-back as a buying opportunity for several sectors and assets I am bullish on. I love the green-energy trades in uranium, copper and carbon credits, but, given how far these sectors and assets have come in the past year I would love to see further weakness before I begin buying. Again, that does not mean opportunities are not present right now, gold is perhaps the perfect example, and it looks like it may be an excellent time for investors to take profits out of the favored and deploy capital into the unfavored.

For a look at all of today’s economic events, check out our economic calendar.

The Case For Deflation

Back in March, I laid out the case for inflation in comprehensive fashion, now, as all good investors ought to do, I will present my case why the disinflationary and deflationary trends that have engulfed markets over the past 40 or so years may continue.

We all know the major deflationary forces of today; debt, demographics, globalization and technology. I will endeavor to address these throughout this article. However, there are also a number of lesser known deflationary forces that perhaps do not get as much attention as they deserve. These too I will endeavor to explain below, along with where we stand with the current inflationary pressures, transitory or not.

Debt

For listeners of Erik Townsend’s excellent MacroVoices podcast, you will be aware of Erik’s proclamations of how many of the best and brightest minds in finance and macro have shifted from the deflation to inflation camps; with Vincent Deluard, Russell Napier and Louis-Vincent Gave being some such examples. However, there does remain a few “deflationists” out there, the most prominent being Lacy Hunt, and it is from Lacy’s arguments for debt and economic growth driving deflation where I will begin.

The chief problem facing most of the worlds developed economies today is the level of outstanding debt, both private and public. Whilst the creation of debt can represent an expansion in the broad money supply, the destruction of debt conversely equates to a contraction in the money supply. As all debts must eventually be repaid, debt by nature is deflationary over time.

This is not so much a problem if the marginal return on debt exceeds the cost of debt. We have however long past that point whereby the creation of new debt lead to a greater increase in productivity. The marginal productivity of debt, or simply the return on debt, is at its lowest levels in over 70 years. As the below chart illustrates, we are now at the point whereby each new dollar of debt created is only able to increase GDP by less than 40 cents.

Source: Hoisington Investment Management
Source: Hoisington Investment Management

An increase in debt is an increase in current spending at the expense of future spending unless the income generated on the debt is sufficient to repay principal and interest. Stimulus hardly meets this criteria. Additionally, given central bankers and policy makers have never allowed the over indebtedness to resolve itself (rightfully or wrongfully) via the process of austerity and creative destruction, what has resulted is the dynamic of this ever falling return on debt being subjugated by the creation of even more debt in a negatively convex manner.

As much as the “MMTers” will argue this is solvable, what we know for sure is this has never worked in history. Folk love to harken how the tale of Japan will not be the fate of the US and how Japan was different (to which Lyn Alden has previously presented an excellent case for, and one in which I largely agree), though we are yet to see any evidence the United States’ spiral down this deflationary debt dynamic is actually different.

This is the greatest flaw in the argument fiscal dominance and MMT will create growth and inflation: we are searching for an easy solution to economic growth, one that has never worked in history. Yes, fiscal dominance may be the catalyst for inflation, but the debt overhang simply does not allow this to be accompanied by sustained growth. Instead, at best we may see stagflation accompanied by financial repression, as I discussed in my previous musing on inflation.

Debt & Money Velocity

To get inflation, we need a pickup in the velocity of money. Money velocity is largely a function of the level of debt relative to GDP. In the chart below, you can see how the year-over-year change in the velocity of money (red line, inverted) has a significant inverse relationship with government debt/GDP (blue line).

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As debt is a constraint on money velocity, for velocity to increase, the economic growth needs to exceed the growth in debt, meaning the debt must be put to productive uses such that it spurs growth greater than its cost. A bet on inflation is a bet on an increase in the velocity of money, which is a bet on the increase in the marginal productivity of debt.

So long as the MMT-style stimulus is debt financed, this dynamic will struggle to reverse. As a result, the historic increases in money supply could be somewhat irrelevant unless the velocity of money increases. You simply cannot look at the growth in money supply without also looking at the velocity of money. Debt financed stimulus ultimately leads to the same conclusion; more debt and less growth. History tells us this has never been more than a temporary solution.

In the long-run, debt is simply a constraint on aggregate demand, and, for prices to rise demand must exceed supply. Whilst certainly possible, unless we go through a period of creative destruction and austerity (unlikely), the debt constraints on the US economy create a significant headwind for sustained inflation moving forward.

Demographics

Demographics remain one of the most powerful drivers of long-term economic growth. I have written extensively on the topic of demographics in the past, as it is a force whose impact on all facets of economics should not be underestimated or overlooked.

The developed world has a demographics problem that is not going away. The largest generation in history is retiring and as a result the number of retirees relative to workers is rising and is likely to continue to do so over the coming decades. Empirical evidence shows productivity, consumption and economic output peaks for workers roughly in their 20s-50s. Conversely, the contribution to GDP growth for the average worker falls negative as people enter their mid-to-late 50s and thus are no longer a contributor to economic growth.

The below chart from the work of Research Affiliates illustrates this relationship between age and economic output.

Source:    Rob Arnott, Denis Chaves, Research Affiliates
Source: Rob Arnott, Denis Chaves, Research Affiliates

A falling support ratio (working age population relative to children and retirees) for countries with an aging population is a powerful constraint on economic growth. This makes sense, as consumption (being the largest input for GDP) is largely based on age. The older we get, the less we consume and contribute to the economy. This dynamic is a deflationary force over the long-term.

As we can see below, the labor force in the US has long since peaked.

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The relationship between the labor force and economic growth is better comprehended when comparing the two in rate-of-change terms.

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Clearly, we can see above how the two are related. Whilst there has been a significant jump in the labor force compared to 12 months ago, it is important to consider the base effects of year-over-year data. This time last year, the worlds economies were on stand-still. On an absolute basis, we remain near the lowest level of labor force participation in about 40 years.

What’s more, similar to how debt is a constraint on the velocity of money, so too is the labor force participation rate.

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The labor force is highly correlated to the velocity of money. To get a pick-up in velocity, what is really needed is a growth in the level of the population who are more willing to spend and consume, which, as we know from the previous chart comparing age groups and growth in GDP, is an increase in those aged between 20 and 50.

However, as we look forward, we can see the level of retirees relative to those working (support ratio) is only going to continue its downward trend for at least the next decade or two as the average age of the population increases. There is a stark contrast between the median age of today relative to that of the structural inflationary 1970s and 1980s.

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The immediate future will continue to see more people leaving the economy and retiring compared to those entering the economy. The demographic headwinds facing not just the US, but most of the developed economies worldwide undoubtedly continues to provide a significant headwind to any form of sustained inflation.

Other Deflationary Forces

Whilst debt and demographics have been two of the most significant deflationary forces at play, along with technology and globalization, there remain a number of lesser known but meaningful dynamics working to reinforce deflation.

Technology & Productivity

Technological advancement and increasing productivity are inherently deflationary. Technology creates efficiency, which increases productivity which reduce costs. Technological innovation is not a trend that will plateau or reverse, technology is exponential.

The trend of investment in information technology hardware and software continues to rise.

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Likewise, productivity on a year over year basis is at its highest point in a decade. Growth in productivity is an inflation killer (core-CPI inverted below).

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Technology will only further allow for the transformation of labor to capital through automation and efficiency. Going forward, the continued shift to a digitalized economy and growth in decentralized finance should only exacerbate this trend. Technology is an inflationary headwind unlikely to subside any time soon.

Money Creation, Quantitative Easing, Banking Lending & Interest Rates

There are two ways broad money supply is created; commercial banking lending and directly monetized government spending. I discussed the dynamics of money creation within my article on inflation in detail, and have again detailed this process as follows.

Historically, it has been the commercial banks that have been able to claim sole responsibility for the growth in the broad money supply. The notion that quantitative easing (QE) conducted by itself is money creation is false. The Federal Reserve and other central banks have the ability to influence the base money supply (M0), but not the broad money supply (M2). They can lend, but they cannot spend. Commercial banks create money via fractional reserve banking when lending occurs between said banks and consumers and businesses.

QE is a means of capitalizing the banks, allowing them further scope to be able to lend against these freshly printed reserves with the central banks, whilst also pushing down interest rates in the hope this will spur an increase in lending. QE is effectively just a swap of government bonds for central bank reserves; unless lent against the two are negligible. Getting banks to lend is what increases the broad money supply.

Unlike the Fed, the Federal government does have the power to spend. If the central banks and governments work together, they are able to rapidly increase the base money supply and the broad money supply. If the central banks are directly funding government spending and outright guaranteeing loans made by banks, then this is money creation and has no doubt played a role in the expansion of the broad money supply we have seen of late.

Indeed, the shift of using monetary policy in isolation to monetary stimulus combined with fiscal stimulus will likely lead to a continued increase in the broad money supply. However, the misunderstood aspect of this dynamic is that ultra low interest rates and QE are in fact more likely to be deflationary, not inflationary. What’s more, whilst the government is spending central bank financed money, the traditional means of broad money creation in the form of commercial bank lending is still non-existent.

Focusing in on QE and interest rates, the primary goal of quantitative easing has been to lower interest rates to spur lending, create economic growth, increase asset prices and create a wealth effect. QE has succeeded in only two of these aspects; increasing asset prices and lowering interest rates. It is no secret QE has been by and large a failure.

The first problem associated with QE is suppressing interest rates to artificially low levels. Artificially low interest rates are not stimulative. In fact, there is evidence to suggest artificially low interest rates are only stimulative to a certain level, once they reach the ultra-low levels of today, these positive effects disappear to the point whereby they could be argued as being entirely deflationary. The below chart illustrates this dynamic well.

Source:    Visual Capitalist
Source: Visual Capitalist

By artificially suppressing interest rates, this works to reduce the interest costs associated with existing debt. Reducing interest costs allow debtors more flexibility to repay the associated principal in addition to the interest payments, and, if these low interest rates are not spurring additional lending and creation of money to offset the repayment of principal, then this process is in fact the outright destruction of money. Likewise, those who live off fixed-income interest payments receive less interest, which leads to less income and thus less consumption.

To solve this problem, banks need to lend. The problem here is demand for credit is still largely contracting. Outside of fiscal stimulus, there is little growth in the broad money supply from commercial bank lending.

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Despite ultra-low interest rates, highly capitalized bank balance sheets and lending standards near-decade lows, this lack of growth in consumer credit creates a headwind for continued structural inflation.

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Broad money is created when consumers borrow and is destroyed when they repay principal. When you have interest rates artificially pinned near the zero-bound, money is destroyed as loans are repaid. It becomes unprofitable for banks to lend and as a result, there is less money moving around the system. This all leads to the suppression of money velocity.

Unless banks are willing or able to lend against the increase in their QE funded bank reserves, the liquidity provided by QE gets stuck inside the banking system. Ultra low interest rates and QE do not create money over the long-term unless they are accompanied by a commensurate increase in commercial bank lending, and a productive use of this debt. Whilst the direct financing of government spending is one avenue to solve this problem, the traditional means of fractional reserve banking needs to follow suit if sustained inflation is possible.

Wealth Concentration

A deflationary force not commonly cited is wealth concentration. As is common knowledge these days, wealth concentration in the top percentiles currently stands at the largest discrepancy since World War 2.

Source: Ray Dalio, Bridgewater Associates
Source: Ray Dalio, Bridgewater Associates

Put simply, those who have amassed more wealth have a far lower marginal propensity to consume. An additional dollar of income for those who are wealthy is far less likely to be spent on the consumption of goods and services than those who are less wealthy. This pushes down the velocity of money, reducing the flow of money throughout the economy.

Capitalism & Free Markets

Capitalism and free markets are not necessarily inherently deflationary. However, a capitalist regime promotes and encourages progress and innovation, which today primarily occurs through technological innovation. As I have discussed above, technology is inherently deflationary. Whilst markets may not necessary be “free” today, so long as we remain a capitalist economy for the most part the result will be continued innovation and progress.

Challenging The Inflation Narrative

Commodities & Supply Driven Inflation

Many people believe commodities and inflation are one and the same, this is simply not the case. Whilst commodity prices and inflation are certainly intertwined, using broad commodity prices as a measure of inflation is inaccurate. On the whole, the impact commodity prices has on core-CPI is less than you might think.

The US economy is largely a service economy, as the growth in globalization has resulted in the US offshoring its labor and supply chains. As such, strong movements in commodity prices generally will only have a small impact on core-CPI. We have had a number of commodity cycles over the past few decades, and as we can see below, the correlation between commodity prices and inflation is not significant.

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Sustained inflation requires a permanent increase in demand relative to supply. Demand driven inflation occurs as a result an increase in demand that is unable to be met by a sustained increase in supply. For example, the 2002-2010 commodity bull market resulted from a sustained increase in demand led by China and the broad adoption of commodities as an asset class by institutional investors and pension funds. Likewise, during the inflationary 1970s and 1980s, the inflationary pressures were a function of an increase in demand as the largest generation in history, the baby-boomers, entered the workforce and significantly increased the labor force participation rate. I have discussed these demographic forces above. Today, we have a contracting labor force and an aging population, which will see a continued contraction in demand.

The commodity and price increases we are witnessing at present appear to be largely a result of supply side constraints, as opposed to a sustained increase in demand. The COVID-19 induced shutdowns interrupted supply chains and the transportation and availability of raw materials. Supply will come back to meet this demand for most commodities, if it hasn’t already.

Supply is almost always less elastic than demand. A result of inelastic supply constraints are short-term disruptions as aggregate supply cannot meet aggregate demand, pushing up prices and lowering corporate profits as less supply results in less revenue. Unless the price increases are demand driven and sustainable (like we saw in the 1970s/80s and 2000s), supply driven price increases are likely to be temporary. The solution to higher commodity prices is higher commodity prices.

However, it is worth noting there will be exceptions to this dynamic. I would argue copper and electrification metals will have a sustained increase in demand due to the electrification of the worlds economies. Longer-term inflationary pressures may indeed result from such trends.

Short-Term Inflation Expectations

Due to this belief held by many that commodities equal inflation, it is unsurprising to see that short-term inflation expectation measures are simply based off commodity prices, the most notable being the price of gasoline and oil.

The issue here is commodities may be more so driven by inflation expectations, or inflation expectations driven by commodities, than any actual increase in aggregate demand capable of sustaining inflation. Commodities are only a part of the inflation story.

Where Are We Now?

The June core-CPI reading of 3.8% is the highest year over year number in nearly 30 years. Whilst this is meaningful, it is important to consider how base effects exacerbate such data. During 2020, the economy basically shut down. Year-over-year economic data for 2021 must be taken with a grain of salt, especially considering core-CPI bottomed in the May to July period of 2020. The pandemic caused a global shock to the worlds economies.

The fall in demand more than offset the fall in supply, creating the conditions of severe disinflation. Now, as the worlds economies are beginning to function closer to full capacity once more, this dynamic is working in reverse. Demand has roared back, spurred on by fiscal stimulus, whilst supply is yet to follow suit. As I have mentioned above, supply will eventually come back to meet demand. This will likely be sooner rather than later.

Indeed, when we look at longer-term inflation expectations, there is still a lack of any significant concerns of structural inflation. The Cleveland Fed’s 10-year inflation expectations measurement is not signaling any long-term inflation.

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Meanwhile, the 10-year breakeven inflation rate and 5-year, 5-year forward inflation rate may be sitting at roughly five year highs respectively, but both remain well below the highs seen post GFC, and below the 2.5% mark. These long-term readings are not meaningfully high.

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It’s not just the long-term inflation expectations sending us this message, but it appears as though the reflation trade and global growth may be nearing a peak. Chinese credit impulse, which measures the creation of new credit and has been an excellent leading indicator of global growth, has rolled over significantly these past months. China is the largest manufacturer in the world and is a key driver of the worlds business cycles.

Source:    Julien Bittel
Source: Julien Bittel

Likewise, the ECRI leading indicator appears to be confirming this message, the business cycle looks to be topping

Source:    Economic Cycle Research Institute
Source: Economic Cycle Research Institute

A slowdown in global growth looks to be the potential story for the second half of 2021. This is what the bond market has been telling us. Despite the continued inflationary pressures through the first half of 2021, long-term yields topped back in March and have been falling ever since. Whether or not the 30-year falls below 2% or holds the line will be telling.

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In every recession over the past 50 years, we have seen a temporary spike in bond yields due to rising inflationary pressures. In almost every instance, the spike in yields were temporary and reversed to the downside as the natural deflationary forces once again took hold. Historical precedence tells us this time will likely not be different.

Looking at the reflation trade itself and using the AUD/JPY as a proxy, this looks a lot like a broken rising wedge pattern at the top of a long-term trading range. A continued pullback in the AUD/JPY would likely signal a further correction in the various reflation trades is imminent.

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Likewise, if we look at tech relative to small-caps, the former appear to be reasserting their dominance.

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However, as I detailed in my article arguing for inflation, there is potentially a path toward sustained inflation laid out in front of us. The move to MMT-style sustained central bank financed fiscal dominance, combined with labor onshoring and de-globalization are both inflationary tailwinds whose forces are only likely to grow over time. For now, despite fiscal stimulus putting money directly in the hands of those with a higher propensity to consume, much of this direct stimulus thus far have not been necessary contributing to economic growth. According to the New York Fed, roughly one-third of all stimulus payments received have been used to pay down debt, which as we know is the destruction of money, whilst only one-quarter is being spent on consumption, with the remainder being saved.

Source:    Federal Reserve Bank of New York
Source: Federal Reserve Bank of New York

Going forward, it is a matter of whether these forces are enough to overcome deflation, history suggests otherwise. However, should such measures as central bank digital currencies be introduced, or laws passed to allow the Fed the ability to spend, not just lend, both would certainly be game changers and would likely spur inflation.

Investment Implications

If it is true these deflationary forces will continue to suppress inflation over time, then for us investors it is important to consider how this might effect our investment decisions.

Unsurprisingly to most of you, the best performing asset classes and equity sectors over the long-term during a deflationary or disinflationary regime are those of a defensive, long-duration nature. Basically everything that has underperformed over the past 12 or so months.

Source:    Incrementum
Source: Incrementum

As boring as it is for investors, in a low growth world of little inflation, we are likely to see continued outperformance of the growth darling FAANG stocks on the whole, despite where valuations sit. We would likely see a continued bull market in bonds, as hard as that is to believe. Until the long-term trend for bonds tells us otherwise, the years ahead may just see more of the same.

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Whether you reside in the deflation camp or the inflation camp, it is important investors assess both sides of the debate and come to their own conclusions. Whether we get inflation or deflation, investors should be prepared for either outcome. It may be we just end up somewhere in the middle.

Why The Dollar Matters (A Lot!)

With the recent rally this past week in the dollar, it is important for investors to understand why such a move matters. For those who love charts, this article is for you.

The most obvious and well-known correlation between the dollar and equities is the association of a weak dollar with the outperformance of most commodities and real assets. It is no coincidence the significant gains in commodities over the past 12 months have come during a period of a declining dollar. We can clearly see this inverse relationship in play by comparing the performance of copper and oil against the dollar.

Dollar & copper
Dollar & copper

Dollar & oil

Dollar & oilAn extension of this relationship is how periods of dollar weakness coincide with the relative outperformance of equity markets sectors reliant on economic growth. As we have witnessed over the past year, the falling dollar has resulted in the outperformance of consumer cyclical versus consumer defensive stocks, as well as materials, industrials, small caps and energy stocks outperformance relative to the broad market. Likewise, this period of dollar weakness has seen the underperformance of defensive sectors such as utilities and bonds.

Consumer cyclicals vs defensive
Consumer cyclicals vs defensive

Basic materials vs S&P 500

Basic materials vs S&P 500Industrials vs S&P 500

Industrials vs S&P 500Utilities vs S&P500

Utilities vs S&P500Small Caps vs Large Caps

Small Caps vs Large CapsDollar & bonds

Dollar & bondsFrom a fundamental perspective, these relationships make sense. A stronger dollar is generally a function of a contractionary or disinflationary outlook. During deflationary shocks à la March 2020, dollars are in high demand and act as a safe haven or risk-off asset. Conversely, a weaker dollar is generally a function of economic growth and rising inflation expectations.

What this means is the dollar tends to appreciate when bond yields fall. This comes about due to the safe have characteristics of the dollar. If the economic outlook looks sluggish and appears to be slowing down, we tend to see money flow into dollars, and by extension, we see money flow out of the growth and inflationary dependent sectors and asset classes of commodities, small caps, cyclicals, industrials and materials and into those of a defensive nature.

Perhaps the most well-known implication of dollar strength or weakness is the performance of foreign and emerging markets relative to the US. Emerging markets in particular are inherently cyclical and dependent on the dollar. This is particularly the case for those countries with high levels of US dollar denominated debt or the commodity producing countries.

Emerging markets vs S&P 500
Emerging markets vs S&P 500

I detailed the dollar and emerging markets dynamic in depth in my article arguing the bull case for emerging markets, most of which is detailed as follows:

A rising US dollar causes the domestic currency of emerging economies to fall and inflation to rise amid weaker economic growth. Contrary to a developed economy whose economic growth is generally associated with inflation, being beholden to foreign-denominated debt reverses this dynamic. Higher inflation results in the central bank needing to raise interest rates and sell their foreign exchange reserves to defend their currency from hyperinflating, which acts as a further headwind to economic growth and exacerbates this dynamic in a self-reflexive manner.

These countries are unable to simply print money to monetize the debt, as is commonplace in developed countries whose debt is denominated in their own currency. The governments will then look to use fiscal policy as a means to stimulate, resulting in increasing budget deficits at the same time foreign and domestic capital flees the country for a safer alternative to preserve wealth, resulting in a negative current account balance along with a budget deficit.

Of course, these dynamics work in reverse too when the dollar is falling and create an economic tailwind that results in strong economic growth and asset price appreciation generally superior to developed markets. As the domestic currency strengthens, inflationary pressures fall, allowing the central banks to lower interest rates whilst the economy is booming, spurring lending and reinforcing growth.

At the same time, the governments are not required to run budget deficits, nor are the central banks required sacrifice their foreign currency reserves and run current account deficits to defend their currencies. You could almost think of a rising dollar as a form of quantitative tightening for most emerging markets, whilst a falling dollar could be considered a form of quantitative easing.

Therefore, for one to be willing to bet on the outperformance of EM relative to US equities, one must have a bearish outlook for the dollar.

Is this dollar rally sustainable?

In my view, the dollar has appeared to be in need of a rebound for a few months now. To be clear, we are far from seeing the start of a new trend higher in the dollar, but, as the consensus towards the dollar has been and remains almost exclusively bearish, it is not often we see price action conform to consensus.

Speculators are still betting heavily against a rally in the dollar.

Conversely, speculators are betting heavily on the relative outperformance of the euro. Meanwhile, commercial hedgers (i.e. the smart money) remain long dollars and short euros.

Technically, the coming weeks will be telling for both the dollar and the euro. With a potential head and shoulders bottom forming on the dollar index, and conversely a head and shoulders top for the euro, should these patterns follow through and the dollar move further to the upside, many of the “consensus” inflationary and growth orientated trades in which investors are all in on, may experience a period of underperformance.

A continued rally in the dollar over the coming months may well be a signal the inflation trade has gotten too ahead of itself. I have written previously how this may be the case. What’s more, the bond market also appears to be signaling a pause in this narrative for the time being, as I too mused upon recently. If the dollar does move higher, expect to see reflation trades dip and thus the outperformance of defensives, utilities, bonds and tech.

Regardless of whether we do see a meaningful move higher over the coming months, it is important for investors to understand the implications of such a move, as is the purpose of this article. Whilst a move higher would not bode well for risk assets, it would likely be unsustainable and thus brief.

With US debt to GDP at an all-time high of 130%, US net international investment position (NIIP) of -65% of GDP, lack of foreign investment in treasuries and an economy heavily reliant on the appreciation of equity prices, for mine, policy makers will understand the damage a dollar rally could cause. In the long-term, I do remain in the dollar bear camp. However, we need to see a rally and wash-out of the negative sentiment before the downtrend is able to continue.

Finally, I will leave you with this excellent chart by Julien Bittel, summarizing the relative return of the major equity sectors and asset classes to moves in the dollar.

Source: Julien Bittel, CFA
Source: Julien Bittel, CFA

Financials Look Ripe For A Reversal

The financials and banking stocks have been some of the best performing of the reflation trade since the second half of 2020. Banks in particular have benefitted handsomely from the rise in yields and steepening of the yield curve. Since last October, the KBE banks ETF is up roughly 100%, rewarding investors who saw fit to take advantage of the immense value on offer at the time. However, there are a number of signs suggesting now may be a prudent opportunity for investors to begin to take profits and redeploy capital elsewhere.

Firstly, from a valuation perspective, the group can no longer be considered cheap on a relative or absolute basis. Of the “big four” banks, JP Morgan Chase and Bank of America are trading at their highest valuations in a decade, as measured by price to book value.

On the whole, we know banks like to make their profits by lending long-term and borrowing short-term. With long-term yields looking to have stalled for the time being, or perhaps even rolling over, the yield curve did not confirm the recent highs in the sector. It looks as though banks may have some catching up to do on the downside.

As banks and financials have largely proven to be a de-facto short-bonds trade of late, the bond market is sending a similar message as the yield-curve.

For the banking sector to continue its outperformance, it needs the tailwind that rising yields provide. With the US 30-year yield recently breaking its uptrend to the downside, it is looking as though this tailwind may be turning into a headwind for the time being. A move down to the 200-day moving average would put the 30-year yield at around 1.9%.

Additionally, there is strong overhead resistance for yields around their current levels. This breakdown coincides with the 30-years recent rejection of said resistance.

Couple this with the fact that small speculators (i.e. the “dumb money”) in the 30-year treasury futures market remain nearly as short as they have ever been, all the while commercial hedgers (i.e. the “smart money”) remain heavily net-long. Such positioning in the past has usually preceded favourable performance for bonds, and thus seen yields fall.

What’s more, we are now entering a seasonally favourable period for bonds and conversely an unfavorable period for yields. This adds to the bearish headwinds for financials.

Turning to the technicals of the financials sector itself, a number of indicators are signaling exhaustion. We are seeing DeMark setup and countdown 9 and 13’s trigger on the daily, weekly and monthly charts. When such exhaustion signals begin to appear on multiple timeframes simultaneously, it is generally a fairly reliable indication a pullback, or at the very least a period of consolidation, is imminent. The 9-13-9 is considered one of the most reliable of the DeMark sequential indicators.

Focusing on the daily chart of the financials sector ETF, we have just seen a breakdown of its ascending wedge pattern. This coincides with bearish divergences in momentum (RSI) and money flow, in conjunction with the aforementioned daily DeMark 9-13-19 sequential sell signals.

A rally to test the underside of the broken trendline could be an attractive point for those looking to take profits, or for those who are so inclined to trade from the short-side. Additionally, seasonality of the financials sector is also signaling that it may be time to take a bearish, or less bullish, stance towards financial stocks.

In summary, the risk-reward setup for banks and financials in the short-term does not appear to be overly favourable, nor do these companies offer the kind value they provided last year. Depending on your intermediate to long-term outlook for the direction of interest rates and whether your are in the inflationary or deflationary camps, a potential pullback may provide an attractive buying opportunity for the inflationist. For the deflationists or for those who believe rates may be peaking, this may be a good time to take profits and redeploy capital in alternative opportunities set to benefit from falling rates.

For a look at all of today’s economic events, check out our economic calendar.

The Best Trades For The Green Energy Revolution

The great bond bull market of the past 40 years has made millionaires out of many, so has the rise of blockchain, cryptocurrencies and the digitalization of the financial system. Another such paradigm shift upon us is the worlds unified move to decarbonize and green the economy.

What we are witnessing is a worldwide push for industries to move away from excessive greenhouse gas (GHG) emissions. Such unification around a common goal is perhaps unlike anything we have witnessed in the entire history of humanity. With governments and companies worldwide fully committing to the green transition and most aiming for net-zero emissions by the middle of this century, many are taking several significant steps to achieve this goal.

The move from internal combustion engines to electric vehicles (EVs) is the most obvious and popularized move thus far. For example, the EU has announced a target of 30 million electric vehicles by 2030, Britain plans to ban the sale of new traditionally powered petrol and diesel engines by 2030 and so too are the Japanese. California is also adopting a similar goal. Likewise, the automakers themselves are largely embracing the change as they realistically have no option but to do so. Ford, Jaguar and Volvo are some such examples. What is abundantly clear is the climate change goals of nations are no longer within the realm of speculation; the transition is real and it is coming, whether we are prepared or not.

People are now far more open-minded, educated, and aware of the potential damage to both our environment and our economy that global warming can unleash. Our world leaders and notably the Biden Administration are agreeing there is much to be done to green the economy. This is a huge task and is occurring from a global, country, sovereign and individual level. Whilst the evidence above suggests most of the action thus far has centered around the use of electric vehicles and renewable energies, the process of electrifying everything is enormous in scope. Upstream, midstream, and downstream; the way we generate, transport, store and use energy must be revolutionized.

The green energy transition is a once-in-a-lifetime paradigm shift that we can trade and profit from. Much will change during this generational transformation.

Copper

Copper and other metals used in the electrification process are undoubtedly a popular way to trade the green energy transition. Regardless of the rapid price appreciation in such metals over the past 12 months, there are abundant reasons why so many investors are bullish over the long-term. The role these metals will play in the green energy transition is so very important.

Front and center of the electrification metals sits copper; perhaps the biggest winner of the green transition. Its role is critical in all aspects of the push to electrify the economy. With the world’s motor vehicles set to become almost completely electrified over the coming decades and coppers use therein being three to fourfold relative to traditional vehicles, we are going to need a lot of copper.

According to the International Copper Association (ICA), a battery-powered electric vehicle (BEV) uses 83 kg of copper, a hybrid electric vehicle 40kg and an internal combustion engine only 23kg of copper. From just the transition to electric vehicles alone, the demand for copper is set to increase three to four times from its current levels. Indeed, the ICA predicts the number of electric vehicles will rise to 27 million by 2027, a nine-fold increase from the roughly 3 million as of 2017. Such an increase is set to increase copper demand for the production of EVs from 185,000 tons to 1.74 million tons.

Source: International Copper Association - The Electric Vehicle Market and Copper Demand
Source: International Copper Association – The Electric Vehicle Market and Copper Demand

Based solely on the adoption of electric vehicles, we can clearly see the demand for copper is set to increase dramatically over coming decades. What’s more, such projections as those of the ICA are modelled only on coppers use within EVs, the green energy transition will require an immense amount of copper for much more than just its use within electric vehicles.

Indeed, according to the ICA, electric vehicle chargers themselves will require from around 0.7 kg up to 8 kg each, equal to an additional 216,000 tons of copper demand by 2027. Additionally, the adoption of renewable energy sources such as wind and solar are heavily dependent on the use of copper n their construction. According to the Breakthrough Institute, a California based environmental research center, “wind energy requires on average 2,000 tons of copper per gigawatt, whilst solar needs 5,000 tons per gigawatt – several times higher than fossil fuels and nuclear energy”.

The graphic below illustrates coppers use in the generation of electricity from conventional methods compared to wind and solar. Copper will be required to a significant degree in all forms of renewable energy generation.

Source: Kutcho Copper
Source: Kutcho Copper

A hugely underappreciated and at this stage seemingly underfunded part of the green transition for many developed countries, notably the US, is the need to rebuild, or at the very least significantly improve their electrical grid. For the most part, the electrical grid does not have the ability to store electrical energy. One of the major issues with wind and solar-generated power is their intermittency, that is, their inability to constantly generate power. The sun is not always shining nor is the wind always blowing. Thus, the ability to be able to store the electrical energy created from such sources for future use becomes paramount.

What’s more, the United State’s electric grid as is currently constructed is not able to provide and transmit the necessary electricity to power an entirely electrified economy. If the majority of the population came home from work in the evening and were to plug their EVs in to charge, the grid would simply be unable to support such demand and would shut down. In some parts of the US, the electrical grid is nearly a century old. It was designed and built from a completely different era. Those living in Texas can no doubt attest to the limitations of the grid.

Rebuilding the electric grid will require astronomical amounts to copper and other important metals. The importance of this enormous task will only become more prevalent in the minds of policymakers as we continue down the road to electrification.

What makes copper so useful is its ability to conduct electricity and transmit heat. It is roughly twice as conductive as aluminum, making it far more efficient in its use. Copper is the primary source of conductors in wires and cabling, electrical equipment and renewable energy infrastructure. Whilst silver is another such metal that can serve a similar purpose, it is simply too expensive and not as abundant.

Precious metals aside, pound-for-pound copper is the best conductor of electricity and heat. It is also one of the few commodities that cannot be feasibly replaced by any alternatives in the electrification process in the way that battery technology is susceptible to innovation. Additionally, copper itself is also renewable and is one of only a few materials that is fully recyclable.

Also favoring copper is its long-term supply dynamics. In spite of this huge forthcoming growth in copper demand, copper itself is notoriously difficult to source. As detailed by energy and commodity experts Leigh Goehring and Adam Rozencwajg in their Q4 2020 market commentary; “a structural deficit has crept into global copper markets that will become increasingly obvious to investors as the decade progresses. Confronting this strong demand is copper mine supply that will show little in the way of growth over the next five years.

Few large copper mining projects are slated to come online over the next five years”. They also note that “the lack of massive new copper mining projects, coupled with an ever-accelerating copper mine depletion problem, means growth in mine supply should remain minimal over the next five years. Global copper consumption exceeds copper mine supply and recovered copper scrap by about 500,000 tons per year presently and will get worse”.

Whilst an increase in the price will of course lead to further capital injected into the sector to source further supply, the process of getting this new supply online to meet demand is not as simple as it may appear. Clearly, there is a structural supply shortage of copper. This presents an incredibly favorable demand and supply dynamic for copper over the comin years, one in which the copper price and the miners themselves will benefit enormously.

Finally, turning to the technicals, lovers of a long-term chart will find it hard not to appreciate the recent bullish breakout from copper’s near two-decade wedge pattern.

Source: StockCharts.com
Source: StockCharts.com

Whilst much of the rapid price appreciation we have seen over the past 12 months can somewhat be attributed to the COVID-19 lockdown induced supply shortages and rampant speculation, it is important to remember this is a long-term trade. Though the immediate risk-reward may not be as attractive, any significant dips in the price of copper and the copper miners should be bought with earnest for those who believe in the long-term viability of this trade, as I do.

Copper and copper miners are the simplest long-term play on the green energy transition.

Uranium

With so much focus and capital being directed towards renewable sources of energy in wind and solar, there is relatively little thought given to the limitations of these as sources of clear energy. Due to such limitations I will endeavor to detail below, herein lies the inevitability of nuclear power’s role in electricity generation as we progress through this green revolution.

The limitations of renewables

Whilst renewable energies will play a significant and important role in the green energy transition, they are not the panacea for carbon reduction as one might initially believe. There are significant limitations to the sole use of renewables as a means to reach net-zero emissions.

Both solar and wind are inefficient generators of electricity. This is primarily a result of their intermittency and energy density, as I have only briefly touched on. According to Goehring and Rozencwajg, who have also released some excellent research on the limitations of renewables, note that a standard solar panel is likely to only generate between 12-20% of its capacity due to intermittent sunshine, whilst a wind turbine is only marginally better at around 25% due to the intermittency of wind.

Goehring and Rozencwajg have developed a metric to track the efficiency of energy generation from its various sources, measured as Energy Return On Energy Invested (EROEI), estimating that between 25-60% of the energy generated by renewable sources is consumed internally by the process of actually generating that electricity, meaning the EROEI for renewables is roughly 3 to 1. Compare this to a traditional gas plant, whose EROEI is around 30 to 1, meaning that it internally consumes only 3% of its generated energy. Traditional and less carbon friendly sources of energy are roughly 30 times more efficient in their energy generation compared to renewables.

What’s more, due to the inefficiency of renewables and their need of servicing and maintenance, which in itself is quite impactful on carbon emissions, in addition to the need to overbuild solar and wind farms as well as the ability to store the energy to counter their intermittency, has largely resulted in those countries who have adopted renewables to a significant degree not seeing the reduction in carbon emissions they would have hoped for.

Source: Goehring & Rozencwajg - Ignoring Energy Transition Realities
Source: Goehring & Rozencwajg – Ignoring Energy Transition Realities

As we can see above, much of the gains toward a green economy made by the adoption of renewables will be offset by their inefficiencies and the additional energy requirements to maintain the infrastructure and store their sourced energy. Few people understand how energy intensive the green transition will be.

Whilst they will play an important role in the green energy transition, renewables will not solve problem of global warming to the degree that is desired. This leads to nuclear power, one of the few solutions able to provide the carbon-free, base load power required.

Why uranium?

Uranium is the fuel that powers nuclear reactors which then generates power. Nuclear power is generally misunderstood. On the whole, it is a clean, safe and reliable source of of base-load energy.

If we return to Goehring and Rozencwajg’s Energy Return On Energy Invested (EROEI), “a modern nuclear reactor generates electricity with an EROEI of nearly 100 compared with 30 for gas and 1-4 for renewables. As a result, only 1% of the generated electricity is consumed internally compared with 3% for gas and 25-60% for renewable energy”.

Compared with renewables, nuclear energy is anywhere from 40-100 times more efficient. What’s more, nuclear energy is far more scalable than renewables and completely avoids their intermittency shortcomings. The green energy transition simply must have an increased reliance on nuclear energy, it is one of the few sources of clear energy that has the ability to drive the green energy transition in an efficient way.

Not only is nuclear energy the most efficient source of electricity generation, but it is also less carbon intensive than renewables.

Source: Sachem Cove Partners
Source: Sachem Cove Partners

Perhaps the biggest reason behind the lack of reliance on nuclear as a source of energy is the negative sentiment towards it. Nuclear energy certainly gets a bad wrap. There have been three significant nuclear incidents responsible for this; Three Mile Island, Chernobyl and Fukushima. Despite the actual loss of life being surprisingly less than one might have thought, these incidents have largely left the industry bereft of capital and acceptance as a source of energy over the past 40 or so years. However, what will likely surprise many is that nuclear energy is actually the safest form of electricity.

Source: Sachem Cove Partners
Source: Sachem Cove Partners

The use of uranium within nuclear energy does have somewhat of a dark history. The uranium cycle of nuclear energy creation, as opposed to using the thorium cycle, was chosen as the by-product of creating electrical energy using uranium is plutonium, which was used to make nuclear weapons.

The reasoning behind this choice was because the heyday of nuclear energy occurred during the Cold War, and it was the agenda’s of the worlds governments to create nuclear weapons. However, the Cold War has long since past. It is now time for policy makers to revisit the use of nuclear energy within their climate goals. Indeed, this negative view towards nuclear energy has created a huge mispricing for the sector. The math no longer is equal to the narrative.

Convincing environmentalists that the positive impacts of nuclear energy do indeed significantly outweigh the negative impacts will likely be a game-changer for how the world produces energy. Likewise, an education of the general public is needed in regards to nuclear energy. We cannot meet our climate objectives without nuclear energy in the mix.

Indeed, we now are seeing sentiment towards nuclear slowly begin to change. The pressure of governments to meet their green energy objectives will ultimately lead to nuclear power having an ever increasing role as a source of carbon free base-load energy. On the whole, nuclear energy is actually very clean, safe and reliable. Nuclear energy simply must be a part of policy makers plans should they wish to achieve their green objectives.

The industry fundamentals for nuclear energy and uranium is quite different to most other commodity and energy markets. As the sector has been in a bear market since the Great Financial Crisis, it has largely been bereft of capital. This seemingly paints a positive picture for the price going forward. Due to the lack of capital and investment, there is very little in the way of new production set to come online in the next few years in order to meet the increasing demand for uranium. This lack of new capital has been beneficial for the sector, as only the strongest, most profitable and best-run producers have survived.

Likewise, the production of uranium is a highly concentrated industry, with the two largest miners, Kazatomprom in Kazakhstan and Cameco in Canada, accounting for roughly 60% the the worlds uranium production. With both producers significantly reducing their production over the past 12 months due to COVID-19, a structural supply shortfall could well be with us for years to come so long as nuclear energy becomes a significant part of the green energy transition. Furthermore, what could result from such supply shortfalls is the producers themselves entering the spot market in order to fulfill their supply obligations to the various reactors; a bullish outcome to be sure.

From a technical perspective, the spot uranium price appears to be finally bottoming after its prolonged bear market.

Source: TradingEconomics.com
Source: TradingEconomics.com

Due to how the industry contracts uranium supply between producers and users, the spot price is perhaps not the most relevant and is a very thinly traded market. For me, I am happy to invest via the URNM ETF, which is superior to the older URA ETF. URA is more of a nuclear energy ETF than a play on uranium, and as a result there are many constituents of the fund which makes little sense as they are not related to the production of uranium. URNM is a better vehicle for those looking for a purer exposure to the uranium miners.

However, similar to copper, it is important to keep in mind the uranium trade is for those with a long-term time horizon. Given the near doubling of the price of both URA and URNM since the reflation trade took off in November of last year, the risk-reward for the immediate-term is perhaps skewed to the downside. Of course any significant pullbacks should be bought in earnest for all those who buy into the long-term bull case for uranium, as I do. The 38.2% Fibonacci retracement of the Novembers lows looms as one such attractive entry point.

Source: StockCharts.com
Source: StockCharts.com

The case for uranium is simple; nuclear energy will ultimately be required in order for governments to meet their carbon goals.

European Carbon Credits

What are European Carbon Credits?

European carbon credits, or perhaps what are more accurately defined as carbon allowances, are part of the European Union’s Emissions Trading Scheme, or EU ETS. The EU ETS is at its core, a market-based approach to controlling carbon emissions introduced by the EU as the cornerstone of their efforts to control emissions and meet their carbon goals. The Emissions Trading Scheme is what’s referred to as a ‘cap and trade’ system, which attempts to set a maximum limit of emissions certain companies and industries involved in the scheme are allowed to emit during a certain period of time. The EU ETS is the worlds first and largest ‘cap and trade’ system aiming to reduce GHG emissions.

The system works by setting an emissions cap and issuing a certain number allowances, which are referred to as EU Emissions Allowances (EUAs). The cap is set by the EU, and all the companies within the scheme are required to accumulate a certain amount of allowances (EUAs) for every ton of CO2 they emit each year. These allowances are issued via auction each year (or issued for free to various industries where there is considered to be a potential risk if they were required to pay the full cost of the allowances they need to cover their emissions), and are tradable between companies. At the end of each year, the participants are required to return an allowance for every ton of CO2 they emitted during that year.

Those companies who were unable to accumulate a sufficient number of allowances to cover their emissions (i.e. the more carbon intensive industries), are required to reduce their emissions or buy surplus allowances from companies whose allowances exceed their carbon emissions during the period. These surplus companies are also allowed to accumulate their unused allowances for use in later years.

The following graphic provides a helpful illustration of how the system works.

Source: EU ETS Handbook
Source: EU ETS Handbook

For those companies who fail to accumulate sufficient allowances or reduce their emissions accordingly, they face a fine of approximately 100 euros per excess ton of carbon emitted, as well as being required to accumulate allowances in future years to cover those not covered in past years. The system is structured such that there are significant penalties for the participants who do not meet the emissions goals.

The benefits of using a ‘cap and trade’ system as a means to meet carbon emissions goals is it allows the market to determine how the emissions can be reduced at the lowest cost to consumers and to the economy. What this means is the price of carbon is effectively set through the market via the supply and demand for allowances. Relative to more traditional methods of simply taxing carbon emitters, a ‘cap and ‘trade’ system offers far more flexibility and efficiency, resulting in carbon emissions being cut by companies and industries who will incur the smallest cost for doing so.

First launched in 2005 as a pilot program, the Emissions Trading Scheme is now in its fourth stage, and has undergone several changes throughout its history. Phase 1 (2005-2007), was the testing phase where too many allowances were issued, resulting in the price effectively falling to zero. This oversupply was partly driven by the companies themselves overestimating their carbon emissions on purpose, allowing them access to a greater number of allowances.

Phase 2 (2008-2012), was similarly driven by an oversupply of allowances from Phase 1, and coincided with the Great Financial Crisis, both working to keep prices down. Phase 3 (2012-2020) on the other hand worked to reduce the supply and increase the amount or participants. Phase 3 has been very successful and has established the EU ETS as one of the worlds most effective measures to combat carbon emissions. The system is set to further reduce supply and increase participants throughout Phase 4 (2021 and beyond).

What is important to note in regards to Phases 3 and 4 is the number of allowances available has been declining, along with the number of participants who were previously entitled to free credits is declining, and finally, the number of industries and countries included as part of the scheme is increasing. As it stands, 27 countries within the European Union are part of the scheme, along with non-EU countries Norway, Liechtenstein and Iceland. As I will touch on the in following section, the supply and demand dynamics for the scheme indicates the prices of these allowances is heavily skewed to the upside.

Demand and supply dynamics

The current supply of allowances is what’s referred to as the Total Number of Allowances in Circulation, or TNAC. This is currently set at around 1.4 billion tons of carbon emissions annually. The emissions targets of the scheme is a reduction of emissions by 43% relative to the 2005 levels when the system was initiated. This implies a linear reduction in emissions of 2.2% annually from 2020 to 2030. The TNAC will reduce accordingly in line with the targeted reduction in emissions. Simply put, the supply of allowances will reduce each year.

This creates a simple dynamic within the scheme; a reduction of supply coupled with an increase in demand. The system is skewed towards higher prices. The brilliance of the scheme is it creates incentives for higher prices of the allowances for almost everyone involved. The higher the price (i.e. the higher cost of emitting carbon), the greater the incentive for companies to own credits and thus fewer greenhouses gases are emitted. What’s more, the governments not only have an environmental incentive for higher prices, but as a result of the sovereign governments of the many nations involved in the scheme being the ones who actually distribute the allowances to the participating companies, they directly receive revenue via the auctions for doing so. Again, higher prices equals higher revenue.

To a certain extent, the allowances themselves are being viewed by the participants as a store of value. They are aware the prices are going to rise, they are aware the supply of allowances is going to continue to fall, and they are required to all hold enough allowances to conduct their business as it stands. There is little incentive to sell. Analyzing this supply and demand dynamic from a stock-to-flow perspective as one would gold, bitcoin or other scarce assets again presents a favourable outlook for the price. What’s more, unlike gold or bitcoin, it is in the governments best interests to see the prices rise. The system is being championed by government policy as opposed to an alternative to government policy.

To give some idea of how the supply and demand dynamics of the scheme are set to work within the coming years, Lawson Steele of Berenberg Bank, one of the worlds leading experts on the EU ETS, projects a cumulative supply shortfall of around 99% by 2024! If such projections were to modestly prove true, there is huge upside of the price of allowances in the coming years.

However, it must be noted the EU is somewhat cautious of a too-rapid increase in price, and do have measures in place to combat such a rapid price rise if it were to be too damaging for the companies involved in the ETS. Should it be deemed necessary, the policy makers will (attempt) to intervene via what is known as the Market Stability Reserve (MSR), as well as there ability to alter the supply of allowances as defined by Article 29a of the ETS.

The MSR is basically a feature of the system that helps to control over an oversupply or undersupply of allowances. Introduced in 2019, the MSR works to reduce the supply (i.e. the TNAC) when there is an abundance of allowances, and increase the TNAC when there is a potentially harmful allowances deficit. The idea behind the MSR is to allow prices to rise in a smooth fashion with minimal volatility.

Likewise, Article 29a of the scheme’s directive obliges the policy makers to monitor the supply and demand dynamics and intervene by reducing or increasing supply should this be deemed necessary. Whilst the purpose of Article 29a is again to try to ensure prices rise in an orderly manner, the actual rules therein are cloudy in nature and very much open to interpretation. What’s more, the many different sovereign’s involved will want different prices depending on their industries included in the ETS, thus creating somewhat of a potential conflict of interest between participants and thereby increasing the difficulty of intervention via Article 29a.

Whilst the biggest risk is an excessive rise in prices to the point whereby policy makers deem it appropriate to intervene, such a risk could be considered immaterial given that prices must rise in the first place to warrant such intervention. To be clear, the policy makers most certainly want higher prices. These measures are more so designed to achieve those higher prices in an orderly manner. At the end of the day, the priority of the scheme is to reduce GHG emissions, and if the price must rise to achieve this then so be it.

Technicals and ways to trade

Capping off the bull case for the EU carbon allowances are the technicals. The allowances themselves can be traded in the futures market. This futures market of EUA’s has a near $300 billion market cap with a significant level of liquidity.

From a long-term technical perspective, the recent breakout of the decade plus basing pattern remains immensely bullish.

Capture.PNG

The allowances can also be traded via the KRBN and GRN exchanges traded funds. The KRBN ETF is made up of roughly 70-80% of EU allowances, with the remaining constituents being that of other, smaller Emission Trading Schemes over the world. The GRN ETF, which is smaller than KRBN, trades nearly exclusively off the EUA futures. I have positions in both ETF’s and intend on adding more as attractive opportunities present themselves. Though the price action over the past 12 months has been near parabolic and I would be more inclined to wait for a pullback of some sort before buying more, the supply and demand dynamics suggest further upside is ahead.

The EU ETS is Europe’s flagship way to meet its carbon goals over the coming years. There remains a vast amount of institutional money yet to make its way into this trade as the ESG incentives for pension funds and institutions to buys allowances will only grow. Remember, a higher price equal fewer emissions.

Final thoughts

What I have discussed here are my favourite trades for the green energy transition. I do not doubt there will be other investments who will benefit significantly over the coming years as the world moves to decarbonize. Whilst EV’s has certainly been the winners to date, the risk-reward for such a trade is not necessarily skewed to the upside as much as one would like.

Geothermal, battery technology and nickel are all themes in which I am sure will receive much investment and whose investors will likely benefit, along with many others.

For a look at all of today’s economic events, check out our economic calendar.