Friday, October 5, 2018

Weekly Commentary: Contemporary Finance's Defect

October 3 - CNBC (Jeff Cox): "Federal Reserve Chairman Jerome Powell said the central bank has a ways to go yet before it gets interest rates to where they are neither restrictive nor accommodative. In a question and answer session Wednesday with Judy Woodruff of PBS, Powell said the Fed no longer needs the policies that were in place that pulled the economy out of the financial crisis malaise. 'The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don't need those anymore. They're not appropriate anymore… Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral… 'We may go past neutral, but we're a long way from neutral at this point, probably.'"

Market bulls grimaced. Powell: "We may go past neutral, but we're a long way from neutral at this point…" CNBC's Jim Cramer called it "amateurish." Chairman Powell was certainly candid, something shockingly unusual for a Fed chair. So atypical was his candor, the Chairman was misconstrued as a novice unschooled in the art of modern central banking.

The bottom line is the Fed waited much too long to begin normalizing monetary policy. Moreover, they pre-committed to an extremely gradual path of rates increases. This policy approach essentially ensured that so-called "tightening" measures would fail to tighten financial conditions. Over-liquefied and speculative markets were content to look right through them, confident that cheap liquidity and easy Credit conditions would run unabated. Clearly, stock gains in the multiple thousands of basis points easily counteracted a couple hundred basis point increase in short-term borrowing costs.

I'll add that this issue of a so-called "neutral" rate only confused the issue. What Fed funds target rate would be just right, neither stimulating nor restricting? Well, in this age of market-based finance, market dynamics have a profound effect on economic performance. "Risk on" in the marketplace ensures strong wealth effects, readily available cheap finance for spending and investment, and easy Credit Availability (throughout the economy) more generally. On the other hand, "Risk Off" would see a tightening of financial conditions, tighter Credit, diminished perceived wealth and more restrictive spending and investing.

Perhaps there's a view that a "neutral" policy would be a target rate that balances "Risk on" and "Risk Off." In a policy paper perhaps, but that's not the way markets function in the real world. In reality, if financial conditions remain too loose for too long, powerful Speculative Dynamics take hold. And once inflation psychology takes deep root in the asset markets, the commanding spell will be broken only from the shock of much tighter financial conditions and painful losses. "Housing prices only go up." "Buy and Hold. Stocks for the long-term."

There's further pertinent monetary policy analysis. Back in 2013, chairman Bernanke resorted to "the Fed will push back against a tightening of financial conditions." It received little attention at the time, but it was a fateful declaration. The backdrop was one where the Fed had employed extraordinary policy measures, inflating securities markets as its primary post-crisis stimulus mechanism. It was Bernanke paddling ever deeper into uncharted waters, explicitly signaling to the markets that the Federal Reserve was ready to respond to an equities market pullback with additional monetary stimulus. This was a game changer for market perceptions and played a major role in exacerbating Bubble Dynamics.

For years now, markets have been operating under the presumption that the Fed would immediately pull back from "normalization" in the event of fledgling risk aversion and/or stock market weakness. Chairman Powell on Wednesday afternoon threw the proverbial monkey wrench into this central market perception.

September's 3.7% Unemployment Rate was the lowest since December 1969. Year-over-year Average Hourly Earnings came in at 2.8% and are poised to soon surpass 3% for the first time since April 2009. The ISM Non-Manufacturing Index jumped three points to the strongest reading since August 1997. The ISM Employment component surged almost six points to 62.4, the highest level in data going back to 1997.

Federal Reserve Bank of Chicago president Charles Evans (on Bloomberg TV): "I think that my own take on a neutral longer run funds rate is 2.75%. So, I think getting policy up to us slightly restrictive setting, 3%, 3.25% would be consistent with the strong economy and good inflation that we're looking at."

When even the most perennially dovish Federal Reserve president uses the word "restrictive" and discusses taking the Fed funds up another 100 bps, one has to take notice.

It took a while, but central bankers have become less complacent with respect to inflation risks. For too long they have been fixated on deflation, in spite of the greatest securities and asset market inflation the world has ever experienced. Clearly, the Fed didn't see a 3.7% unemployment rate coming. More importantly, they never anticipated massive late-cycle fiscal stimulus. A booming economy and Trillion dollar deficits? No way. Way.

They were blindsided by the rise of tariffs and protectionism. To be sure, the Fed today has no way to gauge the economic and inflationary consequences associated with a prolonged trade war with China. Rather suddenly, there's a murky future out there that has Fed officials fretting inflation making a dazzling revival on their watch.

All of a sudden, 2% short rates seem incongruous with a booming economy, rising price pressures and the risk of a trade-related inflationary shock. And if central bankers are now on edge, markets better be on edge. This is new and awkward. But what about faltering EM and slowing global growth? All the overcapacity in China and globally?

Well, there is now a not unlikely scenario of faltering markets concurrent with some stubborn inflationary pressures. The GSCI commodities Index was up another 1.7% this week, with WTI jumping past $74. Confidence that any tightening of financial conditions (i.e. weak equities) would be met with resolute measures from the Fed (and global central banks) is increasingly dubious. Ten-year Treasury yields jumped this week to highs since 2011.

I continue to think back to the nineties. And to know where I'm coming from, I was convinced that finance had fundamentally changed in the nineties. No one, it seemed, was paying any attention. I would share my analysis with market professionals, academics, journalists and even Federal Reserve officials and the response was some variation of "Doug, you don't understand." After all these years, this most critical of issues remains unsolved.

I began posting the CBB analysis back in 1999, on a weekly basis attempting to explain what had changed; what was still changing; and what might be some of the momentous ramifications associated with the combination of unfettered "Wall Street finance" and "activist" central bank monetary management.

It was not until 2007, when Pimco's Paul McCulley coined the term "shadow banking," that some began to take some notice. But with the following year's "greatest financial crisis since the Great Depression," desperation saw the focus shift to extreme monetary stimulus and basically using any means possible to reflate the securities markets and Credit more generally. It was not only that concerns for the inherent instability of contemporary market-based finance were pushed to the side. This high-powered finance machine was the centerpiece of central bank reflationary policymaking - around the world.

In an early CBB, I resorted to my CPA training and went through (in painful detail) a series of debit and Credit journal entries to demonstrate how the GSEs would borrow in the money markets to purchase MBS in the marketplace, and how this "liquidity" could be "recycled" back through the money markets and borrowed again and again. In short, the GSEs would issue new short-term liabilities (IOUs) in exchange for "immediately available funds" (IAF). The IAF provided the purchasing power for MBS, with the GSE's transferring these funds to the MBS seller. The seller would then deposit these IAF right back into the money market, where the GSE's (or others) could borrow them repeatedly (exchanging additional short-term IOUs for IAF).

This was akin to the old bank deposit multiplier (fractional reserve banking) but with zero reserve requirements. Traditionally, a bank might lend 80% of a new $100 deposit (20% reserve requirement), with this loan creating $80 of new funds that would be deposited at other institutions (where the next bank could lend 80% of the $80 deposit, then the next 80% of $64 and so on).

I argued that contemporary non-bank market-based finance, operating outside of bank reserve requirements, created an "infinite multiplier effect." And I posited that "unfettered finance" essentially changed everything (market dynamics, policy, saving & investment, economic structure, etc.) In particular, "money" would circulate freely throughout the securities markets, inflating asset prices and incentivizing speculation. In particular, there was essentially unlimited cheap finance available for securities speculation, ensuring price Bubbles inflated by self-reinforcing speculative leverage. "Money" could be borrowed in, for example, the "repo" market to purchase securities, where the proceeds from the sale would be recycled right back into the money markets where it would be available to borrow again and again without limit.

It amounted to the greatest transformation in financial and market structure in history, all backstopped by the "activist" Federal Reserve and global central bankers. It was a New Era - a New Paradigm - that worked miraculously until its 2008 malfunction risked bringing down the global financial system. Most importantly, this incredible system of ever-expanding speculative leverage, seemingly endless liquidity and powerful asset Bubbles has a fundamental Defect: it doesn't function in reverse (with deleveraging). Yet rather than addressing what went so terribly wrong in 2008, global central banks resuscitated and then bolstered this deviant financial apparatus, sending it on its merry way to reflate global markets and economies.

The past decade has seen similar dynamics to the mortgage finance Bubble period: expanding leverage and liquidity spinning around the system, promoting self-reinforcing securities and asset inflation. The big difference during this cycle has been its unprecedented global scale. Central bankers and market bulls are fond of asserting that leverage is not an issue these days. Yet the most egregious leverage throughout this cycle has been in central bank and sovereign balance sheets. Liquidity created in the expansion of central bank balance sheets, in particular, circulated through the securities and funding markets where it has been "recycled" again and again…

A few examples: A hedge fund borrows at zero in Japan to lever in a higher-yielding dollar denominated EM debt "carry trade." This new liquidity flows into an EM banking system, where it is exchanged for local currency by the domestic central bank. The EM central bank then exchanges these dollar balances for U.S. Treasury bonds in the marketplace. The seller of Treasuries, say a hedge fund, then uses the proceeds from this short sale to leverage U.S. corporate debt. The corporate treasurer then uses the proceeds from the debt issue to repurchase equity shares, creating liquidity in the marketplace for the purchase of U.S. equities or even international shares - where it can begin the cycle anew.

Example 2: The ECB, expanding its liabilities, creates "money" to purchase Italian bonds in the marketplace. The seller transfers the sales proceeds to one of the large German banks where it is held on deposit. The German bank then uses this liquidity to purchase U.S. agency securities from a U.S. broker/dealer that had previously acquired these GSE-issued securities with short-term money market "repo" financing. This "repo" loan is repaid, creating money market liquidity to finance other securities speculations. Or instead, the German bank (rather than holding deposits) buys short-term German debt from a hedge fund happy to short these securities at negative yields (borrow at negative interest-rates) to finance holdings of higher-yielding instruments in the U.S.

Example 3: An Asian hedge fund shorts (sells) one-year Singapore sovereign debt at 1.88% and uses the proceeds to purchase Chinese corporate debt yielding 10%. A Chinese bank swaps the Singapore dollars into U.S. dollars, and then deposits these funds with the People's Bank of China (PBOC). The PBOC then exchanges these U.S. dollar balances for purchasing Treasuries. The U.S. Treasury then uses this "money" to service its debts, liquidity that will then be available to purchase additional securities in the marketplace (or, perhaps, "money" to spend on imported Chinese goods, where the dollars make their way to the PBOC and then back into the Treasury market).

Example 4: A U.S. pension fund shorts (sells) Treasuries to finance higher-yielding dollar-denominated EM debt. The pension fund buys bonds directly from a EM government, with the EM central bank exchanging local currency for dollar balances. The EM central bank then uses these dollars to purchase Treasuries, recycling liquidity right back to U.S. securities markets. The seller of Treasuries, a hedge fund operating an "all weather" strategy, uses the proceeds from shorting Treasuries to finance a leveraged portfolio of stocks, fixed-income, EM securities and commodities - "recycling" this liquidity right back into U.S. and global financial markets.

Just a few basic examples of how various leveraged strategies fuel abundant liquidity flows around the globe. I suspect some of the greatest leverage is associated with sophisticated derivatives strategies - cross currency "swaps," myriad bond "carry trades," the proliferation of equities option strategies and ETF arbitrage, to name but a few. And as market prices rise and leverage increases, self-reinforcing liquidity abundance feeds the perception that the party can last indefinitely.

The amount of global speculative leverage that has accumulated over the past (almost) decade is impossible to know. There is no transparency. Most assume it's not an issue. We'll know more over the coming months, but there is ample support for the view of unprecedented global speculative excess - across regions, countries and asset classes. I have posited that the global Bubble has been pierced at the "Periphery," and that contagion effects have begun gravitating to the "Core." This week offered additional confirmation of this thesis.

Let's begin at the "Periphery." A period of relative EM instability came to an end. The South African rand sank 4.3% this week, with the Chilean peso down 3.0% and the Colombian peso falling 2.0%. Asian currencies were under notable pressure, with the South Korean won down 1.9%, the Indonesian rupiah 1.8%, the Indian rupee 1.7%, and the Thai baht 1.6%. The Russian ruble declined 1.6%, the Polish zloty 1.3% and the Turkish lira 1.3%. As for major equities indices, stocks in both Turkey and India sank 5.1%. Equities fell 4.4% in Taiwan and 3.7% in South Korea. Argentine stocks sank 9.8%, with Mexico down 2.9%.

As much as currencies and stocks were under pressure, the more ominous EM moves were in bond markets. Ten-year (local) sovereign yields surged 33 bps in Indonesia, 26 bps in Russia, 21 bps in South Africa, and 14 bps in Hungary.  Dollar-denominated EM debt provided no safe haven. Venezuela's 10-year dollar yields surged 70 bps to 38.55%; Argentina's 64 bps to 9.90%; and Turkey's 52 bps to 7.86%. Ten-year dollar yields jumped 19 bps in Indonesia, 19 bps in Chile, 18 bps in Russia, 17 bps in Mexico and 14 bps in Colombia.

How were markets faring at the "Periphery of the Core"? Italian 10-year yields surged another 28 bps to 3.42%, the high going back to March 2014. Italian bank stocks were hit another 4.7%, bringing 2018 losses to 19.2%. Contagion saw Greek yields jump 33 bps to 4.45%, with Greece's major equities indices down 5.0%. European bank stocks fell another 1.9% this week. Equities indices were down 2.4% in France and 2.6% in the UK. UK yields jumped 15 bps to the high since January 2016.

It was as if the dam finally broke. Ten-year Treasury yields jumped 17 bps this week to 3.23% (high since May 2011). Interestingly, long-bond yields were under even more pressure, as yields rose 20 bps to 3.41% (high since July '14). Mortgage securities fell under intense pressure, with benchmark MBS yields jumping 20 bps - surpassing 4.00% for the first time since July 2011. The old mortgage duration problem: When rates jump, borrowers are less likely to refinance their mortgages or upgrade to new homes. Investment-grade corporate debt was under pressure as well, with the LQD ETF declining 1.7% to a multi-year low.

The DJIA traded to a record high Wednesday before reality began to set in. The S&P500 also reached all-time highs in Wednesday trading before selling took over. The broader market was under heavy selling pressure.

It certainly had the appearance of incipient fear of tightening financial conditions - contagion having made important headway from the "Periphery" to the "Core." If, as it appears, global "Risk Off" is attaining some momentum, my thoughts return to Contemporary Finance's Defect: it doesn't function in reverse.

For the Week:

The S&P500 declined 1.0% (up 7.9% y-t-d), while the Dow was little changed (up 7.0%). The Utilities rallied 1.8% (up 1.5%). The Banks recovered 1.6% (down 0.1%), and the Broker/Dealers rallied 3.4% (up 3.7%). The Transports fell 1.5% (up 5.6%). The S&P 400 Midcaps dropped 2.6% (up 3.5%), and the small cap Russell 2000 sank 3.8% (up 6.3%). The Nasdaq100 fell 3.0% (up 15.7%). The Semiconductors dropped 3.7% (up 5.0%). The Biotechs sank 3.8% (up 22.5%). With bullion gaining $10, the HUI gold index rallied 1.7% (down 2%).

Three-month Treasury bill rates ended the week at 2.17%. Two-year government yields rose seven bps to 2.89% (up 100bps y-t-d). Five-year T-note yields gained 12 bps to 3.07% (up 86bps). Ten-year Treasury yields jumped 17 bps to 3.23% (up 83bps). Long bond yields surged 20 bps to 3.41% (up 66bps). Benchmark Fannie Mae MBS yields jumped 20 bps to 4.01% (up 101bps).

Greek 10-year yields surged 33 bps to 4.48% (up 41bps y-t-d). Ten-year Portuguese yields rose six bps to 1.94% (unchanged). Italian 10-year yields jumped 28 bps to 3.42% (up 141bps). Spain's 10-year yields gained eight bps to 1.58% (up 1bp). German bund yields rose 10 bps to 0.57% (up 15bps). French yields gained 10 bps to 0.91% (up 12bps). The French to German 10-year bond spread was little changed at 34 bps. U.K. 10-year gilt yields jumped 15 bps to 1.72% (up 53bps). U.K.'s FTSE equities index dropped 2.6% (down 4.8%).

Japan's Nikkei 225 equities index declined 1.4% (up 4.5% y-t-d). Japanese 10-year "JGB" yields rose three bps to 0.155% (up 11bps). France's CAC40 fell 2.4% (up 0.9%). The German DAX equities index declined 1.1% (down 6.2%). Spain's IBEX 35 equities index lost 1.4% (down 7.9%). Italy's FTSE MIB index dropped 1.8% (down 6.9%). EM equities were mostly lower. Brazil's Bovespa index surged 3.8% (up 7.7%), while Mexico's Bolsa sank 2.9% (down 2.6%). South Korea's Kospi index dropped 3.2% (down 8.1%). India's Sensex equities index sank 5.1% (up 0.9%). China's Shanghai Exchange was closed for holiday (down 14.7%). Turkey's Borsa Istanbul National 100 index dropped 5.1% (down 17.7%). Russia's MICEX equities index declined 1.0% (up 16.2%).

Investment-grade bond funds saw inflows of $1.222 billion, and junk bond funds had inflows of $1.389 billion (from Lipper).

Freddie Mac 30-year fixed mortgage rates added a basis point to 4.71% (up 72bps y-o-y). Fifteen-year rates slipped one basis point to 4.15% (up 71bps). Five-year hybrid ARM rates rose four bps to 4.01% (up 83bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down three bps to 4.78% (up 63bps).

Federal Reserve Credit last week declined $15.6bn to $4.146 TN. Over the past year, Fed Credit contracted $274bn, or 6.2%. Fed Credit inflated $1.335 TN, or 47%, over the past 309 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt slipped $2.4bn last week to $3.436 TN. "Custody holdings" were up $70bn y-o-y, or 2.1%.

M2 (narrow) "money" supply rose $17.7bn last week to a record $14.266 TN. "Narrow money" gained $557bn, or 4.1%, over the past year. For the week, Currency increased $2.4bn. Total Checkable Deposits gained $3.8bn, and Savings Deposits increased $9.8bn. Small Time Deposits added $2.7bn. Retail Money Funds slipped $0.9bn.

Total money market fund assets fell $11.7bn to $2.872 TN. Money Funds gained $131bn y-o-y, or 4.8%.

Total Commercial Paper surged $18bn to $1.100 TN. CP gained $31bn y-o-y, or 2.9%.

Currency Watch:

The U.S. dollar index added 0.5% to 95.624 (up 3.8% y-t-d). For the week on the upside, the Brazilian real increased 5.5% and the British pound gained 0.7%. For the week on the downside, the South African rand declined 4.3%, the New Zealand dollar 2.7%, the Australian dollar 2.4%, the Swedish krona 1.9%, the South Korean won 1.9%, the Norwegian krone 1.3%, the Singapore dollar 1.1%, the Swiss franc 1.0%, the euro 0.7%, the Mexican peso 0.6%, and the Canadian dollar 0.2%. The offshore Chinese renminbi declined 0.27% versus the dollar this week (down 5.52% y-t-d).

Commodities Watch:

The Goldman Sachs Commodities Index jumped 1.7% (up 11.7% y-t-d). Spot Gold rallied 0.9% to $1,203 (down 7.7%). Silver gained 1.5% to $14.649 (down 14.6%). Crude rose another $1.09 to $74.34 (up 23%). Gasoline was little changed (up 16%), while Natural Gas surged 4.5% (up 6%). Copper declined 1.5% (down 16%). Wheat gained 2.4% (up 22%). Corn rose 3.4% (up 5%).

Trump Administration Watch:

October 2 - CNBC (Sri Jegarajah): "Using trade deals with Canada, Mexico and South Korea as leverage, Washington looks set to sharpen its hard line trade policy against China and what it deems unfair trade practices from Beijing, strategists told CNBC. Though some experts have said a tariff-impacted slowdown in Chinese economic activity may make Beijing more willing to agree to a deal, many still maintain China won't back down and will respond to further U.S. escalation by raising regulatory obstacles to U.S. businesses operating in the mainland."

October 1 - Reuters (Steve Holland and David Lawder): "President Donald Trump… touted a new trade deal with Canada and Mexico as a win for U.S. workers while investors breathed a sigh of relief that the key pillars of NAFTA had survived his hardball strategy to reshape global commerce. Washington and Ottawa reached an agreement… after weeks of tense bilateral talks to update the 1994 North American Free Trade Agreement. The United States had forged a separate trade deal with Mexico… in August. The new agreement, called the United States-Mexico-Canada Agreement (USMCA), is aimed at bringing more jobs into the United States, with Canada and Mexico accepting more restrictive commerce with the United States, their main export customer."

September 30 - Bloomberg (Christopher Anstey): "With little prospect of a restart for U.S.-China trade talks, JPMorgan… now expects an escalation in tensions that will see higher American tariffs on all Chinese imports, sending the yuan sliding to its weakest against the dollar in more than a decade. 'JPMorgan has adopted a new baseline that assumes a U.S.-China endgame involving 25% U.S. tariffs on all Chinese goods in 2019,' JPMorgan strategists including John Normand wrote… While growth forecasts for both the U.S. and China aren't much affected, thanks in part to Chinese stimulus measures, 'a weaker yuan becomes part of the new equilibrium,' they wrote."

October 3 - AFP: "The bitter trade dispute between China and the US is increasingly spilling into the military domain, with a risky incident in the South China Sea highlighting the dangers of souring relations. In what the US Navy has called an 'unsafe and unprofessional' encounter, a Chinese warship sailed within just 45 yards of a US destroyer Sunday as it passed by Chinese-claimed features in the South China Sea, forcing the American vessel to take evasive action."

September 30 - Bloomberg (Ben Holland and Jeanna Smialek): "With its plaintive call for balanced budgets, the fiscal hawk once pervaded Washington. But it's getting harder to spot one. That's because of President Donald Trump, and the equal-and-opposite reaction he's provoked on the U.S. left. Trump is proving as indifferent to fiscal orthodoxy as to any other kind. The spending measure he signed on Friday, along with the one approved in March and December's tax bill, amount to the biggest stimulus outside recessions since the 1960s. They sailed through a House led by the supposedly hawkish Paul Ryan, who's due to step down in January without much progress on his goal of reining in so-called entitlements like social security -- an illustration of how Republican deficit scolds are in retreat. On the Democratic side, the reaction that's firing up the grassroots isn't 'How could you do that?'' It's: ' Why can't we do that?' … In both parties, deficit spenders are gaining ground… 'The tax cuts really set off a spiral of irresponsible justifications for not caring about fiscal responsibility,' says Maya MacGuineas, president of the CRFB."

Federal Reserve Watch:

October 3 - Financial Times (Chris Giles): "The US economy has reached a 'normal' stage of the economic cycle without any further need for monetary policymakers to be accommodative with interest rates or provide long-term guidance to markets, a Federal Reserve official has said. Speaking to the Financial Times in London, Charles Evans, who will be a voting member of the Fed's policy committee next year, said there was probably a need for a period of tight monetary policy to slow the economy a little and keep inflation under control."

October 2 - Reuters (Howard Schneider and Jonathan Spicer): "U.S. Federal Reserve Chairman Jerome Powell… hailed a 'remarkably positive outlook' for the U.S. economy that he feels is on the verge of a 'historically rare' era of ultra-low unemployment and tame prices for the foreseeable future. It is a view, he said, based on how a changed economy is operating today, with businesses and households immunized by strong central bank policy from the inflationary psychology that caused unemployment, inflation and interest rates to swing wildly in the 1960s and 1970s. It is an outlook that includes an economic performance 'unique in modern U.S. data,' with unemployment of below 4% expected for at least two more years and inflation remaining modest even as wages rise."

October 2 - CNBC (Jeff Cox): "Federal Reserve policymakers have been able to stave off sharply higher inflation even with low unemployment by managing expectations, central bank Chairman Jerome Powell said… Should those attitudes change, Powell said in a speech, the Fed won't hesitate to respond. 'From the standpoint of contingency planning, our course is clear: Resolutely conduct policy consistent with the [Federal Open Market Committee's] symmetric 2% inflation objective, and stand ready to act with authority if expectations drift materially up or down,' he told the National Association for Business Economics… 'What is more likely, in my view, is that many factors, including better conduct of monetary policy over the past few decades, have greatly reduced, but not eliminated, the effects that tight labor markets have on inflation,' he said."

October 1 - Bloomberg (Christopher Condon): "Federal Reserve Bank of Boston President Eric Rosengren said the U.S. central bank should keep raising its benchmark interest rate until it's reached 'mildly restrictive' territory. With a strong labor market expected to become tighter, he said, economic imbalances, including inflationary pressures, will continue to mount. 'Federal Reserve policy makers will likely need to move interest rates gradually from a mildly accommodative stance to a mildly restrictive stance,' Rosengren said… Such a policy 'is fully consistent with a forecast of GDP growth above potential that leads to further tightening of labor markets, and inflation mildly overshooting the Federal Reserve's 2% target.'"

October 1 - Reuters (Howard Schneider): "The tight U.S. labor market may be good for workers, allowing them to jump between jobs more easily and coax higher wages from their boss. But it may also pitch the economy toward unexpected inflation or other problems if it remains as low as the Federal Reserve anticipates, Boston Federal Reserve president Eric Rosengren said… in remarks defending the case for continued interest rate increases by the Federal Reserve."

October 1 - Bloomberg (Timothy A Duy): "The Federal Reserve's 'r-star' has gone full supernova. New York Federal Reserve President John Williams, its key proponent, made clear in a speech late Friday that the neutral interest rate is no longer a guiding star for monetary policy. This means a federal funds rate in the range of what is considered neutral has no special significance as far as policy is concerned. That is hawkish relative to any expectations that the Fed would pause as policy rates approach a level that neither stimulates nor restricts the economy… Williams's attachment to r-star cannot be overstated. At a professional level, it has been a key element of his research agenda. As recently as May he said that for 'the moment, r-star continues to shine brightly, guiding monetary policy, but hold steady, low on the horizon.'"

U.S. Bubble Watch:

October 3 - CNBC (Fred Imbert): "The U.S. services sector expanded last month at its fastest pace on record, according to… the Institute for Supply Management. The ISM non-manufacturing index rose to 61.6 last month. That is the highest level since the index was created in 2008… The index jumped from 58.5 in August. 'The non-manufacturing sector has had two consecutive months of strong growth since the 'cooling off' in July. Overall, respondents remain positive about business conditions and the current and future economy,' said Anthony Nieves, ISM chair… However, 'concerns remain about capacity, logistics and the uncertainty with global trade.'"

October 3 - CNBC (Jeff Cox): "Job growth surged in September to its highest level in seven months as the economy put up another show of strength, according to… ADP and Moody's Analytics. Private companies added 230,000 more positions for the month, the best level since the 241,000 jobs added in February and well ahead of the 168,000 jobs added in August… Construction grew by 34,000 as goods-producing industries overall contributed 46,000 to the final count. 'This labor market is rip-roaring hot,' Mark Zandi, chief economist at Moody's Analytics, told CNBC. 'The risk that this economy overheats is very high, and this is one more piece of evidence of that.'"

October 3 - Wall Street Journal (Anna Wilde Mathews): "The average cost of employer health coverage offered to workers rose to nearly $20,000 for a family plan this year, according to a new survey, capping years of increases… Annual premiums rose 5% to $19,616 for an employer-provided family plan in 2018, according to the yearly poll of employers by the nonprofit Kaiser Family Foundation. Employers, seeking to blunt the cost of premiums, also continued to boost the deductibles that workers must pay out of their pockets before insurance kicks in."

October 1 - Wall Street Journal (Corrie Driebusch and Maureen Farrell): "Stock investors are welcoming money-losing companies into the public markets this year with open arms. About 83% of U.S.-listed initial public offerings in 2018's first three quarters involve companies that lost money in the 12 months leading up to their debut, according to… University of Florida finance professor Jay Ritter. That is the highest proportion on record, according to Mr. Ritter, an IPO expert whose data goes back to 1980. Some analysts and market watchers are concerned. They see similarities with the dot-com bubble of nearly two decades ago that left many investors with enormous losses. The prior high-water mark for money-losing companies going public was 2000, when 81% of stock-market debutantes were unprofitable… Investors' tolerance for red ink has been rewarded so far in 2018. Stocks of money-losing companies listing in the U.S. soared 36% on average from their IPO price through Thursday."

October 1 - Reuters (Richard Leong): "The U.S. housing market, already struggling with tight inventory and rising building costs, faces a fresh headwind as 30-year mortgage rates rise close to the 5% threshold for the first time in years. Even as home prices have climbed steadily thanks largely to a lack of supply of homes for sale, housing affordability has remained relatively stable thanks to historically low borrowing costs. But that is changing."

September 29 - New York Times (Ben Casselman): "By nearly any measure, this city is booming. The unemployment rate is below 3%. There is so much construction that a local newspaper started a 'crane watch' feature. Seemingly every week brings headlines about companies bringing high-paying jobs to the area. Yet, Denver's once-soaring housing market has run into turbulence. Sales and construction activity have slowed in recent months. Houses that would once have drawn a frenzy of offers are sitting on the market for days or weeks. Selling prices are rising more slowly, and asking prices are being slashed to attract buyers. Similar slowdowns have hit New York, Seattle and even San Francisco, cities that until recently ranked among the nation's hottest housing markets. The specifics vary, but economists, real estate agents and home builders say the core issue is the same: Home buyers are reaching a breaking point after years of breakneck price increases that far exceeded income gains."

October 1 - Bloomberg (Oshrat Carmiel): "It's been a rough year for Manhattan's home sellers, and they're not about to catch a break any time soon. In the three months through September, purchases dropped 11% from a year earlier to 2,987 -- the fourth straight quarter with a decline, according to… Miller Samuel Inc. and brokerage Douglas Elliman Real Estate. Listings piled on to the market at an even greater rate, climbing 13% to 6,925 homes, the most for a third quarter since 2011. A surging stock market typically fuels buyer bullishness on Manhattan real estate -- but not this time."

October 2 - Bloomberg (Oshrat Carmiel): "Rent or buy? It's a common debate among people shopping for a home in New York City. And many owners trying to find takers for their properties are appealing to both sides of it. The number of homes simultaneously listed for sale and for rent in New York jumped 51% this year through Sept. 1 -- to 1,087 -- as owners try to get the best price at a time when both markets are weakening, according to data compiled by StreetEasy. They're not exactly offering bargains. Owners of the simultaneously listed homes are seeking to sell them for a median of $1.395 million, or 24% higher than a year earlier for similar properties, the firm said. The owners are seeking a median monthly rent of $4,800 for those same properties, a 14% increase."

October 3 - Bloomberg (Lily Katz): "U.S. regional malls suffered their biggest increase in vacancies in almost a decade as retailers continue to shutter locations with no end in sight. The vacancy rate rose to 9.1% in the third quarter from 8.6% in the prior three-month period, Reis Inc. said in a report, citing closures by Sears Holdings Corp. and Bon-Ton Stores Inc. The average asking rent fell for the first time since 2011, dropping 0.3% to $43.25 a square foot."

China Watch:

September 30 - Wall Street Journal (Liyan Qi and Lingling Wei): "An intensifying trade brawl with the U.S. is starting to take a heavier toll on China's economy, as weakening foreign demand and sluggish domestic consumption cause Chinese manufacturers to significantly scale back production. The manufacturing slowdown, detailed in reports released Sunday, raises the prospect that China's leaders will step up economic stimulus measures to prop up growth. The new data showed that privately owned makers of cars, machinery and other products stopped expanding in September, as export orders dropped the most in more than two years. At the same time, output by large, state-owned manufacturers continued to weaken."

October 2 - Wall Street Journal (Dominique Fong): "Apartment rental prices are soaring across China, posing a new challenge to Chinese authorities and compounding the threat of sky-high housing prices to the economy. Rental prices for apartments are accelerating by double digits in 30 of China's biggest, most vibrant cities. In Beijing, rents are up as much as 21% from a year ago, while in the south-central megacity of Chengdu they have climbed more than 30%... This surge is an unintended consequence of Beijing's efforts to cool off the housing market by steering more home buyers into the rental market… For China's government, the sudden rise in rents poses a new financial risk, as well as a social problem."

September 29 - Reuters (Josephine Mason, Hallie Gu, Ben Blanchard and Kevin Yao): "China's central bank pledged to maintain its 'prudent and neutral' monetary policy and to use multiple tools to keep liquidity ample, as the world's second-biggest economy comes under increasing pressure from a heated trade dispute with the United States."

September 30 - Reuters (Maximilian Heath): "Argentina has 'nearly closed' a new currency swap deal with China that will add the equivalent of $9 billion to the South American country's reserves, the central bank said… Argentina and China first agreed to a swap program in 2009 to boost the South American country's dwindling reserves under former President Cristina Fernandez."

October 1 - Financial Times (Emily Feng): "Beijing will not renew significant cuts on steel production and coal use aimed at improving air quality this winter, as policymakers look to boost China's economic performance in the midst of the country's trade war with the US. The curbs - a rare restriction imposed on industries where state enterprises are prevalent - were meant to target airborne pollution, which worsens during the winter as much of the country's northern cities are heated with coal-fired power."

September 28 - New York Times (Sui-Lee Wee and Li Yuan): "China has long made it clear that reporting on politics, civil society and sensitive historical events is forbidden. Increasingly, it wants to keep negative news about the economy under control, too. A government directive sent to journalists in China… named six economic topics to be 'managed,' according to a copy of the order… reviewed by The New York Times. The list of topics includes: Worse-than-expected data that could show the economy is slowing; Local government debt risks; The impact of the trade war with the United States. Signs of declining consumer confidence. The risks of stagflation, or rising prices coupled with slowing economic growth. 'Hot-button issues to show the difficulties of people's lives.'"

EM Watch:

October 2 - Bloomberg (Onur Ant): "Turkey's consumer inflation climbed to one of the highest levels since President Recep Tayyip Erdogan came to power 15 years ago, spurring calls for higher interest rates to rein in prices. The inflation rate rose for a sixth month to 24.5% in September from a year earlier… The monthly rate was 6.3%, driven by an across-the-board spike provoked by the lira's meltdown. Treasury and Finance Minister Berat Albayrak blamed hoarders and speculators, and predicted inflation would stop quickening in October. Wednesday's inflation report puts monetary policy makers in a bind. The central bank raised borrowing costs last month to their highest level in nearly two decades, yet prices are gaining at their fastest pace since June 2003."

October 2 - Wall Street Journal (Andrew Peaple): "Spotting new 'Lehman moments' has become a pastime for global market watchers since 2008. The latest supposed sighting is in India, where the government this week summarily replaced the board of Infrastructure Leasing & Financial Services-a nonbank lender that regulators have deemed systemically important, and which has recently roiled local markets after defaulting on a string of debts. The story may not herald the collapse of India's financial system. But it raises fresh-and serious-questions about its underlying health. IL&FS's core problem is a classic asset-liability mismatch. Though it invests in infrastructure projects with long payback periods, it has become ever more reliant on short-term funding… Some of the company's projects are now in trouble… That's left it struggling to service its $12.6 billion debt pile…"

October 1 - Reuters (Ezgi Erkoyun and Orhan Coskun): "Turkish manufacturing activity slid to its lowest level in nine years in September, a business survey showed…, in what economists said was among the clearest signs yet that Turkey was headed for a deep recession after months of currency turmoil."

October 2 - Reuters (Anthony Boadle): "Brazil's far-right presidential candidate Jair Bolsonaro is polling ahead of leftist Workers Party rival Fernando Haddad for the expected runoff in this month's election, a Datafolha opinion poll showed… In a simulated second-round vote, the poll found Bolsonaro would get 44% support, beating Haddad's 42%... If no candidate wins a majority in the first round on Sunday, the election will be decided in a second-round run-off on Oct. 28 between the two top vote-getters."

October 3 - Bloomberg (Anirban Nag): "A crisis at one of India's biggest infrastructure financiers is the latest example of how the end of an easy money era is causing strain in the world's fastest-growing economy. Rising borrowing costs are putting pressure on lenders like Infrastructure Leasing & Financial Services Ltd. -- whose recent debt defaults rocked financial markets in India and sparked fears of a contagion -- as well as on debt-focused mutual funds that are liquidating holdings. There's more pain to come as global interest rates rise and the Reserve Bank of India proceeds with its own tightening…"

October 1 - Bloomberg (Liau Y-Sing): "Indonesia's rupiah weakened past 15,000 per dollar for the first time in 20 years as sentiment toward emerging-nation assets soured and oil prices jumped. The currency has tumbled almost 10% this year as rising U.S. interest rates have boosted the dollar and Indonesia's current-account deficit has left the economy exposed to the financial turmoil that afflicted Turkey and Argentina. Crude prices have almost tripled since February 2016, ratcheting up the cost of imports."

September 30 - Reuters (Lisa Barrington and Karin Strohecker): "Lebanon's worst bond market shock in a decade has raised doubts about whether the country's banks are willing and able to continue to bankroll the government, raising pressure on Beirut to step up reforms or risk a destabilizing currency crisis."

Central Bank Watch:

October 2 - Bloomberg: "Global central banks are gradually withdrawing easy monetary policy a decade since they began racing to the rescue of a world economy skidding into recession. The Federal Reserve's benchmark is now the highest since 2008 and officials are signaling another hike in December and more in 2019. Emerging markets from Argentina to India have acted to defend their currencies. All told, 10 of the 22 central banks monitored in Bloomberg Economics' quarterly outlook raised interest rates since the start of July. Seven are predicted to do so again before the end of this year. That's not to say global policy is tight and there is a sense of divergence among the big policy makers. The European Central Bank will buy assets until December and pledges not to increase rates before the summer. The Bank of Japan continues to deliver massive stimulus and the People's Bank of China is alert to weakening growth."

October 3 - CNBC (Weizhen Tan): "The rupee's plunge into record-low territory this year is unlikely to slow - even if India's central bank hikes its rate this week, according to experts… Analysts largely expect India, Asia's third-largest economy, to raise its benchmark rate by 25 bps at its meeting this week, with more increases to come this and next year. But while an interest rate hike would normally be expected to support a currency, the rupee 'is in for continued losses ahead,' according to Prakash Sakpal, vice president of research at Dutch bank ING."

Italy Watch:

October 2 - Reuters (Gavin Jones): "Italy defied pressure from Brussels and its euro zone partners on Tuesday to water down ambitious budget plans, threatening to sue EU officials it said were to blame for a deepening sell-off on Rome's financial markets… 'We are not turning back from the 2.4% target... We will not backtrack by a millimeter,' Luigi Di Maio, deputy prime minister and leader of the anti-establishment 5-Star Movement, said on RTL radio."

October 4 - Reuters (Jan Strupczewski): "Senior European Union officials believe Italy risks facing a massive debt restructuring task - and one that would hit its own citizens hardest - unless it backs down in its unprecedented challenge to Brussels' budget rules. Italy's 2.3 trillion euro national debt dwarfs that of Greece and the euro zone bailout fund would not be able to cope with the costs of supporting its government in a crisis. Any such crisis could threaten the euro itself, seen by many as the EU's greatest achievement."

October 3 - Bloomberg (Kevin Costelloe and Andrew Davis): "Italy's populist government will offer some concessions to fend off European Union pressure about its public finances, committing to reduce its budget deficit targets in 2020 and 2021, while sticking to its guns for next year, Corriere della Sera newspaper reported. The government will maintain its plan for a shortfall of 2.4% of gross domestic product for 2019, while reducing the targeted gap to 2.2% and 2% for the two successive years respectively, according to Corriere. The government had originally said it would aim for 2.4% for all three years."

October 2 - Wall Street Journal (Avantika Chilkoti and Georgi Kantchev): "A deepening selloff of Italian bonds and banks has revived concerns over the 'doom loop' between weak lenders and fragile government finances. Italian banks have large portfolios of the country's bonds and the recent fall in their value will have eroded the sector's capital cushion, which is needed to protect it from future financial shocks. During the sovereign debt crisis earlier this decade, a selloff in government bonds raised concerns about the banks that held them which, in turn, added to worries about the country's economic strength. But this year, Italian banks have loaded up on even more of the country's bonds, even as other eurozone countries have whittled down their portfolios."

October 3 - Financial Times (Miles Johnson in Rome and Jim Brunsden): "As Italy's populist coalition government prepares to submit its draft budget to the European Commission this month all eyes are on the possibility of a dangerous confrontation with Brussels and financial markets. While Luigi Di Maio, leader of the Five Star Movement, and Matteo Salvini, leader of the League, have said they will resist outside attempts to change their plans, senior European figures have warned Rome that their expensive policies are likely to be in breach of budget rules… The Italian government said last week that its plans would see the country's budget deficit for next year rise to 2.4% of gross domestic product. Giovanni Tria, Italy's technocratic economy minister, has said the deficit will come down in 2020 and 2021. But the economic assumptions behind these estimates are likely to be as important in deciding the commission's reaction as the figure itself."

October 1 - Bloomberg (Lorenzo Totaro, Viktoria Dendrinou, and Nikos Chrysoloras): "Italian Finance Minister Giovanni Tria's effort to promote his government's new fiscal strategy ended in failure on Monday, with the head of the European Commission warning of a Greek-style crisis and the nation's bonds dropping to their weakest level in more than four years. 'Recent announcements by the Italian government have raised concerns about its budgetary course,' Mario Centeno, the Portuguese finance minister, said… Dutch Finance Minister Wopke Hoekstra went further, saying 'I'm somewhat less optimistic after having talked to my colleagues than beforehand.'"

Europe Watch:

October 3 - Financial Times (Martin Arnold and Kerin Hope): "Some of Greece's biggest banks suffered steep share price falls on Wednesday as investors worried they may not have enough capital to meet fresh targets on reducing their large portfolios of bad debts. Shares in Piraeus Bank, the country's largest lender by assets, dropped more than 20%, cutting its market capitalisation to less than €600m."

Japan Watch:

September 30 - Reuters (Leika Kihara and Tetsushi Kajimoto): "Rising raw material costs and a string of natural disasters that disrupted production sapped business confidence among Japan's big manufacturers in the September quarter, a central bank survey showed…, taking it to the lowest in more than a year."

Global Bubble Watch:

September 30 - Financial Times (Patrick Jenkins): "Black pots and kettles spring to mind. Over the past couple of weeks, three different policymakers from the European Central Bank have spoken in concerned tones about the risks posed to the financial system by the growing role of 'shadow banking'. Ten years after the world was rocked by an unprecedented banking crisis, policymakers are sounding the alarm about the spread of risk out of the now more regulated banks and into the 'shadows' where asset managers, insurers and others carry out banklike business. First came Mario Draghi, ECB president. …He pointed out that the non-bank financial sector in the EU now harboured €42tn, or 40%, of the region's entire financial system… Next came Fran├žois Villeroy de Galhau, the Banque de France governor, who cited the same figures but added a touch of politics by blaming 'the big investment funds, they are partly American'… Finally, last week, Peter Praet, the ECB's chief economist, told a Financial Times conference that he was particularly worried about 'the degree of leverage in the financial system . . . because of the shadow banking system'."

October 3 - Reuters (Weizhen Tan): "'Irresponsible fiscal policy' is on the rise as governments increasingly try to appeal to angry voters, according to a chief investment officer overseeing international macroeconomic trends. …Michael Hasenstab, chief investment officer at Templeton Global Macro… called the trend a response to populism… and emphasized that political risk had become a pressing investment consideration. 'One of the main factors that we look at throughout emerging markets and the developed markets, take Italy for example, is the rise of populism leading to irresponsible fiscal policy. Probably one of the most important political variables we have to look at,' Hasenstab told CNBC…"

September 30 - Bloomberg (Matthew Burgess): "Australia's property slump has reached the one-year mark as the nation's two major cities have become the biggest drag. National dwelling values dropped 0.5% last month, weighed by declines in Sydney and Melbourne, according to CoreLogic… Prices in the two east coast cities, which make up more than half of the national value of housing, have fallen 6.1% and 3.4% respectively from a year earlier… Values have fallen greatest among the most expensive properties as lenders curb their appetite for high debt to income ratio lending…"

Fixed Income Bubble Watch:

October 3 - Bloomberg (Christopher Anstey and Gowri Gurumurthy): "Risk premiums on U.S. junk-rated bonds have tumbled to the lowest level since the start of the global financial crisis… A dearth of fresh supply, as well as continued investor inflows and rising U.S. government-debt yields, helped push the yield spread on sub-investment grade U.S. bonds over benchmark Treasuries to 3.09 percentage points Monday -- the lowest since July 2007. Issuance of new corporate debt is about 30% lower this year than in the same period of 2017, and is running at the slowest pace since 2009. Against that, the largest junk bond ETF recorded its biggest one-day inflow on record Monday."

Leveraged Speculation Watch:

October 3 - Wall Street Journal (Juliet Chung): "Boston hedge fund Highfields Capital Management is returning billions in client money and converting into a family office, founder Jonathan Jacobson told investors... The decision to return money to investors would mark one of the largest hedge fund closings in recent history. Mr. Jacobson started the $12.1 billion stock-trading firm in 1998… About $9.5 billion of Highfields' assets are outside client money. 'Done correctly, money management is an all-consuming, 24/7 pursuit… After three-and-a-half decades of sitting in front of a screen, I realized I am ready for a change,' Mr. Jacobson, 57 years old, wrote… Mr. Jacobson's decision to return money… is the latest closure by a high-profile manager during a tough period for hedge funds. This year through August, stock hedge funds on average returned 2.3% compared with a 10% return for the S&P 500…"

Geopolitics Watch:

September 29 - Wall Street Journal (Farnaz Fassihi and Chris Gordon): "Top diplomatic officials from China and Russia admonished the U.S. on an array of issues ranging from multilateral agreements to sanctions policy at the United Nations on Friday, portraying Washington as stepping back from world commitments while their own countries were expanding global engagement. Russian Foreign Minister Sergei Lavrov and Chinese Foreign Minister Wang Yi were among the speakers scheduled near the end of a week of addresses by world leaders at the U.N. General Assembly."

October 4 - CNN (Barbara Starr): "The US Navy's Pacific Fleet has drawn up a classified proposal to carry out a global show of force as a warning to China and to demonstrate the US is prepared to deter and counter their military actions, according to several US defense officials. The draft proposal from the Navy is recommending the US Pacific Fleet conduct a series of operations during a single week in November. The goal is to carry out a highly focused and concentrated set of exercises involving US warships, combat aircraft and troops to demonstrate that the US can counter potential adversaries quickly on several fronts."

October 2 - Reuters (Robin Emmott): "Russia must halt its covert development of a banned cruise missile system or the United States will seek to destroy it before it becomes operational, Washington's envoy to NATO said… The United States believes Russia is developing a ground-launched system in breach of a Cold War treaty that could allow Russia to launch a nuclear strike on Europe at short notice, but Moscow has consistently denied any such violation."

October 1 - Reuters (Ben Blanchard and David Stanway): "China expressed anger… after a U.S. Navy destroyer sailed near islands claimed by China in the disputed South China Sea, saying it resolutely opposed an operation that it called a threat to its sovereignty. Beijing and Washington are locked in a trade war in which they have imposed increasingly severe rounds of tariffs on each other's imports. A U.S. official… said the destroyer the USS Decatur traveled within 12 nautical miles of Gaven and Johnson Reefs in the Spratly Islands…"

October 1 - Wall Street Journal (Gordon Lubold and Jeremy Page): "U.S. military officials complained… that a Chinese warship harassed a U.S. Navy vessel as it sailed through the South China Sea, adding to a growing roster of disputes between the two countries in a sudden escalation of tensions. The ship complaint comes as the latest episode between Washington and Beijing after a year-long trade and tariff war has spilled over into political conflict and military strains between the rival powers. Rhetoric has risen markedly in the past week, with President Trump charging at the United Nations last week that China had meddled in U.S. elections by purchasing misleading newspaper ads designed to look like news articles that criticize Trump administration policies."

October 4 - Reuters (Idrees Ali and Robin Emmott): "U.S. Defense Secretary Jim Mattis said… that Russia's violation of an arms control treaty was 'untenable' and unless it changed course the United States would respond. The United States believes Russia is developing a ground-launched system in breach of a Cold War treaty, known as the Intermediate-Range Nuclear Forces Treaty (INF), that could allow Moscow to launch a nuclear strike on Europe at short notice."

Friday Evening Links

[Reuters] Wall Street slides as bond yields climb on jobs data

[BloombergQ] China Slams Brakes on U.S. Crude Oil Imports

[Reuters] Speculators net long U.S. dollar bets highest since Dec. 2016 -CFTC data

[Reuters] A disciple of Brazil's dictatorship moves closer to the presidency

[BloombergQ] Asian Cities Challenge U.S. Dominance in Venture Capital

[WSJ] The Achilles’ Heel for Italy’s Populists: Weak Banks

[WSJ] OPEC’s Wildcards Could Push Oil to $100

[FT] Bond market sell-off weighs on stocks