Fallout

Fallout

What will be the fallout in 2023 with more than 13 trillion USD of wealth vanishing from investment portfolios in 2022 and when central banks abruptly terminate an emergency or an accommodative monetary policy, which has been more than a decade-long pillar of support?

When the structural pillar of a building is removed, the building crashes.

Fed chair Powell knew that terminating more than a decade of accommodative monetary policy in 2022 would be the pin that burst the bubble of everything.

First in line to experience the fallout, where investors with gaping black holes in their portfolios.

The fallout in financial markets also became apparent as turbulence in the treasury market sent the 10Y treasury yield above four percent

Locking down the global economy for two years and keyboarding trillions of dollars will create an inflation fallout with supply restricted and demand stable. 

So the Fed’s transition in monetary policy in 2022 to attempted normalization (it is not even normalization let alone tightening) has triggered calamity in financial markets, the crash of 2022.

The year ends with contagion risks in the bond market.

What I have referred to as the 20-pound gorilla, that mainstream will not dare talk about; The entire treasury market, a pinnacle of western finance, is negative yielding when factoring in core inflation.

In a rational world, why would an investor hold US 10-year treasuries with a 3.7% yield when inflation is 7.2%?

A currency has value when the yields on sovereign bonds and interest rates are higher than inflation. So the Fed fund rate of 4.5% is unlikely to encourage households to save with inflation at 7.2 %.

In other words, a currency crisis plays out when a currency has no store of value due to the supply of that currency exceeding its demand.

Moreover, when supply exceeds demand, the exchange value of the currency depreciates.

Hyperinflation is the story of nine failed currencies over the past century 

What will the fallout be when king USD sovereign yields and base rates remain stubbornly negative in the face of generation-high inflation?

US Treasuries are prime collateral due to the USD reserve currency status.

So commercial banks borrow from each other by pledging prime collateral, US treasuries, to secure the loan.

The holder of treasuries has been promised to receive a bunch of dollars on maturity, plus the yields. But when the music stops, who wants to hold worthless currency?

German sovereign bond investors lost their entire capital in the Germany Weimer Republic 1922-1923 hyperinflation currency failure. 

Investors who saw a currency failure decided to invest in productive tangible assets, machines, and tools

Collapsing market liquidity flashed red in 2022, with the economic fallout spilling in 2023

When collateral loses value banks demand more liquidity to cover the loan. So if treasuries are falling in value, commercial banks will want greater liquidity to underwrite their loans.

Could the stars be aligning for the mother of all credit squeeze triggered by turbulence in the treasuries market?  

In November, I reported that the Fed’s Repo hit a record 351BN, its biggest weekly jump in history in the first week of November.

The Repo market is an important component of the capital market, which provides short-term liquidity.

The last time the $3 trillion Repo Market blew up was in mid-September 2019 when the Repo rates spiked to 10%. 

Moreover, in late October, in a piece entitled “Stealth Bailouts,” I wrote, “the largest USD swap in history, dollar squeeze panic is currently playing out”

SWAP lines are a short-term fix to a liquidity crisis brewing in the plumbing of the financial system.

The credit squeeze in the UK is worse, with GDP temporarily approaching parity with the USD, the lowest exchange rate for GDP in living memory. The UK is deep in recession, and the government can not run a large deficit without triggering a panic in the gilt market. BoE was forced to buy gilts, and QE light to prevent a gilt and GBP meltdown. 

International demand for GBP is also near a record low due to Brexit, and the BoE has raised rates in a recession to try and stabilize GBP.

The UK resembles a failed state with rolling strikes, a withering currency, and a political elite class out of touch with reality.  

The fallout from the Fed’s rate hike is a credit squeeze on a global scale

Rising treasury yields could continue to wreak havoc on weak economies and currencies as the US economy attacks global liquidity. 

The fallout for emerging currencies and markets could be server if 

US rates and treasury yields rise in 2023. 

But the fallout of more expensive credit is dire for leveraged assets such as real estate. US housing sales have collapsed to their lowest level on record in 2022, 

The fallout of Fed tightening and war in Europe could be the worst for the eurozone. The 2013 sovereign debt crisis in euro peripheral bonds could play out again. 

Geopolitical fallout

With already enough to worry about, how about two great powers on the verge of declaring war? Backing a nuclear wolf into a corner will not end well.

Either we have hit rock bottom in the investor psychology cycle, central bank liquidity cycle, and world order cycle, or beam me up, Scotty!

As I noted in a piece in early May 2022, markets are uninvestable, but those conditions cannot persist without a fallout. Capitalism needs investors like plants need sunlight. 

Is there light at the end of the tunnel, or is it a flash from a nuclear blast?

Frankly, at this stage, you might as well stay invested since if you are wrong, you probably will not survive to regret it, and if you get it right, the thrill is all yours.

So let’s all light a candle, hope and pray to whoever your God may be for a peaceful and prosperous 2023. Good luck and a happy new year to you all.