Sunday, March 15, 2020

The start of the end

In February all US stock market indexes were at an all time high. The time was right for President Trump to go to Congress for the State of the Union speech and declare victory over the economy. He would once again justify how awesome the economy is and why the prosperity of the people in the last three years of his Presidency was the best ever in US History. He glorified the rise of the stock market and took full credit for it. Little did he knew then, that the very market he glorified will tank into the bear market in record time. In fact, all indexes hit the bear market territory in the first two weeks of March. Market going to bear market was nothing new but the pace at which it got down from the peak into the bear market is unprecedented. The fear of Coronavirus (Covid-19) becoming a pandemic and dangerously spreading across the world swiftly, triggered the collapse of the markets.

As of today 15-March, We are seeing wide swings on daily trading swinging between + or - 4% on any day. In the process we have almost 10% down and up days within a week. The major indexes haven't seen this kind of swings unless you want to go back to the 1929 era of the great depression.

President Trump's reelection is almost 100% dependent on a good economy in build up to the elections in November. If the economy is in recession, it is almost certain that he will end up as one-term President. To avoid that - Trump would be ready to do extreme intermediate steps to postpone the crisis. The mere idea of payroll tax cut or a tax holiday is a direct reflection of that.

The US Federal reserve has kept the economy on cheap money post financial crisis of 2008, and it never managed to get back to normal interest rate in the last 12 years. They couldn't do it, because they were well aware doing that would cause a recession. Chairman Powell however did manage to get to 2.5% mark - almost half of historic average. Once the late rate rise was too much for the economy to manage, he had to pull it back to 1.5%. As stocks began to tank in the first week of March, the yield on the longer term treasuries began to tank. As the 10-year was dangling around the less than 1% mark, he really didn't have a choice but to make a unplanned 50 bps of emergency cut and bring the Fed funds rate to 1%. What scared chairman Powell the most was there were 7 days market freeze for the investment grade corporate bond. There were no buyers and hence no sellers. Within a week, the yield has further dropped down to 0.3% and back up to the 1% mark. The bond market is still pricing in a 50 bps points on the March 18th Fed meeting. They will cut it further I think. Sooner than we think, they are going back to zero percent. As stocks tanked the bond market crated with yields rising for non-government bonds. The spread looks lot scarier. The Fed has also promised to jump in to buy everything with its $1.5 Trillion QE program announced last week. The TARP in 2008 was $700 billion and it was very famously rejected by Congress initially. The bailout fund this week is almost double of that. This essentially is an admission that the problems are bigger than 2008. What is really interesting is - Can the Fed play its card this time. The last time it worked was because - Bernanke, the Fed Chairman then told Congress - the QE was not debt monetization but was TEMPORARY. But from past experience the QE programs always is repeating and every program dwarfs any previous programs in dollar value. The recent announcement of $1.5 Trillion QE programs is all previous QE program combined in dollar terms. They plan to bail out every industry possible. What needs to be observed is - the dollars don't make business viable but the productivity of the labor makes a business useful, viable and hence profitable.

President Trump is unleashing a "Bailout nation" in the guise of National Emergency because of the Covid-19 pandemic. The bond market went up in smoke last week. Trump really didn't have a choice. He had to come and put a floor to the fall. With fiat currency system in place, these government bond yields don't make sense. In fact these government papers trading at the lower yield is not an issue. The pressing issue is the opposite trade. The yield on the junk bonds are rising more than the fall in the US treasuries. That is the worrying part. The corporate bond market is so leveraged that it cannot handle rising rates. Corporate bonds that have junk status and have ratings just above junk are doomed to fail big time. With this trade "We will buy anything out there in the bond market" is the Fed's new rhetoric. They will go on to say, that it is temporary and they will sell it out during the good time. They couldn't do it fully last time, they will never be able to do it next time as well. Will the market buy it, is the $1.5Trillion question.

In the build up to the 2008 financial crisis - falling house prices was the pin that pricked the debt bubble. The bursting of the bubble exposed the over-leveraged debt market primarily mortgage debt. The mortgage debt market exploded initially in the subprime sector and then it spread to the entire mortgage market. The financial companies - that were part of the industry got burnt first like countrywide and then it spread to Fanie mae and Freddie mac - the quasi government enterprises., finally targeting the banking hierarchy from local & regional banks to international banks like Citi. This will solved by government bailouts to the financial sector.

The bailouts from the last great recession and the subsequent building up of national, corporate and household debt has created a far bigger crisis now than in 2008.

The plot that is playing now, is the Coronavirus is the pin that pricked the debt market, which is many fold bigger than what it was in 2008. First it would hit the easy targets and then finally the full scope of the economy. People ask that FANG stocks are doing ok, in spite of the big market correction. My answer to them is - first the soldiers get killed and then the generals. They are all highly leveraged and substantially over-valued. They will go down significantly as well.

The irrational exuberance on steroids of the last decade finally seems to have started to end.

What to look for? What will confirm this? Looks at the weekly jobless claims numbers. It has to go beyond the 255K number. The jobs number for April and May are getting important. With the economic activity almost coming to a standstill on the fear of contracting the virus., that number should go up. If you seen the job reports numbers from the last 10 years, bulk of the jobs were created in the hospital and leisure sector of the economy. With this sector annihilated - there should be thousands and thousands of job losses. With US job market dominated by women workforce (non-labor intensive) that men, the jobs would disappear sooner.

Bailouts would work, if a part of the economy is struggling and the other part is doing good. With the entire stand-still happening, bailouts won't work. Open ended bailout commitment is a sign of weakness and not strength. Moreover the US government is the biggest debtor in the planet. It offering to bailout other smaller debtors just insults rational intelligence.

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