Bear Traps' Highest Conviction Trade:
A Perfect Storm Is About To Hammer The Dollar
At a time when Wall Street is stuck in a furious debate with itself whether or not the Fed will pivot because inflation this or that, we recently proposed on Sept 1 an alternative theory: the coming Fed pivot will come not because an "inflation target has been hit" (it won't be for quite a while, especially since US unemployment will need to rise by over 4 million to contain inflation, a political unpalatable outcome), but because the dollar is soaring, and recently hit almost daily all time highs. As such we suggested that the Fed pivot will come not because of inflation but due to "devastation across the ROW."
Over a week later, we were surprised that someone even as patently clueless as Paul "fax machine" Krugman had figured out that the multi-trillion global dollar short squeeze is having catastrophic consequences on the rest of the world, when he wrote that "whatever the reasons, however, it’s clear that the strong dollar is inflicting a lot of pain on economies around the world. Once again, it’s our currency but their problem. Should this influence policy?"
Claudia Sahm, a former Fed economist (inventor of the famous Sahm Rule recession indicator), has been a strong critic of the Fed’s hard line on inflation and more recently has been arguing passionately that the Fed has a responsibility to consider the damage its policies are inflicting on the rest of the world. She has a point. Unfortunately, I don’t think the Fed will listen — yet.
Federal Reserve officials are still deeply worried about the possibility that high inflation will get entrenched in the U.S. economy, and that concern will dominate everything else until there are clear signs that underlying inflation is coming down. Once the Fed feels that it has some breathing room, however, it should start taking international repercussions into account. The dollar may be other countries’ problem, but even a purely self-interested America needs to live in the world our policies help shape.
Of course, the growing USD-bearish consensus is hardly news to Zero Hedge readers who knew more than two weeks ago that according to Michael Hartnett, the most accurate Wall Street analyst of 2022 by far, the top trade of 2023 will be to short the dollar, while going long the inverse trade, EMs:
The Trade of 2023: it’s “short US dollar, long Emerging Markets”... but only after the US recession starts (which will mark peak US$) and China troughs (likely after the coming China currency devaluation).
All of which brings us to the latest Bear Traps note by Larry McDonald, who not only echoes everything we have previously said about the Fed's coming funding squeeze (see "The Fed Is Quietly Paying $250 Million To A Handful Of Happy Banks Every Single Day" from July 1) but puts the coming dollars crisis in stark contrast.
Here is how Larry explains it:
After the Great Financial Crisis – regulators wanted to make sure the U.S. financial system would never again succumb to the double-edged sword of excess leverage. Regulators forced U.S. banks to “reserve up” and so – for the last 14 years – Wall Street's financial epicenter stored an ever-enormous dollar number of reserves – mostly found in U.S. Treasuries.
Today, as promised the Fed must pay these banks MORE and MORE interest on these reserves. As the central bank hikes rates – the unintended consequences are MOUNTING along with a political backlash - potentially louder than a Donald Trump appearance on “The View.”
This time next year, the Federal Government is looking at a near $400B negative swing;
- a) from profit to a loss on the Fed's transfer of net interest income – triggered by a surge in interest payments to banks on reserves,
- b) plus $200B additional interest on their $31T debt load.
Dollar headwinds are mounting from; emerging market credit risk, China currency devaluation, the Eurozone energy crisis, a weaker U.S. consumer (see Capital One CDS), and one-year inflation expectations crashing at the fastest pace since the fall of Lehman Brothers.
Sit back, think of taking the Fed Funds rate from 25bps in March to 325bps this month, that's three years of accommodation withdrawal in just six months. The price has yet to be paid for this violent right hook. A freshman-year economist can tell you it will take 12-24 months for the full effects to play out.
Now think of great films. Anyone that ́s ever seen the Hollywood classics in “Top Gun” knows how “Maverick” plays the game. Take extreme chances and push your next move as close to recklessness as possible – make the other-side believe there are no limits to your unpredictable path – when you know in your heart of hearts there are.
Running, not walking while blind in the dark. This is Powell ́s dangerous dollar–rates game.
Make NO mistake, the Fed knows what they don't know. It's time to get real. No academic on this planet can calculate the 12–24-month forward outcome of 300-450bps of rate hikes and $1T of QT - all delivered in less time than a “Hamilton” intermission on Broadway.
The whole lot has been tossed on a massively levered global financial system. They have very publicly sold investors on a path littered with incalculable risks with their pawns delivering weekly golf claps along the way.
After all the drama, genesis knocked on the door early Wednesday morning after breakfast. The truth is starting to come out. “Fed's Brainard: There's a risk of raising rates too much” – said Axios.
Let's be clear, the S&P 500 is up nearly 4% since Lael started to acknowledge two-sided economic risks of a “global nature.... risks with overtightening.” Gold miners are 8-10% higher since the speech.
When stocks rally like this into a tape filled with really bad news, there is almost always a central banker behind the move. As much as “Maverick” shows off his dance with darkness, the political will to kill inflation just isn't there.
Here we agree 100%: in fact this was our (rare) criticism of Zoltan Pozsar's August note "War and Interest Rates", in which the Hungarian predicted that Powell will pull a Volcker and push rates into the stratosphere. We countered that there is no way this will happen, since the tradeoff would be a crushing recession and millions unemployed as even Obama's chief economist Jason Furman admitted late last week. In fact, with inflation now trending back down, we expect the Fed to pivot very soon, a move which will reverberate across commodities and send prices truly exponentially higher... but not for a few months. Meanwhile, the dollar will be crushed as near record longs scramble to cover. And speaking of the cost of fighting runaway inflation, McDonald writes that...
In reality, similar to the 1970s, it's a social price just too high. As the breadth of bearishness rose, in recent weeks we covered half our shorts, and added to longs. JPM notes that after front-end rates have screamed 10x + higher, there are $15T of adjusted excess cash balances outstanding, or 16% of World GDP - highest level on record.
Bottom line: re-read Hartnett's "top trade of 2023" reco: it could, and most likely will be, the most profitable trade of the coming year. Not surprisingly, his top trade is identical to what McDonald sees as the best risk-reward looking out 12 months: "Our high conviction - U.S. dollar bear basket is locked and loaded – EWZ Brazil, EEM Emerging Markets, FXI – KWEB China, global value names in EWU and gold miners GDX."
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