[This blog post is an excerpt from a commentary published last week at https://speculative-investor.com/]

The ‘super’ El Niño currently underway has contributed and will continue to contribute to extreme weather events or very unusual weather conditions, including reduced rainfall (and potentially severe drought) throughout Asia and an absence of Atlantic hurricanes. One of the likely future effects will be a relatively mild US winter. At least, that has been a result of a strong El Niño in the past. However, as discussed in a recent Bloomberg article, the greater the strength of the current El Niño, the greater the risk that historical weather and climate patterns will not be a reliable guide to the future.

The Bloomberg article linked above points out that traders have been betting for a few months now that a strong El Niño will deliver a mild US winter. Apart from the markets that facilitate direct betting on or hedging of future weather, this has been evident in the US natural gas (NG) futures market, where the total speculator net-short position is at its highest level since March-2020 and not far from a 20-year high.

Partly in response to speculation that the coming winter will be unusually mild, the January-2027 NG futures contract is at its lowest level in more than four years. Here’s a daily chart covering the past 12 months:

A relatively mild winter is the most likely outcome, but with this outcome already factored into current prices there is the potential for even an average winter to bring about a meaningful rally in the NG price. Also, the war in the Middle East has caused the price of NG in Europe to almost triple, resulting in Europe’s benchmark NG price now being almost 9-times the NG price in the US and creating an incentive to export as much Liquefied Natural Gas (LNG) as possible from the US. While this currently does not provide us with a set-up for a short-term NG trade with an attractive risk/reward, additional weakness or sideways movement in the price over the coming 1-2 months could generate such an opportunity.

[This blog post is an excerpt from a recent commentary at https://speculative-investor.com/]

A Fed rate hike won’t enable more ships to go through the SOH or refineries to produce more diesel or farmers to grow more corn. In more general terms, when prices are rising due to supply restrictions, central-bank rate hikes are not a reasonable response. In fact, when the underlying problem is reduced supply due to temporary disruptions, a rate hike by the central bank is not only not part of the correct response but also gets in the way of the actions that are needed to fix the problem. What’s required is investment to increase production, not tighter monetary conditions to clamp down on demand. However, many commentators are arguing that the Fed should hike in September because “inflation is well above the Fed’s target!”.

Unfortunately, most members of the FOMC also fail to account for economic reality and instead react blindly to the high-profile “inflation” numbers and to employment reports that are inaccurate to the point of uselessness. Of course, Trump’s threats against the Fed do not help. That’s because to maintain the appearance of independence, if any members of the FOMC were leaning towards rate cuts (none of them are at the moment), the President’s threats likely would push them in the opposite direction.

So, the situation is that regardless of what caused the increased inflation numbers and what’s the best way to address the issue, the financial markets assume that any economic statistic will make a rate hike more likely if it hints at larger price increases or a stronger economy. Consequently, in response to the latest news, last week the probability assigned by the Fed Funds Futures market to a Fed rate hike at the FOMC meeting on 16th September went from 70% on Tuesday down to 50% on Thursday and back up to 59% on Friday. Gold was the market that was most sensitive to these probability swings.

In effect, at the end of last week the Fed Funds Futures market was assigning a probability of almost 60% to a Fed mistake in the form of a rate hike in mid-September. We will be surprised if this particular mistake is made, but if it is it could be the catalyst for deeper corrections in the gold, equity and currency markets, with the gold price and the SPX dropping and the Dollar Index rising.

[This blog post is an excerpt from a recent commentary at https://speculative-investor.com/]

Many articles and internet posts have referred to the decision by US Treasury Secretary Scott Bessent to double the dollar value of US government debt buybacks from US$2B to US$4B per auction as the “Bessent Put”. The implication is that the US Treasury is trying, via its buybacks, to put a floor under long-term government bond prices, or, looking at it from a different angle, to cap long-term interest rates. This is partly true, but most of the articles we’ve read contain a lot of misinformation. Here are two important considerations/misunderstandings.

First, the assertion that the US Treasury is replacing relatively-low-cost debt with relatively-high-cost debt is wrong or at best misleading. While it is true that the interest rate on the bonds that are repurchased will be much lower than the interest rate on the newly issued debt, the fact that the old debt will be repurchased at a large discount to par means that the cost-to-maturity for the Treasury will not necessarily change. This is because an increase in the interest paid will be offset by a reduction in the principal owed.

Second, what the US treasury is doing is very different from the Yield Curve Control (YCC) carried out by Japan’s monetary authorities. In Japan, the central bank added bonds to its balance sheet (purchased bonds using newly-created bank reserves) to keep bond yields within a certain range. In the US case, however, the central bank has no involvement and the Treasury finances the purchase of old debt by issuing new debt, meaning that there is no creation of additional bank reserves.

The debt buybacks make sense because they address a problem without adding to the US government’s debt burden. The problem they address is that due to interest rates being much higher now than they were several years ago, there are now a lot of bonds on the balance sheets of financial institutions that have become illiquid (these days, nobody wants to own government bonds with sub-2% yields). Furthermore, passive investing is exacerbating the problem, because the lower a bond’s price becomes, the smaller the amount of money that will be allocated to its purchase by passive bond funds*. By replacing this old debt that trades at a large discount with new debt that trades at par, the Treasury simultaneously reliquefies the bond market and reduces the downward pressure on bond prices being exerted by passive investing strategies.

The risk is that by replacing old long-term debt with new short-term debt, the US federal government’s finances become more sensitive to changes in short-term interest rates. In other words, the buybacks will make the government’s financial health more vulnerable to Fed rate hikes. Therefore, it’s likely that in the future even greater political pressure will be brought to bear on the Fed to cut its targeted short-term interest rates.

Bessent’s buyback scheme will not address the main problem, which is that the US government continues to do nothing meaningful to reduce its massive annual budget deficit. On the contrary, both major US political parties agree that the government should do (spend) more, with the only disagreements being over the details. Therefore, the scheme will not end the long-term bear market in government bonds. However, despite the small dollar value currently involved, there’s a good chance that it will work in the short-to-intermediate-term by adding liquidity to the financial markets and removing some of the downward pressure on bond prices.

*It’s the opposite situation to the stock market. In effect, passive investing creates a positive feedback loop, in that it tends to magnify up-moves in securities that are becoming relatively expensive and down-moves in securities that are becoming relatively cheap.

[This blog post is an excerpt from a commentary posted at https://speculative-investor.com/ last week]

In several respects, the past few years have been different from anything in the past. In some cases the reason for the unprecedented outcome is not hard to find. However, while it is always possible to concoct an explanation after the fact, in other cases the reason for the unprecedented outcome remains in doubt.

As an example of an easy-to-find explanation, the fact that the US stock market has become more expensive and more concentrated than ever before is a predictable consequence of the increasing influence of passive investing.

A case where the explanation for the divergence from the historical record is far less clear is the fact that in the US, economic conditions that in the past always were followed by a recession did not lead to a recession. Instead, the economy went from one boom to another with an intervening bust phase that lasted about two years and never became severe enough to qualify as a recession.

One of the many indicators we can use to make the point that this time has been different is charted below. The chart shows that with the exception of the extremely short COVID recession of 2020, which was caused by the government suddenly shutting down a large portion of the economy, every recession (the shaded areas on the chart) since the start of data collection in 1985 was preceded by a sharp downturn in Residential Construction Payrolls (RCP). Furthermore, prior to 2022 there were no multi-year periods in which RCP essentially went sideways. Consequently, the period from 2022 onwards stands out. For the first time, RCP peaked and instead of dropping spent years going sideways near its cycle high.

After the fact, we can come up with three main reasons why the US economy never became weak enough during 2022-2024 to officially enter recession territory. Here they are:

1) The government spent money (provided fiscal stimulus, that is) as if a recession were underway while the economy was still growing, boosting employment and economic activity in the process. However, this alone could have done no more than delay a recession. In addition, it would have increased the severity of the eventual recession.

2) During 2023-2024, the Fed released about 2.5 trillion dollars into the economy from its Reverse Repo Facility. This meant that during a 2-year period in which the Fed supposedly was tightening monetary conditions, it actually was a net injector of liquidity into the financial markets and the economy. However, like the ‘amped up’ government spending, this could have done no more than delay a recession.

3) The combination of items 1) and 2) potentially could have delayed the start of a recession by 1-2 years, but at around the time that their positive short-term effects on the economy would have ended, the AI-related investment boom became big enough to counteract all other negatives. This wasn’t planned or — as far as we know — foreseen by anybody. For policymakers in the government and the central bank, it constituted blind luck of a very rare kind, because it is unprecedented for a new technology to have such a substantial effect on economy-wide economic statistics within such a short period.

The effect of the AI-reflated investment boom has been positive as far as economy-wide measures of economic activity are concerned, but for many individuals the effects to date have not been positive. In particular, the demand for energy and materials from AI-related spending has increased significantly the cost of living for the average person. Consequently, datacentres have become an important political issue.

“It is different this time” is said to be the most dangerous expression in the world of investing. It usually is a dangerous idea to hold, but the fact is that sometimes it really is different.