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

A month ago, in our previous Recession Watch discussion, we wrote that although there were economic risks associated with the price action in the energy market (the record-high diesel price, in particular) and Trump’s counterproductive international trade policies, it was still the case that none of the most useful US economic indicators were pointing to an imminent recession. Since then the evidence has become more mixed, most likely because the parts of the economy that are benefiting from AI-related investment are very much still in the boom phase, whereas many other parts of the economy are weak.

Turning to the data, the monthly US employment numbers released on Friday 2nd October were weak in absolute terms and relative to expectations but provided almost no useful information about the state of the economy. Traders focus on these numbers, though, because they influence the Fed. Continued Claims for Unemployment Insurance (CCUI) is a better indicator of the state of the labour market and this statistic points to strength, given that the number of people refiling for unemployment insurance is at a 3.5-year low. Here’s the relevant chart:

As an aside, largely in response to lower-than-expected numbers in an inflation report on Wednesday (the PCE Price Index) and the monthly employment report on Friday, the probability — according to the Fed Funds Futures market — of a Fed rate hike at the next FOMC meeting (28th October) plunged over the past week from 64% to 22%. We reiterate that this shift was a response to economic data that influence the Fed but don’t necessarily say much about the actual economy.

Also pointing to a modicum of economic strength is the ISM Manufacturing New Orders Index (NOI), which, as illustrated below, remains near the top of its 4-year range and a long way above the level that it would have to breach (48) to generate a new recession warning.

CCUI and the NOI are on the positive side of the ledger, but we noted above that US economic indicators have become more mixed over the past month. For example, on the negative side of the ledger we have:

1. Some important cyclical sectors of the US stock market recently have been very weak, despite the boom in datacentre construction. The following daily chart of the iShares Transportation ETF (IYT) shows an example. This suggests that many parts of the economy are being hurt more by the high price of diesel and other cost pressures than helped by the AI-related investment boom.

2. The High Yield Index Option Adjusted Spread (HYIOAS) has signalled an upward trend reversal by breaking above its 65-week MA (the blue line on the following chart), that is, credit spreads have begun to widen. This is a necessary but far from a sufficient condition for a recession.

The longer the war in the Middle East continues the more negative will be the consequences for the US economy, the consequences for many other economies around the world having already been severe. Furthermore, as things stand today the war is far more likely to escalate than to end within the next few months. That being said, to borrow a phrase from the world of central banking, we will be data dependent. Regardless of what we think will be the economic consequences of major policy blunders, we will defer to objective indicators that in combination have worked for decades. At this time, these indicators collectively are becoming more negative, but they are not signalling that a recession is imminent.

[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.