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Julian Brigden Warns The Dollar Will Be "The Final Napalm Run" Into The Crash

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In recent weeks, the flattening yield curve have prompted investment strategists to declare that what looked to be the beginning of a secular bear market in bonds was, in reality, another false alarm. Indeed, all it took was a brief correction in equity markets for Bank of America's Ritesh Samadhiya to puke all over the bank's bullish economic consensus and declare that the greatest risk to asset markets is that nominal global growth slows a lot more than consensus believes.

But during his latest interview with MacroVoices, Julian Brigden of Macro Intelligence Two Partners reminded readers why the bear case for both bonds and equities - a nightmare scenario that would hammer popular risk-parity funds that are, ironically, intended to weather periods of market turbulence based on the notion that stocks and bonds can't sell off at the same time. 

Brigden, who advised clients to close out of a short Treasury trade just before the 10-year bounced off 3%, said he believes the long term case for a bear market in bonds remains intact as the US government tries to inflate away its enormous debt pile.

According to Brigden's modeling, a break above the 3.25% level on the 10-year yield would slice through its 100-month moving average - something that hasn't occurred since the mid-1980s.

Treasury

Brigden believes that a break above this level in nominal yields (while real yields remain anchored thanks to a runup in inflation) will lead to chaos in both bond and equity markets. Disinflation has kept yields tamped down for years. But as it returns and forces the Fed to hike interest rates more quickly - just as the ECB and other central banks are withdrawing their own stimulus - these inflated asset prices will plunge back to Earth.

The Fed thought QE was the reason Treasury yields sank, Brigden said, but they were wrong...

Treasury

...The real reason, he said, was the combination of disinflation and foreign central banks pushing yield-seeking investors into US markets.

What actually lowered Treasury yields through almost all the period of QE was falling inflation. It was disinflation. And I use that term because I’m not a big believer in deflation. Deflation is falling aggregate demand and falling prices. What we had was falling inflation. So it’s disinflation. And that’s really what lowered yields. What’s been interesting, though, is, since the end of 2015, inflation has actually been rising, relatively significantly in the US. It’s gone up a whole 2%. But yields (real yields) have fallen. Why? Because other central banks have come in. And they have – because of the nuances of their policies (particularly NIRP, and particularly regulatory requirements that require European investors to be fully invested and match assets with liabilities) – you’ve had this tsunami of cash that’s come out of Japan and Europe and suppressed our Treasury yields.

And if you look on this slide here, you’ll see. Back then we had this incredible period of low inflation. Incredibly stable. Six years where inflation basically oscillated around 1.3. You had a Fed that thought they could run it a little hot because they believed in the Phillips curve (unlike this lot that don’t believe in the Phillips Curve) and you did. You heated the economy quickly with a bunch of spending. Well, you’ve overcooked the goose.

And I’m not even showing in this slide the ‘70s. I’m not interested. But, in those five years, where inflation goes from 1.6 to the upper 3s, then back down again as they aggressively try to heat again, and it then breaks out again and goes up to almost 6.

Treasury investors lost 36% of their money in real price terms. 36%. A third. And you never got it back. Never got it back. So I do think the analogy is relatively similar.

Moving on to equities, Brigden says that faced with the threat of an overheating economy, the Fed is going to keep hiking until the market breaks - sending stocks spiraling lower. Brigden says we could be on the verge of a 20% correction.

And while over  the next ten years, fine, I’m okay. When it comes to equities, I think, certainly, if we’re in an inflationary environment they’ll outperform fixed income. They’re in for a bit of a shock, I fear.

I fear we’re on the cusp of a 20-percenter. It could be potentially worse. And I do feel, personally, that we’ve put the highs in. I’ve said either the market has to collapse under its own weight, for whatever reason (higher vol, trade talks, whatever), and then the Fed backs off.

Or, faced with the inflation picture, the Fed is just going to keep hiking until they eventually crack the market. It won’t be intentional. It’s never intentional. But it’s what always happens. So I fear that the highs are in.

And just as markets are breaking from the strain of Fed-induced tighter financial conditions, the Trump administration's policies will result in dollars piling back into the US from foreign markets - a scenario that could undermine the currency's long-term value and, ultimately, its status as a reserve currency.

Before it begins the next leg of its secular downtrend, the greenback will be squeezed higher, triggering a punishing selloff across risk assets.

But, when it happens – and we know this Erik – when the dollar rallies at the same time as you get risk-off, it turns things really vicious, really quickly. And, given this massive hole created by a low current account deficit, with the whole world depending on the hot money flows, in a world where you can click and bring that money home, it could be really vicious.

I think – let’s be honest. Up until now we’ve had loose fiscal, relatively loose monetary. Right? It’s only changed in the last couple of months. And arguably even since Powell has come in. We’ve had central banks that have – and I think, big picture, they still want to – the expression we like to use is “run it hot.” They want to boil bond investors slowly. They want to run nominal GDP hot.

This is how we eviscerate the value of the debt in what are aging and very indebted societies. So, yeah, loose fiscal, loose monetary is disastrous for a currency. Things are changing a little. As I said, I think the Fed will be forced, relatively, to become more hawkish. But, bigger picture, what I’m talking about is an episodic, final, nasty, destructive dollar rally. I think it’s a dollar rally that ends up resetting the system. I think after the dollar has rallied and destroyed a lot of things, more people will abandon it. You’ll see more use of the renminbi. We are in a cyclical, I think, decline of the dollar.

...

You get bond pressure and rate pressure and equity problems, and then the dollar. And the dollar comes in and is just the final napalm run into the risk-off move, and then we’ll kick off again.

Listen to the entire interview below:

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