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Novum Alpha - Daily Analysis 26 May 2021 (10-Minute Read)

Markets were more or less drifting rudderless in the U.S. on a dearth of macro data and with more U.S. Federal Reserve officials helping to ease concerns that rising inflation could stamp out growth or prompt the central bank to suddenly tighten policy.

A wonderful Wednesday to you as we hurtle into the last week of May. 

In brief (TL:DR)

  • U.S. stocks slipped on Tuesday, with the blue-chip Dow Jones Industrial Average (-0.24%), S&P 500 (-0.21%) and tech-centric Nasdaq Composite (-0.03%) all marginally lower on volatile trading. 
  • Asian stocks were largely steady Wednesday after softer economic data weighed on U.S. equities.
  • The U.S. 10-year Treasury yield fell to 1.577% with more Fed officials joining a chorus of voices downplaying price pressures (yields generally fall when bond prices rise).
  • The dollar slipped against major trading partners. 
  • Oil was steady with July 2021 contracts for WTI Crude Oil (Nymex) (+0.05%) at US$66.10 as clarity is slowly starting to emerge about Iran's oil exports. 
  • Gold edged up with August 2021 contracts for Gold (Comex) (+0.44%) at US$1,908.80, breaching the US$1,900 level for gold futures for the first time in months on signs of inflation. 
  • Bitcoin (-0.13%) was flat at US$38,734 in a volatile trading session that saw swings in either direction and with inflows into exchanges slowed (inflows suggest that investors are looking to sell Bitcoin in anticipation of lower prices). 


In today's issue...

  1. Time to Put Negative Bonds Away
  2. The Fed is Your Friend Until it Ends 
  3. Could Bitcoin be the Victim of Its Own Success? 

Market Overview

Markets were more or less drifting rudderless in the U.S. on a dearth of macro data and with more U.S. Federal Reserve officials helping to ease concerns that rising inflation could stamp out growth or prompt the central bank to suddenly tighten policy.
That status quo has left investors somewhat ill at ease - continue business as normal and push equities to fresh records, or take some money off the table for now, because of the inevitable correction.
The main difficulty facing investors in the coming period isn't so much inflation, it's timing. 
If central banks withdraw support prematurely, markets will almost inevitably respond with a sharp pullback, but sit on their hands longer and they risk inflation running out of control. 
For now it seems, most central banks are quite happy to kick the can down the road.
And with several U.S. Federal Reserve officials, including Chairman Jerome Powell, due to give up the reigns to the central bank by next year, it would be a brave individual to have the blood of the economy on their hands. 
Which is why the status quo prevails and is likely to prevail for some time more, at least until there are significant leadership changes.
In Asia, stocks trumped Tuesday's performance, buoyed by a recovery in tech stocks on Wall Street bag with Tokyo's Nikkei 225 (+0.07%), Sydney’s ASX 200 (+0.71%) and Hong Kong's Hang Seng Index (+0.72%) higher in the morning trading session and Seoul's Kospi Index (-0.19%) down just slightly. 

Did you miss us at the World Family Office Forum? Watch it here...


1. Time to Put Negative Bonds Away

  • Economic growth in many major economies is forcing yields upwards on debt that had previously been negative yielding 
  • Weaker borrowers may be most at risk, especially high yield bonds that took advantage of markets awash with liquidity 
For years, bond investors were penalized for their conservatism, not just paying a premium for the safety of debt but forking out for the privilege of simply owning what was often perceived as a safe haven asset.
The result of weak economies and unprecedented monetary intervention where central banks cut interest rates to the bone, and bought loads of bonds, sent yields negative.
But an economic resurgence has seen even German bonds, which have been infamously negative, start to pay out, with the benchmark 30-year German government bond which was negative for most of last year, now paying 0.42%. 
A bond ends up producing a negative yield when the price investors pay for it is more than the interest principal that they’ll get back over its lifetime, with some investors willing to accept this loss in exchange for the relative safety that a borrower such as a fiscally solid government or major company provides.
But signs that the global economy is growing again has seen a sharp drop in the supply of negative-yielding bonds, with Europe responsible for as much as 60% of global supply.
Now that Europe’s economy is stirring back to life, with the European Union expected to expand by over 4% this year, that growth could mean falling bond prices and higher yields because investors expect central bankers to raise interest rates if inflation rises.
Growth over time brings inflation and bond buyers will demand higher yields to compensate for inflation concerns, increasing borrowing costs.
While new bond investors will cheer because they have yielding fixed income options again, it also means that current bond investors are losing money (bond prices fall when yields rise) and the higher borrowing costs for everyone from governments to homeowners could be a rude shock.
Those companies that were able to borrow cheaply during the pandemic may also be badly hit, with junk-rated companies and emerging market governments gorging on debt at much lower rates than they deserved now posing a risk to yield-hungry investors.
And that increases risks particularly for the weakest companies and economies, including Greece and Italy, where staggering debt burdens could implode already moribund economies.
Just how far yields could rise though is anyone’s guess.
With the global financial system awash with liquidity and safe haven assets few and far between, investors such as pension funds which need at least some safe positive yields, will be tempted to buy into German government bonds the minute the benchmark 10-year bund peaks above negative – they are unlikely to be alone.
And while that should keep a lid on the negative yields of certain specified classes of debt, the fringes are likely to be the ones to suffer the most, including companies that ought to have been wound up by now, and governments which can’t put a lid on their spending. 

Did you miss us at the World Family Office Forum? Watch it here...


2. The Fed is Your Friend Until it Ends

  • Lack of market sensitivity to shocks reveals just how much investors have come to take for granted that the Fed will keep the liquidity taps flowing 
  • Systemic financial risks are building up, but the Fed is in denial and investors are making too much easy money to care 
The sudden spike in U.S. Treasury yields, the US$10 billion collapse of Archegos Capital Management and the retail pump and dump of GameStop (+16.34%) – in and of themselves, each of these events under normal market conditions, could and would have caused a sharp selloff in risk assets, but these are not normal market conditions, not by a longshot.
With central banks globally acting as enablers, and implying a flood of liquidity no matter what, there is little to no incentive for investors to de-risk.
Yet how long can the show go on?
The central bank community is finally alive to the risk, jolted by the prospect of inflation as well as financial instability and some central banks, including the Bank of England are suggesting that quantitative easing (the purchase of assets) could now slow somewhat.
Last week, the European Central Bank warned of “remarkable exuberance” in the markets, raising the specter of something hitherto unthinkable – the ECB tapering quantitative easing ahead of the U.S. Federal Reserve.
Because if Fed officials are concerned about inflation in any meaningful way, minutes of their recent meetings do not seem to reflect those concerns, and that means that any systemic risks in the financial system will build up.
And as any investor will know, denial is the precursor to perdition.
Having already waited so long, the Fed is now hostage to its “new monetary framework” which accepts higher levels of inflation during certain periods to “make up” or periods of lower inflation, which is a dangerous track to tread.
A worse-case scenario would be extreme market volatility and a loss of Fed credibility.
But investors aren’t interested to admonish the Fed or request that it exercise prudence, punch drunk on excess amounts of liquidity, the Fed is like the bartender pouring one more drink for the alcoholic.
Markets may have a friend in the Fed, but it may not be a healthy relationship.  

3. Could Bitcoin be the Victim of Its Own Success?

  • As cryptocurrencies attract broader appeal and perhaps even institutional adoption, governments concerned over decentralization of economic life may be forced to intervene
  • The possibility of a decentralized medium of exchange and store of value controlled by no centralized entity may force some governments, particularly totalitarian ones, to act 
When Borders was first confronted with Amazon (+0.43%), executives at the book retailer were quick to dismiss the digital upstart as being nothing more than a fad, and nothing to take too seriously, until it was too late.
Similarly, Bitcoin and cryptocurrencies were initially dismissed by Wall Street and governments when they first appeared on the scene over a decade ago, confined to the tech fringe and unlikely to ever have any significant impact on mainstream financial markets.
Fast forward to our present epoch, and it appears that the risk posed by decentralized currencies has crystalized to a point that according to the Bank of International Settlements, no less than 86% of central banks globally are exploring their own central bank digital currencies, with both Bahamas and Beijing already having issued their own CBDCs.
And as Bitcoin has grown in significance over the past year, governments are no longer taking the threat to their seigniorage (the difference between what it costs to print currency and the face value of the currency) lying down, with even the initially dismissive U.S. Federal Reserve now actively studying a digital dollar.
Over the past week, Beijing has also reminded its financial institutions that they are not to deal in cryptocurrencies or accept them as payment.
But what has changed really?
Unlike the possibly complacent central banks of the west, Beijing actually sees the risks from a global decentralization of currency, especially when the economic lives of people can increasingly be lived divorced from the state.
Consider this scenario, if you used your Metamask wallet to send some dollar-backed stablecoin to a merchant in exchange for their goods and they were happy to accept it, there’s nothing really the state can do to stop you from making that transaction.
Bitcoin and its brethren facilitate and enable these sorts of exchanges and they are already happening on a daily basis.
Which is why billionaire hedge fund manager Ray Dalio’s warning about Bitcoin being a possible victim of its own success is so timely.
The founder of Bridgewater Associates, Dalio said in a recorded interview presented yesterday at Coindesk’s Consensus 2021 conference that should cryptocurrencies continue to gain traction, governments may lose control over their ability to raise money.
Dalio even went as far as to declare that he’d rather have Bitcoin than a bond and admitted to holding some Bitcoin, without revealing the amount. 

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May 26, 2021

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