Description

The trade:

Long April 95.5 Call option on June 2023 3-month Secured Overnight Financing Rate (“SOFR” Futures).

 

Let’s discuss what SOFR is and the details of SOFR Futures and its derivatives.   SOFR has replaced LIBOR as the benchmark for the cost of borrowing cash overnight in the repo market.  It is considered more robust and reliable than LIBOR as transactions are secured by Treasury securities, eliminating counter-party risk that is inherent in LIBOR-referenced transactions.

 

The notional amount of SOFR-referenced transactions are greater than Fed Funds-referenced transactions by a 10-1 margin, thus it is the preferred instrument to express our trade. 

 

SOFR Futures and options on SOFR Futures are traded on the Chicago Mercantile Exchange.

 

SOFR trades a little below Fed Funds and is released by the New York Fed every morning.  Today it’s 4.31% while the midpoint of the Fed Funds target range is 4.375%.

 

The rationale for the trade:

The current ask price for the April 95.5 Call option on June ‘23 3-month SOFR Futures is 2 bps.

Yes, that’s correct, a whopping 2 basis points.

Recall, SOFR, today is at 4.31%, thus, intrinsically, the April 95.5 call option is 10 bps IN-THE-MONEY.  (Nomenclature note: take 100 minus the 95.5 call option strike price to get the 4.5% interest rate)

 

The reason is because the option’s underlying is NOT the daily overnight SOFR rate but instead the June 3-month SOFR Futures contract.  That contract closed today at 95.10 (100 minus 95.10 = 4.9%).  So, the market expects overnight SOFR to average 4.9% between June 21, 2023 and September 20, 2023.  Essentially, the market is pricing in another 59 basis points in FED tightening between now and September.

 

(Nomenclature note: The June ‘23 3-month SOFR Futures contract actually settles on September 20th and its settlement price will equal the simple average of the daily overnight SOFR rate as published by the New York Fed between June 21st and September 20, 2023; hope that made sense)

 

Thus, in order to be in-the-money on the April call option that expires on April 14th;  that references the June SOFR futures;  that doesn’t actually settle until Sept (sorry so confusing), by expiration on April 14th, the June 3-month SOFR futures contract must be above 95.5 (below 4.5%).

 

(Hoping you haven’t clicked away yet)

 

We think it will and the asymmetry of this trade is much better than buying CDS on subprime CDO’s in 2007 in our opinion.

Just to put into context the asymmetry of this trade:

Let’s say that the data that continues to roll in continues to show declining inflationary pressure and in fact, we begin to worry about deflation in the coming months, especially as Owner’s Equivalent Rent begins to lap last Spring’s  peaks in both new home prices and rents.

And the Fed raises 25 bps more on February 1st and STOPS THERE.

Well, overnight SOFR will rise from 4.31% to 4.56%.  Hmmm. well that April 95.50 (4.50%) strike is intrinsically out-of-the-money vis a vis the overnight SOFR rate, but remember, the option references the June 3-month SOFR futures that settles in September.

 

The crux of the asymmetric trade is the time value contained in the mechanics on these contracts.  Essentially, the key to this is ultimately being in-the-money on the call option when it expires on April 14th, and then wait as the inflation data starting accelerating to the downside as OER begins its descent lapping last Spring’s peak!

 

Our thesis is that the market will in fact begin to price in cuts in Fed Funds by the Summer/Fall, and that the 3-month June SOFR futures contract declines to well below its current 95.10 (4.9%).

 

For a lousy 2 bps, this contract could easily 10-50x

 

Detailed below is the data that informs our opinion:

 

The June Fed Funds Futures contract is currently priced at 4.90%.   Just one problem:  The US government is out of business at a sustained 4.90%.  Well, the US government is not LITERALLY out of business.  Here is what we mean:

 

Assuming a plain vanilla US recession in 2023 (in which a 20% tax receipt decline is typical), a 12% increase in Entitlement Pay-Go’s for 2023 (conservative with a 8.7% COLA increase for Social Security for 2023, 6-9% Medicare increases common in recent years, and

an implied modest increase in enrollment), and the aforementioned 4.87% rate applied to $31

trillion in US Federal debt, and we find that proforma US “True Interest Expense” would be well

above the levels seen in 2020 that broke the US Treasury market and necessitated

massive Fed QE!

 

What we are suggesting is that with June FFR at the aforementioned 4.90% rate, the US government “True Interest Expense” will be even further above tax receipts in fiscal 2023 than it was in the COVID crisis in 2020. That’s true Interest Expense BEFORE ALL OTHER Treasury liabilities including the $800B defense budget!

 

If the US was a corporation, its bonds would be trading at 10 cents on the dollar.

 

At that point, one of two options are available:

1. The Fed will renew QE in very large amounts, in which case the release valve will be a much

weaker US Dollar (“USD”), much higher inflation, and much higher asset prices.

2. The Fed will NOT renew QE in very large amounts, in which case the release valve will be a

much higher US Dollar, much higher US Treasury yields, and much lower asset prices (as we

have seen in 2022.)

 

So far, Option Two has been pursued, resulting in US Treasury market stress levels rising to the

third highest levels in the past 20 years ( the prior two instances of higher stress both resulted in

massive Fed QE; (nearly immediately btw).

 

As the USD strengthens; foreigners (who either have USD debts or need USD to finance

current account deficits and/or defend their currencies), will likely continue to sell USD assets to

raise USDs (as they did in 2022), and as the Bank of Japan (“BOJ”) did in a big way in October.

.

Here is the critical part: The $21 billion BOJ intervention was the biggest single day intervention

on record, and on that day, the US TLT (long-dated US Treasury ETF) was down nearly 3%.

Let that sink in for a moment: The BOJ sold $21 billion of US Treasuries (USTs), and it knocked

Treasuries down nearly 3%!

 

Do you see the problem? Japan has another $1.2 trillion in USTs it could sell, and the rest of

world owns another $6.3 trillion in USTs they could sell… but we outlined how the US

government’s fiscal math is way worse than it was during the COVID crisis with Fed Fund

Futures Rate at 4.87%.

 What would happen with US FFR at 6%? (higher interest, far lower tax

receipts). How about 7% or 8%? Virtually NOBODY is seeing this problem… yet. But we

suspect they will within weeks.

 

This then brings us to why we think investors are about to begin being very concerned with

western sovereign debt, including US Treasuries.

 

1. Japan has 15 months of foreign exchange reserves to pay for their now energy-driven current

account deficit. That means Japan has a lot more USTs they can sell, putting more upward

pressure on UST yields and downward pressure on the highly interest rate sensitive US

economy and US tax receipts, driving non-linear deterioration in the US fiscal situation that will

drive the USD higher → forcing faster global UST bond sales → driving higher UST yields →

driving the USD higher → forcing faster global UST bond sales; (quoting everyone’s favorite

Journey song Don’t Stop Believin’); and “it goes on and on and on and on” until the financial

system breaks.

 

2. UK and EU sanctions on Russia have pushed their current accounts far into deficit, driven by

spiking energy costs and falling GDP, but the UK and EU only have sufficient FX reserves to buy

2 months worth of imports.  THE UK AND ENTIRE EUROPEAN UNION WILL RUN OUT OF MONEY (w/o turning back on the printing press as the UK already has done) IN TWO MONTHS!

 

Energy imports are a substantial portion of total UK and EU imports, and they need USDs for

those energy imports…which means the UK and EU will have to print GBP and EUR to buy

USDs → weakening their currencies relentlessly against the USD → sending energy inflation

higher, bond yields higher, their economies lower → sending their currencies lower vs. the USD

and energy; and “it goes on and on and on and on” until the financial system breaks.

 

Critically, since the UK and EU only have TWO MONTHS of FX reserves for imports, we can

say with a high degree of confidence that unless the UK and EU seek peace with Russia and

begin buying energy in their own currencies VERY soon (or the Fed renews QE, since the US

has already deployed “energy swap lines” via the unprecedented draining of the US Strategic

Petroleum Reserve (SPR)); the combination of rapidly deteriorating terms of trade and

completely insufficient FX reserves to cover imports is highly likely to introduce significant FX

and then sovereign debt risk to EU and UK debt in very short order. [please re-read that]

 

To state the obvious, increasing default risk on EU and UK debt is likely to be quite negative for

global risk markets.

Most market participants are still looking at western FX and sovereign debt on a relative real

yield basis, but once any non-reserve currency issuing sovereign gets far enough into a current

account deficit with such woefully inadequate FX reserves-import coverage ratios (as the UK

and EU have done), terms of trade and in particular, energy terms of trade, should dominate FX

and sovereign debt trading (as they have in the past few weeks).

Critically, as a more diversified economy with significant energy production and the reserve

currency, the US has more optionality than the UK OR EU – the Fed can print money more

easily, with relatively less inflation than the UK or EU would experience doing the same thing.

However, if the Fed refuses to print the money to finance rising US deficits, the UST market will

likely continue to discount rising sovereign debt risk, like the UK but less severe than the UK (for

now.) Why?

 

As long as the Fed keeps tightening, once foreign UST holders’ domestic currency weakness becomes a national threat (something Japan fired the starting gun on in October  with their first currency intervention in 24 years); the aforementioned $7.5 Trillion (with a T) in USTs that foreigners own is only a minority of the $30+Trillion of gross USD assets they can also dump to raise USDs.

 

***

Many investors ignore what has happened to the US Net Investment Position ("NIIP") since

2008 at their own peril. Foreigners own a net $18T in USD assets (5x greater as a % of GDP

than in 2008). What that means is that as Americans have consumed more than they have

produced since the early 1980s, the rest of the world has been building more and more

productive capacity (explains the hollowing out of industrial America), exporting to the American

consumer relatively inexpensive goods, and then recycling the acquired dollars into ownership

of US stocks, bonds, and real estate. Having the currency that denominates 87% of world trade

sure does have its privileges, but it also has stripped Americans of a significant ownership

percentage of their own country’s assets! Now that USD strength has become an increasing

national security threat to foreigners (via currency weakness vis a vis energy imports driving

current account deficits), those foreigners will likely sell those USD assets in rapid order to

prevent risks of hyper-inflation due to currency collapses. (as they have in the past few weeks).

As foreigners sell USD assets to raise USDs to defend their currencies, it will likely continue to

drive US equity prices down, which as we have shown, will likely drive US tax receipts down

sharply via the US consumer spending link (which is 2/3 of US GDP).

 

This in turn worsens the US fiscal position non-linearly (both higher interest AND lower tax

receipts) → inevitably increasing US government UST issuance → into the aforementioned

likely accelerating foreign UST selling → raising UST rates → pressuring the USD upwards →

accelerating foreign UST selling → raising UST rates; and “it goes on and on and on and on”

until the financial system breaks.

 

[Pivot to a discussion of US monetary policy]: The Federal Reserve.

The market seems to have forgotten just how inept the Fed's forecasting ability is.

It was just 13 months ago on December 15, 2021, the Federal Reserve FOMC statement read;

 

"The Committee seeks to achieve maximum employment and inflation at the rate of 2

percent over the longer run. In support of these goals, the Committee decided to keep

the target range for the federal funds rate at 0 to 1/4 percent. With inflation having

exceeded 2 percent for some time, the Committee expects it will be appropriate to

maintain this target range until labor market conditions have reached levels consistent

with the Committee's assessments of maximum employment..."

“...The unemployment rate has declined substantially – falling 6/10s of a percentage

point since our last meeting and reaching 4.2% in November [2021].”

 

Allow us to translate: "We are aware that inflation has wreaked havoc on ordinary middle class

Americans, and the trajectory is higher, AND unemployment is a miniscule .7% away from the lowest rate (3.5% in Jan 2020) in the last 55 years, AND we’re responsible for the 2021 everything bubble, BUT we think it's STILL appropriate to keep the cost of money at freakin’ zero.”

Fed Chairman J. Powell went on to state during the press conference that the FOMC's

expectation for the Federal Funds rate would be 0.9% by the end of 2022.

The committee was a bit off on that forecast to say the least. Fed Funds ended 2022 at a midpoint of 4.25%!

 

Why does the investing public believe anything these Fed officials say? More evidence of their

inept forecasting ability:

 

Fed Chairman Powell on March 23, 2021: “Inflation may rise this year on base effects and

demand. The impact on inflation won’t be very large or persistent." [phew!]

 

Cleveland Fed President Mester in June 2021: “We want to be very deliberately patient here..

it’s easy to shut down an economy, it’s much harder to have it come back." [ok, cool, low rates

Forever]

 

Cleveland Fed President Mester in June 2022: "More costly error is assuming inflation

expectations are anchored when they are not" [scratches head and raises eyebrows like your great-aunt after a facelift gone awry]

 

And finally, the money shot:

Atlanta Fed President Bostic on March 25, 2021: “I don’t think it is clear that a surge in

underlying inflation is imminent” [phew!]

 

Atlanta Fed President Bostic in May 2021: "I'm comfortable with ultra-loose policy even as

inflation gains steam, Inflation is healthy for the economy." [yeah baby, let’s go buy some dress-wearing monkey NFTs]

 

Atlanta Fed President Bostic on Sept 28, 2022: "Inflation is too high and not moving with

enough speed back to target." [did he just say that? you’re joking.]

 

You can't make this stuff up and the investing public is buying it.

 

Certainly, inflation is the concern that the Fed is aggressively fighting, (as it should have in 2021. But, the Fed is fighting the last war, not the current one. Inflation peaked in the Spring of

2022 and is coming down dramatically; if you, as we do, rely on OBJECTIVE market-based

data and real-world prices.

 

● Key commodities such as oil, copper, lumber, wheat, soybeans, etc. are down between

25%-45% since early '22.

 

● According to public filings and conversations with experts in industries we’re invested in,

thousands of pink slips are being handed out each week by private & public tech

companies now that the free money spigot has been turned off after gushing for more

than a decade. (the long term damage to the economy from this misallocation of financial

and human capital will have long lasting negative effects to the US economy)

 

● Supply chains are healing and China is gradually removing lock-downs which will further

grease the gears.

 

● Most significantly, the all-important owner's equivalent rent (making up 24% of CPI), is

decelerating and on the verge of dropping precipitously due to the following verifiable

Data

:

1. Apartment rental absorption (move-ins minus move-outs) in the just completed Q3 recorded

the first YoY drop in 30 years.

 

2. Apartment vacancies are at 5.9% at YE 2022, quickly increasing from a low of 4.1% last Fall.  And with 917,000 apartments under construction (the highest volume on record in at least 40 years, that rate is set to dramatically increase through 2023.

 

3. 35% YoY drop in existing home sales in the month of November 2022, falling for the tenth consecutive month,

 

4. Mortgage rates rising from below 3% a year ago to 6.15% today obliterating housing demand.

[Please someone explain to us the idiocy of the Fed’s strategy to combat inflation by more than doubling the cost of homeownership (not exactly; very few interest only mortgages out there; you get the point). Doesn’t that increase inflation and destroy velocity of transactions??]

 

5. Nationwide "new" home construction backlog at a record high (we're quickly going from a

lack of inventory of new homes for sale to a glut as builders rush to offload work-in-progress

inventory to generate cash).

 

6. Lumber prices, other than land; the most significant input to a house's cost, down from

$1,700/ mbf in October 2021  to now $444/mbf.

 

We're experiencing housing DEFLATION, not inflation currently.  Just as we experienced after the Fed induced housing bubble of the mid 2000s, there’s a reaction to every action when it comes to financial bubbles, historically.  And if the Fed keeps up this treacherous

path, we'll be bailing out banks (again) in no time.  Not homeowners with locked-in low

mortgage rates, large home equity cushions thanks to ‘20-’21 housing bubble 2.0, and miniscule

number of adjustable rate mortgages this time around [at least they got that mistake fixed].

 

***

The banking system will be screwed for a different reason this time - infinitely levered sovereign

bond linked balance sheets. Just wait: the next logical move the Fed makes is not explicit

quantitative easing. That ain’t good for Fed credibility, right? It will be a relaxation of the

“supplementary leverage ratio” (SLR) for banks just as they did on April 1, 2020, the last time

the US Treasury market broke. Disguised QE but QE nonetheless. We predict the Fed will

“temporarily” [yeah right] exclude treasuries in the leverage rule, thereby “encouraging” banks to

purchase long dated treasuries with limitless regulatory capacity. The Fed’s balance sheet

stands at $8.5 Trillion so the optics ain’t so good if they just do this themselves. But what’s the

difference? Absolutely nothing; just transferring the non-linear balance sheet expansion from

the US government to the banks that are too big to fail. When investors get a whiff of this, we

think markets will wake up to what MUST happen in this recklessly levered financial system

where everything from cars to homes to used Pelotons are financed.

***

IT’S ALL ABOUT THE MONTHLY PAYMENT! Higher interest rates are part of the PROBLEM,

not the solution. Higher interest rates certainly dampens aggregate demand but also increases

prices (stagflation) of critical components of GDP such as houses, autos, appliances, and used

Pelotons SINCE WE FINANCE MOST LARGE PURCHASES THESE DAYS. The other part of

the problem is dubious government policy of VENMO-ing consumers checks to increase

aggregate demand and doing everything possible to depress productive capacity expansion of

the economy. Also, ESG is great but not when fossil fuels are still the lifeblood of the economy.

Instead, relax regulations and allow the free market to allocate capital as a capitalist system is

designed. Encourage investment in green energy with a marginal cost curve of zero at maturity.

(It’s technology that halves in cost every year). And support this pursuit of productivity

expansion by reducing the cost of capital, not increasing it.

 

At this level of Federal/Household/Corporate/off balance sheet, el al. Debt/GDP; nominal GDP

(the denominator) MUST rise faster than the Debt (the numerator). We’ve done it all throughout

history at smaller levels of Debt; a lot smaller than today by orders of magnitude, and it always

worked! (e.g. 1898-1900, 1916-1921, 1934-1937, 1941-1952, 1973-1980, 2002-2005).

There are three ways (or combination thereof) to grow GDP faster than Debt:

 

1. Gross economic productivity rises faster than nominal interest rates

2. Inflation rises faster than nominal interest rates

3. Try not to increase debt, but if you must; don’t do so by increasing aggregate demand;

do so by increasing aggregate productivity!

 

The time to have cared about inflation was a long, long time ago. Perhaps at the turn of the

century with Federal Debt/GDP at 55%; not today, NOT TODAY. It’s too late in the game.

We’ve messed it up so much that we’re all gonna have to take some inflation lumps to get this

financial house in order and implement productivity enhancing vs. consumption driven policy; or

the financial system could spiral into a vicious deflationary cycle that we’re not too far from.

***

[Pivot back to the state of the US debt and deficit situation]

If you think this moment is analogous to the late 1970's, think again. The following data shows

the inconsistency of that comparison. Below is the CURRENT fiscal state of the US vs.

FEBRUARY 1980 at the peak of the late 70's (mostly oil driven) inflation:

 

1. Household debt / GDP [NOW] = 75% vs. [1980] = 48%

2. Corporate debt / GDP [NOW] = 50% vs. [1980] = 31%

 

and last, but certainly not least…

 

3.. Federal government debt / GDP [NOW] = 124% vs. [1980] = 31%

 

We have just about doubled our federal government's Debt/GDP from 64% to 124% since the

Spring of 2008 - that's shameful.

This moment, based on the data, is much more analogous to the 1940’s. On December 8,

1941, at 4:10pm EST, FDR announced a declaration of war against the Empire of Japan as a

result of the previous day’s attack on Pearl Harbor. There was also another enemy that had

reared its head during 1941-- inflation. Coming out of the Great Depression, DEFLATION had

been the issue throughout the entirety of the 1930’s; and to combat the depression, the US

fiscal response was significant deficit spending to make up for the slack in private sector output

and job creation. This intelligently crafted policy necessary to halt the deflationary spiral was

money well spent, but resulted in Federal Debt/GDP expanding from 16% in 1929 to 39% at the

onset of the US involvement in WWII in late 1941. Trade wars (Smoot-Hawley Act and bilateral

responses from trade partners), decimated the world economy and was the reason the Depression lasted as long as it did.

 

Deflation that ushered in the Great Depression ultimately ended as monetary and fiscal policy

drove up aggregate demand from US consumers while trade wars drove down aggregate

supply leading to consumer inflation of around 10% in December 1941. Keep in mind, the US

Fed, at that time, continued to keep nominal interest rates near zero leading to

significantly negative real interest rates. Coincident with FDR’s speech on December 8th,

the Fed and Treasury issued a statement indicating that the Federal Reserve System was:

“Prepared to use its powers to assure at all times an ample supply of funds for financing the war

Effort”.

 

To keep the costs of the war reasonable, the Treasury asked the Federal Reserve to peg

interest rates at low levels. The Reserve Banks agreed to keep 3 month interest rates at

0.375% and long term bond rates at 2.5% (known today as Yield Curve Control). The peg

became effective in July 1942 and remained until January 1948.

 

Despite this policy, inflation barely increased from around 10% at the onset of the US

involvement in WWII to around 13% in Spring 1942 due to significant sacrifices among US

consumers to reduce aggregate demand in response to significant supply reduction of everyday

consumer goods/services due to re-allocation of means of production to the war effort. Prices

reached equilibrium between supply and demand between exceptional government policy and

the beyond-applaudable collective sacrifices amongst Americans to keep inflation in check

during those trying times. [we’ve gotten soft, they don’t make Americans like they used to]

 

However, Federal Debt/GDP did skyrocket between December 1941 and Summer of 1946 from

38% to 121% in just 4.5 years (analogous to today) and inflation did return with a lag

(analogous to today) after WWII concluded. Between Spring 1946 and Spring 1947, inflation

increased from 3% to 20% due to the transitioning (re-opening) back to a peacetime consumer

based economy (analogous to today). However, ahem, HOWEVER, monetary policy

continued to peg 3 month T-Bills at 0.375% and 5 year notes at 2.5% because Federal

Debt/GDP was 121% and the government understood the fragility that created for the

financial system. [Bueller?... Bueller?] 

 

After peaking in the Spring of ‘47, inflation trended downwards reaching 0% by the end of 1948 as US productivity skyrocketed due to great supply-side driven fiscal policy. [What a great idea for today] (GI Bill, Federal Highway Bill, 0% SBA loans, et al.)

 

The main point of re-hashing this history is to point out that nominal interest rates were kept

near zero even as inflation averaged low teens % through the late 1940’s/early 1950’s. Due to

real interest rates being significantly negative during this period, Federal Debt/GDP declined

from 121% at its peak in the Summer of 1946 back down to a manageable level of 68% by

1953.

 

Our further point is with Federal/Household/Corporate, et al. debt levels significantly higher

today than where it was in the 1940’s (orders of magnitude higher for household and corporate

levels), negative real interest rates (inflation) is the ONLY WAY OUT OF THIS MESS, just as it

was at every point in history with high Debt/GDP levels. We cannot stress enough the

significantly negative real interest rates orchestrated by Fed policy during similar

fiscally-stressed environments we face today. All of those periods’ debt levels look like molehills

compared to the Mount Everest of debt levels today.

 

The power of math is magical when real interest rates are negative. Federal Debt/GDP was

halved between 1946 and 1956 from 121% to 62% putting the US government, once again, in a

sound fiscal position and led to the optimal economic environment of low inflation and high

productivity during the late 1950’s and 60’s.

 

The sooner our policymakers figure this out, the better in the long run for the US. Given the

exponential rise in not only US (gov’t/household/corp) debt since 2008, but also the even higher

rise in FOREIGN US dollar-denominated debt (thanks to the USD world’s reserve status), the

light at the end of the tunnel we’re now staring into is from a deflationary depression train if the

Fed continues down this path.

***

In Berkshire Hathaway’s 2002 annual report, Warren Buffett called derivatives “financial

weapons of mass destruction [WMDs], carrying danger that, while now latent, are potentially

lethal”. His sage prediction became reality just a few years later as CDOs / ARMs / liar loans /

NINJA mortgage applications bubbled/then busted housing between 2004 & 2008. Today’s

version of financial WMDs are orders of magnitude greater in quantity and destructive capability;

and their fuses are shortening day by day as the FED continues to fight 2021’s inflation war, missing the forest for the trees.

 

There’s approximately $600 Trillion (with a T) of derivatives written by US and European banks

many of which are tied to low interest rates; most of which have been written since 2007;

coinciding with zero interest rate policy (“ZIRP”).   

 

Last October, the Bank of England pivoted its quantitative tightening monetary policy (to fight inflation) to quantitative easing (to fight systemic risk) literally overnight to prevent a blow up of their Gilts (UK equivalent of Treasuries) market. As UK gov’t bond prices began dropping (due to the energy-crisis driven current account deficit explosion in the UK), margin calls on UK pension funds began forced selling of gilts → driving bond prices lower → creating more margin calls → forcing more selling → driving bond prices lower; and “it goes on and on and on and on”, until the UK financial system was on the precipice of a death spiral. 

 

The culprit was the UK’s version of financial WMDs called “Liability Driven Investing” (“LDI”) - a fancy way of saying leverage with derivatives. As The UK central bank enacted ZIRP (like the US and the rest of the developed world), over a decade ago, it forced their public and private pension plans to search for higher yields to meet their obligations (liabilities) to retirees. In essence, irresponsibly keeping rates near zero for more than a decade induced their pension system to purchase >5x leveraged gilt swaps (financial WMDs) from UK (and UK branches of US) banks. 

 

Don’t think for a second these swaps haven’t been written all over the western developed world. The banking systems of the US, Japan, Germany, Italy, France, South Korea, et al. have one form or another of these freakin’ powder kegs. THE POINT – the higher rates go, the closer every banking system in

the developed world is to collapsing [do the math on $600 Trillion of this toxic stuff].

 

***

The Fed has 2 written mandates:

 

1. Price stability (fighting inflation

 

2. Maximum employment

 

But there's another significantly more important un-written mandate:

3. Financial system stability

 

In conclusion, we have the strongest conviction in our careers about how this plays out in

financial markets. In our resolute opinion, it is a mistake to think this is going to play out like it

did in the Fall of ‘08 after the collapse of Lehman Brothers.

 

The last place you're going to want to have any wealth is in fiat cash, most importantly USD

cash, when this erroneous game the FED is playing comes to its inevitable end.

 

As Winston Churchill famously once said, “Americans will always do the right thing, only after

they have tried everything else.”

***

 

If we’re right, we’ve found the best reward vs. risk way to express our thesis we’ve ever seen;

more asymmetric than shorting AAA-rated subprime in 2007.

 

Catalyst

Imminent pivot by the FED because the real-time data will force them soon as these clowns are driving this economic bus looking through the rear-view mirror instead of the windshield