June 2023: A Real Shock

Real interest spiked in June. Inflation expectations dropped while “higher for longer” nominal Fed rates caused the real rate to spike. Remember that the real rate equals nominal rate less inflation.

According to General Equilibrium economic theory, a spike in real interest rate is followed by a decline in real GDP. And that is one of the predictions that I made earlier this year. A spike in real interest rate and then a recession.

Where are we on the recession front?

One of the earlier signs of the coming recession was Private Investment. It has been in decline for the past year.

According to General Equilibrium economic theory, when investment is reduced, consumption increases temporarily. But then it falls back to its previous level and with temporarily lower growth.

Real Gross Domestic Income should in theory be equal to real GDP. And it has been in a down trend for the past two quarters.

The OECD leading indicator for the U.S. entered recession level in April.

And The Conference Board’s Leading Economic Index (LEI) is deep in recession levels.

Will China or the EU save us?

On June 16 Reuters reported that “Several major banks have cut their 2023 gross domestic product (GDP) growth forecasts for China after May data showed a post-COVID recovery was faltering…”.

And the Wall Street Journal reported on June 15 that “Beijing officials are stepping up plans to jump-start China’s recovery, some economists worry they may have little impact”.

On June 13 Press TV reported that “Inevitable EU recession strikes again”. That’s after Bloomberg reported on May 25 that “Germany is at risk of a long, slow decline — with consequences for the whole of the EU”.

Flows and Liquidity

Given the spike in real interest rate, money should flow from extremely overvalued stocks to undervalued bonds.

Regarding liquidity, there are two sinks. The first is the replenishment of the Treasury General Account (TGA) with $600 billion over 6 months. And the second is the continuation of quantitative tightening by the Fed of $75 billion per month. Together they are going to supply $135 billion in bills and bonds per month.

Many commentators worry that this supply will further devalue bonds while spiking up rates and cause money to flow from deposits to bonds and renew the run on the banks.

Their best case scenario is that Money Market funds will buy up this new supply of bonds. These funds are currently lending $2.5 trillion in reserves to the Fed and borrowing bonds in return as part of its Reverse repo facilities.

My opinion is that people always fight the last war and worry about the problems of yesteryear.

Yes, liquidity will be sucked out of the financial system. But that is the small problem. The exodus out of the stock market will destroy wealth. And treasuries are still the “cleanest dirty shirt”.

The big threat to banks is not further devaluation of treasuries as it was recently. But devaluation of loans on overpriced vehicles, real estate and Private Equity.

Vehicle loans will default at significant enough scale to create problems for banks’ solvency. But the biggest problem is investment funds that borrow from banks to buy assets such as real-estate and companies. When the stock market crashes the value of these assets declines. Many of these loans will go “under water”.

That would put a big damper on banks’ balance sheets and could trigger a run on the banks.

Volatility

With everything that I mentioned above, how is it possible that volatility measured by premia on option hedging is at all time low?

I don’t know. But I remember that my grandmother told me to “buy cheap and sell dear”.

What am I doing?

This material does not constitute an offer or the solicitation of an offer to purchase an interest in Economic Defense Fund (the “Fund”). Such offer will only be made via a confidential private placement memorandum (the “Memorandum”). 

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I’m bearish and hold long dated put options with short dated call options for hedging.

I’m also planning to move my personal money from bank deposits to T-bills.