Federal Reserve interest rate cut decision 20191030

Outcome

Core inflation at 1.8% continues to run below target 2%.

Federal reserve decides upon another 0.25% cut in interest rates, targeting range of 1.5% to 1.75%.

Action is taken to provide meaningful support to the economy in response to global economic slowdown and the increasing disinflationary pressure felt from around the world. The special characteristics of this particular slow down is a lack of any large imbalances in the economy.

Dual mandate of the federal reserve

2% symmetrical inflation target

  • Stable prices
  • Low unemployment rates

economic indicators

  • Consumer confidence remains strong
  • Unemployment rate is at historic low
  • Business fixed investments has slowed
  • Global exports has slowed
  • Manufacturing compared to a year ago is down

macro environment risk

  • protracted US/China trade risk is down
  • No deal Brexit risk is down

economic health monitor

  • Leverage in financial system: low
  • Funding risk in banks and non-banks: low
  • Asset prices: no major bubble, high in some
  • Leverage in non-financial sector
    • households:  gone down
    • businesses + corporate debts: historic high

Liquidity concerns

  • Concerns in Overnight Repo markets persist.
  • Banks have liquidity in excess of required reserves level but choose not to participate in the markets.
  • Federal reserve will seek to inject short term liquidity into the system
    • build up short term treasury reserves
    • buying into short term treasury bills thereby boosting treasury reserves
    • opposed to the standard QE mechanism which entails buying up of assets and securities with longer maturity periods

Related readings

Mother Nature versus City – public utilities

View of wind speeds in the area during the public utilities shutdown
The sizzling power lines
Large dips in PCG attributed to scheduled blackouts and negative ruling by judge.

 

Climate change reduces land mass under occupation.

Overview

Wind speeds across inland California has a negative correlation with public utility company share prices.

Our infrastructure is constructed above ground to avoid disruption from earthquakes when they occur. This makes them susceptible to producing sparks when strong winds blow. Combine that with increasingly dry weather conditions caused by climate change and we have the perfect recipe for power disruptions either by fire hazards or controlled shut downs. 

Utilities are natural monopolies in their region of operations giving them very inelastic demand curves. 

They also happen to be public companies which incentivized them to optimize performance for the short term thereby on a quarterly basis. This thus leaves them disincentivized to invest for the long run (aka infrastructure upgrade) without active government intervention. 

The government does actively intervene when circumstances go awry. They need these companies to continue operating least the whole population plunges back to the Stone Age. The previous instance was when the same utilities went bankrupt during the 2003 oil crisis when prices shot into the stratosphere. They ended up on the receiving end of a government bail out.

In a nutshell, the residents are basically setup to bear the brunt of this shit show. 

The last time I walked under one of those power lines on a windy day, the sound of those sizzling brought a chill down my spine

Proposed models

  • Wildfire (fire)
    • Wind speed
    • Temperature
    • Humidity levels
    • Vegetation density
  • Tornados (air)
  • Earthquakes (earth)
  • Floods (water)
  • Hurricanes (water/air)
  • Tsunami (water/earth)

Related references

 

 

Simultaneous inflation and deflation pressures in China

China simultaneously experiences imported deflation and inflation. 

Drop in global demand for exports causes credit to unwind within the manufacturing sector. 

Swine flu and depleting foreign reserves causes price pig to increase. 

This will be a useful case study to observe the monetary and fiscal policy China implements to deal with simultaneous inflationary and deflationary pressures. 

China Factory Deflation Worsens as Pork Drives Consumer Prices  https://www.bloomberg.com/news/articles/2019-10-15/china-factory-deflation-worsens-as-pork-drives-consumer-prices

An unchanging constant as the source of trust

Trust is the ultimate source of wealth in any society. The level of manifested physical wealth correlates positively with the level of perceived trust members of society have for an entity.

When an entity, be it a phenomena or a behavior, is observed to be consistent across time without much falter, it soon becomes accepted as the norm. Overtime this norm gets deeply embedded within a society and becomes an integral part of its culture. It thus becomes trusted and a source of credibility.

Societal commerce is built on trust. Trust accumulated through consistency overtime can be converted to other forms of tangible currency. These currencies can then be used to direct resources within the society towards the achievement of very material goals.

When comparing between two entities that are embedded within the cultural fabric of society, the one that exhibits a higher level of consistency inevitably gains more trust. This explains why while fiat currencies comes and goes, the value of gold remains consistent across time.

While it might be tempting to equate trust with value, there is a subtle difference. While trust elicits value, value need not necessarily elicit trust.

Expressing the entire civilization’s undertaking at any point in time as an linear equation, any essential variable that happens to be the most restrictive in supply at that point inevitably becomes the most valued. However wide fluctuations in value does not elicit trust in the long run.

Sources of trust

  • the rotation of seasons and our subsequent practice of agriculture
  • the constant speed of light and it’s use in Einstein’s theory of relativity
  • gold with its scarcity and it’s persist use as a store of wealth
  • well run institutions with well defined constitutions
  • fiat currencies with under sound government regimes
  • individuals who exhibit consistent behavior overtime

Qualities of viable currencies

  • Ability to be divisible
  • Ability to be moved
  • Ability as a store of wealth overtime
    • consistent levels of supply
    • scarcity

Functions of currencies

  • a means to facilitate transactions
  • a store of wealth

Examples of trust erosion

Example 1: Michigan Pulls $600 Million From Ken Fisher an individual After Lewd Remarks

https://www.bloomberg.com/news/articles/2019-10-12/michigan-pulls-600-million-from-ken-fisher-after-lewd-remarks

Example 2: 1918 Germany as an institution, towards the tail end of WWI.

When it became evident that the country will loss the war, it experienced increased inability to raise debt to in domestic currency denomination to continue financing its war efforts. It’s currency soon lost it’s reserve currency status and it was increasingly forced to denominate debt in foreign reserve currencies.

Post WWI debts denominated in domestic currency where inflated away through printing of cash by the  German government to pay of debts denominated in foreign currencies.

Example 3: Africa use of glass beads as a failed form of currency

Europe was able to cheaply produce this in abundance . Europeans for a period were able to exploit this asymmetry by exchanging cheap glass beads for valuable natural resources. When value within the African society became depleted,  Europeans were eventually able to subjugate the entire African population and exploit them through the slave trade.

Example 4: Wall Street crash and the Great Depression of the 1930s.

Bankers increasingly became concern of easy credit driving share prices to stratospheric valuations. An eventual tightening of credit lead to rapid deleveraging within the system. The lack of trust within the system prevented the circulation of money and credit. The central bank ultimately had to step in to restore trust.

It did so by first preventing the flight to value. This was achieved through the banning of conversion of USD dollar to gold.

Example 5: An ongoing slow erosion of fiat money

With the deliberate pursuit of constant 2% yearly inflation by central banks around the world current fiat money are failed stores of wealth .

The currency of the Roman Empire is a perfect example of where we will be headed. Overtime less gold per coin is used. Their currency was ultimately replaced by paper which allowed rampant printing by the government during times of war. The effects of inflation eroded the Roman empires currency as a long term store of wealth.

Examples of persistent sources of trust

  • The institution of the Catholic Church
  • The consistent adherence to a set of sound principles by Berkshire Hathaway’s reinsurance business over multiple decades. 
  • Federal reserves consistent adherence to the dual mandate of 2% inflation and low unemployment rates

Conclusion

To build trust is to build wealth. The key to doing so is to adhere and operate on a consistent set of sound principles over across time and in all environments. Being slow and steady is a pre-requisite of this process.

Related readings

Observed unwinding of credit in the market

Priori

  • Federal reserve starts reducing debt bought and brought onto their balance sheet during 2008
  • Federal reserve went on a series of interest rate hike from the period of 2016 to 2018
  • Trump starts Trade war in 2017 resulting in reduced global demand for American exports

Liquidity concerns experienced in sections of the markets around the world

Riots and unrest

Related readings

 

Thoughts of various asset class type and their usage

Investment environment parameters

  • Economic cycle
    • boom
    • recession
  • Inflation rates
    • High
    • Low
  • Currency type
    • Reserved currency
    • Non reserved currency
  • Exchange rates regime for non reserved currency owners
    • Fixed exchanges rate
    • Floating exchange rates
  • Recession type
    • (hyper) inflationary
    • deflationary
  • Federal reserve monetary policy
    • restrictive
    • expansive

Asset class types

Government bonds

  • good position to hold when government is unlikely to default and threat of inflationary recession looms
    • interest rates are inflation adjusted
  • high opportunity cost to hold position when economy is booming

Cash

  • good position to hold when hyper deleveraging is occurring within the system and Federal reserve has not responded with expansionary monetary policy
  • high opportunity cost to hold position when economy is booming

Mortgage REIT

  • good position to hold when threat of deflationary recession looms and the Federal reserve have started loosening monetary policy.
  • a tenuous position to hold during periods of hyper inflation because the interest gets offset by the inflation
  • a tenuous position when the Federal reserve starts tightening monetary policy
  • a tenuous position to hold when over leveraging is rampant within the system
  • high opportunity cost to hold position when the economy is booming

Equity REIT

  • good position to hold when the Federal reserve starts tightening monetary policy.
    • Credit becomes less available and thus more expensive
    • number of construction project drops
    • less supply driving up demand for existing inventory
  • high opportunity cost to hold position when the economy is booming

Gold

  • Use as a protection against hyper inflations
  • a tenuous position when the economy is in the early stage growth
    • demand for gold will drop as more funds gets allocated to risk assets
  • a tenuous position when the economic is heading into deflation
    • there is less money/credit within the system as compared to the amount of gold

Oil

  • Useful for hedging against outbreak of war
  • a tenuous position when recession and economic activity worldwide slows

Growth companies

  • Useful for riding an economy boom
  • a tenuous position to hold during the late stage of a credit cycle when too much leverage has been built up within the system and valuation is excessive

Value companies

  • Useful for riding a deflationary recession when credit becomes more expensive
  • High opportunity cost when economy is booming.

Related references

Oil’s relationship with the macro economic environment

Price of OILU jumps 34% following news on 50% Saudia Arabian refining capacity destruction by Iranian drones.
At the height of the Oil crash in 2016, USO traded at USD8.33 per share on 2nd August 2016. It has since recovered

The price of oil has an positive correlation with likelihood of war and a booming economy. It has a negative correlation with recession and oversupply.

The price of oil did not hit zero even during the height of the oil crash.

Observations on how public opinion is shaped in the US

Public opinion is observed to be very malleable and fickle. It’s highly susceptible to reshaping by main stream media.

In an unlikely twist of events, what was once presented as a war by the White House against China over trade and national security has overnight morphed to become a fight for American values like democracy, free speech and human rights.

While the ongoing unrest in Hong Kong have provided ample fuel, the tweet by NBA Houston Rockets general manager was the spark that caused the fire.

Related Readings

List of companies that have been heavily punished by macro economic trends to consider for purchase

The following list of companies have experienced major headwinds in the public markets

Enterprise SaaS Large Cap

  1. CRM
  2. WDAY
  3. VMW
  4. PANW
  5. INTU
  6. RHT
  7. ADBE
  8. VEEV
  9. NOW
  10. TEAM

Enterprise SaaS Mid Cap

  1. TWLO
  2. ZS
  3. MDB
  4. PCTY
  5. PD
  6. DOMO
  7. DDOG
  8. ZM
  9. WORK
  10. TEAM
  11. STMP
  12. DBX
  13. CRWD
  14. DOCU
  15. HUBS
  16. ESTC
  17. ZEN
  18. OKTA
  19. SPLK
  20. ZUO
  21. ZEN
  22. HUBS
  23. NET

China

  1. CTRIP
  2. BABA
  3. JD
  4. BIDU
  5. WB
  6. PDD
  7. SINA

Semiconductors

  1. MU
  2. NVDA
  3. AMD
  4. MCHP
  5. INTC
  6. QCOM
  7. AVGO
  8. XLNX

Thoughts on excessive use of leverage

One of worst mistakes I made was during the 2015/6 Oil crash. I bought into shares of oil exploration companies instead of buying the oil directly. 

It was a very painful and expensive mistake. While the price of oil made a nice recovery since then, the exploration companies never made it through to the other side. Majority of them filed for bankruptcy during the height of the crisis. Unfortunately they took on too much debt when the times were good and were unable to finance the debts and ongoing operations through the continued sales of their inventory when situations turned south. 

The lesson learned is that when buying the dip, it’s important to make sure that not just yourself but the underlying assets you hold are resilient to the environment shock. Utilization of excessive leverage reduces the resilience. Over expansion into fancy offices and overstaffing is another form of excessive leverage. Tech startup founders are often caught red handed committing these mistakes. 

With regards to oil, until the world stops relying on plastic, chemical lubricants and switches completely to alternative forms of energy, we should not expect the price of oil to fall to zero anytime soon. 

A simple acid test to figure out the intrinsic value of oil is to ask your neighbor for his tank of gasoline for free. The most likely response you will get from him is a suggestion to go f**k yourself…?!?