Money, But Not From Banks? Stablecoins and Capital Adequacy

We're on the precipice of a cumulative 225bp in rate cuts from the Federal Reserve. The market is discounting an effective funds rate at 3% by the end of 2025 (versus 5.33% now). Market rates have already moved significantly in anticipation of cuts to be delivered. The 10yr SOFR rate is at 3.4%. That's down over 100bp in just three months. A key question is what now?

We have some answers, but first the forward discount is worth examining (chart below). It shows the entire curve gapping down to the 3% to 3.5% area on a one year timeframe, and it stays there for five years. Does that make sense? The simple answer is no. If no, what's the more likely prognosis? Read on.

US market rates forward profile shows a (dark blue) dump down to 3% to 3.5% for entire curve

Source: ING estimates, Macrobond

We're in overshoot territory, but here's why market rates will fall some more

We identify the 3% area as neutral for the Fed funds rate. We back this out from analysis of the noughties. During that decade US inflation averaged c.2%-2.5%, a rate the Federal Reserve finds acceptable. And over the same time period the funds rate averaged 3%. We also find the 3% area theoretically appealing as a neutral rate, one that incorporates a mild positive real rate. And it happens to be the area that the Fed is expected to land at; a return to neutrality.

The same exercise based off the noughties finds the average 10yr Treasury yield was 4.5%. That translates to around 4% for 10yr SOFR, and a fair value 100bp curve between the funds rate and the 10yr SOFR. These are fair value reference levels against which we can interpret current, and indeed future levels.

Why do we use the "noughties" as our reference decade? Remarkably, it is the ONLY decade since the 1960's when inflation AVERAGED at a level acceptable to the Federal Reserve. During every other decade the inflation average has been either too high or too low. The choice is simple – it's the only one that fits! 

Based off that, we can see that the current funds rate is high – it's well above the neutrality area of around 3%. The Fed is about to cut; all good.

But what about the 10yr SOFR rate? It's at 3.4%. That's some 60bp below it's neutral area of around 4%. In that sense, the 10yr SOFR rate is already overshooting to the downside, and away from what we would determine a neutral valuation (in an environment where the funds rate lands at around 3%). Does that mean we should position for a rise in the 10yr SOFR rate? Well yes and no.

But mostly no for now. There is no great mystery as to why it's below 4%. The Fed is about to embark on a significant rate cutting exercise, and history shows that the 10yr rate tends to fall both in, 1. Anticipation of cuts (from the moment it peaks) and 2. On actual delivery of cuts. The chart below has a zoomed focus on these two periods. In modern times, there has been no exception to the rule that the 10yr rate falls as the Fed cuts.

Long tenor market rates tend to fall as the Fed cuts rates

The 10yr Treasury yield, 1. As the Fed peaks (blue), and 2. As the Fed cuts (orange)

Source: ING estimates, Macrobond

And here's why the 10yr SOFR rate will be drawn back up to 4% (having potentially touched 3%)

Back to the present, the Fed has not started to cut yet. That suggests that 10yr SOFR should still have some room to move lower in the next month or so at least. We'd argue that it could get down to 3%, a 40bp fall from here.

But getting to 3% would also be an extreme valuation to the downside. Why? The Fed funds rate is discounted to get to 3% and no lower. That must represent a floor for all rates right out the curve. There is no relative value logic for a longer tenor rate to trade below 3%. And if they do, say on a mad rate cutting excitement dash lower, there is no logic for them to stay there.

Our analysis shows that a 100bp curve from the funds rate to the 10yr yield is a fair value one. If the funds rate gets pitched at 3%, then 4% is the level we should be thinking about for 10yr SOFR. It of course can be higher or lower based off other pushes and pulls, but it certainly cannot stay at 3%. Even 3.4% (the current level) is too low against a backdrop where arguably a residual inflation risk remains. And where the US fiscal deficit continues to top 6% of GDP, manifesting in material issuance pressure for Treasuries and upward pressure on long rates.

Bottom line, there are good reasons to anticipate the resumption of a much steeper curve; 100bp at the very least. The chart below shows that the curve has tended to get to 100bp to 200bp as the rate cutting process comes to a conclusion. No reason to think differently this time around.

Rate cuts typcially result in a much steeper curve

The 2/10yr Tresury yield spread, 1. As the Fed peaks (blue), and 2. As the Fed cuts (orange)

Source: ING estimates, Macrobond

So what is the answer to the question posed?

First, the 10yr SOFR rate at 3.4% is already in overshoot territory to the downside. But it can overshoot some more. It should not dip below 3% though. If it does hit 3%, it would be flat to the forward discount for the funds rate. That's not a tenable equilibrium level.

Second, the target beyond 3% should be 4% for 10yr SOFR. That assumes what the fund rate strip assumes; that the Federal Reserve cuts by enough to avert a damaging recession and/or a system break, and no more.

If the 10yr SOFR rate does hit 3% we think it will be in the next few months. Post the US elections, and certainly beyond inauguration in January, we think the dominant direction is towards 4%. That is quite a deviant view from the forward discount of an effective structural dump in the entire curve down to the 3% to 3.5% area.

This points to an optimal issuance window now, and over the coming few months. The some obtains for locking in interest rates on liabilities. And for asset managers it points to fading structural longs towards neutral to short positioning over the next few months.

Inflation is on the path to 2%

Core personal consumer expenditure deflator metrics

Spending is strong, but income growth remains weak

Personal savings rate (%)

A September rate cut is assured but the jobs report will determine the magnitude

Source:ING

Some 21 trillion won ($15.7 billion) in short-term loans and loan guarantees extended to construction projects have been determined "risky" and may be subject to restructuring, the South Korean financial regulator said .

The amount accounts for 9.7 percent of the total 216.5 trillion won in real estate project financing (PF) loans and loan guarantees, according to the Financial Supervisory Service (FSS).

The finding is based on a review of PF loans and loan guarantees, worth 33.7 trillion won in total, that had had delayed payments or their expiration dates extended more than three times.

"The review, along with the improved evaluation standard (announced June 7), is expected to help remove uncertainties in the PF market as it has distinguished good from bad through objective evaluation of normal and risky projects," the FSS said in a press release.

The financial regulator said the financial industry's exposure to such risky loans will not cause any serious problem since most financial firms have been preparing for the worst, partly by boosting their loan-loss reserves.

"Still, for the soft landing of PF loans, financial firms need to actively resolve non-performing loans and delinquent loans as the non-performing loan ratio of PF loans has sharply increased by 6.1 percentage points since the end of last year to 11.2 percent as of end-June," it said in a press release.

The financial regulator added the non-performing loan ratio of most financial firms will improve to a "stable level" in the second half of the year "should the restructuring and (PF loan) liquidation plan currently being prepared be implemented without fail."

By sector, mutual trust funds are exposed to the largest share of 9.9 trillion won among the 21 trillion won of PF loans deemed risky, followed by savings banks with a 4.5 trillion-won exposure, securities firms 3.2 trillion won, credit finance companies 2.4 trillion won, insurance firms 500 billion won and commercial banks with a 400 billion-won exposure, according to the FSS.

The FSS said financial firms will come up with their own PF loan restructuring plans by Sept. 6, and that the financial regulator will check monthly their progress in implementing such plans. (Yonhap)

Source: Koreatimes

Both optimists and pessimists contribute to society. The optimist invents the airplane, the pessimist the parachute.”- George Bernard Shaw.

What will September bring for investors? Here are five predictions for the ninth month of 2024 and what they could mean for the market.

The Yield Curve Normalizes:

The yield curve, specifically the spread between the 2-Year Bond Yield (US2Y) and the 10-Year Treasury Yield (US10Y) has been continuously inverted now since July 2022. Inversions have been reliable predictors of upcoming recessions, like in 2000 and 2008. However, they tend to have long lag times, as can be seen here. The latest inversion has had a particularly long duration. This is most likely due at least somewhat to the trillions of dollars Congress has pushed into the economy over the past few years. This occurred via COVID-19 stimulus programs and other taxpayer largess, such as the misnamed Inflation Reduction Act or IRA and the CHIPS Act. The Federal Reserve also increased the money supply by 40% over two years during the pandemic.

CBO/Capital Economics

These programs were key drivers of the highest inflation levels since the early '80s, with the CPI peaking at 9.1% in June 2022. They also have ballooned the national debt, and the U.S. now has the highest Debt to GDP ratio in its 248-year history. The fiscal deficit through the first ten months of the federal government's FY2024 was $1.52 trillion as well.

CNBC - 08/28/2024

The yield spread has spent some time during this inversion above 100 bps between the two and ten-year treasuries. As of Wednesday, that spread had dropped to just under five basis points. My first prediction for September is that the month will end with this spread “normalized” or with the yield on the 10-Year Treasury above that of the two-year Treasury for the first time since the summer of 2022. Historically, this has happened just as recessions were taking hold. It also could signal a “soft landing” might be ahead. Only time will tell, and this will remain a $64,000 question for investors until resolved one way or another.

Continued Deterioration In The Jobs Market:

It has become clear recently that the jobs market is slowing, and that was before the massive 818,000 downward jobs revision by the Bureau of Labor Statistics, or BLS, last week. Job openings fell to a three-year low in June of this year. And that does not account for the significant rise in “ghost jobs” recently, where jobs are posted with little intention to fill them.

Then we got the dismal July BLS Jobs report on August 5th. It showed only 114,000 positions were created during the month of July. This was far below the consensus estimate of 174,000 jobs. In addition, the June jobs number was revised down by 27,000 positions to 179,000. This marked the 10th time in the past 14 months, that BLS jobs reports were subsequently revised down as well.

The jobs trend does not seem to be our friend currently, so the easiest path of resistance is the prediction that the jobs market continues to be weak in September. The August BLS jobs report is due out just before the bell on Friday, September 6th. It will be one of the key economic readings for investors for the month. Based on recent data points, it most likely will be weak.

A 50bps Cut In The Fed Funds Rate:

Currently, futures are pricing in approximately a two-thirds possibility of a 25bps cut to the Fed Funds rate at the September FOMC meeting and a one-third probability of a 50bps cut. If the jobs number comes in weak for the second month in a row and CPI and PPI readings next month continue to show inflation isn't moving up, I expect the Fed will cut rates by 50bps.

One Sharp Spike Again In Volatility:

Unfortunately, a 50bps cut in interest rates is unlikely to be well-received by the markets. Especially if the main driver of the move is a weakening jobs market. Investors will rightly worry the Federal Reserve is “behind the curve” once again, much like the central bank was all through 2021 on the inflation front. I expect we will see another spike in volatility as well. I don't think it will be the same magnitude as the massive spike investors saw early this month when the S&P VIX Index (VIX) briefly moved above the 60 level for the first time in more than four years. However, I think we will see a move in into the 30-40 range at some point in September. Most likely the result of worries around the Federal Reserve. I could also easily see another two percent down day on the S&P 500 during the coming month, if not multiple declines of this order.

Seeking Alpha

Other potential sources of tension in the markets could be of the geopolitical variety. The war in Ukraine could take a dangerous turn and escalate. Russia is likely to capture the key logistical hub of Pokrovsk, or at least have it surrounded, by the end of September. This would be a key victory on the way to consolidating all the Donbas front. Further escalation between Israel and Iran/Hezbollah also appears to have a significant possibility of occurring in September.

A Down Month For The Markets:

Hulbert Ratings/MarketWatch

As I noted in a recent article, the current stock market is extremely overbought, viewed through numerous valuation metrics. As much or more so than at the beginning of 2022, which was just before the last bear market, equities went through. As investors may recall, the S&P 500 fell 19.64% for that year (18.32% accounting for dividends). The index's worst annual performance since 2008. The Nasdaq (COMP:IND) performed even worse, losing a third of its value in 2022.

Market Desk, Federal Reserve

As a testament to the current level of investor complacency and greed, the household allocation to equities is at/near its highest level in 70 years. And this is with the markets trading at extreme valuation metrics and with the short term “risk-free” treasuries still yielding slightly more than five percent.

As Warren Buffett has long liked to quip, an investor “should be fearful, when others are greedy and greedy when others are fearful.” And with September historically the worst performing month for investors, my final prediction for the coming month is this: Equities will end the month down, and perhaps significantly so. Prudent investors should position their portfolios accordingly.

Source: SEEKINGALPHA

Cboe Exchange, a United States securities exchange, filed an amended application to regulators to list options on Bitcoin (BTC) and Ether (ETH) exchange-traded funds (ETFs), according to two Aug. 28 filings for Bitcoin and Ether options, respectively. 

According to the documents, the exchange seeks to list options linked to ETH and BTC ETFs issued by asset managers, including Fidelity, 21 Shares, Invesco, VanEck, Grayscale, Bitwise, Blackrock’s iShares, and Valkyrie. 

The proposed rule change would categorize the spot cryptocurrency ETFs alongside commodities-based ETFs such as the Goldman Sachs Physical Gold ETF and the iShare Silver Trust as “[s]ecurities deemed appropriate for options trading,” according to exhibits included in the BTC and ETH options filings. 

Related: Expect Bitcoin ETF options to launch before 2025

The news is the latest in a flurry of activity around options on spot cryptocurrencies in the US. On Aug. 27, Nasdaq, another US securities exchange, announced its intention to list Bitcoin options tied to the CME CF Bitcoin Real-Time Index (BRTI), a benchmark for BTC’s spot price. 

In August, the New York Stock Exchange (NYSE) American and Nasdaq International Securities Exchange (ISE) withdrew four applications to the Securities and Exchange Commission (SEC) related to the possible listing of BTC options. On Aug. 8, Cboe withdrew an earlier application to list options on BTC ETFs. 

“There’s definitely some movement on Bitcoin ETF options,” Bloomberg Intelligence analyst James Seyffart said in an Aug. 8 post on X. “The SEC likely gave some sort of feedback.”

Bloomberg predicts spot BTC options go live in the fourth quarter.

Options are contracts that grant the right to buy or sell — “call” or “put” in trader parlance — an underlying asset at a certain price. They are commonly used as hedging instruments and are popular with speculators, too.

Cryptocurrency derivatives on regulated exchanges are gaining popularity in the US. As of the market close on Aug. 9, open options interest on BTC futures ETFs exceeded $3.25 billion, according to data from The Options Clearing Corporation, an industry self-regulatory organization (SRO).

Exchanges also aim to list Solana (SOL) ETFs. Asset manager VanEck’s plans for a Solana exchange-traded fund (ETF) are “still in play” despite the removal of Cboe Global Markets’ regulatory filing proposing to list the fund on its exchange, according to an X post by Matthew Sigel, VanEck’s head of digital assets research.

Source: COINTELEGRAPH

Pessimism among individual investors about the short-term outlook for stocks increased in the latest AAII Sentiment Survey. Meanwhile, both optimism and neutral sentiment decreased.

Bullish sentiment, expectations that stock prices will rise over the next six months, decreased 0.5 percentage points to 51.2%. Bullish sentiment is unusually high for the second consecutive week and is above its historical average of 37.5% for the 42nd time in 43 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, decreased 2.9 percentage points to 21.9%. Neutral sentiment is below its historical average of 31.5% for the eighth consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, increased 3.3 percentage points to 27.0%. Bearish sentiment is below its historical average of 31.0% for the third consecutive week.

The bull-bear spread (bullish minus bearish sentiment) decreased 3.8 percentage points to 24.2%. The bull-bear spread is above its historical average of 6.5% for the 16th time in 17 weeks.

This week's Sentiment Survey results:

Bullish: 51.2%, down 0.5 percentage points.

Neutral: 21.9%, down 2.9 percentage points.

Bearish: 27.0%, up 3.3 percentage points.

Historical averages:

Bullish: 37.5%.

Neutral: 31.5%.

Bearish: 31.0%.

Source: SEEKINGALPHA