Doug Noland: More on China

Let’s return to last week’s theme of China as the “marginal source of global Credit and liquidity” for a runaway global Bubble that has been pierced at the periphery. It is difficult for my thoughts not to return to the analogy of the matador’s sword initially piercing bull flesh. It amounts to the beginning of the end. It could also very well mark the point of maximum bull madness and pandemonium.

From my analytical perspective, the spring of 2007 marked the piercing of the mortgage finance Bubble. The blowup of funds leveraged in subprime mortgage exposure marked a momentous inflection point in terms of speculator deleveraging, the flow of finance to the mortgage sector and an overall tightening of mortgage finance. Federal Reserve measures to hold Bubble bursting at bay pushed the crisis out several quarters into late-2008. Highly unsettled (crazy) markets saw a major bond rally – especially in agency debt and MBS – that extended the period of high-risk mortgage lending. Fed loosening in the midst of a highly unstable Bubble Dynamic also spurred a speculative frenzy in commodities, with crude oil surging to $145. It all exacerbated fragility.

The world has changed profoundly since 2007. For one, total Chinese bank assets have inflated from about $7.0 TN to over $30 TN. Annual growth in Chinese system Credit growth (“total social financing”) expanded from about $900 billion in 2007 to 2015’s $2.35 TN. Momentous changes have rewritten central banking doctrine. Not even contemplated in 2007, QE (ECB and BOJ) will add close to another $2.0 TN to global liquidity in 2016. Central banks will also push short-term rates (and bond yields!) further into negative territory this year, a policy course that would have been totally absurd in 2007. Prior to 2008, no one would have dared imagine today’s “whatever it takes” monetary management.

It’s an incredible confluence. Building on it’s historic $1.0 TN Q1 output, China could surpass $3.0 TN of 2016 system Credit growth. For perspective, Chinese Credit growth will likely expand at least 50% more than U.S. Credit this year. Such unprecedented Credit growth in the face of a stock market collapse, sinking corporate profits and rapidly intensifying Credit deterioration is simply astounding. It’s definitely a testament to the brute power of “whatever it takes” Chinese state-directed finance and investment. Combining Chinese communist leadership with “whatever it takes” global central bankers (with no constraints on their “money” printing operations) creates a backdrop for financial folly unrivaled in history.

Recall that Chinese authorities had previously tightened mortgage Credit in a belated attempt to rein in Credit excess and rapidly inflating housing (apartment) prices. Then to counter a weakening economy and incipient Credit problems, officials loosened policy in 2014. The upshot was a surge of liquidity (and leverage) into stock market speculation. After trading just above 2,000 in July 2014, the Shanghai Composite ballooned to almost 5,200 by June 2015 (Friday’s close 2,959).

The bursting Chinese stock market Bubble spurred “whatever it takes” measures out of Beijing that must leave Draghi, Kuroda and Yellen with deep senses of envy. And with perceptions fully solidified that Chinese officials have no tolerance for financial or economic crisis, “money” and speculative leverage returned with a vengeance in key housing markets and within commodities.

The global backdrop is unique. The late-twenties period does, however, offer some germane similarities. Incredible technological advancement, financial innovation, “globalization” and policy experimentation nurtured the extraordinary “Roaring Twenties” Bubble period (commencing during the first World War). Later in the twenties, the myriad affects of loose financial conditions – certainly including over-investment, mal-investment and income inequality – became more pronounced. There was intensifying downward pressure on commodities and good prices, along with corporate profits.

The late-twenties Bubble period was characterized by an unusual backdrop that promoted financial speculation over productive investment. And as much as the Fed hoped to rein in speculative excess while providing a boost to the flagging real economy, cautious measures to dampened speculation were ineffective. Meanwhile, efforts to bolster the real economy were successful in stoking securities markets Bubbles and speculative leveraging. Money was literally flooding into New York to play the best game in town (and the world).

April 22 – Bloomberg: “Chinese speculators have a new obsession: the commodities market. Trading in futures on everything from steel reinforcement bars and hot-rolled coils to cotton and polyvinyl chloride has soared this week, prompting exchanges in Shanghai, Dalian and Zhengzhou to boost fees or issue warnings to investors. While the underlying products may be anything but glamorous, the numbers are eye-popping: contracts on more than 223 million metric tons of rebar changed hands on Thursday, more than China’s full-year production of the material used to strengthen concrete. ‘The great ball of China money is moving away from bonds and stocks to commodities,’ said Zhang Guoyu, a Shanghai-based analyst at Tebon Securities Co. ‘We’ve seen a lot of people opening accounts for commodities futures recently.’ The frenzy echoes the activity that fueled China’s stock market last year before a rout erased $5 trillion, and follows earlier bubbles in property to garlic and even certain types of tea.”

April 17 – Financial Times (Yuan Yang): “House prices in China’s leading cities surged as much as 63% in the year to March while lower-tier cities saw prices tumble, highlighting the country’s increasingly bifurcated market. In places such as Shanghai and Shenzhen, soaring house prices and subdued wage growth have sparked a frenzy of borrowing — estimated at an additional $48bn in January alone — prompting city governments… to crack down. These measures, introduced in January and including curbs on financing for downpayments and second homes, have had little impact so far in the ‘tier-one’ cities… ‘When you create a lot of liquidity, it flows to the hottest markets,’ said Ms Yao, who suspects easy credit and property speculation have stoked sharp price rises. Homebuyers have circumvented clampdowns on downpayment financing… by finding ever more novel ways to obtain the 20% of value deposit requirement.”

The extreme measures China adopted to counter its stock market crash and unfolding crisis have now incited precarious speculative Bubbles in commodities and housing. This creates extraordinary uncertainties for China and the world. A deepening Credit crisis (see “China Bubble Watch”) would seem to ensure the usual cautious official measures to counter speculative excesses. So the world has of late been contemplating booming China: ongoing loose financial conditions with 2016 Credit growth in the neighborhood of $3.0 TN – providing extraordinary fuel for a rather destabilizing speculative blow-off.

Keep in mind that The Mighty World of Speculative Finance has been positioned long “defensive,” long “deflation,” long “duration” and long sold balance sheets. This world has been short commodities, energy, yields, cyclicals, financials and bad balance sheets. Moreover, many of these (Crowded) macro themes have been combined into leveraged portfolios (“risk parity”, etc.). China with $3.0 TN of Credit growth fueling unpredictable housing and commodities speculative Bubbles upsets the leveraged speculators’ applecart.

We need to deepen our discussion of China as “marginal source of Credit and liquidity.” A three Trillion (in U.S. dollars) Chinese Credit onslaught would bolster a vulnerable Chinese economy, in the process providing a much needed boost to EM economies and the global economy in general. Resurgent Chinese housing and commodities Bubbles would be expected to stoke the real economy and finance more generally – if unpredictably.

Chinese officials have adopted various capital control measures over recent months. These seem to ensure that a less-than-normal amount of newly created Chinese liquidity will make its way out into the global system. At the same time, Chinese Credit and Bubble Dynamics have already begun to have major indirect impacts on global market liquidity.

At this point, China – as the “marginal source of global Credit and liquidity” – is exacerbating what had already evolved into a powerful central-bank induced short squeeze dynamic. Despite the collapse of Doha talks over the weekend, crude’s march higher ran unabated again this week. Industrial metal prices have been surging. Silver jumped 4.4% this week, with copper up 5.4%. The week saw nickel prices rise to a five-month high and aluminum to eight-month highs. Platinum, palladium, zinc and lead prices have all shot higher. Some iron ore prices have jumped to highs since early 2015.

The problem is that China’s newfound commodities speculation is underpinned by historic Credit growth – say, more than $3.0 TN annualized. Meanwhile, global short-squeeze dynamics are bolstered by $2.0 TN of annualized QE (ECB and BOJ). Moreover, there’s the massive pool of speculative finance – including a $3.0 TN hedge fund industry – with large leverage positions throughout global markets. In an extraordinary development, as scores of trades continue to unwind, a destabilizing global dynamic feeds on itself and gathers momentum. It’s monetary disorder on steroids.

Thursday under the prescient Bloomberg (Netty Idayu Ismail) headline, “Yen Bulls Vulnerable to Kuroda Shock Amid Record Hedge Fund Bets: “Yen bulls are at risk from Haruhiko Kuroda’s favorite tactic: surprise. By pushing bets on a stronger currency to the most on record, speculators have left themselves vulnerable should the Bank of Japan governor blindside them with additional stimulus at the April 27-28 policy meeting… “Short dollar-yen is now a consensus trade,’ said James Purcell, cross-asset strategist at UBS Group AG’s wealth-management business in Hong Kong. ‘The market was caught on the wrong side when the cross fell in the first quarter. There is a danger people will get wrong-sided again.’”

Sure enough, Friday trading saw the yen sink 2.13%, “the most in 17 months.” When trade unwinds/blowups proliferate, no trade is safe. Interestingly, the energy and commodities surge even began to garner the attention of global bond markets. Nothing dramatic thus far, yet bonds around the world are priced for deflation. Throughout equities and fixed income the “safety trade” is likely the most Crowded trades of all.

It’s also worth mentioning that the VIX (equity volatility) closed the week at 13.20, down from last week’s 13.62 to near one-year lows (not far from five-year lows). Considering the general mayhem operating below the market’s surface, a 13 VIX is incredible. Then again, the VIX has been right in the thick of the disorderly unwind of hedges and bearish bets. Besides, it’s at best an indication of the short-term probability of stock market dislocation. And for now markets are betting that “whatever it takes” Chinese officials and global central bankers have things under control.

And that’s what makes the current environment so dangerous. From my perspective, things continue to unfold in the worst-case scenario. Beijing has lost control of what has evolved into complex Credit, market and economic systems. Global central bankers have lost control of speculative market dynamics – not to mention inflation dynamics. And it’s not as if current predicaments are inconspicuous. So investors, speculators and investment managers around the world are forced to plug their noses and play the game.

Returning back to China: The “marginal source of global Credit and liquidity” is short-term supportive of global risk markets. Yet its Credit system is self-destructing – and doing so rather conspicuously. If any other country employed a similar policy mix the world would be sprinting from that currency.

Thus far, Chinese officials have been determined to carefully manage China’s pegged currency regime. Yet current Credit and market dynamics are inconsistent with a stable currency. I would furthermore argue that breakneck Credit growth in the face of rapidly deteriorating underlying fundamentals is a proven recipe for a crisis of confidence. Global markets are in the midst of a destabilizing adjustment to China’s resurgent booms in Credit and speculation. This ensures real havoc when global markets are confronted with a Chinese Credit and/or currency dislocation.


Original Post 23 April 2016

Categories: Doug Noland, Perspectives

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