Doug Noland: What a Week

The S&P500 jumped 2.3% Monday in what appeared growing confidence that Hillary Clinton was on the verge of becoming the next POTUS (buoyed by Director of the FBI Comey’s statement). It’s worth noting that Monday trading saw both the Financials (XLF) and the Industrials (XLI) jump 2.5%, only to be bettered by the Biotechs’ (BTK) 4.1% surge. EM equities (EEM) rose 3.6% Monday. Election day trading was then relatively quiet, with the S&P500 adding 0.3% Tuesday.

After closing Tuesday’s session at 2,135.50, S&P 500 futures jumped to 2,151 in evening trading on exit polling and early reports from Florida that appeared favorable for Clinton. Futures, however, reversed course as it became increasingly apparent that Donald Trump was performing better than expected, especially in Florida, Pennsylvania, Michigan and Wisconsin. By midnight on the East Coast, S&P futures were “limit down” 5%. DJIA futures had reversed a full thousand points, and Nasdaq futures had fallen almost 6%.

The huge move in U.S. equity futures was outdone by a stunning 14% collapse in the Mexican peso. In a span of a couple hours, the U.S. dollar/Mexican peso moved from 18.205 to a record high 20.78. After trading near 17,400 (futures) in overnight trading, the DJIA closed Wednesday’s session up 257 points (1.4%) to 18,590. Financial, industrial and biotech stocks, in particular, were in melt-up mode. The Banks (BKX) closed Wednesday trading up 4.9% – then added another 3.8% Thursday, before ending the week up 12.7%. The Broker/Dealers (XBD) surged 5.9% and 3.7%, with a gain for the week of 14.8%. Again not to be outdone, the Biotechs (BTK) spiked 9.2% higher Wednesday and 17% on the week. The Industrials (XLI) gained 2.3% both on Wednesday and Thursday, closing out the week 8.1% higher.

As exuberance took over, the broader market dramatically outperformed. The small caps (RTY) traded higher all five sessions this week, with Wednesday’s 3.1% rise the strongest in a noteworthy 10.3% weekly advance. The mid-caps (MID) gained 1.9% Wednesday and 5.7% for the week. The DJIA traded to a record high this week, with the S&P500, small caps and mid-caps just shy of all-time highs

There are different perspectives through which to interpret this week’s extraordinary market action. The bullish viewpoint will take a casual look at U.S. stock performance and see overwhelming confirmation that the bull trend remains intact. And with news and analysis, as always, following market direction, rather quickly we’re deluged with material professing a bullish outlook courtesy of a Trump Presidency and Republican House and Senate. Apparently the country is now on the verge of a major infrastructure investment program, positive healthcare reform, corporate tax reform, and a dismantling of Dodd-Frank financial regulation (for starters). In particular, a focus on infrastructure and de-regulation implies a Trump Administration not likely to place confrontation with the Yellen Federal Reserve (or the securities markets) high on their priority list.

From my perspective, it was anything but a so-called “bullish” week. I saw alarming evidence of dysfunctional markets. There was also further confirmation of a bursting bond Bubble. Indeed, there was strong support for the view of a faltering global securities Bubble – even in the face of surging U.S. stock prices.

Let’s return to election late-night. I doubt traders and the more sophisticated market operators will easily forget what almost transpired. It’s worth noting that while S&P500 futures and the Mexican peso were collapsing, the Japanese yen was in melt-up. In just over two hours, the dollar/yen moved from 105.47 to 101.22 – an almost 4% move. Meanwhile, EM and higher-yielding currencies were under intense selling pressure – the Brazilian real, South African rand, Turkish lira, Colombian peso, Australian dollar and New Zealand dollar (to name a few). At the same time, gold surged from $1,270 to $1,338. Crude sank 4%. Global markets were on the brink of a serious speculative de-leveraging episode.

There had been significant hedging across global markets going into the U.S. election. Especially after Monday, the markets viewed a Trump win a low probability. With markets shaky of late, along with an approaching historic political event, enormous derivative positions had accumulated in various markets. In the event of a surprising outcome, those that had written (sold) market “insurance” would be forced to aggressively (“dynamically”) hedge their losses by selling/shorting into already weak markets – perhaps even with major markets highly illiquid (or already halted limit down).

When a marketplace significantly hedges against a perceived low-probability event – and the unexpected actually occurs – contemporary markets face dislocation. Markets simply can’t hedge themselves. To offload risk, someone has to be on the other side of hedging trades – and these days that someone generally has a sophisticated trading model requiring selling/shorting to build positions capable of generating the necessary cash-flow to offset derivative losses. Significant derivative-related selling risks a (’87 “Black Monday”) portfolio insurance debacle of selling begetting selling, begetting illiquidity and panic.

Tuesday’s election outcome was at the cusp of creating a very serious test for global derivatives markets. It was not, however, meant to be, as another one of those well-timed miraculous reversals transformed potential panic selling into manic buyers’ panic. Instead of those on the wrong side of derivative trades forced to sell into illiquid markets, it became a frenzy of bearish hedges and speculations unwinds. Another memorable short squeeze.

It’s no coincidence that this week’s melt-up was most acute in sectors that were 2016 underperformers – and generally under-owned (financials, biotechs and industrials). Moreover, many of this week’s top performing stocks were heavily shorted. To be sure, there is no quicker way to trading profits than to jump on a bearish theme that suddenly has a plausible bullish story. It’s spectacular Buyers’ Panic as the desperate shorts, the opportunistic “wise guys” and the trend-following/performance-chasing Crowd brawl over a limited supply of available securities. A destabilizing (downside) systemic liquidity event was avoided Wednesday, which ensured sporadic upside dislocations in various stocks, sector ETFs and “king dollar” more generally.

November 9 – Bloomberg (Lu Wang): “You need to go all the way back to the dark days of 2008 to find a stock market reversal to rival that of the last 12 hours, in which S&P 500 Index futures erased a 5% loss triggered by Donald Trump’s surprise presidential election win. Bigger turnarounds only happened three times before, twice in the final months of 2008 and the other in October 1987…”

It’s no coincidence that Wednesday’s wild reversal ranks right up there with three previous major volatility events – two in late 2008 and the other in October 1987. Fragile fundamental underpinnings foster unstable market dynamics – i.e. significant shorting, hedging and speculation. And there’s no more breathtaking market advance than a major bear market rally.

It’s also worth noting that the favored technology stocks underperformed this week. The Morgan Stanley High Tech Index actually declined 1.5% post-election (up 1.6% for the week). The Nasdaq 100 (NDX) fell 1.1% post-election (up 2.0% for the week). The favorite – and previously outperforming – Utilities dropped 4.2% this week.

It’s such an extraordinary backdrop. I believe the pierced global Bubble continues to flounder, but the policy responses of $2.0 TN annual global QE, near zero rates and record Chinese Credit growth have created major Bubble Anomalies. Surely, all the QE-related global liquidity excess has created aberrant market behavior (on full display this week).

On the one hand, central bank liquidity backstops have thus far allayed fears of “Risk Off” de-leveraging quickly evolving into a systemic liquidity event. On the other, the massive pool of global speculative finance (including hedge funds, ETFs, SWF and trend-followers more generally) foments a liquidity backdrop with extraordinary flow volatility between various sectors and markets. Underlying market instability has made it difficult for fund managers perform (absolute and relative to indices). In particular, this backdrop has ensured that hedges don’t perform well at all. Intense performance pressure then makes it imperative both to rotate quickly into the outperformers and to avoid missing general market rallies.

While resilient U.S. stock prices captured bullish imaginations, this week saw global bond markets get rocked. If not for QE, I believe surging yields and attendant de-leveraging would have spelled major problems for securities markets more generally. Instead, too much speculative “money” chases the outperforming stocks, sectors, asset classes and countries. Importantly, this week’s exuberance at the U.S. “Core” came at the expense of a vulnerable “Periphery.”

Mexico was close to meltdown. The Mexican peso sank 8.7% this week to a record low. Mexican 10-year dollar bond yields surged 74 bps to 3.98%, with peso bond yields surging 95 bps to a multi-year high 7.25%. Mexican stocks dropped 3.7%. The Mexico ETF (EWW) sank 17.9% post-election, with a 12.2% loss for the week. Gold dropped 5.9% this week, while Copper surged 10.8%. Despite all the focus on inflation, crude declined 1.5% to a multi-week low.

EM came under intense selling pressure starting Wednesday. The EEM ETF sank 7.8% post-election (down 3.8% for the week). In the currencies this week, the South African rand fell 5.3%, the Brazilian real 4.9%, the Polish zloty 4.6%, the Hungarian forint 3.6%, the Russian ruble 3.3%, the Romanian leu 3.0% and the Turkish lira 2.8%. China’s currency declined 0.8% vs. the dollar, the biggest weekly decline since January.

In EM equities, Brazil’s Bovespa index dropped 3.9%, the Argentine Merval 3.5%, India’s Sensex 2.5%, Indonesia’s Jakarta Composite 5.2%, South Korea’s Kospi 0.9%, Taiwan’s TAIEX Index 2.1% and Thailand’s Thai 50 1.4%.

Yet the bursting Bubble thesis saw the clearest confirmation in surging global bond yields. EM bonds were just clobbered. Brazil real bond yields jumped 67 bps to 12.02%, with yields up 30 bps in Colombia (7.55%) and 47 bps in Argentina (16.07%). Eastern Europe bonds were also under pressure. This week saw yields surge 27 bps in Poland (3.32%), 32 bps in Hungary (3.38%) and 28 bps in Romania (3.33%). Russian ruble yields surged 43 bps to a five-month high 8.88%. Turkey’s 10-year bond yields jumped 31 bps to a 10-month high 10.10%. South African yields surged a notable 50 bps to a five-month high 9.15%. Yields surged 58 bps in Indonesia to a four-month high 4.12%. Malaysian yields jumped 25 bps to 3.88%. EM ETFs saw outflows of $1.8 billion over the past week, reducing y-t-d flows to $26.3bn (from Bloomberg). It was a rout.

“Developed” bonds didn’t fare much better. Australian ten-year yields surged 22 bps to 2.56%, the high since April. New Zealand yields jumped 26 bps (3.03%) and South Korea’s rose 22 bps (1.94%). Canadian 10-year yields rose 20 bps to a six-month high 1.43%.

European bonds were under heavy selling pressure. German 10-year yields rose “only” 18 bps, as spreads widened significantly throughout the Eurozone. French yields surged 28 bps, Netherlands 21 bps, Spain 21 bps and Portugal 19 bps. Ominously, Italian yields jumped 27 bps, back above 2% for the first time since July 2015. The Italian to German 10-year bond spread widened to a two-year high 171 bps.

Perhaps ominous as well, 10-year Treasury yields surged 37 bps this week to 2.15%, the high since January. Long-bond yields rose 38 bps to an almost 2016 high 2.94%. It was a case of so-called “risk-free” securities showing their true colors. The TLT (Treasury ETF) dropped 7.4% this week, wiping out most of its 2016 return. The popular AGG (IShares Core U.S. Aggregate Bond ETF) and BND (Vanguard Total Bond Market ETF) dropped 1.8% and 1.9%. Corporate high-yield (HYG) and investment-grade (LQD) EFTs this week declined 1.8% and 2.3%, respectively.

Headlines from the FT: “What is the Trump Reflation Trade?” and “’Trumpflation’ Risk Rattles Bond Markets.” From Bloomberg: “Goldman Warns Bond-Market Carnage Threatens Global Reflation.” “Bonds Plunge by $1 Trillion This Week as Trump Seen Game Changer.” And from the Wall Street Journal: “The All-Powerful Bond Market Is Getting Rocked by Trump.”

I guess we’re now in the political “honeymoon” period, one I fear will be short-lived. It would be more gratifying to be optimistic. But watching the global bond Bubble begin to unravel leaves me apprehensive. I fear this week’s wild market instability could portend some type of financial accident. There were some large losses suffered throughout the markets this week.

Inflationary biases were already percolating before the election. It’s worth noting that M2 “money” supply expanded $941bn, or 7.7%, over the past year. The Fed – and global central bankers – have brought new meaning to “behind the curve.” And as speculative markets trade inflation’s revival, the job of the Fed (and global central bankers) becomes a whole lot more challenging. Do they raise rates to help dampen fledgling inflation psychology and support faltering bond markets? Or, instead, will the prospect of a real central bank tightening cycle further weigh on bond market confidence? Hard to imagine halcyon markets in a world devoid of QE and near-zero rates.

Actually, bond trading is bringing back unpleasant memories of early 1994. Yet 2009-2016 Bubble excess makes 1991-1993 looks pretty inconsequential. And this time it’s global. Systemic. Look closely this week and one can see some weak links: Mexico, Brazil, South Africa, Indonesia, Poland, Hungary, Argentina, EM generally, Ireland and Italy. Italian bond yields are all the way back to 2%. It’s worth recalling that they traded at 7% in early-2012.
Original Post 12 November 2016

Categories: Doug Noland, Perspectives