Doug Noland: Trump, Bonds, Peripheries, China and Italy

Surging global bond yields will entail enormous amounts of speculative de-leveraging. This has yet to become a major issue for the markets only because of the ongoing $2.0 TN of global QE. Yet in this post-Bond Bubble and Trump to the White House backdrop, QE is rather suddenly no longer the bond market’s best friend. QE instead only exacerbates flows into stocks and king dollar – and perhaps even real economies where a shift in inflation trends is already indicated.

The trading week saw WTI crude surge 12.2%. The GSCI commodities index jumped 5.8%. Wheat dropped 3.6% and corn fell 3.1%. Italian 10-year yields fell 18 bps, and Greek yields dropped 37 bps. Meanwhile, Portuguese yields jumped 13 bps. In U.S. equities, Bank stocks (BKX) jumped 1.5%, while the Morgan Stanley High Tech index dropped 3.4%. The Biotechs (BTK) sank 6.4%. The DJIA was little changed, while the small caps fell 2.4%. Just another week for unstable global markets.

Pre-election trepidation morphed into post-election market exuberance, in only the latest demonstration of the power of an over-liquefied market backdrop. Here in the U.S., the bullish imagination has been captivated by the Trump administration’s pro-growth agenda, with its focus on tax and health-care reform, deregulation and infrastructure spending. The DJIA this week added slightly to record highs.

Meanwhile, a decidedly less halcyon reality seems to be coming into somewhat clearer focus: Trump’s victory likely marks a major inflection point for global markets. Bond yields have shot higher, while inflation expectations are being reset. The U.S. dollar has surged, while the emerging markets have come under pressure. From U.S. equity and bond ETFs to international financial flows, “money” is sloshing about chaotically.

There’s an extraordinary amount of confusion throughout the markets. For over a year I’ve posited that the global Bubble has been pierced. This view was in response to faltering EM, mounting Chinese instability, the collapse in crude and energy-related debt problems (from U.S. junk to global corporates and sovereigns). Especially in response to early-2016 global market instability, the Fed froze its baby-step “tightening” cycle, while the Bank of Japan and European Central Bank (and others) ratcheted up what were already desperate QE measures. In China, officials threw up their hands and set the Credit floodgates wide open.

It’s worth noting that the S&P500 rallied 22% from February 2016 lows. U.S. bank stocks (BKX) have surged a stunning 60%. From January lows to November highs, Brazilian stocks jumped 75%. Emerging Market equities (EEM) rallied almost 40%. Chinese stocks recovered 25%. Basically, EM stocks, bonds and currencies rallied sharply from Asia to Eastern Europe to Latin America.

Waning badly early in the year, confidence in central banking was rejuvenated by an audacious display of concerted “whatever it takes.” I believe history will view ECB and BOJ QE moves as dangerously misguided, while the Fed (again) failed to heed the lessons of leaving policy way too loose for too long. Forces that central bankers set in motion early in the year may have largely run their course.

These days it’s important to appreciate that the primary effects of monetary stimulus can change profoundly depending on prevailing market dynamics. Recall that the first (2009) QE basically accommodated speculative de-leveraging and the transfer of securities from troubled holders onto the Federal Reserve’s balance sheet. General inflationary impacts – within the securities markets as well as throughout the real economy – were muted. QE2 (late-2010 into 2011) stoked the powerful inflationary (“bullish”) bias that had evolved in bond prices and throughout the emerging markets. Concerted “whatever it takes” “QE3 and beyond” that unfolded in the second-half of 2012 threw fuel both on Bubbling global securities markets as well as China’s “Terminal Phase” of excess. The upshot has been only greater over-investment, over-capacity, asset inflation, inequitable wealth distribution and social tension. In many real economies around the world (notably Japan, Europe and the U.S.), consumer price inflation trended even lower.

Importantly, the predominant consequence from the 2016 QE bonanza was to spur global bond Bubbles to precarious speculative “melt-up” dynamics. Yields around the world collapsed indiscriminately to record lows. Japanese 10-year yields sank to negative 30 bps. German bund yields dropped to negative 19 bps and Swiss yields to negative 63 bps. Having issued bonds going back to 1693, UK Gilt yields dropped to a record low 52 bps. Few, however, benefited more than Europe’s troubled periphery. In one of history’s more spectacular asset mispricings, Italian bond yields sank to an incredible 1.05% and Spanish yields fell to 88 bps. In the U.S., Treasury yields dropped to 1.36%. Brazil (dollar) yields sank to about 4%, with Mexican (dollar) yields below 3%.

There’s a major problem associated with destabilizing speculative “blow-offs:” They notoriously conclude with sharp reversals, catching everyone by surprise and unearthing all kinds of excesses and associated maladjustment. Coming in conjunction with mounting global anti-establishment fervor, political instability and President-elect Donald Trump, the current bond market reversal ensures uncertainty even more acute than normal: A historic bond market Bubble meets historic social, political and geopolitical uncertainty – not to mention uncharted territory with respect to global monetary policy and economic structure.

Trump policies notwithstanding, global economic prospects remain murky at best. Record stock prices more reflect expectations of winning the money game than an indication of a brightening future. And with air now being released from the Bubble, the best days for bond prices have passed. Especially in the era of king dollar, “money” is now fully expected to deluge the world’s premier asset class – U.S. equities.

Let’s ponder for a moment The Other Side of the Story. Surging global bond yields will entail enormous amounts of speculative de-leveraging. This has yet to become a major issue for the markets only because of the ongoing $2.0 TN of global QE. Yet in this post-Bond Bubble and Trump to the White House backdrop, QE is rather suddenly no longer the bond market’s best friend. QE instead only exacerbates flows into stocks and king dollar – and perhaps even real economies where a shift in inflation trends is already indicated.

So, it’s this confluence of surging bond yields, de-leveraging, unwieldy flows and the potential for inflationary pressures to take root that is now rocking Peripheries around the globe. Importantly, policy confusion and uncertainty are poised to become a pressing market issue. With central bank liquidity inflating Bubbles and exacerbating instability more generally (rather than propping up bond prices), will this speed up rate “normalization” in the U.S. and QE “tapering” especially from the ECB and BOJ? Inquiring markets will want to know.

U.S. Treasury yields closed the week up another eight bps to a 16-month high 2.39%, after trading up to 2.49% on Thursday. Higher global yields again weighed on EM. This week’s trading action saw the Argentine peso drop 2.4% and the Brazilian real and Turkish lira fall 1.8%. All three of these Periphery economies have serious issues that will be aggravated by a tightening of global finance. Stocks were down 2.0% in Brazil, 2.5% in Argentina and 1.8% in Mexico this week. More noteworthy, EM yields made another leg higher. Local yields jumped 36 bps in Brazil, 27 bps in Turkey, 19 bps in Argentina, 15 bps in South Africa, 32 bps in Poland, 19 bps in Hungary, 11 bps in South Korea and 14 bps in China.

Pursuing the theme of tightening global liquidity and associated effects on EM, (King of EM) China instability appears poised to reemerge as a market concern. A few headlines from the week: “China Limits Gold Imports and Renminbi Outflows” (FT); “Beijing Plan to Curb Outflows Fuels Fears Over Foreign Deals” (FT); “China Capital Curbs Sow Doubt Over Renminbi Ambitions” (FT); “Bank of China Sharply Limits Forex Sales to Companies in Shanghai” (Reuters); “PBOC Headache Worsens as New $50,000 Conversion Quota Looms” (Bloomberg); “Foreign Companies Face New Clampdown for Getting Money out of China” (WSJ); “China has Quietly Hiked Borrowing Costs Through PBOC Operations” (Bloomberg).

December 1 – Wall Street Journal (James T. Areddy and Lingling Wei): “Multinational companies are suddenly finding themselves in the crosshairs as China dials back its effort to turn the yuan into a global currency, alarmed that it has accelerated the flight of capital from its shores. In recent days, according to bankers and officials familiar with the situation, China’s foreign-exchange regulator has instructed banks to sharply limit how much companies move out of the country and into their other operations around the world. Until this week, it was possible for big companies to ‘sweep’ $50 million worth of yuan or dollars in or out of China with minimal documentation. Now, these people say, the cap is the equivalent of $5 million, a pittance for the largest corporations. Beijing is fighting an increasingly vicious cycle of capital outflows that weaken the yuan.”

December 2 – Reuters (Samuel Shen and Engen Tham): “Bank of China, one of the country’s ‘Big Four’ state banks, has begun to sharply limit corporate customers’ ability to purchase foreign currency in Shanghai, in what sources said on Friday was a bid to help stem capital outflows and ease depreciation pressure on the yuan. Under the unwritten new policy, described by two sources familiar with the details, bankers at China’s fourth-biggest lender began this week to discourage companies wishing to change yuan into dollars. Those firms which insisted on doing so were told they would be restricted to exchanging a maximum of $1 million… The policy comes as China’s government adopts increasingly aggressive measures to control movements of yuan out of the country and snuff out expectations that the currency would continue to spiral lower.”

November 30 – Bloomberg: “China added new restrictions on pulling yuan out of the country as authorities seek to prevent a flood of capital outflows from destabilizing the financial system. Officials won’t approve requests to bring the yuan overseas for the purpose of converting into foreign currencies unless applicants provide a valid business reason… The monetary authority has noticed funds are increasingly leaving the country as yuan payments… The equivalent of $275 billion exited the country via yuan payments this year through October, versus a $101.5 billion inflow in the same period of 2015…”

Keep in mind that Chinese international reserves ended October at a more than five-year low $3.12 TN, this after peaking in June, 2014 at $3.99 TN. Policymakers are surely responding to what must be a surge of outbound flows. So-called “disorderly capital flight” is invariably a risk to an EM economy combating a faltering Bubble with loose finance and monetary inflation. Unprecedented annual Credit expansion of about $3.0 TN has thus far stabilized China’s faltering Bubble. But the issue then becomes an unstable currency as copious amounts of liquidity seek an exit. I would expect this week’s measures meant to slow outflows will heighten anxiety to get “money” out of China before more draconian controls are deemed necessary. King dollar and Trump uncertainty seriously complicate China’s financial and economic dilemmas.

And speaking of serious dilemmas, let’s not forget Europe. Italy’s political referendum will take place Sunday. Prime Minister Matteo Renzi has threatened to resign if voters don’t approve his plan for political reform. Between political opposition and a spirited anti-establishment movement, the vote is not projected to go Renzi’s way. But after sailing through Brexit and Trump’s win, there’s not a great deal of trepidation heading into Sunday. It is true that Italy is well-accustomed to political instability. Perhaps it’s complacency’s turn to be surprised.

The Italian banking system is a mess, and prospects for the Italian economy remain poor. Years of QE have done little to promote reform but a lot to inflate a Bubble in Italian debt (much of it held by Italian banks). It might be at least a year until Italian voters have the opportunity for voicing opinions on remaining in the euro. Yet in this unfolding uncertain global liquidity backdrop, it would not be surprising if the markets again begin pondering the long-term viability of the euro monetary experiment. The Germans and Italians sharing a currency forever? The Trump win has both emboldened Italy’s powerful anti-establishment movements and heightened Italy’s vulnerability to a deteriorating global financial backdrop.

Global financial conditions have begun to tighten – ominously, even in the face of $2.0 TN of ongoing global QE. While pretty clear in the near-term, intermediate and long-term QE prospects are really fuzzy. Heightened uncertainty now has “money” on the move, with associated instability an immediate issue for the fragile Periphery. Europe remains a global weak link, with their banking system at the heart of the continent’s fragility. Italian banks are the European banking system’s weak link. In this context, Italy’s Sunday referendum should not be taken lightly. In the event of a no vote and Renzi resignation, will political uncertainty (and capital flight) push Italy’s fragile banks over the edge? Recall 2012: Fears surrounding Italian banks and Italy’s long-term commitment to the euro over time escalated into fear of euro disintegration.

Original Post 3 December 2016

Categories: Doug Noland, Perspectives